Part 1 Chapter 1 Solutions Answers to Questions 1) Financial accounting is the communication of information about a business or other type of organization (such as a charity or government) so that individuals and any other interested groups can evaluate its financial health and future prospects. Financial accounting provides data needed by decision makers to arrive at wise decisions about an organization as a whole 2) Financial accounting information is used to assess the financial health and future prospects of an organization. Therefore, this information is often analyzed by investors as part of the process of deciding whether to buy (or possibly sell) the capital (ownership) shares of a business. Strong financial results often lead to an increase in the market price of such shares and additional dividend distributions. Financial accounting information can also help determine whether an organization deserves to receive a loan or other forms of credit. If cash inflows seem adequate, a bank or creditor can hope to receive repayment of a loan or liability when due plus a reasonable rate of interest. Financial accounting helps such lenders judge the risk they are taking. 3) Financial accounting encompasses all steps in the process of providing information to those outside of an organization so that they can make decisions about that entity when viewed as a whole. Financial accounting decisions are rather limited – should capital shares be bought or sold and should a loan or other credit be extended? Managerial accounting provides information for those inside of an organization so that they can make decisions on behalf of that organization. There are hundreds, if not thousands, of decisions that can be made using managerial accounting information. Should a new truck be bought with cash or by taking out a loan? Should employee pay raises this year be 3 percent or 4 percent? Should a new computer system be acquired immediately or in two years? 4) Possible users of financial accounting information include potential and current shareholders, potential and current lenders and creditors, potential and current employees of the organization, governments, customers, contractors, and suppliers. 5) Ligando and Zvyvco have been told that they should incorporate their new business. They need to understand the ramifications of that decision so they can make it appropriately. A corporation is a business or other organization that has been formally recognized by a state government as a separate legal entity. It has certain rights such as the right to sell stock to raise funds and the right to form contracts. Therefore, for example, a corporation can borrow money from a bank and not create a liability for its owners.
6) An unincorporated business with more than one owner is automatically labeled as a partnership. Partnerships have certain advantages. For example, they are simple to create, often requiring no more than a general understanding between the partners. In addition, as discussed later in the textbook, they provide certain income tax advantages. However, each partner has what is referred to as “unlimited liability.” In other words, each partner might be held liable for all debts and other obligations incurred by the business. There is no monetary limit to what that amount might be. In addition, because of unlimited liability, partnerships often have difficulty getting new owners unless the person can work as part of management to oversee operations and ensure that liabilities remain reasonable. Thus, partnerships rarely grow into large businesses. 7) In order to become a corporation, the owners of a business must apply to a state government for recognition. A business in the state of Missouri, for example, will probably incorporate according to the laws of Missouri although that does not always happen. Many larger companies incorporate in Delaware because of the simplicity of the process and because of favorable laws. Articles of Incorporation and other required documentation are filed with the state to disclose specific information about such things as the capital stock to be issued and the line of business. Rules for incorporation vary by state. Information about forming a corporation in the state of Illinois can be found at the following Internet site. Most states have similar information available. http://www.citmedialaw.org/legal-guide/illinois/forming-corporation-illinois 8) The owners of a business would want to become a corporation for several reasons. The corporation can issue capital shares to bring in money from new owners and help the business grow. In addition, the owners of a corporation are not faced with unlimited liability like the owners of a partnership or sole proprietorship. 9) The Board of Directors of a corporation is a representative group elected by the shareholders to oversee the management of the business. The Board reviews operating, financing, and investing activities and approval may be required for a number of actions. Future plans and other significant events might also require approval of the Board. The distribution of dividends can only be made through the authorization of the Board. 10) Waters probably hopes to make an investment because he believes that the stock price of the shares issued by the chosen organization (such as Walmart) will go up in value. He could then sell some or all of the shares and earn a profit. He might also believe that the corporation is in a strong financial position and will pay a large cash dividend in the future. Perhaps by studying the financial accounting information published by the business, he has come to believe that a good rate of return can be earned through stock price appreciation and/or through dividends.
11) An investor in a corporation’s capital stock is looking for the possibility of stock price appreciation and/or cash dividends. Thus, an investor hopes to find financial accounting information that indicates future growth or profitability that will cause the stock price to rise or put the business into a position where additional dividends are likely. A creditor or lender simply wants to be paid the amount owed when the debt comes due plus the required amount of interest. Therefore, a creditor or lender is interested in the business’s ability to generate adequate cash inflows in the future to satisfy debt requirements. Growth potential and profitability are only interesting to the creditor or lender in that they can affect the rate of future cash flows. 12) Financial information is data that can be measured in monetary terms. 13) A dividend is a distribution from a corporation to its shareholders from any profits earned by that business. Basically, the corporation earns a profit as a result of operations and then shares a portion with the owners of the company. Dividends can only be distributed by approval of a corporation’s board of directors. A dividend is a payment made to the owners of the capital stock of a corporation as a reward for investing in a business that proves to be profitable. 14) An annual report is the most common vehicle for distributing financial accounting information to owners and other outside parties interested in assessing the financial health and future prospects of an organization. An annual report often contains additional information such as the identity of management and the board of directors. However, the most important section of the annual report is the financial information and the verbal explanations to accompany those monetary balances. 15) Tattaro earned a profit on the savings account of $15 ($515 less $500) in one year from an investment of $500. That is an annual return of 3 percent ($15/$500). In connection with the capital shares, he now has $642 ($4 dividend plus the $638 received from the sale of the investment). That is a total profit of $42 over the original investment of $600 or a 7 percent annual rate of return ($42/$600).
Answers to True or False Questions __F__ 1) Financial accounting provides information to individuals and groups outside of an organization to help them make decisions about that organization. Managerial accounting helps with decisions that are made inside an organization.
__F__ 2) One of the advantages of incorporating is increasing the ease of raising money from the selling of capital shares. The businesses that issue stock which is traded on a stock exchange are almost always corporations rather than partnerships or sole proprietorships. __F__ 3) Employees are certainly interested in the financial health of their employer. Thus, they should take special interest in all financial accounting information that is released. __F__ 4) Virtually all of the shares of the corporations that trade each day on the New York Stock Exchange and other stock markets are bought as investments. The stockholders rarely have any interest in actually being involved with daily operations. __T__ 5) Shareholders elect the Board of Directors to oversee management, set policy, and approve decisions for the corporation. __T__ 6) An investment in capital stock shares that are held longer than a year may be subject to lower capital gains tax rates. This tax advantage encourages more people to invest money in stocks which helps make businesses bigger and aids the economy. __F__ 7) Lenders and other creditors are most interested in information about future cash flows that indicate the possibility of payments being made when due. Drops in stock price can have some potential impact on these cash flows but that is not of primary concern to the lender. __F__ 8) The Board of Directors of a corporation must choose whether or not to distribute dividends to shareholders. There is no requirement that they do so. Different businesses have different philosophies about the payment of dividends. __T__ 9) While no investment is completely free of risk, opening a savings account involves little risk of loss to the account holder. Profits are limited but losses should be close to nonexistent. In contrast, investments in stock are considered much riskier as the stock price could decrease just as easily as increase.
__T__ 10) By definition, financial information is measured in monetary terms. Such a presentation, though, has many limitations. Therefore, verbal clarification is often included to make the information more understandable. __T__ 11) Businesses need a structure for conveying financial accounting information to all interested parties. An annual report serves that purpose. The monetary amounts along with verbal explanations are distributed each year as part of the businesses annual report. The annual report does contain extensive information. __F__ 12) Financial information is used by many different individuals and entities including potential and current creditors, potential and current stockholders, potential and current employees, and governments. Accountants help to convey the information but they certainly are not the only users of that data. __F__13) An entity that loans money to a business or provides credit in some other fashion is known as a lender or creditor. A shareholder is an individual or group that holds the ownership or capital shares of a corporation.
Answers to Multiple Choice Questions
1) Answer is A. Creditors and other lenders are primarily concerned with a client’s ability to repay loan balances along with accompanying interest. To gauge a corporation’s chances of making those payments, Sanchez will most likely look at Medlock’s past cash flow information for an indication of the amount of future positive cash flows that will be available for repayment. Having generated positive cash flows in the past is one sign that the company will be able to continue earning cash so that it can pay its debts as they come due. 2) Answer is D. For relatively large corporations, the vast majority of stockholders do not anticipate participating in day-to-day operations. The business is simply too large and the number of shareholders makes such an arrangement almost impossible to control. Instead, the
shareholders elect a Board of Directors to assume the responsibility of watching over the management, the group that is responsible for day-to-day operations. 3) Answer is C Production decisions are made inside of a business by employees and members of management. Managerial accounting provides the information for these decisions. Decisions on granting credit, investing in the corporation’s capital stock, and providing loans are made externally—by individuals working outside of the business. They need information on which to base those decisions and financial accounting provides that information. 4) Answer is B. Members of the Board of Directors are elected by the stockholders of a corporation specifically to overview management and set policy for the business. 5) Answer is D Williams gains value in two ways from this investment: 1) the stock price increases and 2) he collects dividends paid by the corporation on its stock. His initial investment cost $6,750 (150 shares × $45 per share). By the end of the year, the stock price had risen to $47 per share or $7,050 in total. He had also received a $1.50 per share dividend or $225 in total. Thus, he had received $7,275 ($7,050 + $225) His profit for the year was $525 ($7,275 less $6,750). His annual rate of return was $525/$6,750 or 7.8 percent 6) Answer is B The loan officer is primarily interested in the company’s ability to repay the bank loan when it comes due plus an appropriate amount of interest. The increase in the price of the stock is certainly a good indication of financial health. However, the employee, the member of the board of directors, and the investment advisor are more interested in the future growth and prosperity of the business because of the direct effect on them. The loan officer only cares about the business generating enough cash to pay its debts as they come due. 7) Answer is C The annual report is the delivery mechanism for financial accounting information, monetary balances and verbal explanations that reflect the business as a whole. The decision to rent the airplane rather than buy it is internal in nature. The information to assist in that decision comes from managerial accounting.
8) Answer is D The quick buying and selling of the ownership of a business is most indicative of a corporation. The capital shares make the exchange of corporate ownership interests easier and quicker. The restaurant could have been structured as a sole proprietorship or a partnership but the quickness that took place in switching ownership is more likely to reflect a corporation.
Answers to Problems 1) a. A bank loan officer is primarily concerned with Nguyen Company’s ability to pay back a loan with interest when the debts come due. Thus, the loan officer is going to analyze Nguyen’s past cash flows to help determine future cash flows and whether they will be adequate to meet all obligations. b. A current employee will be interested in the financial health and future prospects of Nguyen. The employee will want to know the likelihood of bonuses if the company is doing well or the risk that the company will eventually have to layoff workers due to poor financial performance. The current employee will also be interested in the financial resources that should be available in the future to help employees do their job efficiently and effectively. c. A potential employee is interested in the same information as a current employee, but from a different perspective. The potential employee will want to gauge the financial health of Nguyen against other companies to which he or she might also be seeking employment. d. A current investor is interested in how the financial status of Nguyen is likely to affect its stock price in both the near and long term. The current investor will also be interested in whether Nguyen has sufficient cash flows to pay dividends. e. Like the current investor, the potential investor is also interested in how the financial health of Nguyen might impact the stock price and the company’s ability to pay dividends in the future. However the potential investor is more likely to use this information to compare Nguyen to other possible investments. f.
A credit analyst working for a potential supplier will be interested in Nguyen Company’s ability to pay for any inventory that it purchases on credit. The credit analyst will look at Nguyen’s liquidity or, in other words, the company’s ability to pay off short-term debts. The analyst wants to see cash flow information but the predictions do not have to be too far into the future since supply payments are usually made within a month or two after purchase.
2) Mark each of the following with an (F) to indicate if it is financial information or an (N) to indicate if it is non-financial information.
Metro Corporation has: a. b. c. d. e. f. g. h. i.
_F__ Cash of $4,000,000 _F__ A building that cost $50,000,000 _N__ 2,000 employees _F__ Inventory costing $16,000,000 _N__ 500 shares of capital stock _N__1,000 trucks _F__ Sales of merchandise for $45,000,000 _N_ 2,000 cans of beans for resale purposes _N_ 2,000 cans of beans to be used in the employee cafeteria
Financial information is designated by monetary amounts.
3) a. Capital shares of Ford Motor Co. are the ownership interests of this corporation. Each share of this capital stock represents one unit of ownership. Thus, for example, the investor gets to participate in any dividend distributions and can vote for the members of the board of directors. The amount of dividends received and the amount of votes that can be cast depends on the number of shares being held. The rights conveyed by the ownership of a share of capital stock depend on the laws of the state of incorporation. As will be learned later in this textbook, the rights for some shares of capital stock are determined based on the terms of the stock contract. b. The acquisition of shares of capital stock normally takes place because the investor has studied the financial accounting information presented by this corporation and believes that the price of the stock should rise over time. This appreciation usually takes place as a business grows or makes exceptionally good use of its resources. The investor might also expect to receive a substantial amount of dividends from Ford Motor Co. in the future. c. Typically, shares of one corporation rather than another are acquired because of one of two reasons. First, the investor might believe that the annual rate of return will be highest for Ford. Between estimated stock appreciation and cash dividends, the investor may well believe that none of these other corporations offer as much potential profit as does Ford. Second, the investor might believe that Ford has the least amount of risk of loss. Perhaps one of the other investments might seem likely to generate a higher rate of return but Ford has a lower level of
risk. Investors make decisions to maximize profits and minimize risks. Some investors emphasize one goal whereas others focus more on the other. d. Each of these businesses will produce and distribute an annual report containing a significant amount of financial information and verbal explanations. Investors should use this information to assess past operational success and the possibility of profits and dividends in the future.
Answers to Research Assignments 1) The chapter introduced several forms of business including corporations, sole proprietorships, and partnerships. Here is information on those three as well as other forms of business as well. Sole Proprietorship: A sole proprietorship is defined as an unincorporated business with one owner, who is also likely to manage day-to-day operations. A sole proprietorship is very easy to start as the only filing requirements include obtaining proper licenses and permits from the local government. It is also easy to get out of business—the owner may just decide to close up shop. The business also ends upon the death of the owner. The owner is liable for all debts incurred by the business. Sole proprietorships are not taxed as a separate entity. Instead, the profits or losses of the business are reported on the owner’s personal tax return, and any taxes are paid by the owner based on that return. The sole proprietorship often experiences troubles when it comes to funding sources. The owner typically makes an investment and may persuade family and friends to invest also. A loan is also possible if the owner has personal or business collateral. Partnership: A partnership is similar in many ways to a sole proprietorship. The most significant difference is that there are at least two owners. These owners should develop a written agreement to start the partnership which details investments by the partners as well as how profits and losses will be divided. However, an agreement is not required legally. The partnership will be dissolved if a partner leaves or dies unless the partnership agreement states otherwise. The partners are liable for the debts of the business and the actions of the other partners. The partners report profits and losses on their personal tax returns as described in the partnership agreement. In the same manner as a sole proprietorship, funding sources include the partners, their friends and family, and bank loans. Limited Partnership: This is a partnership in which some of the partners have limited liability. The partnership agreement has been written so that one or more of the partners can only lose the amount invested. At least one partner must serve as a general partner whose liability is not limited.
C Corporation: A C Corporation (so called because of the appropriate section of the tax code) is formed when Articles of Incorporation are filed with a state government. A C Corporation will typically have many owners. Entities and individuals become owners when they purchase stock in the corporation. Because a C Corporation is a separate entity from its owners, it does not cease to exist upon the death or departure of an owner. This separation between a corporation and its owners also greatly limits the liability of the owners. They can lose the amount of their investment but nothing more. The owners are not typically involved in the day-to-day management of the corporation. This responsibility is left to management and the Board of Directors elected by the stockholders. The corporation is considered a separate entity for tax purposes. It files its own tax return and pays taxes on its profits. If it chooses to distribute those profits to its owners in the form of dividends, the owners are taxed but only on those distributions. In most cases, the corporation has the easiest time raising needed money because it can issue stock in itself as well as obtain loans and lines of credit. S Corporation: Like a C Corporation, an S Corporation (so called because of the relevant section of the tax code) is formed when Articles of Incorporation are filed with its state. However, because of the method used for taxing S Corporations, approval must also be granted by the Internal Revenue Service. Unlike a C Corporation, an S Corporation has a limited number of owners. Currently, this limit is 100 owners. Because an S Corporation is a separate entity apart from its owners, it does not cease to exist upon the death or departure of an owner. This separation between corporation and owners also greatly limits the liability of the owners. The main difference between an S Corporation and a C Corporation is taxation. Like a partnership, an S Corporation pays no income taxes. Instead, the owners pay taxes on their share of profits or losses on their personal tax returns. An S Corporation is more limited in funding than a C Corporation because it cannot sell stock to more than 100 individuals or entities. Limited Liability Corporation (LLC): A limited liability corporation is a combination of a corporation and a partnership. Like a corporation, the proper filings must be made with the state to setup the LLC. The LLC must have at least one owner (called a member), but can have more. Often, the owners will sign an agreement similar to that of a partnership. Unlike a partnership, though, the LLC can continue to exist even upon the death or departure of an owner. Some of the owners will most likely be involved in the day-to-day operations of the LLC, but not all have to be. An LLC has the freedom to choose how it is taxed. It can be taxed like a partnership or S Corporation where the owners will pay taxes on their share of profits or losses on their personal return. It can also choose to file a corporate tax return like a C Corporation. 2) - Answers about Starbucks as found at www.google.com/finance on July 6, 2011 a) – The price of a share of the capital stock of Starbucks Corporation on the afternoon of July 6, 2011, was $40.47.
b) – The capital stock issued by Starbucks is traded on NASDAQ. c) - The ticker symbol used to identify Starbucks is SBUX. d) – The 52 week range for the price of Starbucks’ stock is a low of $22.50 to a high of $41.11. At the current price of $40.47, the stock is selling close to its high point for that period of time. e) – Businesses that are viewed as being in a related industry to Starbucks include Einstein Noah Restaurant, Panera Bread Company, and Caribou Coffee Co. f) – Numerous interesting pieces of information can be found in the description of the company. Those include that (1) the company operates in more than 50 different countries, (2) the company sells a variety of ready to drink items such as Tazo Tea and VIA Ready Brew, and (3) the company had recently acquired Magic Johnson Enterprises. g) – Officers of the company include Howard Schultz (Chief Executive Officer), Clifford Burrows (President, Starbucks Corporation, US), and Michelle Gass (President, Seattle’s Best Coffee). Directors include Kevin Johnson, Sheryl Sandberg, and Mellody Hobson.
3) a) Accountants perform a wide variety of functions including financial record keeping, the filing of taxes, analysis of financial information, budgeting, investment planning and information system consulting. b) – The various types of accountants include all of the following. 1) Public accountants: primarily engaged in accounting, auditing, tax, and consulting services. Many are CPAs and work for themselves or public accounting firms. 2) Management accountants: record, analyze, and report financial information for their employers. 3) Government accountants: record, analyze, and report financial information for the governmental body where they work as well as auditing organizations subject to government regulation. 4) Internal auditors and auditors: analyze internal controls and look for waste and fraud in their organizations. c) – Most jobs in accounting require, at least, a 4 year baccalaureate degree in accounting or a related field. Many states require that a person have 150 hours of college credit (and often specific courses) to serve as an independent auditor.
d) - A CPA is a Certified Public Accountant. A CPA is licensed by the state government and provides a wide range of work. Traditionally, the CPA serves as an independent auditor to examine the financial information released by a business or other organization. The CPA’s report adds credibility to the reported numbers and assures readers that the financial information contains no material misstatements. e) – CPAs are licensed by state governments and, therefore, eligibility requirements are set by the individual states. A CPA must pass a national exam (the CPA Exam) plus meet specified education and experience requirements. Most states require CPAs to possess at least 150 hours of college coursework. f) - Accountants can obtain many additional certifications beyond the CPA. Some of the most common include: Certified Management Accountants (CMAs), Certified Internal Auditors (CIAs), and Certified Fraud Examiner (CFE). g) - The job outlook in accounting is currently strong. Increased regulation has led to an increase in the demand for accounting and finance professionals.
4) – The Letter to Shareholders of Target contains a wide array of interesting information. Here are a few of the most interesting aspects of the letter that was included in the 2010 annual report. --Despite a slow economy, Target made revenues (sales) of $67.4 billion --Earnings were up by 17.3 percent in 2010 --The company increased its quarterly dividend by 47 percent. --Target remodeled 341 of its general merchandise stores --462 stores offer fresh food --Customers get an additional 5 percent discount when they use a Target debit or credit card. --Company plans to start opening stores in Canada in 2013. --Announced plans to donate $500 million to education
Despite being only two pages, the letter provides a good starting spot for learning about the financial health and future prospects of Target.
Chapter 2 Solutions Answers to Questions 1) There are several reasons why reported financial information is often not exactly correct or accurate. Much of the information that is presented has some degree of uncertainty tied to it. Those numbers can only be approximated because they will not be resolved until some future date. In addition, the sheer volume of transactions makes it impossible for gathered and reported data to always be exact. However, the information that is reported must still be fairly presented to allow users to make appropriate decisions. Information is viewed as presented fairly if it contains no material misstatements according to a recognized set of accounting standards such as U.S. GAAP or IFRS. 2) A misstatement is a balance that varies from the underlying reality of the event or transaction that it purports to report. In financial accounting, it is a mistake that was made by accident (an error) or on purpose (fraud). 3) Materiality describes the condition of a misstatement that is of a size or type that has an impact on a decision made by an investor, creditor, or some other decision maker. If a misstatement is immaterial, it poses no problem; no decision is impacted. However, if a decision maker makes a different decision because of the presence of a misstatement, it is viewed as material. 4) In determining whether a misstatement is material, the accountant considers the size of the problem in comparison to the size of the reporting entity. No single dollar amount can be used. In addition, fraud is considered worse than an error because of the intent to deceive. Therefore, a misstatement resulting from fraud is more likely to be material than an error of the same amount. 5) A misstatement is considered to be fraud when information is reported incorrectly on purpose. There is intent to deceive. In accounting, two types of fraud exist. One is a misstatement that occurs because of theft. Either the reported balances are wrong because assets have been removed or because numbers have been changed to cover up the theft. The other type of fraud occurs when reported balances are changed to make the business look different than it actually is. Often, numbers are physically changed so that operations look especially strong and financially healthy. 6) For virtually any business, many possible uncertainties exist. A few examples include: a. a pending lawsuit (what liability amount should be reported), b. a sale has been made but no cash has yet been collected (what asset amount should be reported), c. employees have been promised a bonus based on future stock price (what liability amount should be reported), d. products have been sold along with a warranty requiring that they be fixed if broken (what liability amount should be reported),
e. inventory has been acquired and is getting old but has not yet been sold (what asset amount should be reported). 7) Financial accounting can be compared to the painting of a portrait because the goal is to provide a likeness of a business or other organization that is presented fairly so that investors and creditors can make use of it to make financial decisions. Using numbers and words, the accountant hopes to provide information that will allow the user to see what the organization looks like, at least financially. 8) A language is simply a set of terminology and rules that allows one party to communicate with another. In financial accounting, the communication is financial information about an organization. Financial accounting has set rules (U. S. GAAP in the U. S. and IFRS in most of the rest of the world) along with a fairly set amount of terminology. If the appropriate members of the reporting entity (the accountants who produce the financial statements) understand these rules and terminology and the decision makers do as well, then the financial statements should successfully communicate information from one party to the other. 9) U. S. GAAP encompasses all of the official rules and pronouncements created or accepted by the Financial Accounting Standards Board (FASB). Those rules have now been brought together in the Accounting Standards Codification. Any financial statements or financial information that claims to be created in conformity with U.S. GAAP must follow these rules. Over the past several decades, FASB has issued hundreds of pronouncements that create new rules or modify existing ones. This evolution occurs because new transactions are created or problems are uncovered in connection with previous rules. 10) When companies release financial statements or other information that has been prepared according to U. S. GAAP, decision makers know that they are seeing information on which they can rely. It has been prepared using rules and terminology that they know. This allows for understanding and comparison. Thus, potential investors and creditors can assess their possible risks and rewards and make good investments. Without U. S. GAAP, individuals would have more difficulty evaluating their risks and would likely not make as many investments. Without that capital, significant economic growth is not possible. 11) Decision makers around the world want to compare businesses located in different countries. For example, how does Toyota’s financial health compare with that of Ford? U. S. GAAP has long been required for financial reporting inside of the U.S. However, over the last 10-15 years, the use of country by country accounting rules outside of the U.S. has given way to a single set of standards known as IFRS. Global companies often have to spend the time and money necessary to produce financial statements under both sets of rules or decision makers face serious problems in making comparisons. Because of the sheer complexity of U.S. GAAP, no push exists to accept it outside of the U.S. Therefore, the only viable alternative for a single set of rules is acceptance of IFRS within the U.S. That idea has both proponents and opponents.
Likely, over the next few years, some type of compromise will be worked out so that a single set of accounting rules will apply around the world. 12) An asset is a probable future economic benefit controlled or owned by a business or other organization. Numerous examples exist including cash, inventory, buildings, and equipment. 13) A liability is a probable future sacrifice of economic benefits arising from a present obligation. Examples include notes payable, accounts payable, salary payable, and income tax obligations. 14) The term “net assets” is a computed amount that is found by taking the assets reported by an organization and subtracting its liabilities. It is a measure of the amount of assets that a company has after all liabilities are removed. 15) A revenue is a measure of the increase in (or inflows of) an organization’s net assets from sales of inventory or services. 16) An expense is an outflow or using up of net assets that was incurred by an organization to generate revenue.
Answers to True or False Questions __F__ 1) Only U.S. corporations are required to use U.S. GAAP. Most countries have adopted IFRS in some form or another for financial reporting purposes.
__T__ 2) Companies face many unknowns when preparing financial statements, such as the results of lawsuits, collection of accounts receivables, or the length of time that a building will last. __F__ 3) It is highly unlikely that the equipment’s cost was determined with such precise accuracy. For decision-making purposes, reported information must be presented fairly which means that it contains no material misstatements. Therefore, although the equipment probably did not cost exactly $122,756,255, the cost should not have been materially different than $122,756,255. __F__ 4)
This is the definition of an asset, not a liability.
__F__ 5)
U.S. GAAP is established by the Financial Accounting Standards Board (FASB), a private organization. The Securities and Exchange Commission is the government body that has legal control over much of financial reporting but the SEC has allowed FASB to create U. S. GAAP.
__F__ 6) IFRS has only gained wide scale acceptance in the last 10 years or so as the significance of the global economy has become more evident. __F__ 7) The information provided in financial statements is often not exact (because of uncertainties and the sheer volume of the numbers), but it still provides useful information to decision makers. Reported information needs to be presented fairly which means that it contains no material misstatements according to U.S. GAAP (or IFRS if those standards are applied). __T__ 8) The number that is reported is wrong and, therefore, misstated. Because the misstatement is only $93, it is unlikely to be material but it is still wrong. __T__ 9) Materiality is a relative concept that depends on size. For a small organization, virtually any misstatement might be material. For a large organization, misstatements of millions of dollars might not be material. The cause of the misstatement (whether it is from fraud or error) also impacts the decision about materiality. __F__ 10) It is not acceptable to have any material misstatements in a set of financial statements because a misstatement of that size or nature prevents the information from being fairly presented. __F__ 11) A misstatement can be caused by fraud (intentionally) or by error (unintentionally). __F__ 12) Accounting for a lawsuit or any other type of uncertainty can be extremely difficulty simply because there is no easy way to predict the future. The outcome of the lawsuit will not be
known for months or maybe even years. Until then, the reporting can only be made based on estimations. __F__ 13) In judging materiality, fraud is considered a bigger problem than an error because of the intent to deceive. Thus, an error of $10,000 might not be judged material because it was the result of an accident. At the same time, fraud of $10,000 might be viewed as material because the intention makes it more likely that an investor or creditor’s decision would be impacted. __F__ 14) In order for financial accounting to successfully communicate information, both the preparer of that information (the accountant) and the users of that information (investors and creditors) must understand the meaning of the terminology.
__F__15) While employees certainly help generate revenues, the organization does not own them or have control over them so that they are not viewed as assets from an accounting perspective. __T__16) Revenue is the measure of the increase in net assets caused by the sale of inventory or a service. If a sale is made today but not collected, the seller’s net assets have still increased. Cash does not go up but another asset (accounts receivable) increases to indicate the amount to be received later. Net assets increase as the result of a sale so that revenue is recognized.
__F__17) An expense is a measure of the outflow or reduction in net assets caused by a business’s attempt to generate revenues. Buying a building increases one asset (the building) and reduces another (cash) so that there is no decrease in net assets. Thus, no expense is recorded.
Answers to Multiple Choice Questions 1) Answer is C There is virtually no uncertainty with a loan. Payment dates and amounts are specifically set by the terms of the loan contract. The amount that will be paid as interest will also be given. In contrast, collections of receivables as well as payments on warranties and lawsuits all involve unknown amounts of future cash (either to be collected or paid).
2) Answer is D U.S. GAAP provides the standards and the terminology so that preparers will have a set method for conveying financial information. This standardization makes understanding by investors and creditors much more likely. However, U.S. GAAP is not used around the world and does not present exact information (because, for example, of uncertainty). In addition, U.S. GAAP has been developed over a number of decades although significant changes take place on a regular basis. 3) Answer is B An asset must have probable future economic benefit and be owned or controlled by the reporting company. Inventory, receivables due from customers, and equipment and fixtures all meet this definition. However, the building here is rented by the company and is not owned by it. Therefore, the company does have ownership or control over the building so that it does not qualify as an asset. 4) Answer is A The amount owed to the company is a receivable (an asset). Sales made to customers are reported as revenues. Cash collected from customers is an asset. The liability here is the loan that is owed to the bank. That qualifies as a debt. 5) Answer is B The inflow or increase in net assets as a result of the sale of a good or service is known as revenue. No business is so small that a possible creditor or investor would not care about its financial information. Credit sales are viewed as revenue because receivables (the amount owed to the company by the customer) go up as a result of the sale. That increase in net assets is reported as a revenue. The intent of the company is not shown as an asset because it is not considered a probable future economic benefit. 6) Answer is A When information is identified as presented fairly according to U.S. GAAP, the preparers are stating that no material misstatements exist within that information based on the rules and terminology specified by U.S. GAAP. Although U.S. GAAP predominates in the U.S., IFRS is much more common in the rest of the world. 7) Answer is C IFRS rules are the dominant system outside of the U.S. (where U.S. GAAP continues to be mandated). IFRS rules are viewed as less complex than U.S. GAAP which makes them extremely popular with many people, especially those preparing financial statements. In its current format, IFRS rules have only become popular in the last 10 years or so whereas FASB has been producing U.S. GAAP since 1973 and other groups
produced it prior to that date. Although the U.S. may eventually adopt IFRS rules, no date is currently specified.
8) Answer is D Both the $2,000 and the $3,000 are reductions in the net assets of this business and both were incurred in hopes of generating revenues (both employees and a retail space are needed to earn revenues). In both cases, that meets the definition of an expense. 9) Answer is D The company’s cash (an asset) went up by $25,000 as did its liabilities (debt to the bank). Thus, no change occurs in the total of the net assets (which is the assets of the company less its liabilities).
Answers to Problems 1) a) Cash – Asset because it has probable future economic benefit and it is either owned or controlled by the reporting company. b) Building - Asset because it has probable future economic benefit and it is either owned or controlled by the reporting company. c) Loan due to the bank – Liability because it is a debt of the business. d) Inventory - Asset because it has probable future economic benefit and it is either owned or controlled by the reporting company. e) Salary expense – Expense because it is a measure of the outflow or reduction in net assets caused by a business’s attempt to generate revenue. f) Rent expense – Expense because it is a measure of the outflow or reduction in net assets caused by a business’s attempt to generate revenue. g) Amounts owed to employees for work done - Liability because it is a debt of the business. h) Equipment - Asset because it has probable future economic benefit and it is either owned or controlled by the reporting company. i) Amounts owed to suppliers - Liability because it is a debt of the business. j) Sales – Revenue because it is a measure of the inflow or increase in net assets generated by the sales made of either goods or services.
2) Following are some of the typical uncertainties associated with each of these assets or liabilities.
a. Inventory – whether the item can be sold, how much the sales price might be, how long the company will have to wait before a sale can be made. b. Receivable from a customer – how much of the balance will be collected, when the collection of cash will be made. c. Equipment – how long the asset will last, what the asset will be worth when the company decides to dispose of it, how much maintenance will cost to keep the asset operating efficiently. d. Income taxes payable – because the taxing authority can audit income tax returns, the major uncertainty is whether additional amounts will be demanded at some point in the future. e. Liability from lawsuit – how much (if any) will have to be paid on the lawsuit, when that payment date might occur.
3) The reported balance for inventory at a jewelry store is misstated. The problem could either have occurred because of an error or because of fraud. Here are a number of possibilities. Error: --Jewelry was bought but the amount that was paid was written down incorrectly. --Jewelry was bought and accidentally damaged so that it was worthless. However, no one noticed the damage that was done. --Jewelry was sold at the very end of the year but no record of the sale was made because of the lack of time. Fraud: --Jewelry was stolen. The records were then reduced so that no difference would appear between the amount of jewelry on hand and the reported balance. --Officials wanted the company to look especially prosperous so the inventory balance was reported at a higher amount than was appropriate for the jewelry that was on hand.
4) a. The company owes $1,000 for some purchases made last month and pays that amount now. Answer: The liability for this previous purchase is reduced by $1,000 and cash (an asset) is reduced by $1,000. If both assets and liabilities are reduced by $1,000, no change in net assets takes place. b. The company borrows $220,000 from a bank on a loan. Answer: Cash (an asset) goes up by $220,000 and the liability that is now owed to the bank also goes up by $220,000. If both assets and liabilities are increased by $220,000, no change in net assets takes place.
c. The company sells a service to a customer for $30,000 with payment made immediately. Answer: Cash (an asset) goes up by $30,000. There is no change in liabilities so net assets increase by $30,000. d. The company sells a service to a customer for $40,000 but payment will not be made for several months. Answer: A receivable from the customer (an asset) goes up by $40,000. There is no change in liabilities so net assets increase by $40,000. e. The company pays $8,000 in cash for several pieces of equipment. Answer: Equipment (an asset) goes up by $8,000 and cash (also an asset) goes down by $8,000. If one asset increases while the other decreases, no change in net assets takes place. f. The company rented a large truck for one day for $500 which it paid at the end of the work day. Answer: Cash (an asset) goes down by $500. There is no change in any other asset or in a liability. As the only change in an asset or a liability, net assets decrease by $500.
Answers to Research Assignments 1) a. The largest revenue was “Sales by Company-operated restaurants” and the amount was $16,233.3 million. The largest expense was “Food and paper” and the amount was $5,300.1 million. b. The largest asset was “Property and equipment, at cost” and the amount was $34,482.4 million. The largest liability was “Long-term debt” and the amount was $11,497.0 million. That liability category encompasses all notes and bonds payable that are not due within the next year.
2) Assets – already covered --Companies own things, called assets. --Typical examples of assets include buildings, trucks, inventory, equipment, and cash Assets – not yet covered --Assets includes intangible items such as trademarks and patents --Assets are separated into current and noncurrent categories --Property, plant, and equipment is also known as fixed assets
--Manufacturing businesses usually have more fixed assets than service businesses
Liabilities – already covered --Liabilities are the debts of the business --Common examples include money owed to banks and taxes owed to governments Liabilities – not yet covered --Liabilities are either current (payable within one year) or long-term (not payable within one year) --Failure to pay liabilities can push a company into bankruptcy
3) a. As of January 2, 2011, Johnson & Johnson reports $102,908 million in assets. b. As of January 2, 2011, Johnson & Johnson reports $46,329 million in liabilities. c. As of January 2, 2011, Johnson & Johnson holds net assets of $56,579 million ($102,908 less $46,329).
Chapter 3 Solutions Answers to Questions 1) Financial statements are a formal structure for conveying information to decision makers. Decision makers such as investors, lenders, and the government often require businesses or other organizations to prepare financial statements so that adequate information is available. 2) The financial statements typically produced are an income statement, statement of retained earnings (or the more comprehensive statement of stockholders’ equity), balance sheet, and statement of cash flows. Notes to clarify, expand, and explain the reported information should be attached to the financial statements. 3) The notes to the financial statement provide extensive information about the accounts and amounts being reported. Financial statements tend to report a single amount for each individual account. More information is needed to help decision makers understand the underlying event or account and its implications. The notes are intended to clarify, expand, and explain the information in the financial statements to help provide a fairly presented portrait of the reporting entity (based on the rules of either U.S. GAAP or IFRS). 4) Revenues and expenses are reported on the income statement. 5) Revenues and gains are both increases in net assets. However, revenue results from the business’ primary operations while a gain is created by a tangential activity. For example, sales of muffins at a bakery create revenue. These transactions increase net assets and they are part of the bakery’s primary operations. The sale of an old cash register at an amount above its currently reported balance results in the recognition of a gain. For a bakery, the sale of a cash register is a tangential activity and not part of daily operations. 6) A loss is a decrease in the net assets of an organization created by an occurrence outside its primary operations. For example, the sale by a bakery of an old cash register at an amount below its currently reported balance results in the recognition of a loss. For a bakery, the sale of a cash register is a tangential activity and not part of daily operations. 7) Expenses and losses are both decreases in net assets, but an expense results from the business’ primary operations and a loss does not. For example, the payment of a salary to a sales person at a bakery is an expense. This transaction decreases net assets and the sales person works within the primary operations of the bakery. The sale of a refrigerator at below its currently reported balance results in the reporting of a loss. For a bakery, the sale of a refrigerator is a tangential activity.
8) Revenues and expenses are reported separately from gains and losses to provide decision makers with a clear picture of how a company actually performed during the reporting period. Subtracting expenses from revenues provides an operating income figure that allows investors and creditors to see the success or failure of the business in its primary operations. 9) Decision makers should not be confused as to what they are seeing when they study financial statements. Therefore, three pieces of information should be available for every financial statement: the name of the organization, the name of the financial statement, and the date. For the balance sheet, a single date is used. For the other three financial statements, a period of time is covered. 10) Cost of Goods Sold is an expense which measures the cost of inventory items that a business sells during a period of time. For example, if a hardware store buys a hammer for $12 and sells it for $20, revenue is $20 but cost of goods sold is $12. 11) Gross profit is the difference between revenue and cost of goods sold. It is the amount of markup above cost added by a seller to arrive at the sales price. For example, if a hardware store buys a hammer for $12 and sells it for $20, gross profit is $8. 12) When a cost is incurred, it is reported as an asset if it provides future economic benefit (it will help to generate revenue in the future). It is reported as an expense if it provided economic benefits in the past (it helped to generate earlier revenue). If the timing of the benefits is not clear, the practice of conservatism indicates that the amount should be recognized as an expense. 13) Conservatism is the recognition in financial accounting that decision makers are likely to incur smaller losses if reported financial information is not overly optimistic. According to conservatism, when two outcomes are equally possible, the least favorable one should be chosen for reporting purposes. 14) The loss of $13,000 should be reported because it is more likely. Financial accounting strives to produce fairly presented financial information. Therefore, the most likely outcome should always be reported. Conservatism only becomes relevant when two outcomes are equally possible. Although the $13,000 is reported here in the income statement, the notes to the financial statements should also provide information about the other possible loss amount and its likelihood. 15) Dividends are not expenses as they do not help generate revenue. They are distributions of income to the owners of a corporation. Thus, they are reported as a reduction from net income in the statement of retained earnings (or the more comprehensive statement of stockholders’ equity).
16) The retained earnings balance is a computed amount that reflects the income earned by a business since its inception that has been left in the business (rather than distributed to the owners as a dividend) to create growth. 17) The $127,000 reported balance is the sum of all income earned by this business since its inception less the sum of all dividends distributed to the ownership in that same period of time. Neither the total income nor the total of the dividends is shown but rather the net of the two. 18) The $116,000 capital stock figure is the amount of assets that owners have contributed to this business since its inception in exchange for ownership interests (known as “shares”). 19) Assets and liabilities are reported on the balance sheet. 20) Current assets are expected to be used up or consumed within the next year, whereas noncurrent assets are expected to last longer than a year. Most inventory items are current because they should be sold within a year. Most accounts receivable are current because they should be collected within a year. Most buildings are noncurrent because they will last longer than the current period. 21) The accounting equation is Assets = Liabilities + Stockholders’ Equity. It must balance because what the company owns at any point in time (its assets) must equal the source of those assets (either from debt, investments by owners, or profits). Thus, the accounting equation can be restated as follows Assets = Liabilities + Capital Stock + Retained Earnings 22) The three categories of cash flows are operating activities, investing activities, and financing activities. 23) Operating cash flows come from the central or primary activity of the business such as selling inventory or services. Investing activities are nonoperating transactions that involve cash inflows and outflows from sales and purchases of assets such as buildings and equipment. Financing activities are nonoperating transactions that involve cash inflows and outflows that involve liabilities or stockholders’ equity accounts, such as taking out a loan or paying dividends.
Answers to True or False Questions __F__ 1) The income statement reports revenues and expenses for a period of time, often for an entire year or for three months.
__F__ 2)
Sales of inventory are reported on an income statement as revenue and not as gains.
__F__ 3)
The reported balance for retained earnings is the accumulated net income of a business since its inception less any dividend distributions to owners. Any amount contributed to a business by its owners is referred to as capital stock or contributed capital.
__T__ 4)
Assets and liabilities are shown on the balance sheet as either current or noncurrent depending on the time in which they will be used or paid. If assets are to be consumed within a year or if liabilities are to be paid within a year, they are reported as current. Otherwise, they are shown as noncurrent.
__T__ 5) The payment of income taxes does not help a business generate revenue in the same manner as other expenses. For that reason, it is often shown separately from other expenses on the income statement.
__F__ 6) The practice of conservatism tends to prevent companies from looking overly optimistic so that decision makers do not become too eager to risk their money. It states that when two or more outcomes are equally possible, the least flattering one should be selected for reporting purposes.
__F__ 7) Dividends that a corporation pays are reported on its Statement of Retained Earnings as a reduction in determining the ending retained earnings balance for the year. Dividends are also shown on the Statement of Cash Flows (as a financing activity) because money is paid out to the owners. __F__ 8) Companies receive money from investors only during an initial stock issuance. Assets go into the company and ownership shares are distributed in return to those making payment. When shares are bought and sold on a stock exchange, the company is not directly involved. The old investor receives payment for the shares and the new investor receives the shares. The company changes owners but its net assets are not affected. __T__ 9) A balance sheet must always balance. This is true because what the company owns (assets) must equal the source of those assets (either from debt, investments by owners, or profits). __T__ 10) All cash flows can be identified according to one of these three categories. Labeling cash flows in this way helps decision makers see where a company’s cash came from and where it went. __F__ 11) Working capital is a company’s current assets less its current liabilities so that, in this question, it is $100,000 ($300,000 less $200,000). __F__ 12) Sales revenue less cost of goods sold is reported as gross profit. Net income is all revenue and gains less all expenses and losses. __F__ 13) A gain comes from a sale that is incidental to a business operation. A gain usually occurs when a nonoperational asset (such as a building or equipment) is sold for an amount that is greater than its reported balance. All of a company’s net income less all of its dividends distributed is a figure known as retained earnings.
__T__ 14) The balance sheet, unlike the other financial statements, is prepared as of one specific date. The balance sheet reports the assets of the business on that date as well as its liabilities. __F__ 15) The accounting equation is: assets = liabilities + stockholders’ equity. It indicates that the assets held by an organization must have a source. That source is either from a liability (money is borrowed), an owner (money is contributed in exchange for capital stock), or operations (net income less dividends). __F__ 16) Conservatism merely states that when two events are equally likely to occur, then the accountant should report the one that makes the company look the worse. There is no rule that losses must be reported in all cases regardless of the chance that they will occur. __T__ 17) Gross profit is computed as the sales revenue ($240,000) less the cost of the goods sold ($175,000). Thus, in this case, gross profit is $65,000. __F__ 18) The collection of this receivable increases cash but also decreases accounts receivable. Both accounts are current assets so that this total does not change. The increase in one offsets the decrease in the other. If the current asset total does not change (and current liabilities are not impacted by a collection), the current ratio is not affected. __F__ 19) Net assets (assets minus liabilities) will increase by the company’s net income less any dividend distributions. However, net assets can also go up if assets are contributed by owners in exchange for capital stock. Therefore, this statement might be true (if owners made no investment in the company this period) but it could be wrong if part of the increase came from the owners acquisition of capital stock directly from the company. __F__ 20) Owners typically put assets into a business when it first starts. However, they might also make further contributions at any time after that. Therefore, this $310,000 could have been invested at the start of operations but some portion of the total might have been contributed to the business at any other time in the five years of its operations.
__T__ 21) The money was collected from a long term liability in the first year and is a cash inflow of $900,000 from a financing activity in that year. The subsequent expenditure for the asset is an investing activity on the statement of cash flows for the second year. __F__ 22) The accountant incorrectly reported an asset so the $800,000 total is overstated and should have been only $773,000. The cost should have been reported as an expense. Expenses reduce net income. Therefore, a correction to increase the expense will decrease the reported net income to $173,000 (not $227,000). __T__ 23) The dividend payment is a financing activity and can be ignored since the question specifically asks about operating activities. Inventory was purchased for $9,000 and 60 percent ($5,400) was paid this year. Advertising of $900 was also paid this year. Inventory was then sold for $14,000 and 80 percent of that amount ($11,200) was collected this year. The operating activity cash flows created a net increase for the year of $4,900 ($11,200 - $900 - $5,400). __F__ 24) The most likely outcome for this situation is that there will be no loss. For fair presentation, no loss should be recognized at this time. __T__ 25) Five of the reported figures will appear on the company’s income statement: revenue ($120,000), gain on sale of land ($4,000), cost of goods sold ($50,000), rent expense ($12,000), and advertising expense ($8,000). When combined, the company reports net income of $54,000. __F__ 26) Net income for Year One was the $70,000 revenue figure less expenses of $39,000 or $31,000. Because dividends of $3,000 were distributed to owners during the period, the reported balance for retained earnings after the company’s initial year of operations is $28,000. __T__ 27) Financial information is viewed as fairly presented if it contains no material misstatements according to the accounting basis being following (U.S. GAAP or IFRS). Here, the number is
not exactly correct but the misstatement is not viewed as material. Therefore, the financial information is still deemed to be fairly presented. Investors and creditors should be able to use the reported information to make appropriate financial decisions.
Answers to Multiple Choice Questions 1) Answer is A An accountant should always report any event as it is most likely to happen. In this case, the most likely outcome is that nothing will be lost. Therefore, for fair presentation, no loss is reported. However, the notes to the financial statements must disclose and explain the situation.
2) Answer is A According to the accounting equation, assets equal liabilities plus stockholders’ equity. Here, assets are $500,000 and liabilities are $350,000 so that stockholders’ equity must be $150,000. The capital stock account (the amount contributed by the owners) is $100,000. That leaves $50,000 of the stockholders’ equity total that is unexplained. This amount is the balance of retained earnings.
3) Answer is C Receiving a loan from a bank is not part of daily operations. Therefore, the cash inflow is not shown as an operating activity. Investing activities involve asset transactions while financing activities refer to events dealing with liabilities or stockholders’ equity. Here, money is borrowed on a long-term debt. It is a financing activity.
4) Answer is C Inventory that is held at the end of the year is an asset and, therefore, its cost is reported with all other assets on the balance sheet.
5) Answer is A The cost of inventory that has been sold (and, therefore, been removed from the company) is reported as the expense “cost of goods sold” on the income statement.
6) Answer is C The retained earnings balance is all of a company’s net income since its inception ($23,000 + $31,000 + $37,000 or $91,000) less all dividends distributed to owners ($10,000 + $12,000 or $22,000). Consequently, retained earnings will be reported as $69,000 ($91,000 less $22,000).
7) Answer is B Stockholders’ equity is equal to assets ($560,000) less liabilities ($320,000) or $240,000. In addition, at this point in the coverage, stockholders’ equity is made up of contributed capital ($100,000) plus retained earnings ($140,000) or $240,000.
8) Answer is C Gross profit is sales revenue ($300,000) less cost of goods sold ($170,000) or $130,000. The other expenses ($50,000) are then subtracted and the gain ($14,000) is added to arrive at net income of $94,000.
9) Answer is D Income taxes do not help a company generate revenue and, therefore, are not expenses in a traditional sense. Because of that difference, income taxes are separated from operating expenses such as rent and advertising by being reported at the bottom of the income statement.
10) Answer is B Financing activities are those events that are not part of daily operations and involve either a liability or stockholders’ equity account. In this problem, the category includes the dividend payment ($22,000 outflow), the loan from the bank ($100,000 inflow), and the issuance of capital stock ($35,000 inflow). The sum of those three amounts is a net inflow of $113,000 ($100,000 + $35,000 - $22,000).
11) Answer is D Investing activities are those events that are not part of daily operations and involve an asset. In this problem, the category includes the purchase of the building ($312,000 outflow) and the sale of equipment ($51,000 inflow). The net amount from those two events is a cash outflow of $261,000.
12) Answer is B Working capital is a company’s current assets ($300,000) less its current liabilities ($75,000) or $225,000
13) Answer is B The income statement should be prepared first so that net income is calculated. That figure is then used in the statement of retained earnings. In that statement, after ending retained earnings is derived, the figure is used in the production of the balance sheet. Therefore, to get the needed totals, the statements are prepared in that order.
Answers to Problems
1) a) Sales revenue – income statement b) Cash – balance sheet (the reported figure is also found at the end of the statement of cash flows) c) Gain on sale of building – income statement d) Retained earnings – balance sheet (the reported figure is also found at the end of the statement of retained earnings) e) Salary expense – income statement f) Salary payable – balance sheet g) Capital stock – balance sheet h) Dividends paid – statement of retained earnings i) Loss on sale of land – income statement j) Income tax expense – income statement k) Net income – income statement (the reported figure is also found within the statement of retained earnings) 2) The following relate to Farr Corporation for the month of April: Sales revenue Gain on the sale of land Equipment Tax expense Inventory Dividends paid
$170,000 20,000 125,000 14,000 10,000 7,000
Loss on lawsuit Cost of goods sold Advertising expense
24,000 82,000 15,000
a) Farr’s gross profit for the month of April: Gross profit = Sales revenue − Cost of goods sold Gross profit = $170,000 − $82,000 Gross profit = $88,000
b) Farr’s net income for the month of April. Note: Students could choose to prepare a formal income statement here, or could just use the formula below. Net income = Revenues + Gains – Expenses – Losses Sales revenue Cost of goods sold Advertising expense Gain on sale of land Loss on lawsuit Tax expense
$170,000 (82,000) (15,000) 20,000 (24,000) (14,000)
Net Income
$ 55,000
c) If retained earnings at the beginning of April is reported as $800,000, what balance should be reported for retained earnings at the end of April? Retained earnings, 4/1 Net income (from (b) above) Dividends Retained earnings, 4/30
$800,000 55,000 (7,000) $848,000
3) Show that Maverick’s balance sheet does balance using the accounting equation.
Assets = Liabilities + Stockholders’ Equity Assets = Liabilities + Capital Stock + Retained Earnings
Assets = Cash + Inventory + Building + Equipment Assets = $8,000 + $16,000 + $158,000 + $30,000 Assets = $212,000 Liabilities = Note Payable + Accounts Payable + Salary Payable Liabilities = $45,000 + $11,000 + $7,000 Liabilities = $63,000 Stockholders’ Equity = Capital Stock + Retained Earnings Stockholders’ Equity = $120,000 + $29,000 Stockholders’ Equity = $149,000 Assets = Liabilities + Stockholders’ Equity $212,000 = $63,000 + $149,000 4) a) The prepayment of this rent provides a future economic benefit and is reported on the balance sheet as an asset. b) By the end of this year, the benefit of this insurance policy has been consumed. The economic benefit is in the past and not the future. Therefore, it is reported on the income statement as an expense. c) By the end of this year, the supplies have been consumed. The economic benefit is in the past and not the future. It is reported on the income statement as an expense. d) The supplies are still held at the end of the year and, thus, will provide a benefit in the future. The cost is reported as an asset on the balance sheet. 5) a) This income statement has the following form: Sales Revenue – Cost of Goods Sold – Advertising Expense + Gain on Sale of Equipment – Income Tax Expense = Net Income Or restated:
Sales Revenue = Net Income + Cost of Goods Sold + Advertising Expense – Gain on Sale of Equipment + Income Tax Expense Sales Revenue = $82,900 + $459,030 + $56,000 − $5,000 + $50,000 Sales Revenue = $642,930 b) The statement of retained earnings has the following form: Retained Earnings, 1/1 + Net Income – Dividends = Retained Earnings, 12/31 Or restated: Retained Earnings, 1/1 = Retained Earnings, 12/31 – Net Income + Dividends Retained Earnings, 1/1 = $16,200 − $6,500 + $2,900 Retained Earnings, 1/1 = $12,600 c) At this point in the coverage, current assets are usually found as follows: Current Assets = Cash + Accounts Receivable + Inventory Or restated: Inventory = Current Assets – Cash – Accounts Receivable Inventory = $1,670,000 − $460,000 − $540,200 Inventory = $669,800 d) The accounting equation can be stated as: Assets = Liabilities + Capital Stock + Retained Earnings Or restated: Retained Earnings = Assets – Liabilities – Capital Stock Retained Earnings = $54,000 − $32,000 − $15,000 Retained Earnings = $7,000
6) Rescue Records Income Statement For the year ended December 31, Year One Sales Revenue
$197,000
Expenses: Cost of Goods Sold $109,000 Salary 25,470 Advertising 4,600 Rent 35,000 Total Expenses
(174,070)
Operating income Other gains and losses: Loss on sale of land
22,930 12,090
(12,090)
Income before income taxes
10,840
Income tax expense
(3,800)
Net income
$7,040
7) A Cut Above Balance Sheet December 31, Year One Assets Current Assets Cash Accounts Receivable Supplies Prepaid Insurance Total Current Assets
$2,400 500 300 1,600 $4,800
Noncurrent Assets Equipment, net
$3,000
Total Noncurrent Assets
3,000
Total Assets
$7,800
Liabilities and Stockholders’ Equity Liabilities Current Liabilities Accounts Payable Total Current Liabilities
$ 200
Noncurrent Liabilities Note Payable Total Noncurrent Liabilities
$5,000
$ 200
5,000
Total Liabilities
$5,200 Stockholders’ Equity
Capital Stock Retained Earnings
$2,000 600
Total Stockholders’ Equity
$2,600
Total Liabilities and Stockholders’ Equity
$7,800
8) Maria Sanchez Training Services Statement of Cash Flows For the month ended February 28 Cash Flows from Operating Activities Cash collected from customers $2,200 Cash paid for supplies (500) Cash paid for advertising (400) Cash paid for insurance (700) Cash paid for taxes (400) Total Cash Inflow from Operating Activities $ 200 Cash Flows from Investing Activities Cash paid for equipment $ (900) Total Cash Outflow for Investing Activities
$ (900)
Cash Flow from Financing Activities Cash received from bank loan $1,000 Total Cash Inflow from Financing Activities $1,000 Increase in cash during the month
$ 300
Cash Balance, February 1 Cash Balance, February 28
500 $ 800
9) a) Eli Company Income Statement Year Ended December 31, Year Two Revenues: Sales Revenue
$470,000
Expenses: Cost of Goods Sold
$170,000
Repair Expense
10,000
Advertising Expense
10,000
Salary Expense
40,000
(230,000)
Operating Income
240,000
Other Gains and Losses: Loss on Sale of Equipment
( 10,000)
Income Before Income Taxes
230,000
Income Tax Expense
(30,000)
Net Income
$200,000
b) Eli Company Statement of Retained Earnings Year Ended December 31, Year Two
Retained Earnings, January 1, Year Two*
$70,000
Net Income, Year Two
$200,000
Dividends Paid, Year Two
( 80,000)
Retained Earnings, December 31, Year Two
120,000 $190,000
* The company has only been in business for one previous year. In Year One, it reported net income of $100,000 and paid a dividend of $30,000. Thus, retained earnings at the end of Year One was $70,000. The company’s net assets had grown by that much as a result of its operations. That $70,000 figure carries over to become the retained earnings balance at the beginning of Year Two. c) Eli Company Balance Sheet December 31, Year Two Assets Current Assets Cash
$50,000
Accounts Receivable
100,000
Inventory
120,000
$270,000
Noncurrent Assets Land and equipment
300,000
Total Assets
$570,000
Liabilities Current Liabilities Accounts Payable
$40,000
Salary Payable
10,000
$ 50,000
Noncurrent Liabilities Notes Payable
210,000
Total Liabilities
$260,000
Stockholders’ Equity Contributed Capital
$120,000
Retained Earnings, December 31, Year Two
190,000
Total Liabilities and Stockholders’ Equity
310,000 $570,000
Answers to Research Assignment a. Gross Profit, 2008 = Net Sales less Cost of Sales = $5,132,768,000 - $3,375,050,000 = $1,757,718,000 Gross Profit, 2010 = Net Sales less Cost of Sales = $5,671,009,000 - $3,255,801,000 = $2,415,208,000 Gross Profit Percentage, 2008 = Gross Profit/Net Sales = $1,757,718,000/$5,132,768,000 = 34.2% Gross Profit Percentage, 2010 = Gross Profit/Net Sales = $2,415,208,000/$5,671,009,000 = 42.6% Provision for Income Taxes, 2008 = $180,617,000 Provision for Income Taxes, 2010 = $299,065,000 Net Income, 2008 = $311,405,000 Net Income, 2010 = $509,799,000 The Hershey Company appears to be doing much better in 2010 than it was in 2008. Gross profit is up considerably, both in terms of its size and its percentage in comparison to net sales. In other words, the company’s markup above cost has improved. Net income is also up by a substantial amount. Even the amount paid for income taxes has risen by well over $100 million. b. Working Capital, December 31, 2009 = Current Assets less Current Liabilities = $1,385,434,000 - $910,628,000 = $474,806,000 Working Capital, December 31, 2010 = Current Assets less Current Liabilities = $2,005,217,000 - $1,298,845,000 = $706,372,000 Current Ratio, December 31, 2009 = Current Assets divided by Current Liabilities = $1,385,434,000 divided by $910,628,000 = 1.52 : 1.00 Current Ratio, December 31, 2010 = Current Assets divided by Current Liabilities = $2,005,217,000 divided by $1,298,845,000 = 1.54 : 1.00 Retained Earnings, December 31, 2009 = $4,148,353,000 Retained Earnings, December 31, 2010 = $4,374,718,000
c. Net Cash Provided from Operating Activities, 2010 = $901,423,000 d. The Hershey Company has two types of capital stock (Common Stock and Class B Common Stock) so two separate dividends were paid each year. Dividends, 2008 Common stock = Class B Common stock = Total Dividends, 2008 =
$197,839,000 65,110,000 $262,949,000
Dividends, 2009 Common stock = Class B Common stock = Total Dividends, 2009 =
$198,371,000 65,032,000 $263,403,000
Dividends, 2010 Common stock = Class B Common stock = Total Dividends, 2010 =
$213,013,000 70,421,000 $283,434,000
Chapter 4 Solutions Answers to Questions 1) A transaction is any event that has a financial impact on a business or other organization. When a transaction takes place, some aspect of that organization’s financial condition must be affected. 2) The double-entry bookkeeping system that is used today was first developed over 500 years ago by merchants in and around the City of Venice in Italy. 3) Double-entry bookkeeping is a system used to record the impact of financial transactions by separating the causes and the effects that result from these events. It is based on an acknowledgement that each financial effect must have a cause. This cause and effect lead to the “double-entry” aspect indicated by the title. 4) In an accounting system, the first step is analyzing the financial impact of each transaction. All of these monetary effects are then recorded in journal entries and Taccounts based on the rules of debits and credits. As will be discussed in Chapter 5, some of these balances must then be adjusted periodically to capture the impact caused by the passage of time. Finally, the resulting balances are reported to decision makers, often in the form of financial statements. The steps are: analyze, record, adjust, and report. 5) The financial effect of a transaction is analyzed and recorded initially as a journal entry (using debits and credits) in a company’s journal. The impact of most transactions is repetitive and can be easily anticipated. Complex transactions may take considerable more thought and study to determine what has transpired and the resulting impact. 6) Balances for every specific account are maintained in T-accounts which a company maintains in a ledger (also called a “general ledger”). By its structure, the T-account has a left side (debit) and a right side (credit) which can be used to record increases and decreases. 7) Debits are used to show increases in assets, expenses and losses, and dividends paid. These are sometimes referred to as the “DEAD” accounts because Debits increase Expenses and losses, Assets, and Dividends paid. 8) Credits are used to show increases in liabilities, capital stock (also known as contributed capital), revenues and gains, and retained earnings. 9) A journal is the physical location where all journal entries are recorded. Therefore, it serves as a history of all monetary transactions and their impact on the financial position of the Nelson Company.
10) Debits will equal credits in all journal entries because each effect on an account balance has to have a cause. An account can simply not change without a reason. Recording the effect along with the cause of that effect means that each journal entry must reflect an equilibrium which necessitates that debits and credits will equal. 11) A trial balance is the listing of the present balances for all of the T-accounts found in a company’s ledger. It is used to ensure that the debit balances do properly equal the credit totals. It also allows for an easy visualization of all account balances so that the accountant is more likely to spot obvious errors or potential problems. 12) Accrual accounting encompasses the rules used to standardize the timing of the recognition of revenues and expenses. Should revenue be reported in this year or the next? Does an expense need to be recorded now or in the future? Guidance for those types of decisions comes from the rules established by accrual accounting. 13) The Revenue Realization Principle states that revenue is recognized when 1) the earnings process is substantially complete and 2) the amount to be received is reasonably subject to estimation. The Matching Principle states that expenses should be recognized in the same time period as the revenues they help to generate. 14) Recognizing an expense in the current period based on the matching principle means that the revenue which this expense helped to generate has been identified and it was recorded in this period. According to the matching principle, each expense is reported in the same time period as the revenue which it helped to generate. 15) Cash has been received for a job but the earning process is not yet substantially complete. Therefore, revenue cannot be recorded at this time. Instead, an unearned revenue balance is established. It is reported as a liability to show that the Abraham Company has an obligation or responsibility to finish the required work or return the money.
Answers to True or False Questions __T__ 1) The rules of double-entry bookkeeping dictate that debits and credits must be equal for every transaction. For each change in an account balance, a definite cause must exist. In reporting both the change and its cause, the amounts must be the same. This creates equilibrium in the reporting process between debits and credits. __F__ 2) Journal entries are recorded in the journal. T-accounts (maintaining balances for individual accounts) are gathered in the ledger.
__F__ 3) According to accrual accounting, revenue is recognized when the earning process is substantially complete (if the amounts to be collected can be reasonably estimated) and not necessarily when cash is collected. __T__ 4) Any event that has a financial impact on a company or other type of organization is said to be a transaction. It is an event that changes the financial condition of that organization. __F__ 5) An expense (like an asset and a dividend) is a cost. All costs are increased with debits. __T__ 6) The word “accrue” means to grow. So, an accrued expense is one that grows gradually with the passage of time. The costs associated with salary, rent, and interest do grow over time and, therefore, they are often referred to as accrued expenses. __F__ 7)
Revenue is a measure of the increase in net assets that occurs from selling the normal goods and services of a business. A gain is a measure of the increase in net assets that occurs from a sale of an item that is not a normal good or service (such as a delivery truck or piece of land). A gain is recorded rather than a loss if the sales price exceeds the recorded amount for that item. __F__ 8) The term ”posting” refers to the process of transferring the debit and credit amounts in journal entries to the appropriate T-accounts in the ledger. __F__ 9) Accrued expenses can be recognized as they are incurred. A company’s accounting system can be programmed to make those daily or weekly journal entries. However, for convenience, many accrued expenses are not recognized until paid or until financial statements are to be made.
__T__ 10) The matching principle provides guidance on the timing of the recognition of expenses. As indicated, it requires that expenses should be recognized in the same fiscal period as the revenue they help to generate. __T__ 11) An unearned revenue balance indicates that money has been received by a business but the earning process is not yet substantially complete. Therefore, the business still has an obligation to the customer which is reflected by the unearned revenue being reported as a liability on the balance sheet. __F__ 12) Instead of a gain of $12,000, this company should recognize revenue of $40,000 and cost of goods sold of $28,000. That is the appropriate reporting for the sale of inventory. __T__ 13) The dividend can be ignored because it is not an expense. The revenue is $11,000 and advertising expense is $700. The real question is about the reporting of cost of goods sold. Goods were bought for $8,000 but only 60 percent were sold this period. Thus, cost of goods sold is $4,800 and net income is $5,500 ($11,000 - $4,800 - $700). __F__ 14) Working capital is a company’s current assets less its current liabilities. Inventory should have been increased by $6,000. Instead, it was decreased by $6,000. Therefore, the reported current asset total is $12,000 too low. Accounts payable should have been increased by $6,000. Instead, it was also decreased by $6,000. Therefore, the reported current liability total is $12,000 too low. Both current assets and current liabilities are too low by $12,000. In determining working capital, those two errors offset. Working capital is correctly stated as $140,000. __F__ 15) The matching principle is the component of accrual accounting within U.S. GAAP that provides guidance for the timing of the recognition of expenses. __F__ 16) Gross profit is sales revenue less cost of goods sold. Here, revenue is $9,000. The inventory costs $3,000 to acquire. Only 30 percent of the merchandise was sold this period so the
reported cost of goods sold is $900 and not the entire $3,000. Revenue of $9,000 less cost of goods sold of $900 gives a gross profit of $8,100.
Answers to Multiple Choice Questions 1) Answer is D Transactions can be quite complicated and often impact more than two accounts. Thus, journal entries may have a number of debits and credits. One debit and one credit must always be present but there is no upper limit to the number that can be included.
2) Answer is C Cash or accounts receivable (or both) might be increased at the time that a sale is made but accounts payable (a liability) will not be impacted. A sale does not create a liability for the seller.
3) Answer is A The payment of cash is an actual event which impacts the financial condition of this company. C and D are commitments; the company has agreed to have a transaction at some point in the future. B is merely a consideration In B, neither a commitment nor a transaction has yet occurred.
4) Answer is A Gross profit is the sales revenue ($40) less the cost of the goods sold ($26). Thus, gross profit per unit is $14. For 400 units, the total gross profit is $5,600.
5) Answer is C Buying inventory is a cost to a company. Costs (expenses, assets, and dividends) are always recorded through the use of a debit.
6) Answer is B Cash is received from a customer but the earning process is not yet substantially complete. Therefore, revenue cannot be recognized. Instead, a liability (unearned revenue) is recorded through a credit.
7) Answer is B A journal contains all of the journal entries for a business or other organization. Each entry shows the impact of an individual transaction. However, the actual balance of those accounts is not maintained in the journal. The entries are posted to T-accounts so that balances can be determined. T-accounts are gathered together in a ledger. Periodically, these balances are listed on a trial balance so that the figures can be reviewed and analyzed prior to the preparation of financial statements.
8) Answer is A Transactions occur and are analyzed and recorded in a journal (as a journal entry). The debits and credits are then posted to individual T-accounts located in the ledger. Those balances are eventually used to produce financial statements.
9) Answer is B Equipment is a cost for a company. All costs (assets, expenses, and dividends paid) are increased as debits. Consequently, unless they contain negative amounts (which is highly unlikely), these costs will have debit balances.
10. Answer is B Based on the information provided, the expense has already been recorded by the accounting system along with the related liability. Therefore, payment does not create the expense again but rather removes the liability.
11. Answer is A The accounting system did not record the expense. When paid, the expense must be recognized. No liability has been established so there is no rent payable balance to remove.
Answers to Problems 1) a. Cash increases by $30,000 and capital stock (or contributed capital) increases by $30,000. b. Cash increases by $15,000 and notes payable increases by $15,000
c. Equipment increases by $19,000 and cash decreases by $19,000. d. Machinery increases by $11,000 and accounts payable increases by $11,000. e. Cash increases by $2,000, accounts receivable increases by $12,000, and sales revenue increases by $14,000. f. Rent expense increases by $5,000 and cash decreases by $5,000. g. Dividends paid increases by $3,000 and cash decreases by $3,000 h. Inventory increases by $10,000 and accounts payable increases by $10,000 i. Cash increases by $7,000, accounts receivable increases by $11,000, and sales revenue increases by $18,000. In addition, cost of goods sold increases by $10,000 and inventory decreases by $10,000 j. Accounts payable decreases by $10,000 and cash decreases by $10,000. k. Cash increases by $11,000 and accounts receivable decreases by $11,000
2) a. Asset increases – debit b. Liability increases – credit c. Asset decreases – credit d. Expense increases – debit e. Revenue increases – credit f. Asset decreases – credit g. Capital stock increases – credit h. Asset decreases – credit i. Liability decreases – debit j. Expense decreases – credit
3) a)
Cash Note Payable
$ 4,500 $ 4,500
Cash Capital Stock
$10,000 $10,000
Inventory Accounts Payable
$ 2,000 $ 2,000
Accounts Receivable Revenue
$ 600
Cost of Goods Sold Inventory
$ 400
Equipment Cash
$ 500
Cash Accounts Receivable
$ 600
Accounts Payable Cash
$ 2,000 $ 2,000
b)
c)
d)
$ 600
$ 400
e)
$ 500
f)
$ 600
g)
h) Prepaid Insurance Cash
$1,200
Salary Expense Salary Payable
$ 3,000 $ 3,000
Salary Payable Cash
$2,900
$1,200
i)
j)
$2,900
4) a) Raymond records unearned revenue of $1,500 in May. Raymond cannot record any revenue because it has not yet done any of the work. b) Raymond records $6,000 in revenue in May because the earning process is substantially complete and a reasonable estimation can be made of the amount to be received. c) Raymond records $3,400 in revenue in May because the earning process is substantially complete and Raymond knows the amount that will be collected. d) Raymond does not record any revenue in May. The company would have recorded the entire revenue in April when the inventory was sold.
5) a) Cash Unearned Revenue
$1,500
Accounts Receivable Revenue
$6,000
Cost of Goods Sold Inventory
$3,600
Cash Revenue
$3,400
Cash Accounts Receivable
$2,300
$1,500
b)
$6,000
$3,600
c)
$3,400
d)
$2,300
6) A trial balance can be created for the Ester Company with the number that is needed to bring the debits and credits into agreement assumed to be the balance for Sales Revenue. This process shows that sales revenue for the year was $340,000. Ester Company Trial Balance December 31, Year Four
Account
Debit
Cash
$ 22,000
Accounts Receivable
85,000
Credit
Inventory
113,000
Land
175,000
Accounts Payable
$ 14,000
Salary Payable
7,000
Notes Payable
125,000
Capital Stock
90,000
Retained Earnings, 1/1/04
114,000
Cost of Goods Sold
185,000
Salary Expense
89,000
Utilities Expense
15,000
Dividends Paid
6,000
_______
$690,000
$350,000
Balance into Agreement
_______
340,000
Totals
$690,000
$690,000
Totals Amount needed for Sales Revenue to Bring Trial
7) a) b) c) d) e) f) g) h)
Cash (Asset) - debit Dividends paid (Dividends paid) - debit Notes payable (Liability) - credit Unearned revenue (Liability) - credit Cost of goods sold (Expense) - debit Prepaid rent (Asset) - debit Accounts receivable (Asset) - debit Capital stock (Capital stock) - credit
8) A) Prepare journal entries for Sew Cool a) Cash Contributed capital
$ 1,000 $ 1,000
b) Equipment Note payable
$ 1,000 $ 1,000
Inventory Cash
$ 1,000 $ 1,000
c)
d) Rent Expense Utilities Expense Cash
$ 70 10 $ 80
e) Cash Accounts Receivable Revenue
$ 720 480
Cost of Goods Sold Inventory
$ 700
Advertising Expense Cash
$
Dividends paid Cash
$ 10
Tax Expense Cash
$ 87
$ 1,200
f)
$
700
$
50
$
10
g) 50
h)
i)
$ 87
B) Prepare T-accounts for each account and post entries made to date. Cash Accounts Receivable Inventory (a)1,000 1,000(c) (e)480 (c)1,000 700(f) 80(d) (e) 720 50(g) 10(h) 87(i) 493
480
Note Payable 1,000(b)
Capital Stock 1,000(a)
1,000 Rent Expense (d)70
70 Utilities Expense (d) 10
10
300
1,000
Revenue 1,200(e)
1,000 Advertising Expense (g) 50
50
Equipment (b)1,000
1,200 Tax Expense (i) 87
87
Cost of Goods Sold (f)700
700 Dividends (h)10
10
C) Prepare a trial balance for Sew Cool for June. Sew Cool Trial Balance 6/30/20xx Account Title Cash Accounts Receivable Inventory Equipment Note Payable Capital Stock Retained Earnings, 6/1/20XX Revenue Cost of Goods Sold Rent Expense Utilities Expense Advertising Expense Tax Expense Dividends
Debits $493 480 300 1,000
Credits
700 70 10 50 87 10
______
Totals
$3,200
$3,200
1,000 1,000 0 1,200
9) A) Prepare journal entries for the transactions of the Bowling Corporation. a) Inventory Accounts Payable
$450,000 $450,000
Cash Unearned Revenue
$ 13,000 $ 13,000
Note Payable
$ 67,000 $ 67,000
b)
c) Cash
d) Accounts Receivable Revenue
$700,000 $700,000
Cost of Goods Sold Inventory
$450,000 $450,000
Salaries Payable Cash
$120,000 $120,000
Land
$ 56,000 $ 56,000
e)
f)
Cash g) Cash
$650,000 Accounts Receivable $650,000
h) Dividends Cash
$
4,000 $ 4,000
Salaries Expense Salaries Payable
$123,000 $123,000
Accounts Payable Cash
$300,000 $300,000
i)
j)
k) Tax Expense Cash
$ 45,000 $ 45,000
B) Complete the T-accounts below. The prior balances are given. Cash Accounts Receivable Inventory Land 500,000 120,000(e) 650,000 650,000(g) 0 450,000(d) 22,000 (b) 13,000 56,000(f) (d)700,000 (a)450,000 (f)56,000 (c) 67,000 300,000(j) (g)650,000 4,000(h) 45,000(k) 705,000 700,000 0 78,000 Accounts Payable Unearned Revenue Salary Payable (j)300,000 100,000 0 (e)120,000 120,000 450,000 (a) 13,000(b) 123,000(i) 250,000
13,000
Capital Stock 302,000
Retained Earnings 220,000
302,000
220,000
Salary Expense 0
Tax Expense 0 (k)45,000
123,000 Revenue 700,000(d)
700,000
Dividends 0 (h)4,000
(i) 123,000 123,000
45,000
Note Payable 430,000 67,000(c)
4,000
497,000 Cost of Goods Sold (d)450,000
450,000
C) Bowling Corporation Trial Balance January 31 Account Title Cash Accounts Receivable Land Accounts Payable Unearned Revenue Salaries Payable Note Payable Capital Stock Retained Earnings, 2/1 Revenue Cost of Goods Sold Salaries Expense Tax Expense Dividends
Debits $705,000 700,000 78,000
Credits
450,000 123,000 45,000 4,000
_________
Totals
$2,105,000
$2,105,000
$ 250,000 13,000 123,000 497,000 302,000 220,000 700,000
10) A) Prepare journal entries for the above transactions. a) Inventory Accounts Payable
$ 1,800 $ 1,800
Cash Accounts Receivable Revenue
$ 4,000 800 $ 4,800
Cost of Goods Sold Inventory
$ 1,920 $ 1,920
b)
c) Cash
$ 500 Accounts Receivable
$ 500
d) Cash
$ 400 Note Payable
$ 400
e) Dividends Cash
$ 350
Cash
$ 600
$ 350
f)
Capital Stock
$ 600
g) Equipment Cash
$ 1,000 $ 1,000
Accounts Payable Cash
$ 500
Salaries Expense Salaries Payable
$ 500
Rent Expense Cash
$ 300
Prepaid Insurance Cash
$ 200
h)
$ 500
i)
$ 500
j)
$ 300
k)
$ 200
l) Tax Expense Cash
$ 110 $ 110
B) Complete the T-accounts below. The prior balances are given. Cash 500 350(e) (b)4,000 1,000(g) (c) 500 500(h) (d) 400 300(j) (f) 600 200(k) 110(l) $3,540
Accounts Receivable Inventory Prepaid Insurance Equipment 200 500(c) 150 1,920(b) 0 2,000 (b) 800 (a)1,800 (k) 200 (g)1,000
$500
Accounts Payable (h)500 600 1,800(a)
Salaries Payable 0 500(i)
$1,900 Retained Earnings 750
$30
Notes Payable 0 400(d)
$500 Revenue 0 4,800(b)
$200
$400 Cost of Goods Sold 0 (b) 1,920
$750
$4,800
$1,920
Rent Expense 0 (j)300
Tax Expense 0 (l)110
Dividends 0 (e)350
$300
$110
$350
$3,000
Capital Stock 1,500 600(f) $2,100 Salaries Expense 0 (i)500 $500
C) Prepare a trial balance for January McClain Company Trial Balance January 31 Account Title Cash Accounts Receivable Inventory Prepaid Insurance Equipment Accounts Payable Salaries Payable Note Payable Capital Stock Retained Earnings, 5/1 Revenue Cost of Goods Sold Salaries Expense Rent Expense Tax Expense Dividends
Debits $ 3,540 500 30 200 3,000
Credits
1,920 500 300 110 350
_______
Totals
$10,450
$10,450
$1,900 500 400 2,100 750 4,800
Answers to Research Assignments
According to the December 26, 2010, balance sheet of The New York Times Company, “unexpired subscriptions” amount to $72,896,000. Apparently, customers have paid that much money to this company in advance for newspapers that will be delivered at some point in the future. When the earning process is substantially complete, this liability will be reclassified as revenue. Within the notes to these financial statements, The New York Times Company presents information on its policy for recognizing revenue. At the end of the fourth bullet point on this page, the note states: “Proceeds from subscription revenue are deferred at the time of sale and are recognized in earnings on a pro rata basis over the terms of the subscriptions.” Thus, no revenue is recorded initially when the subscription is paid but the amount is recognized gradually as revenue as the newspapers are delivered over time.
Chapter 5 Solutions Answers to Questions 1) Not all changes in account balances are the result of physical events. Many increases and decreases are caused by the passing of time or from some other very gradual changes. Prior to the production of financial statements, these effects on account balances must be entered into the accounting process through adjusting entries. 2) The four general types of adjustments discussed in this chapter are accrued expenses, prepaid expenses, accrued revenue, and unearned revenue. 3) Possible examples of accrued expenses are: rent expense, interest expense, salary or wage expense, utility expense, and advertising expense. Accrued expenses are common and include costs that grow gradually over time as the benefit is used. 4) At the end of the year, the company owes its employees for 6 days of work (December 26-31). At $2,000 per day, that equals a total amount due of $12,000. Salary or wage expense should be debited and salary or wage payable should be credited. 5) As was mentioned in a previous chapter, the revenue recognition principle states that revenue is recorded when the earning process is substantially complete and the amount to be collected is subject to a reasonable estimation. For some jobs, it can be difficult to determine at what point the earning process is “substantially complete.” Some jobs can be viewed as one job that covers a period of time or as many separate jobs done within a set time period. If work is performed on a single job, no revenue can be recognized until the entire project is virtually finished. If a job is really multiple independent tasks, the earning process will probably be substantially complete for some of the work before the rest. Revenue can be recognized for the portion deemed as substantially complete. 6) Because $9,000 in supplies were bought but only $1,000 remain, apparently $8,000 has been consumed. Thus, the final figures should show an asset of $1,000 and an expense of $8,000. Currently, a total of $9,000 is reported as an asset. To reduce that figure to the proper balance, Supplies Expense is debited for $8,000 while Supplies is credited for $8,000 (to reduce it to the proper $1,000 figure). 7) Because $9,000 in supplies were bought but only $1,000 remain, apparently $8,000 has been consumed. Thus, the final figures should show an asset of $1,000 and an expense of $8,000. Currently, a total of $9,000 is reported as an expense. To reduce that figure to the proper balance, Supplies Expense is credited for $1,000 (to reduce it to the proper $8,000 figure) while Supplies is debited for $1,000 (to increase it to the proper $1,000 figure).
8) The company has earned $6,000 rent ($3,000 times 2 months). The money has been earned and it is due. Thus, before financial statements are prepared, rent receivable is debited for $6,000 and rent revenue is credited for $6,000. 9) Because of the proliferation of “gift cards” in recent years, a great many businesses actually receive cash prior to providing any product or service. Traditionally, newspapers and insurance companies were two examples mentioned as businesses having unearned revenue. However, that type of transaction affects a large number of businesses in today’s world. 10) An unearned revenue is reported as a liability because the company owes a good or service to the person who made the payment. There is an obligation that can be measured monetarily and, therefore, is reported as a liability. 11) As a result of the revenue recognition principle, revenue is always recognized when two criteria are met. First, the earning process that the seller has agreed to fulfill must be substantially complete. Second, the amount of cash or other assets that will eventually be received is the subject of a reasonable estimation. 12) A trial balance is normally produced whenever a company is beginning the process of producing financial statements. However, officials often create a trial balance more frequently so the financial results can be reviewed by officers and other members of the management. 13) Revenues, expenses, gains, and losses are all included on an income statement. Assets and liabilities (along with capital stock and retained earnings) are reported on a company’s balance sheet. 14) Closing entries are prepared to bring temporary accounts (revenues, expenses, gains, losses, and dividends paid) back to a zero balance for the start of the next period. The process also moves these temporary account balances into the retained earnings account so that it is correctly stated as of the end of the year. 15) As with all temporary accounts, revenues and expenses are closed out (returned to a zero balance) at the end of each fiscal period by moving their balances into retained earnings.
Answers to True or False Questions __T__ 1) Often, accountants will find it easy to determine when the earning process is substantially complete and whether the amount to be received is subject to a reasonable estimation.
However, as discussed in this chapter, there are times when the earning process is more complex and determining when it is substantially complete can be difficult. Upper level accounting courses often spend considerable time on the challenge of that judgment. Furthermore, there are situations when a reasonable estimate of the amount to be received can be difficult because of various uncertainties. __F__ 2) Permanent accounts (such as assets and liabilities) maintain their balances from one period to the next. Only temporary accounts (revenues, expenses, gains, losses, and dividends paid) are closed at the end of the financial accounting process. __F__ 3) According to the revenue recognition principle, revenue should be recognized when the earning process is substantially complete and the amount that will be collected can be reasonably estimated. Cash collection can occur before this time or after revenue is earned. Revenue recognition is not directly tied to the collection of cash. __T__ 4) Many accounts (especially revenues and receivables as well as expenses and liabilities) change virtually every day as time passes. Examples include rent, salaries, and interest. __F__ 5) Accounting certainly has a large number of rules but most of these rules (although not all) do require some amount of judgment in the application process. An accounting education requires that students learn the rules and then develop the judgment necessary to apply those rules successfully. __T__ 6) Assets, liabilities, and stockholders’ equity accounts are all permanent. That means they do not measure changes for a specific period of time (usually a year). Thus, there is no reason to close out the balances each period to return the accounts to a zero figure. __T__ 7) Accrue means “to grow” so an accrued revenue is one that gets larger gradually over time. A good example is rent revenue or interest revenue, both of which are earned as time passes. __T__ 8) Depending on the method used to structure an accounting system, accruals can be recorded automatically as time passes or recorded through an adjusting entry at the end of the fiscal period as a prerequisite step in producing financial statements.
__F__ 9) Closing entries, and not adjusting entries, reduce the balance of each temporary account (revenues, expenses, gains, losses, and dividends paid) to zero so that recording for a new year can begin. __F__ 10) A trial balance can be produced whenever company officials want to review operating results or the accountant wants to search for any balances that might need to be adjusted. __F__ 11) The company is recording the expense as it accrues. Consequently, when financial statements are to be produced, the figure is already fairly presented and needs no further adjustment. __T__ 12) In determining net income, the expense has been improperly omitted. Because the reported expense figure is too low, reported net income will be too high (overstated). __F__ 13) Number 12 indicates that reported net income is too high. Therefore, retained earnings will also be too high at the end of the year. In addition, because the expense was recorded as an asset, the asset total is overstated by the same amount. Both the assets and retained earnings are overstated. Since the errors are for the same amount, they will offset and the balance sheet will stay in balance. __F__ 14) The expense was omitted. Therefore, net income is too high so that retained earnings is also too high by the same amount. However, the liability balance was also omitted. The liability total is too low. If the retained earnings account is too high by $9,000 and liabilities are too low by $9,000, the balance sheet will still balance. __T__ 15) The accrued expense at the end of the period was not reported. Therefore, the reported expense is too low and the resulting net income is too high.
Answers to Multiple Choice Questions
1) Answer is C Temporary accounts (revenues, expenses, gains, losses, and dividends paid) are closed out (returned to a zero balance) at the end of each period. Cost of goods sold is an expense. All of the other choices are either assets or liabilities.
2) Answer is B The entire $600 amount was recorded as unearned revenue when received. The revenue had not been earned at that time and the problem indicates that the appropriate entry was made. By the end of the year, 1/3 of that amount has been earned and should be recognized (one job out of three is substantially completed). Unearned revenue is reduced by $200 (a debit) and revenue is increased by $200 (a credit).
3) Answer is B Dividends paid, losses, and expenses all reflect reductions in the net assets of a company. Therefore, when closed into retained earnings, they cause a reduction. Revenue (and gains) measure increases in the net assets of a company. When closed into retained earnings, they create an increase.
4) Answer is A Financial transactions take place and they are analyzed by the accountant to determine the accounts that are impacted. These effects are recorded by means of a journal entry with the debits and credits posted to the appropriate T-accounts. When financial statements are to be produced, accounts are adjusted to reflect changes caused by the passage of time and other reasons such as errors. After all accounts are presented fairly, financial statements can be created for reporting purposes.
5) Answer is D The $42,000 payment was recorded as an asset (prepaid rent). Because this amount was for a six-month period of time, the expense is $7,000 per month. After four months (September – December), the asset should have been reduced by $28,000 and an expense recognized of that amount. Because the accountant failed to make this adjustment, reported assets are too high by $28,000 and reported expenses are too low by $28,000. The expense is too low; therefore, net income will be overstated by that same $28,000.
6) Answer is B Eleven days passed in Year One and no adjusting entry was made for this accrued expense. Consequently, the reported expense for Year One was too low by $11,000 as was the related liability. Because the expense was too low, reported net income was too high by that same $11,000.
7) Answer is D At the end of Year One, a liability of $11,000 was recorded through an adjusting entry to show the accrued expense for the 11 days in Year One. In Year Two, $31,000 is paid. The extra $20,000 is for the 20 days that pass in Year Two. At the time of payment, cash of $31,000 is credited while the $11,000 liability is removed though a debit and a $20,000 expense is also recognized (for Year Two) through a debit.
8) Answer is C No liability or expense was recorded in Year One. If that $11,000 adjustment had been recorded at the end of Year One, the payment in Year Two would have reduced (debited) the liability by $11,000 and also increased (debited) expense for $20,000. Because the accountant thought the adjusting entry had been made, that was the journal entry recorded at time of payment. The $20,000 expense is correct for Year Two because that was the amount incurred in the first 20 days of that year. The actual journal entry reduced the liability by $11,000 although it was never recorded in the first place. Thus, the liability balance now reports a negative of $11,000 and is too low.
9) Answer is C The accounts that will appear on the Cone Company income statement are: cost of goods sold - $72,000, sales revenue - $191,000, rent expense - $23,000, and salary expense - $34,000. They net to a $62,000 net income balance.
10) Answer is B After 19 days, the expense figure should be $19,000 and the prepaid rent (asset) should be the remaining $21,000. Before adjustment, the only figure reported is a $40,000 expense. This expense should be reduced by $21,000 (credit entry) and the prepaid rent should be increased by $21,000 (debit entry).
Answers to Problems 1) a) – Unearned revenue (Atlas collected revenue for the magazines before they were delivered.) b) - Accrued revenue (Hornsby has completed the required work but not yet collected the money due.) c) – Accrued expense (The debt owed by Nancy and Sons to its employees has grown up gradually but has not yet been paid.) d) – Accrued expense (Replay Inc. has incurred the advertising cost but has not yet made any payment.) e) – Prepaid expense – (Centurion paid the cost of its insurance several months in advance so that the benefit will gradually be consumed over time.) f) – Unearned revenue – (Reliable Insurance received payment several months before the money was actually earned.)
2) a) - Interest on a note or other debt has been incurred over time but no payment or entry has been made to date so that the adjustment is required to recognize the expense and the liability. b) – Supplies have been bought at some previous point in time. By the present time, a portion of these supplies have been consumed so that this portion of the cost is now an expense. The expense is determined by subtracting the amount remaining from the amount acquired. The adjustment moves the cost from the asset to the expense to indicate that it has been consumed. c) – Previously, money was received from a customer for a good or service prior to the earning process being substantially complete and was recorded as a liability – unearned revenue. All (or a separate portion) of that work has now been completed and the applicable unearned revenue is reclassified as revenue. d) – Rent was paid in advance at some previous point in time. Part or all of that rent has now been consumed so that the asset (or that portion of the asset) should be reclassified as an expense. e) – Work has been done and money is owed by the customer but has not yet been recorded or collected.
f) – The company has incurred some sort of advertising cost recently but this advertising has not yet been paid or recorded. 3) a) – One of the three jobs is substantially complete and that portion of the revenue (1/3 x $90,000) should be reclassified from unearned revenue to revenue. Unearned Revenue Revenue
$ 30,000 $ 30,000
b) – The money has been earned by the employees but not recorded. That expense and the related debt must be added to the accounting records by means of an adjusting entry. Salaries Expense Salaries Payable
$480,000 $480,000
c) – Payment was made for rent of $300,000 for six months. One of those months has now passed and the related cost ($300,000/6 months or $50,000) has been consumed. That amount should be moved from the asset account to the expense account. Rent Expense Prepaid Rent
$ 50,000 $ 50,000
d) – According to the problem, no part of the work is yet substantially complete. Therefore, no revenue should be recognized and no adjusting entry is needed.
4) a) – Rent is paid in advance. Prepaid Rent Cash
$60,000 $60,000
b) – The rent is received in advance. Cash Unearned Revenue
$60,000 $60,000
c) – Four months have passed and the benefit for those months ($10,000 x 4 or $40,000) has been consumed. Rent Expense Prepaid Rent
$40,000 $40,000
d) – The earning process is substantially complete for four of the six months. Unearned Revenue Revenue
$40,000 $40,000
5) a) – Adjusting entries needed by Osgood Company as of December 31, Year One [1] – Remove revenue that has not yet been earned. Revenue Unearned revenue
$32,000 $32,000
[2] – Rent expense is reported as $56,000. However, a portion of the payment made on October 1 still provides a future benefit and should be moved to an asset account. That second payment was $20,000 for 5 months or $4,000 per month. Three months have passed (October – December) so two months of rent ($8,000) remain for January and February. That amount should be removed from the expense account and recognized as an asset (prepaid rent). Prepaid rent Rent expense
$ 8,000 $ 8,000
[3] – The Supplies account reports $14,000 but only $2,000 in supplies remain. Thus, $12,000 in supplies must have been consumed and should be reclassified as an expense. Supplies expense Supplies
$12,000 $12,000
[4] – An error took place. Interest payable was debited rather than interest expense. The Interest Payable account shows the debit balance as $3,000. That amount should be moved to interest expense to correct the mistake made in recording the payment. Interest expense Interest payable
$ 3,000 $ 3,000
[5] – A total of $51,000 was paid ($24,000 + $27,000) and that amount was apparently recorded as prepaid insurance because that is the balance of that T-account. However, only the final three months of the second payment still reflect a future economic benefit. That payment was $27,000 for 9 months or $3,000 per month. With three months of coverage still remaining, the asset should be $9,000 ($3,000 x 3 months). The remaining $42,000 ($51,000 less $9,000) is the expense for the current year. Insurance expense Prepaid insurance
$42,000 $42,000
[6] – The work has been done on this job and the revenue should have been recorded. Accounts receivable Revenue
$17,000 $17,000
b) The various adjusted balances can be determined as follows: Interest expense = $16,000 + $3,000 = $19,000 Interest payable = $3,000 - $3,000 = -0Prepaid insurance = $51,000 - $42,000 = $9,000 Rent expense = $56,000 - $8,000 = $48,000 Revenue = $411,000 - $32,000 + $17,000 = $396,000 Supplies = $14,000 - $12,000 = $2,000 Accounts receivable = $17,000 Insurance expense = $42,000 Prepaid rent = $8,000 Supplies expense = $12,000 Unearned revenue = $42,000
6) [1] Journal entry – employee hired No journal entry is recorded because the hiring of an employee is not a monetary transaction. The monetary transaction is created by the person’s work and the company’s subsequent payment. Adjusting entry – the person works for a month and is owed $4,000 which will be paid in January. Salary expense Salary payable
$ 4,000 $ 4,000
[2] Journal entry – payment of rent for following six months Prepaid rent Cash
$18,000 $18,000
Adjusting entry – one month out of six has now passed Rent expense Prepaid rent
$ 3,000 $ 3,000
[3] Journal entry – Supplies were purchased on account Supplies Accounts payable
$10,000 $10,000
Adjusting entry – only $3,600 in supplies remain; thus, $6,400 of the $10,000 have been consumed and that amount should be recorded as an expense Supplies expense Supplies
$ 6,400 $ 6,400
[4] Journal entry – because services were expected to be provided immediately, recognition of revenue is most likely. Cash
$ 9,000 Revenue
$ 9,000
Adjusting entry – because the work did not get completed before the end of the year, the revenue has to be reclassified as unearned revenue. Revenue Unearned revenue
$ 9,000 $ 9,000
As a second possibility, a $9,000 unearned revenue could have been recorded initially. If that were done, no adjusting entry is needed. [5] Journal entry – problem indicates that nothing was recorded during this year. Adjusting entry – the work was done so the transaction should be recorded. Accounts receivable Revenue
$ 8,000 $ 8,000
7) (A) - Adjusting entries: [1] – Recognize the amount owed for utilities for the last two months of the year Utilities expense Utilities payable
$ 2,000 $ 2,000
[2] – Insurance expense has a balance of $7,400 ($2,000 + $5,400). Thus, all of the payments were originally put into the expense account. However, the payment on July 1 covered 18 months. By the end of the year, 12 months of that insurance are still prepaid. This coverage was for $300 per month ($5,400/18 months) so $3,600 is still prepaid ($300 x 12 months). That amount should be reclassified from expense to asset (prepaid insurance). Prepaid insurance Insurance expense
$ 3,600 $ 3,600
[3] – Rent of $10,000 ($2,000 + $8,000) has been paid this year and apparently recorded in the Prepaid Rent account since that balance can be seen in the trial balance. The company paid for 20 months (4 + 16) but has only used 12 of those months by the end of Year Four. Thus, cost for the remaining 8 months is still a prepaid rent. The final payment was $8,000 for 16 months or $500 per month. Prepaid rent should now be $4,000 ($500 times 8 months). The other $6,000 ($10,000 less $4,000) is reclassified from prepaid rent to rent expense in the following adjusting entry. Rent expense Prepaid rent
$ 6,000 $ 6,000
[4] – In the trial balance, no amount appears as a salary payable for December so the balance for that month must be recorded by means of an adjusting entry. Salary expense Salary payable
$ 8,000 $ 8,000
(B) The above adjusting entries have been entered to the various accounts, where appropriate, to arrive at the following balances. Account
Debit
Accounts payable Accounts receivable Capital stock
Credit $33,400
$79,000 90,000
Cash
41,000
Cost of goods sold
180,000
Dividends paid
20,000
Insurance expense
3,800
Inventory
98,000
Land
320,000
Notes payable
130,000
Prepaid Insurance
3,600
Prepaid rent
4,000
Rent expense
6,000
Retained earnings, January 1, Year Four
200,000
Salary expense
96,000
Salary payable
8,000
Sales revenue
400,000
Utilities expense
12,000
Utilities payable
________
2,000
Totals
$863,400
$863,400
8) (A) – Adjusting entries [1] – The income tax expense for Year Three must be recorded immediately because of the matching principle even though payment will not be made until Year Four Income tax expense Income tax payable
$ 9,000 $ 9,000
[2] – The purchase of supplies for $8,000 was apparently recognized as supplies expense since an $8,000 balance is currently in that account on the trial balance. However, only $3,000 of those supplies remain at the end of the year. Therefore, the expense for the period is $5,000 ($8,000 less $3,000). The expense account is reduced by $3,000 (to arrive at $5,000) and the asset is recognized as $3,000. Supplies Supplies expense
$ 3,000 $ 3,000
[3] – During the year, insurance was paid for 23 months. During the year, 12 months of the insurance was consumed leaving an asset (prepaid insurance) for the subsequent 11 months. The payment on September 1 was $6,000 for 15 months or $400 per month. At the end of the year, the prepaid amount should be reported as $4,400 (11 months x $400 per month). According to the trial balance, the company has recorded the entire amount paid this year ($4,000 + $6,000 or $10,000) in insurance expense. Therefore, the prepaid part should be reclassified from expense to asset. Prepaid insurance Insurance expense
$ 4,400 $ 4,400
[4] – The journal entry to utilities expense should have be made to advertising expense. The recording error needs to be corrected. Advertising expense Utilities expense
$ 5,000 $ 5,000
[5] – During the year, rent was paid for 20 months. Of that amount, 12 months of rent was consumed leaving an asset (prepaid rent) for the subsequent 8 months. The payment on May 1 was $8,000 for 16 months or $500 per month. The prepaid amount remaining at the end of the year is $4,000 (8 months x $500 per month). According to the trial balance, the company has recorded the entire amount paid this year ($2,000 + $8,000 or $10,000) in prepaid rent. The prepayment should be lowered from $10,000 to $4,000 with the reduction recorded as expense. Rent expense Prepaid rent
$ 6,000 $ 6,000
[6] – Amount owed to employees at the end of the year must be recognized before financial statements are made. This amount has not yet been recorded because no salary payable is shown in the trial balance. Salary expense Salary payable
$10,000 $10,000
(B) Based on posting the effect of each of these adjusting entries, an updated trial balance can be created. Washburn Company Updated Trial Balance December 31, Year Three Account
Debit
Accounts payable
$27,000
Accounts receivable
$65,000
Advertising expense
5,000
Capital stock
120,,000
Cash
29,000
Cost of goods sold
232,000
Dividends paid
14,000
Income tax expense
9,000
Income tax payable Insurance expense
9,000 5,600
Inventory
132,000
Land
270,000
Notes payable
170,000
Prepaid insurance
4,400
Prepaid rent
4,000
Rent expense
6,000
Retained earnings, January 1, Year Three Salary expense
Credit
150,000 120,000
Salary payable
10,000
Sales revenue
450,000
Supplies
3,000
Supplies expense
5,000
Utilities expense
32,000
________
$936,000
$936,000
Totals
The above balances can then be used to produce financial statements for the Washburn Company
Washburn Company Income Statement Year Ended December 31, Year Three Revenues: Sales revenue Expenses: Cost of goods sold Rent expense Salary expense Utilities expense Advertising expense Supplies expense Insurance expense
$450,000
232,000 6,000 120,000 32,000 5,000 5,000 5,600
(405,600)
Operating income before income taxes
44,400
Income tax expense
(9,000)
Net income
$35,400
Washburn Company Statement of Retained Earnings Year Ended December 31, Year Three Retained earnings balance, January 1, Year Three Net income, Year Four Dividends paid
$150,000 $35,400 ( 14,000)
Retained earnings balance, December 31, Year Three
21,400 $171,400
Washburn Company Balance Sheet December 31, Year Three Assets Current assets Cash Accounts receivable Inventory Supplies Prepaid insurance Prepaid rent Total current assets
$29,000 65,000 132,000 3,000 4,400 4,000 $237,400
Noncurrent assets Land
270,000 $507,400
Total assets Liabilities and Stockholders’ Equity Liabilities Current Liabilities Accounts payable Salary payable Income tax payable Total current liabilities
$27,000 10,000 9,000 $ 46,000
Noncurrent Liabilities Notes payable Total liabilities
170,000 $216,000
Stockholders’ Equity Capital stock Retained earnings
$120,000 171,400
Total liabilities and stockholders’ equity
291,400 $507,400
9) Part A a) Cash Note Payable
$10,000 $10,000
b) Cash
$2,000 Capital Stock
$2,000
c) Equipment Cash
$3,000
Supplies Accounts Payable
$200
$3,000
d)
$200
e) No entry needed. There is no immediate financial change created by the hiring of an employee. f) No entry needed. The revenue has not yet been earned.
g) Accounts Receivable Revenue
$600
Accounts Receivable Revenue
$450
Cash
$600
$600
h)
$450
i)
Accounts Receivable
$600
j) Salaries expense Cash
$100
Cash
$500
$100
k)
Unearned Revenue
$500
l) Tax expense Cash
$200 $200
Part B Cash (a)10,000 3,000(c) (b) 2,000 100(j) (i) 600 200(l) (k) 500
Accounts Receivable (g)600 600(i) (h)450
$9,800 Accounts Payable 200(d)
$450
Retained Earnings 0
Sales Revenue 600(g) 450(h) $1,050
$3,000
Note Payable 10,000(a)
Capital Stock 2,000(b)
$10,000
$2,000
Salaries Expense (j)100
Tax Expense (l)200
$500
$0
Equipment (c)3,000
$200
Unearned Revenue 500 (k)
$200
Supplies (d)200
$100
$200
Part C Webworks Unadjusted Trial Balance June 30 Account Title Cash Accounts Receivable Supplies Equipment Accounts Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 6/1 Revenue Cost of Goods Sold Salaries Expense Tax Expense
Debits $ 9,800 450 200 3,000
Credits
100 200
_______
Totals
$13,750
$13,750
$
200 500 10,000 2,000 0 1,050
Part D m) Salaries Expense Salaries Payable
$100 $100
n) Utilities Expense $ 80 Accounts Payable $ 80 (could also be Utilities Payable) o) Supplies Expense Supplies Cash (a)10,000 3,000(c) (b) 2,000 100(j) (i) 600 200(l) (k) 500 $9,800
$100
Accounts Receivable (g)600 600(i) (h)450
$450
Accounts Payable 200(d) 80(n)
Salaries Payable 100(m)
$280 Capital Stock 2,000(b)
$100 Retained Earnings 0
$2,000 Tax Expense (l)200
$200
$100
$0 Utilities Expense (n) 80
$80
Supplies (d)200 100(o)
Equipment (c)3,000
$100
$3,000
Unearned Revenue 500 (k)
Note Payable 10,000(a)
$500 Sales Revenue 600(g) 450(h) $1,050 Supplies Expense (o)100
$100
$10,000 Salaries Expense (j)100 (m)100 $200
Part E Webworks Adjusted Trial Balance June 30 Account Title Cash Accounts Receivable Supplies Equipment Accounts Payable Salaries Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 6/1 Revenue Cost of Goods Sold Salaries Expense Tax Expense Utilities Expense Supplies Expense
Debits $ 9,800 450 100 3,000
Credits
200 200 80 100
______
Totals
$13,930
$13,930
$
10) Part A a) Prepaid Rent Cash
$2,000
Prepaid Insurance Cash
$2,400
Accounts Payable Cash
$ 900
$2,000
b)
$2,400
c)
$ 900
280 100 500 10,000 2,000 0 1,050
d) Salaries Payable Cash
$1,000
Supplies Accounts Payable
$2,400
Salaries Expense Cash
$1,000
Accounts Receivable Revenue
$8,000
Cash
$6,300
$1,000
e)
$2,400
f)
$1,000
g)
$8,000
h)
Accounts Receivable
$6,300
i) Tax Expense Cash
$750 $750
Part B
Cash 5,000 2,000(a) (h)6,300 2,400(b) 900(c) 1,000(d) 1,000(f) 750(i)
Accounts Receivable 6,500 6,300(h) (g)8,000
$3,250
$8,200
Prepaid Rent Prepaid Insurance Supplies 0 0 0 (a)2,000 (b)2,400 (e)2,400
$2,000
$2,400
$2,400
Accounts Payable (c)900 1,200 2,400(e)
Salaries Payable (d)1,000 1,000
$2,700 Retained Earnings 2,300
$0
Capital Stock 3,000
$4,000
$3,000
$0 Revenue 0 8,000(g)
$2,300 Rent Expense 0
Note Payable 4,000
Supplies Expense 0
$8,000
$0
Insurance Expense 0
Tax Expense 0 (i)750
$0
Salaries Expense 0 (f)1,000 $1,000
$750
Part C Haley’s Dry Cleaners Unadjusted Trial Balance December 31, Year Two Account Title Cash Accounts Receivable Prepaid Rent Prepaid Insurance Supplies Accounts Payable Note Payable Capital Stock Retained Earnings, 12/1 Revenue Salaries Expense Tax Expense
Debits $ 3,250 8,200 2,000 2,400 2,400
Credits
1,000 750
_______
Totals
$20,000
$20,000
$ 2,700 4,000 3,000 2,300 8,000
Part D
j) Rent Expense Prepaid Rent
$1,000
Insurance Expense Prepaid Insurance
$400
Salaries Expense Salaries Payable
$1,000
Supplies Expense Supplies
$2,000
$1,000
k):
$400
l)
$1,000
m)
$2,000
Cash Accounts Receivable Prepaid Rent Prepaid Insurance Supplies 5,000 2,000(a) 6,500 6,300(h) 0 1,000(j) 400(k) 2,000(m) (h)6,300 2,400(b) (g)8,000 (a)2,000 (b)2,400 e)2,400 900(c) 1,000(d) 1,000(f) 750(i) $3,250 $8,200 $1,000 $2,000 $400 Accounts Payable (c)900 1,200 2,400(e) $2,700 Retained Earnings 2,300
$2,300
Salaries Payable (d)1,000 1,000 1,000(l) $1,000 Revenue 0 8,000(g)
$8,000
Note Payable 4,000
Capital Stock 3,000
$4,000
$3,000
Supplies Expense 0 (m)2,000
$2,000
Salaries Expense 0 (f)1,000 (l)1,000 $2,000
Rent Expense 0 (j)1,000 $1,000
Insurance Expense 0 (k)400 $400
Tax Expense 0 (i)750 $750
Part E Haley’s Dry Cleaners Adjusted Trial Balance December 31, Year Two Account Title Cash Accounts Receivable Prepaid Rent Prepaid Insurance Supplies Accounts Payable Salaries Payable Note Payable Capital Stock Retained Earnings, 12/1 Revenue Supplies Expense Salaries Expense Rent Expense Insurance Expense Tax Expense
Debits $ 3,250 8,200 1,000 2,000 400
Credits
2,000 2,000 1,000 400 750
_______
Totals
$21,000
$21,000
$ 2,700 1,000 4,000 3,000 2,300 8,000
Part F Haley’s Dry Cleaners Income Statement As of December 31, Year Two Revenue Expenses: Supplies Salaries Rent Insurance Income before taxes Taxes Net income
$8,000 $2,000 2,000 1,000 400
5,400 2,600 750 $1,850
Haley’s Dry Cleaners Stmt. of Retained Earnings As of December 31, Year Two Retained Earnings, December 1 Net Income Retained Earnings, December 31
$2,300 1,850 $4,150
Haley’s Dry Cleaners Balance Sheet December 31, Year Two Assets:
Liabilities:
Current: Cash Accounts Receivable Prepaid Rent Prepaid Insurance Supplies Total Current Assets
Current: Accounts Payable Salaries Payable Total Current Liabilities
Total Assets
$ 3,250 8,200 1,000 2,000 400 $14,850
$14,850
$2,700 1,000 $3,700
Noncurrent: Notes Payable Total Liabilities
$4,000
Stockholders’ Equity: Capital Stock Retained Earnings Total Stockholders’ Equity
$3,000 4,150
$7,700
7,150
Total Liabilities and Stockholders’ Equity $14,850
11) Part I A) (1) Cash
$ 500 Capital Stock
$ 500
(2) Cash
$1,000 Note Payable
$1,000
(3) Equipment Cash
$1,300
Inventory Accounts Payable
$ 150
Advertising Expense Cash
$ 20
Cash Accounts Receivable Revenue
$ 240 80
Cost of Goods Sold Inventory
$ 120
$1,300
(4)
$ 150
(5)
$ 20
(6)
$ 320
$ 120
(7) Accounts Payable Cash
$ 100
Cash
$ 40
$ 100
(8)
Unearned Revenue
$ 40
(9) Tax Expense Taxes Payable
$ 40 $ 40
B) Cash (1)500 1,300(3) (2)1,000 20(5) (6)240 100(7) (8)40 $360
Accounts Receivable (6)80
Inventory (4)150 120(6)
$80
Accounts Payable (7)100 150(4)
$30 Taxes Payable 40(9)
$50
Unearned Revenue 40(8)
$40
Capital Stock 500(1)
$1,000
$320
$1,300
$40
Note Payable 1,000(2)
Revenue 320(6)
Equipment (3)1,300
Retained Earnings 0
$500 Cost of Goods Sold (6)120
$120
$0 Advertising Expense (5)20
$20
Tax Expense (9)40
$40
C) KCDK Unadjusted Trial Balance January 31, Year One Account Title Cash Accounts Receivable Inventory Equipment Accounts Payable Taxes Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 1/1 Revenue Cost of Goods Sold Advertising Expense Tax Expense
Debits $ 360 80 30 1,300
Credits
120 20 40
.______
Totals
$1,950
$1,950
Inventory (4)150 120(6)
Equipment (3)1,300
$
50 40 40 1,000 500 0 320
D) 10) Salaries Expense Salaries Payable
$50
Interest Expense Interest Payable
$10
$50
11)
Cash (1)500 1,300(3) (2)1,000 20(5) (6)240 100(7) (8)40 $360
Accounts Receivable (6)80
$80
$10
$30
$1,300
Accounts Payable (7)100 150(4)
Interest Payable 10(11)
$50 Salaries Payable 50(10)
$10
$40
Note Payable 1,000(2)
Capital Stock 500(1)
$50 Revenue 320(6)
$320
Taxes Payable 40(9)
$1,000
$120
$50
$40 Retained Earnings 0
$500
Cost of Goods Sold (6)120
Salaries Expense (10)50
Unearned Revenue 40(8)
$0
Advertising Expense (5)20
Tax Expense (9)40
$20
$40
Interest Expense (11)10
$10
E) KCDK Adjusted Trial Balance January 31, Year One
Account Title Cash Accounts Receivable Inventory Equipment Accounts Payable Interest Payable Taxes Payable Unearned Revenue Salaries Payable Note Payable Capital Stock Retained Earnings, 1/1 Revenue
Debits $ 360 80 30 1,300
Credits
$
50 10 40 40 50 1,000 500 0 320
Cost of Goods Sold Advertising Expense Tax Expense Salaries Expense Interest Expense Totals
120 20 40 50 10
______
$2,010
$2,010
F) KCDK Income Statement For Month Ended January 31, Year One Revenue $320 Cost of Goods Sold (120) Gross Profit 200 Other Expenses Salary $50 Advertising 20 Interest 10 (80) Earnings before tax 120 Tax Expense (40) Net Income $ 80 KCDK Statement of Retained Earnings For Month Ended January 31. Year One Retained Earnings, January 1 Net Income Retained Earnings, January 31
$ 0 80 $80
KCDK Balance Sheet January 31, Year One Assets:
Liabilities:
Current: Cash Accounts Receivable Inventory Total Current Assets
Noncurrent: Equipment
$ 360 80 30 $ 470
$1,300
Total Assets
$1,770
Current: Accounts Payable Taxes Payable Unearned Revenue Salaries Payable Interest Payable Total Current Liabilities
$1,000
Stockholders’ Equity: Capital Stock Retained Earnings Total Stockholders’ Equity
$ 500 80 $ 580
Total Liabilities and Stockholders’ Equity
$1,770
Closing Entries – Reducing Revenue to Zero $320
Retained earnings
$320
Closing Entries – Reducing Expenses to Zero Retained earnings
$
50 40 40 50 10 190
Noncurrent: Notes Payable
G)
Revenue
$
$240
Cost of goods sold
$120
Advertising expense
20
Salaries expense
50
Interest expense
10
Tax expense
40
Part II A) 12) Prepaid Advertising Cash
$20
Cash
$80
$20
13)
Accounts Receivable
$80
14) Accounts Payable Salaries Payable Taxes Payable Interest Payable Cash
$50 $50 $40 $10
Inventory Accounts Payable
$135
Cash Accounts Receivable Revenue
$360 40
Cost of Goods Sold Inventory
$150
Unearned Revenue Revenue
$40
Cost of Goods Sold Inventory
$15
$150
15)
$135
16)
$400
$150
17)
$40
$15
18) Tax Expense Taxes Payable
$80 $80
B) Cash Accounts Receivable Inventory Prepaid Advertising 360 20(12) 80 80(13) 30 150(16) 0 (13)80 150(14) (16)40 (15)135 15(17) (12)20 (16)360 $630
$40
Accounts Payable (14)50 50 135(15)
$0
Interest Payable 10 (14)10
$135
$20
Taxes Payable (14)40 40 80(18)
$0
Salaries Payable (14)50 50
Note Payable 1,000
Capital Stock 500
Retained Earnings 80
$1,000
$500 Advertising Expense
$165 Salaries Expense
$0
Unearned Revenue (17)40 40
$0
Cost of Goods Sold (16)150 (17) 15
$440
$1,300
$80
$0 Revenue 400(16) 40(17)
Equipment 1,300
$0
$80 Tax Expense (18)80
$80
Interest Expense
$0
C) – Unadjusted trial balance at end of February. Revenue and expense accounts from January have been closed to retained earnings.
KCDK Unadjusted Trial Balance February 28, Year One Account Title Cash Accounts Receivable Inventory Prepaid Advertising Equipment Accounts Payable Interest Payable Taxes Payable Unearned Revenue Salaries Payable Note Payable Capital Stock Retained Earnings, 1/1 Revenue Cost of Goods Sold Advertising Expense Tax Expense Salaries Expense Interest Expense
Debits $630 40 0 20 1,300
Credits
165 0 80 0 0
______
Totals
$2,235
$2,235
$ 135 0 80 0 0 1,000 500 80 440
D) 19) Salaries Expense Salaries Payable
$50
Advertising Expense Prepaid Advertising
$10
Interest Expense Interest Payable
$10
$50
20)
$10
21)
$10
E Cash Accounts Receivable Inventory Prepaid Advertising 360 20(12) 80 80(13) 30 150(16) 0 10(20) (13)80 150(14) (16)40 (15)135 15(17) (12)20 (16)360 $630
$40
$0
$10
$1,300
Accounts Payable (14)50 50 135(15)
Interest Payable 10 (14)10 10(21)
$135
$10
$80
$0
Note Payable 1,000
Capital Stock 500
Retained Earnings 80
$1,000
$500
Salaries Payable (14)50 50 50(19) $50 Revenue 400(16) 40(17)
Taxes Payable (14)40 40 80(18)
Equipment 1,300
Cost of Goods Sold (16)150 (17) 15
$440
Advertising Expense (20)10
$165 Salaries Expense (19)50 $50
Unearned Revenue (17)40 40
$10 Interest Expense (21)10 $10
$80 Tax Expense (18)80
$80
E) KCDK Adjusted Trial Balance February 28 Account Title Cash Accounts Receivable Inventory Prepaid Advertising Equipment Accounts Payable Interest Payable Taxes Payable Unearned Revenue Salaries Payable Note Payable Capital Stock Retained Earnings, 1/1 Revenue Cost of Goods Sold Advertising Expense Tax Expense Salaries Expense Interest Expense
Debits $ 630 40 0 10 1,300
Credits
165 10 80 50 10
______
Totals
$2,295
$2,295
$ 135 10 80 0 50 1,000 500 80 440
F) KCDK Income Statement For the Month Ended February 28, Year One Revenue $440 Cost of Goods Sold (165) Gross Profit 275 Other Expenses Salary $50 Advertising 10 Interest 10 (70) Earnings before tax 205 Tax Expense (80) Net Income $125
KCDK Stmt. of Retained Earnings For the Month Ended February 28, Year One Retained Earnings, February 1 Net Income, February Retained Earnings, February 28
$ 80 125 $205
KCDK Balance Sheet February 28, Year One Assets:
Liabilities:
Current: Cash Accounts Receivable Prepaid Advertising Total Current Assets
$ 630 40 10 $ 680
Current: Accounts Payable Taxes Payable Salaries Payable Interest Payable Total Current Liabilities
Noncurrent: Equipment
$1,300
Total Assets
$1,980
Noncurrent: Notes Payable
$135 80 50 10 $275
$1,000
Owners’ Equity: Capital Stock $ 500 Retained Earnings 205 Total Stockholders’ Equity $ 705 Total Liabilities and Stockholders’ Equity $1,980
Answers to Research Assignment The balance sheet for Johnson & Johnson as of January 2, 2011 reported an asset titled “prepaid expenses and other receivables” with a total balance of $2,273 million. However, that figure apparently did not include any advertising. In the notes to the financial statements as indicated in the question, Johnson & Johnson reported that “costs associated with advertising are expensed in the year incurred and are included in the selling, marketing and administrative expenses.” Therefore, if Johnson & Johnson had incurred any advertising costs late in 2010, that amount would have been reported as an expense even if benefits might have been anticipated during 2011. This handling reflects the conservative nature of financial accounting.
Chapter 6 Solutions Answer to Questions 1) Most people and organizations will not be willing to entrust their money to a company without having a reasonable idea of the financial standing of that company. Decision makers want financial statements and other information that they can trust to use as they estimate future stock prices, dividends, and cash flows. In simple terms, investors and creditors must have faith in the available financial information or they will not risk their money. 2) The Securities and Exchange Commission is an independent agency within the federal government that regulates capital markets. The SEC is charged with protecting investors and creditors by ensuring that adequate and fair information is available so that wise financial decisions can be made. 3) Companies, both domestic and foreign, that issue publicly-traded securities within the U.S. come under the SEC’s jurisdiction. Securities are both ownership (capital or equity) shares and debt instruments such as bonds. 4) The SEC has opted to assign the responsibility for creating U.S. GAAP to the Financial Accounting Standards Board (FASB). Apparently, the SEC believes that a better analysis and development of accounting standards can come about through the research and consideration that this private group performs. 5) The Accounting Standards Codification is the accumulation of all U.S. GAAP by FASB into a single database that is logically organized to allow for easier access. Hundreds of different authoritative pronouncements were brought together into this one official source. 6) A Form 10-K is an annual document required by the SEC of most publicly-traded companies. It contains a full set of financial statements and notes as well as a considerable amount of other required information. The Form 10-Q serves a somewhat similar purpose except that it must be filed every quarter during the year. 7) EDGAR is the electronic database maintained by the SEC that allows interested parties to access the various filings that a particular company has made with the SEC during the current or recent years. 8) The EITF is a group created by the FASB to examine new accounting issues. The members of the EITF hope to come to a consensus as to how a particular problem under question should be reported based on the application of U.S. GAAP. The EITF does not actually set standards but gives guidance on applying U. S. GAAP to new situations. In many cases, if the EITF is able to achieve consensus, FASB does not have to step in and study the problem and create new rules. 9) The SEC receives a huge quantity of financial statements and other information. The cost of examining each of those statements is simply too expensive. Instead, the SEC
allows each company to hire an independent expert (a CPA) to perform the audit and report the results. An examination is required to be performed on every set of financial statements but it is not carried out by the SEC. 10) A public company must hire an auditing firm to: 1) perform an audit of its financial statements and 2) report on whether those statements are presented fairly according to U.S. GAAP. Such an examination and report are required by the SEC to ensure that the information available to decision makers contains no material misstatements. 11) Nonpublic companies are not under the jurisdiction of the SEC. Therefore, they are not legally required to have their financial statements audited. However, they might still choose to have an audit to enhance the credibility of the information with potential investors or creditors. A bank, for example, could require audited statements or one of the owners might feel that an audit was a good internal control strategy. 12) A CPA is a Certified Public Accountant, an individual licensed by a specific state to perform audits. Each state has established its own requirements for becoming a CPA. In general, a person must have an appropriate amount of college education (usually including specific courses in accounting, tax, auditing, and the like) as well as some amount of practical experience. The person must also pass all four parts of the Uniform CPA Examination (Financial Accounting and Reporting, Auditing and Attestation, Regulation, and Business Environment and Concepts). 13) Since its formation, the Public Company Accounting Oversight Board (PCAOB) has held the legal authority to set standards for and regulate firms who audit companies with publicly traded securities. The PCAOB was created by the U.S. Congress to operate under the oversight and enforcement authority of the SEC. 14) The PCAOB was created as one of the many parts of the Sarbanes-Oxley Act of 2002. This legislation came about as a result of several massive accounting scandals that occurred in the 1990s and early in the 2000s. The U.S. Congress felt that the auditing profession needed more oversight. 15) The PCAOB only sets standards for companies that have securities (stocks or bonds) that are publicly traded. Thousands of smaller companies do not meet this criterion. Auditing rules for these engagements must come from a different source. The Auditing Standards Board, a technical committee of the AICPA, establishes auditing standards for CPA firms that examine the financial statements of these nonpublic companies. 16) A company must pay an independent CPA to perform an audit examination. However, the work is carried out for the benefit of outside investors, creditors, and others who need financial information (and need to trust that financial information) for decisionmaking purposes. 17) For a number of reasons, the auditor is unable to provide perfect or absolute assurance. Risk can simply not be eliminated entirely. Therefore, the auditor is said to provide
reasonable assurance that the financial statements are presented fairly because they contain no material misstatements according to U.S. GAAP. 18) Auditors cannot provide absolute assurance because they only investigate a sample of a company’s transactions. Thus, the chance that a material misstatement might be missed is always present. Even if the auditor examined every transaction, it is possible that management could be engaged in fraudulent activities that are so well hidden that they could not be found by the auditor. Finally, many numbers on any set of financial statements are estimations and cannot be determined with absolute certainty. 19) Internal controls are all of the extra rules and procedures within each operating system designed to ensure that the system works as intended by management. In this way, the system is created so that errors, theft, and other misstatements will either be prevented in advance or detected after occurring. 20) If a company’s internal control is well designed and also operating effectively, the chance of a material misstatement existing within the financial statements is reduced. Because of that reduction in risk, the independent auditor can rely on performing fewer tests to be able to provide reasonable assurance that the statements are presented fairly according to U.S. GAAP. Risk of a problem is less so that a smaller amount of evidence is needed. 21) An unqualified opinion indicates that the auditor has obtained sufficient evidence to substantiate that the financial statements contain no material misstatements according to U.S. GAAP and, therefore, are presented fairly. 22) An additional paragraph located between the scope (2nd) and opinion (3rd) paragraphs is included to draw a reader’s attention to a particular problem. Based on the location of that paragraph, the reader knows that the problem was of such a nature or size that the auditor was unable to issue an unqualified opinion. The auditor’s opinion is being qualified because of either a lack of evidence or the discovery of a material misstatement. 23) There are two possible reasons for an auditor to give a qualified opinion. First, the auditor may not have been able to gather sufficient evidence to determine if the statements are fairly presented. In some situations, obtaining enough evidence is simply impossible. Second, the auditor may believe a material misstatement exists. Obviously, an unqualified opinion cannot be rendered if the statements contain a material misstatement.
Answers to True or False Questions __F__ 1) Good internal controls will lower the risk of a material misstatement. With less risk, the amount of testing performed on the financial statements by the auditor can be reduced. __F__ 2) The federal government does not set rules for becoming a CPA. That is done by each individual state. Therefore, the rules for becoming a CPA in the state of Georgia might be different than the rules for becoming a CPA in the state of Wyoming. __F__ 3) Practical work experience is one of the requirements for becoming a CPA. However, that is not the only requirement. The person must also meet specified educational requirements and pass the Uniform CPA Exam. __F__ 4) The SEC has legal authority over all financial reporting for companies that issue publicly-traded securities within the U.S. Responsibility for establishing U.S. GAAP has been given to the FASB, a private organization. Apparently, the SEC believes that better standards can be developed through the careful research and deliberation offered by FASB. __F__ 5) An added paragraph inserted in an audit report after the scope paragraph indicates that the auditor (a) was unable to gain sufficient evidence to provide an unqualified opinion or (b) discovered the presence of a material misstatement according to U.S. GAAP. It does not necessarily indicate a material misstatement. __T__ 6) The U.S. Congress created the PCAOB (through the Sarbanes-Oxley Act of 2002) to oversee the auditors of companies that issue publicly-traded securities such as capital stock shares and bonds. __F__ 7) Nonpublic companies do not have the same legal requirements for an audit as those companies that fall under the jurisdiction of the SEC. However, they often do pay for an independent audit because it will increase the credibility of their statements and potential (or current) investors or creditors may insist.
__F__ 8) The Auditing Standards Board (ASB) is a technical committee of the AICPA that sets standards for the audits of companies that do not issue securities that are publiclytraded. It is only involved in auditing issues. FASB is in charge of determining proper financial reporting. They are unrelated. __T__ 9) The Emerging Issues Task Force (EITF) examines new transactions or issues that arise and tries to come to a consensus as to how U.S. GAAP should be applied. The EITF gives guidance on application of U.S. GAAP but does not actually create U.S. GAAP. __T__ 10) EDGAR (Electronic Data Gathering and Retrieval) is the system used by the SEC to make available to the public the information filed by the companies under its jurisdiction. Any decision maker that wants to analyze one of these businesses should be able to find a wealth of information in the EDGAR files. __F__11) The Accounting Standards Codification was created by FASB as a source of all U.S. GAAP. Authoritative pronouncements from several decades were gathered and organized so that access would be easier for anyone who needs to determine U.S. GAAP for a particular transaction or other event. __F__ 12) An independent audit is provided for the benefit of decisions makers such as investors and creditors. However, payment for this service comes from the reporting company that prepares the financial statements under audit. Such an arrangement has often been questioned because it seems to hinder the auditor’s independence. __F__ 13) CPA firms often have hundreds and even thousands of auditors. Many of the companies being examined are massive and could only be audited by a large number of CPAs. Four of the firms are known as the “Big Four” because they employee tens of thousands of CPAs and other experts around the world. __F__ 14) Financial information is almost never viewed as being correct because that degree of accuracy is virtually impossible to obtain and not really necessary for decision-making.
The term “presents fairly” indicates that the auditor believes the information contains no material misstatements in conformity with U. S. GAAP. __F__ 15) FASB is a private organization. The SEC has allowed FASB to create U.S. GAAP but FASB remains an independent body that is not part of the government.
Answers to Multiple Choice Questions
1) Answer is B Auditing firms work for the benefit of outside decision makers. However, in the U.S., the hiring, firing, and payment for that service rests with the reporting company. FASB produces U.S. GAAP and does not regulate companies or auditors. The ASB only produces auditing standards for firms that are not auditing companies that issue publiclytraded securities. Auditors examine financial statements; they do not prepare financial statements for their clients. 2)
Answer is D The auditor’s opinion is provided in the opinion (usually third) paragraph of the audit report. An extra paragraph after the scope paragraph indicates that the auditor has not issued an unqualified opinion. An unqualified opinion cannot be given if the financial statements contain a material misstatement. The audit report is normally addressed to the stockholders and/or to the board of directors. Only D is not true.
3)
Answer is C FASB produces U.S. GAAP which provides the rules for financial reporting in the U.S. Because IFRS has become popular, FASB’s pronouncements are not followed in many places outside of the U.S. FASB was created in 1973 but was not created by either the EITF or the SEC.
4)
Answer is A The EITF, FASB, and ASB are private organizations or exist within private organizations. In the list provided, only the SEC is a government agency.
5) Answer is C The SEC is the federal agency that works to ensure that capital markets operate efficiently. One of the ways this mission is accomplished is by making sure that investors, creditors, and other decision makers have adequate and fair information about each company that issues publicly-traded securities. The SEC has assigned the
authority for the creation of U.S. GAAP to FASB. However, the SEC has retained the ability to enforce all of its rules and regulations. It is a U.S. agency and only has authority within the U.S. 6)
Answer is A The PCAOB only regulates and sets standards for CPA firms that audit companies that issue securities (shares or debt instruments) that are publicly-traded. It was created in 2002 and does not have jurisdiction over companies that do not issue publicly-traded securities.
7)
Answer is B The first paragraph of the audit report should always state that the company is responsible for the financial statements whereas the auditor is responsible for providing an opinion about those financial statements. Because no information was provided about whether this particular company issues publicly-traded securities, it is impossible to determine whether either the ASB or the FASB are applicable. Finally, if a problem arises that prevents an unqualified opinion from being rendered, an extra paragraph is inserted after the scope paragraph and not before.
8)
Answer is C Absolute assurance is not possible when estimations are involved or when management has the ability to hide fraud from the auditors. In addition, many companies have so many transactions (millions) that no auditing firm can look at every single transaction. Thus, although reasonable assurance is possible, absolute assurance is not. However, U.S.GAAP has been created in one form or another for many decades. The process became more organized in the 1960s and especially in 1973 when FASB was formed.
9)
Answer is B The requirements to become a CPA are set by state law. They involve some degree of education and experience. In addition, each state requires the candidate to pass all four parts of the CPA Exam. No state requires that the work experience must be specifically with one of the Big Four international auditing firms.
Answer to Problems 1) ___b.__ FASB
b. Sets U.S. generally accepted accounting principles
___a.__ PCAOB
a. Sets auditing standards for auditors of publicly traded companies
___e.__ SEC
e. Created by the Securities Exchange Act of 1934 to protect investors
___c.__ EITF
c. Helps apply U.S. generally accepted accounting principles to new situations
___d.__ ASB
d. Sets auditing standards for auditors of private companies
2) Introductory paragraph --Identifies specific financial statements that were audited. --Indicates that the company’s management was responsible for the financial statements. --Indicates that the independent auditor is responsible for providing an opinion based on audit. Scope paragraph --Audit is conducted according to rules of PCAOB (or ASB if applicable). --Audit is designed to obtain reasonable assurance as to whether statements are free of material misstatement. --Auditor examines, on a test basis, evidence to support amounts and disclosures. --Auditor assesses accounting principles in use and significant estimations. --Auditor evaluates overall statement presentation. --Auditor believes audit is a reasonable basis for opinion. Opinion paragraph --Provides opinion that financial statements are presented fairly, in all material respects, in conformity with U.S. GAAP (or IFRS, if applicable). 3) The PCAOB (Public Company Accounting Oversight Board) was created by the U.S. Congress as part of the Sarbanes-Oxley Act of 2002 to both regulate and set standards for auditors that examine the financial statements of companies that issue publicly-traded securities. The PCAOB has a wide range of powers because it was created under the oversight and enforcement authority of the SEC. The ASB (Auditing Standards Board) is a technical committee of the AICPA (American Institute of Certified Public Accountants). It was created by the Accounting profession (rather than by the government) to provide standards for audits that are performed on private companies that do not issue publicly-traded securities. Its role is limited to the production of generally accepted auditing standards when the PCAOB does not have authority.
4) Since 1973, FASB (Financial Accounting Standards Board) has held the primary authority to produce U.S. GAAP. FASB is constantly looking for areas that need additional or new rules because of problems that are found (or begin to appear) in the financial reporting process. The members study these issues in depth, often for years, before arriving at approved resolutions. The EITF (Emerging Issues Task Force) was created in 1984 to solve reporting issues that arose about the implementation of U.S. GAAP. The members of the EITF look at new issues and try to arrive at a consensus (no more than three members disagreeing) as to the method by which U. S. GAAP should be applied. The FASB Web site explains the role of the EITF as follows: “The EITF was designed to promulgate implementation guidance within the framework of the Accounting Standards Codification to reduce diversity in practice on a timely basis.” 5) FASB – an independent board that has the authority to establish U.S. GAAP. The group and its staff analyze financial reporting concerns and develop standards for U.S. GAAP through changes made in its Accounting Standards Codification. Big Four – the term that is applied to the four largest independent public accounting firms. These four perform the audits of most of the largest companies in the world. They have offices in scores of countries and employ tens of thousands of accountants and other experts. The Big Four hold considerable influence in the accounting world simply by their dominant size. Unqualified audit opinion – the report of an independent auditor that provides reasonable assurance that an identified set of financial statements is presented fairly because the auditor believes there are no material misstatements in conformity with U.S. GAAP. The unqualified audit opinion adds credibility to financial statements so that investors and creditors are willing to rely on the information in making financial decisions. EDGAR – the Electronic Data Gathering and Retrieval system operated by the SEC. EDGAR allows companies to file information electronically with the SEC so that it can be easily accessed by any party seeking to know more about that company. Internal control – all of the rules and procedures added to any one of the operating systems of a company to help ensure that all actions are performed as intended by management. The term “internal control” encompasses all actions that are included in a system purely to make certain that the system functions properly. If all systems operate efficiently, assets will be safeguarded and appropriate documentation will be prepared as needed.
Answers to Research Assignments 1. The specific list created by each student will depend on which link is followed. However, below is a site map for the four links that were listed to provide an idea of the types of information that the student might be able to find. The Profession --Why Be a CPA? --Salary & Demand --Industries & Specializations --CPA Profiles --Find Yourself Education --Choosing (Well) --Applying (Yourself) --Studying (Up) --College Search --Scholarship Search --Scholarship Recipient Profiles Career Tools --Jobs & Internships --Resume & Interviewing --Networking & Organizations --Interview Simulation Exam & Licensure --Prepare for the Exam --Get Licensed --Exam Prep Course Reviews --State Requirements
--Exam & Licensure Timeline --Exam Diary
2. By following the steps listed in this question, the student should be able to find that PepsiCo held inventory of $2,618 million at the end of 2009 and $3,372 million at the end of the 2010. That is an increase of $754 million or 28.8 percent in just one year. That is a fairly significant jump in inventory levels which is what the boss might be investigating at the moment.
Chapter 7 Solutions Answers to Questions 1) Accounts receivable are amounts owed to a company by its customers usually resulting from the sale of inventory or services on credit. They are assets of the company because they have probable future economic benefit. The receivable balance is reported on the balance sheet at its estimated net realizable value, the amount of cash that is expected to be collected. 2) The net realizable value of accounts receivable is determined by subtracting the amount of accounts receivable the company believes it will not collect from the total of all accounts receivable. This estimation is derived by studying numerous factors such as the past history of collections and current economic conditions. 3) To estimate the amount of uncollectible accounts, a company might consider its history of collections, the effectiveness of its credit policy, current economic conditions, trends in its industry, amounts reported by similar companies, the current percentage of its accounts that are overdue, and the efficiency of its collection policies. 4) The Allowance for Doubtful Accounts represents the amount of accounts receivable held at the present moment that a reporting company believes will not be collected. It is a contra asset account used to reduce reported receivables from the current total to an expected net realizable value. 5) A contra account is one that always appears with another account to lower the value reported for that account. In Chapter 7, the allowance for doubtful accounts reduces the amount reported for accounts receivable to net realizable value. 6) Bad debt expense should be recorded in the period that allows it to be matched with the revenue generated from these sales. Because the exact amount will not be known at that time, bad debts are initially reported based on an estimate. 7) Companies do not know which of their receivables will prove to be uncollectible when preparing information for reporting purposes. Plus, the allowance amount is no more than an estimate. There is simply too much uncertainty to reduce the accounts receivable T-account balance directly. By setting up a separate contra account, the actual receivables can be kept separate from the estimation of the uncollectible amounts but the net realizable value can still be reported by netting the two. 8) To write off an account, a company debits the Allowance for Doubtful Accounts and credits Accounts Receivable. In both cases, the balance is being reduced. The company has less receivables and the amount estimated as uncollectible has also been decreased. 9) The write off of an account receivable does not change the amount shown as the net realizable value. Removing an account does not alter the estimation of the amount of
cash that will be collected. The receivable balance is reduced by $12,000 as is the allowance account. The net of the two remaining figures has not changed. 10) Writing off a specific account as uncollectible has no direct impact on reported net income. Bad debt expense is determined whenever financial statements are to be produced. Subsequently, whenever an account is actually determined to be uncollectible, the amount is removed from the allowance account rather than recognize the expense for a second time. In this way, the expense is matched with the revenue with which it is associated. 11) When the account was originally written off, accounts receivable was credited and the allowance for doubtful accounts was debited. Later, when actually collected, this entry is reversed to put the account back on the financial records. After being reinserted into accounts receivable, cash can be debited and accounts receivable credited. That, of course, is the normal entry to record any cash collected from a receivable. For convenience, these two entries can be combined into a single entry by debiting cash and crediting the allowance for doubtful accounts. 12) Accountants do not restate previously reported estimations when actual numbers turn out to be different (as long as the estimation is viewed as reasonable). There are a number of reasons for this handling. (1) Estimations are a normal part of the reporting process and investors and creditors should factor the uncertainty into their decision making. (2) Those decisions have already been made based on the previously reported information and cannot be undone by any revision of the estimates. (3) The number of estimations is significant so that updating them would take considerable time and effort and would go on for years if not decades. (4) If the original estimations were unbiased, the effect of all overstatements of net income should offset the effect of all understatements of net income with no net result (or not a material result). 13) The most common methods of estimating the amount of bad accounts are: • •
The percentage of sales method - estimates bad debt expense as a percentage of sales that will never be collected. The percentage of receivables method - estimates the allowance for doubtful accounts as a percentage of the gross accounts receivable balance.
14) The allowance for doubtful accounts begins each new year with an estimation of bad accounts. During the year, actual accounts are written off as uncollectible and, possibly, previously written off accounts might be collected. Therefore, unless the amount of uncollectible balances turns out to be exactly as estimated, a residual amount will be left in the allowance at the end of each fiscal year. 15) At the end of each year, the allowance account will hold a balance which indicates that previous estimations were too low (a debit balance) or too high (a credit balance). Therefore, bad debt expense has a zero balance but the allowance does not. When the current year estimate is made, bad debt expense is debited and the allowance for
doubtful accounts is credited. Since they held different amounts before this adjusting entry, they will report different figures after it is posted. 16) The subsidiary ledger allows the company to monitor individual accounts receivable. In that way, the general ledger T-account shows the total of all accounts receivable while the subsidiary ledger shows the balance owed by each separate customer. 17) The exchange rates between currencies are in constant fluctuation. Therefore, if a company has a balance denominated in a currency other than its functional currency, the question arises as to which exchange rate should be used for reporting purposes. If inventory is bought on Monday when one exchange rate existed, what should be reported on Friday if a different exchange rate exists? 18) Monetary assets and liabilities are amounts that are held by an organization as either cash or balances that will provide receipts or payments of a specified amount of cash in the future. In this textbook, monetary assets and liabilities are identified as cash, receivables, and payables. 19) All monetary assets and liabilities (cash as well as receivables and payables to be collected or paid in cash) are reported at the current exchange rate. All other accounts are reported at the historical exchange rate in effect as of the date of the original transaction. 20) The current ratio is a company’s current assets divided by its current liabilities. Working capital is the total of current assets less all current liabilities. Both figures provide a measure of liquidity, a company’s ability to pay its debts as they come due and still have funds available for operating purposes. 21) The average age of accounts receivable is the accounts receivable balance (either the current figure or the average for the period) divided by sales per day. Sales per day is total sales (or credit sales, if known) divided by 365. 22) Receivables turnover is the sales for a specified period generated by a company divided by its average receivables balance for the same period. It is a measure of the speed by which a company collects the accounts receivable resulting from sales. 23) Any slowdown in the collection of accounts receivable should be studied carefully by officials because the company is taking longer to get cash to put back into operations. Thus, lengthening of the collection period will have an adverse effect on profitability. In addition, as accounts get older, the chance of them becoming uncollectible increase creating another adverse effect on net income. Company officials can attempt to shorten the collection period in many ways such as offering a discount for quick payment or charging interest when an account goes beyond a certain age. The company can also work to have the credit, billing, and collection processes become more efficient. All of those techniques can shorten the period of collection.
Answers to True or False Questions __T__ 1) Because the total amount of accounts receivable is a fact but the amount to be collected is merely a guess, companies maintain one general ledger balance for the accounts receivable and a separate general ledger balance for the allowance for doubtful accounts. Thus, both can be monitored and then netted to arrive at the net realizable value to be reported. __F__ 2) Bad debt expense appears as an expense in the income statement and not as a reduction to accounts receivable (that is the allowance for doubtful accounts). __T__ 3) Where possible, all expenses are recognized in the same period as the revenue that they help to generate in conformity with the matching principle __T__ 4) Because bad debt expense is an estimated figure, companies typically wait until they prepare their financial statements to make the adjusting entry. The amount should be a better estimate if the company waits as long as possible. Thus, prior to the adjustment, the bad debt expense T-account will reflect a zero balance. __F__ 5) The allowance for doubtful accounts starts each year with a credit balance representing the estimated amount of uncollectible receivables. Whenever an account is deemed to be worthless, the amount is removed from the allowance for doubtful accounts. Therefore, if a credit balance remains at year end, the original estimation was larger than the number of accounts written off. The estimation was too high. __F__ 6) Normally, a company can make an estimate by any method that is logical. Unless a compelling reason exists, the same method of estimation must be used each year to promote consistency and comparability. __T__ 7) Because the actual amount of uncollectible accounts will almost always differ from the actual figure, the allowance for doubtful accounts is left with a residual balance at the end of each period. In contrast, bad debt expense has no balance until time of
financial reporting. When bad accounts are estimated and entered through an adjusting entry, the resulting allowance account will differ from bad debt expense because of the balance found in the allowance for doubtful accounts prior to that entry. __F__ 8) Bad debt expense will be reported as $18,000 ($600,000 times 3 percent). Adding that amount to the allowance for doubtful accounts will change the account from a $1,000 debit balance to a $17,000 credit balance. __T__ 9) Bad debt expense will be reported as $18,000 ($600,000 times 3 percent). When the percentage of sales method is used, the balance in the allowance for doubtful accounts has no impact on expense recognition. __T__ 10) The company estimates that 6 percent of its receivables will prove uncollectible or $6,000 ($100,000 times 6 percent). Because the allowance already has a $1,000 debit balance, a $7,000 expense figure must be recognized to turn this $1,000 debit into the appropriate $6,000 credit. __T__ 11) The company estimates that 6 percent of its receivables will prove uncollectible or $6,000 ($100,000 times 6 percent). Because the allowance already has a $1,000 credit balance, a $5,000 expense figure must be recognized to turn this $1,000 credit into the appropriate $6,000 credit. __F__ 12) The write off of a receivable reduces the accounts receivable account and the allowance for doubtful accounts (both on the balance sheet). No entry is made to an income statement account so there is no change in net income. Bad debt expense is recognized through an adjusting entry when financial statements are being prepared. __F__ 13) When an account is written off as uncollectible, accounts receivable is reduced as is the allowance for doubtful accounts. Because these two figures are netted to arrive at the net realizable value figure to be reported for this asset, the two reductions offset so that no change occurs to the net accounts receivable shown on the balance sheet. __T__ 14) A company updates any receivable to be collected in cash at the current exchange rate if a currency outside of the reporting company’s functional currency is to be received. At the time of the sale, the receivable will be reported as $8,400 (20,000
vilsecks times $.42). Later, on the balance sheet date, the receivable will be reported as $7,800 (20,000 vilsecks times $.39). The drop in the reported value of the receivable causes the company to report a $600 loss ($8,400 less $7,800). __F__ 15) Only monetary assets and liabilities are remeasured using current exchange rates prior to reporting. All other reported balances continue to be reported based on the historical exchange rate in effect at the time of the original transaction. Thus, the sale should be shown as 20,000 vilsects times $.42 or $8,400 and not $7,800. __F__ 16) For this company, sales per day is $2,000 ($730,000/365 days). Because the receivable balance is $48,000, the average customer is taking 24 days to make payment ($48,000/$2,000) and not 27 days. __F__ 17) Cash will increase by $3,800 while accounts receivable will decrease by $3,800 so that no change occurs in the total of current assets or current liabilities. Thus, the current ratio is unaffected. __T__ 18) The accounts receivable balance at the end of the year is $500,000 ($300,000 + $800,000 - $600,000). Therefore, the average accounts receivable for this period is $400,000 ([$300,000 + $500,000]/2). The receivables turnover is $800,000/$400,000 or 2.
Answer to Multiple Choice Questions
1. Answer is B In judging the collectability of its accounts receivable, the length of time that a company takes to pay its own debts is not relevant. Many factors such as industry averages, current economic conditions, and the efficiency of the company’s own credit, billing, and collection processes should be taken into consideration. However, the company’s own payments are not directly connected to the collections received from customers. 2. Answer is A Bad debt expenses are reported in the same time period as the revenues which they help to generate. This recognition is an example of the application of the matching principle to the actual reporting of an expense.
3. Answer is A Whenever an account is written off as uncollectible, both the allowance for doubtful accounts and the accounts receivable should be reduced. Bad debt expense was recognized previously through an estimate and adjusting entry. Furthermore, no cash was collected at this time. 4. Answer is C Neither of these events has an impact on the total amount reported as assets by this company. The uncollectible account reduces accounts receivable and the allowance for doubtful accounts so that the net reported asset balance remains unchanged. The collection increases cash but decreases accounts receivable. Increasing one asset and decreasing another also leaves the balance the same. 5. Answer is C Bad debt expense is 1 percent of $1.9 million or $19,000. That adjustment will increase the allowance for doubtful accounts from $4,000 to $23,000. 6. Answer is B Prior to the year-end adjusting entry, the allowance will hold a debit balance of $3,000 ($25,000 less $28,000). Bad debt expense for the year is 8 percent of $520,000 or $41,600 which creates a $38,600 balance in the allowance. The receivable is $500,000 plus $520,000 less $440,000 and less $28,000 or $552,000. Net realizable value is $552,000 less $38,600 or $513,400. 7. Answer is C Prior to the year-end adjusting entry, the allowance will hold a debit balance of $2,000 ($23,000 less $25,000). The receivable is $400,000 plus $450,000 less $380,000 and less $25,000 or $445,000. The allowance for doubtful accounts is 6 percent of $445,000 or $26,700. To go from a $2,000 debit balance to a $26,700 credit balance, the company needs to record bad debt expense of $28,700. 8. Answer is C To begin, accounts receivable is increased (debit) and the allowance is also increased (credit) to put the receivable back on the financial records. Then, cash is increased (debit) and accounts receivable is reduced (credit) to record the impact of the collection. Accounts receivable both increases and decreases so there is no net effect. Both the cash and the allowance accounts increase. 9. Answer is C Prior to the year-end adjusting entry and the handling of this $6,000 receivable, the allowance will hold a credit balance of $2,000 ($15,000 less $13,000). The receivable is
$300,000 plus $1 million less $800,000 and less $13,000 or $487,000. The allowance for doubtful accounts is 5 percent of $487,000 or $24,350. To go from a $2,000 credit balance to a $24,350 credit balance, the company needs to record bad debt expense of $22,350. However, if the $6,000 account had been written off, the process would have been slightly different. With that change, the allowance will hold a debit balance of $4,000 ($15,000 less $19,000). The receivable is $300,000 plus $1 million less $800,000 and less $19,000 or $481,000. The allowance for doubtful accounts is 5 percent of $481,000 or $24,050. To go from a $4,000 debit balance to a $24,050 credit balance, the company needs to record bad debt expense of $28,050. By not writing off the $6,000, the expense stays at $22,350 rather than being raised to $28,050. The expense is lower so net income is $5,700 higher. 10. Answer is A Bad debt expense will be 3 percent of $1 million or $30,000. That figure is not affected by the possible write off of the $6,000 account. Therefore, that decision does not change net income reported for this period. 11. Answer is D When currency exchange rates change, the only balances impacted for reporting purposes are monetary assets and liabilities. Here, the only monetary account is accounts receivable of 10,000 euros. It is reported at a value of $20,000 on November 28, Year One (10,000 euros X $2.00) but is reported at a value of $19,000 on December 31, Year One (10,000 euros X $1.90). The $1,000 reduction in the reported receivable balance creates a $1,000 loss to be included on the company’s income statement. 12. Answer is B The account receivable is a monetary asset that should be updated based on the current exchange rate. It will now be reported as $7,300 (10,000 scoobies times $.73). The inventory is not a monetary account and will continue to be reported based on its historical rate of $6,100 (10,000 scoobies times $.61). 13. Answer is B The payment reduces both current assets and current liabilities. However, because current assets are larger, the $5,000 payment has a smaller percentage impact on that total. Consequently, the current ratio goes up. To illustrate, assume that the company has $20,000 in current assets and $10,000 in current liabilities for a current ratio of 2.0 : 1.0. As a result of the payment, current assets fall to $15,000 whereas current liabilities drop to $5,000. The current ratio has gone up to 3.0 : 1.0. Current assets dropped by 25 percent ($5,000/$20,000) whereas current liabilities went down by 50 percent ($5,000/$10,000).
14. Answer is C Current assets are $90,000 (30 percent of $300,000) and current liabilities are $40,000 (40 percent of $100,000). Working capital is $50,000 ($90,000 less $40,000) and the current ratio is 2.25 : 1.00. The current ratio and the amount of working capital are a measure of a company’s liquidity, its ability to pay debts as they come due and still have money available to fund operations. 15. Answer is C In the current year, the company is making $10,959 in sales per day ($4 million/365) so the age of ending receivables is $590,000/$10,959 or 54 days (rounded) which is 8 days longer than in the previous year. The average receivable balance for the period is $520,000. Thus, the receivables turnover is $4 million/$520,000 or 7.69 times. External decision-makers do monitor the time it takes to collect accounts receivable because any change might signal a problem. The answer is C because the age is getting longer rather than shorter. 16. Answer is A Company A makes sales of $1,096 per day. Because it holds accounts receivable of $120,000, Company A is taking 109.5 days to make its collections. Company Z makes sales of $2,466 per day. Because it holds accounts receivable of $280,000, Company Z is taking 113.5 days to make its collections. Company Z is taking 4 days longer.
Answers to Problems 1) a. Net Credit Sales Uncollectible Bad Debt Expense
$500,000 2% $10,000
Bad Debt Expense Allowance for Doubtful Accounts
$10,000 $10,000
b. The $1,000 credit balance in the allowance plus the $10,000 entry above creates a balance of $11,000. Accounts Receivable $100,000 Less: Allowance for Doubtful Accounts (11,000) Net Accounts Receivable $ 89,000
c. It is unlikely that a company will be able to collect all of its accounts receivable. Customers will die, go bankrupt, leave the area, or simply refuse to pay. Showing the estimated net realizable value allows users of the financial information to see the amount that company officials believe will ultimately be collected. 2) a. Accounts Receivable $100,000 Uncollectible 5% Target Allowance for Doubtful Accounts 5,000 Allowance for Doubtful Accounts 1,000 4,000 number to arrive at 5,000 $5,000
Bad Debt Expense Allowance for Doubtful Accounts
$4,000 $4,000
b. Accounts Receivable $100,000 Less: Allowance for Doubtful Accounts (5,000) Net Accounts Receivable $ 95,000 c. These two methods are simply different ways of estimating the amount of bad accounts. In financial accounting, estimations are typically allowed to be made in any logical and consistent manner. 3) Income Statement – Year Two Sales - $800,000 (given) Bad debt expense - $40,000 ($800,000 times 5 percent) Balance Sheet – end of Year Two (entries included for both years) Accounts receivable – $678,000 ($800,000 - $430,000 - $31,000 + $800,000 $430,000 - $31,000) Allowance for doubtful accounts – $18,000 ($40,000 - $31,000 + $40,000 - $31,000) Net accounts receivable - $660,000 ($678,000 - $18,000)
4) To apply the percentage of receivables method, the beginning allowance balance for the year is needed which means that the ending figures for Year One are needed. Financial Information - Year One Sales - $1,200,000 (given) Accounts receivable – $370,000 ($1,200,000 - $800,000 - $30,000) Allowance for doubtful accounts prior to adjustment - $30,000 debit (amount written off during Year One) Allowance for doubtful accounts to be reported – $18,500 ($370,000 x 5 percent) Bad debt expense - $48,500 (amount needed to turn $30,000 debit into $18,500 credit) Financial Information - Year Two Sales - $1,200,000 (given) Accounts receivable – $740,000 ($370,000 + 1,200,000 - $800,000 - $30,000) Allowance for doubtful accounts prior to adjustment - $11,500 debit ($18,500 $30,000) Allowance for doubtful accounts to be reported – $37,000 ($740,000 x 5 percent) Bad debt expense - $48,500 (amount needed to turn $11,500 debit in the allowance into a $37,000 credit) 5)
a. Allowance for Doubtful Accounts Accounts Receivable
$6,000
Accounts Receivable Allowance for Doubtful Accounts
$500
Cash Accounts Receivable
$500
Accounts Receivable Sales Revenue
$145,000 $145,000
Cash Accounts Receivable
$115,000 $115,000
$6,000
b.
$500
$500
c.
d. Accounts Receivable 27,000 6,000 (a) (b) 500 500 (b) (c) 145,000 115,000 (c)
Allowance for Doubtful Accounts (a) 6,000 4,000 500 (b) 5,070 to get to $3,570
$ 51,000
$3,570
Accounts Receivable $51,000 % uncollectible 7% Target Allowance for Doubtful Accounts 3,570
Bad Debt Expense Allowance for Doubtful Accounts
$5,070 $5,070
6) Financial Information Sales - $800,000 (given) Accounts receivable – $402,000 ($300,000 + 800,000 - $680,000 - $18,000) (the $2,000 collected account is both added and removed so it causes no change in accounts receivable) Allowance for doubtful accounts prior to adjustment - $1,000 debit ($15,000 $18,000 + $2,000) Allowance for doubtful accounts to be reported – $20,100 ($402,000 x 5 percent) Bad debt expense - $21,100 (amount needed to turn a $1,000 debit in the allowance into a $20,100 credit) a. Balance Sheet Accounts receivable Allowance for doubtful accounts Net accounts receivable b. Income Statement Sales Bad debt expense
$402,000 (20,100) $381,900
$800,000 $21,100
7) Company A – Financial Information, Bad Debt Expense – Year Two Sales - $700,000 (given) Bad debt expense - $14,000 ($700,000 times 2 percent)
Company Z - Financial Information, Bad Debt Expense – Year Two Sales - $700,000 (given) Accounts receivable – $381,000 ($200,000 + 700,000 - $500,000 - $19,000 + $5,000 – $5,000) Allowance for doubtful accounts prior to adjustment - $4,000 debit ($10,000 $19,000 + $5,000) Allowance for doubtful accounts to be reported – $19,050 ($381,000 x 5 percent) Bad debt expense - $23,050 (amount needed to turn a $4,000 debit into a $19,050 credit) Company A reported bad debt expense of $14,000 in arriving at net income of $100,000. Because Company Z reported bad debt expense of $23,050, its expenses are $9,050 larger. Thus, its net income is $9,050 lower or $90,950. 8) The Springs Company used the percentage of sales method to estimate its bad accounts and then reports net income of $80,000 and the total of all reported assets of $460,000. Another receivable proves to be uncollectible. This does not change the sales figure and, thus, has no impact on bad debt expense. Net income remains reported at $80,000. Discovery of this additional uncollectible account reduces both the accounts receivable and the allowance for doubtful accounts by $1,000. Consequently, net accounts receivable is not affected. The two decreases offset. If that balance does not change, the total of reported assets stays at $460,000. 9) The Wallace Company uses the percentage of receivables method to estimate its bad accounts and then reports net income of $220,000 and the total of all reported assets of $1.1 million. Another account ($1,000) proves to be uncollectible. Before that event, accounts receivable reported a total of $776,000 ($500,000 + $1,600,000 - $1,300,000 $24,000). The allowance for doubtful accounts had a debit balance of $4,000 ($20,000 - $24,000). The allowance should be 4 percent of $776,000 or $31,040. To turn a $4,000 debit into a $31,040 credit, bad debt expense of $35,040 is recognized. After the final $1,000 is written off as uncollectible, the accounts receivable balance has fallen to $775,000 ($776,000 - $1,000) and the allowance is a $5,000 debit balance ($20,000 - $24,000 - $1,000). The allowance should be 4 percent of $775,000 or $31,000. To turn a $5,000 debit into a $31,000 credit, bad debt expense of $36,000 is recognized. The net accounts receivable balance goes from $744,960 ($776,000 - $31,040) to $744,000 ($775,000 - $31,000). The balance drops by $960 so that total assets also falls by that much from $1.1 million to $1,099,040.
Bad debt expense rises from $35,040 to $36,000, an increase of $960. Increasing bad debt expense by $960 drops net income from $220,000 to $219,040.
10) On November 1, Year One Inventory – 8,000 euros x $1.72 = $13,760 Accounts payable – 8,000 euros x $1.72 = $13,760 On December 31, Year One (balances reported on balance sheet) Inventory – 8,000 euros x $1.72 = $13,760 Accounts payable – 8,000 euros x $1.61 = $12,880 Drop in reported balance of accounts payable - $880 ($13,760 - $12,880) (gain reported on income statement because reported value of liability is reduced) 11) a. 267,000 euros x $1.32 = $352,440 Accounts Receivable Sales Revenue
$352,440 $352,440
b. Updated value - 267,000 euros x $1.27 = $339,090 Reported value of accounts receivable falls from $352,440 to $339,090 creating a loss of $13,350. Sales figure remains reported at $352,440. Loss in value of foreign $13,350 currency receivable Accounts Receivable $13,350 12) Payment of the $12,000 account payable reduces current assets from $90,000 to $78,000 and the current liabilities from $40,000 to $28,000. Collection of the $21,000 account receivable both increases and decreases current assets so they remain at $78,000. Current liabilities were not affected in any way by this second transaction.
a. Working capital was $90,000 - $40,000 or $50,000. Now, it is $78,000 - $28,000 which still gives $50,000.
b. The current ratio was $90,000/$40,000 or 2.25 : 1.00. Now it is $78,000/$28,000 or 2.79 : 1.00. 13) Ending accounts receivable - $157,000 ($83,000 + $511,000 - $437,000) Average sales per day – $1,400 ($511,000/365 days) Time average customer takes to pay – 112.1 days ($157,000/$1,400) 14) Ending accounts receivable - $157,000 ($83,000 + $511,000 - $437,000) Average accounts receivable for Year Two – $120,000 ([$83,000 + $157,000]/2) Receivables turnover for Year Two – 4.26 times ($511,000/$120,000) 15) a. Current ratio Current ratio = Current Assets/Current Liabilities Current ratio = $2,120/$1,020 Current ratio = 2.08 b. Working capital Working capital = Current Assets − Current Liabilities Working capital = $2,120 − $1,020 Working capital = $1,100 c. Age of Receivables Age of Receivables = Receivables/Sales per day Age of Receivables = $500/($4,000/365) Age of Receivables = 45.62 days d. Receivables Turnover (Accounts Receivable on 1/1/20X8 were $460)
Receivables Turnover = Sales/Average Receivables Receivables Turnover = $4,000/(($460 + $500)/2) Receivables Turnover = 8.33 times
Answer to Comprehensive Problem A) Prepare journal entries for the above events. a) Webworks purchases additional equipment for $4,000 cash. Equipment Cash
$4,000 $4,000
b) Webworks purchases supplies worth $90 on account. Supplies Inventory Accounts Payable
$90 $90
c) Webworks pays off accounts payable and salaries payable from June. Accounts Payable Salaries Payable Cash
$280 100 $380
d) Webworks starts and completes four more Web sites and bills clients for $1,800. Accounts Receivable Revenue
$1,800 $1,800
e) In June, Webworks received $500 in advance to design a restaurant Web site. Webworks completes this site during July. Unearned Revenue Revenue f)
$500 $500
Webworks collects $1,200 in accounts receivable. Cash
$1,200 Accounts Receivable
$1,200
g) Webworks pays Nancy Po (the company employee hired in June) $500 for her work during the first three weeks of July.
Salaries Expense Cash
$500 $500
h) Webworks receives $200 in advance to work on a Web site for a local dry cleaner and $300 in advance to work on a website for a local animal hospital. Work will not begin on these Web sites until August.
Cash
$500 Unearned Revenue
i)
Leon’s parents decide to charge rent after seeing how successful the business is and how much space it is taking up in their house. They all agree that rent will be $200 per month. Webworks pays $600 for July, August and September. Prepaid Rent Cash
j)
$500
$600 $600
Webworks pays taxes of $300 in cash. Tax Expense Cash
$300 $300
B) Post the journal entries to T-accounts.
Cash Accounts Receivable 9,800 4,000(a) 450 1,200(f) (f)1,200 380(c) (d)1,800 (h)500 500(g) 600(i) 300(j) $5,720
$1,050
$190
Accounts Payable (c)280 280 90(b)
Salaries Payable (c)100 100
$90
$0
Capital Stock 2,000
$2,000 Tax Expense (j)300
$300
Supplies 100 (b)90
Retained Earnings 470
Prepaid Rent (i)600
Equipment 3,000 (a)4,000
$600
$7,000
Unearned Revenue (e)500 500 500(h)
Note Payable 10,000
$500
$10,000
Revenue 1,800(d) 500(e)
Salaries Expense (g)500
$470
$2,300
Utilities Expense
Supplies Expense
$500
C) Prepare an unadjusted trial balance for Webworks for July. Webworks Unadjusted Trial Balance July 31 Account Title Cash Accounts Receivable Supplies Prepaid Rent Equipment Accounts Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 7/1 Revenue Salaries Expense Tax Expense
Debits $ 5,720 1,050 190 600 7,000
Credits
500 300
______
Totals
$15,360
$15,360
$
90 500 10,000 2,000 470 2,300
D) Prepare adjusting entries for the following and post them to T-accounts. k) Webworks owes Nancy Po $200 for her work during the last week of July. Salaries Expense Salaries Payable l)
$200 $200
Leon’s parents let him know that Webworks owes $150 towards the electricity bill. Webworks will pay them in August. Utilities Expense Accounts Payable
$150 $150
m) Webworks determines that it has $50 worth of supplies remaining at the end of July. Because the T-account balance shows $190, the company must have used $140. Supplies Expense Supplies
$140 $140
n) Prepaid rent should be adjusted for July’s portion that has now been consumed. Rent Expense Prepaid Rent
$200 $200
o) Leon now believes that the company may not be able to collect all of its accounts receivable. A local CPA helps Leon determine that similar businesses report an allowance for bad debt at an average of 10 percent of their accounts receivable. Webworks will use this same approach. The trial balance shows accounts receivable of $1,050 so the allowance should be increased to $105 (10 percent of the receivable balance). Bad Debt Expense $105 Allowance for Doubtful Accounts
Cash Accounts Receivable 9,800 4,000(a) 450 1,200(f) (f)1,200 380(c) (d)1,800 (h)500 500(g) 600(i) 300(j) $5,720
Allow. Doubtful Accounts 105(o)
$1,050
Equipment Accounts Payable 3,000 (c)280 280 (a)4,000 90(b) 150(l) $7,000
$105
$105 Salaries Payable (c)100 100 200(k)
$240
Capital Stock 2,000
$2,000
$50
$400
Unearned Revenue (e)500 500 500(h)
$200
Retained Earnings 470
Supplies Prepaid Rent 100 140(m) (i)600 200(n) (b)90
Note Payable 10,000
$500 Revenue 1,800(d) 500(e)
$470
$2,300
$10,000 Salaries Expense (g)500 (k)200 $700
Tax Expense (j)300
Utilities Expense Supplies Expense Rent Expense Bad Debt Expense (l)150 (m)140 (n)200 (o)105
$300
$150
$140
$200
$105
E) Prepare an adjusted trial balance. Webworks Adjusted Trial Balance July 31 Account Title Cash Accounts Receivable Allowance for Doubtful Accounts Supplies Prepaid Rent Equipment Accounts Payable Salaries Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 7/1 Revenue Salaries Expense Tax Expense Utilities Expense Supplies Expense Rent Expense Bad Debt Expense
Debits $ 5,720 1,050
700 300 150 140 200 105
_______
Totals
$15,815
$15,815
$
105
50 400 7,000 240 200 500 10,000 2,000 470 2,300
F) Prepare financial statements for July. Webworks Income Statement As of July 31 Revenue Expenses Earning before tax Tax Expense Net Income
Credits
$2,300 (1,295) 1,005 (300) $ 705
Webworks Stmt. of Retained Earnings As of July 31 Retained Earnings, July 1 Net Income Retained Earnings, July 31
$ 470 705 $1,175
Webworks Balance Sheet July 31 Assets:
Liabilities:
Current: Cash $ 5,720 Accounts Receivable 1,050 less Allow. for Doubt. Accts. (105) Net Accounts Receivable 945 Supplies Inventory 50 Prepaid Rent 400 Total Current Assets $ 7,115
Current: Accounts Payable Salaries Payable Unearned Revenue
Noncurrent: Equipment
Total Assets
$ 7,000
$14,115
$
240 200 500
Total Current Liabilities
$
940
Noncurrent: Notes Payable
$10,000
Owners’ Equity: Capital Stock Retained Earnings Total Owners’ Equity
$ 2,000 1,175 $ 3,175
Total Liabilities & Owners’ Equity
$14,115
Answers to Research Assignment According to the information provided in these statements and notes, net accounts receivable at the end of 2009 was $407,507,000. The allowance for doubtful accounts at that date was $102,800,000 so the total amount of accounts receivable was $510,307,000. Sales during 2010 were reported as $9,156,274,000.
Net accounts receivable at the end of 2010 was $454,366,000. The allowance for doubtful accounts at that date was $86,500,000 so the total amount of accounts receivable was $540,866,000. a. Age of receivables at the end of 2010. If based on the net accounts receivable reported on the balance sheet. Sales per day - $25,085,682 ($9,156,274,000/365) Age of receivables – 18.11 days ($454,366,000/$25,085,682) If based on the gross accounts receivable before the allowance is subtracted. Sales per day - $25,085,682 ($9,156,274,000/365) Age of receivables – 21.56 days ($540,866,000/$25,085,682) b. Receivables turnover for 2010. If based on the net accounts receivable reported on the balance sheet. Average receivables for the year – $430,936,500 ([$407,507,000 + $454,366,000]/2) Receivables turnover – 21.2 times ($9,156,274,000/$430,936,500) If based on the gross accounts receivable before the allowance is subtracted. Average receivables for the year – $525,586,500 ([$510,307,000 + $540,866,000]/2) Receivables turnover – 17.4 times ($9,156,274,000/$525,586,500) c. Allowance for doubtful accounts at December 31, 2010 - $86,500,000 Accounts receivable before allowance is subtracted - $540,866,000 Percentage of receivables expected to be uncollectible – 15.99 percent ($86,500,000/$540,866,000) It seems apparent that at the end of 2010 eBay estimated that 16 percent of its ending receivables would prove uncollectible.
Chapter 8 Solutions Answers to Questions 1) In the reporting of inventory, the term “cost” includes all normal and necessary amounts to get merchandise into the condition and position to be sold (so that revenues can be generated). 2) The inventory account reported on the balance sheet will be overstated by $12,400 because this cost was recorded as an asset rather than as an expense. For the same reason, net income on the income statement will be overstated by $12,400 because these expenses were not recorded as they should have been. 3) A cash discount is a reduction in the amount that must be paid to settle a debt. It is offered to encourage customers to pay these debts more quickly. Such payments allow the collector to make use of the money sooner in order to generate additional revenues. In addition, the availability of a cash discount encourages payment thereby reducing the amount of money lost through uncollectible accounts. 4) The term “3/10, n/30” informs a customer that a 3% discount can be taken if payment is made within 10 days. Any amount that remains must be paid in full within 30 days. 5) For the buyer, taking advantage of cash discounts is usually a wise business decision. Failure to take a discount effectively creates an interest cost at a relatively high annual rate. In other words, paying the extra amount of money simply to put off making the payment for a few days is quite costly when that rate is spread over an entire year. Therefore, if necessary, the buyer will probably be wise to borrow money in order to take advantage of cash discounts. Interest is still paid but at a lower rate. 6) A cash discount reduces the cost of acquiring inventory. Therefore, a cash discount serves to decrease the amount reported as the inventory balance. 7) A perpetual inventory system keeps a record of the ongoing balance of the inventory that is on hand as well as the cost of units that have already been sold. Purchases increase the inventory total whereas sales decrease that balance. The advantages of a perpetual system involve the availability of information about inventory. At any point in time, company officials can know what inventory is present as well as the inventory that has been sold during the period. This information should make for better decision making. 8) A periodic inventory system does not keep track of a company’s inventory on an ongoing basis. The costs incurred (the invoice price, transportation, and the like) are monitored but the cost and number of units on hand and sold are unknown. Periodic inventory systems produce balances when financial statements are to be prepared. The inventory total is determined by a physical count (a physical inventory). Cost of goods sold can then be calculated by determining the amount of inventory that is missing
(beginning inventory plus purchase costs less ending inventory). Periodic systems are generally less costly to maintain than perpetual systems. In addition, a periodic system will allow company officials to monitor individual cost figures such as the invoice price and the transportation charges. 9) “FOB” stands for “free on board” which is a legal term to indicate the point at which title to property is conveyed from seller to buyer. Legally, the FOB point is important because it indicated who owns the property during transit and is, therefore, responsible for shipping charges. In addition, if property is lost along the way, the owner (as established by the FOB point) suffers the loss. To the accountant, the FOB point is important because it indicates when the buyer should record the purchase and related liability and when the seller should record the revenue and the related receivable. 10) If the goods were shipped “FOB destination,” they continue to belong to the seller (Allen Company) until received by the buyer. The loss while in transit is the responsibility of the owner which is Allen. However, if the sale had been designated “FOB shipping point,” the goods belong to the buyer (Gracie Company) as soon as they are shipped. In that case, the loss that occurred during the transfer is assigned to Gracie. The owner bears the loss and the FOB point identifies the owner. 11) If goods are sold “FOB shipping point,” legal title is conveyed from seller to buyer at the point of shipment. At that time, the buyer should record the purchase and the seller should record the sale. 12) If goods are sold “FOB destination,” conveyance of the legal title from seller to buyer is delayed until the goods are delivered to the buyer. 13) The real differences between a perpetual inventory system and a periodic inventory system involve (a) the amount of information that is available and (b) the cost of maintaining the systems. In a perpetual system, company officials are able to know the number of units on hand at all times and often the cost of those goods. Information is also available about the items that have been sold to date. In a periodic system, the only information available concerns the costs that have been incurred during the period such as the total of all invoice prices and transportation. Company officials can only determine the quantities that are physically available through visual inspection. However, a perpetual system—because of the need for computer monitoring—is more costly to design and operate. Periodic systems rarely require any amount of substantial costs. In comparing the two, company officials must determine whether the available information generated by a perpetual system is worth the added cost.
14) In a perpetual system, the following entries are made: Purchase of inventory (not required by question) Inventory Cash
$ 77 $ 77
Sale of Inventory Accounts receivable Sales revenue
$109
Cost of goods sold Inventory
$ 77
$109
$ 77
In a periodic system, the following entries are made: Purchase of inventory (not required by question) Purchases of Inventory Cash
$ 77 $ 77
Sale of Inventory Accounts receivable Sales revenue
$109 $109
15) The beginning amount of inventory was determined from the opening balance in the inventory T-account for the year. This figure came from a physical inventory count taken at the end of the previous year. This figure could also have been found on the balance sheet prepared at the end of that period. The inventory purchases total for the year is recorded in the T-accounts found in the general ledger. The $387,000 balance may have been a summation of several accounts (purchases of inventory, transportation, discounts, and the like). Finally, as indicated in the question, the ending inventory balance was determined through a year-end count. Cost of goods sold is calculated as the beginning inventory + the total amount of the inventory purchased during the period – the ending inventory. Cost of goods sold for the Westmoreland Corporation is $177,000 + $387,000 - $145,000 or $419,000. 16) A year-end adjustment is needed here to change the beginning inventory to the ending balance and record the cost of goods sold for the current period. Based on the answers determined above in problem 15, the year-end adjustment is:
Inventory $145,000 Cost of goods sold 419,000 Inventory Purchases of inventory
$177,000 387,000
17) For decision-making, company officials often need to know the number of inventory units on hand as well as the number that have been sold to date. This information helps them make decisions on which items to buy at the present time and, perhaps, which items need to be sold before they get too old and outdated. Such decisions do not always require knowledge of the actual cost of the inventory. Therefore, officials can reduce the cost of record-keeping by monitoring units in a perpetual system that does not include cost figures. This approach may also make sense if there is little variation in costs over time. For example, if a certain type of inventory always costs about $12 per unit, spending money to monitor the exact cost on an ongoing basis might not be worthwhile. 18) As the name implies, “purchase value” is the cost that a company would have to pay to replace inventory items that it currently holds. It is often referred to as “replacement cost.” For example, if inventory on hand was bought for $1.30 per pound but could only be purchased today for $1.43 per pound, that number is its purchase value. Because of the application of lower of cost or market, the purchase value becomes an accounting problem if it is less than historical cost. For example, if the above inventory could be acquired for $1.17 per pound, replacement cost is below the historical cost. Normally, because of the practice of conservatism, inventory is reported at its purchase value if it falls below historical cost. 19) The term “sales value” is a measure of the amount a company can get from the disposal of an inventory item. It is the net realizable value of the item—the expected sales price less any costs that are necessary to enable the sale. In applying lower of cost or market to inventory, the reported balance is normally reduced when net realizable value is lower than historical cost. An item that is out of fashion or out of date might suffer this problem because the owner cannot sell it for as much as originally anticipated. 20) A large number of companies should be especially alert to the possibility that reductions will be necessary because of the use of lower of cost or market. Here are a few examples. a. Any company that sells items that are subject to fashion and fads (clothing, for example) can always have a problem if merchandise is not sold before those fashions and fads change. b. Technology companies have a similar problem if a new product is brought to the market so that previous items are now viewed as obsolete or, at least, outdated. c. Any company that buys huge quantities of inventory must worry that the merchandise will become old before it can be sold.
d. Seasonal merchandise such as skis and swimsuits may cause a problem because their value falls as the season ends. e. Finally, companies that sell merchandise that can be easily damaged face the risk of having to reduce prices if damage does occur. 21) Even in a perpetual inventory system, a physical inventory count should be taken on a regular basis although it does not have to occur near the end of the year. Over time, inventory records can become wrong because of theft or loss. Errors can occur simply because of human mistakes. A physical inventory is not necessary to produce financial statements (as in a periodic system) but is needed to keep the financial records in line with the actual inventory balances being held. 22) Current inventory balances can be estimated in a number of different ways and for a number of reasons. If inventory is destroyed (such as by fire, flood, or other disaster), an estimation might be necessary to determine the amount of loss. If a company wants to prepare financial statements more often than once a year, inventory can be reported based on an estimate rather than incurring the cost of a physical inventory. If a company takes a physical inventory, an estimate can be determined to measure the likelihood that the count was reasonably accurate.
Answers to True or False Questions
__T__ 1) Companies capitalize all of the normal and necessary costs of getting inventory into the condition and position to be sold. Transportation costs fit into that definition so that they are capitalized rather than being expensed. __F__ 2) In a periodic inventory system, no ongoing record is maintained of the current inventory balance. That process is only done in a perpetual system. However, the individual costs are monitored so that they are subject to better control by company officials. For that reason, a separate “Transportation-in” T-account is set up and this cost is recorded in that account. __F__ 3) All normal and necessary costs paid to get an inventory item into the condition and position to be sold are capitalized (added to the asset). All other costs, especially those costs incurred after revenue is generated, are expensed. According to those rules, transportation costs to get inventory is added to the Inventory account. Delivery
costs to get the merchandise to the customer occur after the revenue has been generated and should be expensed. This cost has no future economic benefit. __F__ 4) These terms allow the buyer to take a 2 percent discount if payment is made within 10 days. Because 2 percent of $600 is $12, the buyer here only has to pay $588 ($600 less $12). __F__ 5) If a company does not take advantage of the discounts offered, an extra amount must be paid. That cost is the equivalent of interest for the extra few days that payment is delayed. Over an entire year, those small interest charges equate to a very high annual rate. Consequently, most companies choose to take all cash discounts even if they have to borrow money to make the payments in a timely manner. __T__ 6) A perpetual inventory system maintains an ongoing record of all inventory on hand as well as the merchandise that has been sold. For that reason, cost of goods sold is determined and recorded at the time of sale. Bar coding and computer software programs make this process possible. __T__ 7) The primary advantage of a periodic inventory system is its cost. Because goods on hand are not monitored and cost of goods sold is not calculated at the time of each sale, very little record-keeping is necessary. Neither computers nor special computer software programs are needed. __F__ 8) The availability of computers and computer software at lower prices has made perpetual inventory systems much more common. The major disadvantage of perpetual systems has always been its cost. That problem has been reduced dramatically over the years as more sophisticated technology has become available at affordable prices. __T__ 9) In a perpetual inventory system, all normal and necessary inventory costs are capitalized and recorded in an Inventory T-account. However, in a periodic inventory system, the individual costs are monitored for control purposes. Thus, the Purchases of Inventory account will be found in a periodic system but not in a perpetual system.
__T__ 10) The designation “FOB shipping point” will let all parties to the transaction know that legal title is conveyed to the buyer at the point in time when the merchandise leaves the seller. This knowledge allows the parties to resolve legal and accounting issues that can arise because of the conveyance. __T__ 11) Because inventory balances are not monitored in a periodic inventory system, company officials have no direct knowledge of the cost of goods sold balance. Instead, they must determine the amount of inventory that is missing and make the assumption that this figure represents the cost of goods sold. The beginning inventory balance plus the cost of all purchases for the period provides the amount of inventory available to be sold. A physical count is taken to determine the ending inventory cost and that is subtracted. The computed figure is the amount of inventory that is no longer being held by the company. It is assumed to be the cost of goods sold. __T__ 12) In a periodic inventory system, the amount of inventory on hand is not maintained during the period. Consequently, the balance in the Inventory T-account stays at the beginning figure throughout the year. When financial statements are to be prepared, a physical count is taken and the Inventory T-account is updated to this new balance. __F__ 13) These goods were neither recorded nor counted but they did belong to Ace because they were shipped “FOB shipping point” during December. In computing cost of goods sold, the Purchases of Inventory figure should have been higher by $6,000 since these goods were actually bought in this period. Also, the ending inventory figure (a negative in computing cost of goods sold) should have been $6,000 higher for the same reason. If both purchases and ending inventory are raised by the same amount, the changes will cancel out. Cost of goods sold stays the same ($324,000). However, on the balance sheet, inventory and accounts payable are both $6,000 higher. __F__ 14) Because of the practice of conservatism, all inventory balances are reported at the lower of historical cost or current market value. __F__ 15) Because of the practice of conservatism, all inventory balances are reported at the lower of historical cost or current market value.
__F__ 16) Because of the practice of conservatism, all inventory balances are reported at the lower of historical cost or current market value. Inventory is not written up to a higher figure when its market value exceeds historical cost. __T__ 17) In a perpetual system, inventory counts are still necessary to find errors in the accounting records and to recognize possible losses from breakage or theft. However, these counts do not necessarily have to take place near the end of the fiscal period. __T__ 18) In a perpetual system, an ongoing record is maintained of all inventory balances. The need for an estimate of the amount on hand is less likely. In a periodic system, whenever the amount of inventory is needed without a count (to produce interim financial statements, for example, or to determine the loss from a disaster), an estimate has to be made. __T__ 19) Sales were $120,000. Because the gross profit percentage is 30 percent, gross profit is estimated at $36,000 ($120,000 x 30 percent). Thus, cost of goods sold is approximately $84,000 ($120,000 less $36,000). The company held inventory this period costing $150,000 ($50,000 beginning inventory plus $100,000 of purchases). If $84,000 was sold, the remaining inventory can be estimated as costing $66,000 ($150,000 less $84,000). If $6,000 of the merchandise was saved, then $60,000 was lost ($66,000 less $6,000). __T__ 20) A forensic accountant is somewhat like a private investigator who tries to replicate financial information from clues and other incomplete information. For example, if money has been stolen, the forensic accountant would attempt to compute the amount taken.
Answers to Multiple Choice Questions 1) Answer is A Arne is charged $400 for the merchandise but also receives a $9 cash discount so that the payment is only $391. Because the goods were shipped “FOB destination,” the transportation charges were the responsibility of the seller unless separate arrangements were made. The delivery charges to get the merchandise to the customer are reported as an expense.
2) Answer is B The sofas had a total invoice price of $900 ($300 x 3 sofas). The buyer is entitled to a 2 percent discount is payment is made within ten days. Payment was made on the 8th day so NC Sofa was able to take a discount of $18 (2 percent of $900). Payment was $882 ($900 less $18). 3) – Answer is D Cost of goods sold can always be determined as beginning inventory plus the total of all purchases for the period less ending inventory. Total purchases for this year is $1,090,000 (purchases of $1,060,000 plus transportation of $30,000). Therefore, cost of goods sold is $490,000 + $1,090,000 - $450,000 or $1,130,000. As noted in the textbook, this figure is the cost of the inventory that is no longer being held. By using this formula, the company assumes that all missing inventory has been sold. 4) – Answer is B Cost of goods sold can always be determined as beginning inventory plus the total of all purchases for the period less ending inventory. Total purchases for this year is $224,000 (purchases of $232,000 plus transportation-in of $15,000 less cash discounts of $23,000). Therefore, cost of goods sold is $90,000 + $224,000 - $123,000 or $191,000. This figure is the cost of the inventory that is no longer being held which is assumed to be the cost of goods sold. 5) – Answer is C The designation “FOB shipping point” indicates that Raceway receives title as soon as the supplies leave Delta. 6) – Answer is C Because this cost is normal and necessary to get the inventory in position to sale, it is capitalized in some manner and not expensed immediately. In a perpetual inventory system, the Inventory account keeps up with the total for the goods on hand. It is increased and decreased to reflect purchases and sales. In a periodic system, the individual costs are monitored and controlled. Therefore, this cost should be in a “Transportation-In” account or accumulated in a “Purchases” account. 7) – Answer is B Both transactions have been shipped before the end of the year. Since the transactions were FOB shipping point, the $40,000 purchase has been added to inventory. However,
the $30,000 cost of the sold inventory has been removed. As a result of these two transactions, the Inventory account only reports the $40,000 that has been shipped but not yet received. If the designations had been FOB destination, neither transaction would have been recorded in the first year. The $40,000 purchase is not included in Inventory but the $30,000 in goods to be sold continues to remain on the company’s books. With this FOB point, the inventory balance is $30,000. Therefore, if FOB destination had been used, ending inventory would have been $10,000 lower ($30,000 rather than $40,000). 8) – Answer is C None of this inventory was included in the ending inventory balance. The purchased inventory should not have been included because it was shipped FOB designation and was not received prior to the end of the year. However, the inventory costing $6,000 should have remained in ending inventory. It was shipped to the customer FOB designation but was not received until the next year. Thus, at the balance sheet date, it is still the property of the reporting entity. Adding the $6,000 brings the reported total up to $106,000. 9) – Answer is A For lower of cost or market, the 500 units of XY are reported at the lower figure of $6 (or $3,000 in total). Likewise, the 700 units of AB can only be sold for a net realizable value of $10 each ($12 sales price minus $2 cost to sell). That is lower than cost and is used for reporting giving a total of $7,000 (700 times $10). The reported inventory figure is $3,000 plus $7,000 or $10,000. 10) – Answer is B When applying lower of cost or market, the amount reported for inventory on the balance sheet can be written down because of a drop in the value of the merchandise. However, because of the practice of conservatism, inventory cannot be written up and a gain reported if the value rises. 11) – Answer is D The discrepancy was not caused by the loss or theft of inventory. Thus, recognition of a loss is not appropriate. Instead, accounting errors occurred so that both the cost of goods sold and inventory balances were incorrectly determined. The adjusting entry for these additional 25 units is made to correct those two reported figures.
11) – Answer is A At the beginning of the year, the company held inventory costing $400,000 and then bought another $190,000 for a total of $590,000. During that period, inventory was sold for $530,000. That figure was a retail amount and not the cost of those goods. Historical records indicated that the gross profit percentage (gross profit/sales price) was 25 percent. The markup on the goods sold is estimated to be $530,000 times 25 percent or $132,500. Thus, the cost of those goods that were sold is $397,500 ($530,000 sales price less $132,500 gross profit). The estimation of the cost of the inventory on hand at the time of the flood is $192,500 ($590,000 less $397,500). Because only $15,000 remained after the disaster, inventory costing $177,500 was lost.
Answers to Problems 1) a. Cost of goods available for sale: Beginning inventory
$ 77,000
Purchases of inventory Purchases
$332,000
Purchase discounts
(14,000)
Transportation-in
8,000
Goods available for sale
326,000 $ 403,000
b. Cost of goods sold Cost of goods available for sale (above) Ending inventory (given) Cost of goods sold
$ 403,000 (84,000) $319,000
c. Adjusting entry for inventory and cost of goods sold. Above account balances are closed out and ending inventory and cost of goods sold for the period are recorded. Inventory (ending) Cost of goods sold Purchase discounts Inventory (beginning) Purchases of inventory Transportation-in
$ 84,000 319,000 14,000 $ 77,000 332,000 8,000
2) a. The company holds 6,000 units of inventory at the end of Year Two (8,000 units plus 20,000 less 22,000). Without the transportation costs, they are reported at a cost of $1.00 each or $6,000. Cost of goods sold will be $8,960 plus $20,000 less $6,000 or $22,960. Gross profit will be $44,000 (22,000 times $2.00 each) less $22,960 or $21,040. b. Purchases should have been $22,400 (20,000 times $1.12) and ending inventory should have been $6,720 (6,000 times $1.12). Cost of goods sold should have been $24,640 ($8,960 plus $22,400 less $6,720). Gross profit should have been $44,000 less $24,640 or $19,360. The same gross profit figure could have been determined by subtracting the $1.12 cost of one unit from the $2.00 sales price to get a gross profit for each sale of $.88. With 22,000 units sold, that also leads to a gross profit of $19,360 (22,000 times $.88). 3)
January 15
February 19
Inventory
$2,600 Accounts Payable Cash
$2,400 200
$3,300 Revenue
$3,300
Cost of Goods Sold $1,950 Inventory
$1,950
Cash
($650 each times 3 = $1,950) April 3
June 15
Inventory
$3,250 Accounts Payable Cash
$3,000 250
$3,600 Revenue
$3,600
Cost of Goods Sold $1,950 Inventory
$1,950
Cash
September 4
October 5
Inventory
$3,900 Accounts Payable Cash
$3,600 300
$5,000 Revenue
$5,000
Cost of Goods Sold $2,600 Inventory
$2,600
Cash
4)
January 15
February 19
The numbers in parentheses are totals for the period to date. Purchases of Inventory $2,400 ($2,400) Accounts Payable $2,400 Transportation In Cash
$ 200
Cash
$3,300
$ 200
Revenue April 3
June 15
$3,300
Purchases of Inventory $3,000 Accounts Payable $3,000
($5,400)
Transportation In Cash
$ 250
($ 450)
Cash
$3,600
$ 250
Revenue September 4
October 5
$3,600
Purchases of Inventory $3,600 Accounts Payable $3,600
($9,000)
Transportation In Cash
$ 300
($ 750)
Cash
$5,000 Revenue
Year-end
($ 200)
$ 300
$5,000
Inventory $3,250 Cost of Goods Sold 6,500 Purchases $9,000 Transportation In 750
Ending inventory is the 5 remaining boxes at $650 each or $3,250 Cost of goods sold is zero (beginning inventory) plus $9,750 (the total cost of the purchases) less ending inventory $3,250 or $6,500. Cost of goods sold could also have been computed as 10 boxes at $650 each. 5) a.
Inventory Accounts Payable
$120,000 $120,000
Inventory Cash
$
260 $
260
b. Sales revenue is 220 units times $550 each or $121,000. The cost per unit of the inventory is $120,260/400 or $300.65. Cost of goods sold is 220 units times $300.65 each or $66,143 Cash Sales Revenue Cost of Goods Sold Inventory
$121,000 $121,000 $ 66,143 $ 66,143
c. Ending inventory is 180 units (400 units bought less 220 sold) times a per unit cost of $300.65 or $54,117. The same amount could be determined by taking the total cost of the inventory ($120,260) and subtracting cost of goods sold ($66,143). 6) a. No discount can be taken because payment is not made within 10 days. Montez must pay the entire $120 (600 pounds at $.20 per pound). b. Because payment is made within 10 days, a 2 percent discount is received or $2.40 (2% of $120). Payment is $117.60 ($120.00 less $2.40). c. Montez is entitled to a 2% discount on the $60 paid on May 7, but not on the remaining $60 paid on May 18. The discount is 2 percent of $60 or $1.20. Payment is $118.80 ($120.00 less $1.20). 7) a. January 14
Purchases Transportation In Accounts Payable Cash
$34,700 1,200 $34,700 1,200
May 19
November 1
Purchases Transportation In Accounts Payable Cash
$36,900 950
Purchases Transportation In Accounts Payable Cash
$67,800 1,750
$36,900 950
$67,800 1,750
b. Beginning inventory was $48,600. Purchases for the period totaled $139,400 ($34,700 + $36,900 + $67,800). Transportation In for the period totaled $3,900 ($1,200 + $950 + $1,750). Total purchase costs are $143,300 ($139,400 + $3,900). Ending inventory is given as $35,800. Cost of Goods Sold = Beginning Inventory + Purchases − Ending Inventory Cost of Goods Sold = $48,600 + $143,300 − $35,800 Cost of Goods Sold = $156,100 c. Gross profit = Sales − Cost of Goods Sold Gross profit = $296,700 − $156,100 Gross profit = $140,600 d. Student memos will vary, but should address the fact that a perpetual inventory system provides more up-to-date information for management and, therefore, can be quite helpful in making appropriate decisions as to what inventory items to buy and when. However, a perpetual system is more costly and time-consuming to maintain than a periodic system. Fortunately, as technology continues to develop, the cost and time required of a perpetual inventory system is shrinking. The management must decide whether the increased quantity and quality of information outweighs the cost and time considerations. 8) a. $310,000. The inventory has a cost of $10,000. It has not reached the FOB point (FOB destination). At the end of the year, the goods have not yet been sold and should be included in the company’s ending inventory. Adding the $10,000 to the $300,000 gives a reported balance of $310,000 b. $300,000. The inventory is being purchased. It has not yet reached the FOB point (FOB destination). Therefore, the goods should not yet be included in inventory at the end of the year. c. $300,000. The inventory is being sold. Because it is FOB shipping point and has been shipped, the goods are considered sold and should be removed from the company’s ending inventory balance. The problem indicates that these goods have been omitted from the final count. Thus, the reported balance is correct.
d. $313,000. The inventory was bought and reached the FOB point (FOB shipping point) prior to the end of the year. Hence, the inventory belongs to the company and its $13,000 cost should be included in the final reported balance. 9) a. First, determine market value as it is used in the lower of cost or market calculation. That figure is the lower of replacement cost or net realizable value (sales price less cost to sell).
Replacement
Cost
Cost
Sales Price
to Sell
Market Value
High Flyers
$240
$350
$40
$240
Midflight
$120
$220
$25
$120
Under the Radar
$100
$110
$20
$90
Next, compare the historical cost of each type of rug to the market value computed above
Cost
Market Value Lower of Cost or Market
High Flyers
$230
$240
$230
Midflight
$150
$120
$120
Under the Radar
$100
$90
$90
b. The High Flyers rug is still reported at cost so no loss has occurred with that type of rug. The Midflight rug’s reported balance has dropped $30 per unit (from $150 to $120). The company holds 125 of these rugs so that is a loss of $3,750. The Under the Radar rug’s reported balance has dropped $10 per unit (from $100 to $90). The company holds 165 of these rugs so that is a loss of $1,650. The total loss to be reported is $3,750 + $1,650 or $5,400. 10) a. A perpetual inventory system allows a company to know the balance in its inventory account at any time. However, it is possible that inventory may be lost, stolen, or destroyed or an error may occur in the inventory records. A physical inventory count enables company officials to catch these mistakes and update the inventory balance.
b. Theft, spoilage, and breakage are all possible reasons that the inventory on hand will not reconcile to the numbers in the perpetual inventory records. Companies can also make errors in maintaining the accounting records. The recording of a sale, for example, might be missed or a purchase could be entered into the records twice. c. The difference in the physical count ($39,780) and the recorded balance ($45,270) is $5,490. If an accident occurred that destroyed or damaged these items, a loss has taken place and is recorded as follows. Loss on Inventory Shortage Inventory
$5,490 $5,490
d. The difference here was an accounting problem. The goods were sold but not removed from inventory. In that case, the appropriate entry records the cost of that sale that did not get entered at the time. Cost of Goods Sold Inventory
$5,490
March
Inventory Cash
$ 800
Inventory Cash
$1,600
Inventory Cash
$ 800
Cash
$2,400
$5,490
11) a.
April
July
$ 800
$1,600
$ 800
b.
March
Revenue
April
$2,400
Cost of Goods Sold Inventory
$ 800
Cash
$4,940
$ 800
Revenue (38 units at $130 sales price each)
$4,940
Cost of Goods Sold Inventory
$1,520 $1,520
(38 units at $40 cost each) July
Cash
$1,950 Revenue
$1,950
(15 units at $130 sales price each) Cost of Goods Sold Inventory
$ 600 $ 600
(15 units at $40 cost each) c. Inventory___ $800 $800 $1,600 $1,520 $800 $600 $280 The answer could also have been determined as 7 remaining units (40 + 40 + 20 less 40 + 38 + 15) times a cost of $40 each.
d. Three units were destroyed by the damage from the leaky pipe at a cost of $40 each. Loss on Inventory Shortage Inventory
$120
Inventory, beginning of year Purchases Inventory available for sale
$369,000 218,000 $587,000
Sales Cost of goods sold percentage Cost of goods sold - estimate
$450,000 55% $247,500
$120
12) a.
Inventory available for sale Cost of goods sold - estimate Inventory, March 31
$587,000 (247,500) $339,500
b. 70 percent of inventory destroyed $339,500 times 70% = $237,650 Comprehensive Problem Part A a. Purchases Accounts Payable
$8,100 $8,100
b. Supplies Accounts Payable
$ 100 $ 100
c. Accounts Receivable Revenue
$2,700 $2,700
d. Unearned Revenue Revenue
$ 500 $ 500
e. Cash
$2,400 Accounts Receivable
$2,400
f. Salaries Expense Cash
$ 600 $ 600
g. Allowance for Doubtful Accounts Accounts Receivable
$ 100 $ 100
h. Cash
$7,500 Revenue
$7,500
i. Salaries Payable Cash
$ 200 $ 200
j. Accounts Payable Cash
$6,000 $6,000
k. Cash
$ 100 Unearned Revenue
$ 100
l. Salaries Expense Cash
$2,000 $2,000
m. Tax Expense Cash
$ 475 $ 475
Part B. Allow. Doubtful Cash Accounts Receivable Accounts 5,720 600(f) 1,050 2,400(e) (g)100 105 (e)2,400 200(i) (c)2,700 100(g) (h)7,500 6,000(j) (k)100 2,000(l) 475(m) $6,445
$1,250
Prepaid Rent Equipment 400 7,000
$400
$7,000
Note Payable 10,000
Capital Stock 2,000
$10,000
$2,000
Tax Expense (m)475
$475 Purchases (a)8,100
$8,100
$5
Accounts Payable (j)6,000 240 8,100(a) 100(b) $2,440
Retained Earnings 1,175
$1,175
Utilities Expense Supplies Expense
Inventory 0
$0
Salaries Payable (i)200 200
$0
Revenue 2,700(c) 500(d) 7,500(h)
Supplies 50 (b)100
$150
Unearned Revenue (d)500 500 100(k)
$100
Salaries Expense (f)600 (l)2,000
$10,700
$2,600
Rent Expense
Bad Debt Expense
Part C Webworks Unadjusted Trial Balance August 31 Account Title Cash Accounts Receivable Allowance for Doubtful Accounts Inventory Supplies Prepaid Rent Equipment Accounts Payable Salaries Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 8/1 Revenue Salaries Expense Tax Expense Utilities Expense Supplies Expense Rent Expense Bad Debt Expense Purchases
Debits $ 6,445 1,250
2,600 475 0 0 0 0 8,100
______
Totals
$26,420
$26,420
$
2,440 0 100 10,000 2,000 1,175 10,700
n. $ 250 $ 250
o. Utilities Expense Accounts Payable
5
0 150 400 7,000
Part D
Salaries Expense Salaries Payable
Credits
$ 250 $ 250
p. Supplies Expense Supplies
$
90 $
90
($150 in supplies bought less the $60 that remains) q. Rent Expense Prepaid Rent
$ 200 $ 200
r. Bad Debt Expense Allowance for Doubtful Accounts
$ 120 $ 120
(Accounts receivable is $1,250 according to the trial balance. At 10 percent the allowance for doubtful accounts should be $125. As can be seen in the trial balance, a $5 credit remains in that account. Thus, another $120 is added here to arrive at the $125 balance required.) s. Cost of Goods Sold Inventory Purchases
$5,100 $3,000 $8,100
(Purchases account is removed so that ending inventory balance can be recorded. The remaining inventory is assumed to have been sold.)
Cash Accounts Receivable 5,720 600(f) 1,050 2,400(e) (e)2,400 200(i) (c)2,700 100(g) (h)7,500 6,000(j) (k)100 2,000(l) 475(m) $6,445
$1,250
Allow. Doubtful Accounts Inventory (g)100 105 0 120(r) (s)3,000
$125
$3,000
Supplies 50 90(p) (b)100
$60
Prepaid Rent 400 200(q)
Equipment 7,000
Accounts Payable (j)6,000 240 8,100(a) 150(b) 250(o)
$200
$7,000
Note Payable 10,000
Capital Stock 2,000
$10,000
$2,000
$2,690
$1,175
Salaries Expense Tax Expense (f)600 (m)475 (l)2,000 (n)250 $2,850 Bad Debt Expense (r)120
$120
Retained Earnings 1,175
$475
Utilities Expense (o)250
$250
Purchases (a)8,100 8,100(s)
$0
Salaries Payable (i)200 200 250(n)
Unearned Revenue (d)500 500 100(k)
$250
$100
Revenue Cost of Goods Sold 2,700(c) (s)5,100 500(d) 7,500(h) $10,700
$5,100
Supplies Expense (p)90
$90
Rent Expense (q)200
$200
Part E. Webworks Adjusted Trial Balance August 31 Account Title Cash Accounts Receivable Allowance for Doubtful Accounts Inventory Supplies Prepaid Rent Equipment Accounts Payable Salaries Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 8/1 Revenue Cost of Goods Sold Salaries Expense Tax Expense Utilities Expense Supplies Expense Rent Expense Bad Debt Expense Purchases
Debits $ 6,445 1,250
5,100 2,850 475 250 90 200 120 0
_______
Totals
$27,040
$27,040
$
125
3,000 60 200 7,000 2,690 250 100 10,000 2,000 1,175 10,700
Part F. Webworks Income Statement As of August 31 Revenue Cost of Goods Sold Gross Profit Other Expenses Earning before tax Tax Expense Net Income
Credits
$10,700 (5,100) 5,600 (3,510) 2,090 (475) $ 1,615
Webworks Stmt. of Retained Earnings As of August 31 Retained Earnings, August 1 Net Income Retained Earnings, August 31
$1,175 1,615 $2,790
Webworks Balance Sheet August 31 Assets:
Liabilities:
Current: Cash $ 6,445 Accounts Receivable 1,250 less Allow. for Doubt. Accts. (125) Net Accounts Receivable 1,125 Merchandise Inventory 3,000 Supplies Inventory 60 Prepaid Rent 200 Total Current Assets $10,830
Current: Accounts Payable Salaries Payable Unearned Revenue
$ 2,690 250 100
Total Current Liabilities
$ 3,040
Noncurrent: Equipment
Noncurrent: Notes Payable
$10,000
Owners’ Equity: Capital Stock Retained Earnings Total Owners’ Equity
$ 2,000 2,790 $ 4,790
Total Assets
$ 7,000
$17,830
Total Liabilities & Owners’ Equity
$17,830
Research Assignment
a. (dollar figures are in millions)
Merchandise sales and services Cost of sales, buying and occupancy
2010 43,326 31,448
2009 44,043 31,824
2008 46,770 34,118
Gross profit
11,878
12,219
12,652
Gross profit percentage
27.4%
27.7%
27.1%
The gross profit percentage has stayed very consistent over these three years. Unfortunately, in the same period, sales have declined. The company will have trouble generating significant improvements in net income without an increase in sales, an increase in the gross profit percentage, or a decrease in its other expenses
b. (dollar figures are in millions)
Merchandise inventories Total Assets
2011 9,123 24,268
2010 8,705 24,808
Inventory / Total Assets
37.6%
35.1%
Inventory as a percentage of total assets has increased from 2010 to 2011 by 2.5 percent. If that increase had been accompanied by an increase in sales revenue, it would have seemed appropriate. However, at the same time, this company’s sales are actually declining. Thus, the concern is that the merchandise is not selling as quickly as in the past and might get old, out-of-date, or damaged.
Chapter 9 Solutions Answers to Questions 1) In accounting for the sale of an inventory item, an appropriate cost must be moved from inventory to cost of goods sold. Often, the specific cost of the item sold is unknown. This is especially true when many similar items are bought over time at differing costs. Therefore, a cost flow assumption must be made to select the cost to be transferred from the asset account (inventory) to the expense account (cost of goods sold). A cost flow assumption is necessary because the actual cost of the inventory that is held and that is sold is unknown. 2) A cost flow assumption is not required in two cases. First, no cost flow assumption is made when all inventory items are purchased at the same cost. In that situation, the cost of the item sold is known in every case. Second, for some merchandise (usually unique items with a relatively high cost), the actual cost is maintained and moved to cost of goods sold when that specific item is sold. For example, a new car dealership is very likely to know the exact cost of every car on its lot. When one is sold, that actual cost is transferred to cost of goods sold. 3) Specific identification is used when a company keeps records of the actual cost of individual inventory items. When a sale is made, the cost of that particular piece of inventory is moved from inventory to cost of goods sold. Because the actual cost is known, no cost flow assumption is needed. 4) First in, first out (FIFO) assumes that the cost of the oldest inventory item is the first cost moved to cost of goods sold. If the actual identity of the item sold cannot be determined, an assumption must be made. With FIFO, the assumption is that the oldest cost is moved from asset to expense. Here, that would be the $700 cost of the oldest refrigerator. 5) Last in, first out (LIFO) assumes that the cost of the most recently purchased inventory item is the first cost moved to cost of goods sold. If the actual identity of the item sold cannot be determined, an assumption must be made. With LIFO, the assumption is that the most recent cost is moved from asset to expense. Here, that would be the $790 cost of the last refrigerator acquired during the period. 6) Averaging assumes that the average cost of all inventory items acquired is the first cost moved to cost of goods sold. If the actual identity of the item sold cannot be determined, an assumption must be made. The average cost is moved from asset to expense. This average cost can be computed as a weighted average or a moving average. In this question, because the one inventory item was sold at the end of the period, the same average is computed by either approach: ($700 + $730 + $790)/3 or $740.
7) When using FIFO, during a period of inflation, the oldest and cheapest inventory costs go to cost of goods sold so that gross profit and, therefore, net income are higher. The most recent (and higher) costs remain in ending inventory which is also higher. The figure reported as inventory under FIFO is normally considered to be closer to its actual value. When using LIFO, during a period of inflation, the most recent and most expensive inventory costs go to cost of goods sold so that gross profit and, therefore, net income are lower. The oldest and cheapest inventory costs remain in ending inventory which is lower. Because LIFO reports a lower net income during inflationary periods, its use is often associated with the savings of income tax dollars. However, over extended periods of time, the reported inventory balance may become significantly lower than the current worth of the merchandise. 8) Income tax laws enable the government to help regulate the health of the economy, simply by raising or lowering tax rates. Certain elements of the economy can also be impacted by changes in tax laws. For example, reduced tax rates on capital (investment) gains are viewed as a method for encouraging more investment and growth. Income tax laws are also used to assist certain members of society who are viewed as deserving of help. For example, tax benefits are available for individuals with high medical expenses, for individuals who adopt children, and for individuals who suffer casualty losses. 9) Companies (and individuals) must file and pay federal income taxes based on the laws and regulations created by the US Congress and applied by the Internal Revenue Service. In contrast, a company must create its financial statements based on US GAAP created by FASB. Because two different sets of rules are involved, the resulting information will vary at key points. To ensure that both their income tax returns and financial statements are prepared properly, companies must keep adequate records. Where the rules and laws vary from each other, the company may have to maintain two sets of records to ensure that the proper information is available to meet each set of requirements. 10) The LIFO conformity rule allows LIFO be used for income tax purposes but only if the company also uses LIFO for financial reporting. In periods of inflation, LIFO can be used to reduce tax payments. That is a real advantage and not just a reporting advantage. However, according to the US tax laws, the company must also use this method for financial reporting purposes and, consequently, will report a lower net income. The US Congress, by continuing to uphold the LIFO conformity rule, basically keeps alive the use of LIFO in financial reporting. Without the LIFO conformity rule, companies would likely use LIFO for tax purposes and FIFO (or averaging) for financial reporting. The use of LIFO would decline precipitously 11) Several practical problems exist that cause the use of LIFO to be rare in countries outside of the US where the LIFO conformity rule does not exist. Because older costs remain in inventory, the asset figure reported on the balance sheet can become
outdated and misleading (often extremely misleading). In addition, any LIFO liquidation will likely cause a quick and sudden jump in net income without any theoretical justification. Often other application problems exist with LIFO that allow numbers to be manipulated so that a fair presentation seems problematic. 12) Because of the assumption that underlies LIFO (last-in, first-out), inventory is reported on the balance sheet at the cost of the first 100 loaves of bread that were bought when the store originally opened. Whenever inventory quantities are brought back each period to a set quantity, the cost of the purchases becomes the cost of goods sold while the cost of the first items bought remain in the inventory account. 13) In applying LIFO, the older costs are maintained within the inventory account. If the quantity of that inventory is reduced (either by a significant amount of sales or by a reduction in purchases), these older costs are moved from inventory to cost of goods sold. If inflation has occurred, older costs will be cheaper (often considerably cheaper). Moving this cost to cost of goods sold makes the company look as if it has a much larger gross profit (and, hence, net income). This reported increase in profitability is not the result of improved sales or better purchasing practices but simply a mismatching of earlier costs with current revenue. LIFO liquidation is often associated with an artificial inflation of reported profits. 14) Petrakellon apparently monitors its inventory on a daily basis using FIFO and has arrived at a final cost for the period of $900,000. Internal decisions are made within the company based on that figure. However, at the end of that year, the company took a physical inventory and applied the LIFO cost flow assumption to arrive at a reported balance that was $300,000 lower. Most likely, the reduced figure was being used for reporting purposes because of the LIFO conformity rule. With the physical presentation of the accounts on the balance sheet, investors and creditors could still see the required LIFO balance of $600,000. At the same time, they would also know that ending inventory actually had a current cost of approximately $900,000 based on the application of FIFO. 15) In a periodic system, a cost flow assumption is used once each period. When financial statements are being prepared and a physical inventory count is taken, the cost of those units must be determined. At that point, the cost flow assumption is applied in a periodic inventory system. In a perpetual system, a cost flow assumption is used each time that a sale occurs. When a perpetual system is in place, a cost is transferred from inventory to cost of sales at the time of each sale. The cost to be moved from asset to expense is determined based on a cost flow assumption such as FIFO or LIFO. 16) Under FIFO, the earliest costs are always moved from inventory to cost of goods sold. Regardless of whether that assessment is made at the end of the year (periodic) or at the time of the sale (perpetual), the earliest goods are always the same. The perspective does not change the identity of the first inventory items that were acquired.
17) In a periodic system, the identity of the cost transferred to cost of goods sold is determined at the end of the year (or the point in time when financial statements are to be prepared). Here, if LIFO is applied, the last unit is moved from inventory to expense. That cost is $90. Obviously, the units costing $90 were not even acquired by the company until after the sale. However, the cost assignments are made based on the end-of-the-year perspective. No attempt is made during the period to monitor the costs. In contrast, if a perpetual system is being applied, the movement of the cost takes place at the time of the sale. On that date, the cost of the most recent purchase was $80 which becomes the cost of goods sold. In a LIFO system (and an averaging system), cost of goods sold will differ based on the time perspective. The key is whether the decision is made at the end of the year (periodic) or at the time of the sale (perpetual)? 18) In a periodic system (weighted average), no attempt is made to determine cost of goods sold or cost of the ending inventory until the end of the period. Therefore, the weighted average cost is the cost of all inventory for that period divided by the total number of units. In a perpetual system (moving average), an updated average cost is calculated each time that a new purchase is made. 19) All information for LIFO is available here except for the inventory purchases for the period. That number is the same for LIFO and FIFO and can be determined based on the following formula: Cost of Goods Sold = Beginning Inventory + Purchases – Ending inventory. Therefore, $300,000 = $44,000 + Purchases - $48,000 so that Purchases for the period is $304,000. Beginning and ending inventory figures are available for FIFO. Purchases of inventory for the period is also now known. Cost of goods sold using FIFO can be determined as $76,000 + $304,000 - $114,000. Cost of goods sold according to the FIFO cost flow assumption is $266,000. 20) The gross profit percentage is the gross profit for the year (net sales less cost of goods sold) divided by the net sales figure. This percentage allows a decision maker to determine the size of the markup the company is able to demand and still sell its inventory. For example, if a company has a gross profit percentage of 38 percent and sales an average item for $140, the markup above cost is $53.20 ($140 times 38 percent). As long as sales are not reduced by the decision, the larger the gross profit percentage the larger the net income will be for the reporting company. 21) The number of days in inventory informs decision makers of the number of days that inventory is held (on the average) before being sold. Normally, companies prefer that this number stay relatively short. The longer inventory is held the more likely it is that it will get lost, broken, or stolen. In addition, companies frequently have a large portion of their monetary funds tied up in inventory. That money cannot be used to generate additional profits as long as the inventory remains unsold. Companies monitor the age of their inventory carefully and take action if the number of days begins to increase
without adequate explanation. The age is mathematically determined by first dividing cost of goods sold by 365 to get the cost of inventory sold each day (on the average). That figure is then divided into the average inventory balance for the year (or the ending balance if that figure is being examined). 22) Inventory turnover is a measure of the speed at which inventory is sold. It is calculated by taking the cost of goods sold for the period and dividing that figure by the average inventory for the period. Cost of goods sold is beginning inventory + purchases – ending inventory. In this question, that works out to be $700,000 ($300,000 + $800,000 - $400,000). Average inventory is ($300,000 + $400,000)/2 or $350,000. Therefore, inventory turnover is $700,000/$350,000 or 2 times. An amount of inventory equal to the company’s average inventory was sold twice in the last year, roughly every 180 days. 23) a. Under FIFO, three pieces of inventory were acquired and one was sold so two are left. b. Under LIFO, three pieces of inventory were acquired and one was sold so two are left. c. Under FIFO, the company had $60 in cash and then spent that entire amount on three pieces of inventory but did manage to sell one unit for $40 so that the cash on hand is $40. d. Under LIFO, the company had $60 in cash and then spent that entire amount on three pieces of inventory but did manage to sell one until for $40 so that the cash on hand is $40 e. The purpose of the first four question is to show that a cost flow assumption does not directly change the company. Regardless of the assumption in use here, the company holds two pieces of inventory at the end of the period and $40 in cash. What does change is the appearance. Note here that since only one unit was sold and since it was sold after all purchases had been made, periodic LIFO and perpetual LIFO will report the same figures. That always happens in applying FIFO but here is also does for LIFO. Therefore, the use of either a perpetual or a periodic system does not change the reported number. Using FIFO, the cost of the first unit ($16) is moved to cost of goods sold while the cost of the last two units ($19 and $25) stays in ending inventory. Reported gross profit is $40 - $16 or $24. Ending inventory is $19 + $25 or $44. f. Using LIFO, the cost of the last unit ($25) is moved to cost of goods sold while the cost of the first two units ($16 and $19) stays in ending inventory. Reported gross profit is $40 - $25 or $15. Ending inventory is $16 + $19 or $35. The normal characteristics of FIFO and LIFO can be seen in this example. During inflation, FIFO reports a higher gross profit ($24 versus $15) and also a higher ending inventory ($44 versus $35).
Answers to True or False Questions __F__ 1) LIFO only gives a lower reported net income than FIFO in a period of rising prices. costs are going down for a company’s inventory, the opposite impact occurs.
If
__T__ 2) Because LIFO moves the most recent cost of inventory to cost of goods sold, it is a closer matching of revenue and expense. In contrast, FIFO moves an earlier cost into the expense account. Therefore, under FIFO, additional time passes between the cost incurred for the inventory and the sale. __F__ 3) This statement is backwards. The LIFO conformity rule is not an accounting rule but rather a tax rule. It states that if LIFO is used for income tax purposes then it must also be used for financial reporting. __F__ 4) Companies that apply LIFO will provide information in their financial statements that allows decision makers to adjust reported figures to those that would have been appropriate if FIFO was applied. Thus, comparisons based on a FIFO cost flow assumption can be made. __T__ 5) Companies that sell unique items with a relatively high cost often keep individual records for each item for internal decision making. This recordkeeping enables the company to apply specific identification for external reporting purposes. __T__ 6) One of the main arguments for the use of FIFO is that it best mirrors reality. Companies do not want merchandise to get old or spoil. Therefore, they usually attempt to sell their oldest items first. In most cases, FIFO paints a portrait that most resembles the operations of an actual company. __T__ 7) Because a perpetual system is in use, costs are transferred to cost of goods sold at the time of the sale. No sale was made after this last purchase was made. Thus, no additional change is made in the expense account and the reported net income.
__F__ 8) When FIFO is applied, the resulting figures are the same whether a periodic or a perpetual system is used to monitor inventory. The remaining 5,000 units will be the last 5,000 units that were acquired. That is 2,000 units at $14 each ($28,000), 2,000 units at $12 each ($24,000), and 1,000 units at $9 each ($9,000). That provides an ending inventory of $61,000 ($28,000 + $24,000 + $9,000). __T__ 9) In a periodic system, cost of goods sold is determined by formula: beginning inventory plus purchases less ending inventory. This last inventory item acquired in the question increases the purchases amount by $16. The real question is how it impacts the reported balance of the ending inventory. That decision is made at the end of the year after all transactions have occurred. This last purchase increases the number of units on hand from 5,000 to 5,001. Because periodic LIFO is applied, the ending inventory always comes from the first costs. For the 5,000 units, it was 3,000 at $9 and 2,000 at $12. For 5,001 units, it is 3,000 at $9, 2,000 at $12, and one at $14. Those costs were the first incurred. Ending inventory increases by $14. If the purchases balance goes up by $16 but ending inventory only goes up by $14, cost of goods sold is $2 higher. This change makes gross profit $2 lower. __F__ 10) A LIFO liquidation is a reduction in the quantity of ending inventory. Because of inflation, costs reported by LIFO are often considerably below current prices. However, they remain in ending inventory until the cost of ending inventory is decreased. Moving those early costs (rather than more recent costs) to cost of goods sold can create a significant jump in reported net income. It is not an increase in income that was created by a rise in sales or more efficient operations but, rather, by a mismatching of expenses and revenue. __T__ 11) In applying FIFO, the earliest costs for the period are quickly moved to cost of goods sold as sales are made during the period. In this question, the costs were put into inventory early in the year. By the end of the year, those costs will have been transferred to cost of goods sold. They should have originally been recorded as an expense. They are eventually recorded as an expense. At year’s end, net income is not misstated. __F__ 12) The gross profit percentage is the amount of the sales price that reflects the markup above cost. It does not indicate the speed at which inventory is sold.
__F__ 13) Beginning inventory was 3,000 units $9 each or $27,000. Purchases are 2,000 units at $12 each ($24,000) and 2,000 units at $14 each ($28,000). Total purchases are $52,000. Since 4,000 units were sold, the company must still have 3,000 units in ending inventory. Because FIFO is used, those units were viewed as the last ones acquired: 2,000 units at $14 each ($28,000) and 1,000 units at $12 each ($12,000) or a total of $40,000. Cost of goods sold is $27,000 plus $52,000 less $40,000 or $39,000. Cost of goods sold per day is $107 which is found by dividing the expense figure by 365. The average inventory for the period is ($27,000 + $40,000)/2 or $33,500. The average age of inventory for the period is $33,500/$107 or 313 days. If the ending inventory figure is used rather than the average it is $40,000/$107 or 374 days. __F__ 14) Beginning inventory was 4,000 units $8 each or $32,000. Purchases are 3,000 units at $10 each ($30,000) and 2,000 units at $14 each ($28,000). Total purchases are $58,000. Since 6,000 units were sold, the company must have had 3,000 units in ending inventory. Because periodic LIFO is used, those units are viewed as the first ones acquired: 3,000 units at $8 each ($24,000). Cost of goods sold is $32,000 plus $58,000 less $24,000 or $66,000. Cost of goods sold per day is $180.8 which is found by dividing the expense figure by 365. The average inventory for the period is ($32,000 + $24,000)/2 or $28,000. The average age of inventory for the period is $28,000/$180.8 or 154.9 days. If the ending inventory figure is used rather than average inventory it is $24,000/$180.8 or 132.7 days. __F__ 15) Beginning inventory was 10,000 units $10 each or $100,000. Total purchases are 40,000 units at $15 each or $600,000. A physical count shows that 11,000 units remain in ending inventory. Because periodic LIFO is used, those units were assumed to be the first ones acquired: 10,000 units at $10 each ($100,000) and 1,000 at $15 each ($15,000). Cost of goods sold is $100,000 plus $600,000 less $115,000 or $585,000. The average inventory for the period is ($100,000 + $115,000)/2 or $107,500. Inventory turnover is cost of goods sold divided by average inventory ($585,000/$107,500) or 5.44 times. __T__ 16) Beginning inventory was 10,000 units $10 each or $100,000. Total purchases are 40,000 units at $15 each or $600,000. A physical count shows that 11,000 units remain in ending inventory. Because periodic FIFO is used, those units were assumed to be the last ones acquired: 11,000 units at $15 each ($165,000). Cost of goods sold is $100,000 plus $600,000 less $165,000 or $535,000. The average
inventory for the period is ($100,000 + $165,000)/2 or $132,500. Inventory turnover is cost of goods sold divided by average inventory ($535,000/$132,500) or 4.04 times
Answers to Multiple Choice Questions 1) Answer is A Specific identification provides an exact matching because it is the cost of the actual item being sold that is moved from the asset account to expense. 2) Answer is A FIFO assumes that the hats purchased in February and April were sold first. Cost of Goods Sold is $5 + $6 = $11. 3) Answer is B In a period of rising prices, LIFO provides the lowest net income and not the highest. The most recent (and most expensive) purchases are moved first to cost of goods sold. 4) Answer is A Sales are 8 units at $9 each or $72. In a periodic LIFO system, the most recent purchases are transferred to cost of goods sold. Here, that is 2 units at $6.50 each ($13), 5 units at $5 each ($25), and 1 unit at $4 each ($4) for a total of $42. Gross profit is $72 less $42 (or $30). 5) Answer is C Here, the sales figure goes up by $12. That is known. The answer to the question depends on the increase in cost of goods sold. Beginning inventory was 10 units $8 each or $80. Purchases are 10 units at $10 each ($100) and 10 units at $13 each ($130). Total purchases are $230. Since 14 units were sold, the company must have had 16 units remaining in ending inventory. Because periodic LIFO is applied, those units are viewed as the first ones acquired: 10 units at $8 each ($80) and 6 units at $10 each ($60) for a total of $140. Cost of goods sold is $80 plus $230 less $140 or $170 before the final sale is made. If that sale is made, the company will only have 15 units left in ending inventory: 10 units at $8 each ($80) and 5 units at $10 each ($50) for a total of $130. Cost of goods sold is $80 plus $230 less $130 or $180. Cost of goods sold goes up by $10 from $170 to $180. Another way to look at this is to realize that one of the units bought at $10 is moved from inventory to cost of goods sold. If sales go up by $12 and cost of goods sold goes up by $10, net income will increase by $2.
6) Answer is B In a perpetual LIFO system, whenever a sale is made, the cost of the most recent purchase is moved from inventory to cost of goods sold. Here, at the end of the year, the most recent purchase was made at a cost of $13 per unit. Thus, selling an additional item increases sales by $12 but also increases cost of goods sold by $13. Thus, reported net income falls by $1. 7) Answer is C In this problem, the sales figure goes up by $12. Thus, the answer to the question depends on the increase in cost of goods sold. Beginning inventory was 10 units $8 each or $80. Purchases are 10 units at $10 each ($100) and 10 units at $13 each ($130). Total purchases are $230. Since 14 units were sold, the company must have had 16 units in ending inventory. Because FIFO is used, those units are viewed as the last ones acquired: 10 units at $13 each ($130) and 6 units at $10 each ($60) for a total of $190. Cost of goods sold is $80 plus $230 less $190 or $120 before the final sale is made. If that sale is made, the company will only have 15 units left in ending inventory: 10 units at $13 each ($130) and 5 units at $10 each ($50) for a total of $180. Cost of goods sold is $80 plus $230 less $180 or $130. Cost of goods sold goes up by $10 (from $120 to $130). If sales go up by $12 and cost of goods sold goes up by $10, net income will increase by $2. 8) Answer is D The company starts the year with 30 units costing $20 each. Of that amount, 20 are sold leaving 10 units at $20 each ($200). Then, 20 more or bought for $24.50 each ($490). That means the company has 30 units costing $690 ($200 + $490) or $23 each. Next, 20 are sold leaving 10 at $23 each ($230). An additional group of 20 units is bought for $24.50 each ($490). The company then holds 30 units costing $720 ($230 + $490) or $24 each. The average moves when each new purchase is made. A final sale of 20 units leaves 10 units on hand costing an average of $24 each or $240. 9) Answer is C A LIFO liquidation means that costs from an earlier period of time are expensed in the current year as a result of a decrease in the quantity of inventory being held. Because inflation has occurred over the years, those earlier costs are reported at an outdated (and low) cost. When moved to cost of goods sold, net income can jump substantially because of the mismatching of early costs with current revenues.
10) Answer is C Sales revenue and cost of goods sold were omitted so gross profit was understated by the amount of the markup. However, they were replaced with a gain for the same amount, the difference in cost and sales price. Therefore, net income is brought back to its correct figure. The profit is simply moved from gross profit to a gain. In addition, inventory should have been reduced and it was. That balance is properly presented. 11) Answer is D A FIFO cost assumption is in use and 16 units remain. In FIFO, the assumption is made that the first units have been sold and that cost moved to cost of goods sold. The cost of the most recent purchases remains in inventory. The last 16 units are assumed to be 10 at $16 ($160) and 6 at $15 ($90). Ending inventory is reported as $250. 12) Answer is A At the end of Year One, 12 units were held. Under periodic LIFO, those 12 units are the first 12 acquired or 10 at $12 ($120) and 2 at $13 ($26). At the end of Year Two, 16 units are held. Using LIFO, the costs are assumed to be those reported for the 12 units carried over from Year One plus the first four units bought in Year Two (at $15 each or $60). The 16 units held at the end of Year Two are assumed to have a cost of $120 + $26 + $60 or $206. 13) Answer is C In a perpetual inventory system, cost is moved from inventory to cost of goods sold at the time of the sale. In Year One, 8 units are sold after the initial purchase. Thus, at the end of Year One, the company has an assumed cost of 2 units at $12 each and 10 units at $13 each. Then, eight units are sold which leaves 2 units at $12 and 2 more units at $13 based on applying LIFO. Buying 10 more units for $15 apiece brings the company total to 2 units at $12 each, 2 units at $13 each, and 10 units at $15 each. Eight units are sold which leaves the following costs: 2 units at $12, 2 units at $13, and 2 units at $15 when applying LIFO. The final purchase of ten units brings the ending total to 2 units $12 each ($24), 2 units at $13 each ($26), 2 units at $15 each ($30), and 10 at $16 ($160). Ending inventory is $240 ($24 + $26 + $30 + $160). 14) Answer is B At the end of Year One, the company holds 12 units bought at an average price of $12.50 each. The first ten units at $12 each give a total cost of $120. The ten units at $13 each give a total cost of $130. The overall total cost is $250 ($120 + $130) which is divided over 20 units to arrive at the initial $12.50 average. The company has 12 units
left at the end of Year One or a total of $150 based on the $12.50 average. In Year Two, the company buys 10 units at $15 each ($150) and 10 more units at $16 each ($160). That is a total of 32 units costing $460 ($150 + $150 + $160). The average cost is now $14.375 ($460/32 units). At the end of the period, 16 units are still held at this average of $14.375 or $230. 15) Answer is A In periods of inflation, LIFO gives a higher balance in cost of goods sold and, therefore, reduces reported net income (probably in order to reduce income tax payments). Here, the company is experiencing deflation because prices are dropping. In that situation, the impact of using LIFO is reversed. The company will have a lower cost of goods sold and a higher reported net income. 16) Answer is C Inventory turnover is found by taking cost of goods and dividing it by average inventory for the period. Average inventory is ($230,000 + $390,000)/2 or $310,000. Inventory turnover is $2,800,000/$310,000 or 9.03 times. 17) Answer is B Inventory turnover is found by taking cost of goods and dividing it by average inventory for the period. Here, cost of goods sold is $280,000 (beginning inventory) plus $3,600,000 (purchases for the period) less $320,000 (ending inventory) or $3,560,000. Average inventory is ($280,000 + $320,000)/2 or $300,000. Inventory turnover is $3,560,000/$300,000 or 11.87 times. 18) Answer is A Inventory turnover is found by taking cost of goods and dividing it by average inventory for the period. Here, cost of goods sold is $240,000 (beginning inventory of 30,000 units at $8 each) plus $1,200,000 (purchases of 100,000 units at $12 each) less $480,000 (ending inventory of 40,000 units at $12 each – as a result of applying FIFO) or $960,000. Average inventory is ($240,000 + $480,000)/2 or $360,000. Inventory turnover is $960,000/$360,000 or 2.67 times. 19) Answer is A To find the age of inventory, the cost of goods sold per day is computed. Here, that is $2,920,000/365 days or $8,000 per day. The average inventory is ($250,000 + $390,000)/2 or $320,000. Therefore, inventory is held for an average of 40 days during this year ($320,000/$8,000).
20) Answer is C To find the age of inventory, the cost of goods sold per day is computed. Here, cost of goods sold is $320,000 (beginning inventory) plus $4,340,000 (purchases for the period) less $280,000 (ending inventory) or $4,380,000. Cost of goods sold per day is $4,380,000/365 days or $12,000 per day. The average inventory is ($320,000 + $280,000)/2 or $300,000. Therefore, inventory is held for an average of 25 days during this year ($300,000/$12,000).
Answers to Problems 1) a. April
Purchases $44,000 Cash (or Accounts Payable)
$44,000
August Purchases $92,000 Cash (or Accounts Payable)
$92,000
b. If inventory is not broken, stolen, or lost, the company will hold 2,000 units at the end of the year: 5,000 units in beginning inventory + 6,000 units purchased – 9,000 units sold c. Beginning inventory is 5,000 units at a cost of $20 each or $100,000. Purchases of inventory (as shown above) total $136,000 ($44,000 + $92,000). Because FIFO is applied, the 2,000 units that remain at the end of the year are assumed to have a cost of $23 per unit (last cost of the year) or $46,000 in total. Therefore, cost of goods sold is $100,000 + $136,000 - $46,000 or $190,000. 2) As in problem (1), beginning inventory will still be $100,000 and purchases of inventory total $136,000. Because LIFO is applied, the 2,000 units that remain at the end of the year are assumed to have a cost of $20 per unit (first cost of the year) or $40,000. Cost of goods sold is $100,000 + $136,000 - $40,000 or $196,000. Notice that, in comparing problem (2) to problem (1) cost of goods sold is a larger number when LIFO is used than with FIFO. That reduces reported net income which is the impact that is expected when LIFO is applied during inflationary times. 3) As in problem (1), beginning inventory will still be $100,000 and purchases of inventory total $136,000. That gives a total cost of $236,000 for these 11,000 units (5,000 + 2,000 + 4,000) for an average of $21.45 (rounded). Because weighted averaging is applied, the 2,000 units that remain at the end of the year are assumed to have the average cost of $21.45 per unit or $42,900. Cost of goods sold is $100,000 + $136,000 - $42,900 or $193,100. Notice that, in comparing problems (1), (2), and (3), cost of goods sold is
between LIFO ($196,000) and FIFO ($190,000) when averaging is used. When costs increase or decrease throughout the year, averaging will fall between the two extreme methods. 4) In switching from LIFO to FIFO, the beginning inventory increases by $3,000,000 (from $20,000,000 to $23,000,000). Beginning inventory is added to cost of goods sold so this change represents a $3,000,000 increase. The ending inventory increases by $7,200,000 (from $21,500,000 to $28,700,000). Ending inventory is subtracted in computing cost of goods sold so this change represents a $7,200,000 decrease. The net effect is a $4,200,000 reduction in cost of goods sold ($3,000,000 increase and a $7,200,000 decrease). Cost of goods sold under LIFO was reports as $34,900,000. The net decrease of $4,200,000 if FIFO had been applied drops that reported number to $30,700,000. Although it was not asked in the question, reported net income would have been $4,200,000 higher if FIFO had been utilized. 5) a. The company has a beginning inventory of 400 units at $10 per unit or $4,000. Purchases for the period are 140 units at $12 each ($1,680), 150 units at $13 each ($1,950), and 180 units at $15 each ($2,700) or a total cost of $6,330. Ending inventory is also 400 units. Because periodic LIFO is applied, the cost of the first 400 units is assumed to be the cost of the ending inventory or 400 units at $10 per unit ($4,000). Cost of goods sold is $4,000 + $6,330 - $4,000 or $6,330. b. Under a perpetual system, inventory costs are moved to cost of goods sold when the inventory is sold. October begins with 400 units at a cost of $10 per unit. In that month, 140 units are sold and $1,400 is moved to cost of goods sold (140 units at $10 each) leaving 260 units at $10 per unit. At the end of October, 140 units are bought for $12 each. Thus, at the beginning of November, the company holds 260 units at an assumed cost of $10 per unit and 140 units at the new cost of $12 per unit. In that month, 150 units are sold. Because LIFO is being applied, the cost of the last units bought (140 units) is moved to cost of goods sold (140 units at $12 each or $1,680). In addition, because 150 units were sold, the cost of another 10 units must also be moved to cost of goods sold. The cost of these ten units is assumed to be $10 each or $100 in total. As a result, the inventory costing $10 each falls from 260 units to 250 units. At the end of November, another 150 units are bought for $13 each. At the beginning of December, using perpetual LIFO, the company holds 250 units with a cost of $10 each and 150 units at the new cost of $13 each. The company then sells 180 units in December. Using LIFO, the cost of the first 150 units comes from items bought at the end of November for $13 each ($1,950). The remaining 30 come from items costing $10 each ($300).
Cost of goods sold for these three months is $1,400 (October), $1,680 and $100 (November), and $1,950 and $300 (December) or $5,430 in total.
6) a. Paula’s Parkas Cost of Goods Sold and Ending Inventory for January based on applying perpetual FIFO. Inventory Acquired → Inventory On Hand → Inventory Sold 1/1 Beginning balance
20 units @ $35
1/2 12 units purchased
12 units @ $36
20 units @ $35 12 units @ $36
1/8 10 units purchased
10 units @ $36.50
20 units @ $35 12 units @ $36 10 units @ $36.50
1/10 15 units sold
1/17 14 units sold
1/22 8 units purchased
8 units @ $37
1/28 10 units sold
5 units @ $35 12 units @ $36 10 units @ $36.50
15 units @ $35=$525
3 units @ $36 10 units @ $36.50
5 units @ $35 9 units @ $36=$499
3 units @ $36 10 units @ $36.50 8 units @ $37 3 units @ $36.50 8 units @ $37
Totals
$109.50 + $296 = $405.50
3 units @ $36 7 units @ $36.50=$363.50 $525 + $499 + $363.50 = $1,387.50
Ending inventory is $405.50. Cost of goods sold is $1,387.50 b. Parka’s gross profit for January based on applying perpetual FIFO. Sales (39 units × $60) Cost of Goods Sold Gross Profit
$2,340.00 (1,387.50) $ 952.50
7) a. Paula’s Parkas Cost of Goods Sold and Ending Inventory for January based on applying perpetual LIFO. Inventory Acquired → Inventory On Hand → Inventory Sold 1/1 Beginning balance
20 units @ $35
1/2 12 units purchased
12 units @ $36
20 units @ $35 12 units @ $36
1/8 10 units purchased
10 units @ $36.50
20 units @ $35 12 units @ $36 10 units @ $36.50
1/10 15 units sold
20 units @ $35 7 units @ $36
10 units @ $36.50 5 units @ $36=$545
1/17 14 units sold
13 units @ $35
7 units @ $36 7 units @ $35=$497
1/22 8 units purchased
8 units @ $37
1/28 10 units sold
Totals
13 units @ $35 8 units @ $37 11 units @ $35
8 units @ $37 2 units @ $35=$366
11 units @ $35 = $385
$545 + $497 + 366 = $1,408
Ending inventory is $385 Cost of goods sold is $1,408 b. Determine Parka’s gross profit for January. Sales (39 units × $60) Cost of Goods Sold Gross Profit
$2,340.00 (1,408.00) $ 932.00
8) a. Paula’s Parkas Cost of Goods sold and Ending Inventory for January based on applying a moving average system. Inventory Acquired → Inventory On Hand → Inventory Sold 1/1 Beginning balance
20 units @ $35
1/2 12 units purchased
12 units @ $36
20 units @ $35 12 units @ $36 32 units @ $35.38
1/8 10 units purchased
10 units @ $36.50
32 units @ $35.38 10 units @ $36.50 42 units @ $35.65(1)
1/10 15 units sold
27 units @ $35.65 15 units @ $35.65=$534.75
1/17 14 units sold
13 units @ $35.65 14 units @ $35.65=$499.10
1/22 8 units purchased
8 units @ $37
1/28 10 units sold
13 units @ $35.65 8 units @ $37 21 units @ $36.16(2) 11 units @ $36.16 10 units @ 36.16=$361.60
Totals
11 units @ $36.16 = $397.76
$534.75 + $499.10 + $361.60 = $1,395.45
(1) – 32 units @ $35.38 cost $1,132.16 while 10 units @ $36.50 cost $365. That is 42 units costing a total of $1,497.16 ($1,132.16 + $365) for an average of $35.65. (2) – 13 units @ $35.65 cost $463.45 while 8 units @ $37 cost $296. That is 21 units costing a total of $759.45 ($463.35 + $296) for an average of $36.16. Ending inventory is $397.76 Cost of goods sold is $1,395.45 b. Determine Parka’s gross profit for January. Sales (39 units × $60) Cost of Goods Sold Gross Profit
$2,340.00 (1,395.45) $ 944.55
9) Basic information: --Year One sales – 800 units at $12 ($9,600) and 700 units at $14 ($9,800). Total sales are $19,400. --Year One purchases – 1,000 at $7 ($7,000), 1,000 at $8 ($8,000), and 1,000 at $10 ($10,000). Total purchases are $25,000. --Inventory at end of Year One – 3,000 units purchased less 1,500 units sold = 1,500 units in ending inventory. --Year Two sales – 700 units at $17 ($11,900), 900 units at $20 ($18,000), and 700 units at $22 ($15,400). Total sales are $45,300. --Year Two purchases – 1,000 at $11 ($11,000) and 1,000 at $12 ($12,000). Total purchases are $23,000. --Inventory at end of Year Two – beginning inventory of 1,500 units plus 2,000 units purchased less 2,300 units sold = 1,200 units in ending inventory.
a. Periodic LIFO YEAR ONE Beginning inventory Purchases Ending inventory (1,000 at $7 and 500 at $8) Cost of goods sold Sales Cost of goods sold Gross profit
YEAR TWO Beginning inventory (1,000 at $7 and 500 at $8) Purchases Ending inventory (1,000 at $7 and 200 at $8) Cost of goods sold Sales Cost of goods sold Gross profit
-0$25,000 ( 11,000) $ 14,000 $19,400 ( 14,000) $ 5,400
$ 11,000 23,000 ( 8,600) $25,400 $45,300 ( 25,400) $ 19,900
b. Perpetual LIFO – Year One Inventory Acquired → Inventory On Hand → Inventory Sold 3/1 1,000 units purchased 1,000 units @ $7 5/1 800 units sold
1,000 units @ $7 200 units @ $7
8/1 1,000 units purchased 1,000 units @ $8
10/1 700 units sold
200 units @ $7 1,000 units @ $8 200 units @ $7 300 units @ $8
12/1 1,000 units purchased 1,000 units @ $10
800 units @ $7 ($5,600)
700 units @ $8 ($5,600)
200 units @ $7 300 units @ $8 1,000 units @ $10
Ending inventory: 12/31/1 – 200 @ $7 ($1,400) + 300 @ $8 ($2,400) + 1,000 @ $10 ($10,000) = $13,800 Cost of goods sold for Year One: $5,600 + $5,600 = $11,200 Sales Cost of goods sold Gross profit-Year One
$19,400 ( 11,200) $ 8,200
Perpetual LIFO – Year Two Inventory Acquired → Inventory On Hand → Inventory Sold 1/1 Beginning inventory 200 units @ $7 300 units @ $8 1,000 units @ $10 4/1 700 units sold
6/1 1,000 units purchased 1,000 units @ $11
200 units @ $7 300 units @ $8 300 units @ $10 200 units @ $7 300 units @ $8 300 units @ $10 1,000 units @ $11
700 units @ $10 ($7,000)
9/1 900 units sold
200 units @ $7 300 units @ $8 300 units @ $10 100 units @ $11 900 units @ $11 ($9,900)
11/1 1,000 units purchased 1,000 units @ $12
200 units @ $7 300 units @ $8 300 units @ $10 100 units @ $11 1,000 units @ $12
12/1 700 units sold
200 units @ $7 300 units @ $8 300 units @ $10 100 units @ $11 300 units @ $12 700 units @ $12 ($8,400)
Ending inventory: 12/31/2 – 200 @ $7 ($1,400) + 300 @ $8 ($2,400) + 300 @ $10 ($3,000) + 100 @ $11 ($1,100) + 300 @ $12 ($3,600) = $11,500 Cost of goods sold for Year Two: $7,000 + $9,900 + $8,400 = $25,300 Sales Cost of goods sold Gross profit
$45,300 ( 25,300) $ 20,000
10) Basic information: The company starts with 20 units costing $20 ($400) each and buys 10 more units at $22 each ($220) and a final 10 units at $27 each ($270). The company sold 30 units so there are 10 units left at the end of the period (20 + 10 + 10 – 30). a. Applying a weighted average system Total cost is $890 ($400 + $220 + $270) and the number of units is 40 (20 + 10 + 10) so the average for the period is $22.25 ($890/40 units). Because 10 units are left, the ending inventory balance is $222.50 ($22.25 times 10 units).
b. Applying a moving average system Inventory Acquired → Inventory On Hand → Inventory Sold Beginning inventory
20 @ $20 = $400
Sold 10 units
10 @ $20 = $200
Bought 10 units
10 @ $22 = $220
Sold 10 units Brought 10 units
20 costing $420 or $21 each 10 @ $21 = $210
10 @ $27 = $270
Sold 10 units
10 @ $20 = $200
10 @ $21 = $210
20 costing $480 or $24 each 10 @ $24 = $240
10 @ $24 = $240
Ending inventory = 10 units @ 24 each or $240 Cost of goods sold = $200 + $210 + $240 = $650 11) a. Applying a perpetual FIFO system Inventory Acquired → Inventory On Hand → Inventory Sold Year One 6/1 400 units purchased
400 units @ $4
9/1 300 units sold 11/1 400 units purchased
400 units @ $4 100 units @ $4
400 units @ $7
300 units @ $4
100 units @ $4 400 units @ $7
Year Two 2/1 300 units sold
7/1 200 units purchased
8/1 100 units sold
200 units @ $7
200 units @ $9
200 units @ $7 200 units @ $9 100 units @ $7
100 units @ $4 200 units @ $7
200 units @ $9 12/1 100 units purchased
100 units @ 10
100 units @ $7
100 units @ $7 200 units @ $9 100 units @ $10
Cost of goods sold for Year Two using perpetual FIFO: 100 @ $4 ($400) + 200 @ $7 ($1,400) + 100 @ $7 ($700) or $400 + $1,400 + $700 or $2,500.
b. Applying a perpetual LIFO system Inventory Acquired → Inventory On Hand → Inventory Sold Year One 6/1 400 units purchased
400 units @ $4
9/1 300 units sold 11/1 400 units purchased
400 units @ $4 100 units @ $4
400 units @ $7
300 units @ $4
100 units @ $4 400 units @ $7
Year Two 2/1 300 units sold
7/1 200 units purchased
100 units @ $4 100 units @ $7 200 units @ $9
8/1 100 units sold
12/1 100 units purchased
100 units @ $4 100 units @ $7 200 units @ $9 100 units @ $4 100 units @ $7 100 units @ $9
100 units @ 10
300 units @ $7
100 units @ $9
100 units @ $4 100 units @ $7 100 units @ $9 100 units @ $10
Cost of goods sold for Year Two using perpetual LIFO: 300 @ $7 ($2,100) + 100 @ $9 ($900) or $2,100 + $900 or $3,000.
12) Beginning inventory is $20,000 higher if the company applies FIFO rather than LIFO ($52,000 versus $32,000). Ending inventory is $43,000 higher if the company applies FIFO rather than LIFO ($78,000 versus $35,000) In computing cost of goods sold using FIFO, an extra $20,000 is added (beginning inventory) and an extra $43,000 is subtracted (ending inventory). That causes cost of goods sold to go down by a net of $23,000. Decreasing cost of goods sold by $23,000 causes net income to go up by $23,000 from $328,000 to $351,000.
13) Montana uses periodic FIFO. In Year One, the beginning inventory is 10,000 units at $6 each. Inventory purchases that year are 20,000 units at $8 each. Because the company sold 20,000 units, ending inventory for Year One is also 10,000 units. FIFO is used so a cost of $8 is assigned to those remaining units or $80,000 in total. Cost of goods sold for Year Two (ending 10,000 units has an assigned cost of $9 each based on application of FIFO): Beginning inventory (10,000 units @ $8 each) Purchases (30,000 units @ $9 each) Ending inventory (10,000 units $9 each) Cost of goods sold
$ 80,000 270,000 ( 90,000) $250,000
Florida uses periodic LIFO. In Year One, the beginning inventory is 10,000 units at $6 each. Inventory purchases that year are 20,000 units at $8 each. Because the company sold 20,000 units, ending inventory for Year One is also 10,000 units. LIFO is used so a cost of $6 is assigned to those remaining units or $60,000 in total. Cost of goods sold for Year Two (ending 10,000 units is $6 each based on application of LIFO): Beginning inventory (10,000 units @ $6 each) Purchases (30,000 units @ $9 each) Ending inventory (10,000 units $6 each) Cost of goods sold
$ 60,000 270,000 ( 60,000) $270,000
Florida has a cost of goods sold in Year Two that is $20,000 higher than that reported by Montana ($270,000 versus $250,000). The extra expense reduces reported net income from $100,000 down to $80,000. 14) a. Furn’s cost of goods sold and ending inventory under periodic FIFO. Beginning Inventory, 16 units @ $19 = Purchase, 5 units @ $20 = Purchase, 8 units @ $21 = Purchase, 11 units @ $22 = Cost of Goods Available for Sale Ending Inventory, 2 units @ $22 Cost of Goods Sold
$304 100 168 242 $814 (44) $770
b. Furn’s cost of goods sold and ending inventory under perpetual FIFO. Inventory Acquired → Inventory On Hand → Inventory Sold 1/1 Beginning balance 1/17 5 units purchased
16 units @ $19 5 units @ $20
1/24 7 units sold
2/10 8 units purchased
9 units @ $19 5 units @ $20 8 units @ $21
2/19 15 units sold
3/1 11 units purchased
16 units @ $19 5 units @ $20
9 units @ $19 5 units @ $20 8 units @ $21 7 units @ $21
11 units @ $22
3/20 16 units sold
Totals
7 units @ $19=$133
9 units @ $19 5 units @ $20 1 units @ $21=$292
7 units @ $21 11 units @ $22 2 units @ $22
7 units @ $21 9 units @ $22=$345
$44
$133 + $292 + $345 = $770
In applying FIFO, periodic and perpetual systems always have the same results.
15) a. Rollrbladz’s cost of goods sold and ending inventory determined using periodic LIFO. The company started with 150 units and then acquired 410 more units (120 + 180 + 110). During the year, 460 units were sold (160 + 190 + 50 + 60). The ending inventory is 100 units (150 + 410 – 460). In applying LIFO, those 100 units are assumed to have the cost of the first 100 units purchased or $34 per unit ($3,400). Beginning Inventory, 150 units @ $34 = Purchase, 120 units @ $35 = Purchase, 180 units @ $36 = Purchase, 110 units @ $37 = Cost of Goods Available for Sale Ending Inventory, 100 units @ $34 Cost of Goods Sold
$ 5,100 4,200 6,480 4,070 $19,850 (3,400) $16,450
b. Rollrbladz’s cost of goods sold and ending inventory determined using perpetual LIFO. Inventory Acquired → Inventory On Hand → Inventory Sold 1/1 Beginning balance 1/22 120 units purchased
150 units @ $34 120 units @ $35
2/21 160 units sold
4/8 180 units purchased
110 units @ $34
180 units @ $36
6/10 190 units sold
8/19 110 units purchased
150 units @ $34 120 units @ $35
110 units @ $34 180 units @ $36 100 units @ $34
110 units @ $37
120 units @ $35 40 units @ $34=$5,560
180 units @ $36 10 units @ $34=$6,820
100 units @ $34 110 units @ $37
9/28 50 units sold
100 units @ $34 60 units @ $37
50 units @ $37=$1,850
10/14 60 units sold
100 units @ $34
60 units @ $37=$2,220
100 units @ $34 or $3,400
$5,560 + $6,820 + $1,850 + $2,220 or $16,450
Totals
Periodic and perpetual LIFO typically give different reporting results. That is not the case here. Both systems arrive at ending inventory of $3,400 and cost of goods sold of $16,450. The results will be the same for LIFO when each subsequent sale is equal to or larger than the previous purchase (for example, the sale of 160 units on 2/21 is greater than the previous purchase of 120 units on 1/22). In that situation, additional cost layers do not accumulate during the year when a perpetual system is in use.
16) a. Highlander’s cost of goods sold and ending inventory using a weighted average system. Beginning Inventory, 1,700 units @ $70 = $119,000 Purchase, 600 units @ $72 = 43,200 Purchase, 800 units @ $73 = 58,400 Cost of Goods Available for Sale $220,600 Ending Inventory, 600 units @ $71.16* (42,696) Cost of Goods Sold $177,904 *The average inventory cost for the period is the total cost of $220,600 divided by the total number of units (1,700 + 600 + 800 or 3,100). $220,600/3,100 units = $71.16 b. Highlander’s cost of goods sold and ending inventory using a moving average system. Inventory Acquired → Inventory On Hand → Inventory Sold 4/1 Beginning balance 4/13 600 units purchased
1,700 units @ $70 600 units @ $72
5/5 1,000 units sold 5/25 800 units purchased
2,300 units @ $70.52(1) 1,300 units @ $70.52
800 units @ $73
6/10 1,500 units sold Totals
1,000 units @ $70.52=$70,520
2,100 units @ $71.46(2) 600 units @ $71.46
1,500 units @ $71.46=$107,190
600 units @ $71.46 or $42,876
$70,520 + $107,190 = $177,710
(1) – Average cost determined after 4/13 purchase. 1,700 units costing $70 each gives a total cost of $119,000. 600 units costing $72 each gives a total cost of $43,200. Total of these costs is $162,200 ($119,000 + $43,200). The total of the units is 2,300 (1,700 + 600). Average cost per unit is $162,200/2,300 units or $70.52.
(2) – Average cost determined after 5/25 purchase. 1,300 units costing $70.52 each is a total cost of $91,676. 800 units costing $73 each is a total cost of $58,400. Total of these costs is $150,076 ($91,676 + $58,400). The total of the units of 2,100 (1,300 + 800). Average cost per unit is $150,076/2,100 units or $71.46.
17) Cost of goods sold for the year: Beginning inventory Purchases Ending inventory Cost of goods sold
$1,030,000 7,500,000 ( 500,000) $8,030,000
Average cost of goods sold per day: $8,030,000/365 = $22,000 Average inventory for the period: ($1,030,000 + $500,000)/2 = $765,000 Average number of days that inventory is held: $765,000/$22,000 = 34.77 days 18) Cost of goods sold for the year based on FIFO: Beginning inventory (80,000 units @ $10 each) Purchases (100,000 units @ $12) $1,200,000 (120,000 units @ $13) 1,560,000 Ending inventory (70,000 units @ $13) Cost of goods sold Average inventory for the year: ($800,000 + $910,000)/2 = $855,000 Inventory turnover for the year: $2,650,000/$855,000 = 3.10 times 19) Average inventory for the year: ($420,000 + $500,000)/2 = $460,000 Inventory turnover for the year: $9,200,000/$460,000 = 20 times
$800,000 2,760,000 ( 910,000) $2,650,000
20) a. Gross profit percentage Gross profit/sales = $2,000/$4,000 = 50 percent b. Number of days inventory is held Cost of goods sold per day $2,000/365 days = $5.48 Average inventory (0 + $700)/2 = $350 Number of days inventory is held $350/$5.48 = 63.9 days c. Inventory turnover Cost of goods sold/average inventory $2,000/$350 = 5.71 times
Answer to Comprehensive Problem Part A a) Supplies Accounts Payable
$ 120 $ 120
b) No entry needed. This is a listing of properties held. c) Purchases Accounts Payable
$3,700
Accounts Receivable Revenue
$3,000
Salaries Expense Cash
$ 500
$3,700
d) $3,000
e) $ 500
f) Cash
$8,400 Revenue
$8,400
g) Cash
$2,500 Accounts Receivable
$2,500
h) Salaries Payable Cash
$ 250
Accounts Payable Cash
$5,500
Note Payable Cash
$5,000
Salaries Expense Cash
$2,000
Tax Expense Cash
$795
$ 250
i) $5,500
j) $5,000
k) $2,000
l) $795
Part B
Cash 6,445 500(e) (f)8,400 250(h) (g)2,500 5,500(i) 5,000(j) 2,000(k) 795(l) 3,300
Accounts Receivable 1,250 2,500(g) (d)3,000
1,750
Prepaid Rent Equipment 200 7,000
200
7,000
Allow. Doubtful Accounts 125
125 Accounts Payable (i)5,500 2,690 120(a) 3,700(c) 1,010
Inventory 3,000
3,000
Salaries Payable (h)250 250
0
Supplies 60 (a)120
180 Unearned Revenue 100
100
Note Payable (j)5,000 10,000
Capital Stock 2,000
5,000
2,000
Tax Expense (l)795
795 Purchases (c)3,700
3,700
Retained Earnings 2,790
Revenue 3,000(d) 8,400(f)
2,790
11,400
Utilities Expense Supplies Expense
0
Salaries Expense (e)500 (k)2,000 2,500
Rent Expense
0
Bad Debt Expense
0
0
Cost of Goods Sold
0
Part C Webworks Unadjusted Trial Balance September 30 Account Title Cash Accounts Receivable Allowance for Doubtful Accounts Inventory Supplies Prepaid Rent Equipment Accounts Payable Salaries Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 9/1 Revenue Salaries Expense Tax Expense Utilities Expense
Debits $3,300 1,750
Credits
$
125
3,000 180 200 7,000 1,010 0 100 5,000 2,000 2,790 11,400 2,500 795 0
Supplies Expense Rent Expense Bad Debt Expense Purchases Cost of Goods Sold Totals
0 0 0 3,700 0
______
$22,425
$22,425
Part D m) Salaries Expense Salaries Payable
$300
Utilities Expense Accounts Payable
$275
Supplies Expense Supplies
$110
Rent Expense Prepaid Rent
$200
$300
n) $275
o) $110
p) $200
q) Bad Debt Expense $50 Allowance for Doubtful Accounts
$50
Cost of Goods Sold Purchases Inventory
$3,700 $1,615
r) $5,315
Part E
Cash 6,445 500(e) (f)8,400 250(h) (g)2,500 5,500(i) 5,000(j) 2,000(k) 795(l) 3,300
Accounts Receivable 1,250 2,500(g) (d)3,000
1,750
Allow. Doubtful Accounts 125 50(q)
175
Inventory Supplies 3,000 1,615(r) 60 110(o) (a)120
1,385
70
Prepaid Rent Equipment 200 200(p) 7,000
0
Accounts Payable (i)5,500 2,690 120(a) 3,700(c) 275(n)
7,000
1,285
Note Payable (j)5,000 10,000
Capital Stock 2,000
5,000
2,000
Tax Expense (l)795
795
Salaries Payable (h)250 250 300(m)
Unearned Revenue 100
300
Retained Earnings 2,790
2,790
100
Revenue 3,000(d) 8,400(f)
Salaries Expense (e)500 (k)2,000 (m)300
11,400
2,800
Utilities Expense Supplies Expense Rent Expense (n)275 (o)110 (p)200
275
110
Bad Debt Expense (q)50
200
50
Purchases Cost of Goods Sold (c)3,700 3,700(r) (r)5,315
0
5,315
Part E Webworks Adjusted Trial Balance September 30 Account Title Cash Accounts Receivable Allowance for Doubtful Accounts Inventory Supplies Prepaid Rent Equipment Accounts Payable Salaries Payable
Debits $3,300 1,750
Credits
$
175
1,385 70 0 7,000 1,285 300
Unearned Revenue Note Payable Capital Stock Retained Earnings, 9/1 Revenue Salaries Expense Tax Expense Utilities Expense Supplies Expense Rent Expense Bad Debt Expense Purchases Cost of Goods Sold
100 5,000 2,000 2,790 11,400
Totals
2,800 795 275 110 200 50 0 5,315
_______
$23,050
$23,050
Part F Webworks Income Statement As of September 30 Revenue Cost of Goods Sold Gross Profit Other Expenses Earning before tax Tax Expense Net Income
$11,400 (5,315) 6,085 (3,435) 2,650 (795) $1,855
Webworks Stmt. of Retained Earnings As of September 30 Retained Earnings, September 1 Net Income Retained Earnings, September 30
$2,790 1,855 $4,645
Webworks Balance Sheet September 30 Assets:
Liabilities:
Current: Cash $ 3,300 Accounts Receivable 1,750 less Allow. for Doubt. Accts. (175) Net Accounts Receivable 1,575 Merchandise Inventory 1,385 Supplies Inventory 70 Total Current Assets $ 6,330
Current: Accounts Payable Salaries Payable Unearned Revenue
$ 1,285 300 100
Total Current Liabilities
$ 1,685
Noncurrent: Equipment
Noncurrent: Notes Payable
$ 5,000
Owners’ Equity: Capital Stock Retained Earnings Total Owners’ Equity
$ 2,000 4,645 $ 6,645
$ 7,000
Total Assets
$13,330
Total Liabilities & Owners’ Equity
$13,330
Answer to Research Assignment a. Average number of days that inventory was held during year ended October 31, 2010 Cost of sales per day = $17,398.8 million/365 days = $47.667 million Average inventory = ($3,063.0 million + $2,397.3 million)/2 = $2,730.15 million Number of days that inventory was held during year ended October 31, 2010 = $2,730.15 million/$47.667 million = 57.28 Assessing whether this number is particularly high or particularly low can be difficult without additional information. A financial analyst would likely look at the trend over a number of years and also in comparison to similar companies. However, Deere sells large tractors and other similar equipment. Holding such inventory for 57.28 days before it is sold does not seem particularly high.
b. Impact of applying LIFO Cost of sales reported for year ended October 31, 2010 = $17,398.8 million Beginning inventory reported for year = $2,397 million Ending inventory reported for year = $3,063 million Beginning inventory if FIFO alone had been applied = $3,764 million Ending inventory if FIFO alone had been applied = $4,461 million Increase in beginning inventory if FIFO alone were applied ($3,764 million less $2,397 million) or $1,367 million. Increase in ending inventory if FIFO alone were applied ($4,461 million less $3,063 million) or $1,398 million
If FIFO alone were used, beginning inventory would increase by $1,367 million making cost of sales that much larger. Ending inventory would increase $1,398 million making cost of sales that much smaller. The net effect is a $31 million decrease ($1,367 million less $1,398 million) decrease in cost of sales. Thus, change to applying FIFO alone would create a $31 million increase in reported net income for the year ended October 31, 2010.
Chapter 10 Solutions Answers to Questions 1) Property and equipment accounts (a category that includes land, buildings, equipment, and other tangible, long-lived assets that are used by the owner to generate revenue) are normally presented on an organization’s balance sheet at net book value. That figure is the historical cost of the asset less any portion of that cost that has already been assigned to expense (an amount that is reflected by the contra account “accumulated depreciation”). However, any property and equipment that is found to have an impaired value is reported at fair value if that figure is less than this net book value amount. 2) Accumulated depreciation is a contra asset account that reflects the amount of the historical cost of a building, machinery, or the like that has been assigned to expense by this point in time. The cost of such assets is expensed as revenues are generated, a process that is recorded through a periodic depreciation expense entry. Because the assets do not get literally smaller, the asset account is not directly reduced (as happens, for example, with prepaid rent). Rather, a separate cost reduction account is established that is known as “accumulated depreciation.” 3) Historical cost includes all of the normal and necessary amounts incurred to get an asset into the position and condition to help generate revenues. As an example, for machinery, this figure includes the direct cost of the asset less any discounts that were received plus any transportation costs that had to be paid to gain possession of the asset. Assembly costs and employee training costs might also be viewed as normal and necessary. 4) Market capitalization is a figure computed by multiplying the current price of a company’s capital stock times the number of shares outstanding in the hands of the public. Market capitalization is a derived figure used to gauge the fair value of a business as a whole at the current time. 5) Several reasons exist for not normally reporting property and equipment at fair value. Items bought as property and equipment are not acquired for resale purposes and they are usually kept for years and, often, decades. Therefore, the fair value at the current time does not necessarily provide information that is relevant to decision-makers. If an asset is not to be sold, how important is its fair value at the moment? In addition, fair value is a very subjective figure. Ten different experts could arrive at ten different estimates of fair value. Choosing one particular number to use would be quite arbitrary.
Finally, even if fair value is known, there is no guarantee that the owner could get that amount. A building might be worth $88 million but, if no one wants that type of building in that location, finding a buyer to pay $88 million might be impossible. 6) Other than land, most property and equipment will only generate revenue for a finite period of time. At the end of that time, the asset will be disposed of in some manner. The difference in the original cost and the eventual residual value (if any) at the time of disposal is a cost of generating revenue during this period. That cost should be recognized as an expense and matched with the revenue the asset helped to generate. The recognition of depreciation expense each period serves this purpose. 7) The cost of land is not depreciated to expense over time because land does not have a finite life. Thus, the use of land by an organization to generate revenue does not have an actual cost. Without a cost, depreciation expense is not appropriate. 8) The specific amount of depreciation expense for a period of time is determined using four variables: historical cost of the asset, expected useful life (the number of years the asset will be used to generate revenue), any residual (or salvage) value anticipated at the end of the expected useful life, and an allocation pattern (such as straight-line or accelerated depreciation). 9) Annual adjusting entry to record depreciation: Depreciation Expense $25,000 Accumulated Depreciation – Machine
$25,000
Net book value at the end of Year Two is $250,000 ($300,000 cost less accumulated depreciation of $50,000 based on two years of depreciation) Depreciation expense reported for Year Two is $25,000, the amount assigned to each year. 10) To be classified within the property and equipment category of a balance sheet, an asset must have tangible physical substance and be expected to help generate revenues for longer than a single year. 11) Straight-line depreciation is determined by subtracting the estimated residual value from the cost of the asset and dividing that figure by the expected useful life (normally stated in years). 12) The following entries are necessary in order to record the sale of any depreciable asset: ---Record the appropriate amount of depreciation for the period of use during the current year. Because the asset helped to generate revenue in the current period, an expense assignment is needed.
---Record the amount received from the sale and then remove the net book value of the asset (both its cost and accumulated depreciation.) ---Record any gain or loss resulting from the sale of the asset. If the owner receives less for the asset than net book value, a loss is recognized for the difference. If more is received than net book value, the excess is recorded as a gain (so that reported net income increases). 13) The half-year convention is a method of simplifying depreciation calculations. Any asset which is owned for a period of less than a full year is always depreciated for a half year. Whether the asset is held for 78 days or 10.3 months, depreciation is based on a half year. The process is simple and, because depreciation is a mechanical allocation process, no need for absolute precision is warranted. And, over time, with the buying and selling of enough assets, the average length of time that assets are held in these partial years should approximate six months. 14) When applying accelerated depreciation, more depreciation expense is recorded in the early years of an asset’s life. This method is most often justified by the assumption that some assets generate more revenues in their early years than they do in their later years. Thus, the matching principle is more closely met by recognizing larger expenses in these same earlier years. 15) In the double-declining balance method, annual depreciation is determined by multiplying the current net book value of the asset (cost minus accumulated depreciation) times two divided by the total expected years of the asset’s useful life. The double-declining balance method is an accelerated depreciation pattern because the highest expense is recognized in the first years of operation with gradually smaller amounts in the years after that. 16) The units-of-production method can be used for property and equipment where the quantity of work performed is easily monitored (a truck, for example, or an airplane). The units-of-production method is based on the same logic as the straight-line method because an equal amount of cost is assigned to expense constantly. In straight-line depreciation, the cost is assigned constantly over time. In the units-of-production method, the cost is assigned constantly over the units of output. 17) The units-of-production seems to be a logical fulfillment of the matching principle. Cost is assigned to expense based on the output that creates revenue. However, the actual number of units of work done by most assets is difficult if not impossible to monitor. How many units of work does a desk or a file cabinet do each day? Thus, although the unitsof-production is applied to some assets, its use is not prevalent in most industries. 18) The term “MACRS” stands for Modified Accelerated Cost Recovery System. MACRS is the required depreciation method used by business organizations for US federal income tax purposes. It was created years ago to establish standard rules for all businesses.
Possibly more importantly, MACRS provides certain benefits for the acquisition of depreciable assets as a way of encouraging more purchases to help each business and the entire economy to grow. 19) Common characteristics associated with MACRS include: ---Each depreciable asset must be placed into one of 8 defined classes based upon its type and life. ---For most of these asset classes, the number of years is relatively short so that the tax benefit of the expense (income is reduced and, thus, tax payments are reduced) is received quickly. ---Residual value is ignored completely. Over the life, the entire cost of the asset can be used to reduce taxable income. ---For six of the 8 asset classes, accelerated depreciation is required which, again, creates more expense in the initial years so that the business sees immediate tax benefits from the acquisition of the property. All of these characteristics are tax incentives inserted to encourage businesses to acquire more depreciable assets to help stimulate the economy and create jobs. 20) Depletion is the removal of assets like oil, trees, silver, or gold from land over time. Unlike depreciation, depletion is based on the quantity of assets physically removed and not useful life. Furthermore, depletion does not lead immediately to the recognition of an expense but rather to an inventory item such as barrels of oil. With depletion, expense is only recognized when the inventory item is eventually sold. 21) Land and buildings are often bought for one combined cost. This single cost must be allocated in some logical manner between the two types of property. Although both are assets, land is not depreciated so any cost assigned to it will never be added to expense. In contrast, because a building does have a finite life, any cost assigned to it will impact future expense recognition and the reporting of net income. Not surprisingly, because of the impact on reported earnings, management will usually take special interest in this allocation. 22) The combined cost of buying land with a building on it is allocated between the two assets based on their relative fair values. For example, if the land is worth $3 million while the building is valued at $7 million, then 30 percent ($3 million/$10 million) of the total cost incurred is assigned to the land. However, if only one of the fair values can be determined with sufficient accuracy, that value is used with the remainder of the combined cost arbitrarily assigned to the other asset. 23) Additional money spent simply to keep a long-lived asset operating with no change in the expected revenues that it will help to generate (such as through an extension in the expected life or improvement in future productivity) is recorded as maintenance expense. However, costs incurred in connection with an asset that has already been in
use for a time are capitalized if they are expected to lead to more revenues (for example, because they make the asset bigger or better in some way or just more efficient). 24) Money has been spent to install a sewer system on a parcel of land. Is that a normal and necessary cost of getting the land into condition so that revenue can be generated? Or, is that a separate asset because that cost will help the business generate revenue for an expected period of time? Is the sewer system somewhat the equivalent of grading that puts land into the needed condition or is it a truly separate asset? No definitive answer to these questions is available but rather judgment is needed. If the cost is assumed to be necessary for the land, the cost of the sewer system is not depreciated. Rather, future repair and replacement costs are viewed as expenses. If the sewer system is considered a separate asset, the cost should be depreciated over the expected life with eventual replacement costs being capitalized. 25) According to US GAAP, if the total of the future cash flows that are expected to be generated by a piece of property or equipment is less than its net book value, impairment exists. This comparison is known as the recoverability test. Then, the fair value test is required. The net book value of the asset is reduced to fair value but only if that figure is less. A loss is recognized to reflect the impact of any drop in the reported balance. 26) Costs such as those incurred for interest must be either capitalized (added to an asset account) or expensed. During construction of a warehouse or other asset, no revenue is generated. Without revenue, expenses are not normally recognized. Thus, in this period of time, any interest incurred is capitalized. This process increases the capitalized cost of the asset. As part of the cost of the warehouse, the interest is expensed over the asset’s useful life – as depreciation – in the future years when revenues are earned. 27) The figure known as the fixed asset turnover is calculated by dividing net sales for a period of time by the average net book value of the company’s property and equipment (often referred to as “fixed assets”).
Answers to True or False Questions __F__ 1) The starting basis for reporting property, equipment, and other tangible operating assets with a life of over one year is historical cost. Historical cost includes all normal and necessary amounts incurred to get the asset into position and condition to help generate revenues. The invoice price here of $13,250 is one element of historical cost but not the only amount that is likely to be included. Transportation charges and set up fees are other costs that are often included in the capitalized balance reported for such assets.
__F__ 2) Fair value is not viewed as relevant information to describe items of property and equipment that are not being held for sale. Thus, no attempt is made to align their reported balances with fair value. Instead, the cost of using the asset over time to generate revenue is expensed according to some systematic and rationale method. __T__ 3) Depreciation reflects the cost of a long-lived tangible asset that is assigned to expense in the current year. For Year Three, that amount is $12,000. Accumulated depreciation is the total of the asset’s cost that has been expensed since the date of acquisition. Here, that is $10,000 + $20,000 + $12,000 or $42,000 in total. __T__ 4) Depreciation for Year One is ($75,000 less $5,000)/5 years times 1/2 or $7,000. Depreciation for Year Two is the same computation except that the 1/2 year convention is not relevant. The expense for Year Two is $14,000 to bring the Accumulated Depreciation total to $21,000. __F__ 5) The double-declining balance method creates an accelerated depreciation pattern: a larger expense in the initial years of use. Consequently, net book value drops relatively fast in comparison to the straight-line method. With the resulting lower net book value, assets that have been depreciated by the double-declining balance method will report larger gains or smaller losses than if the straight-line method had been applied. __T__ 6) Depreciation for Year One is ($480,000 less zero) times 2 divided by 8 or $120,000. The asset was held for the entire year so no further adjustment is needed for a partial year. Depreciation for Year Two is ($480,000 less $120,000) times 2 divided by 8 or $90,000. Accumulated depreciation is raised now to $210,000. Depreciation for Year Three is ($480,000 less $210,000) times 2 divided by 8 or $67,500. However, because the asset was sold on April 1, this total annual expense must then be multiplied by 3/12 to arrive at depreciation of $16,875. On the date of sale, the total accumulated depreciation is $226,875 for a net book value of $253,125 ($480,000 less $226,875). Because the asset is sold for cash of $280,000, a gain of $26,875 is reported ($280,000 less $253,125).
__T__ 7) Accelerated depreciation patterns such as the double-declining balance method record more depreciation in the initial years of use than in later years. Consequently, the net book value drops rather rapidly and will be lower than if the straight-line method had been applied. The straight-line method gives a higher net book value whereas accelerated depreciation methods show a lower net book value. __F__ 8) Depreciation for Year One is ($500,000 less zero) times 2 divided by 10 or $100,000. The asset was held for less than a full year so this figure must be reduced by half which brings the expense down to $50,000. Depreciation for Year Two is ($500,000 less $50,000) times 2 divided by 10 or $90,000. Depreciation for Year Three is ($500,000 less $140,000) times 2 divided by 10 or $72,000. The asset was held for less than a full year so this figure must be reduced by half which brings the expense down to $36,000. Net book value is $500,000 less $176,000 or $324,000. The insurance company pays only $300,000. That payment results in a loss of $24,000 rather than $27,000. __T__ 9) Although residual value is not taken into consideration in determining annual depreciation expense when using the double-declining balance method, the owner of the property should stop recording depreciation when net book value falls to the amount of the residual value. Therefore, at the end of this asset’s useful life, net book value should be equal to the $20,000 expected residual value. Because the company only received $19,000 at that time for the asset, a loss of $1,000 is recognized. __F__ 10) In applying MACRS, any expected residual value is ignored. Because of this rule, the entire cost of the asset will eventually be recorded as an expense for federal income tax purposes. Thus, the owner is able to deduct a larger amount of expense each other providing a reduction in the amount of taxes to be paid. This effect encourages businesses to buy more assets so that they will grow more quickly. The anticipated purchases and growth serve to help the economy. __F__ 11) In applying MACRS, greater depreciation expense is allowed especially in the earlier years of use than is appropriate for financial reporting purposes. This effect is
created by requiring accelerated depreciation for most classes of assets and by also ignoring any expected residual value. __F__ 12) Depletion for the first year is $1,760,000 as shown below. However, that cost figure is recorded in an inventory account because the oil is being held to sale. Only when the oil is sold is the $1,760,000 recorded as an expense (cost of goods sold). This problem does not specify whether any or all of the oil has been sold to date so the amount of expense is unknown. $8 million / 1 million = $8 per barrel $8 x 220,000 barrels = $1,760,000 cost moved to inventory __F__ 13) In accounting for an exchange of assets, the acquired asset is reported at the fair value of the asset or assets that are surrendered. Here, equipment worth $15,000 and cash worth $4,000 are given up to get the new asset. The new asset should be reported at this historical cost figure of $19,000. __F__ 14) In accounting for an exchange of assets, the acquired asset is reported at the fair value of the asset or assets that are surrendered. Here, equipment worth $15,000 and cash worth $4,000 are given up to get the new asset. The new asset should be reported at this historical cost of $19,000. __F__ 15) Annual depreciation for this equipment is the $360,000 cost less the $30,000 residual value divided evenly over the expected ten year life. That computation provides an annual rate of $33,000. After two years, on January 1, Year Three, accumulated depreciation is $66,000 and net book value is $294,000 ($360,000 less $66,000). Because the fair value of the asset surrendered is unknown, the new asset is recorded at its own fair value of $288,000. Removing a net book value of $294,000 and recognizing a new cost of only $288,000 in exchange, necessitates the reporting of a $6,000 loss. __F__ 16) Initially, the annual depreciation for this equipment is the $360,000 cost less the $30,000 residual value divided evenly over the expected ten-year life. That provides an annual rate of $33,000. After two years, on January 1, Year Three, accumulated depreciation is $66,000 and net book value is $294,000 ($360,000 less $66,000). The $39,000 expenditure extends the life (so that additional revenues can be generated) and is, therefore, capitalized. This additional cost raises the net book value from $294,000 to $333,000. The asset had an eight year remaining life but
this new cost extended it by four years so that the asset now has a remaining life of 12 years. Depreciation for Year Three is $333,000 divided by 12 years or $27,750. __T__ 17) If Epstein officials believe that both the $1.9 million (building) and $100,000 (land) are reliable fair values, then the $1.7 million cost will be allocated between the two assets based on those relative values. The total of the two values is $2.0 million and 95 percent of that amount relates to the building ($1.9 million/$2.0 million). Therefore, the building is recorded at 95 percent of the $1.7 million cost or $1,615,000. Applying straight-line depreciation over the expected 20 year life, depreciation expense will be $80,750 per year. __T__ 18) Annual depreciation expense for this asset will be its $500,000 historical cost less $100,000 expected residual value divided evenly over the estimated live of 10 years or at a rate of $40,000 per year. In Year One, the half-year convention is used so only $20,000 is recognized. The full amount of expense is recognized in Year Two ($40,000) and Year Three ($40,000). Thus, the net book value is now $400,000. Because the estimated future cash flows of $406,000 exceed this net book value, no impairment loss is recognized at the present time according to US GAAP. __F__ 19) The asset was bought for $320,000 and eventually sold after three years for $210,000. Regardless of the method of depreciation, the total income effect over this period has to be a reduction of $110,000 because that is what actually happened. That number is not subject to any estimation or pattern. The different methods will record different amounts of depreciation each year and the resulting gains and losses will vary. However, the combination of the depreciation expense and the gain or loss on the sale has to report a negative impact on reported net income of $110,000. __T__ 20) During construction of property and equipment, interest is capitalized rather than expensed because revenues are not being generated. Normally, expenses are not recognized unless they can be matched to the revenues generated. __T__ 21) The fixed asset turnover is determined as the net sales for the period divided by the average of the net fixed assets reported for the same period. Average net fixed assets = ($1.0 million + $2.4 million)/2 = $1.7 million
Fixed asset turnover = Net sales/Average net fixed assets = $10 million/1.7 million = 5.88 times
Answers to Multiple Choice Questions 1) Answer is D The cost of this equipment is $16,690 which includes all of the normal and necessary costs incurred: $15,600 + $450 + $290 + $350. Annual depreciation is $16,690/5 years or $3,338. After two years, the accumulated depreciation will be $6,676. Depreciable cost of asset = Invoice price + Transportation + Set up + Training Depreciable cost of asset = $15,600 + $450 + $290 + $350 Depreciable cost of asset = $16,690 Depreciation expense per year = $16,690/5 years Depreciation expense per year = $3,338 Accumulated depreciation after two years = $6,676 2) Answer is C For Year One, the net book value is $16,690 which is multiplied by 2/5 for depreciation expense of $6,676. For Year Two, the net book value is $16,690 less $6,676 or $10,014 which is multiplied by 2/5 for depreciation expense (rounded) of $4,006. Total accumulated depreciation at that time is $6,676 plus $4,006 or $10,682. 3) Answer is D Annual depreciation is $50,000 less $10,000 or $40,000/10 years or $4,000. On the date of sale, accumulated depreciation is $2,000 (Year One) plus $4,000 (Year Two) plus $2,000 (Year Three) or $8,000. Net book value is $50,000 (cost) less $8,000 (accumulated depreciation) or $42,000. The loss to be reported on the sale is $2,100 ($42,000 less $39,900). 4) Answer is A The company should have recorded an expense of $5,000 this year. How much of that cost was actually put into expense in Year One? Annual depreciation was $60,000 less $10,000 (or $50,000) divided by 5 years. The annual expense being recognized is $10,000 per year. Because the half-year convention is applied, depreciation expense for Year One is $5,000. The $5,000 should not have been capitalized so the cost of this asset was actually $55,000 rather than $60,000. The appropriate annual depreciation should have been $55,000 less $10,000 (or $45,000) divided by 5 years. That gives an annual
depreciation of $9,000. In Year One, using the half-year convention, depreciation expense should have been $4,500. The company should have recognized expense of $5,000. Instead, because of the handling of this cost, the company recognized an additional depreciation expense of $500 ($5,000 less $4,500). Changing the reported impact from $500 to $5,000 increased the total expense by $4,500. As a result, reported net income falls from $70,000 to $65,500 ($70,000 less $4,500). 5) Answer is B Depreciation expense for Year One is the net book value of $80,000 which is multiplied times 2/10 and then times 1/2 (because of the half-year convention) or $8,000. Depreciation expense for Year Two is the net book value of $72,000 ($80,000 cost less $8,000 accumulated depreciation) which is multiplied times 2/10 or $14,400. Depreciation expense for Year Three is the net book value of $57,600 ($80,000 cost less $22,400 accumulated depreciation) which is multiplied times 2/10 or $11,520. The net book value at the end of Year Three is the $80,000 cost less $33,920 accumulated depreciation or $46,080. 6) Answer is A Depreciation expense for Year One is the net book value of $50,000 which is multiplied times 2/10 and then times 1/2 (because of the half-year convention) or $5,000. Depreciation expense for Year Two is the net book value of $45,000 ($50,000 cost less $5,000 accumulated depreciation) which is multiplied times 2/10 or $9,000. Depreciation expense for Year Three is the net book value of $36,000 ($50,000 cost less $14,000 accumulated depreciation) which is multiplied times 2/10 and then times 1/2 (because of the half-year convention) or $3,600. The net book value at the time of sale in Year Three is the $50,000 cost less $17,600 accumulated depreciation ($5,000 + $9,000 + $3,600) or $32,400. The machinery was sold for that exact amount so that no gain or loss is recognized. 7) Answer is D Many characteristics associated with MACRS were put into the tax rules to encourage businesses to purchase more assets. By buying more machinery and the like, the business will grow as well as the economy in general. Large amounts of expense in the earlier years of an asset’s life create quick reductions in taxable income and, thus,
smaller tax payments. The positive tax effect of the purchase can be gained by the business almost immediately which serves as an encouragement for such acquisitions. 8) Answer is A Many characteristics associated with MACRS were put into the rules by the government to encourage businesses to buy more assets. Large amounts of expense in the earlier years of an asset’s life create quick reductions in taxable income and, thus, smaller tax payments. Those initial large expenses cause a business’s taxable income to be lower than the amount reported for financial reporting purposes. 9) Answer is C Depletion is based here on a cost of $560,000 and a residual value of $100,000. The drop in value of the mine that occurs over time as the amethyst is removed is $460,000. Based on an estimation of 4,000 pounds being present, that is a cost of $115 per pound ($460,000/4,000 pounds). In the first year, 400 pounds are removed. Thus, a cost of $46,000 ($115 per pound times 400 pounds) is moved from the Mine account into an Inventory account. The net book value reported for the mine is $560,000 less $46,000 or $514,000. 10) Answer is B The net book value of the assets given up is removed from the Kite’s books ($4,000 and $600 for a total of $4,600). The new asset is recorded at the fair value of the assets that are surrendered ($4,500 and $600 for a total of $5,100). Removing $4,600 from the records and adding $5,100 creates a reported gain of $500. 11) Answer is A The net book value of the assets given up is removed from the company’s books ($15,000 and $12,000 for a total of $27,000). The new asset is recorded at the fair value of the assets that are surrendered ($18,000 and $12,000 for a total of $30,000). Removing $27,000 from the records and adding $30,000 creates a reported gain of $3,000. 12) Answer is C Depreciation expense for Year One is the net book value of $50,000 which is multiplied times 2/10 or $10,000. The asset was held for the entire year. Depreciation expense for Year Two is the net book value of $40,000 ($50,000 cost less $10,000 accumulated depreciation) which is multiplied times 2/10 or $8,000. When the asset is exchanged, a net book value of $32,000 ($50,000 cost less $18,000 accumulated depreciation) is removed from the accounting records.
The asset loses 10 percent of its initial value every year. That is $5,000 ($50,000 x 10 percent) each year or $10,000 after two years. Thus, when traded, the asset is actually worth $40,000 ($50,000 less $10,000). The new asset is recorded at the fair value of the asset surrendered. The new asset will be reported at a cost of $40,000. 13) Answer is B Because the asset will now last longer, it should be able to generate more revenues. Thus, the $50,000 is capitalized. The only change that took place was a longer life. For that reason, the $50,000 is added to net book value by reducing accumulated depreciation. This depreciation has been recaptured. After computation of depreciation expense for the year, accumulated depreciation is $2,760,000. Reduced Accumulated Depreciation = $2,000,000 - $50,000 Reduced Accumulated Depreciation = $1,950,000 Adjusted net book value = $7,000,000 - $1,950,000 Adjusted net book value = $5,050,000 Annual Depreciation = ($5,050,000 - $1,000,000)/5 years Annual Depreciation = $810,000 Balance in Accumulated Depreciation = $1,950,000 + $810,000 Balance in Accumulated Depreciation = $2,760,000 14) Answer is A Annual depreciation is $80,000. Therefore, after three years, the building has a net book value of $560,000 ($800,000 cost less $240,000 accumulated depreciation). The estimated future cash flows total $574,000 ($82,000 per year for seven years). That figure is larger than the net book value. As a result, no impairment is recognized even though fair value at the present time is only $480,000. 15) Answer is A No revenues are to be generated in Year One. Because of the matching principle, no expense should be recognized in that period. Depreciation is simply ignored during this first year. However, because interest is physically incurred during Year One, it cannot be ignored. Instead of reporting the interest as an expense, it is capitalized (added to the cost of the property under construction).
Answers to Problems 1) a. The $40,000 cost was erroneously recorded as an expense. It should have been recorded as an asset and then depreciated over its five-year life (with a $5,000 residual value). This depreciation expense is calculated as $40,000 less $5,000 divided by 5 years. That is $7,000 per year. The company should have recorded an expense of $7,000 but accidentally recorded the entire $40,000. Removing this $33,000 excess expense increases reported net income from $100,000 to $133,000 In this transaction, no asset was recorded by the company. The asset should have been reported at its $40,000 cost less $7,000 in accumulated depreciation. For proper reporting, assets should be increased by $33,000 ($40,000 less $7,000). That increases the reported amount of assets from $300,000 to $333,000. b. The $40,000 cost was erroneously recorded as an expense. It should have been recorded as an asset and then depreciated over its five-year life (with a $5,000 residual value). Depreciation expense for the first year is calculated as $40,000 times 2 divided by 5. That is $16,000. The company should have recorded an expense of $16,000 but accidentally recorded $40,000. Removing the $24,000 in excess expense increases reported net income from $100,000 to $124,000 In this transaction, no asset was recorded by the company. The asset should have been reported at its $40,000 cost less $16,000 in accumulated depreciation. For proper reporting, assets should now be increased by $24,000 ($40,000 less $16,000). That adjustment increases the reported amount of assets from $300,000 to $324,000. 2) Company X records depreciation expense for this year on the machinery of $3,500. That is the $80,000 cost less $10,000 residual value ($70,000) divided by 10 years. The expense is $7,000 per year. Because the half-year convention is applied, the expense for this year is only $3,500.
Company Y records depreciation expense for this year on the machinery of $8,000. That is the $80,000 book value times 2 divided by 10. The expense is $16,000 for a full year but only $8,000 for a half-year. Company Y has a greater expense by $4,500 ($8,000 less $3,500). If Company X reported net income of $160,000, Company Y reported net income that is $4,500 less or $155,500. 3) a. Straight-line depreciation. Depreciable value is the $10,000 cost less the $1,000 residual value ($9,000). This figure is then allocated over the 10-year expected life of the asset at the rate of $900 per year. Year One - Income Statement: Depreciation Expense - $900 December 31, Year One – Balance Sheet: Equipment $10,000 Accumulated Depreciation ( 900) Net Book Value $ 9,100 Year Two - Income Statement: Depreciation Expense - $900 December 31, Year Two – Balance Sheet: Equipment $10,000 Accumulated Depreciation ( 1,800) Net Book Value $ 8,200 b. Double-declining balance depreciation. In Year One, the net book value is $10,000 which is multiplied times 2/10 for an expense of $2,000. In Year Two, the net book value is $8,000 which is multiplied times 2/10 for an expense of $1,600. Year One - Income Statement: Depreciation Expense - $2,000 December 31, Year One – Balance Sheet: Equipment $10,000 Accumulated Depreciation ( 2,000) Net Book Value $ 8,000 Year Two - Income Statement: Depreciation Expense - $1,600 December 31, Year Two – Balance Sheet: Equipment $10,000 Accumulated Depreciation ( 3,600) Net Book Value $ 6,400
c. Units-of-production depreciation. Depreciable value is the $10,000 cost less the $1,000 residual value ($9,000). This figure is allocated over the 100,000 dozen donuts that the company expects to produce (or $.09 per dozen). In Year One, 13,000 dozen are manufactured so depreciation is $1,170 (13,000 dozen times $.09 per dozen). In Year Two, 11,000 dozen are manufactured so depreciation is $990 (11,000 dozen times $.09 per dozen). Year One - Income Statement: Depreciation Expense - $1,170 December 31, Year One – Balance Sheet: Equipment $10,000 Accumulated Depreciation ( 1,170) Net Book Value $ 8,830 Year Two - Income Statement: Depreciation Expense - $990 December 31, Year Two – Balance Sheet: Equipment $10,000 Accumulated Depreciation ( 2,160) Net Book Value $ 7,840 d. Equipment and other similar assets are not purchased for the purpose of sale. Thus, while in use, they are not reported at fair value (unless the value has been impaired). Therefore, regardless of the depreciation method that is applied, the balance sheet does not reflect the fair value of the donut maker. e. Many accountants would argue that the units-of-production method is the fairest representation because the periodic depreciation expense is matched directly with the work actually performed during the period. However, this method can only be applied to a few specific types of assets such as a truck or an airplane. f. Depreciation should be recorded for the period up to the date of sale of the donut maker on October 1, Year Three because revenues are generated in that period. Whenever revenues are generated, all related expenses must also be recognized to determine the appropriate profit for that period. In addition, depreciation should be recognized for the nine month period in Year Three to update the net book value of the donut maker so that the gain or loss on the sale can be determined in an proper fashion.
g. From a. above, annual depreciation when the straight-line method is in use is $900. The asset was held for 9 months in Year Three (and the half-year convention is not applied) so depreciation is $900 x 9/12 or $675. Total accumulated depreciation is now $2,475 ($900 + $900 + $675). Net book value is $7,525 ($10,000 cost less $2,475 accumulated depreciation). The asset is sold for only $7,100 so a loss of $425 is recognized ($7,525 less $7,100). Depreciation expense $ 675 Accumulated depreciation – equipment
$
Cash $7,100 Accumulated depreciation – equipment 2,475 Loss on sale of equipment 425 Equipment
$10,000
675
h. If the half-year convention is applied, depreciation for Year Three is $900 times 1/2 or $450. Total accumulated depreciation is now $2,250 ($900 + $900 + $450). Net book value is $7,750 ($10,000 cost less $2,250 accumulated depreciation). The asset is sold for only $7,100 so a loss of $650 is recognized ($7,525 less $7,100). Depreciation expense $ 450 Accumulated depreciation – equipment
$
Cash $7,100 Accumulated depreciation – equipment 2,250 Loss on sale of equipment 650 Equipment
$10,000
450
4) Company A capitalizes the $60,000. Thus, the building is recorded at a cost of $760,000. Annual depreciation is this $760,000 cost less a residual value of $50,000 or a depreciable value of $710,000. That balance is assigned to expense over ten years at the rate of $71,000 per year. In contrast, Company Z expensed the $60,000. Thus, the building is recorded at a cost of $700,000. Annual depreciation is this $700,000 cost less a residual value of $50,000 or a depreciable value of $650,000. That balance is assigned to expense over ten years at the rate of $65,000 per year. Year One: Company A recognizes expense of $71,000 while Company Z recognizes expense of $60,000 + $65,000 for a total of $125,000. Company Z recognizes a larger expense by $54,000 and, thus, reports a smaller net income by that same $54,000.
Year Two: Company A recognizes expense of $71,000 while Company Z recognizes expense of $65,000. Company Z recognizes a smaller expense by $6,000 and, thus, reports a higher net income by that same $6,000. 5) a. Depreciation Expense Rate = $50,000/1,400,000 balls = $0.036 per ball Depreciation Expense, Year 1 = $0.036 × 450,000 balls or $16,200 Year 1
Depreciation expense Accumulated depreciation
$16,200 $16,200
Depreciation Expense, Year 2 = $0.036 × 600,000 balls or $21,600 Year 2
Depreciation expense Accumulated depreciation
$21,600 $21,600
Year 3
Cash Accumulated depreciation Machine Gain on sale
$15,000 37,800 $50,000 2,800
b.
6) a. The cost of the equipment is $35,600 plus $3,400 or $39,000 Equipment Cash
$39,000 $39,000
b. Straight-line depreciation method: Depreciation expense = $39,000/5 years or $7,800 per year Take 1/2 of the first year due to the half year convention = $3,900 Year 1
Depreciation expense Accumulated depreciation
$ 3,900 $ 3,900
Year 2
Depreciation expense Accumulated depreciation
$ 7,800 $ 7,800
c. Double-declining balance depreciation method: Year One: Net book value = $39,000 Depreciation for Year One = $39,000 x 2/5 x 1/2 = $7,800
Year Two: Net book value = $31,200 Depreciation for Year Two = $31,200 x 2/5 = $12,480 Year 1
Depreciation expense Accumulated depreciation
$ 7,800 $ 7,800
Year 2
Depreciation expense Accumulated depreciation
$12,480 $12,480
d. Units-of-production method: Depreciation Rate = $39,000/2,400,000 units = $ 0.01625 per unit Year 1 Depreciation Expense = 600,000 units × 0.01625 = $9,750 Year 2 Depreciation Expense = 578,000 units × 0.01625 = $9,393 Year 1
Depreciation expense Accumulated depreciation
$ 9,750 $ 9,750
Year 2
Depreciation expense Accumulated depreciation
$ 9,393 $ 9,393
7) a. Double-declining balance depreciation. In Year One, the net book value is $200,000 which is multiplied times 2/10 for an annual expense of $40,000. That figure is then multiplied times 1/2 for $20,000 in Year One. In Year Two, the net book value is $180,000 which is multiplied times 2/10 for an expense of $36,000. In Year Three, the net book value is $144,000 which is multiplied times 2/10 to get $28,800 which is then multiplied by 1/2 to arrive at the $14,400 depreciation for that year. Total accumulated depreciation at the time of sale is $70,400 ($20,000 + $36,000 + $14,400). Net book value is the $200,000 cost less the $70,400 accumulated depreciation or $129,600. The sale was for $165,000; thus, a gain of $35,400 is recognized ($165,000 less $129,600). 12/1/One
12/31/One
12/31/Two
Equipment Cash
$200,000 $200,000
Depreciation expense $ 20,000 Accumulated depreciation – equipment
$ 20,000
Depreciation expense $ 36,000 Accumulated depreciation – equipment
$ 36,000
3/1/Three Depreciation expense $ 14,400 Accumulated depreciation – equipment $ 14,400 Cash Accumulated depreciation - equipment Equipment Gain on sale
$165,000 70,400 $200,000 35,400
b. Straight-line depreciation. Depreciable value is the $200,000 cost less the $40,000 expected residual value or $160,000. Over ten years, that amount is assigned to expense at the rate of $16,000 per year (or $8,000 in the year of purchase and again in the year of sale). Total accumulated depreciation at the time of sale is $32,000 ($8,000 + $16,000 + $8,000). Net book value is the $200,000 cost less the $32,000 accumulated depreciation or $168,000. The sale was for $165,000; thus, a loss of $3,000 is recognized ($165,000 less $168,000). 12/1/One
12/31/One
Equipment Cash
$200,000 $200,000
Depreciation expense $ 8,000 Accumulated depreciation – equipment
$
Depreciation expense $ 16,000 Accumulated depreciation – equipment
$ 16,000
3/1/Three Depreciation expense $ 8,000 Accumulated depreciation – equipment
$ 8,000
12/31/Two
Cash Accumulated depreciation – equipment Loss on sale Equipment
8,000
$165,000 32,000 3,000 $200,000
8) Straight-line depreciation. Depreciable value is the $120,000 cost less the $30,000 expected residual value or $90,000. Over ten years, that amount is assigned to expense at the rate of $9,000 per year (or $2,250 in both Years One and Three when the asset was held for only three months). Total accumulated depreciation at the time of sale is $13,500 ($2,250 + $9,000 + $2,250). Net book value is the $120,000 cost less the $13,500 accumulated depreciation or $106,500. The sale was for $107,000; thus, a gain of $500 is recognized ($107,000 less $106,500).
The total income effect for Year Three was a decrease of $1,750 ($2,250 depreciation expense netted with the $500 gain).
Double-declining balance depreciation. In Year One, the net book value is $120,000 which is multiplied times 2/10 for an annual expense of $24,000 and then times 1/2 for $12,000 in Year One. In Year Two, the net book value is $108,000 which is multiplied times 2/10 for an expense of $21,600. In Year Three, the net book value is $86,400 which is multiplied times 2/10 to get $17,280 which is then multiplied by 1/2 to arrive at the $8,640 depreciation for that year. Total accumulated depreciation at the time of sale is $42,240 ($12,000 + $21,600 + $8,640). Net book value is the $120,000 cost less the $42,240 accumulated depreciation or $77,760. The sale was for $107,000; thus, a gain of $29,240 is recognized ($107,000 less $77,760). The total income effect for Year Three was an increase of $20,600 ($8,640 depreciation expense netted with the $29,240 gain). If the double-declining balance method had been used instead of straight-line, a decrease in reported net income in Year Three of $1,750 would have changed to an increase of $20,600. Thus, the company’s net income reported for that one year would be $22,350 higher ($1,750 plus $20,600). 9) Depletion will be at the rate of $5 per barrel of oil ($2 million cost/400,000 expected barrels). In Year One, 100,000 barrels ($500,000) are pumped out of the ground and 70,000 barrels ($350,000) are sold. In Year Two, another 50,000 barrels ($250,000) are pumped out of the ground while 60,000 barrels ($300,000) are sold. In Year One, the 70,000 barrels are sold for $19 per barrel ($1,330,000). In Year Two, the 60,000 barrels are sold for $20 per barrel ($1,200,000).
1/1/One
12/31/One
Land with mineral rights Cash
$2,000,000
Inventory of crude oil Accumulated depletion
$ 500,000
Cash
$1,330,000
$2,000,000
$ 500,000
Revenue Cost of goods sold Inventory of crude oil
$1,330,000 $ 350,000 $ 350,000
12/31/Two
Inventory of crude oil Accumulated depletion
$ 250,000
Cash
$1,200,000
$ 250,000
Revenue Cost of goods sold Inventory of crude oil
$1,200,000 $ 250,000 $ 250,000
10) The property cost $360,000 but will be worth only $20,000 when the wood has been harvested. That is a drop of $340,000. Thus, depletion is at the rate of $85 per ton of wood ($340,000/4,000 expected tons). In Year One, 2,500 tons of wood ($85 times 2,500 = $212,500) are harvested and 2,200 tons ($85 times 2,200 = $187,000) are sold. In Year Two, another 1,500 tons ($85 times 1,500 = $127,500) are harvested while 1,800 tons ($85 times 1,800 = $153,000) are sold. In Year One, the 2,200 tons are sold for $120 per ton ($264,000). In Year Two, the 1,800 tons are sold for $120 per ton ($216,000). a. 1/1/1
Land
$360,000 Cash
During Year 1 Inventory of Wood Accumulated Depletion During Year 1 Cash
$360,000
$212,500 $212,500
$264,000 Revenue from Sale of Wood
Cost of Goods Sold Inventory of Wood
$264,000 $187,000 $187,000
b. During Year 2 Inventory of Wood Accumulated Depletion During Year 2 Cash
$127,500 $127,500
$216,000 Revenue from Sale of Wood
Cost of Goods Sold Inventory of Wood
$216,000 $153,000 $153,000
11) The depreciable value of the first truck is its cost of $53,000 less the expected residual value of $5,000 or $48,000. Over a six-year anticipated life, annual depreciation is $8,000 ($48,000/6 years). For Years One and Three (when the truck is held for less than a full year), depreciation is half of that amount or $4,000. At the time of sale, accumulated depreciation is $16,000 ($4,000 + $8,000 + $4,000) and net book value is $37,000 ($53,000 cost less $16,000 accumulated depreciation). The new asset is recorded at the $40,000 fair value of the asset given up. The $3,000 excess is reported as a gain. Truck (new) Accumulated Depreciation Truck (old) Gain on Exchange
$40,000 16,000 $53,000 3,000
12) The depreciable value of the first machine is its cost of $360,000 less its expected residual value of $20,000 or $340,000. Over a ten-year anticipated life, annual depreciation is $34,000 ($340,000/10 years). At the time of sale, accumulated depreciation for the first two years is $68,000 so that the net book value is $292,000 ($360,000 cost less $68,000 accumulated depreciation). However, the fair value of this machine is now only $240,000 ($360,000 cost less $60,000 Year One drop in value and $60,000 Year Two drop in value). The new asset is recorded at this $240,000 because that figure is the fair value of the asset surrendered. The difference between the $292,000 net book value given up and the $240,000 fair value recorded for the new asset is reported as a $52,000 loss. Machine (new) Accumulated Depreciation Loss on Exchange Machine (old)
$240,000 68,000 52,000 $360,000
13) a. The depreciable value of the furniture and fixtures is the cost of $440,000 less its expected residual value of $10,000 or $430,000. Over a ten-year anticipated life, annual depreciation is $43,000 ($430,000/10 years). Depreciation Expense Accumulated Depreciation
$ 43,000 $ 43,000
b. At the time of sale, accumulated depreciation for the five years of use is $215,000 (5 years times $43,000 depreciation per year). The net book value at that time is $225,000 ($440,000 cost less $215,000 accumulated depreciation).
c. The furniture and fixture being traded have a fair value of $250,000. Of that amount, $50,000 must be assigned to the cash that is received. The remaining $200,000 is assigned to the new vehicles. A net book value of $225,000 is removed while a fair value of $250,000 is recognized. Thus, a gain of $25,000 must be reported. Cash Trucks Accumulated Depreciation Furniture and Fixtures Gain on Exchange
$ 50,000 200,000 215,000 $440,000 25,000
14) a. This cost did not generate any additional revenues and, therefore, cannot be capitalized. Because the cost was expected, it is reported as a maintenance expense. Maintenance expense Cash
$ 22,000 $ 22,000
Because this cost was not capitalized, annual depreciation expense is not affected. The straight-line method is applied. Thus, the cost of $1.5 million is allocated over 30 years or $50,000 per year ($1,500,000/30 years).
Depreciation expense = $50,000 b. Because the room makes the building bigger, the asset should be more efficient at generating revenues. Thus, the cost is capitalized. The Building account is increased since the asset is actually bigger. Building Cash
$ 80,000 $ 80,000
The net book value of the asset has changed. It was $900,000 ($1.5 million cost less $600,000 in accumulated depreciation). With the addition of this room, the book value at this moment is increased to $980,000. Since 12 years have passed out of a total life of 30 years, the building has 18 years remaining to generate revenues. Depreciation for the current period is $980,000/18 years or $54,444. Depreciation expense = $54,444
c. This cost did not generate additional revenues and, therefore, cannot be capitalized. Because the cost was not expected, it is reported as a repair expense. Repair Expense Cash
$ 22,000 $ 22,000
Because this cost was not capitalized, annual depreciation expense is not affected. The straight-line method is applied. Thus, the cost of $1.5 million is allocated over 30 years or $50,000 per year ($1,500,000/30 years). Depreciation expense = $50,000 d. The new type of foundation improvement will extend the life of the building by five years. Thus, the asset should help the company to generate additional revenues. Thus, the cost is capitalized. However, the building is not larger; it will simply last longer. Therefore, the cost is added to the net book value through a reduction in accumulated depreciation. Accumulated Depreciation Cash
$ 30,000 $ 30,000
The net book value of the asset has changed. It was $900,000 ($1.5 million cost less $600,000 in accumulated depreciation). Now that accumulated depreciation has been reduced by $30,000 to $570,000, the net value is $930,000 ($1.5 million cost less $570,000 in accumulated depreciation). Since12 years have passed (out of a total life of 30 years), the building has 18 years remaining to generate revenues. However, the improvement in the foundation increased that life by five years (to 23 years). Depreciation for each of the remaining periods is $930,000/23 years or $40,435. Depreciation expense = $40,435 15) The depreciable value of the machine is the cost of $500,000 less its expected residual value of $100,000 or $400,000. Over a ten-year anticipated life, annual depreciation is $40,000 ($400,000/10 years). At the beginning of Year Three, the asset account is still $500,000 whereas accumulated depreciation is now $80,000. The $30,000 attachment makes the asset bigger so that more revenues can be generated. It is capitalized by being added to the cost of the machine (now $530,000). The $40,000 gives an additional five years of life to the asset so that more revenues can be generated. It is capitalized by reducing accumulated depreciation (now
$40,000). The machine had a remaining life of 8 years but that has been extended by five years (now 13 years). Net book value is now $490,000 ($530,000 less $40,000). Assuming that the expected residual value is still $100,000, the company must depreciate $390,000 ($490,000 less $100,000) over 13 years at the rate of $30,000 per year. Income Statement for Year Three: Depreciation Expense = $30,000 Balance Sheet at End of Year Three: Machine Accumulated Depreciation ($40,000 + $30,000) Net Book Value
$530,000 70,000 $460,000
16) The depreciable value of the equipment is the cost of $190,000 less its expected residual value of $40,000 or $150,000. Over a 12-year anticipated life, annual depreciation is $12,500 ($150,000/12 years). At the beginning of Year Three, the asset account is still $190,000 but accumulated depreciation is now $25,000. The $40,000 expenditure makes the equipment more effective at generating revenue. It is capitalized by being added to the cost of the asset (now $230,000). Net book value is now $205,000 ($230,000 less $25,000). Assuming that the expected residual value is still $40,000, the company must depreciate $165,000 ($205,000 less $40,000) over the remaining 10 years of the equipment’s life at the rate of $16,500 per year. Year 3 Journal Entries (the first entry is made at the beginning of the year and the second is an adjusting entry at the end of the year. Equipment Cash
$40,000
Depreciation Expense Accumulated Depreciation
$16,500
$40,000
$16,500
17) a. The total fair value of the two vehicles is $85,000 ($45,000 plus $40,000). Thus, 52.9 percent of the fair value comes from the limousine ($45,000/$85,000) and the remaining 47.1 percent of the fair value comes from the Hummer. The $75,000 cost is split in the same ratio. Of the total paid, 52.9 percent or $39,675 is assigned to the limousine and 47.1 percent or $35,325 is assigned to the Hummer.
Vehicles—Limousine Vehicles—Hummer Cash
$39,750 35,250
Maintenance Expense Cash
$
Vehicles—Limousine Cash
$ 4,000
$75,000
b. 600 $
600
c. $ 4,000
18) The depreciable value of the asset is the cost of $360,000; it has no expected residual value. Over a ten-year anticipated life, annual depreciation is $36,000 ($360,000/10 years). At the beginning of Year Three, the asset account is still $360,000 whereas accumulated depreciation is now $72,000. Net book value is $288,000 ($360,000 less $72,000). At this time, the future anticipated cash flows are a net $35,000 per year. Consequently, the company expects to generate a total of $280,000 in cash in the future ($35,000 times 8 remaining years). That figure is below the net book value of $288,000. Because the company cannot recover the remaining net book value, the asset is viewed as impaired and recorded at the lower fair value of $240,000. Reducing the reported net figure from $288,000 to $240,000 necessitates the recognition of a $48,000 loss. 19) a. At the current time, the building has a net book value of $900,000. The future anticipated cash flows are a net $86,000 per year. Consequently, company officials expect to generate total cash from this asset of $860,000 ($86,000 times the 10 remaining years). That figure is below the net book value of $900,000. Because the company cannot recover the remaining net book value, the asset is deemed to be impaired and is recorded at the lower fair value of $576,000. Reducing the reported net figure from $900,000 to $576,000 necessitates the recognition of a $324,000 loss.
b. At the current time, the building has a net book value of $900,000. The future anticipated cash flows are a net $93,000 per year. Consequently, company officials expect to generate total cash of $930,000 ($93,000 times the 10 remaining years). That figure is above the net book value of $900,000. Because the company expects to recover the remaining net book value, the asset is not viewed as impaired and retains its net book value. No loss is reported. Note that the cash flows in the first example here were only $7,000 lower per year than in the second case. However, the loss reported in the first example was $324,000 whereas no loss was recognized in the second case. 20) a. The capitalized cost of the manufacturing plant was $46,790,000 plus $3,780,000 for a total of $50,570,000. Year One Depreciation: $50,570,000 – 0 = $50,570,000 x 2/30 x 10/12 = $2,809,444 Year Two Depreciation: $50,570,000 - $2,809,444 = $47,760,556 x 2/30 = $3,184,037 Year Three Depreciation: $50,570,000 - $5,993,481 = $44,576,519 x 2/30 = $2,971,768 March 1, Year One Manufacturing Plant Cash (or liabilities)
$50,570,000
December 31, Year One Depreciation Expense Accumulated Depreciation
$ 2,809,444
December 31, Year Two Depreciation Expense Accumulated Depreciation
$ 3,184,037
December 31, Year Three Depreciation Expense Accumulated Depreciation
$ 2,971,768
$50,570,000
$ 2,809,444
$ 3,184,037
$ 2,971,768
b. Net book value at the end of Year Three is the cost of $50,570,000 less accumulated depreciation of $8,965,249 ($2,809,444 + $3,184,037 + $2,971,768) or $41,604,751. Expected future cash flows are $2 million per year for 15 years or $30,000,000. Because the future cash flows are below the net book value, the asset’s value is considered impaired. c. Net book value at this time is $41,604,751. If the value of the asset is assumed to be impaired, the reported balance must be reduced to fair value but only if that figure is below net book value. Fair value is given in the problem as $15.6 million. The reported balance is reduced to that figure and a loss of $26,004,751 is recognized. 21) Company A has a store building that had originally cost $4 million. With a 20-year expected life and no anticipated residual value, the annual depreciation is $200,000. Therefore, on the company’s Year Two income statement, depreciation expense of $200,000 is reported. On the balance sheet at the end of Year Two, Company A reports a store building costing $4 million and accumulated depreciation of $400,000 ($200,000 multiplied by two years) for a net book value of $3.6 million. Because Company Z constructed its store building, interest during Year One ($240,000) is capitalized. Therefore, Company Z has a store building with a cost of $4,240,000. No depreciation is recognized in Year One but depreciation of $212,000 is reported for Year Two ($4,240,000/20 years). On the company’s Year Two income statement, this depreciation expense of $212,000 is reported. On the balance sheet at the end of Year Two, Company Z reports a store building costing $4,240,000 with accumulated depreciation of $212,000 for a net book value of $4,028,000. Company Z’s depreciation expense for Year Two is $12,000 higher ($212,000 less $200,000) and the net book value of the store building is $428,000 higher ($4,028,000 less $3,600,000).
Answer to Comprehensive Problem A) a) Supplies Inventory Accounts Payable b) Prepaid Rent Cash
$100 $100
$600 $600
c) Opening balances – no journal entry needed. d) Purchases Accounts Payable
$6,700 $6,700
e) Accounts Receivable Revenue
$3,900
Salaries Expense Cash
$700
$3,900
f)
$700
g) Cash
$9,700 Revenue
$9,700
h) Unearned Revenue Revenue
$100
Note Payable Cash
$5,000
$100
i)
$5,000
j) Cash
$4,000 Accounts Receivable
$4,000
k) Salaries Payable Cash
$300
Accounts Payable Cash
$6,000
$300
l)
$6,000
m) Allowance for Doubtful Accounts Accounts Receivable
$ 200
n) Salaries Expense Cash
$2,000
o) Furniture Accounts Payable
$1,000
p) Tax Expense Cash
$868
$ 200
$2,000
$1,000
$868
B) Cash 3,300 600(b) (g)9,700 700(f) (j)4,000 5,000(i) 300(k) 6,000(l) 2,000(n) 868(p)
Accounts Receivable 1,750 4,000(j) (e)3,900 200(m)
1,532
1,450
Prepaid Rent Equipment (b)600 7,000
600
Unearned Revenue (h)100 100
868 Purchases (d)6,700
6,700
Accounts Payable (l)6,000 1,285 100(a) 6,700(d) 1,000(o)
Capital Stock 2,000
0
2,000
Salaries Payable (k)300 300
0
Revenue 3,900(e) 9,700(g) 100(h)
4,645
Rent Expense
0
0
170
Retained Earnings 4,645
Utilities Expense Supplies Expense
Cost of Goods Sold
Supplies 70 (a)100
3,085
Note Payable (i)5,000 5,000
0
Inventory 1,385
1,385
1,000
0
Tax Expense (p)868
25
Furniture (o)1,000
7,000
Allow. Doubtful Accounts (m)200 175
0 Salaries Expense (f)700 (n)2,000 2,700
13,700
Bad Debt Expense
0
C) Webworks Unadjusted Trial Balance October 31 Account Title Cash Accounts Receivable Allowance for Doubtful Accounts Inventory Supplies Prepaid Rent Equipment Furniture Accounts Payable Salaries Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 10/1 Revenue Salaries Expense Tax Expense Utilities Expense Supplies Expense Rent Expense Bad Debt Expense Purchases Cost of Goods Sold
Debits $ 1,532 1,450 25 1,385 170 600 7,000 1,000
Credits
2,700 868 0 0 0 0 6,700 0
_______
Totals
$23,430
$23,430
$ 3,085 0 0 0 2,000 4,645 13,700
D) q) Salaries Expense Salaries Payable
$100
Utilities Expense Accounts Payable
$300
$100
r) $300
s) Supplies Expense Supplies Inventory
$120
Rent Expense Prepaid Rent
$200
$120
t) $200
u) Bad Debt Expense $170 Allowance for Doubtful Accounts
$170
Depreciation Expense $584 Accumulated Dep.—Equipment
$584
Depreciation Expense $ 17 Accumulated Dep.—Furniture
$ 17
Cost of Goods Sold Inventory Purchases
6,700
v)
w)
Cash 3,300 600(b) (g)9,700 700(f) (j)4,000 5,000(i) 300(k) 6,000(l) 2,000(n) 868(p)
$ 6,615 85
Accounts Receivable 1,750 4,000(j) (e)3,900 200(m)
1,532
1,450
Prepaid Rent Equipment (b)600 200(t) 7,000 400
Allow. Doubtful Accounts (m)200 175 170(u)
7,000
145
Inventory 1,385 (w)85
1,470
Accum. Depr.—Equip Furniture 584(v) (o)1,000 584
1,000
Supplies 70 120(s) (a)100
50 Accum. Depr.—Furn 17(v) 17
Accounts Payable (l)6,000 1,285 100(a) 6,700(d) 1,000(o) 300(r)
Salaries Payable (k)300 300 100(q)
3,385 Retained Earnings 4,645
Unearned Revenue (h)100 100
100 Revenue 3,900(e) 9,700(g) 100(h)
Note Payable (i)5,000 5,000
0 Tax Expense (p) 868
Capital Stock 2,000
0
2,000
Utilities Expense Supplies Expense (r)300 (s)120
4,645 13,700 868 300 120 Rent Expense Bad Debt Expense Purchases Cost of Goods Sold Salaries Expense (t)200 (u)170 (d)6,700 6,700(w) (w)6,615 (f)700 (n)2,000 (q)100 200
170
Depreciation Expense (v)584 (v)17 601
0
6,615
2,800
E) Webworks Adjusted Trial Balance October 31 Account Title Cash Accounts Receivable Allowance for Doubtful Accounts Inventory Supplies Prepaid Rent Equipment Accum. Depreciation—Equipment Furniture Accum. Depreciation—Furniture Accounts Payable Salaries Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 10/1 Revenue Salaries Expense Tax Expense Utilities Expense Supplies Expense Rent Expense Bad Debt Expense Purchases Cost of Goods Sold Depreciation Expense
Debits $ 1,532 1,450
Credits
2,800 868 300 120 200 170 0 6,615 601
______
Totals
$24,576
$24,576
$
145
1,470 50 400 7,000 584 1,000 17 3,385 100 0 0 2,000 4,645 13,700
F) Webworks Income Statement As of October 31 Revenue $13,700 Cost of Goods Sold (6,615) Gross Profit 7,085 Depreciation Expense (601) Other Expenses (3,590) Earnings before Tax 2,894 Tax Expense (868) Net Income $2,026 Webworks Stmt. of Retained Earnings As of October 31 Retained Earnings, October 1 Net Income Retained Earnings, October 31
$4,645 2,026 $6,671
Webworks Balance Sheet October 31 Assets:
Liabilities:
Current: Cash $ 1,532 Accounts Receivable 1,450 less Allow. for Doubt. Accts. (145) Net Accounts Receivable 1,305 Merchandise Inventory 1,470 Supplies Inventory 50 Prepaid Rent 400 Total Current Assets $ 4,757
Current: Accounts Payable Salaries Payable
$ 3,385 100
Total Current Liabilities
$ 3,485
Owners’ Equity: Capital Stock Retained Earnings Total Owners’ Equity
$ 2,000 6,671 $ 8,671
Noncurrent: Equipment less Accumulated Depreciation Furniture less Accumulated Depreciation Total Noncurrent Assets
Total Assets
$ 7,000 (584) 1,000 (17) $ 7,399
$12,156
Total Liabilities & Owners’ Equity
$12,156
Answer to Research Assignment
a. (in millions) December 31, 2011 Property, plant and equipment $32,761 Accumulated depreciation 19,349 Net property, plant & equipment $13,412 $13,412/$32,761 = 40.9% $19,349/$32,761 = 59.1% As is seen in the next part of this assignment, the straight-line method is used with lives ranging from 15 to 25 years. Because the net book value is only 40.9 percent of the cost of these assets, the average piece of property, plant and equipment is in the later half of its life. Financial analysts can use this figure to ascertain which businesses have older operating assets and which have younger operating assets. b. “Property, plant and equipment is carried at cost and is depreciated using the straight-line method. Property, plant and equipment placed in service prior to 1995 is depreciated under the sum-of-the-years' digits method or other substantially similar methods. Substantially all equipment and buildings are depreciated over useful lives ranging from 15 to 25 years. Capitalizable costs associated with computer software for internal use are amortized on a straightline basis over 5 to 7 years. When assets are surrendered, retired, sold or otherwise disposed of, their gross carrying values and related accumulated depreciation are removed from the accounts and included in determining gain or loss on such disposals.” c. Assuming assets have no expected residual value and an estimated 20 year life, the estimated age of the property, plant and equipment held by DuPont is 59.1 percent of 20 years or 11.82 years of age.
Chapter 11 Solutions Please note that all present value calculations in this solutions manual will be determined using the tables that appear in the back of the Financial Accounting textbook. Calculations made using an Excel spreadsheet, mathematical formulas, or calculators may differ slightly because of rounding. Answers to Questions 1) An intangible asset is one that lacks physical substance but is still expected to provide future benefits for longer than one year. They can be divided into several categories: artistic-related (copyrights), technology-related (patents), marketing-related (trademarks), customer-related (databases), contract-related (franchises), and goodwill. 2) Intangible assets are reported at historical cost less accumulated amortization. They are reported in the same basic manner as equipment or machinery. 3) The six general types of intangibles reported as assets are as follows: 1. 2. 3. 4. 5. 6.
Artistic-related (such as copyrights) Technology-related (patents) Marketing-related (trademarks) Customer-related (a database of customer information) Contract-related (franchises) Goodwill
4) In the same manner as depreciation, amortization is the assignment of the cost of an intangible asset to the periods of time in which it is expected to provide benefit to the owner (usually it helps to generate revenue). More specifically, that period of time is the asset’s useful life unless its legal life is shorter. The useful life is the expected period that the asset will be used by the current owner. 5) Amortization of the cost of an intangible asset should extend over the shorter of the asset’s useful life or its legal life. Fifteen years is used in this case. That length of time could either be the expected useful life or the legal life (as established by law or contract). However, fifteen years has to be the shorter of the two possible lengths of time. 6) The patent is reported on the company’s balance sheet at its net book value of $82,000. The accounting for intangible assets is similar to that of machinery and equipment. Intangibles are not usually reported at fair value because they are not held for the purpose of being sold. Thus, fair value is not considered relevant. Furthermore, fair value for such assets is usually difficult to determine. Experts may not agree on the fair value of an intangible, whereas historical cost is a verifiable number.
7) Amortization of an intangible asset is sometimes reflected as a direct reduction in the asset balance rather than indirectly through a separate contra account because the utility of the asset is literally shrinking. The asset is getting smaller. Here, the company had a five-year copyright that became a four-year copyright and so on. Company officials can choose to reduce the asset balance because the amount paid initially is not likely to be considered as important information over time. This process is different than the depreciation of a building. That asset is still intact even after being fully depreciated. Thus, the original cost of the asset and the amount that has been assigned to expense are both considered of significant interest to decision makers. 8) The cost of defending a patent successfully is capitalized (added to the net book value of the intangible asset) and then amortized over the shorter of its remaining legal life or estimated useful life. However, if the defense proves unsuccessful, the legal cost is expensed and the remaining intangible asset balance is written off as a loss. 9) When one company acquires another, the parent will often have to pay additional amounts in recognition of intangibles such as customer loyalty or an experienced work force. In consolidated financial statements produced after the business combination is created, these payments are reported as identifiable assets but only if 1) contractual or other legal rights have been gained or 2) the asset can be separated and sold. Any excess payment that does not meet either of these two criteria is reported as goodwill. 10) When one company acquires another, the parent will often have to pay additional amounts (such as the $3 million in this problem) in recognition of intangibles such as customer loyalty or an experienced work force. In consolidated financial statements, these payments are reported as specific identifiable assets but only if 1) contractual or other legal rights have been gained or 2) the asset can be separated and sold. Here, the $3 million payment does not meet either of these two criteria and, therefore, must be reported on the consolidated balance sheet as goodwill. 11) Whenever a decision maker analyzes a balance sheet that reports a goodwill balance, the person knows that the reported company has purchased one or more other companies. In that acquisition process, the parent company paid an amount ($13.8 million in this case) in excess of the fair value of the identifiable net assets owned by the subsidiary. The parent can only recognized specific assets that meet at least one of two criteria: 1) contractual or other legal rights are gained or 2) the asset could be separated from the company and sold. Any acquisition price that exceeds the identifiable net assets is shown as goodwill. For example, the December 31, 2011, balance sheet for General Electric Company and consolidated affiliates reported a goodwill balance of $72.6 billion. 12) Goodwill is not amortized to expense over time because it is not viewed as having a finite life. Thus, this asset balance often remains unchanged over many subsequent years. However, the figure is reduced for reporting purposes if its value is ever judged to be impaired.
13) Unless the $15 million figure reported for goodwill is ever judged to be impaired, the figure will remain unchanged on the balance sheet forever. However, if at any time, evidence indicates that the value of the goodwill has been impaired, the reported figure is reduced and a loss recognized. 14) According to U. S. GAAP, research and development costs are expensed as incurred. Therefore, Hammerstine recognizes an $8 million research and development expense in the current year despite the creation of a valuable new product. 15) Research and development costs are expensed as incurred when applying U.S. GAAP. In contrast, if specified criteria are met, IFRS requires the capitalization of development costs. Therefore, the balance sheet of a company with extensive research and development costs will report more assets under IFRS whereas the income statement will show a smaller amount of expense (and, hence, a larger net income) because of the mandated method of reporting research and development costs. 16) A decision maker should know that the U.S. GAAP requirement to expense all research and development prevents possible manipulation of reported figures (uncertainty does not impact the accounting) while disclosing the monetary amount spent by management each year on this essential function. However, this method of reporting also means that companies with significant research and development activities often fail to report some of their most important assets on their balance sheet. 17) U.S. GAAP requires all research and development costs to be expensed as incurred. This approach has a number of advantages including the following: (1) The rule is simple to apply since no estimations of future success are required. (2) Manipulation of reported balances can be avoided because no part of the cost is capitalized regardless of the possibility of future success. The problem of reporting the uncertainty of success is eliminated. (3) Decision makers are provided with the figure that might be the most important to them: the monetary amount spent on research and development each year. 18) The present value of the future cash flows to be paid in a purchase does not need to be determined if all payments are to be made within one year. In that case, the amount of those payments attributable to interest is considered insignificant. A present value calculation is also not needed if a reasonable amount of interest is paid along with the purchase price. For example, if the $2 million is to be paid in 5 years along with annual interest computed at a rate of 7 percent and that 7 percent is viewed as reasonable for this transaction, no present value computation is required. There is no interest in the $2 million.
19) A present value computation mathematically determines the amount of interest within the total future cash flows and then removes it to leave only the amount of the cash flows being paid for the asset. 20) According to U.S. GAAP, $3 million of this future payment is owed for the purchase of the intangible asset. The other $1 million has been removed because it relates to the interest expense to be recognized over the period of the payments. Initially, both the asset and the liability are reported at the $3 million present value. As time passes, this $1 million of interest is gradually recognized on the debt. During the first year, the liability balance is $3 million. At a rate of 10 percent, the interest expense to be recognized in the first year is $300,000 ($3 million liability balance times the 10 percent reasonable interest rate). 21) According to U.S. GAAP, $3 million of this future payment is owed for the purchase of the intangible asset. Initially, both the asset and the liability are reported at the $3 million present value. During the first year, the liability balance is $3 million. At a rate of 10 percent, the interest expense to be recognized in the first year is $300,000 ($3 million liability balance multiplied times the 10 percent reasonable interest rate). Because interest is recognized for Year One but not paid at the time, it is compounded. That means the interest amount is added to the liability balance bringing it up to $3.3 million for Year Two. Interest expense to be recognized in connection with Year Two is $330,000 (the updated $3.3 million liability balance multiplied times the 10 percent reasonable interest rate). 22) To determine the present value of future cash flows, three factors (beyond just the amount of cash being paid or received) must be identified. (1) – A reasonable rate of interest for this type of transaction. (2) – The number of time periods until all of the cash is paid or received. (3) – The pattern of the cash flows. The pattern can be a single amount at a particular point of time in the future. The pattern can also be an annuity: equal payments at equal time intervals. An annuity can be an annuity due with the initial payment made immediately at the time of the transaction or an ordinary annuity where the first payment is made at the end of the first period of time. 23) Interest on a receivable or payable must be recognized periodically as time passes. If that interest is computed and recognized but not paid, the amount is added to the receivable or payable balance. The increase in the receivable or payable—because of interest being recognized but not paid at the current time—is referred to as “compounding.” 24) An annuity due is an annuity with the initial payment starting at the time the transaction is created. An ordinary annuity is an annuity with the first payment made after a period of time has passed. For example, if a contract is signed on January 1, Year One, and the first of several equal payments is made on that date and each January 1 thereafter, it is an annuity due. If a contract is signed on January 1, Year One, and the first of
several equal payments is made on December 31, Year One, and on each December 31 thereafter, the pattern is an ordinary annuity.
Answers to True or False Questions __T__ 1) At the date of acquisition, an intangible asset is most likely to be recorded at its historical cost. __F__ 2) To help companies identify their intangible assets, FASB has listed a number of different categories such as technology-related and marketing-related. These categories are intended to assist companies in knowing what intangible assets to report. The list is not designed to prevent any intangible assets from being reported. __F__ 3) The amortization process should expense the cost of an intangible over a period of time that is the asset’s legal life or useful life, whichever is shorter. Because some legal lives are relatively long, the useful life is more often used for amortization purposes. __T__ 4) Any amount expended for the successful legal defense of a patent is viewed as a normal and necessary cost of ensuring that the intangible asset can be used to generate future revenues. Therefore, that cost is capitalized and reported within the net book value of the intangible. __F__ 5) Intangible assets are reported at historical cost less accumulated amortization. Fair value is only used to determine historical cost when one company buys another and the intangible assets of the new subsidiary are being included within consolidated financial statements. __F__ 6) When one company acquires another, the intangible assets of the acquired company are included on the consolidated balance sheet at fair value. Fair value is used in such cases because that figure reflects the amount of the acquisition price for the entire company that was paid in connection with the purchase of these intangible assets. __F__ 7) Being able to separate an intangible from a company and sell it is one of the available criteria for reporting an asset on the consolidated balance sheet. However, that is not the only criterion. Within the consolidation process, the fair value of each potential intangible is recorded by the parent as an asset but only if (1) contractual or other legal rights have been gained or (2) the intangible can be separated and sold. __F__ 8) Goodwill is the price paid by one company to acquire another that is in excess of the fair value of the net identifiable assets and liabilities of the other company. It is often associated with intangibles that cannot be recognized such as employee expertise and customer loyalty, attributes which make the company especially profitable. Or, the excess payment may result from the price negotiations between the parties and have
no relationship to any specific intangible. Thus, a talented workforce can lead to the recognition of goodwill but it is not the only possible cause. __F__ 9) Goodwill is the price paid by one company to acquire another that is in excess of the fair value of the net identifiable assets and liabilities of the other company. It is often associated with intangibles that cannot be recognized such as employee expertise and customer loyalty, which make the company especially profitable. Or, the excess payment may result from the price negotiations and have no relationship to any specific intangible. Goodwill has nothing to do with gifts made to charity unless those donations help the company to be especially profitable. __F__ 10) At one time, years ago, goodwill had to be amortized to expense over a period of time not to exceed 40 years. Most companies simply used 40 years to reduce the impact of the expense each year. That rule has long been changed. Today, goodwill is not amortized to expense at all. A goodwill balance can remain unchanged for an indefinite period. However, the reported balance for goodwill must be written down if the value is found to be impaired. __F__ 11) Unless the value of goodwill is found to be impaired, the account will remain on the balance sheet for an indefinite period of time. However, goodwill must be written down and a loss recorded if the value is ever found to be impaired. __F__ 12) Goodwill is the price paid by one company to acquire another that is in excess of the fair value of the net identifiable assets and liabilities of the other company. Although the excess payment may be related to a specific intangible such as the quality of the workforce, such a connection is not required and is frequently not found. __F__ 13) According to U.S. GAAP, all research and development costs are expensed as incurred. As is explored in upper-level accounting classes, a few minor exceptions to this rule do exist. __F__ 14) Research and development costs are expensed under U.S. GAAP. Therefore, any assets resulting from such work, which can often have a significant value, are usually reported at a small amount or not reported at all. Therefore, the accounting mandated by U.S. GAAP causes the asset totals reported by many companies to be understated. __F__ 15) Research and development costs are expensed as incurred under U.S. GAAP. If specified criteria are met, IFRS requires the capitalization of development costs. The accounting is clearly not the same. __F__ 16) No determination of present value is needed here because a reasonable rate of interest is being explicitly paid. Present value is calculated when cash flows will last for longer than one year and a reasonable interest rate is not paid over this period of time. __T__ 17) Whenever equal payment amounts are made at equal time intervals ($300,000 per year for five years), the cash pattern is referred to as an annuity. If the first payment
is made immediately and each period thereafter, the pattern is known as an annuity due (sometimes referred to as an annuity in advance). __T__ 18) Interest is recognized on this liability by taking the book value for the period and multiplying the number by a reasonable rate of interest. For Year One, the liability balance is $170,000. Because a reasonable rate of interest is 10 percent per year, interest of $17,000 ($170,000 times 10 percent) is recognized for this first year. This interest is not paid during the year (it will eventually be paid when $300,000 is remitted on the note rather than $170,000). Therefore, this $17,000 must be compounded. When interest is recognized but not paid, it is added to the principal balance bringing the liability up from $170,000 to $187,000. __T__ 19) Interest is recognized on this liability by taking the book value for the period and multiplying the number by a reasonable rate of interest. For Year One, the liability balance is $310,000. Because a reasonable rate of interest is 10 percent per year, interest of $31,000 ($310,000 times 10 percent) is recognized at the end of Year One. This interest is not paid during the year; thus, the $31,000 must be compounded. When interest is recognized but not paid, it is added to the principal balance bringing the liability up from $310,000 to $341,000. In Year Two, the principal balance is $341,000 because of the compounding and interest is $34,100 ($341,000 times 10 percent). __T__ 20) The intangible asset is recorded initially at the present value of the future cash flows or $400,000. The expected useful life is 8 years with no anticipated residual value. Straight-line amortization is commonly used for intangible assets giving an annual expense balance of $50,000 ($400,000/8 years).
Answers to Multiple Choice Questions 1) Answer is C The capitalized cost of this asset is $140,000 ($50,000 + $90,000). That is the normal and necessary costs of establishing and defending the company’s right to that patent. According to U. S. GAAP, research and development costs are expensed rather than capitalized even if a patent is eventually received. 2) Answer is B The intangible asset is recorded initially at its historical cost of $300,000. That amount is then amortized to expense over the expected useful life of six years because that is a shorter period than the 10 year useful life. Annual amortization is $50,000 ($300,000/6 years). Amortization will be a total of $100,000 for the first two years bringing the net book value down to $200,000 ($300,000 - $50,000 - $50,000).
3) Answer is A Because goodwill does not have a finite life (it can last for a short period of time or forever), any reported balance is not amortized but stays on the company’s balance sheet until such time (if ever) as the value is judged to be impaired. Most other intangibles have a finite life and are amortized based on that life. 4) Answer is A The patent is reported at its historical cost of $350,000. Amortization over ten years will be at the rate of $35,000 per year ($350,000/10 years). After two years, the net book value is $280,000 ($350,000 less $35,000 and $35,000). Fair value is not relevant unless the asset is to be sold or the whole company is to be sold. 5) Answer is A Despite the possible fair values for this asset, Earth Company must continue to report the patent at its historical cost of $14,000. 6) Answer is A Mitchell will capitalize the $34,000 in legal fees, but not the $5,100,000 in research and development costs (according to U.S. GAAP). The $34,000 must be amortized over its 17 year life at the rate of $2,000 per year ($34,000/17 years). Amortization for the first year reduces the net book value from $34,000 to $32,000. 7) Answer is A To qualify as an identifiable intangible asset, at least one of the two following criteria must be met: (1) contractual or other legal rights have been gained or (2) the intangible can be separated and sold. 8) Answer is B Goodwill is the price paid by one company to acquire another in excess of the fair value of the net identifiable assets and liabilities of the company being acquired. Goodwill can result because the company being acquired possesses intangibles of value that do not qualify for separate reporting as intangible assets. Goodwill might also result simply from the price negotiations that are carried on when one company buys another. 9) Answer is C When the parent purchases the subsidiary, the assets of the acquired company are reported at fair value on consolidated financial statements. In this problem, the building is reported at $2.8 million, the equipment at $900,000, and the patents at $1.3 million. That is a total of $5.0 million for these identifiable assets. Because the parent actually paid $7.0 million to acquire this company, the excess $2.0 million is reported
as goodwill. Goodwill is not amortized and no indication is given that its value is impaired during the first year. Thus, the reported balance at the end of Year One continues to be $2.0 million. 10) Answer is B Here, the new parent paid $2.9 million for the subsidiary although the assets for that company were worth only $2.5 million. The extra $400,000 is reported as goodwill. 11) Answer is D Because research and development costs are expensed as incurred, any resulting assets are reported at little or no historical cost. This required accounting means that companies that carry out a lot of research and development often have many valuable assets left off their balances sheets. 12) Answer is D Although this company has been successful in the past in a number of its research and development projects, these assets are reported at balances that do not include any portion of the research and development costs. According to U. S. GAAP such costs are expensed as incurred so that little or nothing is capitalized. Consequently, for financial reporting purposes, valuable assets are understated. 13) Answer is C Project Three is the only current project that is viewed as more than 70 percent likely to be successful. For the company’s internal reporting, this project’s $900,000 cost was capitalized with only $180,000 recognized as expense this year ($900,000/5 years). Because the first two projects were less than 70 percent likely to succeed, their costs were expensed as incurred. That handling is consistent with U.S. GAAP. The only difference is with Project Three where $180,000 was expensed while the entire $900,000 in research and development costs should have been expensed. The $720,000 difference reduces the net income being presented for external reporting purposes. 14) Answer is B The payment is to be made in six years and no interest is explicitly paid in the interim. Therefore, U.S. GAAP holds that the $900,000 payment is partially for the asset with the rest serving as interest over that period of time. The payment is a single amount paid in 6 years with a reasonable annual interest rate of 5 percent. Using the tables at the back of the textbook, the present value factor for a single payment of $1 in six periods at 5 percent interest is 0.74622. The present value is $900,000 times 0.74622 or $671,598. (Answer B in the textbook was determined using a table where the factors had a different number of decimal places causing a small rounding difference.)
15) Answer is B Payments are made here over five years and no interest is explicitly paid in the interim. Therefore, U.S. GAAP holds that the five $100,000 payments are made partially for the asset with the rest serving as interest over that period of time. The payment pattern is that of an annuity due because the payments are of an equal amount at equal time intervals with the first payment made immediately. A reasonable annual interest rate is judged to be 8 percent. Using the tables at the back of the textbook, the present value factor for an annuity due of $1 for five periods at an 8 percent annual interest rate is 4.31213. The present value of these cash payments is $100,000 times 4.31213 or $431,213. 16) Answer is B The present value of the future cash flows is $478,107. Therefore, when the agreement is finalized on January 1, Year One, both the asset and the liability are reported at that amount. Future interest has been removed through the present value computation. Over time, the interest will be put back into the liability through periodic compounding entries. At the end of Year One, interest is computed and recognized. The liability balance for the period was $478,107. Because a reasonable annual interest rate is viewed as 10 percent, interest expense for Year One will be $47,811 ($478,107 multiplied by 10 percent). 17) Answer is C The present value of the future cash flows is $451,580. When the agreement is finalized on January 1, Year One, both the asset and the liability are reported at that amount. Future interest has been removed through the present value computation. Over time, the interest will be put back in through periodic compounding entries. At the end of Year One, interest is computed and recognized. The liability balance for the period was $451,580. Because a reasonable annual interest rate is viewed as 10 percent, interest expense for Year One will be $45,158 ($451,580 multiplied by 10 percent). No interest is paid at that time so the interest is compounded – added to the liability balance to bring it up from $451,580 to $496,738. Interest for the second year will be this updated principal balance times the 10 percent annual interest rate or $49,674 (rounded). 18) Answer is B The present value of the future cash flows is $586,840. On January 1, Year One, both the asset and the liability are reported at that amount. Future interest has been removed through the present value computation. Over time, the interest will be put back in through periodic compounding entries. The first payment is made immediately which reduces the liability by $100,000 to $486,840. At the end of Year One, interest is computed and recognized on that balance. Because a reasonable annual interest rate is 10 percent, interest expense for Year One will be $48,684 ($486,840 multiplied
by 10 percent). No interest is paid at that time so the interest is compounded – added to the liability balance to bring it up from $486,840 to $535,524. On the first day of Year Two, another $100,000 payment is made which reduces the liability balance to $435,524. That is the balance for all of Year Two. Interest for the second year will be this updated balance times the 10 percent annual interest rate or $43,552 (rounded).
Answers to Problems 1) a. Licensing agreement Cash
$1,500,000
Amortization expense Licensing agreement
$ 300,000
$1,500,000
b. $ 300,000
The $1.5 million cost is being expensed by the straight-line method over five years. The above credit could also have been made to “Accumulated Amortization.” c. Licensing agreement (cost) Less: Amortization expense to date ($300,000 x 3 years) Licensing agreement, 12/31/Three
$1,500,000 (900,000) $ 600,000
2) a. Patent Cash
$4,000,000 $4,000,000
To record acquisition of patent. Patent Cash
$ 200,000 $ 200,000
To record payment of legal fees in connection with purchase of patent. b. Year One Amortization expense Patent
$ 600,000
Year Two Amortization expense Patent
$ 600,000
$ 600,000
$ 600,000
Annual amortization is the $4.2 million cost paid to acquire the patent assigned evenly over an expected seven year life (or $600,000 per year). c. Cost of patent Less: Three years of amortization at $600,000 per year Net book value – 12/31/Three
$4,200,000 ( 1,800,000) $2,400,000
d. Patent Cash
$ 600,000 $ 600,000
To record successful defense of patent rights. e. Legal expense Cash
$ 600,000 $ 600,000
To record unsuccessful defense of patent rights 3) a. Donut maker Cookie machine Goodwill Cash
$ 360,000 440,000 400,000 $1,200,000
b. Depreciation expense $ 80,000 Accumulated depreciation – donut maker Accumulated depreciation – cookie machine
$
36,000 44,000
c. Goodwill is recorded initially at the amount paid by one company to acquire another that is in excess of the fair value of all of the subsidiary’s identifiable assets and liabilities. Goodwill does not have a finite life and, therefore, will remain on the balance sheet indefinitely. However, periodically, the goodwill balance must be tested for the possible impairment of its value. If impaired, goodwill is written down and a loss reported. 4) a. --The company could capitalize all $3 million that has been spent. The company spent the money with the idea that future revenues would result from these expenditures. The $3 million provides a future benefit. --The company could capitalize $1.8 million (and expense the remaining $1.2 million). Here, the asset is determined as the weighted average based on the anticipated chances for success (30% x $1 million plus 60% x $1 million plus 90% x
$1 million). This approach is the closest attempt to reflect the actual anticipated results of the work that has been carried out to date. --The company could capitalize $2.0 million (and expense the remaining $1.0 million). The recorded asset amount is the cost of each project that is over 50 percent likely to succeed. If a project is more likely to succeed than not, the cost should be capitalized until future evidence is available. The reporting is based on ascertaining what is most likely to happen. --The company could capitalize $1.0 million (and expense the remaining $2.0 million). Because financial accounting is conservative, the only project that is capitalized here is the one that is almost certainly destined for success (90 percent likelihood). Unless that level of assurance has been achieved, conservatism would indicate that an expense should be recorded. --The company could capitalize $1.0 million (and expense the remaining $2.0 million) based on the company’s past history with such projects. Many aspects of financial reporting (bad debt expense, for example) are based on monitoring previous results as a way of predicting the future. This company has historically been successful on 1 project out of every three. This approach can be viewed as the most documented way to anticipate future success. --The company could expense the entire $3.0 million as incurred. This approach is very conservative and is based on the concern that uncertainty is always present in any research and development activity. By recording the expenditures as an expense, the company does not have to guess at the chance for success. b. According to U.S. GAAP, the entire $3 million in research and development costs must be expensed as incurred. This approach enables decision makers to learn the amount of resources that management has chosen to spend on research and development activities. It also avoids the problem of guessing at the likelihood that such projects will become successful. Finally, requiring all costs to be expensed eliminates the chance for manipulation of reported figures. An assessment of the chance that a project will be successful is quite subjective and could be increased or decreased to achieve a desired reporting outcome. c. If specified criteria are met, IFRS requires the capitalization of development costs. However, research costs are expensed as incurred as with U.S. GAAP. 5) a. For internal reporting purposes, in Year One, the company recorded an expense of $100,000 (research costs) and a capitalized cost of $200,000 (development costs). According to U.S. GAAP, the entire $300,000 amount expended in Year One should have been recorded as an expense. To adjust the internal figures to U.S. GAAP, the expense must be increased by $200,000 ($100,000 up to $300,000) which reduces reported net income by the same amount. b. For internal reporting purposes, in Year Two, the company recorded an expense of $100,000 (research costs) and a capitalized cost of $200,000 (development costs). In addition, the amortization of the $200,000 capitalized cost from Year One must be
started. Because a five-year life is applied, another expense of $40,000 is recognized in Year Two ($200,000/5 years) for a total expense of $140,000. According to U.S. GAAP, the entire $300,000 expended in Year Two should have been recorded as an expense. To adjust the internal figures to U.S. GAAP, the expense must be increased by $160,000 ($140,000 up to $300,000) which reduces reported net income by the same amount. 6) a. In Year One, the company capitalized all $16,000 of its research and development costs. That figure was then amortized over four years with the half-year convention applied. Thus, in Year One, the recorded expense is $2,000. That is the $16,000 cost divided by 4 years to get $4,000 per year. Half of that is then recorded in this first year. According to U.S. GAAP, the entire $16,000 expended in Year One should have been recorded as an expense. To adjust the company’s figures to U.S. GAAP, the expense must be increased by $14,000 (from $2,000 to $16,000) which reduces reported net income by the same amount. Reported net income drops from $90,000 to $76,000. b. In Year Two, the company recorded amortization of $4,000 on its Year One expenditures as explained above. In addition, the company capitalized all $24,000 of its research and development costs incurred during that year. That figure was then amortized over four years with the half-year convention applied. Thus, in Year Two, another expense of $3,000 is recorded to bring the total up to $7,000. The $3,000 for the Year Two is the $24,000 cost divided by 4 years to get $6,000. Then, half of that amount is recorded in this year. According to U.S. GAAP, the entire $24,000 expended in Year Two should have been recorded as an expense. To adjust the company’s figures to U.S. GAAP, the expense is increased by $17,000 (from $7,000 to $24,000) which reduces reported net income by the same amount. Reported net income drops from $140,000 to $123,000. 7) a. In Year One, the American Corporation records a total expense of $300,000 because both the research and the development costs must be expensed as incurred. In that same year, the French Corporation records expense of $200,000 (research) and an asset of $100,000 (development). The $100,000 is amortized over 4 years ($25,000 per year) along with the application of the half-year convention ($12,500 for Year One). The only difference is the handling of the research costs. The American Corporation expenses $100,000 whereas the French Corporation expenses $12,500. The net income reported by the French Corporation is $87,500 higher. b. In Year Two, the American Corporation records no expense because no more amounts were spent in this year on research or development. The French Corporation recognizes a full year of amortization expense or $25,000 ($100,000/4 years). The reported net income for the French Corporation is $25,000 lower.
8) a. In this first case, the parent (Star) paid exactly the same amount as the fair value of the identifiable net assets of the subsidiary (Trek). Thus, no goodwill is recognized. Inventory Land Trademarks Patent Accounts payable Cash
$
480,000 50,000,000 20,000,000 1,850,000 $
650,000 71,680,000
b. In this second case, the parent (Star) paid $11,320,000 more than the fair value of the identifiable net assets of the subsidiary (Trek). That excess amount is recorded as goodwill. Inventory Land Trademarks Patent Goodwill Accounts payable Cash
$ 480,000 50,000,000 20,000,000 1,850,000 11,320,000 $ 650,000 83,000,000
c. Goodwill is not amortized over time because it does not have a finite life. Instead, a test to check for any loss of value is performed periodically. In the event that goodwill is found to be impaired, a loss is recorded.
9) a. Future cash flow $400,000 400,000 400,000 400,000
Interest rate 4% 6% 4% 6%
Number of periods 7 years 7 years 12 years 12 years
These present value amounts are determined as follows: --$400,000 x .75992 = $303,968 --$400,000 x .66506 = $266,024 --$400,000 x .62460 = $249,840 --$400,000 x .49697 = $198,788
Present value $303,968 $266,024 $249,840 $198,788
A present value computation takes a specified amount of future cash payments or collections and removes all future interest based on a reasonable rate. The remaining figure is the present value of those cash flows. If the interest rate is higher, more interest is removed so that the present value is less. This effect can be seen above in the first two computations. When the reasonable rate of interest increases from 4 percent to 6 percent, the present value of $400,000 in 7 years decreases from $303,968 to $266,024. More interest is removed. b. A present value computation takes a specified amount of future cash payments or collections and removes interest based on a reasonable rate. The remaining figure is the present value of those cash flows. If the number of time periods increases then more interest will accrue. When this larger amount of interest is removed, the present value is less. This effect can be seen above by comparing the first and third computations (or the second and fourth). When the time periods increase from 7 years to 12 years (and the periodic interest is held constant at 4 percent), the present value of $400,000 decreases from $303,968 to $249,840.
10) a. The present value of $10 million in cash to be paid in three years based on a reasonable annual interest rate of 6 percent is computed as follows: $10,000,000 x .83962 = $8,396,200 1/1/One Patent
$8,396,200 Note Payable
$8,396,200
b. 12/31/One Interest Expense Note Payable
$ 503,772 $ 503,772
$8,396,200 x 6% = $503,772 (interest for Year One) This compounding entry increases the Note Payable to $8,899,972 Amortization Expense Patent
$ 839,620 $ 839,620
$8,396,200/10 years = $839,620 (annual amortization for ten years)
12/31/Two Interest Expense Note Payable
$ 533,998 $ 533,998
$8,899,972 x 6% = $533,998 (rounded) This compounding entry increases the Note Payable to $9,433,970 Amortization Expense Patent
$ 839,620 $ 839,620
$8,396,200/10 years = $839,620 (annual amortization for ten years) 12/31/Three Interest Expense Note Payable
$ 566,030 $ 566,030
$9,433,970 x 6% = $566,038 (rounded) Note that the above entry is adjusted by $8 so that the final balance in the Note Payable is exactly $10,000,000. This is necessary because the factor used to compute present value is slightly rounded as are some of the interest calculations. Amortization Expense Patent
$ 839,620 $ 839,620
$8,396,200/10 years = $839,620 (annual amortization for ten years) c. 12/31/Three Note Payable Cash
$10,000,000 $10,000,000
11) Payment per period $30,000 60,000 25,000 56,000
Interest rate 5% 4% 8% 6%
Number of periods 8 years 7 years 10 years 4 years
Present value $203,591 $374,528 $181,172 $205,689
These present value amounts are determined as follows (rounded): --$30,000 x 6.78637 = $203,591 --$60,000 x 6.24214 = $374,528
--$25,000 x 7.24689 = $181,172 --$56,000 x 3.67301 = $205,689
12) a. The present value of $800,000 in cash to be paid in four years based on a reasonable annual interest rate of 5 percent is computed as follows: $800,000 x .82270 = $658,160 1/1/One Copyright Note Payable
$658,160
12/31/One Interest Expense Note Payable
$ 32,908
$658,160
b.
$ 32,908
$658,160 x 5% = $32,908 (interest for Year One) This compounding entry increases the Note Payable to $691,068 Amortization Expense Copyright
$164,540 $164,540
$658,160/4 years = $164,540 (annual amortization for four years) 12/31/Two Interest Expense Note Payable
$ 34,553 $ 34,553
$691,068 x 5% = $34,553 (rounded) This compounding entry increase the Note Payable to $725,621 Amortization Expense Copyright 12/31/Three Interest Expense Note Payable
$164,540 $164,540
$ 36,281 $ 36,281
$725,621 x 5% = $36,281 (rounded) This compounding entry increase the Note Payable to $761,902
Amortization Expense Copyright
12/31/Four Interest Expense Note Payable
$164,540 $164,540
$ 38,098 $ 38,098
$761,902 x 5% = $38,095 (rounded) Note that the above entry is adjusted by $3 so that the final balance in the Note Payable is exactly $800,000. This is necessary because the factor used to compute present value is slightly rounded and because the annual interest computations are also rounded. Amortization Expense Copyright
$164,540 $164,540
c. 12/31/Four Note Payable Cash
$800,000 $800,000
13) a. The present value of an annuity due of $200,000 paid annually in cash over four years based on a reasonable annual interest rate of 8 percent is computed as follows: $200,000 x 3.57710 = $715,420 1/1/One Copyright Note Payable Cash
$715,420 $515,420 200,000
b. The same amortization entry will be made at the end of each of these four years: Amortization Expense Copyright
$178,855 $178,855
$715,420/4 years = $178,855 (annual amortization for four years)
c. 12/31/One Interest Expense Note Payable
$ 41,234 $ 41,234
$515,420 x 8% = $41,234 (interest for Year One) This compounding entry increases the Note Payable to $556,654 1/1/Two Note Payable Cash
$200,000
12/31/Two Interest Expense Note Payable
$ 28,532
200,000
$ 28,532
The principal balance for Year Two is $556,654 - $200,000 = $356,654 $356,654 x 8% = $28,532 (rounded) This compounding entry increases the Note Payable to $385,186 1/1/Three Note Payable Cash
$200,000
12/31/Three Interest Expense Note Payable
$ 14,814
200,000
$ 14,814
The principal balance for Year Three is $385,186 - $200,000 = $185,186 $185,186 x 8% = $14,814 (rounded) This compounding entry increases the Note Payable to $200,000 1/1/Four Note Payable Cash
$200,000 200,000
Answer to Comprehensive Problem A) a) Accounts Receivable Revenue
$ 4,600 $ 4,600
b) Supplies Inventory Accounts Payable
$80 $80
c) No entry needed. d) Purchases Accounts Payable
$7,830
Salaries Expense Cash
$800
Cash
$11,400
$7,830
e)
$800
f)
Revenue
$11,400
g) Cash
$400 Unearned Revenue
$400
h) License Agreement Cash
$2,400
Cash
$4,200
$2,400
i)
Accounts Receivable
$4,200
j) Salaries Payable Cash
$100 $100
k) Accounts Payable Cash
$9,000
Salaries Expense Cash
$2,000
Allowance for Doubtful Accounts Accounts Receivable
$100
Tax Expense Cash
$1,135
$9,000
l)
$2,000
m)
$100
n)
$1,135
B)
Cash Accounts Receivable 1,532 800(e) 1,450 4,200(i) (f)11,400 2,400(h) (a)4,600 100(m) (g)400 100(j) (i)4,200 9,000(k) 2,000(l) 1,135(n) 2,097
Allow. Doubtful Accounts (m)100 145
1,750
Prepaid Rent 400
Equipment 7,000
400
7,000
45
Accum. Depr.—Equip 584 584
2,295
Supplies 50 (b)80
1,470
130
Furniture 1,000
Accum. Depr.—Furn 17
1,000
License Agreement Accounts Payable Salaries Payable (h)2,400 (k)9,000 3,385 (j)100 100 80(b) 7,830(d) 2,400
Inventory 1,470
0
17
Unearned Revenue 400(g)
400
Note Payable
0
Capital Stock 2,000
Retained Earnings 6,671
2,000 Supplies Expense
0 Salaries Expense (e)800 (l)2,000 2,800
Revenue 4,600(a) 11,400(f)
6,671
16,000
Rent Expense
Bad Debt Expense
0
0
Depreciation Expense
0
Tax Expense (n)1,135
1,135 Purchases (d)7,830 7,830
Utilities Expense
0 Cost of Goods Sold
0
C) Prepare an unadjusted trial balance for Webworks for November. Webworks Unadjusted Trial Balance November 30 Account Title Cash Accounts Receivable Allowance for Doubtful Accounts Inventory Supplies Prepaid Rent Equipment Accum. Depreciation—Equipment Furniture Accum. Depreciation—Furniture License Agreement Accounts Payable Salaries Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 11/1 Revenue Salaries Expense Tax Expense Utilities Expense Supplies Expense Rent Expense Bad Debt Expense Purchases Cost of Goods Sold
Debits $ 2,097 1,750
Credits
2,800 1,135 0 0 0 0 7,830 0
_______
Totals
$28,012
$28,012
$
45
1,470 130 400 7,000 584 1,000 17 2,400 2,295 0 400 0 2,000 6,671 16,000
D) Prepare adjusting entries for the following and post them to your T-accounts. o) Salaries Expense Salaries Payable
$150
Utilities Expense Accounts Payable
$290
Supplies Expense Supplies
$110
Rent Expense Prepaid Rent
$200
Bad Debt Expense Allowance for Doubtful Accounts
$130
$150
p)
$290
q)
$110
r)
$200
s)
$130
t) Depreciation Expense $146 Accumulated Depreciation—Equipment
$146
Depreciation Expense $ 17 Accumulated Depreciation—Furniture
$ 17
Amortization Expense Licensing Agreement
$200
u) $200
v) Cost of Goods Sold Purchases Inventory
$8,171 $7,830 341
Allow. Doubtful Cash Accounts Receivable Accounts 1,532 800(e) 1,450 4,200(i) (m)100 145 (f)11,400 2,400(h) (a)4,600 100(m) 130(s) (g)400 100(j) (i)4,200 9,000(k) 2,000(l) 1,135(n) 2,097
1,750
Prepaid Rent 400 200(r)
Equipment 7,000
200
7,000
175
Accum. Depr.—Equip 584 146(t) 730
2,585
Capital Stock 2,000
Supplies Expense (q)110 110
200
16,000
Supplies 50 110(q) (b)80
20 Accum. Depr.—Furn 17 17(t) 34
Unearned Revenue 400(g)
Note Payable
400
Revenue Tax Expense 4,600(a) (n)1,135 11,400(f)
6,671 Rent Expense (r)200
Furniture 1,000
150
Retained Earnings 6,671
2,000
1,129
1,000
License Agreement Accounts Payable Salaries Payable (h)2,400 200(u) (k)9,000 3,385 (j)100 100 80(b) 150(o) 7,830(d) 290(p) 2,200
Inventory 1,470 341(v)
1,135
0 Utilities Expense (p)290
290
Bad Debt Expense Purchases Cost of Goods Sold (s)130 (d)7,830 7,830(v) (v)8,171 130
0
8,171
Salaries Expense (e)800 (l)2,000 (o)150 2,950
Depreciation Expense (t)146 (t)17
163
Amortization Expense (u)200
200
E) Webworks Adjusted Trial Balance November 30 Account Title Cash Accounts Receivable Allowance for Doubtful Accounts Inventory Supplies Prepaid Rent Equipment Accum. Depreciation—Equipment Furniture Accum. Depreciation—Furniture License Agreement Accounts Payable Salaries Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 11/1 Revenue Salaries Expense Tax Expense Utilities Expense Supplies Expense Rent Expense Bad Debt Expense Purchases Cost of Goods Sold Depreciation Expense Amortization Expense Totals
Debits $ 2,097 1,750
Credits
$
175
1,129 20 200 7,000 730 1,000 34 2,200 $ 2,585 150 400 0 2,000 6,671 16,000 2,950 1,135 290 110 200 130 0 8,171 163 200
_______
$28,745
$28,745
F) Webworks Income Statement As of November 30 Revenue $16,000 Cost of Goods Sold (8,171) Gross Profit 7,829 Deprec. and Amort. Expense (363) Other Expenses (3,680) Earnings before tax 3,786 Tax Expense (1,135) Net Income $2,651 Webworks Stmt. of Retained Earnings As of November 30 Retained Earnings, November 1 Net Income Retained Earnings, November 30
$6,671 2,651 $9,322
Webworks Balance Sheet November 30 Assets:
Liabilities:
Current: Cash $ 2,097 Accounts Receivable 1,750 less Allow. for Doubt. Accts. (175) Net Accounts Receivable 1,575 Merchandise Inventory 1,129 Supplies Inventory 20 Prepaid Rent 200 Total Current Assets $ 5,021
Current: Accounts Payable Salaries Payable Unearned Revenue
$ 2,585 150 400
Total Current Liabilities
$ 3,135
Owners’ Equity: Capital Stock Retained Earnings Total Owners’ Equity
$ 2,000 9,322 $11,322
Property, Plant and Equipment Equipment $ 7,000 less Accumulated Depreciation (730) Furniture 1,000 less Accumulated Depreciation (34) Total Property, Plant, & Equipment $ 7,236 Other Noncurrent Assets: Licensing Agreement, net
Total Assets
$ 2,200
$14,457
Total Liabilities & Owners’ Equity
$14,457
Answer to Research Assignment a. Goodwill (in millions) 2009 $1,234 2010 $1,349 As discovered in the notes to the financial statements, company acquisitions were made during the year that increased the balance reported for goodwill. According to notes attached to the financial statements, no impairment of goodwill was reported during 2010.
b. As can be seen from the balance sheet, goodwill as a percentage of this company’s assets went down during 2010. The figures below are reported in millions: Goodwill / Total Assets 2009 $1,234 / $13,813 2010 $1,349 / $18,797
9.0% 7.2%
Thus, the company did not pay a relatively huge premium for any other company that it acquired during 2010. c. According to footnote 4 attached to the 2010 consolidated financial statements, Amazon acquired certain companies in 2010 resulting in goodwill of $111 million. The footnote goes on to say that the primary reason for these acquisitions was to expand the company’s customer base and its sales channels. As discussed in this chapter, the purchase price of each acquisition was allocated to the tangible and intangible assets and liabilities based on the estimated fair value at the date of acquisition. Any remaining unallocated portion of the purchase price was reported as goodwill.
Chapter 12 Solutions Answers to Questions 1) Investments in the shares of another company are made for several possible reasons. 1. Lawrence might hope to receive cash dividends as a result of its ownership in Memphis. Many companies distribute dividends periodically and one of the main reasons for making such investments is to receive this cash. 2. Lawrence might have reason to believe that the price of the Memphis shares will appreciate over time or in the near future. Any rise in the value of Memphis stock increases the wealth of every owner. 3. Lawrence might want to influence or control the operating and financing decisions made by Memphis. If a sufficient quantity of shares is acquired, Lawrence can impact decisions made by the board of directors and management. 2) A stock purchase is classified as a trading security if management intends to sell the shares in the near term. In such cases, management expects to need the money in the near future and hopes to gain a dividend or stock appreciation in the interim period until the cash is needed. 3) In accounting for investments in both trading securities and available-for-sale investments, dividend revenue is reported on the owner’s income statement. No distinction is made between these two types of investments as far as the receipt of dividends is concerned. 4) The price of these 1,000 shares has appreciated by $9 each or $9,000 in total. If the shares are sold in Year One, Amos Corporation will report a realized gain of $9,000. If the shares are not sold, Amos Corporation will report an unrealized gain of $9,000 at the end of Year One. Because the shares are classified as trading securities, net income increases by $9,000 whether they are sold or not. The only difference is the method of labeling the gain. 5) Unlike equipment and inventory, trading securities can be immediately sold on an exchange so their fair value is easily determined at any point in time. The value is known and that balance can be received in a matter of seconds. 6) The classification of an investment in the shares of a company’s stock as either trading securities or available-for-sale securities is based on management’s intentions. If the investment is only to be held for a short period of time, it is reported as a trading security. In contrast, the investment in stock is classified as available for sale if no sale is expected in the near term. The investment is held for dividend collection and price appreciation until cash is needed by the management.
7) These investments will be reported at fair value on Company A’s balance sheet whether they are classified as trading securities or available-for-sale securities. The investment in Company Y is reported at $15,000 (1,000 shares x $15 per share) while the investment in Company Z is reported at $28,000 (2,000 shares x $14 per share) If they are trading securities, the $2 per share ($2,000) rise in the value of the Company Y investment as well as the $4 per share ($8,000) drop in the share price of Company Z are reported as a $6,000 net unrealized loss on the company’s income statement. If these investments are classified as available-for-sale securities, the $6,000 net unrealized loss is reported as accumulated other comprehensive income within the stockholders’ equity section found on the company’s balance sheet. For available-forsale securities, net income is not impacted by any changes in fair value until the shares are actually sold. 8) If this investment is held to be a trading security, the $1,000 rise in price during Year One ($9,000 to $10,000) is reported on the income statement as a $1,000 unrealized gain. In Year Two, the $4,000 drop in value ($10,000 to $6,000) is shown on the income statement as a $4,000 realized loss If this investment is classified as an available-for-sale security, the $1,000 rise in price during Year One has no impact on reported net income. Instead, the unrealized gain is included in accumulated other comprehensive income within stockholders’ equity on the company’s balance sheet. Because no income is recorded on the income statement prior to Year Two, the entire gain or loss is recognized at that time. The shares were bought for $9,000 and sold for $6,000; thus, a realized loss of $3,000 is reported on the Year Two income statement. Overall the results are the same: Trading security: $1,000 unrealized gain in Year One $4,000 realized loss in Year Two $3,000 overall loss Available-for-sale: $3,000 realized loss in Year Two 9) Because the company has classified this investment as an available-for-sale security, no change occurs in net income although that asset actually did lose $4,000 of its value. The loss is not taken into consideration in computing net income but is included in moving from net income to comprehensive income. Net income Unrealized loss in available-for-sale securities Comprehensive income
$200,000 (4,000) $196,000
10) The company anticipates a gain of $5 per share ($26 less $21) on these 1,000 availablefor-sale shares. If the sale is made on December 30, this $5,000 gain increases net income in Year One and nothing further is reported in Year Two. However, if the sale is not made until Year Two, no impact occurs on Year One net income. Instead, the $5,000 unrealized gain appears in accumulated other comprehensive income within stockholders’ equity. Then, in Year Two, at the time of sale, this gain is removed from stockholders’ equity on the balance sheet and reported on the income statement. 11) Whenever one company obtains enough shares of another company to exert significant influence over that company’s operating and financing decisions, the equity method is adopted for financial reporting purposes. 12) In theory, the equity method is applied to an investment if the investor gains the ability to exert significant influence over the operating and financing decisions of the investee. This is often demonstrated by being able to place a member on the board of directors. In practice, significant influence is often hard to ascertain. Thus, when applying U.S. GAAP, unless evidence to the contrary is available, significant influence is said to exist if the investor owns between 20% and 50% of the investee’s stock. 13) When accounting for an investment using the equity method, fair value is not reported unless impairment has occurred. Instead, the owner’s portion of the investee’s net income is recognized as it is earned. Because income is recognized when earned by the investee, dividends conveyed by the investee cannot also be reported as income. That would double count the income effect. Dividend distributions make the investee smaller; therefore, the investor reports their receipt as a reduction in the investment account. Archibald recognizes investment income of $45,000 (30% of Saratoga’s $150,000 reported net income) and increases the investment in Saratoga by the same amount. Archibald collects $18,000 in cash dividends (30% of Saratoga’s $60,000 dividend distribution) and reduces its investment in Saratoga by that amount. 14) When the equity method is applied, the investor recognizes income at the same time that it is earned by the investee. If the investor was to recognize that income again when the investee distributed it as a dividend, the income would be counted twice. Income from an investment has to be recognized when earned or when received but not at both times. 15) Because Walters Company acquired 40 percent of the Ameston Company, the investment is reported by means of the equity method. Unless an impairment of value occurs, the investment is not reported at fair value. The investment is initially recorded at its cost of $388,000. After that, the investment changes based on the income
reported by the investee. In addition, dividends received from Ameston reduce the investment balance rather than being reported as revenue. At the end of Year One, the investment is reported by Walters at $412,000. That is the original cost plus Walters’s share of the net income reported by Ameston less Walters’s share of the dividend distributions: The reported number represents neither cost nor fair value but an amalgamation of financial impacts. Investment on 1/1/Year One Recognized income of investee Dividend received from investee Investment on 12/31/Year One
$388,000 40,000 ($100,000 x 40%) (16,000) ($40,000 x 40%) $412,000
16) Because Giant Corporation now holds 54 percent of the outstanding shares of Small Corporation, it has control of that company and its operations. Consolidated financial statements must be prepared and reported to bring together the financial accounts from both companies. The assets, liabilities, revenues, expenses, etc. should be reported as if one entity exists rather than two. 17) Lauderdale Corporation has two identifiable assets with a total fair value of $950,000 (land $220,000 and building $730,000). To acquire this company, Yarrow had to pay $1 million. Because the additional $50,000 that was paid cannot be associated with any identifiable asset, it is reported as goodwill. Land Building Goodwill Cash
$220,000 730,000 50,000 $1,000,000
18) In consolidated financial statements for the year ended December 31, Year One, Donnelly Corporation reports only the parent company revenues of $900,000. The revenues generated during Year One by Nelson Company benefitted the previous owners of that company’s stock and not Donnelly. Revenues earned by a subsidiary are only included in consolidated figures for periods of time after the acquisition. 19) A company’s total asset turnover is found by taking sales revenue and dividing that figure by the average of the company’s total assets for that same period of time. The total asset turnover provides a picture of how efficiently management uses all available assets to generate revenue. 20) Financial analysts calculate a company’s return on assets by taking reported net income for a period of time and then dividing that figure by the average of the company’s total assets for that period.
Answers to True or False Questions __F__ 1) Investments in the shares of another company can be accounted for as trading securities or available-for-sale securities. Such investments can also be reported by applying the equity method or through the consolidation of the financial information. Accounting for investments in stock is unusual because so many different methods are available. These different approaches are appropriate based on the percentage of ownership that is obtained and management’s intentions for the investment. __T__ 2) A company that holds an investment labeled as a trading security (or as available for sale) records the dividends that are received as dividend revenue on the income statement. __F__ 3) Investments in both available for sale and trading securities are reported at their fair values. Equity method investments and investments that are consolidated are also accounted for by applying methods that differ from simply reporting historical cost. __F__ 4) As an investment in a trading security, a $2,000 unrealized gain is recognized in the Year One income statement and a $1,000 gain on sale is recognized in the Year Two income statement. __F__ 5) Whether the investments are viewed as trading securities or as available-for-sale investments, the asset balance is reported at fair value. The total of all assets does not change because of the method of reporting. The difference is in the handling of the gains and losses that result because of changes in fair value. __T__ 6) Gains or losses in the fair value of available-for-sale investments are included as accumulated other comprehensive income within the stockholders’ equity section of the balance sheet. These gains and losses do not impact net income (until the investment is sold) but are included within the computation of comprehensive income. __F__ 7) The impact on net income cannot be determined here without knowing whether the shares are considered an investment in trading securities or an investment in available-for-sale securities. However, in both cases, the increase in net income is not $3,800. If the shares are trading securities, the increase is $2,300 (the dividends received plus the increase in value during Year Two). If the shares are available-forsale securities, the increase is $3,300 (the dividends received plus the increase in value since the date of purchase). __T__ 8) Net income here is $40,000 and that figure does include the dividend revenue but not the $5,000 increase in value (because the shares are judged to be available-for-sale securities). Comprehensive income is intended to present a number that does include all such gains and losses. Adding the $5,000 unrealized gain to net income brings comprehensive income to $45,000.
__F__ 9) Accumulated other comprehensive income is found with the stockholders’ equity section of the balance sheet and includes certain gains and losses that are not viewed (according to U.S. GAAP) as applicable to the computation of net income. __F__ 10) In most cases, the ownership of a 25 percent stake in another company leads to the application of the equity method. However, use of the equity method whenever ownership is in the 20-50 percent range is a guideline and not a requirement. The actual rule states that the equity method should be adopted if the investor has the ability to apply significant influence over the operating and financing decisions of the investee. If less than 20 percent ownership is held but significant influence is still present, the equity method is appropriate. Conversely, if 20 to 50 percent ownership is maintained but the investor does not have the ability to apply significant influence over the operating and financing decisions of the investee, the equity method should not be used. __F__ 11) Equity method investments are reported at cost plus or minus the investor’s ownership percentage of the investee earnings. The investment balance is also reduced for any dividends that are received. __F__ 12) When applying the equity method, any dividends received are not reported as dividend revenue. Instead, they are recorded as a reduction in the balance of the investment account. __T__ 13) When applying the equity method, the investment is initially recorded at its historical cost. That figure is then raised by the investor’s percentage of any investee net income. It is lowered by the investor’s percentage of any dividends that are distributed. Here, the balance after one year will be $315,000. That is $300,000 (cost) + $21,000 (30% of $70,000 net income) - $6,000 (30% of $20,000 dividend). __T__ 14) When applying the equity method, the assumption is made that the investor is so closely attached to the investee that the investor should report income from the investment as soon as it is earned by the investee. __F__ 15) Consolidated financial statements are necessary when one company acquires control over another. According to U.S. GAAP, control is established when a company obtains over 50 percent of the voting ownership of another company. __F__ 16) At the date of an acquisition, neither the subsidiary’s revenues nor its expenses are included in consolidated financial statements. Those revenues and expenses were earned and incurred when another set of owners was in control. Those revenues and expenses affected the previous owners. Therefore, only revenues and expenses that are recognized after a subsidiary is acquired are reported within consolidated figures. __T__ 17) In consolidating the assets and liabilities of a newly-acquired subsidiary, all of the assets and liabilities of that company are consolidated at fair value. If the acquisition price is greater than the total fair value of those identifiable assets and liabilities, the
excess is reported as goodwill. In this question, no excess amount was paid so no goodwill is recognized. __T__ 18) In consolidating the assets and liabilities of a newly-acquired subsidiary, all of the assets and liabilities of that company are consolidated at fair value. The building held by the company that is being bought has a fair value of $960,000. That figure is then reported for the building in consolidated financial statements. __T__ 19) A company’s return on assets (ROA) reflects how efficiently management is making use of the assets at hand. A higher ROA indicates a higher level of efficiency.
Answers to Multiple Choice Questions 1) Answer is B Because of management’s intention to sell these shares in a short period of time, they are viewed as an investment in trading securities. As an investment in trading securities, the $2 rise in value of the 70 shares creates an unrealized gain of $140 that is shown on the income statement. 2) Answer is D The fair value of a trading security is very easy to determine. However, fair value is really no easier to determine than historical cost, the amount paid to acquire the shares originally. 3) Answer is D Investments in both trading securities and available-for-sale securities are reported at fair value ($18,000 in this case). The change in fair value is reported on the income statement if the shares are viewed as trading securities. In contrast, the change in fair value is reported in stockholders’ equity (as accumulated other comprehensive income) and not in net income if viewed as available-for-sale securities. 4) Answer is C As a trading security, the impact on net income in Year Two is the increase in value during that period ($2,000) plus the dividends received ($1,200) for a total of $3,200. 5) Answer is D As a trading security, the impact on net income in Year Two is the increase in value during that period ($4,000) plus the dividends received ($900) for a total of $4,900.
6) Answer is C The investment here is recorded as the ownership of available-for-sale securities. Consequently, the $3 per share drop in value is not recorded as a $450 unrealized loss (150 shares at a $3 per share loss) on the owner’s income statement. Instead, it is recorded in stockholders’ equity on the balance sheet. Because that loss was not included in the computation of net income, it must be recognized in adjusting net income to comprehensive income. The $235,000 net income is reduced by the $450 loss to a $234,550 comprehensive income. 7) Answer is A The $4,000 unrealized gain created by the increase in the value of this investment is reported within net income because the shares are viewed as trading securities. The gain has taken place and has already been recorded as a part of computing net income. No further adjustment is necessary to determine comprehensive income. 8) Answer is D Dividends received from an investee are considered dividend revenue if the investment is viewed as a trading security or as an available-for-sale security. Differences exist between the two methods of accounting but not in the handling of any dividends that are received. 9) Answer is D The accounting for trading securities and available-for-sale securities are the same as far as the reporting of the asset: the investment is shown on the balance sheet at fair value. Similar handling is also seen in the handling of dividends that are received. They are recognized as dividend revenue. However, with the equity method, the asset is initially recorded at cost but then goes up and down each period based on the earnings of the investee as well as the dividends received from that investee. 10) Answer is A Accounting for an investment by means of the equity method is required when the ability to apply significant influence is present regardless of the level of ownership. Even 15 percent ownership requires the equity method if the ability to apply significant influence exists. Conversely, an investor can hold 20-50 percent of another company and the equity method is not applicable if the ability to apply significant influence is lacking. Holding 4 percent of another company is either viewed as a trading security or an available-for-sale security. Holding 56 percent of another company provides control so that consolidated financial statements are necessary.
11) Answer is A Because the equity method should be applied, the original cost of $400,000 is increased by 40 percent of the net income reported by Hailey ($80,000 in Year One and $100,000 in Year Two). Rocko recognizes a total of $72,000 ($180,000 x 40 percent). Rocko also reduces its investment by 40 percent of the dividends paid by Hailey ($30,000 each year). Rocko decreases the investment by $24,000 ($60,000 x 40 percent). After two years, the investment balance is $448,000 ($400,000 + $72,000 - $24,000). 12) Answer is C When one company gains control over another, the financial statements are consolidated based on the acquisition price. First, each identifiable asset is reported at its fair value. Thus, the patent is reported at $159,000. Then, any amount paid in excess of the total fair value of all such assets and liabilities is reported as goodwill. Goodwill is $1,600,000 ($4,500,000 less $2,900,000). 13) Answer is C When one company gains control over another company, the financial statements are consolidated based on the acquisition price. Each identifiable asset is reported at its fair value. Thus, the trademark is reported at $45,000. The net book value of the subsidiary is $3 million. The $30,000 adjustment for the value of the trademark means that the subsidiary’s net assets are worth $3,030,000. Any amount paid by the new parent in excess of the total of the fair value of all identifiable assets and liabilities is reported as goodwill. Thus, goodwill is $370,000 ($3,400,000 less $3,030,000). 14) Answer is A At the date of an acquisition, neither the subsidiary’s revenues nor expenses are included in consolidated financial statements. Those revenues and expenses were earned and incurred when another set of owners was in control. Thus, those earlier revenues and expenses affected the previous owners. Only revenues and expenses recognized after a subsidiary is acquired are reported within consolidated figures. Here, the purchase of Osbourne took place at the end of Year One; revenues and expenses for that period should not be included in the Year One consolidated income statement. 15) Answer is D Hydro has a total asset turnover of $47,800 in sales/$35,000 average total assets or 1.37 times. Aqua has a total asset turnover of $56,900 in sales/$49,000 average total assets or 1.16 times. From this one test, Hydro appears to be making better use of its assets than Aqua. The return on assets cannot be computed here based on the information given because net income was not disclosed for the companies.
16) Answer is B Return on assets is found by dividing net income by the average of the company’s total assets. Net income in this problem is $46,000. The average total assets is ($450,000 + $530,000)/2 or $490,000. The return on assets is 9.4% ($46,000/$490,000).
Answers to Problems 1) a. As a trading security, this investment is recorded at the end of Year One at its fair value of $23,000. On the income statement for Year One, the $4,000 increase in fair value ($19,000 to $23,000) is reported as an unrealized gain. Also, on the income statement for Year One, dividend revenue of $1,000 is reported. b. As a trading security, the $2,000 increase ($23,000 to $25,000) in the value of the investments (leading up to the sale) is reported on the income statement as a realized gain. c. As an available-for-sale security, this investment is recorded at the end of Year One at its fair value of $23,000. On the income statement for Year One, dividend revenue of $1,000 is reported. The $4,000 increase in fair value ($19,000 to $23,000) is reported as an unrealized gain within accumulated other comprehensive income in the stockholders’ equity section of the balance sheet. d. As an available-for-sale security, a realized gain of $6,000 (sales price of $25,000 less cost of $19,000) is reported on the income statement for Year Two. 2) a. Investment in Trading Securities Cash
$36,000 $36,000
b. Investment in Trading Securities $ 1,800 Unrealized Gain—Trading Securities
$ 1,800
To record $3 per share increase in the value of investment being reported as a trading security ($3 x 600 shares).
c. Cash
$ 1,200 Dividend Revenue
$ 1,200
To record collection of $2 per share cash dividend ($2 x 600 shares) . d. Unrealized Loss—Trading Securities Investment in Trading Securities
$ 2,400 $ 2,400
To record $4 per share ($63 less $59) drop in the value of investment recorded as a trading security ($4 x 600 shares). Loss appears on income statement. Book value decreases to $35,400. e. Cash
$37,200 Investment in Trading Securities Gain on Sale of Trading Securities
$35,400 1,800
To record cash received from sale and remove book value of investment. Difference is reported on income statement as a realized gain. 3) a. Because the shares will be sold in a short time, they are classified as trading securities on the balance sheet so that any change in value is reported on the income statement. Income Statement, Year Ended December 31, Year One Unrealized loss = 500 shares × ($20 − $18) Unrealized loss = $1,000 Dividend revenue = 500 shares x $.32 Dividend revenue = $160 b. Current Assets Investment in Trading Securities
$9,000
The reported balance for this asset is the number of shares (500) multiplied by the year-end stock price ($18 per share).
c. As a trading security, gains and losses in value are reported immediately within net income. Therefore, no adjustment is needed to determine a different comprehensive income. Net income is $79,000; comprehensive income will be the same amount. 4) As an available-for-sale security, the $2,000 dividend is reported as revenue in Year One. Then, in Year Two, a realized gain of $1,000 is recognized (sales price of $54,000 less cost of $53,000). Until sold, changes in fair value were reported within stockholders’ equity. If this investment had been classified as a trading security, the dividend revenue of $2,000 is still reported in Year One but so is the $5,000 increase in the value of the investment ($53,000 up to $58,000) for a total of $7,000. In Year Two, the value drops from $58,000 to $54,000 (when sold) causing a reported loss of $4,000. Year One. If the investment had been a trading security rather than an available-forsale security, the total income would be $7,000 rather than $2,000. Reported net income is $5,000 higher. Year Two. If the investment had been a trading security rather an available-for-sale security, related income would have been a $4,000 loss rather than a $1,000 gain. Reported net income is $5,000 lower. 5) a. Investment in Available-for-Sale Securities $30,000 Cash
$30,000
On that date, the investment appears on the company’s balance sheet at its $30,000 cost. b. Unrealized Loss $ 5,000 Investment in Available-for-Sale Securities
$ 5,000
At the end of Year Two, the investment appears on the company’s balance sheet at its $25,000 fair value. The unrealized loss of $5,000 appears in accumulated other comprehensive income within the stockholders’ equity section of the balance sheet.
c. Investment in Available-for-Sale Securities $ 3,000 Unrealized Gain
$ 3,000
At the end of Year Three, the investment appears on the company’s balance sheet at its $28,000 fair value. A net unrealized loss of $2,000 now appears in accumulated other comprehensive income within the stockholders’ equity section of the balance sheet ($5,000 loss in Year Two partially offset by a $3,000 gain in Year Three). d. Cash
$
600
Dividend Revenue
$
600
The reported balance for the investment account is not affected by the dividend. The cash account appearing as an asset on the company’s balance sheet will now include this $600. e. Cash $36,000 Investment in Available-for-Sale Securities Unrealized Loss (net) Gain on Sale of Available-for-Sale Securities
$28,000 2,000 6,000
The $6,000 gain is the difference in the cost ($30) and sales price ($36) of these 1,000 shares. The $2,000 net unrealized loss is removed from accumulated other comprehensive income. The cash balance is included as an asset on the company’s balance sheet. 6) a. Because Youngstown plans to hold these shares indefinitely, the investment is classified as available-for-sale. At the end of this year, the investment in the available-for-sale securities is reflected at its fair value of $18,000 (900 shares at $20 per share). In addition, an unrealized gain of $4,500 (increase from $15 per share to $20 per share for the 900 shares) is reported within accumulated other comprehensive income (AOCI) in the stockholders’ section of the balance sheet. Year One net income – no impact Year One Balance Sheet: Asset - Investment in Available-for-Sale Securities AOCI - Unrealized Gain, Available-for-Sale Securities
$18,000 4,500
b. The $4,500 unrealized gain was not included in net income because the shares were classified as available for sale. In determining comprehensive income for the year, this $4,500 gain is included in the computation. Net Income Unrealized Gain – Available-for-Sale Securities Comprehensive Income
$190,000 4,500 $194,500
c. Cash $21,600 Unrealized Gain - Available-for-Sale Securities 4,500 Investment in Available-for-Sale Securities Gain on Sale of Available-for-Sale Investment
$18,000 8,100
These available-for-sale shares were bought for $15 per share and sold for $24 per share. The $9 gain is recognized for these 900 shares ($9 x 900 shares = $8,100). 7) a. Investment Classified as Available-for-Sale Year One Investment in Available-for-Sale Securities Cash
$370,000 $370,000
Cash (20% x $30,000) Dividend Revenue
$
Investment in Available-for-Sale Securities Unrealized Gain (AOCI)
$ 50,000
Year Two Cash (20% x $30,000) Dividend Revenue Investment in Available-for-Sale Securities Unrealized Gain (AOCI)
6,000 $
6,000
$ 50,000
$
6,000 $
6,000
$ 50,000
Year Three Cash $470,000 Unrealized Gain (AOCI) 100,000 Investment in Available-for-Sale Securities Realized Gain (Income Statement)
$ 50,000
$470,000 100,000
b. Investment Monitored Using Equity Method Year One Investment in Pottsboro-Equity Method Cash
$370,000 $370,000
Cash (20% x $30,000) Investment in Pottsboro-Equity Method
$
6,000
Investment in Pottsboro-Equity Method Investment Income--Pottsboro
$ 16,000
$
6,000
$ 16,000
Income: 20 percent of reported $80,000 Year Two Cash (20% x $30,000) Investment in Pottsboro-Equity Method Investment in Pottsboro-Equity Method Investment Income—Pottsboro
$
6,000 $
6,000
$ 20,000 $ 20,000
Income: 20 percent of reported $100,000 Year Three The investment account has a balance of $394,000 ($370,000 – $6,000 + $16,000 - $6,000 + $20,000) when the shares are sold at the beginning of Year Three for $470,000. Cash
$470,000 Investment in Pottsboro-Equity Method Realized Gain (Income Statement)
$394,000 76,000
8) a. Investment in Canadian Paper-Equity Method Investment Income—Canadian Paper
$228,000 $228,000
Recognition of proportionate share of investee’s income ($760,000 x 30 percent) b. Cash
$ 24,000 Investment in Canadian Paper
Collection of cash dividend ($80,000 x 30 percent)
$ 24,000
c. Investment in Canadian Paper-Equity Method, December 31, Year One Original investment Share of income Share of dividends Investment in Canadian Paper
$6,000,000 228,000 (24,000) $6,204,000
9) a. Investment in Nealy—Equity Method Investment Income—Nealy
$100,000 $100,000
Recognition of proportionate share of investee’s income ($400,000 x 25 percent)
b. Cash
$ 12,500 Investment in Nealy—Equity Method
$ 12,500
Collection of cash dividend from Nealy ($50,000 x 25 percent) c. BALANCE SHEET, December 31, Year One Investment in Nealy-Equity Method Original investment $1,000,000 Share of income 100,000 Share of dividends ( 12,500) Investment in Nealy $1,087,500 INCOME STATEMENT, Year Ended December 31, Year One Investment income--Nealy $100,000 d. Investment in Nealy, December 31, Year One Year Two: Share of income ($440,000 x 25%) Share of dividends ($60,000 x 25%) Investment in Nealy, December 31, Year Two
$1,087,500
Cash
$1,200,000
110,000 ( 15,000) $1,182,500
e. Investment in Nealy—Equity Method Gain on Sale of Equity Method Securities
$1,182,500 17,500
10) a. Fair Value of Feather’s Net Assets: Cash Inventory Land Patent Accounts payable Total Fair Value
$ 456,000 873,000 700,000 1,000,000 (500,000) $2,589,000
Acquisition Price Paid for Feather Fair value of Feather’s Net Assets Goodwill
$5,000,000 (2,589,000) $2,411,000
b. The following balance sheet is created by taking the book value of each of Teckla’s assets and liabilities (as the parent company) and adding the fair value of each of Feather’s assets and liabilities (as the subsidiary company). Cash is reduced by the amount that Teckla paid for Feather. The owner’s equity accounts at the date of the acquisition are those of the parent company. Teckla Corporation Consolidated Balance Sheet January 1, 20X3 Assets: Cash Inventory Land Patent Goodwill
$ 4,856,000 1,573,000 5,760,000 1,000,000 2,411,000
Total Assets
$15,600,000
Liabilities: Accounts Payable Notes Payable
$ 2,450,000 4,895,000
Owners’ Equity: Capital Stock Retained Earnings
$ 5,000,000 3,255,000
Total Liabilities & Owners’ Equity
11) a. Total Asset Turnover: Average Total Assets = ($0 + $3,120)/2 Average Total Assets = $1,560 Total Asset Turnover = $4,000/$1,560 or 2.56 times
$15,600,000
b. Return on Assets Return on Assets = $198/$1,560 Return on Assets = 12.7% (since the company was started on June 1, the return on assets computed here is for only seven months)
Answer to Comprehensive Problem A) a) Accounts Receivable Revenue
$5,000
Supplies Inventory Accounts Payable
$130
$5,000
b) $130
c) No entry needed. d) Purchases Accounts Payable
$9,410
Investment in Trading Securities Cash
$300
Salaries Expense Cash
$750
Cash
$11,550
$9,410
e) $300
f) $750
g) Revenue
$11,550
h) Unearned Revenue Revenue
$400 $400
i) Cash
$4,500 Accounts Receivable
$4,500
j) Salaries Payable Cash
$150
Accounts Payable Cash
$10,500
Cash
$40
$150
k) $10,500
l) Dividend Revenue
$40
m) Salaries Expense Cash
$2,000
Taxes Expense Cash
$1,272
$2,000
n) $1,272
B)
Cash Accounts Receivable 2,097 300(e) 1,750 4,500(i) (g)11,550 750(f) (a)5,000 (i)4,500 150(j) (l)40 10,500(k) 2,000(m) 1,272(n) 3,215 Supplies 20 (b)130 150
Allow. Doubtful Accounts 175
2,250 Prepaid Rent 200
200
175 Equipment 7,000
7,000
Investment in Trading Securities Inventory (e)300 1,129
300
Accum. Depr.—Equip 730
730
1,129 Furniture 1,000
1,000
Accum. Depr.—Furn 34
34
License Agreement Accounts Payable 2,200 (k)10,500 2,585 130(b) 9,410(d) 2,200
1,625
Unearned Revenue Note Payable (h)400 400
0
Bad Debt Expense
0 Depreciation Expense
0
Capital Stock 2,000
0
0
Retained Earnings 9,322
2,000
Dividend Revenue Tax Expense 40(l) (n)1,272 40
Salaries Payable (j)150 150
Utilities Expense
9,322 Supplies Expense
1,272
0
Purchases (d)9,410
Cost of Goods Sold
9,410
0
0
Amortization Expense
0
Revenue 5,000(a) 11,550(g) 400(h) 16,950 Rent Expense
0 Salaries Expense (f)750 (m)2,000 2,750
C) Webworks Unadjusted Trial Balance December 31 Account Title Cash Accounts Receivable Allowance for Doubtful Accounts Investment in Trading Securities Inventory Supplies Prepaid Rent Equipment Accum. Depreciation—Equipment Furniture Accum. Depreciation—Furniture License Agreement Accounts Payable Salaries Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 12/1 Revenue Dividend Revenue Salaries Expense Tax Expense Utilities Expense Supplies Expense Rent Expense Bad Debt Expense Purchases Cost of Goods Sold Depreciation Expense Amortization Expense
Debits $ 3,215 2,250
Credits
2,750 1,272 0 0 0 0 9,410 0 0 0
_______
Totals
$30,876
$30,876
$
175
300 1,129 150 200 7,000 730 1,000 34 2,200 $ 1,625 0 0 0 2,000 9,322 16,950 40
D) o) Salaries Expense Salaries Payable
$200
Utilities Expense Accounts Payable
$300
Supplies Expense Supplies Inventory
$90
Rent Expense Prepaid Rent
$200
Bad Debt Expense Allowance for Doubtful Accounts
$50
$200
p) $300
q) $90
r) $200
s) $50
t) Depreciation Expense $146 Accumulated Depreciation—Equipment
$146
Depreciation Expense $17 Accumulated Depreciation—Furniture
$17
Amortization Expense License Agreement
$200
u) $200
v) Investment in Trading Securities $60 Unrealized Gain on Trading Securities
$60
Cost of Goods Sold Inventory Purchases
$9,410
w) $8,657 753
x) Loss on Obsolete Inventory Inventory
Cash 2,097 300(e) (g)11,550 750(f) (i)4,500 150(j) (l)40 10,500(k) 2,000(m) 1,272(n)
$200 $200
Allow. Doubtful Accounts Receivable Accounts 1,750 4,500(i) 175 (a)5,000 50(s)
3,215
2,250
Supplies 20 90(q) (b)130
225
Prepaid Rent 200 200(r)
60
Equipment 7,000
0
Accum. Depr.—Furn 34 17(t)
51
360
876
License Agreement Accounts Payable 2,200 200(u) (k)10,500 2,585 130(b) 9,410(d) 300(p) 2,000
0
Capital Stock 2,000
1,272
Salaries Payable (j)150 150 200(o)
200
Retained Earnings 9,322
2,000 Utilities Expense (p)300 300
Furniture 1,000
1,000
1,925
0
Dividend Revenue Tax Expense 40(l) (n)1,272
1,682
Accum. Depr.—Equip 730 146(t)
7,000
Unearned Revenue Note Payable (h)400 400
40
Investment in Trading Securities Inventory (e)300 1,129 200(x) (v)60 (w)753
9,322 Supplies Expense (q)90 90
Revenue 5,000(a) 11,550(g) 400(h) 16,950 Unrealized Gain 60(v) 60
Rent Expense Bad Debt Expense Purchases (r)200 (s)50 (d)9,410 9,410(w)
200 Depreciation Expense (t)146 (t)17 163
50
0 Amortization Expense (u)200
200
Cost of Goods Sold Salaries Expense (w)8,657 (f)750 (m)2,000 (o)200 8,657
2,950
Loss on Obsolete Inventory (x)200
200
E) Webworks Adjusted Trial Balance December 31 Account Title Cash Accounts Receivable Allowance for Doubtful Accounts Investment in Trading Securities Inventory Supplies Prepaid Rent Equipment Accum. Depreciation—Equipment Furniture Accum. Depreciation—Furniture License Agreement Accounts Payable Salaries Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 12/1 Revenue Dividend Revenue Unrealized Gain on Trading Securities Salaries Expense Tax Expense Utilities Expense Supplies Expense Rent Expense Bad Debt Expense Purchases Cost of Goods Sold Depreciation Expense Amortization Expense Loss on Obsolete Inventory
Debits $ 3,215 2,250
Credits
2,950 1,272 300 90 200 50 0 8,657 163 200 200
_______
Totals
$31,649
$31,649
$
225
360 1,682 60 0 7,000 876 1,000 51 2,000 $ 1,925 200 0 0 2,000 9,322 16,950 40 60
F) Webworks Income Statement As of December 31 Revenue $16,950 Cost of Goods Sold (8,657) Gross Profit 8,293 Deprec. and Amort. Expense (363) Other Expenses and Losses (3,790) Investment Income 100 Earnings before tax 4,240 Tax Expense (1,272) Net Income $ 2,968 Webworks Stmt. of Retained Earnings As of December 31 Retained Earnings, December 1 Net Income Retained Earnings, December 31
$ 9,322 2,968 $12,290
Webworks Balance Sheet December 31 Assets:
Liabilities:
Current: Cash $ 3,215 Accounts Receivable 2,250 less Allow. for Doubt. Accts. (225) Net Accounts Receivable 2,025 Trading Securities, net 360 Merchandise Inventory 1,682 Supplies Inventory 60 Total Current Assets $ 7,342
Current: Accounts Payable Salaries Payable
$ 1,925 200
Total Current Liabilities
$ 2,125
Owners’ Equity: Capital Stock Retained Earnings Total Owners’ Equity
$ 2,000 12,290 $14,290
Property, Plant and Equipment Equipment less Accumulated Depreciation Furniture less Accumulated Depreciation Total P, P, and E
$ 7,000 (876) 1,000 (51) $ 7,073
Other Noncurrent Assets: License Agreement, net
$ 2,000
Total Assets
$16,415
Total Liabilities & Owners’ Equity
$16,415
Answer to Research Assignment a. At the end of 2010, approximately 37 percent of Google’s assets were marketable securities: (in millions)
December 31, 2010
Marketable securities
$21,345
Total assets
$57,851
Marketable securities as percent of total assets = 36.9%
b. According to the section of Note One of Google’s 2010 financial statements labeled as “Cash, Cash Equivalents, and Marketable Securities,” “we have classified and accounted for our marketable securities as available-for-sale.”
Chapter 13 Solutions Answers to Questions 1) Before the reporting of a liability is necessary, three characteristics must all be found: (1) there is a probable future sacrifice, (2) this sacrifice requires the use of the reporting entity’s assets or services, and (3) this sacrifice arises from a present obligation that is the result of a past transaction or event. 2) The definition of a current liability is refined a bit in upper-level accounting courses. However, in a vast majority of cases, a current liability is one that will be settled within a year from the balance sheet date. A noncurrent liability will take longer than a year to settle. 3) Decision makers pay close attention to the amount of a company’s current liabilities (especially in comparison to the size of its current assets) because the ability to meet debts as they come due is necessary if a company hopes to stay in business. In addition, current liabilities require current resources. Thus, their payment limits the amount of available resources that can be used by management to generate revenues. The volume and change in current liabilities are both important measures of a company’s financial health and future prospects. 4) Before this payment, the current ratio was 3.0 to 1.0 because current assets were $300,000 and current liabilities were $100,000. The payment reduces both of these totals by $20,000 so that the current ratio rises to 3.5 to 1.0 ($280,000/$80,000). 5) Accrued liabilities are debts that grow because of the passage of time. Common examples are rent, salary, and interest because each liability gets larger every day until payment is made. Companies can record those daily increases as they occur. If that happens, no adjusting entry is necessary before making financial statements. However, little benefit is gained from that level of precise recording. Many companies, if not most, simply make no recording of accrued liabilities until payment is made or until financial statements are produced. Thus, adjusting entries are often required at the end of a reporting period to recognize accrued liabilities that have been omitted from the general ledger. 6) Gift cards are considered liabilities and, as such, are recorded as unearned revenue. The company has an obligation to provide an asset or service. When redeemed, the unearned revenue balance is reclassified as revenue because the earnings process is substantially complete. Unearned revenue is also changed to a reported revenue when adequate evidence is available to show that a gift card will never be redeemed (because it has been lost, destroyed, or the like).
7) When a gift card is redeemed, the liability balance on the balance sheet is removed and replaced with an equal amount of revenue on the income statement. The redemption of the card ends the company’s obligation. The earnings process is now complete. 8) Companies typically report revenue from unused gifts cards when sufficient evidence exists to indicate that the chance of redemption has become remote. That reclassification is normally made at one of three possible times: 1. When the cards expire if a time limit is imposed. 2. After the passage of a specified period of time such as eighteen months or two years. 3. In proportion to the cards that are actually redeemed. 9) Commitments are unexecuted contracts. A contract has been agreed to by all parties but no transaction has yet taken place. A contract, for example, has been signed to buy 10,000 bushels of wheat next month. Both parties have made a commitment (one to buy, one to sell) but no financial event has occurred to date. Commitments are included in the notes to financial statements but no amounts are reported on either the income statement or the balance sheet. Commitments signal transactions that will take place in the future but these events have not yet reached the point where all the characteristics of a liability are present. Decision makers are interested in the ramifications of such future events so disclosure of commitments is appropriate although there has been no change in financial condition. 10) To record a possible future event on a balance sheet as a contingency, a probable loss must have been incurred and the amount of that loss is subject to a reasonable estimation. An event has already taken place that will cause the reporting company to have a probable loss and the amount of that loss can be reasonably estimated. The event is not in question; all of the uncertainty surrounds the outcome. 11) In business, a wide number of events qualify as contingencies because the outcome is uncertain. Examples include collection of receivables, product warranties, threat of expropriation of assets, pending or threatened litigation, and guarantees for the debts of others. 12) A future loss to Salem Corporation is judged here to be only reasonably possible. Because the loss is not probable, recognition as a loss and liability is not appropriate. Instead, Salem will disclose the contingent loss in the notes to its financial statements. 13) Because the loss here is only viewed by management as remote, no recognition at all is required. The loss is not probable so recognition on the balance sheet and income statement is not required. The loss is not reasonably possible so disclosure is not required.
14) An interesting difference exists between U.S. GAAP and IFRS in connection with the reporting of contingent losses. According to both sets of standards, a contingent loss is recognized when it is probable and a reasonable estimation of the amount can be made. However, the definition of the term “probable” differs. According to U.S. GAAP, that word means “likely.” Under IFRS, “probable” is defined as “more likely than not.” In practice “more likely than not” is a benchmark that is easier to reach than “likely.” As a result, more contingent losses are reported when IFRS is applied than under U.S. GAAP. 15) Because of the conservative nature of accounting, contingent gains cannot be anticipated for reporting purposes. They are only recognized when they are finalized. For that reason, contingent losses and contingent gains are not handled in the same manner in financial accounting. Such losses are recognized when probable but gains are only recognized when they are finalized. 16) The selling of live plants creates a contingency because some of the plants might die and have to be replaced. That possibility seems likely. Therefore, the real issue here is the determination of a reasonable estimate. Historical trends can be the very helpful in estimating warranty liabilities of this type if that data is available. Companies often have the same programs available for years and, therefore, have considerable evidence about returns. Other information which should be considered include changes to the warranty program (for example, returns are allowed for 12 months rather than for just 6 months) and changes in business operations (for example, a new breed of plants is being sold that is more likely to die). 17) For embedded warranties of this type (provided for free with the purchase), an anticipated expense and related liability are both recognized at the time of the sale of the computer. This approach goes along with the matching principle that requires all expenses to be recognized in the same period as the revenues they help to generate. The only revenue here is in the year of the computer sale so all related expenses are reported in that same period. 18) Extended warranties (sold along with the computer) are recorded initially as liabilities (unearned revenue) at the time of their purchase. That amount is then reclassified to revenue over the time of the obligation. Subsequent costs are expensed as incurred. This matches the expense with the revenue that it helps to generate (the revenue from the sale of the warranty rather than the revenue from the sale of the computer). 19) The age of accounts payable is calculated to show the number of days that a company takes to pay for its inventory purchases. A lengthening of this period indicates that a company is holding on to its money (and using it) for a longer period of time but can also warn that the company is having trouble paying its debts as they come due.
The amount of inventory purchases for the year (or other specified period of time) is divided by 365 to determine the average purchases made per day. That figure is divided into the balance of accounts payable to get the average age of those accounts. In this computation, the ending liability balance for the period can be used or the average balance.
Answers to True or False Questions __F__ 1) Most financial analysts and other decision makers pay close attention to the amount of a company’s current liabilities because those debts will require the use of current resources. Failure to make these payments as they come due can well lead to bankruptcy. Plus, payments reduce the resources that are available to help generate revenues and, thus, net income. __F__ 2) Current ratio is determined by dividing a company’s current assets by its current liabilities. Therefore, a current ratio of less than 1.0 to 1.0 means that a company has more current liabilities than current assets. __F__ 3) The signing of this contract in Year One represents a commitment and not a contingency. The company is obligated to take part in a future transaction. No transaction has yet taken place so no liability exists. The commitment to buy this oil should be disclosed by the company but no journal entry is recorded. __T__ 4) In reporting a contingent liability, the accountant faces two uncertainties: will the loss actually occur and, if so, how much will that loss be? According to U.S. GAAP, a contingency loss (and related liability) are reported in a company’s financial statements if the loss is judged to be probable and can be reasonably estimated. __F__ 5) Although financial accounting has conservative tendencies, it is not obsessively conservative. If the chance of a contingent loss is merely remote, neither recognition nor disclosure is necessary according to U.S. GAAP. __F__ 6) Because of the conservative nature of financial accounting, contingent gains are not recognized until finalized. They cannot be anticipated. Therefore, a contingent loss (recognized when probable) is often recorded in a period prior to the other party’s contingent gain (recognized when the process is substantially complete). __F__ 7) Liabilities for gift cards remain on a company’s balance sheet until sufficient evidence exists to indicate that the likelihood of redemption is remote. That is often for an established period of time (such as two years). Removal of unredeemed gift cards can also be recorded in proportion to the amount of gift cards that are turned in for the appropriate product or service during the current period. __T__ 8) When a gift card is sold initially, a liability (unearned revenue) is reported for this amount. At the time the gift card is turned in for a product or service, the liability is removed and replaced with a revenue balance.
__T__ 9) Normally, the restatement of previously released financial figures is not done. Earlier decisions have already been made by decision makers and cannot be reversed based on new information. However, if fraud occurred in the accounting process, the company cannot continue to report those fraudulent figures. The earlier figures must be restated. Any attempt to mislead investors is considered fraudulent behavior. __F__ 10) Under IFRS, contingent liabilities are reported as soon as they are judged to be more likely than not (and a reasonable estimation of the amount can be made). This reporting benchmark means that the chance of a loss occurring only has to be over 50 percent. In contrast, U.S. GAAP requires the reporting of a contingency when the loss becomes probable. No percentage is associated with the term “probable” but it is viewed as considerably higher than simply being over 50 percent. Thus, for example, if a contingent loss is 51 percent likely, it is recognized if applying IFRS but not if applying U.S. GAAP. __F__ 11) For an embedded warranty, the eventual cost is estimated and recognized as an expense and a liability at the time of the product sale. Neither revenue nor expense is recorded after that period (except for the correction of estimation errors). With an extended warranty, the sale of the warranty is recorded as unearned revenue (a liability) but no expense is recognized at that time because no revenue is reported in connection with the warranty. Over time, the liability is reclassified as revenue and expenses are recognized as costs are incurred. __F__ 12) An accountant cannot simply assume that the past is a perfect reflection of what is going to happen in the future. The accountant must always be aware of possible changes that have taken place. For example, has the product design or manufacturing process changed in some way so that it is either more or less likely to break? Or, has the price changed? If the price has been raised substantially will that impact the number of customers who go to the trouble to get a problem fixed? A reasonable estimate almost always begins with a study of past results but should also include an analysis of any relevant changes that may have taken place. __F__ 13) The length of time that a company takes to pay debts can reflect its financial health. However, other issues frequently come in to play. For example, the two companies in this question might be in different industries where typical payment schedules vary. Perhaps 22 days is normal for one industry while 31 days is normal for a different one. Company philosophies can also cause a difference. Some management teams prefer to wait as long as possible before making payment. Others are more likely to pay quickly to take advantage of cash discounts. Therefore, more information is needed here before an evaluation of financial health is made.
Answers to Multiple Choice Questions 1) Answer is A For reporting purposes, a liability requires a probable future sacrifice of an asset or a service. It does not require a payment of cash. That is common but not required. A gift card liability, for example, is almost always satisfied by the conveyance of an inventory item or a service 2) Answer is D The current assets reported by this company are cash, inventory, and prepaid rent with a total balance of $1,590. The current liabilities reported by this company are accounts payable and rent payable with a total balance of $760. The current ratio is $1,590/$760 or 2.09 to 1.00 3) Answer is A An accrued liability is one that grows purely because of the passage of time. Typical examples include interest, rent, and salaries because the amount of their cost increases each day. Accounts payable is not an accrued liability. This account reflects the amount that is owed as a result of a purchase, usually of either inventory or supplies. It gets larger because of a physical transaction and not as a result of time. 4) Answer is B For the 96 cards that are redeemed, the company makes a profit of $150 each ($250 sales price less $100 cost) or a total of $14,400. Because the cards are valid for only one year, the revenue of the other four cards (4 x $250 or $1,000) must also be recognized now. However, those cards have no corresponding expense since they were not redeemed. Total profit for the period is $14,400 + $1,000 or $15,400. 5) Answer is C As a free embedded warranty, the estimated cost is recognized as an expense and liability in the year of sale (Year One). That estimate is 1,000 sales multiplied times an expected rate of 5 percent or 50 broken systems. At an anticipated cost of $40 each, the total expense and liability is $2,000. In Year Two, the company actually had to spend $21,000 ($70 each to fix 300 music systems). The additional expense of $19,000 ($21,000 less $2,000) is reported in Year Two. The general rule is that an accountant fixes an estimation error when it is discovered. Here, that is Year Two. If this $19,000 mistake was considered fraud (the company purposefully overstated net income in Year One and understated liabilities), a restatement of the Year One expense to $21,000 is necessary. However, nothing in the problem seems to indicate fraud.
6) Answer is B As an extended warranty, the $10,000 that is received is acknowledged as a liability (unearned revenue) and then reclassified as revenue as earned in Year Two. Because no revenue is recognized in connection with the warranty in Year One, no expenses are recorded. The $10,000 revenue is recognized in Year Two as is the $21,000 in expenses (300 x $70). Thus, the impact on net income in that year is an $11,000 decrease ($10,000 less $21,000). 7) Answer is A Contingent gains are not recognized until finalized. Here, that occurs in Year Two so Company A reports the entire $97,000 gain that year. Contingent losses are recognized when they become probable (if a reasonable estimate of the loss can be made). Company Z recognizes a loss of $80,000 in Year One. When the actual amount proves to be $97,000, an additional $17,000 loss is reported in Year Two. 8) Answer is A Stimpson estimates the liability from this embedded warranty to be 540 broken cameras (6 percent of the 9,000 units sold).times a cost of $190 each or $102,600 in total. The expense is recognized in Year One along with the related liability. The actual cost in Year Two is 590 units times $180 each or $106,200. The actual cost is $3,600 higher than the amount anticipated. The extra expense is recorded in Year Two. 9) Answer is C Financial figures that have already been reported are rarely restated in financial accounting. The main reason is simple: decision makers have already used the original numbers to make their decisions. Those decisions cannot be undone now. In addition, decision makers should understand the uncertainty inherent in financial accounting and factor that into each decision. However, if fraud has occurred, the originally reported numbers cannot be left unchanged. They are not errors; they were produced with fraudulent intent. Fraud is said to occur when company officials do not present information in good faith. 10) Answer is C If the company had sold the warranty, neither revenue nor expense would be recognized in Year One. There is no income effect in that year. However, by giving the warranty away, the company has to estimate and recognize the expense immediately. There is no future revenue. The company sells 1,000 units and expects 10 percent to break (100) and cost $7 each to fix for an estimated expense of $700. Going from no income effect to an expense of $700 reduces net income in Year One by $700.
11) Answer is A If the company had sold this warranty as they had planned, officials expected to sell 400 at $3 each. Thus, a liability of $1,200 is recognized at the end of Year One. Instead, the company gives a warranty on each of the 1,000 units sold. Officials expect 10 percent to break (100) and cost $7 to fix. The liability actually recognized is $700. Reducing the reported liability from $1,200 to $700 is a drop of $500 12) Answer is D If the warranty had been sold, revenue of $1,200 would have been reported in Year Two (400 purchased warranties x $3 each). The cost incurred in that year would then be 400 toaster ovens under warranty x 11% x $7 or $308. The impact on net income would have been an increase of $892 ($1,200 less $308). Instead, the company gave the warranty away for free and recognized an expense of $700 in Year One (1,000 x 10% x $7). The actual cost was $770 for all of the breakage (1,000 x 11% x $7). An additional $70 in expense was recognized in Year Two. Going from an expected profit of $892 to a recognized loss of $70 is a $962 decrease in reported net income. 13) Answer is B Contingent gains are not recognized until finalized. That occurs in Year Two so Purple reports the entire $120,000 gain that year. Contingent losses are recognized when they become probable (if a reasonable estimate of the loss can be made). Thus, Yellow recognizes a loss of $170,000 in Year One. When the actual settlement proves to be only $120,000, a gain (or recovery) is reported in Year Two. 14) Answer is C According to IFRS, contingent losses are recognized when probable but that is defined as more likely than not. In this case, the 51 percent likelihood meets that criterion. According to U.S. GAAP, contingent losses are recognized when probable but that is defined as likely. In this case, the 51 percent chance fails to meet that criterion. The liability is recognized if IFRS is followed but not if U.S. GAAP is followed. 15) Answer is B When an extended warranty is sold, cash is debited (increased). However, no revenue is yet earned. Thus, unearned revenue (liability) is credited until the time of coverage has passed. 16) Answer is B The company expects 4 percent of the 450,000 toasters to break and cost $10 each to fix. Thus, a liability of $180,000 should be recognized in the year of sale (450,000 x 4% x $10). Because a cost of $38,000 was incurred in Year One and a cost of another $65,000 was incurred by the end of Year Two, the reported liability has dropped to $77,000 by the end of Year Two ($180,000 - $38,000 - $65,000).
17) Answer is A Purchases for the period must be determined. Inventory costing $1,960,000 was sold but the inventory balance went up $40,000 (from $238,000 to $278,000). This indicates that $2,000,000 of inventory must have been purchased this year. This computation can also be made using the following formula: Cost of goods sold = Beginning inventory plus Purchases less Ending inventory. If restated, that formula is: Purchases = Cost of goods sold plus Ending inventory less Beginning inventory Purchases for the year is $1,960,000 - $238,000 + $278,000 or $2,000,000 That amount is equal to buying $5,479 of inventory each day ($2,000,000/365) This rate of purchase indicates that the average age of accounts payable is 33.2 days or $182,000/$5,479.
Answers to Problems 1) a. The following entry assumes that a perpetual inventory system is used. Inventory Accounts Payable
$300,000
Salaries Expense Salaries Payable
$45,000
Payroll Tax Expense Taxes Payable
$7,000
Income Tax Expense Income Taxes Payable
$120,000
Cash
$23,000
$300,000
b. $45,000
$7,000
c. $120,000
d. Unearned Revenue
$23,000
e. Interest Expense Interest Payable
$4,000 $4,000
f. Rent Expense Rent Payable
$9,000
Cash
$578,000
$9,000
2) a. Unearned Revenue
$578,000
b. Unearned Revenue Revenue
$327,000
Cost of Goods Sold Inventory
$190,000
$327,000
$190,000
c. On December 31, the company has gift cards outstanding equal to $979,000 ($728,000 + $578,000 - $327,000). If 3 percent have expired, then $29,370 in revenue is recognized ($979,000 x 3 percent) without having to give away any inventory. Unearned Revenue Revenue
$29,370 $29,370
d. The $979,000 computed above is reduced by $29,370 so that the reported liability is $949,630. 3) a. Sox Corporation recognizes no income effect in either Year One or Year Two. The entire $275,000 gain is recognized when finalized in Year Three. In contrast, contingent losses are recognized when they become probable. Yankee Corporation records a $300,000 loss in Year One. Another $40,000 loss is recognized in Year Two to increase the liability up to $340,000. The actual settlement in Year Three is only $275,000 so a gain (often referred to as a recovery) of $65,000 is appropriate for Year Three. b. The financial reporting for Sox does not differ between U.S. GAAP and IFRS. Because of the conservative nature of financial accounting, contingent gains are not recorded until finalized. However, the estimated losses booked by Yankee Corporation might have been different under IFRS. Using IFRS, the amount of loss viewed as more likely than not should be recognized. That standard is easier to achieve so the liability on the balance sheet might be higher in Years One and Two. A different liability will lead to a different income effect each year.
4) a. Whalens sells 700 warranties during Year One for $40 each. However, none of the televisions break during Year One. No warranty revenue is reported in Year One because no work is done. Because no revenue is recognized, no corresponding expense is recognized (based on the matching principle). b. Whalens sells 700 warranties during Year One for $40 each. The televisions break during Year Two and are fixed at that time. Thus, all $28,000 of the revenue is recognized in Year Two. Nine televisions break at a cost of $140 each or $1,260 in total. The televisions break in Year Two. Because the revenue is recorded in Year Two, the $1,260 in expense is also recognized in Year Two. 5) Year One – No loss is recognized. At that time, no loss is probable. Year Two – No loss is recognized. At that time, no loss is probable. Disclosure of the $2,000,000 reasonably possible loss is necessary. Year Three -- $3,000,000 loss is recognized because that is the probable amount. Year Four - $400,000 recovery (gain) is recognized because that adjusts the liability that had been recognized in Year Three to the actual amount paid. 6) a. Neither party records any amount but both should disclose appropriate information in the notes to the financial statements. Contingent gains cannot be anticipated. Unless a reasonable estimation can be made, no contingent loss is recognized. b. Contingent gains cannot be anticipated so Atlanta recognizes no part of this expected gain. However, because the gain is likely, disclosure is appropriate. Seattle reports a $9 million loss because that amount is probable. In addition, Seattle should disclose that a loss of up to $46 million is reasonably possible. c. Neither party will record any amount but both should disclose all appropriate information in the notes to the financial statements. Contingent gains cannot be anticipated. A contingent loss is only recognized if judged to be probable. A reasonably possible contingent loss is only disclosed. d. Contingent gains cannot be anticipated so Atlanta recognizes no part of this expected gain even though it is probable. Because the gain is likely, disclosure is appropriate. Seattle should report an $8 million loss because that amount is probable. The discrepancy in the two estimates is not unusual. Each side looks at
the facts of the case based on their own beliefs and biases. One party expects a big win whereas the other side anticipates suffering only a small loss. Regardless of the rules, human nature plays a significant role in financial reporting. 7) a. Ingalls must record a contingent liability. The likelihood of loss is both probable and can be reasonably estimated. The company anticipates having to pay 20 percent of $800,000 (or $160,000) Loss from Lawsuit—Estimated Estimated Liability from Lawsuit
$160,000
Estimated Liability from Lawsuit Cash Recovery on Estimated Liability
$160,000
Cash
$10,000,000
$160,000
b. $ 97,000 63,000
8) a. Revenue
$10,000,000
Cost of Goods Sold Inventory
$5,800,000
Warranty Expense Warranty Liability
$74,000
$5,800,000
b. $74,000
Liability is estimated as 20,000 lawnmowers times 10 percent times $37 each c. Warranty Liability Cash
$24,000
Warranty Expense Warranty Liability
$14,800
$24,000
d. $14,800
The total liability is now estimated as 20,000 times 12 percent times $37 each or $88,800. Because $24,000 has been paid, the reported amount should be $64,800. The original liability was recorded as $74,000 and is reduced by entry (c) to $50,000. The adjustment here increases that $50,000 to $64,800.
9) a. Warranty Expense Warranty Liability
$66,000 $66,000
The expected liability for the embedded warranty is 55,000 pairs of glasses times 6 percent times a cost of $20 each to fix. b. Cash
$200,000 Unearned Revenue
$200,000
c. Warranty Liability Warranty Expense Cash
$ 4,000 66,000
Warranty Expense Cash
$102,000
$70,000
d. $102,000
Recognition of the unearned revenue is also needed for Year Three: Unearned Revenue Revenue
$200,000 $200,000
10) a. Company A has an embedded warranty so it immediately estimates and recognizes the cost that will be incurred under this policy: 1,000 times 5 percent times $600 each or $30,000. Company Z has an extended warranty where all of the related revenue and expense will be reported in Year Two. As far as the warranty is concerned, no income effect occurs in Year One. For Year One, Company A has expense of $30,000 whereas Company Z has neither revenue nor expense. Company Z will have a higher net income by that $30,000. b. Company A has already estimated the cost of its warranty. Thus, the only expense in Year Two is any adjustment made to that estimation. The expense did not turn out to be $30,000. Instead, it was 1,000 times 6 percent times $550 each or $33,000. The extra $3,000 in expense is recognized in Year Two.
Company Z must recognize the entire amount of its warranty revenue in Year Two. That is 1,000 times $50 or $50,000. It also recognizes the entire $33,000 cost to repair computers as an expense. Thus, net income increases by $17,000 ($50,000 less $33,000). For Year Two, Company A reports an expense of $3,000 whereas Company Z has an increase in reported net income of $17,000. Company Z will have a higher net income by the $20,000 difference. 11) a. Current Ratio Current Ratio = Current Assets divided by Current Liabilities Current Ratio = $2,120/$1,020 Current Ratio = 2.08 b. Age of Accounts Payable Purchases = Cost of Goods Sold + Ending Inventory − Beginning Inventory Purchases = $2,000 + $700 − $0 Purchases = $2,700 Average Purchases per Day = Purchases/210 Average Purchases per Day = $2700/210 Average Purchases per Day = $12.86 Age of Accounts Payable = Accounts Payable/Average Purchases per Day Age of Accounts Payable = $900/$12.86 Age of Accounts Payable = 70 days
Answer to Comprehensive Problem A) a) Accounts Receivable Revenue
$4,500
Supplies Inventory Accounts Payable
$100
$4,500
b) $100
c) No entry needed. d) Purchases Accounts Payable
$9,405
Salaries Expense Cash
$775
Allowance for Doubtful Accounts Accounts Receivable
$150
Cash
$450
$9,405
e) $775
f) $150
g) Unearned Revenue
$450
h) Cash
$11,500 Revenue
$11,500
i) No entry needed. Loss is considered remote. j) Cash
$5,000 Accounts Receivable
$5,000
k) Cash
$480 Investment in Trading Securities Gain on Sale of Trading Securities
$360 120
l) Prepaid Advertising Cash
$200
Salaries Payable Cash
$200
$200
m) $200
n) Investment in Available-for-Sale Securities $1,750 Cash
$1,750
Accounts Payable Cash
$9,000 $9,000
Salaries Expense Cash
$2,000
Prepaid Rent Cash
$600
Cash
$30
o)
p) $2,000
q) $600
r) Dividend Revenue
$30
s) Taxes Expense Cash
$1,000 $1,000
B)
Cash 3,215 775(e) (g)450 200(l) (h)11,500 200(m) (j)5,000 1,750(n) (k)480 9,000(o) (r)30 2,000(p) 600(q) 1,000(s) 5,150 Supplies 60 (b)100 160
Accounts Receivable 2,250 150(f) (a)4,500 5,000(j)
Allow. Doubtful Accounts (f)150 225
1,600 Prepaid Rent (q)600
600
Prepaid Advertising (l)200
200
Investment in Trading Securities Inventory 360 360(k) 1,682
75
0
Equipment 7,000
Accum. Depr.—Equip 876
7,000
1,682
876
Furniture 1,000
Investment in Availablefor-Sale Securities (n)1,750
Accum. Depr.—Furn 51
1,000 Accounts Payable (o)9,000 1,925 100(b) 9,405(d)
51
1,750
Salaries Payable (m)200 200
Unearned Revenue 450(g)
2,430
0
License Agreement 2,000 2,000
Note Payable
0
2,000
Unrealized Gain/Loss— Retained Earnings Revenue Dividend Revenue Trading Securities 12,290 4,500(a) 30(r) 11,500(h)
Unrealized Gain/Loss— AFS Securities
12,290
16,000
Gain/Loss on Sale of Trading Securities 120(k)
30
Tax Expense (s)1,000
120 Rent Expense
450
Capital Stock 2,000
0
Purchases (d)9,405
Depreciation Expense
9,405 Amortization Expense
0
0
Supplies Expense
0
0
0
Utilities Expense
1,000 Bad Debt Expense
0
0 Cost of Goods Sold Salaries Expense (e)775 (p)2,000 0
2,775
Advertising Expense
0
C) Webworks Unadjusted Trial Balance January 31 Account Title Debits Cash $ 5,150 Accounts Receivable 1,600 Allowance for Doubtful Accounts Investment in Trading Securities 0 Inventory 1,682 Supplies 160 Prepaid Rent 600 Prepaid Advertising 200 Equipment 7,000 Accum. Depreciation—Equipment Furniture 1,000 Accum. Depreciation—Furniture Investment in AFS Securities 1,750 License Agreement 2,000 Accounts Payable Salaries Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 1/1 Revenue Dividend Revenue Unrealized Gain/Loss on Trading Securities Unrealized Gain/Loss on AFS Securities Gain/Loss on Sale of Trading Securities Salaries Expense 2,775 Tax Expense 1,000 Utilities Expense 0 Supplies Expense 0 Rent Expense 0 Bad Debt Expense 0 Purchases 9,405 Cost of Goods Sold 0 Depreciation Expense 0 Amortization Expense 0 Advertising Expense 0
_______
Totals
$34,322
$34,322
Credits
$
75
876 51
$ 2,430 0 450 0 2,000 12,290 16,000 30 0 0 120
D) t) Salaries Expense Salaries Payable
$200
Utilities Expense Accounts Payable
$320
Supplies Expense Supplies Inventory
$120
Rent Expense Prepaid Rent
$200
Advertising Expense Prepaid Advertising
$100
Bad Debt Expense Allowance for Doubtful Accounts
$85
Depreciation Expense Accumulated Depreciation—Equip
$146
Depreciation Expense Accumulated Depreciation—Furn
$17
Amortization Expense License Agreement
$200
$200
u) $320
v) $120
w) $200
x) $100
y) $85
z) $146
$17
aa) $200
bb) Unrealized Loss on AFS Securities $175 Investment in Available-for-Sale Securities
$175
Cost of Goods Sold Inventory Purchases
$9,405
cc) $8,664 741
Cash Accounts Receivable 3,215 775(e) 2,250 150(f) (g)450 200(l) (a)4,500 5,000(j) (h)11,500 200(m) (j)5,000 1,750(n) (k)480 9,000(o) (r)30 2,000(p) 600(q) 1,000(s) 5,150
Allow. Doubtful Accounts (f)150 225 85(y)
1,600
Supplies Prepaid Rent Prepaid Advertising 60 120(v) (q)600 200(w) (l)200 (x)100 (b)100 40
400
Furniture 1,000
100
Accum. Depr.—Furn 51 17(z)
1,000
68
Accounts Payable (o)9,000 1,925 100(b) 9,405(d) 320(u) 2,750
Investment in Trading Securities Inventory 360 360(k) 1,682 (cc)741
160
0
2,423
Equipment 7,000
Accum. Depr.—Equip 876 146(z)
7,000
1,022
Investment in Availablefor-Sale Securities (n)1,750 175(bb)
License Agreement 2,000 200(aa)
1,575
Salaries Payable (m)200 200 200(t)
1,800
Unearned Revenue Note Payable 450(g)
0
2,000
Unrealized Gain/Loss— Retained Earnings Revenue Dividend Revenue Trading Securities 12,290 4,500(a) 30(r) 11,500(h)
Unrealized Gain/Loss— AFS Securities (bb)175
12,290
200
16,000
450
Capital Stock 2,000
30
0
175
Gain/Loss on Sale of Trading Securities 120(k)
Tax Expense (s)1,000
120
Utilities Expense (u)320
1,000
Supplies Expense (v)120
320
120
Rent Expense Bad Debt Expense Purchases (w)200 (y)85 (d)9,405 9,405(cc)
Cost of Goods Sold Salaries Expense (cc)8,664 (e)775 (p)2,000 (t)200
200
8,664
85
Depreciation Expense (z)146 (z)17 163
0 Amortization Expense (aa)200
200
Advertising Expense (x)100
100
2,975
E) Webworks Adjusted Trial Balance January 31 Account Title Debits Cash $ 5,150 Accounts Receivable 1,600 Allowance for Doubtful Accounts Investment in Trading Securities 0 Inventory 2,423 Supplies 40 Prepaid Rent 400 Prepaid Advertising 100 Equipment 7,000 Accum. Depreciation—Equipment Furniture 1,000 Accum. Depreciation—Furniture Investment in AFS Securities 1,575 License Agreement 1,800 Accounts Payable Salaries Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 1/1 Revenue Dividend Revenue Unrealized Gain/Loss on Trading Securities Unrealized Gain/Loss on AFS Securities 175 Gain/Loss on Sale of Trading Securities Salaries Expense 2,975 Tax Expense 1,000 Utilities Expense 320 Supplies Expense 120 Rent Expense 200 Bad Debt Expense 85 Purchases 0 Cost of Goods Sold 8,664 Depreciation Expense 163 Amortization Expense 200 Advertising Expense 100
______
Totals
$35,090
$35,090
Credits
$
160
1,022 68
$ 2,750 200 450 0 2,000 12,290 16,000 30 0 120
F) Webworks Income Statement As of January 31 Revenue Cost of Goods Sold Gross Profit Deprec. and Amort. Expense Other Expenses and Losses Investment Income Earnings Before Tax Tax Expense Net Income
$16,000 (8,664) 7,336 (363) (3,800) 150 3,323 (1,000) $ 2,323
Webworks Stmt. of Retained Earnings As of January 31 Retained Earnings, January 1 Net Income Retained Earnings, January 31
$12,290 2,323 $14,613
Webworks Balance Sheet January 31 Assets:
Liabilities:
Current: Cash $ 5,150 Accounts Receivable 1,600 less Allow. for Doubt. Accts. (160) Net Accounts Receivable 1,440 Merchandise Inventory 2,423 Supplies Inventory 40 Prepaid Rent 400 Prepaid Advertising 100 Total Current Assets $ 9,553
Current: Accounts Payable Salaries Payable Unearned Revenue
$ 2,750 200 450
Total Current Liabilities
$ 3,400
Property, Plant, and Equipment Equipment less Accumulated Depreciation Furniture less Accumulated Depreciation Total P, P, and E
$ 7,000 (1,022) 1,000 (68) $ 6,910
Other Noncurrent Assets: Available-for-Sale Securities License Agreement, net
$ 1,575 1,800
Total Assets
$19,838
Owners’ Equity: Capital Stock $ 2,000 Retained Earnings 14,613 Other Accumulated Comprehensive Income: Unrealized loss on Available-forSale securities (175) Total Owners’ Equity $16,438 Total Liabilities & Owners’ Equity
$19,838
Answer to Research Assignment a. The gift card liability on April 30, 2011, was $311,092,000. The gift card liability on May 1, 2010, was $292,127,000. The gift card liability rose by 6.49 percent in this one-year period of time. b. The revenue recognized for the fiscal year ending April 30, 2011, that came from breakage (gift cards that were not redeemed) was $25,904,000. The note in the company’s financial information describes in detail how this amount is determined and recognized.
Chapter 14 Solutions Please note that all present value calculations in this solutions manual will be determined using the tables that appear in the back of the Financial Accounting textbook. Calculations made using an Excel spreadsheet, mathematical formulas, or calculators may differ slightly because of rounding. Answers to Questions 1) When deciding whether to raise money by issuing debt (borrowing money) or issuing shares of capital stock (selling an ownership interest), company officials should know that both have their advantages and disadvantages. The advantages of issuing debt include the ability to deduct the interest expense paid on debt when computing taxable income (in contrast, dividends paid are not tax deductible). Thus, a portion of the cost of debt financing is borne by the government. In addition, debt can be eliminated (paid off). This advantage is especially important if interest charges become relatively high. Finally, debt provides the benefits of financial leverage. If borrowed money can be used to increase net income by an amount that is greater than the associated interest cost, the owners increase profitability without investing more of their own money. 2) Some business executives prefer to avoid incurring significant amounts of noncurrent debt. The two major reasons are flexibility and risk. Debts and their interest must be paid when they come due. Whether times are good or bad, payment has to be made. If cash payments cannot be made when due, creditors can petition to have the company put into legal bankruptcy where the outcome might be either liquidation or reorganization. 3) The president of Nelson Company intends to increase reported net income by earning more money (through an expansion of operations) on borrowed funds than the associated cost of interest. Here, the annual interest is $5.6 million ($70 million times an 8 percent interest rate). If the company uses that money to increase net income by more than $5.6 million, overall profitability will go up without stockholders having to invest any additional funds. They are making a larger profit off the same investment. 4) A term bond is a debt instrument where interest is paid periodically (often quarterly or annually) but the entire face value is only paid when the bond finally becomes due. For example, a company could issue a five-year $100,000 term bond with annual interest at a 7 percent rate to be paid each December 31. Every December 31 for 5 years, the company will pay $7,000 ($100,000 times 7 percent) to the holders of the bond. At the end of the five years, the $100,000 face value is paid. 5) A serial bond is a debt instrument where both interest and a portion of the face value are paid periodically. Therefore, the debt balance as well as the periodic interest payments
decline over time. For example, most home mortgages are really serial debts because each payment is part to reduce the principal and part to cover the interest cost. 6) An indenture is a debt contract that specifies all of the legal terms: face value, cash interest rate, cash interest payment dates, payment date for the face value, security terms, covenants, and the like. 7) In any bankruptcy that is not dismissed by the bankruptcy court, only two outcomes are possible. First, the company can be forced to liquidate its assets with the proceeds distributed to the creditors in a prearranged fashion. Second, the company can be legally reorganized so that it can continue in existence. For example, Circuit City went into bankruptcy and was quickly liquidated. In contrast, Delta Airlines went into bankruptcy in September 2005 and exited as a reorganized company in April 2007. 8) The term “callable” means that the debtor Arapo Corporation has the right to pay off the debt at any time that it wishes (or at a specified time prior to the maturity date) for a set amount of money. Normally, the debtor will not take advantage of this right unless the interest charges become too high. For example, if a company borrows money at a 9 percent annual rate and available interest rates fall to a 5 percent annual rate, the company certainly does not want to continue paying the excessively high rate. If the debt is callable, money can be borrowed at the lower rate and used to pay the old debt. 9) All cash payments are set based on the terms of the bond and are not impacted by the issuance price. The face value here is $30 million and the annual interest rate is 6 percent so, on December 31, Year One, payment of $1.8 million in interest is made. 10) A mortgage agreement is any type of debt instrument where the debtor has pledged the right to real property to provide security for the creditor on a loan. In most cases, if the debt or interest is not paid when due, the creditor can force the sale of the real property with the proceeds going to pay off the debt. 11) A debenture is a debt contract that does not include any type of security. Normally, the debtor (the Philadelphia Corporation, in this example) is such a strong organization that the debt can be issued at a reasonable interest rate without having to add any type of security agreement. The debtor believes that the buyers of the debenture will not view the risk as significant and demand a higher interest rate. 12) The bond here is issued for face value. Therefore, the stated annual cash rate of 10 percent is also the effective yield rate applicable to the two parties. Interest expense for the period from March 1 to December 31is computed as the $12 million face value times the 10 percent annual cash interest rate times 10/12 of a year or $1 million. The interest payable on the balance sheet is computed in the same way but only for the period of September 1 to December 31: $12 million face value times 10 percent times 4/12 of a year or $400,000.
13) The cash interest to be paid on this bond is the $18 million face value times the 10 percent annual cash interest rate or $1.8 million per year which is $150,000 per month. One month passed between the cash interest date and the issuance of the bond ($150,000). Five months passed between the July 31 payment and the end of the year ($750,000). Six months pass between each interest payment date ($900,000).
3/1/Year One
Cash
$18,150,000 Bond Payable Interest Payable
7/31/Year One
12/31/Year One
$18,000,000 150,000
Interest Payable Interest Expense Cash
$150,000 750,000
Interest Expense Interest Payable
$750,000
$900,000
$750,000
14) A zero coupon bond is a debt instrument that does not pay any stated cash interest. Investors are only willing to acquire such bonds because they can buy them at a discount below face value with that reduction serving as interest. The price of a zerocoupon bond is calculated mathematically by computing the present value of the required cash payment to be made on the maturity date based on the effective interest rate (yield rate) negotiated by the two parties. 15) The term “compounding” refers to the recognition of any interest that is not paid at the time so that the amount is added to the principal balance. Because of compounding, subsequently recognized interest amounts will be higher. 16) On January 1, Year One, the liability is recorded at its issuance price of $7.8 million. At the end of the first year, interest of 9 percent is computed based on the negotiated effective rate. That interest is $702,000 ($7.8 million times 9 percent). Because this debt is a zero-coupon bond, no stated interest is actually paid. Therefore, the $702,000 is compounded which brings the reported liability up from $7.8 million to $8,502,000. Interest for the second year is $765,180 ($8,502,000 times 9 percent). Again, this interest is not paid at that time so compounding brings the reported liability up from $8,502,000 to $9,267,180. 17) If the straight-line method is applied to the bond in problem 16, the total interest of $4.2 million ($12 million face value less $7.8 million issuance price) is allocated evenly to
interest over the five-year period. Interest of $840,000 is compounded each year. At the end of Year One, the liability balance rises to $8,640,000 ($7,800,000 plus $840,000). At the end of Year Two, the liability balance is $9,480,000 ($8,640,000 plus $840,000). 18) Bond prices are set based on an effective interest rate (yield rate) that is negotiated between the debtor and the creditor. That rate is a central element in this process. However, the straight-line method ignores that yield rate completely and bases the recognized interest on an equal allocation every year. The accounting does not mirror the event that it is reporting. However, the straight-line method can be applied according to U.S. GAAP whenever the reported results are not materially different from those derived using the effective rate method. 19) The amount of interest paid at the end of Year One, is the $20 million face value times a 6 percent annual interest rate or $1.2 million. However, the bond was issued at only $18 million to yield an annual rate of 8 percent. The interest expense recognized for that first year is $1.44 million ($18 million times 8 percent). The amount to be compounded is always the difference in the interest expense recognized on the income statement ($1,440,000) and the interest payment amount ($1,200,000). The compounding here is $240,000 which raises the $18 million liability to a reported balance of $18,240,000. 20) As a serial bond, the interest and a portion of the face value are both paid each period. Here, the $10 million face value is paid over 5 years (apparently at the rate of $2 million per year). Hence, the face value for the first year is $10 million, for the second year is $8 million, for the third year is $6 million, and so on. The interest payments are based on taking 5 percent times the face value amount owed during each period. Year One - $10 million face value times 5 percent or $500,000 Year Two - $8 million face value times 5 percent or $400,000 Year Three - $6 million face value times 5 percent or $300,000 Year Four - $4 million face value times 5 percent or $200,000 Year Five - $2 million face value times 5 percent or $100,000 Total payments each year are the $2 million face value payment plus the interest amounts computed above: $2,500,000 (Year One), $2,400,000 (Year Two), $2,300,000 (Year Three), $2,200,000 (Year Four), $2,100,000 (Year Five).
Answers to True or False Questions __T__ 1) The cost of the debt here was $80,000 per year ($1,000,000 face value times 8 percent annual rate). The company is able to use that money to generate profits of $93,000. Net income increases by the $13,000 difference without stockholders having to make any additional investment. Financial leverage is the ability to increase net income by using debt to make money over and above the cost of the interest. __F__ 2) Interest payments made on debt are tax deductible expenses. However, payments that are made on the debt itself are repayments and not expenses. Those payments are not tax deductible. The question here specifies “payments made on the liability.” Those payments are not tax deductible. __F__ 3) Liquidation is certainly one possible outcome of a business bankruptcy but other results are also possible. The bankruptcy petition might be dismissed by the bankruptcy judge (for example, being slow to pay does not necessarily mean that a company lacks adequate financial resources). The company can also be reorganized and then exit bankruptcy as a viable business. __F__ 4) Bank charges are typically inversely related to the amount of risk involved. If a debtor is financially strong, risk for the bank is small so that interest charges are low. If a debtor is financially weak, the banks face an increased risk of default. To compensate for that risk, a higher rate of interest is charged. __F__ 5) Many bonds are issued for amounts equal to the face value of the debt. In such cases, the two parties believe that an effective rate (yield rate) that is the same as the stated cash rate is fair. However, if the debtor and creditor agree on any negotiated rate that differs from the stated rate, the bond is issued for either a discount or premium. __F__ 6) A convertible bond is one that can be exchanged by the creditor for a different item, often the common stock of the debtor. A callable bond is one where the debtor has the option of paying off the face value prior to maturity. That decision is often allowed on one or more specified dates. __F__ 7) A serial bond is a debt where periodic payments are made to reduce the face value of the debt and also cover the cost of interest. The frequency of those payments can vary significantly and should be set in the bond contract. __T__ 8) Many bonds contain security arrangements to reduce the risk accepted by the creditor. However, if a bond is completely unsecured, it is known as a debenture. __T__ 9) The term “indenture” refers to the bond contract which will contain all the terms applicable to that debt agreement.
__T__ 10) In this case, the debt is outstanding for 11 months of the year. Interest expense is recognized for that same period of time. __F__ 11) Interest payment amounts are set by the terms of the indenture and are not affected by the exact date on which the bond is issued. For example, a bond that pays interest every six months will make the first payment on the specified date whether the debt has been outstanding for two days or the entire six months. As a result, the creditor may receive interest at the time of the first payment for a period longer than the bond has been held. To compensate, any accrued interest as of the issuance date is typically paid to the debtor at that time. In this way, the net impact of the first payment is that it covers just the period of time that the debt has been outstanding. __F__ 12) A zero-coupon bond is issued for a price determined by computing the present value of its face value. All bonds are issued at a price based on the computation of the present value of the cash payments promised in the indenture. No cash interest payments are made in connection with a zero-coupon bond. For a zero-coupon bond, the only cash payment is the face value of the bond. __T__ 13) Whenever the amount of interest expense recognized for a period of time is different than the cash interest payment, any excess that is not paid is added to the principal of the debt. This process is known as compounding. Interest expense will differ from the interest payments if a bond is sold at a discount or premium. __F__ 14) To determine the price of this bond, the present value of a single amount of $1 million must be determined along with the present value of an ordinary annuity of $80,000. Cash interest paid at the end of each period of time is an ordinary annuity and not an annuity due. __F__ 15) According to U.S. GAAP, the straight-line method can be applied if the reported results are not materially different from those derived using the effective rate method. Because differences are frequently small, the straight-line method is commonly seen in practice. __F__ 16) The payment here reduces the principal balance from $885,000 to $835,000. The compounding of the interest then increases the principal balance so that it rises from $835,000 to $852,000.
Answers to Multiple Choice Questions 1) Answer is C The issuance of debt for financing purposes has several advantages. The owners can hope to increase their earnings because of financial leverage. Interest expense payments are tax deductible so the government actually helps pay for those costs. Debts can be eliminated if that outcome is beneficial to the business. However, adding debt (rather than raising more capital from stockholders) increases the likelihood of bankruptcy because all payments must be paid when due. 2) Answer is C The cash interest to be paid on this bond is the $12 million face value times the 10 percent annual cash interest rate or $1.2 million per year which is $100,000 per month. The bonds were outstanding for seven months during the year so interest expense for the period is $700,000. Three months passed between the October 1 payment and the end of the year so the liability on the balance sheet is $300,000. 3) Answer is B Cash interest on this bond is the $12 million face value times the 10 percent annual interest rate or $1.2 million. Consequently, interest of $600,000 is paid every six months. During Year One, only one actual payment is made and that is on October 1. Thus, that is the cash interest payment for the year or $600,000 4) Answer is B These bonds were issued for their face value of $105,000 plus accrued interest. Cash interest is $6,300 per year ($105,000 face value times 6 percent stated interest rate) or $525 per month ($6,300/12 months). Two months (June and July) passed between the June 30 interest payment date and the September 1 issuance date. Thus, the accrued interest for that period is $1,050 ($525 times those 2 months). The total amount paid is $106,050 ($105,000 plus $1,050). 5) Answer is A As a zero-coupon bond, the only cash payment is the $500,000 face value in 15 years. To determine the price, the present value of that cash payment is determined. The payment is a single amount and not an annuity so the $500,000 is multiplied times $0.36245 (the present value of a single payment of $1 in 15 periods at a 7 percent effective rate) to arrive at the price of $181,225. 6) Answer is B Interest for Year one is the principal of $502,550 multiplied times the effective annual rate of 6 percent or $30,153. No interest is paid over the life of a zero-coupon bond
so this recognized interest is compounded which increases the principal to $532,703 for Year Two. In Year Two, the effective interest rate is still 6 percent per year or $31,962 (rounded) when multiplied by the $532,703 principal. 7) Answer is A Interest for Year one is the principal of $408,350 multiplied times the effective annual rate of 8 percent or $32,668. No interest is paid over the life of a zero-coupon bond so this recognized interest is compounded which brings the principal up to $441,018 for Year Two. In Year Two, the effective rate is still 8 percent per year or $35,281 (rounded) when multiplied by the new principal of $441,018. Again, this interest is not paid at that time so it is added to the $441,018 to bring the reported balance up to $476,299. 8) Answer is D Because the straight-line method is applied here, the difference between the face value of $800,000 and the issuance price of $541,470 (or $258,530) is assigned to interest expense evenly over the debt’s eight-year life. That allocation is $32,316 (rounded) per year. No amount is paid each year so this interest is compounded. After two years, the principal amount is $606,102 ($541,470 plus $32,316 plus $32,316). 9) Answer is A Annual cash interest will be the $100,000 face value times the stated annual rate of 4 percent or $4,000. Payments are made semi-annually so two payments of $2,000 each are made every year. Over these ten years, there are twenty six-month periods of time. An effective annual rate of 6 percent was negotiated to set the bond price. That is 3 percent for each six-month period. Therefore, the present value of the interest payments is $2,000 multiplied by $14.87747 (the present value of an ordinary annuity of $1 for 20 periods at a 3 percent rate for each period) or $29,755 (rounded). The present value of the face value is $100,000 multiplied by $0.55368 (the present value of a single amount of $1 in 20 periods at a 3 percent rate for each period) or $55,368. The total amount paid to yield the negotiated interest rate is $85,123. 10) Answer is D For Year One, interest expense of $55,250 (rounded) is recognized. That is the principal balance of $789,292 multiplied times the 7 percent effective rate. However, a cash interest payment of only $40,000 is made. That is the face value of $1 million multiplied times the 4 percent stated rate. The excess amount that is not paid ($15,250 or $55,250 less $40,000) is compounded. That raises the principal from $789,292 to $804,542. Interest expense for Year Two is this $804,542 principal balance times the 7 percent effective rate or $56,318 (rounded).
11) Answer is D For Year One, interest expense of $36,905 (rounded) is recognized. That is the principal balance of $461,315 multiplied times the 8 percent effective rate. However, a cash interest payment of only $18,000 is made. That is the face value of $600,000 multiplied times the 3 percent stated rate. The excess amount that is not paid ($18,905 or $36,905 less $18,000) is compounded. That raises the principal from $461,315 to $480,220. That is the amount reported on the December 31 Year One, balance sheet. 12) Answer is B Cash payments are based on the terms of the contract. These payments are not influenced by the issuance price of the debt instrument. The debtor pays $100,000 of the face value each year because this is a serial bond. Consequently, the face value during Year One is $1 million but only $900,000 in Year Two. The debtor also pays interest of 8 percent each year based on that face value. At the end of Year Two, the interest payment will be 8 percent of $900,000 or $72,000. Total payment is $172,000 ($100,000 plus $72,000).
13) Answer is C For Year One, interest expense of $26,162 (rounded) is recognized. That is the principal balance of $373,740 multiplied times the 7 percent effective rate. However, a cash interest payment of only $16,000 is made. That is the face value of $400,000 multiplied times the 4 percent stated rate. The excess amount that is not paid ($10,162 or $26,162 less $16,000) is compounded. That raises the principal from $373,740 to $383,902. The first $100,000 payment is also made at the end of Year One which reduces the balance to be reported on the balance sheet to $283,902.
Answers to Problems 1) a. Cash
$500,000 Note Payable
$500,000
b. Interest Expense Cash
$10,000 $10,000
$500,000 face value times 4 percent stated rate times 1/2 year
c. Interest Expense Interest Payable
$8,333 $8,333
$500,000 face value times 4 percent stated rate times 5/12 year d. Interest Expense Interest Payable Cash
$1,667 8,333
Cash
$50,000
$10,000
2) a. Bonds Payable
$50,000
b. Interest Expense Cash
$1,250 $1,250
$50,000 face value times 5 percent stated rate times 1/2 year c. Interest Expense Interest Payable
$625 $625
$50,000 face value times 5 percent stated rate times 3/12 year d. Interest Expense Interest Payable Cash
$625 625
Cash
$50,625
$1,250
3) a. Bonds Payable Interest Payable
$50,000 625
$50,000 face value times 5 percent stated rate times 3/12 year b. Interest Expense Interest Payable Cash
$625 625 $1,250
$50,000 face value times 5 percent stated rate times 1/2 year
c. Interest Expense Interest Payable
$625 $625
$50,000 face value times 5 percent stated rate times 3/12 year d. Interest Expense Interest Payable Cash
$625 625 $1,250
4) a. The only cash payment is the $80,000 face value in three years. The effective interest rate (yield rate) is 7 percent. The present value of a single amount of $1 in three periods at an effective rate of 7 percent is $0.81630. The bonds will be issued for $65,304 ($80,000 multiplied times $0.81630). b. Cash
$65,304 Bonds Payable
$65,304
c. Interest Expense Bonds Payable
$4,571 $4,571
Principal of $65,304 multiplied times 7 percent effective rate = $4,571 Reported liability at end of Year One = $69,875 ($65,304 + $4,571) d. Interest Expense Bonds Payable
$4,891 $4,891
Principal of $69,875 multiplied times 7 percent effective rate = $4,891 Reported liability at end of Year Two = $74,766 ($69,875 + $4,891)
5) January 1, Year One Cash
$129,986 Bond Payable
$129,986
December 31, Year One Interest Expense Bond Payable
$11,699 $11,699
Principal of $129,986 multiplied times 9 percent effective rate = $11,699 Reported liability at end of Year One = $141,685 ($129,986 + $11,699) December 31, Year Two Interest Expense Bond Payable
$12,752 $12,752
Principal of $141,685 multiplied times 9 percent effective rate = $12,752 Reported liability at end of Year Two = $154,437 ($141,685 + $12,752) January 1, Year Three Bond Payable Loss on Debt Retirement Cash
$154,437 563 $155,000
6) January 1, Year One Cash
$129,986 Bond Payable
$129,986
December 31, Year One Interest Expense Bond Payable
$14,003 $14,003
Interest to be recognized over these five years is $70,014 ($200,000 face value less $129,986 issuance price) or $14,003 (rounded) per year ($70,014/5 years). Reported liability at end of Year One = $143,989 ($129,986 + $14,003)
December 31, Year Two Interest Expense Bond Payable
$14,003 $14,003
Reported liability at end of Year Two = $157,992 ($143,989 + $14,003) January 1, Year Three Bond Payable Cash Gain on Debt Retirement
$157,992 $155,000 2,992
7) a. Year One Principal of $474,186 multiplied times 4 percent effective rate = $18,967, the interest expense for Year One. Reported liability at end of Year One = $493,153 ($474,186 + $18,967) Year Two Principal of $493,153 multiplied times 4 percent effective rate = $19,726, the interest expense for Year Two. b. The total interest on these zero-coupon bonds is $125,814 ($600,000 face value less $474,186 issuance price). Over the six-year life of the bonds, using the straight-line method, the interest is $20,969 per year ($125,814/6 years). Year One Under the straight-line method, interest expense for Year One is higher by $2,002 ($20,969 less $18,967) so net income is lower by the same amount. Year Two Under the straight-line method, interest expense for Year Two is higher by $1,243 ($20,969 less $19,726) so net income is lower by the same amount. 8) a. Year One Principal of $92,974 multiplied times 7 percent effective rate = $6,508, the interest expense for Year One. Cash interest is face value of $100,000 multiplied times 6 percent stated rate = $6,000. The excess $508 ($6,508 less $6,000) is compounded. Reported liability at end of Year One = $93,482 ($92,974 + $508)
b. Year Two Principal of $93,482 multiplied times 7 percent effective rate = $6,544, the interest expense for Year Two. Cash interest is face value of $100,000 multiplied times 6 percent stated rate = $6,000. The excess $544 ($6,544 less $6,000) is compounded. Reported liability at end of Year Two = $94,026 ($93,482 + $544) 9) a. The future cash flows on these bonds are $21,000 per year ($300,000 face value multiplied times 7 percent stated interest rate) for four years and then a face value payment of $300,000. The effective annual interest rate (yield rate) negotiated by these two parties was 9 percent. The $21,000 is an ordinary annuity and the $300,000 is a single payment amount. $21,000 x 3.23972 = $68,034 (rounded) $300,000 x 0.70843 = $212,529 Issuance price: $68,034 + $212,529 = $280,563
b. January 1, Year One Cash Bonds payable
$280,563 $280,563
c. December 31, Year One – Cash Interest Payment Interest expense Cash
$21,000 $21,000
December 31, Year One – Compounding Entry Interest expense Bonds payable
$4,251 $4,251
Principal of $280,563 times 9 percent effective interest rate equals $25,251 Interest recognized in excess of cash payment is $4,251 ($25,251 less $21,000) d. Year One principal = $280,563 Year One compounding entry = $4,251 December 31, Year One, balance = $284,814
e. December 31, Year Two – Cash Interest Payment Interest expense Cash
$21,000 $21,000
December 31, Year Two – Compounding Entry Interest expense Bonds payable
$4,633 $4,633
Principal of $284,814 times 9 percent effective interest rate equals $25,633 Interest recognized in excess of cash payment is $4,633 ($25,633 less $21,000) f. Year Two principal = $284,814 Year Two compounding entry = $4,633 December 31, Year Two, balance = $289,447 10) a. January 1, Year One Cash Bonds payable
$695,470 $695,470
b. December 31, Year One – Cash Interest Payment Interest expense Cash
$56,000 $56,000
Face value of $800,000 times 7 percent stated interest rate equals $56,000 December 31, Year One – Compounding Entry Interest expense Bonds payable
$13,547 $13,547
Principal of $695,470 times 10 percent effective interest rate equals $69,547 Interest recognized in excess of cash payment is $13,547 ($69,547 less $56,000) c. Year One principal = $695,470 Year One compounding entry = $13,547 December 31, Year One, balance = $709,017 d. December 31, Year Two – Cash Interest Payment Interest expense Cash
$56,000 $56,000
December 31, Year Two – Compounding Entry Interest expense Bonds payable
$14,902 $14,902
Principal of $709,017 times 10 percent effective interest rate equals $70,902 (rounded) Interest recognized in excess of cash payment is $14,902 ($70,902 less $56,000) e. Year Two principal = $709,017 Year Two compounding entry = $14,902 December 31, Year Two, balance = $723,919 11) a. The future cash flows on these bonds are $2,000 every six months ($100,000 face value multiplied times 4 percent stated interest rate times 6/12 year) for 20 six-month periods and then a face value payment of $100,000. The effective annual interest rate (yield rate) negotiated by these two parties was 6 percent or 3 percent for each six-month period. The $2,000 is an ordinary annuity and the $100,000 is a single payment amount. $2,000 x 14.87747 = $29,755 (rounded) $100,000 x 0.55368 = $55,368 Issuance price: $29,755 + $55,368 = $85,123 January 1, Year One Cash Bonds payable
$85,123 $85,123
b. June 30, Year One – Cash Interest Payment Interest expense Cash
$2,000 $2,000
June 30, Year One – Compounding Entry Interest expense Bonds payable
$554 $554
Principal of $85,123 times 6 percent effective interest rate equals $5,107 (rounded) Interest expense for six months equals $5,107 times 6/12 year or $2,554 (rounded) Interest recognized in excess of cash payment is $554 ($2,554 less $2,000) Year One principal (first six months) = $85,123 June 30, Year One, compounding entry = $554 June 30, Year One, balance = $85,677
c. December 31, Year One – Cash Interest Payment Interest expense Cash
$2,000 $2,000
December 31, Year One – Compounding Entry Interest expense Bonds payable
$571 $571
Principal of $85,677 times 6 percent effective interest rate equals $5,141 (rounded) Interest expense for six months equals $5,141 times 6/12 year or $2,571 (rounded) Interest recognized in excess of cash payment is $571 ($2,571 less $2,000) d. Interest expense first six months of Year One $2,554 Interest expense second six months of Year One 2,571 Interest expense, Year One $5,125 e. Year One principal (second six months) = $85,677 December 31, Year One, compounding entry = $571 December 31, Year One, balance = $86,248 12) a. The face value for the first year is $4 million and the stated cash interest rate is 4 percent per year or $160,000 for Year One. Because these bonds were sold at face value, the cash interest is the same as the interest expense and no compounding entry is needed. December 31, Year One Bonds payable Interest expense Cash
$2,000,000 160,000 $2,160,000
b. The face value for the second year is $2 million and the stated cash interest rate is 4 percent per year or $80,000 for Year Two. December 31, Year Two Bonds payable Interest expense Cash
$2,000,000 80,000 $2,080,000
13) a. The contractual cash flows must be determined first. Because of the annual $1 million payment of the face value, the balance is $3 million for Year One, $2 million for Year Two, and $1 million for Year Three. The annual stated interest rate is 6 percent so the interest payments are: $180,000 at the end of Year One ($3 million face value times 6 percent), $120,000 at the end of Year Two ($2 million face value times 6 percent), and $60,000 at the end of Year Three ($1 million face value times 6 percent). Combining the face value payments with the interest payments and the following cash flows are scheduled: December 31, Year One - $1,180,000 December 31, Year Two - $1,120,000 December 31, Year Three - $1,060,000 b. These are three separate single payments listed above. The effective interest rate (yield rate) is 8 percent. The present value of these cash payments is determined below (rounded). $1,180,000 x $0.92593 = $1,120,000 x $0.85734 = $1,060,000 x $0.79383 = Present value (issuance price)
$1,092,597 960,221 841,460 $2,894,278
c. December 31, Year One – Cash Interest Payment Interest expense Cash
$180,000 $180,000
December 31, Year One – Compounding Entry Interest expense Bonds payable
$51,542 $51,542
Principal of $2,894,278 times 8 percent effective interest rate equals $231,542 (rounded) Interest recognized in excess of cash payment is $51,542 ($231,542 less $180,000) December 31, Year One – Face Value Payment Bonds payable Cash
$1,000,000 $1,000,000
The previous three entries can be combined or made separately as shown here.
December 31, Year One – Liability Balance Year One principal = $2,894,278 December 31, Year One, compounding entry = $51,542 December 31, Year One, liability payment = $1,000,000 December 31, Year One, balance = $1,945,820
d. December 31, Year Two – Cash Interest Payment Interest expense Cash
$120,000 $120,000
December 31, Year Two – Compounding Entry Interest expense Bonds payable
$35,666 $35,666
Principal of $1,945,820 times 8 percent effective interest rate equals $155,666 (rounded) Interest recognized in excess of cash payment is $35,666 ($155,666 less $120,000) December 31, Year Two – Face Value Payment Bonds payable Cash
$1,000,000 $1,000,000
14) a. Althenon Corporation Present value of cash payments --$50,000 per year for 8 years x $5.33493 --$1,000,000 in 8 years x $0.46651 Present value (issuance price)
$266,747 (rounded) 466,510 $733,257
Year One – Interest Expense: Principal of $733,257 times 10 percent effective interest rate equals $73,326 (rounded) Interest recognized in excess of cash payment is $23,326 ($73,326 less $50,000) December 31, Year One – Liability Balance Year One principal = $733,257 December 31, Year One, compound interest = $23,326 December 31, Year One, balance = $756,583
Year Two – Interest Expense: Principal of $756,583 times 10 percent effective interest rate equals $75,658 (rounded) Interest recognized in excess of cash payment is $25,658 ($75,658 less $50,000) December 31, Year Two – Liability Balance Year Two principal = $756,583 December 31, Year Two, compound interest = $25,658 December 31, Year Two, balance = $782,241 b. Zephyr Corporation Present value of cash payments --$80,000 per year for 8 years x $5.33493 --$1,000,000 in 8 years x $0.46651 Present value (issuance price)
$426,794 (rounded) 466,510 $893,304
Year One – Interest Expense: Principal of $893,304 times 10 percent effective interest rate equals $89,330 (rounded) Interest recognized in excess of cash payment is $9,330 ($89,330 less $80,000) December 31, Year One – Liability Balance Year One principal = $893,304 December 31, Year One, compound interest = $9,330 December 31, Year One, balance = $902,634 Year Two – Interest Expense: Principal of $902,634 times 10 percent effective interest rate equals $90,263 (rounded) Interest recognized in excess of cash payment is $10,263 ($90,263 less $80,000) December 31, Year Two – Liability Balance Year Two principal = $902,634 December 31, Year Two, compound interest = $10,263 December 31, Year Two, balance = $912,897 15) Years One and Two – Bonds Actually Issued at an Annual Effective Interest Rate of 8 Percent The future cash flows on this bond are (a) $50,000 interest every December 31 ($1,000,000 face value multiplied times 5 percent stated interest rate) for twenty years and (b) a face value payment of $1,000,000 in twenty years.
The effective annual interest rate (yield rate) negotiated by the debtor and creditor was 8 percent per year. The $50,000 is an ordinary annuity and the $1,000,000 is a single payment amount. $50,000 x 9.81815 = $490,908 (rounded) $1,000,000 x 0.21455 = $214,550 Issuance price: $490,908 + $214,550 = $705,458 Year One – Interest Expense: Principal of $705,458 times 8 percent effective interest rate equals $56,437 (rounded) Interest recognized in excess of cash payment is $6,437 ($56,437 less $50,000) December 31, Year One – Liability Balance Year One principal = $705,458 December 31, Year One, compound interest = $6,437 December 31, Year One, balance = $711,895 Year Two – Interest Expense: Principal of $711,895 times 8 percent effective interest rate equals $56,952 (rounded) Interest recognized in excess of cash payment is $6,952 ($56,952 less $50,000) December 31, Year Two – Liability Balance Year Two principal = $711,895 December 31, Year Two, compound interest = $6,952 December 31, Year Two, balance = $718,847 **** Years One and Two – Bonds Could Have Been Issued at an Annual Effective Interest Rate of 10 Percent The future cash flows on this bond are still (a) $50,000 interest every December 31 ($1,000,000 face value multiplied times 5 percent stated interest rate) for twenty years and (b) a face value payment of $1,000,000 in twenty years. The effective annual interest rate (yield rate) negotiated by the debtor and creditor was first proposed as 10 percent per year. The $50,000 is an ordinary annuity and the $1,000,000 is a single payment amount. $50,000 x 8.51356 = $425,678 $1,000,000 x 0.14864 = $148,640 Issuance price: $425,678 + $148,640 = $574,318 Year One – Interest Expense: Principal of $574,318 times 10 percent effective interest rate equals $57,432 (rounded) Interest recognized in excess of cash payment is $7,432 ($57,432 less $50,000)
December 31, Year One – Liability Balance Year One principal = $574,318 December 31, Year One, compound interest = $7,432 December 31, Year One, balance = $581,750 Year Two – Interest Expense: Principal of $581,750 times 10 percent effective interest rate equals $58,175 Interest recognized in excess of cash payment is $8,175 ($58,175 less $50,000) December 31, Year Two – Liability Balance Year Two principal = $581,750 December 31, Year Two, compound interest = $8,175 December 31, Year Two, balance = $589,925 a. The company recognized interest expense in Year One (at the 8 percent negotiated rate) of $56,437. Had the company issued the bonds at the proposed 10 percent rate, the interest expense would have been $57,432. By negotiating the lower rate, interest expense reported for Year One is $995 lower. However, the reported liability at the end of Year One is $711,895 which is $130,145 higher than the $581,750 liability that would have been shown had the 10 percent rate been accepted. b. The company recognized interest expense in Year Two (at the 8 percent negotiated rate) of $56,952. Had the company issued the bonds at the proposed 10 percent rate, the interest expense would have been $58,175. By negotiating the lower rate, interest expense reported for Year Two is $1,223 lower. However, the reported liability at the end of Year Two is $718,847 which is $128,922 higher than the $589,925 liability that would have been shown had the 10 percent rate been accepted.
Answer to Comprehensive Problem A) a) Accounts Receivable Revenue
$5,400
Supplies Inventory Accounts Payable
$150
$5,400
b) $150
c) No entry needed. d) Purchases Accounts Payable
$10,460
Cash
$3,000
$10,460
e) Note Payable
$3,000
f) Equipment Cash
$5,500
Salaries Expense Cash
$800
Cash
$13,950
$5,500
g) $800
h) Revenue
$13,950
i) Cash
$5,200 Accounts Receivable
$5,200
j) Investment in Trading Securities Cash
$1,800
Salaries Payable Cash
$200
Cash
$600
$1,800
k) $200
l) Unearned Revenue
$600
m) Accounts Payable Cash
$11,300 $11,300
n) Salaries Expense Cash
$2,000
Unearned Revenue Revenue
$450
Cash
$25
$2,000
o) $450
p) Dividend Revenue
$25
q) Tax Expense Cash
$1,558 $1,558
B)
Cash 5,150 5,500(f) (e)3,000 800(g) (h)13,950 1,800(j) (i)5,200 200(k) (l)600 11,300(m) (p)25 2,000(n) 1,558(q) 4,767 Supplies 40 (b)150 190
Furniture 1,000
1,000
Accounts Receivable 1,600 5,200(i) (a)5,400
Allow. Doubtful Investment in Accounts Trading Securities Inventory 160 (j)1,800 2,423
1,800 Prepaid Rent 400
400
160
Prepaid Advertising 100
100
Accum. Depr.—Furn 68
68
1,800
Equipment 7,000 (f)5,500
2,423 Accum. Depr.—Equip 1,022
12,500 Investment in Availablefor-Sale Securities 1,575
1,575
1,022
License Agreement 1,800
1,800
Accounts Payable Salaries Payable Interest Payable Unearned Revenue Note Payable (m)11,300 2,750 (k)200 200 (o)450 450 3,000(e) 150(b) 600(l) 10,460(d) 2,060
Capital Stock 2,000
0
Retained Earnings 14,613
2,000
0
175
Unrealized Gain/Loss— Trading Securities
Gain/Loss on Sale of Trading Securities
0
0
Rent Expense
0
0
Depreciation Expense
0
3,000
Unrealized Gain/Loss— AFS Securities Revenue Dividend Revenue 175 5,400(a) 25(p) 13,950(h) 450(o)
14,613
Bad Debt Expense
600
19,800
Tax Expense (q)1,558
Utilities Expense
1,558
Cost of Goods Sold
10,460
0
0
Supplies Expense
0
Purchases (d)10,460
Amortization Expense
25
Advertising Expense
0
0
Salaries Expense (g)800 (n)2,000 2,800
C) Webworks Unadjusted Trial Balance February 28 Account Title Debits Cash $ 4,767 Accounts Receivable 1,800 Allowance for Doubtful Accounts Investment in Trading Securities 1,800 Inventory 2,423 Supplies 190 Prepaid Rent 400 Prepaid Advertising 100 Equipment 12,500 Accum. Depreciation—Equipment Furniture 1,000 Accum. Depreciation—Furniture Investment in AFS Securities 1,575 License Agreement 1,800 Accounts Payable Salaries Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 2/1 Revenue Dividend Revenue Unrealized Gain/Loss on Trading Securities Unrealized Gain/Loss on AFS Securities 175 Gain/Loss on Sale of Trading Securities Salaries Expense 2,800 Tax Expense 1,558 Utilities Expense 0 Supplies Expense 0 Rent Expense 0 Bad Debt Expense 0 Purchases 10,460 Cost of Goods Sold 0 Depreciation Expense 0 Amortization Expense 0 Advertising Expense 0
_______
Totals
$43,348
$43,348
Credits
$
160
1,022 68
2,060 0 600 3,000 2,000 14,613 19,800 25 0 0
D) r) Salaries Expense Salaries Payable
$220
Utilities Expense Accounts Payable
$300
Supplies Expense Supplies Inventory
$120
Rent Expense Prepaid Rent
$200
Advertising Expense Prepaid Advertising
$100
Bad Debt Expense Allowance for Doubtful Accounts
$20
Depreciation Expense Accumulated Depreciation—Equip
$238
Depreciation Expense Accumulated Depreciation—Furn
$17
Amortization Expense License Agreement
$200
$220
s) $300
t) $120
u) $200
v) $100
w) $20
x) $238
$17
y) $200
z) Investment in Available-for-Sale Securities $525 Unrealized Gain on AFS Securities
$525
Unrealized Loss on Trading Securities Investment in Trading Securities
$200
$200
aa) Interest Expense Interest Payable
$15
Cost of Goods Sold Inventory Purchases
$10,201 259
$15
bb)
Cash 5,150 5,500(f) (e)3,000 800(g) (h)13,950 1,800(j) (i)5,200 200(k) (l)600 11,300(m) (p)25 2,000(n) 1,558(q) 4,767
$10,460
Accounts Receivable 1,600 5,200(i) (a)5,400
Allow. Doubtful Investment in Accounts Trading Securities Inventory 160 (j)1,800 200(z) 2,423 20(w) (bb)259
1,800
180
Supplies Prepaid Rent Prepaid Advertising 40 120(t) 400 200(u) 100 100(v) (b)150 70
Furniture 1,000
200
0
Accum. Depr.—Furn 68 17(x)
1,000
85
1,600
Equipment 7,000 (f)5,500
2,682 Accum. Depr.—Equip 1,022 238(x)
12,500 Investment in Availablefor-Sale Securities 1,575 (z)525
1,260
License Agreement 1,800 200(y)
2,100
1,600
Accounts Payable Salaries Payable Interest Payable Unearned Revenue Note Payable (m)11,300 2,750 (k)200 200 15(aa) (o)450 450 3,000(e) 150(b) 220(r) 600(l) 10,460(d) 300(s) 2,360
220
15
600
3,000
Capital Stock 2,000
Unrealized Gain/Loss— Retained Earnings AFS Securities Revenue Dividend Revenue 14,613 175 525(z) 5,400(a) 25(p) 13,950(h) 450(o)
2,000
14,613
Unrealized Gain/Loss— Trading Securities (z)200
350
Gain/Loss on Sale of Trading Securities
200
0
19,800
Tax Expense (q)1,558
Utilities Expense (s)300
1,558
20
Depreciation Expense (x)238 (x)17 255
0 Amortization Expense (y)200
200
Supplies Expense (t)120
300
Bad Debt Rent Expense Expense Purchases Cost of Goods Sold (u)200 (w)20 (d)10,460 10,460(bb) (bb)10,201
200
25
120
Salaries Expense (g)800 (n)2,000 (r)220
10,201
3,020
Advertising Expense (v)100
Interest Expense (aa)15
100
15
E)
Webworks Adjusted Trial Balance February 28 Account Title Debits Cash $ 4,767 Accounts Receivable 1,800 Allowance for Doubtful Accounts Investment in Trading Securities 1,600 Inventory 2,682 Supplies 70 Prepaid Rent 200 Prepaid Advertising 0 Equipment 12,500 Accum. Depreciation—Equipment Furniture 1,000 Accum. Depreciation—Furniture Investment in AFS Securities 2,100 License Agreement 1,600 Accounts Payable Salaries Payable Interest Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 2/1 Revenue Dividend Revenue Unrealized Gain/Loss on Trading Securities 200 Unrealized Gain/Loss on AFS Securities Gain/Loss on Sale of Trading Securities Salaries Expense 3,020 Tax Expense 1,558 Utilities Expense 300 Supplies Expense 120 Rent Expense 200 Bad Debt Expense 20 Purchases 0 Cost of Goods Sold 10,201 Depreciation Expense 255 Amortization Expense 200 Advertising Expense 100 Interest Expense 15 Totals $44,508
Credits
$
180
1,260 85
$ 2,360 220 15 600 3,000 2,000 14,613 19,800 25 350 0
$44,508
F) Webworks Income Statement As of February 28 Revenue Cost of Goods Sold Gross Profit Deprec. and Amort. Expense Other Expenses and Losses Investment Income (Loss) Earnings Before Interest & Taxes Interest Expense Earnings Before Tax Tax Expense Net Income
$19,800 (10,201) 9,599 (455) (3,760) (175) 5,209 (15) 5,194 (1,558) $ 3,636
Webworks Stmt. of Retained Earnings As of February 28 Retained Earnings, February 1 Net Income Retained Earnings, February 28
$14,613 3,636 $18,249
Webworks Balance Sheet February 28 Assets:
Liabilities:
Current: Cash $ 4,767 Accounts Receivable 1,800 less Allow. for Doubt. Accts. (180) Net Accounts Receivable 1,620 Trading Securities, net 1,600 Merchandise Inventory 2,682 Supplies Inventory 70 Prepaid Rent 200 Total Current Assets $10,939
Current: Accounts Payable Salaries Payable Interest Payable Unearned Revenue
$ 2,360 220 15 600
Total Current Liabilities
$ 3,195
Property, Plant, and Equipment Equipment less Accumulated Depreciation Furniture less Accumulated Depreciation Total P, P, and E
Noncurrent: Note payable
$ 3,000
$12,500 (1,260) 1,000 (85) $12,155
Other Noncurrent Assets: Available-for-Sale Securities Licensing Agreement, net
$ 2,100 1,600
Total Assets
$26,794
Owners’ Equity: Capital Stock $ 2,000 Retained Earnings 18,249 Other Accumulated Comprehensive Income: Unrealized gain on Available-forSale Securities 350 Total Owners’ Equity $ 20,599 Total Liabilities & Owners’ Equity
$26,794
Answer to Research Assignment a. For Marriott International, interest expense incurred in 2010 was $180 million, an increase of $62 million over 2009 or a 53 percent jump. b. At the end of 2010, long-term debt (including long-term debt, liability for guest loyalty program, and other long-term liabilities) was $4,897 million, an increase of $393 million over 2009 or 8.7 percent. c.
Series F Series G Series H Series I Series J
Stated Interest Rate 4.625% 5.810% 6.200% 6.375% 5.625%
Effective Interest Rate 5.02% 6.53% 6.30% 6.45% 5.71%
Marriott also had non-recourse debt associated with securitized notes receivable, interest rates ranging from 0.31% to 7.20% and other debt with no specified interest rates.
Chapter 15 Solutions Please note that all present value calculations in this solutions manual will be determined using the tables that appear in the back of the Financial Accounting textbook. Calculations made using an Excel spreadsheet, mathematical formulas, or calculators may differ slightly because of rounding. Answers to Questions 1) Ace Company holds ownership to the property in this situation and is, thus, the lessor. Zebra Corporation has physical use of the property which makes the company the lessee. 2) An operating lease is a rental agreement. In this type arrangement, the lessee does not gain the benefits and risks of ownership; the lessor continues to hold those benefits and risks. In a capital lease, the contract is the equivalent of a purchase by the lessee, one where the lessee does gain substantially all of the benefits and risks of owning the leased asset. 3) As an operating lease, the future cash payments are viewed as a commitment by the lessee and not as an obligation. Therefore, no liability is reported and the first payment is reported on the asset side of the balance sheet as a prepaid rent. 4) A company is said to use off-balance sheet financing when it has an obligation to pay more money than the debt reported on the balance sheet. In the previous question, the lessee is obligated to make annual payments of $100,000 in each of the next eight years. However, no liability is reported on the balance sheet because the lease qualifies as an operating lease. The debt is not recognized and, therefore, is off the balance sheet. 5) On December 31, Year One, because the lease qualifies as a capital lease, the company reports the leased truck as an asset on its balance sheet at an amount equal to the present value of the six payments to be made on that lease. At the same time, the company also reports a lease liability for the present value except that the debt balance is reduced by the first $100,000 payment that is made immediately. 6) A bargain purchase option (one that is sufficiently below the expected fair value of the property so that it is reasonable to anticipate that the lessee will make the payment) is one of the four criteria used to identify a capital lease. With a purchase option that is viewed as a bargain, the assumption is made that the lessee expects to gain legal title to the property by means of the payments. That is the equivalent of a purchase transaction.
7) A lease that is 75 percent or more of the life of leased property meets one of the four criteria used to identify a capital lease. Although the lessee never expects to obtain legal title to the property, that party will gain a vast majority of the asset’s utility. Consequently, according to U.S. GAAP, the lease is the equivalent of a purchase. 8) Only one of the four official criteria must be met for a lease contract to qualify as a capital lease. 9) In determining the present value of future cash amounts, an appropriate interest rate must be used. In a capital lease arrangement, the lessee usually applies its own incremental borrowing rate for that purpose. The incremental borrowing rate is the interest rate the lessee would have to pay to borrow this same amount of money from a bank or other lending institution based on its current financial strength. 10) Where possible, officials for a lessee prefer to report leases as operating leases rather than capital leases. With operating leases, future payments are not shown on the balance sheet by the lessee as liabilities. However, in reporting capital leases, future payments are included as liabilities at the present value of the cash amounts (with all future interest removed). Thus, the debt balances to be reported by a lessee are lower when an operating lease is signed rather than a capital lease. That omission makes the company look more prosperous and financially healthy. 11) Because the lease is an operating lease, the first payment is initially recorded as a prepaid rent. At the end of that year, the balance is reclassified from this asset account to rent expense. Therefore, the payment will be the amount recorded as the expense for the first year. 12) Because the lease is a capital lease, the reported asset balance is depreciated each year based on the passage of one year out of five. Thus, annual depreciation expense is recognized. In addition, the reported debt balance for that year is multiplied by the incremental borrowing rate to determine the interest expense to be recognized (and compounded). Depreciation expense is recorded on the asset balance and interest expense is recorded on the liability balance. 13) In a legal sense, this contract is a rental arrangement because the lessor retains title to the property. The form of the transaction is that of an operating lease. However, the reality of the lease is closer to a purchase agreement than to a rent. In substance, the contract is more like a purchase of the property. Accounting seeks to report the reality (the substance) of each transaction and not merely record what it purports to be. 14) The Marlento Company reports its net income in Year One based on U.S. GAAP which attempts to provide a fair representation of the financial operations, financial position, and cash flows of the company. In contrast, taxable income is based entirely on the laws and regulations of the government’s Internal Revenue Code (IRC). The IRC has
been created over a long period of time to accomplish a number of goals: the raising of revenues, management of the economy, and the satisfaction of societal goals such as helping the poor and the infirm. Because U.S. GAAP and the IRC have different objectives, their rules vary considerably so that reported income amounts will almost always differ. 15) A temporary tax difference occurs when an income amount is reported on financial statements according to U.S. GAAP and on the tax return according to IRC but in two different time periods. The figure is recorded in both but not in the same year. For example, one might report revenue of $79,000 in Year One while the other reports the same revenue but not until Year Three. The $79,000 is a temporary tax difference for those two years. 16) Company officials will most likely be very happy about deferring tax payments. Unless tax rates are expected to climb, management prefers to postpone payments of income taxes so that the money can remain in the company and generate additional profits. Once payment of a tax is made, no further benefit can be derived from that money. Here, the tax to be paid on the $3 million gain is delayed from Year One to Year Four. The company can continue to use the tax money during these three years in order to grow more profitable. 17) The income was earned for financial reporting purposes in Year One. Consequently, any related income tax expense (and liability) should also be recognized in Year One. Even though payment will not occur for three years, the expense and liability ($1.2 million times 30 percent or $360,000) is recorded in Year One through the following entry. Income tax expense – deferred Deferred income tax liability
$360,000 $360,000
18) The $100,000 gain was earned for financial reporting purposes in Year Two at the time the land is sold. Consequently, the resulting income tax expense (and related liability) should also be recognized in Year Two. Even though payment will not occur until Years Three and Four, the expense and liability ($100,000 times 30 percent or $30,000) is recorded in Year Two through the following entry. December 31, Year Two Income tax expense – deferred Deferred income tax liability
$30,000 $30,000
19) As this employee works, the company incurs a liability for the medical insurance that will be paid after her retirement. For accounting purposes, the company must recognize this obligation as it is earned by the employee. However, the actual dollar amount to be
paid is extremely difficult to anticipate. How long will the employee live after retirement? What will be the annual cost of the policy in the future? Because the employee is only 30, the company is incurring a liability for an unknown amount where some of the payments might not be made for another 50-70 years. The accounting problem is simple: What liability should be recognized now? The answer is not nearly so simple. 20) The company has decided to pay for life insurance for its employees even after they retire. To determine the liability, two primary questions must be answered: How long will the employees live after they retire and how much will these policies cost during that period. An actuary uses historical data, computer programs, and statistical models to estimate these amounts. The process allows the actuary to form a reasonable approximation of the future amounts that will have to be paid. Then, the present value of those projected cash payments can be calculated and recognized presently by the company as a noncurrent liability. 21) An actuary calculates an estimate of the cash amounts that will eventually have to be paid as a result of promises made to employees for postretirement benefits (such as payments to be made after retirement for medical insurance or life insurance). 22) At one time years ago, liabilities incurred for postretirement benefits were not reported by most companies because no official requirement existed. The justification for such an omission was that the eventual payments could not be reasonably estimated. In addition, they were more like commitments than liabilities. Eventually, this thinking gave way to the required recognition of postretirement benefits. The costs of such promises then became apparent to decision makers inside the company and investors and creditors outside of the company. In some cases, these costs turned out to be significantly higher than had been previously thought. As a result, some companies opted to cut back on the amount of these promises. The accounting profession was even blamed for the loss of employee retirement benefits. However, the accounting rules merely served to give people better, more complete information so that decisions were made logically. 23) The term “EBIT” reflects the earnings of a company before interest expense and taxes have been deducted. Analysts like to study this figure because it focuses on the profitability of the company’s operations. Interest is viewed as a financing charge not related to operations. Taxes are really a government assessment. Those two figures are often rather large and fall outside the operating activities of the business. 24) Prior to this payment, the debt-to-equity ratio was $3.5 million to $2.0 or 1.75 to 1.00. After the $500,000 payment, the debt-to-equity ratio has dropped to $3.0 million to $2.0 or 1.50 to 1.00. Payment of the debt prior to the end of the year reduces the reported debt-to-equity ratio.
25) To determine the number of times interest is earned this period, earnings before interest and taxes (EBIT) is computed. Net income is $1.8 million but that is only after $500,000 in interest expense and $400,000 in taxes have been subtracted. EBIT is computed before those two subtractions so it is $2.7 million. Times interest earned is EBIT/interest expense. Here, that is $2.7 million/$500,000 or 5.4 times.
Answers to True or False Questions __T__ 1) With a capital lease, the leased asset is capitalized at the present value of the future cash payments and that cost is then depreciated over the number of years that the asset will be used to generate revenue. __F__ 2) Operating leases are one of the most common examples of “off-balance sheet financing” because future payments are not reported on the liability section of the balance sheet. In contrast, in a capital lease, the liability is reported on the balance sheet at the present value of the future cash flows. The debt is shown. __T__ 3) In most cases, the lessee prefers to structure a lease contract as an operating lease because future payments are not recorded on the balance sheet as liabilities. The company will look more financially healthy without those liabilities. __F__ 4) According to U.S. GAAP, four criteria exist to qualify as a capital lease. A lease is reported as a capital lease if any one of these criteria is met. __T__ 5) A lessee normally prefers a lease contract that qualifies as an operating lease because future payments are not recorded on the balance sheet as liabilities. With a capital lease, the lessee must record the present value of the future cash flows as a liability at the time the contract is signed. __T__ 6) In a capital lease, the leased asset and the leased liability are both recognized. Over time, depreciation expense is recorded in connection with the cost of the asset and interest expense is recorded on the liability balance. __F__ 7) In an operating lease, no liability is recognized in connection with future cash payments. However, the present value of those cash flows is reported if the lease qualifies as a capital lease. If this lease contract is a capital lease, the liability is reported at $53,000 (the $73,000 present value less payment of $20,000). __F__ 8) Only leases that meet at least one of four criteria are recorded as capital leases. The $14,000 purchase option in this contract might be a bargain but not enough information is available to make that determination. An accountant cannot make a certain declaration as to whether this lease is an operating lease or a capital lease without more information. __F__ 9) The liability on the date that the contract is signed is $65,860, the present value of the future cash payments. The first $10,000 payment reduces that account to $55,860
which is the liability balance for the year. At a 10 percent annual rate, interest is $5,586 for Year One. __F__ 10) Many differences exist between the amounts reported on an income statement created according to U.S. GAAP and a tax return that follows the laws and regulations of the Internal Revenue Code (IRC). U.S. GAAP and the IRC have significantly different objectives. For that reason, the handling of reported balances frequently differ. __T__ 11) On a set of financial statements that are prepared according to U.S. GAAP, income tax expense and the related liability are reported in the same period that the underlying cause (taxable income) is reported. Here, the gain is reported in Year One so the tax effects are reported in the same period. __T__ 12) The gain here is reported in Year One so the related tax effects are reported in the same period even though payment is not to be made until Year Three. To indicate the nature of the debt, the liability is referred to as a deferred income tax liability. __T__ 13) Deferral of income tax payments is a strategy used by virtually all companies to postpone payment of income taxes. This delay allows the company to keep the money for one or more years so it can be used to generate additional profits. __F__ 14) When using the installment sales method for tax purposes, recognition of the profit is delayed until cash is collected. For example, if a sale is made in Year One but the cash is not collected until Year Five, the gain is not taxed until Year Five. The company can continue to make use of that tax money for those years. __F__ 15) Postretirement benefits are expensed as employees earn them. No revenue is earned by an employee for the company during retirement. Therefore, the expense is recognized as the employee works and not after the person retires. __F__ 16) The cost of postretirement benefits is very difficult to anticipate. Most such benefits continue until the employee dies. Therefore, the accountant does not know the number of years payments will be required and rarely knows the specific cost each year. An actuary is usually hired to help make these estimations. __T__ 17) Postretirement benefits are expensed as employees earn them. Melody Stuart works for a company this year. An expense will be recorded in connection with the benefits she earns even though she will not begin to receive these benefits until after her retirement in 2020. __T__ 18) The debt-to-equity ratio can make a company’s financial position look especially precarious. The more debt that a company has in comparison to its stockholders’ equity the more difficulty it faces in making payments as they come due. Companies prefer to look financially strong. Therefore, they try if possible to reduce the reported debt-to-equity ratio to lower the perceived amount of risk.
__F__ 19) Times interest earned is EBIT (earnings before interest expense and taxes) divided by interest expense.
Answers to Multiple Choice Questions 1) Answer is D Four criteria have been designated that qualify a lease contract as a capital lease for reporting purposes. Examples of these criteria include: title is transferred to the lessee (answer C), a bargain purchase option exists (answer B), and the life of the lease is 75 percent or longer of the life of the asset (answer A). Answer D is only for 70 percent of the life of the asset and the payment pattern is not discussed in the four criteria. 2) Answer is D In a capital lease, depreciation expense (on the asset) and interest expense (on the liability) are recorded by the lessee. In an operating lease, only rent expense is recorded by the lessee. 3) Answer is C A lessee normally prefers that a lease qualifies as an operating lease because future payments are not recorded on the company’s balance sheet as a liability. In contrast, with a capital lease, the lessee must record the present value of the future cash flows as a liability at the time the contract is signed. 4) Answer is D Because the lease qualifies as a capital lease, the present value of the future cash flows is determined and recorded as the leased asset balance. The first payment is made immediately so the series of payments is an annuity due. The present value is $20,000 times $3.72325 or $74,465. The lease is for four years so the annual depreciation is $74,465/4 years or $18,616 (rounded). 5) Answer is B None of the four criteria for a capital lease is met in this contract. Therefore, the lease is an operating lease and the first payment is recorded as a prepaid expense. 6) Answer is A This lease is identified as an operating lease and, therefore, no amount is reported as the capitalized cost of the truck. A capitalized cost for the leased asset is only recognized in a capital lease.
7) Answer is D The contract is for the entire life of the asset so it is capital lease. The first payment is made immediately which makes this series of payments an annuity due (virtually every lease is an annuity due). Present value of the future cash flows is $12,000 times $4.16987 or $50,038 (rounded). Annual depreciation is $50,038/5 years or $10,008 (rounded). After one year, on December 31, Year Two, the net book value of the leased asset is $40,030 ($50,038 less $10,008). 8) Answer is B In the above problem, the present value of the future cash flows was $50,038. This balance is initially recorded for both the asset and the liability. An immediate payment of $12,000 is made which reduces the liability to $38,038. The annual interest rate is 10 percent so that interest expense for Year Two is $3,804 (rounded). 9) Answer is B As shown above, the liability balance for Year Two is $38,038. At the end of that year, interest expense of $3,804 is recognized and compounded. In addition, a second payment of $12,000 is made which reduces the liability. The reported balance is $29,842 ($38,038 plus $3,804 less $12,000). 10) Answer is A Company A believes this lease is an operating lease. In Year Two, it records its annual $10,000 payment as a prepaid rent and then as rent expense. Company B believes this lease is a capital lease. The asset and liability are recorded at the present value of the future cash flows or $37,232 ($10,000 times $3.7232). The lease is for four years so annual depreciation expense is $37,232/4 years or $9,308. The liability starts out at $37,232 but the first payment reduces that debt to $27,232. At a 5 percent annual interest rate, interest expense for Year Two is $1,362 (rounded). Total expense for Company B is $9,308 plus $1,362 or $10,670. In that year, Company B reports a total expense that is $670 more than Company A. 11) Answer is C The income that led to the tax is reported on the Year One income statement. Consequently, according to U.S. GAAP, the related tax expense and tax liability must also be reported in Year One.
12) Answer is C The income that led to the tax is reported on the Year One income statement. Consequently, the related tax expense and tax liability must also be reported in Year One. The income is $800,000 and the tax rate is 40 percent so the deferred liability recognized on the balance sheet in Year One is $320,000. 13) – Answer is C The $110,000 gain ($200,000 sales price less $90,000 cost) will create a $44,000 income tax ($110,000 times 40 percent). This gain was reported in the financial statements for Year Two when the property was sold. Therefore, the related tax expense and the deferred tax liability must also be reported in Year Two. 14) – Answer is D Most postretirement benefits will be paid over an uncertain number of years. The annual cost is also difficult to anticipate. However, that cost must be anticipated (usually be an actuary) with the present value recorded immediately as the employee does the work. The liability is the present value of those estimated future payments and not the actual amount that will be paid. 15) – Answer is C Mathematical estimations of future events are most likely determined by an actuary, a person trained in actuarial sciences. 16) – Answer is C The Arkansas Company expects to pay $3.3 million in cash but much of that money will not be paid for a number of years. Therefore, future interest is removed so that the present value of those cash flows can be shown immediately as the liability. 17) – Answer is B The company has total debt of $200,000 and total stockholders’ equity of $250,000 ($450,000 assets less $200,000 in liabilities). The debt-to-equity ratio is $200,000 to $250,000 or 0.80 to 1.00. 18) – Answer is B Contributed capital is the $120,000 put into the business by the owners. Retained earnings is the $210,000 net income earned over these three years ($70,000 net income times 3 years) less $30,000 in dividends ($10,000 times three years) or $180,000. Stockholders’ equity at the end of three years is $300,000 ($120,000 plus $180,000). The company reports $900,000 in assets which means that the total
liabilities must be $600,000 ($900,000 in assets less $300,000 stockholders’ equity). The debt-to-equity ratio is $600,000 to $300,000 or 2.00 to 1.00. 19) – Answer is A The payment of a cash dividend reduces retained earnings and, hence, stockholders’ equity. Debt is not affected. If debt stays the same and stockholders’ equity decreases, the debt-to-equity ratio increases. 20) - Answer is D The number of times interest is earned is the earnings before interest expense and income taxes (EBIT) divided by the interest expense. EBIT is $65,000 + $10,000 + $15,000 or $90,000 in total. Because interest expense is $10,000, the times interest is earned is $90,000/$10,000 or 9.0 times.
Answers to Problems
1) a. Prepaid rent Cash
$30,000
Rent expense Prepaid rent
$7,500
Rent expense Prepaid rent
$22,500
Leased equipment Lease liability
$388,092
$30,000
b. $7,500
c. $22,500
2) a. $388,092
$90,000 x 4.31213 = $388,092 (rounded) b. Lease liability Cash
$90,000 $90,000
c. Depreciation expense Accumulated depreciation
$77,618 $77,618
$388,092/5 years = $77,618 (rounded) d. Interest expense Lease liability $388,092 - $90,000 = $298,092
$23,847 $23,847 $298,092 x 8 = $23,847
e. Lease liability Cash
$90,000 $90,000
3) a. If the contract had been for three years, the lease would have been recorded as an operating lease because the contract was for less than 75 percent of the asset’s life (three years out of five). As an operating lease, the only expense recognized in Year One would have been rent expense of $20,000. When the contract is changed to four years, the lease becomes a capital lease because it covers 80 percent of the asset’s life (four years out of five). As a capital lease, the asset and the liability are both recorded at the present value of the future cash payments ($20,000 times 3.48685 or $69,737). Depreciation expense on the asset’s cost for the first year is $17,434 ($69,737/4 years). The liability is reduced immediately by the first $20,000 payment so the balance drops from $69,737 to $49,737. At a 10 percent annual interest rate, interest expense for Year One is $4,974 ($49,737 times 10 percent). The total expense for Year One as a capital lease is $17,434 plus $4,974 or $22,408. Adding the extra year to the contract increases the recognized expense for Year One from $20,000 to $22,408, an increase of $2,408. b. The expense recognized for the second year if the lease had been for only three years is still rent expense of $20,000. As a capital lease (four year contract), one expense changes and one expense stays the same. Depreciation expense remains $17,434 in the second year if the lease is extended to four years. However, the interest expense will differ. The liability balance for Year One was $49,737. The compounding of interest at the end of Year One adds $4,974 to that balance. Then, the payment at the start of Year Two drops that balance by $20,000 to $34,711 ($49,737 + $4,974 - $20,000). Interest is recognized at a 10 percent annual rate or $3,471 for Year Two ($34,711 times 10
percent). As a capital lease, total expense for Year Two is $17,434 plus $3,471 or $20,905. Adding the extra year to the contract increases the recognized expense for Year Two from $20,000 to $20,905, an increase of $905. c. The capitalized cost of the truck is $69,737. Annual depreciation is $17,434. At the end of Year One, the net book value of the leased truck is $52,303 ($69,737 less $17,434). d. The initial liability as computed above is $69,737. The first payment immediately reduces that balance to $49,737. The interest compounded at the end of Year One increases that balance by $4,974 to $54,711. (The second payment reduces that balance but that occurs on January 1, Year Two.) 4) a. 12/31/Year One
Prepaid rent Cash
$22,000 $22,000
12/31/Year Two
Rent expense Prepaid rent
$22,000 $22,000
12/31/Year Two
Prepaid rent Cash
$22,000 $22,000
b. As an operating lease, the only account that will appear on the December 31, Year Two, balance sheet is the asset Prepaid Rent with a balance of $22,000. c. 12/31/Year One
Leased asset $153,896 Lease liability $153,896
$22,000 times 6.99525 = $153,896 (rounded) 12/31/Year One
Lease liability Cash
$22,000 $22,000
12/31/Year Two
Depreciation expense $15,390 Accumulated depreciation $15,390
$153,896/10 years = $15,390 (rounded)
12/31/Year Two
Interest expense Lease liability
$11,871 $11,871
$153,896 - $22,000 = $131,896 (liability balance for Year Two) $131,896 x 9 percent = $11,871 (interest expense for Year Two) 12/31/Year Two
Lease liability Cash
$22,000 $22,000
d. December 31, Year Two - Leased asset December 31, Year Two - Accumulated depreciation Net book value, December 31, Year Two
$153,896 (15,390) $138,506
January 1, Year Two - Lease liability Year Two – Interest compounded December 31, Year Two – Lease payment Lease liability, December 31, Year Two
$131,896 11,871 (22,000) $121,767
5) a. If any one of the following four criteria is met, the lease is reported as a capital lease: 1. Legal ownership is conveyed to the lessee. 2. A bargain purchase option is included in the contract. 3. The life of the lease is equal to or greater than 75 percent of the life of asset 4. Payments approximate the acquisition value of the asset. b. The term “off-balance sheet financing” is commonly used when a company is obligated for more money than the debt that is reported on the balance sheet. Operating leases are one of the primary examples of off-balance sheet financing because the only reported liability amount is to recognize any payment that is currently due. Future payments are disclosed but not recognized on the balance sheet. c. In form, all lease contracts are rental agreements. The arrangement is not for a purchase but for a lease. However, in substance, a lease contract can go beyond a pure rental agreement so that the lessee actually gains the benefits and risks incident to the ownership of the property. One goal of financial accounting is to report the substance of events and not merely the legal form.
6) a. As a capital lease, the liability is the present value of the future cash payments: $5,000 x 4.46511 = $22,326 (rounded) This liability balance is immediately reduced to $17,326 by the first payment. Interest expense for Year One is based on the 6 percent rate: $17,326 x 6 percent = $1,040 (rounded) b. Times interest earned is the company’s earnings before interest expense and income taxes (EBIT) divided by interest expense. Interest expense of $1,040 was computed above. $18,224/$1,040 = 17.5 times (rounded) c. Before signing the contract, stockholders’ equity was $280,000 (assets of $500,000 less liabilities of $220,000) so the debt-to-equity ratio was $220,000 to $280,000 or 0.79 to 1.00 (rounded). After signing the contract, stockholders’ equity is still $280,000 but the initial liability from the lease of $22,326 increases the reported debt. The debt-to-equity ratio is now $242,326 to $280,000 or 0.87 to 1.00 (rounded). The company incurred a new debt so the debt-to-equity ratio goes up. If the first payment is taken into consideration, the debt-to-equity ratio is $237,326 to $280,000 or 0.85 to 1.00 (rounded). 7) a. The gain on the sale of land is $230,000 ($300,000 sales price less $70,000 cost). The company’s total income before income taxes is $630,000 ($400,000 plus $230,000). With an effective tax rate of 30 percent, the income tax expense for the year is $189,000 ($630,000 times 30 percent). Net income reported for Year One is $630,000 less $189,000 or $441,000.
b. The company does not have to pay the income tax on the $230,000 gain (a tax of $69,000 based on the 30 percent tax rate) until it appears on the tax return in Year Three. However, the $69,000 is reported on the December 31, Year One, balance sheet as a deferred income tax liability. The gain is earned in Year One so the resulting income tax should also be reported at that time. 8) a. The figures that appear on a company’s income statement follow U.S. GAAP. These rules are created to ensure that financial statements fairly present the financial affairs of the organization. The figures that appear on a company’s tax return follow the laws and regulations of the Internal Revenue Code (IRC). Tax laws are written for many purposes including: the collection of tax revenues to run the government, the management of the economy, and to aid elements of society where that is considered appropriate. With such differing goals, many differences exist between financial reporting and tax reporting. b. A temporary tax difference refers to a revenue or an expense that appears in both the income statement and the tax return but in two different years. Often a company will attempt to recognize income immediately for financial reporting purposes (to help the company look financially healthy) but delay payment of taxes for as long as possible (to make further use of the money). Any difference in the two periods is a temporary tax difference. c. A deferred income tax liability indicates that a company has earned income that has been reported on its income statement. However, because of the tax laws, the income has not yet appeared on the company’s tax return. The company will eventually have to pay the appropriate tax on this income but that payment has been delayed by differences between U.S. GAAP and the IRC. d. Liabilities indicate that payments will have to be made in the future so that financial resources will be lost. A deferred income tax liability does have to be paid but that payment has been delayed. During the interim period, the company can make use of those resources to generate additional profits. 9) a. Income tax expense – current Income tax payable – current
$45,000 $45,000
Income to be taxed currently: $300,000 times 60 percent = $180,000 Income tax currently due: $180,000 times 25 percent = $45,000 Income tax expense – deferred Deferred income tax liability
$30,000 $30,000
Income to be taxed in the future: $300,000 times 40 percent = $120,000 Income tax payments deferred: $120,000 times 25 percent = $30,000 b. Earnings before income taxes Income taxes Current Deferred Net income
$300,000 $45,000 30,000
75,000 $225,000
10) a. At some point, the company agreed to make specified payments for the benefit of employees after they retire. Such benefits can include health insurance, life insurance, and educational costs. b. Step one: Future payments to be made by the company are estimated by an actuary. The actuary uses historical data, computer programs, and statistical models to estimate eventual payment amounts. Step two: The present value of the estimated future cash payments is calculated to derive the figure to be reported as the company’s present liability on the balance sheet. c. Because of the amount of uncertainty, the reported numbers are not expected to be very accurate. The anticipated length of the employee’s life can vary by years or even decades. The costs for health care and the like to be paid in the distant future are no more than guesses. A liability is not normally reported until the amount is reasonably subject to estimation. Critics argue that the liability for most postretirement benefits does not meet that standard. Others counter that the amount of these obligations can be so large that any estimate is better than reporting no liability.
11) a. Myrtle’s debt-to-equity ratio before the transactions in this problem occur. Debt-to-Equity Ratio = Total liabilities/Total stockholders’ equity Debt-to-Equity Ratio = $456,000/$320,000 Debt-to-Equity Ratio = 1.43 to 1.00 (rounded) b. The payment of the operating lease increases one asset (prepaid rent) and decreases another (cash) but has no impact on either debt or equity. The borrowing increases the reported liabilities by $103,000 to $559,000 The ownership investment increases stockholders’ equity by $57,000 to $377,000 Debt-to-Equity Ratio = $559,000/$377,000 Debt-to-Equity Ratio = 1.48 to 1.00 (rounded) 12) a. Total liabilities: $1,020 + $1,060 = $2,080 Total stockholders’ equity: $500 + $540 = $1,040 Debt-to-equity ratio: $2,080/$1,040 = 2.00 to 1.00 b. Times Interest Earned = Earnings before interest and taxes/Interest expense Times Interest Earned = $335/$30 Times Interest Earned = 11.17 times (rounded)
Answer to Comprehensive Problem A) a) Accounts Receivable Revenue
$5,000
Supplies Inventory Accounts Payable
$110
$5,000
b) $110
c) No entry needed. d) Purchases Accounts Payable
$11,900
Cash
$15,510
$11,900
e) Revenue
$15,510
f) Cash
$5,000 Accounts Receivable
$5,000
g) Accounts Payable Cash
$12,000
Cash Accumulated Depreciation Loss on Sale Equipment
$1,650 297 53
Salaries Expense Cash
$750
Salaries Expense Cash
$550
Allowance for Doubtful Accounts Accounts Receivable
$200
Salaries Payable Cash
$220
Salaries Expense Cash
$3,500
$12,000
h)
$2,000
i) $750
j) $550
k) $200
l) $220
m) $3,500
n) Unearned Revenue Revenue
$300
Cash
$200
$300
o) Prepaid Rent
$200
Rent Expense Cash
$500
Tax Expense Cash
$580
$500
p) $580
B)
Cash 4,767 12,000(g) (e)15,510 750(i) (f)5,000 550(j) (h)1,650 220(l) (o)200 3,500(m) 500(o) 580(p)
Allow. Doubtful Investment in Accounts Receivable Accounts Trading Securities Inventory 1,800 5,000(f) (k)200 180 1,600 2,682 (a)5,000 200(k)
9,027 Supplies 70 (b)110 180
Furniture 1,000 1,000
1,600 Prepaid Rent 200 200(o)
20 Prepaid Advertising
0
0
Accum. Depr.—Furn 85 85
1,600
2,682
Equipment Accum. Depr.—Equip 12,500 2,000(h) (h)297 1,260
10,500
Investment in Availablefor-Sale Securities 2,100 2,100
963
License Agreement 1,600 1,600
Accounts Payable (g)12,000 2,360 110(b) 11,900(d)
Salaries Payable Interest Payable Unearned Revenue Note Payable (l)220 220 15 (n)300 600 3,000
2,370
Capital Stock 2,000
0
15
3,000
Unrealized Gain/Loss— Retained Earnings AFS Securities Revenue Dividend Revenue 18,249 350 5,000(a) 15,510(e) 300(n)
2,000 Unrealized Gain/Loss— Trading Securities
18,249
350
Gain/Loss on Sale of Trading Securities
0
500
0
Utilities Expense
580
0
Depreciation Expense
20,810
Tax Expense (p)580
Rent Expense Bad Debt Expense Purchases (o)500 (d)11,900
Amortization Expense
0
Loss on Sale of Equipment (h)53
0
Supplies Expense
0
0
Cost of Goods Sold
Salaries Expense (i)750 (j)550 (m)3,500
11,900
0
53
300
0
4,800
Advertising Expense
Interest Expense
0
0
C) Webworks Unadjusted Trial Balance March 31 Account Title Debits Cash $ 9,027 Accounts Receivable 1,600 Allowance for Doubtful Accounts 20 Investment in Trading Securities 1,600 Inventory 2,682 Supplies 180 Prepaid Rent 0 Prepaid Advertising 0 Equipment 10,500 Accum. Depreciation—Equipment Furniture 1,000 Accum. Depreciation—Furniture Investment in AFS Securities 2,100 License Agreement 1,600 Accounts Payable Salaries Payable Interest Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 3/1 Revenue Dividend Revenue Unrealized Gain/Loss on Trading Securities Unrealized Gain/Loss on AFS Securities Gain/Loss on Sale of Trading Securities Salaries Expense 4,800 Tax Expense 580 Utilities Expense 0 Supplies Expense 0 Rent Expense 500 Bad Debt Expense 0 Purchases 11,900 Cost of Goods Sold 0 Depreciation Expense 0 Amortization Expense 0 Advertising Expense 0
Credits
$
963 85
2,370 0 15 300 3,000 2,000 18,249 20,810 0 0 350 0
Interest Expense Loss on Sale of Equipment
0 53
_______
Totals
$48,142
$48,142
Salaries Expense Salaries Payable
$350
Utilities Expense Accounts Payable
$400
Supplies Expense Supplies
$130
Bad Debt Expense Allowance for Doubtful Accounts
$180
Depreciation Expense Accumulated Depreciation—Equip
$175
Depreciation Expense Accumulated Depreciation—Furn
$17
Amortization Expense License Agreement
$200
D) q) $350
r) $400
s) $130
t) $180
u) $175
$17
v) $200
w) Investment in AFS Securities $175 Unrealized Gain on AFS Securities
$175
Investment in Trading Securities $200 Unrealized Gain on Trading Securities
$200
Interest Expense Interest Payable
$15
x) $15
y) Cost of Goods Sold Purchases Inventory
Cash 4,767 12,000(g) (e)15,510 750(i) (f)5,000 550(j) (h)1,650 220(l) (o)200 3,500(m) 500(o) 580(p)
$11,900 358
Allow. Doubtful Investment in Accounts Receivable Accounts Trading Securities 1,800 5,000(f) (k)200 180 1,600 (a)5,000 200(k) 180(t) (w)200
9,027
1,600
Supplies 70 130(s) (b)110
Prepaid Rent 200 200(o)
50
Furniture 1,000
$12,258
160
Prepaid Advertising
0
0
Accum. Depr.—Furn 85 17(u)
1,000
102
Accounts Payable (g)12,000 2,360 110(b) 11,900(d) 400(r) 2,770
1,800
2,324
Equipment Accum. Depr.—Equip 12,500 2,000(h) (h)297 1,260 175(u) 10,500
Investment in Availablefor-Sale Securities 2,100 (w)175 2,275
Inventory 2,682 358(y)
1,138
License Agreement 1,600 200(v)
1,400
Salaries Payable Interest Payable Unearned Revenue Note Payable (l)220 220 15 (n)300 600 3,000 350(q) 15(x)
350
30
300
3,000
Unrealized Gain/Loss— AFS Securities Revenue Dividend Revenue 350 5,000(a) 175(w) 15,510(e) 300(n)
Capital Stock 2,000
Retained Earnings 18,249
2,000
18,249
Unrealized Gain/Loss— Trading Securities 200(w)
Gain/Loss on Sale of Trading Securities
200
525
20,810
Tax Expense (p)580
0
0
Utilities Expense (r)400
580
400
130
Rent Expense Bad Debt Expense Purchases Cost of Goods Sold (o)500 (t)180 (d)11,900 11,900(y) (y)12,258
500
180
Depreciation Expense (u)175 (u)17
0 Amortization Expense (v)200
192
Supplies Expense (s)130
Salaries Expense (i)750 (j)550 (m)3,500 (q)350
12,258
5,150
Advertising Expense
200
Interest Expense (x)15
0
15
Loss on Sale of Equipment (h)53 53 E) Webworks Adjusted Trial Balance March 31 Account Title Cash Accounts Receivable Allowance for Doubtful Accounts Investment in Trading Securities
Debits $ 9,027 1,600
Credits
$ 1,800
160
Inventory 2,324 Supplies 50 Prepaid Rent 0 Prepaid Advertising 0 Equipment 10,500 Accum. Depreciation—Equipment Furniture 1,000 Accum. Depreciation—Furniture Investment in AFS Securities 2,275 License Agreement 1,400 Accounts Payable Salaries Payable Interest Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 3/1 Revenue Dividend Revenue Unrealized Gain/Loss on Trading Securities Unrealized Gain/Loss on AFS Securities Gain/Loss on Sale of Trading Securities Salaries Expense 5,150 Tax Expense 580 Utilities Expense 400 Supplies Expense 130 Rent Expense 500 Bad Debt Expense 180 Purchases 0 Cost of Goods Sold 12,258 Depreciation Expense 192 Amortization Expense 200 Advertising Expense 0 Interest Expense 15 Loss on Sale of Equipment 53
______
Totals
$49,634
$49,634
1,138 102
2,770 350 30 300 3,000 2,000 18,249 20,810 0 200 525 0
F) Webworks Income Statement As of March 31 Revenue Cost of Goods Sold Gross Profit Deprec. and Amort. Expense Other Expenses and Losses Investment Income (Loss) Earnings Before Interest & Tax Interest Expense Earnings Before Tax Tax Expense Net Income
$20,810 (12,258) 8,552 (392) (6,413) 200 1,947 (15) 1,932 (580) $ 1,352
Webworks Stmt. of Retained Earnings As of March 31 Retained Earnings, March 1 Net Income Retained Earnings, March 31
$18,249 1,352 $19,601
Webworks Balance Sheet March 31 Assets: Current: Cash Accounts Receivable 1,600 less Allow. for Doubt. Accts.(160) Net Accounts Receivable Trading Securities, net Merchandise Inventory Supplies Inventory Total Current Assets Property, Plant, and Equipment Equipment less Accumulated Depreciation Furniture less Accumulated Depreciation Total P, P, and E
Liabilities:
$ 9,027
1,440 1,800 2,324 50 $14,641
$10,500 (1,138) 1,000 (102) $10,260
Other Noncurrent Assets: Available-for-Sale Securities License Agreement, net
$ 2,275 1,400
Total Assets
$28,576
Current: Accounts Payable Salaries Payable Interest Payable Unearned Revenue
$ 2,770 350 30 300
Total Current Liabilities
$ 3,450
Noncurrent: Note payable
$ 3,000
Owners’ Equity: Capital Stock $ 2,000 Retained Earnings 19,601 Other Accumulated Comprehensive Income: Unrealized gain on Available-forSale Securities 525 Total Owners’ Equity $22,126 Total Liabilities & Owners’ Equity
$28,576
Answer to Research Assignment a. The February 26, 2011, balance sheet for this company indicates that the current maturity of long-term debt and capital lease obligations is $403 million and that the longterm debt and capital lease obligation is $6,348 million. Note 6 gives more detail and indicates that $1,154 million of this debt was incurred in connection with capital lease obligations.
b. According to note 7, the company will have to pay $3,111 million in cash because of its operating leases. c. According to note 7, the company will have to pay $1,914 million in cash because of its capital leases. However, the present value of those cash flows is $1,154 million. Of that amount, $66 million is a current liability and the remaining $1,088 is noncurrent.
Chapter 16 Solutions Answers to Questions 1) In the U.S., the three primary legal forms used to establish businesses are sole proprietorships (one owner), partnerships (more than one owner), and corporations (created by the state government). 2) In some states, the incorporation process can be both costly and time-consuming and expose the business to additional amounts of government regulation. These partners might also have wanted to avoid the double taxation effect that often makes corporate ownership costly over time. In some situations, those negatives outweigh the positives that can be derived from incorporation. 3) As a sole proprietor, Hans Iverson will include the business’s entire $600,000 profit on his individual income tax return but pays no further tax on the $400,000 distribution. Conversely, if formed as a separate corporation, the business will report $600,000 as its income and pay the appropriate tax on that amount. In addition, Hans Iverson will pay a second tax on the $400,000 distribution included on his individual income tax return as a dividend. This situation illustrates the double taxation effect that is an inherent disadvantage to the owners of a corporation. 4) As a corporation, Jill’s potential loss is limited to the amount she contributed or $30,000. Corporations are popular because of the owners are exposed to only limited liability. As a partnership, both Jill and Jack are liable personally for all business debts. If the bank proceeds against her, she could lose her original $30,000 contribution and still be held liable for the entire $1 million debt. For that reason, partners in a partnership are said to have unlimited liability. 5) The specific rights of the holders of common stock shares are set by the laws of the state in which the business was incorporated. For example, common share stockholders are normally allowed to vote for the members of the board of directors. Plus, if a dividend is declared on the common stock, each stockholder is entitled to a percentage equal to his or her percentage ownership. Other rights vary by state. 6) The original issuance of the share came from the company. Therefore, the $13 paid by Beckett increased the assets (cash) of Anston Company and is also reflected through an increase in the balance reported as contributed capital within stockholders’ equity. Beckett’s sale of the share to O’Coron was a transaction between two investors and had no financial impact on the company at all. For Anston, the identity of one of its owners changed. 7) In many states, a par value has long been required for a share of a corporation’s capital stock. Over time, the significance of the meaning of that par value has largely faded. The par value of a share is the minimum amount of money that the owner must legally
leave in the business. However, par values for common stock shares are typically set so low that the minimum is virtually zero. 8) The authorized number of shares of capital stock of a corporation is the maximum number of shares it is allowed to issue by the state government where it was incorporated. The number of issued shares of capital stock is the quantity that has been sold or otherwise conveyed to owners since the corporation’s inception. The number of outstanding shares of capital stock is the total amount of stock currently in the hands of the public. The quantity of issued and outstanding shares will differ if a corporation has repurchased any of its own capital stock shares as treasury stock. 9) Issued shares of common stock are recorded at par value with any amount received above that number identified as “capital in excess of par value.” These two accounts must be added to arrive at the total amount of capital contributed by stockholders. Cash
$9,000 Common stock Capital in excess of par value
$2,000 7,000
10) The land should be recorded at the $9,000 fair value of the 1,000 shares that were issued to obtain this property. The fair value of the land is only used for recording purposes if the value of the shares is unknown. Land
$9,000 Common stock Capital in excess of par value
$2,000 7,000
11) A corporation’s reported net income is never affected by transactions that occur in its own capital stock. Those transactions merely increase or decrease the amount that the stockholders have contributed to the business and are not viewed as income producing transactions. 12) Preferred stock shares provide owners with one or more preferences to specified rights. Those rights then take precedence before the rights of the common shareholders. These preference rights are not set by state law but by the preferred stock certificate. Basically, the common stockholders agree to surrender or subrogate some of their legal rights in order to get money from these other owners. One common preference is the right to a set dividend before any distributions can be made to the owners of the common stock. Other possible preferences include additional voting rights, assured
representation on the board of directors, and the right to residual assets if the company ever liquidates. By offering additional, specified rights, the issuance of preferred stock provides the corporation with a way of enticing additional investors to contribute money. In addition, especially if a large set dividend is provided for the preferred stock, the owners of the common stock might be able to reduce the voting power assigned to the new owners (and, hence, maintain its own voting power). Many investors are inclined to buy preferred stock because the anticipated return (the dividend) is often known in advance. Therefore, the investor faces less risk. Some investors want safer investments. Because of the reduction in risk, the stock market price of preferred shares tends to be much less volatile than that of common stock. 13) Corporations often repurchase shares of their own capital stock as a strategy for reducing the risk of a hostile takeover. Buying back treasury stock makes a takeover more difficult for two related reasons. First, after the repurchase, fewer shares are available on the market. Most of the outstanding shares of many companies are not held for sale and, therefore, are not on the market for purchase. If the company removes shares from the market by repurchase, the number of available shares will decrease making it harder for an outside party to gain control. Second, because the number of available shares has gone down, the price of the stock will usually rise which can make the takeover more expensive. 14) Acquisition of treasury stock can be used as a tactic by the management (or board of directors) to push up the market price of a company’s stock in order to please the remaining stockholders. Buying treasury stock reduces the supply of shares in the market and, according to economic theory, forces the price to rise. In addition, because of the repurchase announcement, outside investors often rush in to buy the stock ahead of the expected price increase. Supply of shares on the market is decreased while demand is increased. The stock price should go up. 15) March 17 is the date of declaration by the board of directors. The number of outstanding shares (5 million) is multiplied by the dividend ($0.60 per share) to arrive at the amount to be distributed. The debit in this entry can also be made to Dividends Paid instead of directly to Retained Earnings. Retained earnings Dividend payable
$3,000,000 $3,000,000
March 29 is the date of record, the date on which the identity of the owners who will receive the dividend is determined. No transaction occurs so no entry is made.
April 11 is the date of payment (or date of distribution) when the checks are mailed or otherwise conveyed to the owners. Dividend payable Cash
$3,000,000 $3,000,000
16) When the term “cumulative” is applied to preferred stock, it means that any dividends that have been missed in the past (known as “dividends in arrears”) must be paid before the owners of common stock can receive a dividend. It does not promise or guarantee that the dividend will be distributed only that it must be paid before money is given to the common stockholders. Therefore, if a dividend is not paid on a cumulative preferred stock, that information must be disclosed but no liability is recognized because no debt exists. A liability is only reported when a dividend has been formally declared by a company’s board of directors. A noncumulative preferred stock is one where the company has no contractual need to pay a dividend that is missed. Consequently, no reporting is necessary if a noncumulative dividend is not paid in a timely manner on preferred stock. 17) The preferred stock dividend is cumulative. Therefore, the first $30,000 ($100 par value times 6 percent times 5,000 shares outstanding) distributed in Year Two goes to the preferred stockholders to settle their Year One dividend. The next $30,000 also goes to the preferred stockholders as the Year Two dividend. The residual $20,000 ($80,000 less $30,000 and less $30,000) is paid to the owners of the common stock. With 40,000 shares outstanding, that dividend is $0.50 per share for the common stock ($20,000/40,000 shares). 18) Before the stock dividend, Fonseca held 8 percent of the outstanding shares (8,000 shares/100,000 shares) of a company with net assets of $900,000 ($1.4 million less $500,000). After the 20 percent stock dividend, she holds 8 percent of the outstanding shares (9,600 shares/120,000 shares) of a company that still has net assets of $900,000 ($1.4 million less $500,000). Although she holds more shares, she has the same percentage of a company that has not changed. Consequently, an owner who receives a stock dividend makes no journal entry because no financial effect has taken place. 19) When a stock dividend or stock split is distributed, the additional number of shares causes the market price to go down (the pie is the same size but it has been cut into more pieces so each piece is smaller and, therefore, sells for less). At the lower price, owners hope that the stock will be more attractive to potential investors so that the level of market trading activity will increase. According to economy theory, an increase in demand for the shares should cause an increase in market price. In addition, some companies that distribute a stock dividend or stock split will try not to reduce future dividends proportionally. Therefore, the stockholders can hope that the increase in shares held will lead to a greater amount of cash dividends in the future.
20) According to U.S. GAAP, a small stock dividend (one that is 20 to 25 percent additional shares or less) is recorded at the fair value of the shares issued. If the 35,000 additional shares was caused by a 10 percent stock dividend, retained earnings is reduced by $1,015,000 (35,000 shares times $29 per share). However, for a large stock dividend (one that is greater than 20 to 25 percent additional shares), retained earnings is only reduced by the par value of these shares. Thus, if this stock dividend is equal to 40 percent of the outstanding shares, retained earnings is only reduced by $70,000 (35,000 shares times $2 per share). In an odd result of the official accounting rules, the reduction in retained earnings is considerably higher here if the dividend is a small stock dividend rather than a large stock dividend. 21) Return on equity (ROE) is calculated by taking the reported net income for the year and dividing it by the average amount of stockholders’ equity for the same period. ROE measures management’s ability to make profitable use of the business’s net assets (assets less liabilities). ROE helps to indicate what impact an increase in stockholders’ equity (an additional contribution from owners, for example) might have on reported net income. 22) Earnings per share (EPS) is a computation that determines the portion of net income that can be assigned to each share of common stock. Common stock is known as a residual ownership because its owners are entitled to any net income that remains after all other claims (such as preferred stock dividends) have been settled. Basic EPS is computed by first subtracting preferred stock dividends from net income to derive the income balance left for the common stock shares. That figure is then divided by the average number of common stock shares outstanding during the year. 23) 120,000 shares x 3 months = 360,000 140,000 shares x 9 months = 1,260,000 Total / 12 months 1,620,000 / 12 = 135,000 shares Basic EPS = $300,000 / 135,000 shares = $2.22 per share Total net income is used here because no preferred stock dividends are indicated. 24) A company’s price-earnings ratio (P/E ratio) is calculated by dividing the current price of the company’s common stock by its most recent earnings per share. Many investors and financial analysts use the P/E ratio as a way to anticipate stock prices in the future. For example, if a company has a P/E ratio of 14.6 and is expected to report EPS of $5.00 in the next period, then one prediction is that the stock price will move to $73.00 per share (14.6 times $5). As might be imagined, a lot of time and energy goes into predicting a company’s future EPS and the related impact on the P/E ratio to provide an
approximation of the future stock price. The ability to predict stock prices is one key for success in investing. 25) Diluted EPS is a hypothetical computation that reduces basic earnings per share to reflect the possible decrease if outstanding convertible items are actually turned into common stock. Conversion is assumed and the anticipated results are measured and reflected in the determination of diluted EPS. This lowered number provides a warning to investors that outstanding convertible items (such as convertible preferred stock, convertible bonds, or stock options) can reduce EPS in the future simply by being converted.
Answers to True or False Questions __T__ 1) A person can create a sole proprietorship simply by starting to do business. No formal documents are necessary and approval by the state is not needed. __T__ 2) The corporate form of business allows owners to have limited liability and makes transfer of ownership easier. For those and other reasons, most businesses of any size either begin as corporations or are converted to corporations. As businesses grow larger, the benefits of the corporate form begin to far outweigh the disadvantages. __T__ 3) In a corporation, an owner risks losing the amount invested in the business but, usually, no more than that. The owner’s liability is limited to that known amount. In a partnership, the partners can be held liable for all the debts of the business. The maximum loss for a partner is uncertain. __F__ 4) Mutual agency is a characteristic of a partnership whereby any partner can obligate other partners to an agreement without their direct consent. For owners, mutual agency is a major disadvantage of a partnership because they can be held responsible for obligations that they did not create. __F__ 5) All corporations in the U.S. issue common stock but only a small minority (maybe 510 percent) issue preferred stock. __F__ 6) The par value listed on capital stock shares indicates the minimum amount of money owners must legally leave in the business. Most states, but not all, require a par value to be identified with the shares of a corporation’s capital stock. In recent years, the par value for many common stock shares has been an extremely low amount such as a penny or a nickel. __F__ 7) The owners of a corporation’s capital stock have the right to vote on the election of the board of directors to oversee the management of the company and set its policies and priorities.
__T__ 8) Any difference in the number of outstanding shares (those shares held by the public at the current time) and the number of shares originally issued represents shares that have been issued but repurchased by the company. These shares are known as treasury stock. __F__ 9) Dividends are only paid by a corporation on those shares of capital stock that are outstanding, the shares that are being held by the public. __F__10) For a dividend distribution, the liability is first reported by a corporation on the date that the board of directors declares the dividend, a day that is often referred to as the date of declaration. __F__11) Only dividends that have been formally declared by a corporation’s board of directors are recorded as liabilities. A cumulative dividend is not a guaranteed dividend so no liability exists until the date of declaration. For disclosure purposes, a note should be included with the financial statements to explain the obligation for any cumulative preferred stock dividends that are in arrears. __T__12) The sale of a corporation’s capital stock from one stockholder to another changes the identity of the owner but has no financial impact on the company. A corporation’s net assets neither increase nor decrease as a result of a change in ownership. __F__13) A company never records an income effect resulting from a transaction in its own capital stock. Those events are considered changes in the amount of contributed capital and not income producing transactions. Here, the land is recorded at $36,000, the fair value of the shares issued. Contributed capital is also increased by this same $36,000 so that no gain or loss is recorded. __F__14) If a company repurchases shares of its own capital stock, the cost is recorded as treasury stock and shown as a reduction within stockholders’ equity. By this reporting, the treasury stock is reported in a manner somewhat the opposite of contributed capital because the money is paid to the owners rather than coming from the owners. __T__15) A company never records an income effect (neither a gain nor a loss) from a transaction in its own capital stock. Such events are considered changes in the amount of contributed capital and not income producing transactions. __T__ 16) Any purchaser of a share of capital stock on the ex-dividend date will not be entitled to receive a dividend that has been declared but not yet paid. Starting on that date, the stock is acquired without the dividend. Because the right to the dividend has been lost, the stock is not viewed as quite so valuable and the price will tend to fall by roughly the amount of the dividend. __T__ 17) On December 18, Year One, the dividend declaration leads to the reporting of a liability. Working capital is reduced. On January 22, Year Two, both the liability and the cash accounts will decrease so no change is made in the amount of working capital.
__F__ 18) The term “cumulative” means that the preferred stock dividend must be paid before any dividend can be distributed to the holders of common stock. However, the term does not obligate the corporation to pay the dividend. Without a legal obligation, the holders of preferred shares cannot petition a company into bankruptcy. __F__ 19) The receipt of a stock dividend or stock split does not improve an investor’s financial position. The same percentage of ownership is held before and after the receipt of the shares. And, the amount of net assets reported by the company is not affected. Without some change in financial position, the stockholder has no reason to make any entry. __F__ 20) In recording a small stock dividend (one of 20-25 percent additional shares or less), retained earnings is reduced by the fair value of the shares issued. Here, that decrease is 15,000 shares times the fair value of each share. In recording a large stock dividend (one of more than 20-25 percent additional shares), retained earnings is reduced by the par value of the shares issued. Here, that decrease is 30,000 shares times the par value of each share. For example, if the par value is $1 per share whereas the fair value is $18 per share, the 15,000 share dividend reduces retained earnings by $270,000 (15,000 shares times $18) but the 30,000 share dividend only reduces retained earnings by $30,000 (30,000 shares times $1). With these amounts, the small stock dividend reduces retained earnings by nine times more than the large stock dividend. __F__ 21) Return on equity (ROE) is found by dividing net income for a period of time by the average amount of total stockholders’ equity for the same period. __T__ 22) Basic earnings per share is studied by many investors and other decision makers to help anticipate future stock prices. Therefore, the information is required by U.S. GAAP for companies that are publicly traded. If a company is not publicly traded, stock price is rarely considered so that earnings per share figures serve little purpose and are not required to be disclosed. __F__ 23) Earnings per share is a common stock computation. Common stock is a residual ownership entitled to whatever remains after all other claims have been settled. As such, the net income allocated to common stock is determined first by subtracting preferred stock dividends from reported net income. Because that figure is for a period of time, it is divided by the weighted average number of common stock shares outstanding for that same period __T__ 24) The price-earnings ratio (P/E ratio) is found by dividing the current price of a company’s common stock by its earnings per share. __F__ 25) To compute basic earnings per share (EPS), any preferred stock dividends for the current period are subtracted from net income to derive the portion of net income assigned to common stock. Here, that amount is $500,000 less $100,000 or
$400,000. This earnings figure is then divided by the weighted average number of shares of common stock outstanding for the period (100,000 in this question). Basic EPS is $400,000/100,000 shares or $4.00 per share. The common stock cash dividend is not subtracted because it is part of the earnings amount that goes to the common stock shareholders. __T__ 26) Diluted earnings per share (EPS) takes a company’s basic EPS figure and adjusts it for any potentially negative impact that would occur if convertible items (such as convertible bonds, convertible preferred stock, or stock options) were to be converted into additional shares of common stock.
Answers to Multiple Choice Questions 1) Answer is A Limited liability is one of the primary reasons that owners choose to create corporations rather than partnerships. In a corporation, all of the owners know they can lose their investments but the risk does not go beyond that amount. In a partnership, because of the legal concept of mutual agency, individual partners can be held liable for all debts of the business. That amount is unlimited. Therefore, the corporate form is popular despite the drawback of double taxation and the cost and time that it takes to get state approval for incorporation. 2) Answer is A The rights of the owners of a corporation’s common stock are set by the state government in which the business was originally incorporated. Those rights will vary a bit between states. However, all common stockholders have the right to vote in the election of a smaller group (a board of directors) to oversee the management of the company and set its policies. 3) Answer is A The issuance of capital stock is always recorded at par value which in this case is 16,000 shares times $0.50 or $8,000. Any amount received in excess of that par value is recorded in a contributed capital account often labeled as “capital in excess of par value.” The total contributed by the owners can be found by adding the common stock balance with the capital in excess of par value. 4) Answer is D When the 4,000 shares were issued, the company received $8 more than par value ($9 less $1) or $32,000. No other transaction impacted the Capital in Excess of Par Value account. The dividend reduces retained earnings and the repurchased shares are recorded within stockholders’ equity at cost as treasury stock.
5) Answer is B If a company acquires property, such as this licensing agreement, by issuing shares of its own capital stock, the transaction is recorded at cost which is the fair value of the shares surrendered. Here, that is 2,000 shares at $14 per share or $28,000. Traylor records the issuance of this common stock at its $4,000 total par value (2,000 shares times $2 per share) with the remaining $24,000 increasing capital in excess of par value. 6) Answer is B The preferred stock dividend is $8 per year ($100 par value times 8 percent rate). To date, 5,000 shares have been issued and remain outstanding. The dividend was declared on December 13, Year One. The liability on the year-end balance sheet is $8 per share times 5,000 shares or $40,000. 7) Answer is A Initially, the company issued 10,000 shares of its common stock for $13 per share so stockholders’ equity increased by $130,000. Later, the company bought back 2,000 of these shares at $19 per share so stockholders’ equity dropped by $38,000. No other transactions directly impacted the company. Stockholders’ equity is reported as $92,000 ($130,000 less $38,000). 8) Answer is B Under normal conditions, the balance of retained earnings is total net income ($40,000 per year for three years or $120,000) less total dividends ($10,000 per year for three years or $30,000). Those events leave a balance of $90,000. However, the company also repurchased and sold treasury stock during the year. The reissuance of 2,000 shares created a loss which (as shown in the following entries) reduces retained earnings by $4,000. Thus, after three years, the reported retained earnings balance is $86,000 ($90,000 less $4,000). ---Treasury stock Cash
$150,000 $150,000
10,000 shares repurchased at a cost of $15 per share ---Cash
$17,000 Treasury stock Capital in excess of cost-treasury stock
$15,000 2,000
1,000 shares bought for $15 per share are sold for $17 per share. $2,000 “gain” is recorded as capital in excess of cost.
---Cash Capital in excess of cost-treasury stock Retained earnings Treasury stock
$24,000 2,000 4,000 $30,000
2,000 shares bought for $15 per share are sold for $12 per share. $6,000 “loss” is first used to reduce previous $2,000 balance established as “capital in excess of cost.” Remaining $4,000 reduces retained earnings. 9) Answer is B When a stock dividend is issued, no change occurs in the net assets of the company. Each owner simply has more shares of stock. Because each owner receives the same proportion as its current ownership, they maintain their current level of ownership. The increase in the quantity of shares with no change in the net assets of the company causes the stock price to drop rather dramatically. At lower prices, more investors are often interested in buying shares. Hopefully, this increase in demand and trading activity will cause a rise in the stock price. 10) Answer is D If the stock dividend is 10 percent, it will be viewed for accounting purposes as a small stock dividend (20-25 percent additional shares or less). As a small stock dividend, the reduction in retained earnings is measured at the fair value of the 20,000 shares. Retained earnings will drop by $300,000 (20,000 shares issued with a $15 per share fair value). If the stock dividend is raised to 30 percent, it will be viewed for accounting purposes as a large stock dividend (more than 20-25 percent additional shares). As a large stock dividend, the reduction in retained earnings is measured at the par value of the 60,000 shares. Retained earnings will drop by $60,000 (60,000 shares issued with a $1 per share par value). Because the drop is less with the large stock dividend, retained earnings will be a higher reported balance by $240,000 ($300,000 less $60,000). 11) Answer is A Treasury stock is normally recorded at cost as a negative figure within stockholders’ equity on the balance sheet. It is not reported as a reduction in retained earnings or as an asset. If resold at either above or below cost, no income effect can be recognized. These transactions are viewed as changes in the amount that owners have contributed to the corporation and not as income producing events.
12) Answer is B A small stock dividend (one that issues 20-25 percent additional shares or less) is recorded at the fair value of those shares. In a 5 percent stock dividend, 4,500 additional shares (90,000 times 5 percent) are issued and recorded at their fair value of $26 per share or $117,000. A large stock dividend (one that issues more than 20-25 percent additional shares) is recorded at the par value of those shares. In a 40 percent stock dividend, 36,000 additional shares (90,000 times 40 percent) are issued and recorded at their par value of $0.25 per share or $9,000. 13) Answer is A Net income for the year was $12,000 and an $8,000 dividend was paid. Thus, stockholders’ equity increased during this period by the $4,000 net difference. Ending stockholders’ equity was $492,000 so beginning stockholders’ equity was $488,000 and the average for the year was $490,000. ROE is net income divided by average stockholders’ equity or $12,000/$490,000 which is 2.45 percent (rounded). 14) Answer is B Basic EPS = (Net Income − Preferred Dividends)/Number of outstanding shares of common stock Basic EPS = ($480,000 − $30,000)/50,000 shares Basic EPS = $9.00 per share 15) Answer is C Average number of shares of common stock for the year: 190,000 x 3 months 570,000 230,000 x 9 months 2,070,000 Average shares 2,640,000 / 12 = 220,000 Basic EPS = (Net Income − Preferred Dividends)/Weighted average number of shares of common stock outstanding Basic EPS = ($710,000 − $50,000)/220,000 shares Basic EPS = $3.00 per share 16) Answer is C Basic EPS = (Net Income − Preferred Dividends)/Weighted average number of shares of common stock outstanding Basic EPS = ($400,000 − $60,000)/100,000 shares Basic EPS = $3.40 per share
17) Answer is C Average number of shares of common stock for the year: 600,000 x 8 months 4,800,000 450,000 x 4 months 1,800,000 Average shares 6,600,000 / 12 = 550,000 Basic EPS = (Net Income − Preferred Dividends)/Weighted average number of shares of common stock outstanding Basic EPS = ($1,870,000 − -0-)/550,000 shares Basic EPS = $3.40 per share Price-earnings ratio = $26.00/$3.40 = 7.65
Answers to Problems
1) No journal entry is made for the authorization of shares. The state government is merely allowing the corporation to issue a maximum number of shares to raise capital. March 15 Cash
$6,000 Common stock Capital in excess of par value
$1,000 5,000
1,000 shares of $1 par value stock issued for $6 per share April 19 Cash
$5,600 Common stock Capital in excess of par value
$ 800 4,800
800 shares of $1 par value stock issued for $7 per share
2) a. January 22 Cash $7,200,000 Preferred stock Capital in excess of par value
$6,400,000 800,000
32,000 shares of $200 per share par value stock issued for $225 per share b. September 1 Retained earnings Cash dividend payable
$320,000 $320,000
Annual dividend is $10 per year ($200 par value times 5 percent dividend rate). Total dividend on the 32,000 shares outstanding is $320,000 October 1 Cash dividend payable Cash
$320,000
Monday Treasury stock Cash
$87,500
$320,000
3) a.
$87,500
b. Tuesday Cash
$37,000 Treasury stock Capital in excess of cost-treasury stock
$35,000 2,000
Wednesday Cash $17,000 Capital in excess of cost-treasury stock 500 Treasury stock
$17,500
Thursday Cash $16,800 Capital in excess of cost-treasury stock 1,500 Retained earnings 2,700 Treasury stock
$21,000
c.
d.
e. Friday Retained earnings Cash dividends payable
$32,600 $32,600
4) a. No journal entry is needed. The authorization has no financial impact on the company. b. Cash
$12,000 Common stock Capital in excess of par
$10,000 2,000
c. Equipment Common stock Capital in excess of par
$6,000 $5,000 1,000
Transaction recorded at the fair value of the shares issued (500 shares times $12 per share or $6,000). d. Retained earnings Cash dividend payable
$3,000 $3,000
Divided declared of $2 per share times 1,500 shares outstanding or $3,000. e. No journal entry is needed. The listing of owners who will receive the dividend does not have a financial impact on the company. f. Cash dividends payable Cash
$3,000
Retained earnings Common stock Capital in excess of par
$2,850
$3,000
g. $1,500 1,350
Stock dividend is equal to 10 percent of the 1,500 outstanding shares or 150 additional shares. As a small stock dividend, these shares are recorded at a fair value of $19 per share or $2,850 in total.
h. Treasury stock Cash
$4,800
Cash
$3,400
$4,800
i. Treasury stock Capital in excess of cost
$3,200 200
j. Cash Capital in excess of cost Retained earnings Treasury stock
$1,100 200 300
Retained earnings Common stock
$6,600
$1,600
k. $6,600
Stock dividend is equal to 40 percent of the 1,650 outstanding shares or 660 additional shares. As a large stock dividend, these shares are recorded at the par value of $10 per share or $6,600 in total. 5) a. No recording is necessary for the Year One dividend that was missed. The company has no obligation to make any payment so a liability should not be recognized. b. The preferred stock will be paid a total of $40,000 (10 percent times the $40 par value times the 10,000 shares outstanding). That payment leaves $60,000 to be distributed to the common stock. The company has 40,000 shares of common stock outstanding. The owner of each share will be paid $1.50 ($60,000/40,000 shares). c. Even if a cumulative dividend is missed, no guarantee exists that payment will ever be made. Dividends are only distributed based on the declaration of the board of directors. However, any dividends in arrears must be paid to the preferred stock before common stock receives any money. This information is important to decision makers and must be disclosed in the financial statements.
d. The preferred stock will be paid a total of $80,000 (10 percent per year times the $40 par value times the 10,000 shares outstanding or $40,000 per year for two years). This payment leaves $20,000 to be distributed to the owners of common stock. The company has 40,000 shares of common stock outstanding so the owner of each share will be paid $0.50 ($20,000/40,000 shares). 6) a. Rostinaja Company Stockholders’ Equity Section of Balance Sheet December 31, Year One Contributed capital Common stock (200,000 shares authorized with a $3.00 per share par value, 40,000 shares issued and outstanding) Capital in excess of par value Contributed capital Retained earnings, December 31, Year One Total stockholders’ equity
$120,000 200,000 $320,000 80,000 $400,000
b. Rostinaja Company Stockholders’ Equity Section of Balance Sheet December 31, Year Two Contributed capital Common stock (200,000 shares authorized with a $3.00 per share par value, 40,000 shares issued and 35,0000 shares outstanding) Capital in excess of par value Contributed capital
$120,000 200,000 $320,000
Retained earnings, December 31, Year Two
160,000
Less: Treasury stock (5,000 shares at cost)
(60,000)
Total stockholders’ equity
$420,000
c. Rostinaja Company Stockholders’ Equity Section of Balance Sheet December 31, Year Three Contributed capital Common stock (200,000 shares authorized with a $3.00 per share par value, 40,000 shares issued and 36,0000 shares outstanding) Capital in excess of par value Capital in excess of cost – treasury stock Contributed capital
$120,000 200,000 2,000 $322,000
Retained earnings, December 31, Year Three
240,000
Less: Treasury stock (4,000 shares at cost)
(48,000)
Total stockholders’ equity
$514,000
d. Rostinaja Company Stockholders’ Equity Section of Balance Sheet December 31, Year Four Contributed capital Common stock (200,000 shares authorized with a $3.00 per share par value, 40,000 shares issued and outstanding) Capital in excess of par value Contributed capital
$120,000 200,000 $320,000
Retained earnings, December 31, Year Four
310,000
Total stockholders’ equity
$630,000
Retained earnings increases by $80,000 each year. That is the net income of $130,000 each year less the annual $50,000 dividend. When the final 4,000 shares of treasury stock are reissued, a loss of $3 per share is incurred ($12 cost per share less $9 cash received) or $12,000 in total. The first $2,000 of that amount eliminates the Capital in Excess of Cost-Treasury Stock account. The remaining $10,000 reduces retained earnings which is $320,000 after four years so that only $310,000 is reported.
7) a. Cash
$336,000 Common stock Capital in excess of par
$ 14,000 322,000
b. Retained earnings, January 1, Year Seven Net income
$80,000
Dividends distributed
(19,000)
Retained earnings, December 31, Year Seven
$1,950,000
61,000 $2,011,000
c. Treasury stock Cash
$242,000 $242,000
d. Grayson Corporation Stockholders’ Equity Section of Balance Sheet December 31, Year Seven Contributed capital Common stock (2 million shares authorized with a $1.00 per share par value, 74,000 shares issued and 63,0000 shares outstanding) $ 74,000 Capital in excess of par value 982,000 Contributed capital $1,056,000 Retained earnings, December 31, Year Seven
2,011,000
Less: Treasury stock (11,000 shares at cost)
(242,000)
Total stockholders’ equity
$2,825,000
Beginning stockholders’ equity – Year Seven: Contributed capital 60,000 shares times $12 per share Retained earnings Total
$ 720,000 1,950,000 $2,670,000
e.
Average stockholders’ equity for Year Seven ($2,670,000 + $2,825,000)/2 = $2,747,500 ROE = Net income/Average stockholders’ equity ROE = $80,000 / $2,747,500 ROE = 2.91% (rounded)
8) a. Cash
$30,000,000 Common stock Capital in excess of par-common stock
Cash
$ 2,000,000 28,000,000
$15,000,000 Preferred stock $ 2,500,000 Capital in excess of par-preferred stock 12,500,000
b. March 9, Year Two Treasury stock Cash
$1,300,000 $1,300,000
August, Year Two Cash $1,600,000 Treasury stock Capital in excess of cost-treasury stock
$1,300,000 300,000
November 3, Year Two Retained earnings Common stock
$600,000
c. $600,000
600,000 shares (2,000,000 shares outstanding times 30 percent) issued as a large stock dividend and valued at the $1 per share par value. December 1, Year Two Retained earnings $2,950,000 Cash dividend payable-common stock Cash dividend payable-preferred stock
$1,950,000 1,000,000
$0.75 per share common stock dividend declared on the 2,600,000 outstanding shares and $2.00 per share preferred stock dividend declared on the 500,000 outstanding shares December 20, Year Two Cash dividend payable-common stock Cash dividend payable-preferred stock Cash
$1,950,000 1,000,000 $2,950,000
9) a. A 10 percent stock dividend is classified as a small stock dividend (one that issues 20-25 percent or less additional shares). As such, it is recorded at the fair value of these shares. Therefore, the reduction in retained earnings is 1,000 shares times $13 fair value or $13,000.
b. A 30 percent stock dividend is classified as a large stock dividend (one that issues more than 20-25 percent additional shares). As such, it is recorded at the par value of the shares. The reduction in retained earnings is 1,000 shares times $1 par value or $1,000. 10) a. The common stock account increased $40,000 this year ($200,000 less $160,000). The capital in excess of par on the common stock account increased by $4 million. ($16 million less $12 million). The total amount received on the issuance of the common stock this year was $4,040,000. b. The preferred stock dividend was 6 percent of $2 million or $120,000. This amount can also be computed by determining that 20,000 shares of preferred stock are outstanding (the $2 million total par value divided by the $100 per share par value). Each of these shares is entitled to a dividend of $6 (6 percent of $100) or a total of $120,000 for all 20,000 shares. Net income caused retained earnings to go up $1.2 million and the preferred stock dividend caused it to decrease by $120,000. Thus, if nothing else happened, retained earnings would have risen during the year by a net $1,080,000. Retained earnings only went up by $700,000 ($1.8 million less $1.1 million). The $380,000 difference must be the amount of dividends paid to common stock shareholders this year. c. Net income assigned to common stock: Net income Preferred stock dividend Net income assigned to common stock
$1,200,000 (120,000) $1,080,000
Weighted-average number of shares of common stock outstanding: 160,000 shares outstanding x 8 months 1,280,000 200,000 shares outstanding x 4 months 800,000 Total 2,080,000 Divide by 12 to get monthly average Basic EPS - $1,080,000/173,333 = $6.23 (rounded)
173,333 (rounded)
11) Net income assigned to common stock: Net income Preferred stock dividend Net income assigned to common stock
$750,000 ( 30,000) $720,000
Weighted-average number of shares of common stock outstanding: 300,000 shares outstanding x 6 months 1,800,000 330,000 shares outstanding x 6 months 1,980,000 Total 3,780,000 Divide by 12 to get monthly average 315,000 Basic EPS - $720,000/315,000 = $2.29 (rounded) 12) In recording a large stock dividend, the additional shares are recorded at par value. Thus, no change takes place in the capital in excess of par balance. Because a change took place here, this stock dividend must have been a small stock dividend. Capital in excess of par value prior to stock dividend: Issuance price – 60,000 shares x $24 $1,440,000 Par value – 60,000 shares x $10 ( 600,000) Capital in excess of par value $ 840,000 Change in capital in excess of par value – stock dividend: Current account balance $ 960,000 Previous account balance ( 840,000) Increase in capital in excess of par $120,000 The current fair value of $30 per share is $20 in excess of the $10 par value. To create this $120,000 increase, 6,000 new shares must have been issued ($120,000 total/$20 increase per share). 13) a. Even though incorrect, the accounting for the stock dividend has no impact on the reporting of the company’s assets. The $300,000 is still the amount to be reported. b. Retained earnings was reduced by the fair value of the shares($21 per share). As a 50 percent stock dividend, 10,000 additional shares (50 percent times the 20,000 shares outstanding) were issued. Retained earnings was reduced by $210,000. Retained earnings should have been reduced by the par value of the shares ($10 per share) or $100,000 (10,000 shares times $10). Thus, the retained earnings account was reduced by $110,000 too much ($210,000 less $100,000). An increase in the $80,000 balance is needed to give a reported balance of $190,000.
c. Stockholders’ equity is properly stated at $220,000. The retained earnings balance was reduced by $110,000 too much. Therefore, contributed capital was increased by $110,000 too much. Although both balances are incorrect, they offset within stockholders’ equity so that the total does not need to be changed. 14) Return on Equity = Net Income/Average Owners’ Equity Return on Equity = $198/((0 + $1,040)/2) Return on Equity = 38.08% (rounded) This ROE is not for a full year because the business was not started until June of the current year.
Answer to Comprehensive Problem A) a) Accounts Receivable Revenue
$7,000
Cash
$2,000
$7,000
b) Capital Stock
$2,000
c) Supplies Inventory Accounts Payable
$125 $125
d) No entry required. e) Purchases Accounts Payable
$13,745
Cash
$15,900
$13,745
f) Revenue
$15,900
g) Cash
$6,400 Accounts Receivable
$6,400
h) Rent Expense Cash
$500
Accounts Payable Cash
$14,000
Cash
$2,000
$500
i) $14,000
j) Investment in Trading Securities Gain on Sale of Trading Securities
$1,800 200
k) Salaries Expense Cash
$700
Allowance for Doubtful Accounts Accounts Receivable
$150
Salaries Payable Cash
$350
Salaries Expense Cash
$7,000
Unearned Revenue Revenue
$300
Dividends Cash
$500
Tax Expense Cash
$372
$700
l) $150
m) $350
n) $7,000
o) $300
p) $500
q) $372
B)
Cash 9,027 500(h) (b)2,000 14,000(i) (f)15,900 700(k) (g)6,400 350(m) (j)2,000 7,000(n) 500(p) 372(q)
Allow. Doubtful Investment in Accounts Receivable Accounts Trading Securities 1,600 6,400(g) (l)150 160 1,800 1,800(j) (a)7,000 150(l)
11,905
2,050
Supplies 50 (c)125
Prepaid Rent
175
0
Furniture 1,000
10 Prepaid Advertising
0
Accum. Depr.—Furn 102
1,000
102
0
Inventory 2,324
2,324
Equipment 10,500
Accum. Depr.—Equip 1,138
10,500
1,138
Investment in Availablefor-Sale Securities 2,275
License Agreement 1,400
2,275
1,400
Accounts Payable Salaries Payable Interest Payable Unearned Revenue Note Payable (i)14,000 2,770 (m)350 350 30 (o)300 300 3,000 125(c) 13,745(e) 2,640
Capital Stock 2,000 2,000(b)
4,000
0
Retained Earnings 19,601
19,601
30 Unrealized Gain/Loss— AFS Securities 525
525
0
3,000
Revenue Dividend Revenue 7,000(a) 15,900(f) 300(o) 23,200
0
Unrealized Gain/Loss— Trading Securities
Gain/Loss on Sale of Trading Securities 200(j)
0
200
Tax Expense (q)372
0
Depreciation Expense
0
0
0
0
Cost of Goods Sold Salaries Expense (k)700 (n)7,000
13,745 Amortization Expense
0
7,700
Advertising Expense
0
Loss on Sale of Equipment
Supplies Expense
372
Rent Expense Bad Debt Expense Purchases (h)500 (e)13,745
500
Utilities Expense
Interest Expense
0
0
Dividends (p)500 500
C) Webworks Unadjusted Trial Balance April 30 Account Title Cash Accounts Receivable Allowance for Doubtful Accounts Investment in Trading Securities Inventory Supplies Prepaid Rent Prepaid Advertising Equipment Accum. Depreciation—Equipment Furniture Accum. Depreciation—Furniture Investment in AFS Securities License Agreement
Debits $11,905 2,050
Credits
$
10
0 2,324 175 0 0 10,500 1,138 1,000 102 2,275 1,400
Accounts Payable Salaries Payable Interest Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 4/1 Revenue Dividend Revenue Unrealized Gain/Loss on Trading Securities Unrealized Gain/Loss on AFS Securities Gain/Loss on Sale of Trading Securities Salaries Expense 7,700 Tax Expense 372 Utilities Expense 0 Supplies Expense 0 Rent Expense 500 Bad Debt Expense 0 Purchases 13,745 Cost of Goods Sold 0 Depreciation Expense 0 Amortization Expense 0 Advertising Expense 0 Interest Expense 0 Loss on Sale of Equipment 0 Dividends 500
2,640 0 30 0 3,000 4,000 19,601 23,200 0 0 525 200
_______
Totals
$54,446
$54,446
Salaries Expense Salaries Payable
$100
Utilities Expense Accounts Payable
$440
Supplies Expense Supplies
$110
D) r) $100
s) $440
t) $110
u) Bad Debt Expense Allowance for Doubtful Accounts
$195
Depreciation Expense Accumulated Depreciation—Equip
$175
Depreciation Expense Accumulated Depreciation—Furn
$17
Amortization Expense License Agreement
$200
$195
v) $175
$17
w) $200
x) Investment in AFS Securities $175 Unrealized Gain on AFS Securities
$175
Interest Expense Interest Payable
$15 $15
Cost of Goods Sold Inventory Purchases
$12,707 1,038
y)
z)
Cash 9,027 500(h) (b)2,000 14,000(i) (f)15,900 700(k) (g)6,400 350(m) (j)2,000 7,000(n) 500(p) 372(q) 11,905
$13,745
Allow. Doubtful Investment in Accounts Receivable Accounts Trading Securities 1,600 6,400(g) (l)150 160 1,800 1,800(j) (a)7,000 150(l) 195(u)
2,050
205
0
Inventory 2,324 (z)1,038
3,362
Supplies 50 110(t) (c)125
Prepaid Rent
65
0
Prepaid Advertising
0
Equipment 10,500
10,500
1,313
Investment in AvailableAccum. Depr.—Furn for-Sale Securities 102 2,275 17(v) (x)175
Furniture 1,000
1,000
Accum. Depr.—Equip 1,138 175(v)
119
License Agreement 1,400 200(w)
2,450
1,200
Accounts Payable Salaries Payable Interest Payable Unearned Revenue Note Payable (i)14,000 2,770 (m)350 350 30 (o)300 300 3,000 125(c) 100(r) 15(y) 13,745(e) 440(s) 3,080
Capital Stock 2,000 2,000(b)
100
Retained Earnings 19,601
4,000 Unrealized Gain/Loss— Trading Securities
45 Unrealized Gain/Loss— AFS Securities 525 175(x)
19,601
700
Gain/Loss on Sale of Trading Securities 200(j)
0
Tax Expense (q)372
200
372
0
3,000
Revenue Dividend Revenue 7,000(a) 15,900(f) 300(o) 23,200
Utilities Expense (s)440 440
0
Supplies Expense (t)110 110
Rent Expense Bad Debt Expense Purchases Cost of Goods Sold Salaries Expense (h)500 (u)195 (e)13,745 13,745(z) (z)12,707 (k)700 (n)7,000 (r)100 500
195
0
12,707
7,800
Depreciation Expense (v)175 (v)17 192
Amortization Expense (w)200
Advertising Expense
200
Loss on Sale of Equipment
0
Interest Expense (y)15
0
15
Dividends (p)500 500
E) Webworks Adjusted Trial Balance April 30 Account Title Debits Cash $11,905 Accounts Receivable 2,050 Allowance for Doubtful Accounts Investment in Trading Securities 0 Inventory 3,362 Supplies 65 Prepaid Rent 0 Prepaid Advertising 0 Equipment 10,500 Accum. Depreciation—Equipment Furniture 1,000 Accum. Depreciation—Furniture Investment in AFS Securities 2,450 License Agreement 1,200 Accounts Payable Salaries Payable Interest Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 4/1 Revenue Dividend Revenue Unrealized Gain/Loss on Trading Securities Unrealized Gain/Loss on AFS Securities Gain/Loss on Sale of Trading Securities Salaries Expense 7,800
Credits
$
205
1,313 119
3,080 100 45 0 3,000 4,000 19,601 23,200 0 0 700 200
Tax Expense Utilities Expense Supplies Expense Rent Expense Bad Debt Expense Purchases Cost of Goods Sold Depreciation Expense Amortization Expense Advertising Expense Interest Expense Loss on Sale of Equipment Dividends
372 440 110 500 195 0 12,707 192 200 0 15 0 500
_______
Totals
$55,563
$55,563
F) Webworks Income Statement As of April 30 Revenue Cost of Goods Sold Gross Profit Deprec. and Amort. Expense Other Expenses and Losses Investment Income (Loss) Earnings Before Interest & Tax Interest Expense Earnings Before Tax Tax Expense Net Income
$23,200 (12,707) 10,493 (392) (9,045) 200 1,256 (15) 1,241 (372) $ 869
Webworks Stmt. of Retained Earnings As of April 30 Retained Earnings, April 1 Net Income Dividends Retained Earnings, April 30
$19,601 869 (500) $19,970
Webworks Balance Sheet April 30 Assets:
Liabilities:
Current: Current: Cash $11,905 Accounts Payable Accounts Receivable 2,050 Salaries Payable less Allow. for Doubt. Accts. (205) Interest Payable Net Accounts Receivable 1,845 Merchandise Inventory 3,362 Supplies Inventory 65 Total Current Assets $17,177 Total Current Liabilities
$ 3,080 100 45
$ 3,225
Property, Plant, and Equipment Equipment less Accumulated Depreciation Furniture less Accumulated Depreciation Total P, P, and E
Noncurrent: $10,500 Note payable (1,313) 1,000 (119) $10,068
Other Noncurrent Assets: Available-for-Sale Securities Licensing Agreement, net
Owners’ Equity: $ 2,450 Capital Stock $ 4,000 1,200 Retained Earnings 19,970 Other Accumulated Comprehensive Income: --Unrealized gain on Available-forSale Securities 700 Total Owners’ Equity $24,670
Total Assets
$30,895 Total Liabilities & Owners’ Equity
$ 3,000
$30,895
Answer to Research Assignment a. Basic earnings per share Diluted earnings per share Difference
$0.66 $0.64 $0.02
This difference is created by taking into consideration the potential impact of the conversion of any items that can be turned into common stock.
b. P/E Ratio = 8.05 / .66 P/E Ratio = 12.20 c. Stock options, restricted stock awards, and shares issuable upon the conversion of convertible debt. d. Common shares in basic EPS = 711 million Common shares in diluted EPS= 733 million 22 million shares were added to arrive at diluted earnings per share. They were not common stock this year but they have the potential to become common stock.
Chapter 17 Solutions Answers to Questions 1) According to U.S. GAAP, a statement of cash flows is only required to be included within financial statements if an income statement is presented. In this question, only a balance sheet is reported. Therefore, because an income statement is not shown for the Ashton Corporation, a statement of cash flows is not necessary. 2) Normally, in financial reporting, cash amounts include coins, currencies, bank deposits (both checking accounts and savings accounts) and some negotiable instruments (for example, money orders, checks, and bank drafts.) 3) Cash equivalents are short-term, highly liquid investments that are readily convertible into known amounts of cash. Only securities with original maturities of 90 days or fewer are included in this asset classification. Company officials do not like to hold large amounts of cash because the profitability is so slight. Cash equivalents allow a company to maintain a necessary amount of liquidity while earning a higher rate of return. 4) In the U.S., virtually all businesses report their operating activities within the statement of cash flows by using the indirect method. With that method, the first number presented is net income which is then adjusted for a variety of non-cash and non-operating items. In addition, the results of accrual accounting must be adjusted to correspond to cash accounting. The direct method does not report adjustments but rather specific cash inflow sources and cash outflow uses are listed such as “cash received from customers” and “cash paid for inventory.” 5) The three sections of the statement of cash flows are operating, investing, and financing. Operating activities: Identifies cash flows that arise from the daily operations of a business. Examples include receipts from the sale of goods or services, payments for inventory, payments to employees, payments for taxes, and payments for rent and other operating expenses. Investing activities: Identifies cash flows that arise from transactions that are not part of daily operations and involve an asset. Examples include the sale or purchase of land, buildings, and equipment and the sale or purchase of long-term investments and intangible assets. Financing activities: Identifies cash flows that arise from transactions that are not part of daily operations and involve either a liability or stockholders’ equity account. Examples include the issuance or repurchase of the company’s own stock, issuance or payment of a noncurrent debt, and the distribution of cash dividends.
6) This transaction does not involve any cash and is not, therefore, reported on the statement of cash flows. The increase in the land and contributed capital balances are shown on the company’s balance sheet. However, because the transaction is so significant, it should be included in a supplemental schedule to the statement of cash flows. 7) A company reports rent expense for the current year of $74,000. That balance is determined using accrual accounting which requires that expenses be matched with the revenue they help to generate. Changes in prepayments and liability balances are necessary to conform financial reporting to accrual accounting. Such changes prevent cash payments from creating an equal amount of reported expense. 8) A salary payable balance goes up during a period when the amount paid is less than the related expense. It is that failure to pay the expense that creates the rise in the liability. Here, the debt rose by $39,000. Therefore, although an expense of $875,000 was incurred, the actual payment was $39,000 less (causing the debt to go up by that amount) or $836,000. 9) The Lewiston Corporation sold merchandise this period with a cost of $376,000. Despite those sales, the inventory balance still went up by $72,000. That can only happen if the company buys more goods than it sells. The company sold inventory costing $376,000 but bought other items at a cost of $448,000 ($376,000 plus $72,000). That additional cost was responsible for the increase in the inventory account balance. In addition, the accounts payable balance fell by $19,000. Liabilities decrease because more cash is paid. Thus, the company paid $19,000 more this period than it bought. The amount of cash payments made to acquire inventory totals $467,000 ($448,000 plus $19,000). 10) If a company uses the direct method to report cash flows from operating activities, depreciation expense is simply omitted because it does not cause an increase or decrease in cash. If the indirect method is applied, the presentation starts with net income. Depreciation expense is a negative within that figure. Because depreciation does not result from a cash inflow or outflow, it is removed from net income when cash flows are determined. As a negative, it is removed by adding the figure. Only cash flows from operating activities should be included so it must be eliminated. 11) If a company uses the direct method to report cash flows from operating activities, the $85,000 gain on the sale of land is omitted entirely. The amount of cash received from the sale is not part of daily operations. Instead, because an asset (land) is involved, the cash received is reported as an investing activity. If the indirect method is applied, the gain must be eliminated from the operating activities. The presentation starts with net income. The gain is a positive number within that figure. Because the gain relates to an investing activity, it is eliminated from net income. As a positive, it is removed by subtracting the $85,000.
12) A drop in accounts receivable indicates that the amount of cash collected exceeded the sales for the period. Hence, the reduction amount is added to net income to adjust from accrual accounting figures to a cash basis. An increase in salary payable shows that less was paid to employees this period than the salary expense they earned. It is the lack of payment that creates the increase in the debt. Because less was paid, the change is added to net income to arrive at the amount of cash generated from operating activities. Both changes are reported as increases to net income when the indirect method is applied to report the operating activity cash flows. 13) An $11,000 increase in prepaid rent indicates that the company paid more for rent this period than the expense that was incurred. It was the extra payment that caused the asset to rise. In applying the indirect method, the increase in prepaid rent is subtracted from net income to indicate that more cash was spent than the expense. In addition, the accounts payable balance fell by $23,000. Liabilities drop because additional cash payments are made. So, once again, if the indirect method is used, that change is subtracted from net income to arrive at the cash flows generated by operating activities. 14) Under U.S. GAAP, the dividend payment is reported as a cash outflow in the financing activities section of the statement of cash flows whereas the dividend that is received is reported as a cash inflow in the operating activities section. Some critics have argued these treatments are not consistent. IFRS tends to have more flexibility in its reporting and that is the case here. Under IFRS, the dividend payment may be classified as either an operating or financing activity and the dividend receipt may be classified as either an operating or investing activity. IFRS usually allows companies more discretion in their financial reporting. 15) The building has a book value of $550,000 ($950,000 less $400,000). However, it was sold at a gain of $18,000. The company apparently received $568,000 ($550,000 plus $18,000) and that receipt is shown as a cash inflow within the investing activity section of the statement of cash flows. If the direct method is used to show operating activities, the gain is omitted entirely because the cash impact appears in the investing activities. If the indirect method is used, the gain must be subtracted from net income in the operating activity section to remove its positive effect. 16) Two separate events are reported here. Because they are not part of daily operations and impact stockholders’ equity accounts, the cash impact of each is reported within the financing activity section of the statement of cash flows. The repurchase of the 10,000 shares of stock is shown as a cash outflow of $370,000 while the reissuance of 3,000 shares is a cash inflow of $120,000.
Answers to True or False Questions __F__ 1) Cash consists of coins, currencies, bank deposits and some negotiable instruments. Cash equivalents are short-term, highly liquid investments that are readily convertible into known amounts of cash. Cash and cash equivalents are certainly similar and are often reported together but they do have different meanings. __F__ 2) In the operating activities section of the statement of cash flows, the indirect method always begins with net income. The direct method lists individual sources of cash and uses of cash. Thus, “cash collected from customers” signals use of the direct method. __F__ 3) Under the direct method of presenting operating activity cash flows, depreciation is simply excluded because it neither increases nor decreases a company’s cash balance. In contrast, the indirect method adds depreciation expense to net income to remove that negative balance because cash is not involved in the depreciation process. __T__ 4) A sale of equipment is reported on a statement of cash flows as an investing activity because the transaction is not part of daily operations and involves an asset. The loss on that transaction is included in the determination of the cash amount that was received. Therefore, the loss has no impact on operating activities. When using the indirect method, the operating activities section starts with net income. The loss must be removed because it relates to an investing activity. Within net income, it is a negative and is eliminated by addition. __T__ 5) The $9,000 increase in prepaid rent indicates that the company paid more for rent this period than the $75,000 expense that was incurred. The extra payment caused the asset to rise. To get the prepaid expense to go up $9,000, the company must have paid $84,000 for rent during this period ($75,000 plus $9,000). __F__ 6) The $9,000 increase in rent payable indicates that the company paid less for rent this period than the $43,000 expense that was incurred. Liabilities go up because less is paid. For the liability to increase by $9,000, the company did not pay all $43,000 of the expense but only $34,000. __T__ 7) The indirect approach is used here to determine operating activity cash flows because net income is given but not the individual components of the income statement. Depreciation must be eliminated from net income because it does not change cash. The expense is a negative within net income so a $30,000 addition is necessary to remove it. The gain must also be eliminated because it relates to an investing activity rather than an operating activity. As a positive in net income, it is removed by subtracting $8,000. Finally, accounts receivable increased by $9,000. An increase in a receivable shows that less cash is collected. That reduced amount of cash is reflected here by subtracting the $9,000 change. Thus, the net cash inflow from operating activities is $213,000 ($200,000 plus $30,000 less $8,000 less $9,000).
__F__ 8) The $34,000 drop in inventory indicates that less inventory was bought this period than was sold (that is why the balance went down). If the company sold $500,000 of merchandise, it must have only bought $466,000 ($500,000 less $34,000). In addition, accounts payable increased by $9,000. An increase in the liability shows that less was paid. So, although $466,000 in inventory was bought, the cash payment was only $457,000 ($466,000 less $9,000). __T__ 9) The purchase of treasury stock does not fall within a company’s daily operating activities and involves a stockholders’ equity account. Thus, the cash payment is a financing activity. __T__10) Significant investing and financing activities not involving cash are shown in a supplemental schedule. They are important transactions and must be disclosed. __T__11) According to U.S. GAAP, the payment of the debt is a financing activity but the payment of the interest is an operating activity. They are shown separately. __F__12) According to IFRS, the payment of this debt is a financing activity. However, the company has a choice in connection with the payment of interest. The cash outflow can be shown as an operating activity or as a financing activity. Therefore, companies have the option of reporting both payments as financing activity cash flows. __F__13) The equipment has a cost of $320,000 and accumulated depreciation of $240,000 for a net book value of $80,000. Because a loss of $22,000 was recognized, the company only received $58,000 ($80,000 less $22,000) at the time of the sale. However, as an asset, this $58,000 cash inflow is shown as an investing activity rather than as a financing activity.
Answers to Multiple Choice Questions 1) Answer is A Cash collected from customers is a transaction that is part of daily operations. It is shown within the operating activities section of the statement of cash flows. 2) Answer is B Accounts receivable dropped this year by $150,000 ($900,000 less $750,000). Accounts receivable fall because more payments are received. Therefore, although sales revenue is $7 million, the cash collected from customers is $7,150,000. 3) Answer is C Payment of a noncurrent liability is not part of daily operations. Because the transaction involves a liability account, the cash payment is disclosed within the financing activities on the statement of cash flows.
4) Answer is A FASB has stated its preference for presenting operating activity cash flows by means of the direct method. Showing the individual amounts for the cash collected from customers, the cash paid for inventory, and the like is viewed as a better method of presentation. The information is more useful. However, the indirect method has long been the traditional approach and continues to be widely used in practice. 5) Answer is C Of these transactions, only two are classified as financing activities: the $23,000 dividend distribution and the $105,000 received from the note. Netting these two amounts gives an $82,000 cash inflow from financing activities. The purchase of equipment is an investing activity and the receipt of the dividend is an operating activity (according to U.S. GAAP). 6) Answer is D The cost of goods sold for the period was $25,000. However, the amount of inventory actually held went up by $1,700 ($2,700 less $1,000) indicating that the company bought $26,700. The additional purchase is what made the inventory balance rise. At the same time, accounts payable fell by $700 ($4,500 less $3,800). Accounts payable decrease when more money is paid during the year. If $26,700 is bought and an additional $700 is paid, the cash outflow to acquire inventory is $27,400. 7) Answer is A Indirect method must be used. Net income is provided but not the entire income statement. Net income $48,900 + Depreciation Expense 13,000 (eliminate—noncash) − Gain on Sale of Equipment (4,000) (eliminate—investing activity) − Increase in Accounts Receivable (16,000) (adjustment—less collected + Decrease in Inventory 5,090 (adjustment—less bought) − Decrease in Accounts Payable (4,330) (adjustment—more paid) + Increase in Interest Payable 1,200 (adjustment—less paid) Cash flow from operations $43,860 8) Answer is D Rent expense was $98,000 but prepaid rent went up during the same period by $34,000. An increase in this asset indicates that more cash was paid than the expense for the period. The amount paid was $132,000 ($98,000 plus $34,000).
9) Answer is D Rent expense was $60,000 but prepaid rent for Building One went up during the period by $9,000. An increase in this asset indicates that more cash was paid than the expense for the period. In addition, rent payable in connection with Building Two dropped by $5,000. The liability decreases because more is paid than the expense incurred. Consequently, the cash paid for rent this period is $74,000 ($60,000 plus $9,000 plus $5,000). 10) Answer is B Annual depreciation for this building is ($500,000 - $20,000)/20 years or $24,000 per year (and $12,000 for each half year). When the building is sold during Year Four, the accumulated depreciation is $72,000 ($12,000 + $24,000 + $24,000 + $12,000). Net book value is $428,000 ($500,000 cost less $72,000 accumulated depreciation). The building was sold at a loss of $13,000 so the company only received $415,000 ($428,000 less $13,000). 11) Answer is D Net income $400,000 + Depreciation Expense 70,000 − Gain on Sale of Land (30,000) + Decrease in Accounts Receivable 2,000 + Increase in Accounts Payable 7,000 Cash flow from operations $449,000
(eliminate—noncash) (eliminate—investing activity) (adjustment—more cash collected) (adjustment—less cash paid)
12) Answer is D The cost of goods sold for the period was $300,000. However, the amount of inventory on hand went up by $3,000 indicating that the company bought more than it sold (or $303,000 in total). At the same time, accounts payable fell by $6,000. Accounts payable decrease because more money is paid during the year. If $303,000 is bought and an additional $6,000 is paid, the cash outflow for inventory this year is $309,000. 13) Answer is B Net income $30,000 + Depreciation Expense 50,000 (eliminate—noncash) − Gain on Sale of Equipment (23,000) (eliminate—investing activity) + Decrease in Accounts Receivable 17,000 (adjustment—more cash collected) - Increase in Inventory (3,000) (adjustment—more inventory bought) − Decrease in Accounts Payable (6,000) (adjustment—more cash paid) Cash flow from operations $65,000
14) Answer is C The equipment balance dropped by $70,000 in Year One which was apparently the cost of the equipment that was sold. However, the amount of accumulated depreciation for this asset must be determined to arrive at its net book value. Accumulated depreciation increased by only $29,000 although depreciation expense for the period was $50,000. Apparently, accumulated depreciation also fell by $21,000 ($50,000 less $29,000). Because no other transactions occurred, that drop must be the removal of the balance for the equipment that was sold. Net book value was $49,000 ($70,000 cost less $21,000 accumulated depreciation). The equipment was sold at a gain of $23,000 indicating that $72,000 was received ($49,000 plus $23,000). 15) Answer is D Net income for the year was $30,000. However, retained earnings only went up by $11,000. Almost without exception, retained earnings is made up entirely of net income less dividends distributed. Therefore, the dividend distribution must have been $19,000 ($30,000 less $11,000). As a stockholders’ equity account, that transaction is reported as a financing activity.
Answers to Problems 1) a. Issuance of bonds payable – financing activity. Transaction is not part of daily operations and involves a liability account. b. Cash paid for interest – operating activity. According to FASB, interest payments are to be viewed as operating activities and not financing activities. c. Cash collected from customers – operating activity. A normal transaction within the daily operations of a business. d. Paid dividends – financing activity. Transaction is not part of daily operations and involves a stockholders’ equity account. e. Sold equipment for cash – investing activity. Transaction is not part of daily operations and involves an asset account. f. Issued preferred stock for cash – financing activity. Transaction is not part of daily operations and involves a stockholders’ equity account.
g. Cash paid for inventory purchases – operating activity. A normal transaction within the daily operations of a business. h. Purchased a small percentage of the ownership shares of another company – investing activity. Transaction is not part of daily operations and involves an asset account. i. Cash received as dividend income – operating activity. According to FASB, dividends that are received should be viewed as operating activities and not investing activities. 2) a. The sale of equipment for cash is reported as an investing activity because it is not part of daily operations and involves an asset account. Net book value is $19,000 ($33,000 cost less $14,000 accumulated depreciation). A $5,000 gain was reported so the company must have received $24,000. Investing activity cash inflow of $24,000. The indirect method is applied; therefore, the $5,000 gain is subtracted from net income to remove it because it was not an operating activity. b. The receipt of $200,000 cash from signing a note is reported as a financing activity because the transaction is not part of daily operations and involves a liability account. Financing activity cash inflow of $200,000. c. No cash is collected or paid so no financing or investing activity is reported. Because the indirect method is applied, the loss is added to net income to remove it because it was a noncash amount. d. No cash is collected or paid so no financing or investing activity is reported on the statement of cash flows. e. The receipt of $49,000 cash from issuing the shares of common stock is reported as a financing activity because transaction is not part of daily operations and involves a stockholders’ equity account. Financing activity cash inflow of $49,000. f. The $10,000 cash payment on the note is reported as a financing activity because the transaction is not part of daily operations and involves a liability. According to FASB, the $1,000 interest payment is an operating activity cash flow. Financing activity cash outflow of $10,000. The $1,000 interest payment is recorded in net income as an expense. Assuming that the cash payment and the expense amount are the same, no adjustment is needed to net income.
g. The sale of this building for cash is reported as an investing activity because the transaction is not part of daily operations and involves an asset account. Net book value is $360,000 ($530,000 cost less $170,000 accumulated depreciation). A $15,000 loss was reported so the company must have received $345,000 ($360,000 less $15,000). Investing activity cash inflow of $345,000. The indirect method is applied; therefore, the $15,000 loss is added to net income to remove it because the transaction was not an operating activity. 3) Depreciation caused the accumulated depreciation to increase from $200,000 to $310,000. The equipment purchase caused that asset account to rise from $900,000 to $1.35 million. Because only $180,000 of the $450,000 purchase was covered with a note, the other $270,000 must have been paid in cash. The equipment account was not $1.35 million at the end of the year (as above) but only $1.20 million. Thus, the $150,000 reduction must have been the cost of the asset that was sold. Accumulated depreciation was not $310,000 at the end of the year but only $260,000. The $50,000 reduction must have been the accumulated depreciation on the asset that was sold. Based on this information, the sold equipment had a net book value of $100,000 ($150,000 cost less $50,000 accumulated depreciation). A gain of $13,000 was recognized so the company received $113,000. Statement of cash flows Investing Activities: --Purchased equipment --Sold equipment
($270,000) 113,000
Operating Activities: (assuming the indirect method is applied) --Depreciation expense of $110,000 is added to net income. --Gain of $13,000 is subtracted from net income. If the direct method is applied, neither the $110,000 depreciation expense (a noncash item) or the $13,000 gain (an investing activity) are shown within the operating activities. 4) Accounts receivable increased this year by $23,000 ($79,000 less $56,000). Accounts receivable increase because fewer payments are received than the amount of sales made during the period. Therefore, although sales revenue is $120,000, the cash collected from customers was only $97,000.
5) A $50,000 payment was made on a note payable (as well as a $20,000 payment of interest). Equipment with a net book value of $60,000 ($100,000 cost and $40,000 accumulated depreciation) was sold for cash. Because a loss of $24,000 is reported on the sale of equipment, the company apparently received only $36,000 in cash ($60,000 less $24,000). The sale of the equipment reduces that asset account by the $100,000 cost figure. However, rather than drop by $100,000, the equipment account actually increases by $40,000. This change indicates that equipment costing $140,000 was acquired this year. The note payable account was reduced above by a $50,000 payment. That account did not drop by $50,000 but actually increased by $30,000. Therefore, in acquiring this equipment, the company apparently signed an $80,000 note (to change the $50,000 decrease to a $30,000 increase). The amount of cash paid was $60,000 ($140,000 less $80,000). a. Investing Activities: Sold equipment Purchased equipment
$36,000 cash inflow 60,000 cash outflow
Financing Activities: Payment on note payable
$50,000 cash outflow
b.
6) a. The cost of goods sold for the period was $320,000. However, the amount of inventory on hand went down by $2,000 indicating that the company bought less than it sold (or $318,000). At the same time, accounts payable fell by $4,000. Accounts payable decrease because more money is paid during the year. If $318,000 is bought and an additional $4,000 is paid (reducing the liability), the cash outflow this year for inventory is $322,000. b. Rent expense was $30,000 but prepaid rent went up during the period by $5,000. An increase in this asset indicates that more cash was paid than the expense recognized for the period. The amount paid for rent was $35,000 ($30,000 plus $5,000). c. Salary expense was $90,000 but salary payable went up during the period by $3,000. An increase in the liability indicates that less cash was paid than the expense for the period. The amount paid was $87,000 ($90,000 less $3,000).
7) Cash Flows from Operating Activities - Direct Method: Cash Collected from Customers Cash Paid to Acquire Inventory Cash Paid for Other Expenses Cash Paid for Taxes Cash Generated by Operating Activities Supporting Calculations: Cash Collected from Customers: Revenue + Beginning Accounts Receivable − Ending Accounts Receivable
Cash Paid to Acquire Inventory: Cost of Goods Sold + Ending Inventory − Beginning Inventory Inventory Purchased + Beginning Accounts Payable − Ending Accounts Payable
Cash Paid for Other Expenses: Other Expenses + Ending Prepaid Expenses − Beginning Prepaid Expenses + Beginning Salaries Payable − Ending Salaries Payable
Cash Paid for Taxes Tax Expense + Beginning Taxes Payable − Ending Taxes Payable
$74,950 (47,570) (20,960) ( 3,336) $ 3,084
$76,450 32,590 (34,090) $74,950
$40,740 35,020 (23,100) $52,660 39,870 (44,960) $47,570
$19,000 11,340 (13,970) 22,030 (17,440) $20,960
$ 2,076 12,490 (11,230) $ 3,336
Cash Flows from Operating Activities - Indirect Method: Net Income Depreciation Expense Increase in Accounts Receivable Increase in Inventory Decrease in Prepaid Expenses Increase in Accounts Payable Decrease in Salaries Payable Decrease in Taxes Payable Cash Generated by Operating Activities
$ 6,394 8,240 (eliminate – noncash) (1,500) (adjust – less cash collected) (11,920) (adjust – more inventory bought) 2,630 (adjust – less cash spent) 5,090 (adjust – less cash spent) (4,590) (adjust – more cash spent) (1,260) (adjust – more cash spent) $ 3,084
8) Statement of Cash Flows, Operating Activities - Indirect Method Net Income Depreciation Expense Gain on Sale of Land Adjust Revenues and Expenses from Accrual Accounting to Cash --Increase in Accounts Receivable --Decrease in Prepaid Rent --Increase in Inventory --Decrease in Accounts Payable --Increase in Salaries Payable
$ 78,000 34,000 (eliminate – noncash) (9,000) (eliminate – investing activity)
Cash Generated by Operating Activities
$ 86,000
(11,000) (less cash collected) 6,000 (less cash spent) (11,000) (more inventory bought) ( 5,000) (more cash spent) 4,000 (less cash spent)
9) a. Issued 1,000 shares of common stock Financing activity Cash inflow of $19,000 b. Distributed cash dividend Financing activity Cash outflow of $16,000 c. Receipt of cash dividend Operating activity Cash inflow of $9,000 d. Payment on note payable Financing activity Cash outflow of $6,000 Payment of interest expense Operating activity Cash outflow of $1,000 e. Sale of a building Investing activity Cash inflow of $173,000 (sold for $17,000 less than the $190,000 net book value)
10) Two mistakes have been made in this determination of the operating activity cash flow: the gain should be subtracted to eliminate the positive effect within net income and the decrease in the interest payable should be subtracted because it takes additional payments to cause a liability to go down. Corrected Version of the Operating Activity Cash Flows – Indirect Method Net income Depreciation expense Gain on sale of equipment Increase in accounts receivable Decrease in interest payable Cash inflow from operations
$90,000 +20,000 ( 11,000) ( 6,000) ( 8,000) $ 85,000
11) One mistake was made in this determination of the cash paid for rent: the increase in rent payable saves cash (payment is deferred) and should be subtracted. The liability goes up because less cash is paid this period. Corrected Version of the Cash Paid for Rent Rent expense Decrease in prepaid rent Increase in rent payable Cash paid for rent
$120,000 (11,000) (18,000) $ 91,000
12) Investing Activity Sold Common Stock Signed a Note Payable for Cash Purchased Equipment by signing a Note Payable Sold Land Redeemed Bonds Payable Declared Dividends to be paid next year Purchased an Investment in Knox Company
Financing Activity
Neither
x x
x x x x x
13) Ruthers Corporation Statement of Cash Flows For the Year Ended December 31, 20X5 Cash Flows from Operating Activities: Net Income Adjust Revenues and Expenses from Accrual Accounting to Cash Increase in Accounts Receivable Increase in Inventory Increase in Prepaid Expenses Increase in Accounts Payable Increase in Salaries Payable Cash Generated by Operating Activities
$ 2,947
(1,990) (2,510) (577) 1,830 700 $
400
Cash Flows from Investing Activities: Purchased Land Cash Outflow from Investing Activities
($14,000) ($14,000)
Cash Flows from Financing Activities: Issued Common Stock Signed Note Payable Cash Generated from Financing Activities Increase in Cash Cash, 1/1/X5 Cash, 12/31/X5
$ 4,500 10,000 $14,500 $ $
900 -0900
14) Looney Company Statement of Cash Flows For the Year Ended December 31, 20X9 Cash Flows from Operating Activities: Cash Collected from Customers $6,358 Cash Paid to Acquire Inventory (4,863) Cash Paid for Selling and Administrative Expenses (895) Cash Paid for Interest (130) Cash Paid for Taxes (118) Cash Generated by Operating Activities
$ 352
Cash Flows from Investing Activities: Purchased Equipment Cash Outflows from Investing Activities
($90) ($90)
Cash Flows from Financing Activities: Issued Common Stock Issued Long-term Debt Cash Generated by Financing Activities
$
55 70 $ 125
Increase in Cash Cash, 1/1/X9 Cash, 12/31/X9
$ 387 98 $ 485
Supporting Calculations: Cash Collected from Customers: Revenue + Beginning Accounts Receivable − Ending Accounts Receivable
Cash Paid to Acquire Inventory: Cost of Goods Sold + Ending Inventory − Beginning Inventory Cost of Goods Purchased + Beginning Accounts Payable − Ending Accounts Payable
Cash Paid for Interest: Interest Expense + Beginning Interest Payable − Ending Interest Payable
$6,328 990 (960) $6,358
$4,740 1,580 (1,802) $4,518 545 (200) $4,863
$ 100 80 (50) $ 130
Cash Paid for Taxes: Tax Expense + Beginning Taxes Payable − Ending Taxes Payable
$ 108 130 (120) $ 118
15) Henrich’s Hat Store, Inc. Statement of Cash Flows For the Year Ended December 31, 20X8 Cash Flows from Operating Activities: Net Income Depreciation Expense Increase in Accounts Receivable Increase in Inventory Increase in Accounts Payable Increase in Taxes Payable Cash Generated by Operating Activities
$400,000 20,000 (60,000) (340,000) 30,000 30,000 $ 80,000
Cash Flows from Investing Activities: Purchase Building and Fixtures Purchased Land Cash Outflows from Investing Activities
($150,000) (300,000) ($450,000)
Cash Flows from Financing Activities: Issued Common Stock Paid Dividends Cash Generated by Financing Activities
$520,000 (170,000) $350,000
Increase in Cash Cash, 1/1/X8 Cash, 12/31/X8
($ 20,000) 300,000 $280,000
Answer to Comprehensive Problem A) a) Accounts Receivable Revenue
$9,000 $9,000
b) Supplies Inventory Accounts Payable
$140 $140
c) No entry needed. d) Purchases Accounts Payable
$12,466
Cash
$17,700
$12,466
e) Revenue
$17,700
f) Cash
$9,000 Accounts Receivable
$9,000
g) Rent Expense Cash
$500
Accounts Payable Cash
$14,000
$500
h) $14,000
i) Cash $2,450 Unrealized gain on AFS Securities 700 Available-for-Sale Securities Gain on Sale of AFS Securities
$2,450 700
Salaries Expense Cash
$750 $750
Salaries Payable Cash
$100
Salaries Expense Cash
$8,000
j)
k) $100
l) $8,000
m) Note Payable Interest Payable Cash
$3,000 45
Tax Expense Cash
$740
$3,045
n) $740
B) Allow. Doubtful Investment in Cash Accounts Receivable Accounts Trading Securities Inventory 11,905 500(g) 2,050 9,000(f) 205 3,362 (e)17,700 14,000(h) (a)9,000 (f)9,000 750(j) (i)2,450 100(k) 8,000(l) 3,045(m) 740(n) 13,920
2,050
Supplies 65 (b)140
205
Prepaid Rent
205
Prepaid Advertising
0
Furniture 1,000
0
Accum. Depr.—Furn 119
1,000
119
Accounts Payable (h)14,000 3,080 140(b) 12,466(d) 1,686
0
3,362
Equipment 10,500
Accum. Depr.—Equip 1,313
10,500
Investment in Availablefor-Sale Securities 2,450 2,450(i)
1,313
License Agreement 1,200
0
1,200
Salaries Payable Interest Payable Unearned Revenue Note Payable (k)100 100 (m)45 45 (m)3,000 3,000
0
0
0
0
Capital Stock 4,000
Unrealized Gain/Loss— Retained Earnings AFS Securities Revenue Dividend Revenue 19,970 (i)700 700 9,000(a) 17,700(e)
4,000 Unrealized Gain/Loss— Trading Securities
19,970
0
Gain/Loss on Sale of Trading Securities
Gain/Loss on Sale of AFS Securities 700(i)
0
0
26,700
500
0
Depreciation Expense
Amortization Expense
Advertising Expense
0
0
Cost of Goods Sold
0
0 Dividends
Supplies Expense
0
12,466
0 Loss on Sale of Equipment
0
Utilities Expense
700
Rent Expense Bad Debt Expense Purchases (g)500 d)12,466
0
Salaries Expense (j)750 (l)8,000 8,750 Interest Expense
0
0
Tax Expense (n)740 740
C) Webworks Unadjusted Trial Balance May 31 Account Title Cash Accounts Receivable Allowance for Doubtful Accounts Investment in Trading Securities Inventory Supplies
Debits $13,920 2,050
Credits
$ 0 3,362 205
205
Prepaid Rent 0 Prepaid Advertising 0 Equipment 10,500 Accum. Depreciation—Equipment Furniture 1,000 Accum. Depreciation—Furniture Investment in AFS Securities 0 License Agreement 1,200 Accounts Payable Salaries Payable Interest Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 5/1 Revenue Dividend Revenue Unrealized Gain/Loss on Trading Securities Unrealized Gain/Loss on AFS Securities Gain/Loss on Sale of Trading Securities Gain/Loss on Sale of AFS Securities Salaries Expense 8,750 Tax Expense 740 Utilities Expense 0 Supplies Expense 0 Rent Expense 500 Bad Debt Expense 0 Purchases 12,466 Cost of Goods Sold 0 Depreciation Expense 0 Amortization Expense 0 Advertising Expense 0 Interest Expense 0 Loss on Sale of Equipment 0 Dividends 0
______
Totals
$54,693
$54,693
1,313 119
1,686 0 0 0 0 4,000 19,970 26,700 0 0 0 0 700
D) o) Salaries Expense Salaries Payable
$200
Utilities Expense Accounts Payable
$450
Supplies Expense Supplies Inventory
$135
$200
p) $450
q) $135
r) No adjustment needed – the allowance is currently at 10 percent of accounts receivable ($205/$2,050 = 10 percent) s) Depreciation Expense $175 Accumulated Depreciation—Equip
$175
Depreciation Expense $17 Accumulated Depreciation—Furn
$17
Amortization Expense License Agreement
$200 $200
Cost of Goods Sold Inventory Purchases
$14,506
t)
u) $ 2,040 12,466
Allow. Doubtful Investment in Cash Accounts Receivable Accounts Trading Securities Inventory 11,905 500(g) 2,050 9,000(f) 205 3,362 2,040(u) (e)17,700 14,000(h) (a)9,000 (f)9,000 750(j) (i)2,450 100(k) 8,000(l) 3,045(m) 740(n) 13,920
2,050
Supplies 65 135(q) (b)140
205
Prepaid Rent
70
Prepaid Advertising
0
Furniture 1,000
0
Accum. Depr.—Furn 119 17(s)
1,000
2,136
Capital Stock 4,000
4,000
1,322
Equipment 10,500
Accum. Depr.—Equip 1,313 175(s)
10,500
Investment in Availablefor-Sale Securities 2,450 2,450(i)
136
Accounts Payable (h)14,000 3,080 140(b) 12,466(d) 450(p)
0
1,488
License Agreement 1,200 200(t)
0
1,000
Salaries Payable Interest Payable Unearned Revenue Note Payable (k)100 100 (m)45 45 (m)3,000 3,000 200(o)
200
0
0
0
Unrealized Gain/Loss— Retained Earnings AFS Securities Revenue Dividend Revenue 19,970 (i)700 700 9,000(a) 17,700(e)
19,970
0
26,700
0
Unrealized Gain/Loss— Trading Securities
Gain/Loss on Sale of Trading Securities
0
Gain/Loss on Sale of AFS Securities 700(i)
0
Utilities Expense (p)450
700
Supplies Expense (q)135
450
135
Rent Expense Bad Debt Expense Purchases Cost of Goods Sold (g)500 d)12,466 12,466(u) (u)14,506
500
0
0
14,506
Depreciation Expense Amortization Expense (s)175 (t)200 (s)17 192
0
8,950
Advertising Expense
200
Loss on Sale of Equipment
Interest Expense
0 Dividends
0
Salaries Expense (j)750 (l)8,000 (o)200
0
Tax Expense (n)740 740
E Webworks Adjusted Trial Balance May 31 Account Title Cash Accounts Receivable Allowance for Doubtful Accounts Investment in Trading Securities Inventory Supplies Prepaid Rent Prepaid Advertising Equipment Accum. Depreciation—Equipment Furniture Accum. Depreciation—Furniture Investment in AFS Securities License Agreement
Debits $13,920 2,050
Credits
$
205
0 1,322 70 0 0 10,500 1,488 1,000 136 0 1,000
Accounts Payable Salaries Payable Interest Payable Unearned Revenue Note Payable Capital Stock Retained Earnings, 5/1 Revenue Dividend Revenue Unrealized Gain/Loss on Trading Securities Unrealized Gain/Loss on AFS Securities Gain/Loss on Sale of Trading Securities Gain/Loss on Sale of AFS Securities Salaries Expense 8,950 Tax Expense 740 Utilities Expense 450 Supplies Expense 135 Rent Expense 500 Bad Debt Expense 0 Purchases 0 Cost of Goods Sold 14,506 Depreciation Expense 192 Amortization Expense 200 Advertising Expense 0 Interest Expense 0 Loss on Sale of Equipment 0 Dividends 0
______
Totals
$55,535
$55,535
F) Webworks Income Statement As of May 31 Revenue Cost of Goods Sold Gross Profit Deprec. and Amort. Expense Other Expenses and Losses Investment Income (Loss) Earnings Before Tax Tax Expense Net Income
$26,700 (14,506) 12,194 (392) (10,035) 700 2,467 (740) $ 1,727
2,136 200 0 0 0 4,000 19,970 26,700 0 0 0 0 700
Webworks Statement of Retained Earnings As of May 31 Retained Earnings, May 1 Net Income Retained Earnings, May 31
$19,970 1,727 $21,697
Webworks Balance Sheet May 31 Assets:
Liabilities:
Current: Cash $13,920 Accounts Receivable 2,050 less Allow. for Doubt. Accts. (205) Net Accounts Receivable 1,845 Merchandise Inventory 1,322 Supplies Inventory 70 Total Current Assets $17,157
Current: Accounts Payable Salaries Payable
$ 2,136 200
Total Current Liabilities
$ 2,336
Owners’ Equity: Capital Stock Retained Earnings Total Owners’ Equity
$ 4,000 21,697 $25,697
Property, Plant, and Equipment Equipment less Accumulated Depreciation Furniture less Accumulated Depreciation Total P, P, and E Other Noncurrent Assets: License Agreement, net
Total Assets
$10,500 (1,488) 1,000 (136) $ 9,876
1,000
$28,033
Total Liabilities & Owners’ Equity
$28,033
Webworks Statement of Cash Flows As of May 31 Cash Flows from Operating Activities: Net Income Depreciation Expense Amortization Expense Gain on Sale of AFS Securities Decrease in Inventory Increase in Supplies Decrease in Accounts Payable Decrease in Interest Payable Increase in Salaries Payable Cash Generated by Operating Activities
$1,727 192 200 (700) 2,040 (5) (944) (45) 100 $ 2,565
Cash Flows from Investing Activities: Sold Available-for-Sale Securities Cash Generated by Investing Activities
$2,450 $ 2,450
Cash Flows from Financing Activities: Repaid Note Payable Cash Outflows from Financing Activities Increase in Cash Cash, 1/1 Cash, 12/31
($3,000) ($3,000) $ 2,015 11,905 $13,920
Answer to Research Assignment a. Net Income: Year ended January 2, 2011 Year ended January 3, 2010
$9,400,000 $5,138,000
The biggest cause for this jump in net income is the increase in commercial and franchise sales, net, which rose from $35,315,000 to $51,889,000. That increase represents a 46.9 percent growth rate in this one year. b. Net cash inflow from operating activities: Year ended January 2, 2011 $7,517,000 Year ended January 3, 2010 $15,594,000 The cash inflow is lower than net income for the year ended January 2, 2011, ($7,517,000 versus $9,400,000) whereas cash inflow is significantly higher than net
income for the year ended January 3, 2010 ($15,594,000 versus $5,138,000). Although several reasons can be spotted for the change in cash flow pattern, the biggest change by far is the increase in inventory. It was $12,653,000 for the year ended January 2, 2011, but only $3,060,000 for the year ended January 3, 2010. The company obviously poured a lot of resources into increasing its inventory levels this year. c. Cash spent as payments on property and equipment: Year ended January 2, 2011 $8,037,000 Year ended January 3, 2010 $2,969,000 A large increase in the cash spent on property and equipment occurred between these two years ($8,037,000 versus $2,969,000). This particular information indicates that the company is growing rapidly and having to acquire a substantial amount of property and equipment as a result. This information also supports the growth of inventory levels in that year as discovered above.
Part 2 CHAPTER 1 What Is Financial Accounting, and Why Is It Important? 1. MAKING GOOD FINANCIAL DECISIONS ABOUT AN ORGANIZATION 1. Define “financial accounting.” 2. Understand the connection between financial accounting and the communication of information about an organization. 3. Explain the importance of gaining an understanding of financial accounting. 4. List decisions that an individual might make about an organization. 5. Differentiate between financial accounting and managerial accounting. 6. Provide reasons for individuals to study the financial accounting information supplied by their employers.
1.1—Financial Accounting and Information [PowerPoint 1-4] Financial accounting is the communication of information about a business or other type of organization (such as a charity or a government) so that individuals can assess its financial health and future prospects. Financial accounting provides the rules and structure for the conveyance of financial information about businesses (and other organizations) to maximize clarity and understanding. Organization → reports information based on the principles of financial accounting → interested individuals assess financial health and future prospects
1.2—Financial Accounting and Wise Decision Making [PowerPoint 15]
Many possible benefits can be gained from acquiring a strong knowledge of financial accounting because it provides the accepted methods for communicating relevant information about an organization. Developing the ability to analyze financial ©2012 Flat World Knowledge, Inc.
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information and then making use of that knowledge to arrive at sound decisions can be critically important. Example: A recent college graduate looking at full-time employment opportunities might want to determine the probability that Company A will have a brighter economic future than Company B.
1.3—Common Decisions about Organizations [PowerPoint 1-6] Many decisions deal with the organization’s current financial condition and its future prospects. Having knowledge of the principles of financial accounting can help an individual make better decisions. Examples of individuals using financial information include: • Loan officers, who must make decisions about loaning money to companies, are concerned with the companies’ ability to repay the money plus interest in the future. • Credit analysts must decide whether to extend credit to customers. Companies need to find new customers to whom to sell their products, but they do not make money if those customers do not pay. • Investment counselors advise clients about making investments in companies. These individuals need to understand the financial situation of the investment opportunities if they are going to help their clients make wise decisions.
1.4—Financial Accounting versus Managerial Accounting [PowerPoint 1-7]
Examples: • Should a business buy or rent its headquarters? • What price should a business charge for its services? • Should a business advertise on television or the Internet? Decisions like these are made within the organization, not about the organization. 1.4.1—Managerial Accounting [PowerPoint 1-8] Managerial accounting refers to the communication of information within an organization so that internal decisions can be made in an appropriate manner. 1.4.2— Financial Accounting versus Managerial Accounting [PowerPoint 18]
Financial accounting is not better, more useful, or more important than managerial accounting. They have been created to achieve different objectives.
1.5—Financial Accounting Information and Company Employees [PowerPoint 1-9]
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Every employee should be interested in studying information produced by financial accounting to judge future employment prospects. • A business that is doing well will possibly award larger pay raises or perhaps significant end-of-year cash bonuses. • A financially healthy organization can afford to hire new employees, buy additional equipment, or pursue major new initiatives. • A business that is struggling might anticipate layoffs, pay cuts, or reductions in resources. 1.5.1—Teaching Tip: Value of Information [PowerPoint 1-10] You might want to mention a quote by Kofi Annan, former secretary-general of the United Nations: “Knowledge is power. Information is liberating.”
2. INCORPORATION AND THE TRADING OF CAPITAL SHARES 1. Define “incorporation.” 2. Explain the popularity of investing in the capital stock of a corporation. 3. Discuss the necessity and purpose of a board of directors. 4. List the potential benefits gained from acquiring capital stock. 2.1—The Ownership Shares of an Incorporated Business [PowerPoint 1-12]
2.1.1—The Ownership Shares of an Incorporated Business [PowerPoint 112]
Incorporation is the process undertaken by owners of a business or other type of organization where they apply to the state government to become identified as an entity legally set apart from its owners. A corporation is an organization that has been formally recognized by the state government as a separate legal entity that can act independently of its owners. A corporation has the ability to obtain monetary resources by selling (also known as issuing) capital shares that allow investors to become owners. They are then known as stockholders or shareholders. One of the great advantages of incorporation is the ease by which most capital stock can be exchanged.
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A business that has not been incorporated is either a sole proprietorship (one owner) or a partnership (more than one owner). Without the separation provided by incorporation, a clear distinction between owner and business does not exist. For example, debts incurred by a business that is a sole proprietorship or partnership may ultimately have to be satisfied by the owner personally. Thus, individuals tend to avoid making investments in unincorporated businesses unless they can be involved directly in the management. However, partnerships and sole proprietorships remain popular because they are easy to create and offer possible income tax benefits 2.1.2—Trading Shares of Stock [PowerPoint 1-13] Often, capital stock is sold on a public exchange like the New York Stock Exchange or NASDAQ. If traded on a stock exchange, shares of the capital stock of a corporation continually go up and down in value based on myriad factors, including the perceived financial health and future prospects of the organization. 2.1.3—Teaching Tip: Global Stock Exchanges [PowerPoint 1-13] A good opportunity to introduce the global nature of business is to introduce students to stock exchanges around the world. Bring the focus back to the U.S. exchanges at the end as you transition into the In-Class Activity.
2.1.2—IN-CLASS ACTIVITY Movement of Stock Prices Description: Before class, assign two publicly traded companies to each student or allow them to choose their own. Have them find each company’s high and low stock price during the past year. Potential web sites to use include http://finance.yahoo.com and http://moneycentral.msn.com. During class, break students into groups to discuss how widely their companies’ stock prices have varied over the year. Have them brainstorm potential reasons for these variations. 2.1.2—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
√
10 Minutes
Students will need to look up stock prices prior to class
2.2—The Operational Structure of a Corporation [PowerPoint 1-14]
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Obviously, a great many corporations like The Coca-Cola Company have an enormous quantity of capital shares held by tens of thousands of investors. Virtually none of these owners can expect to have any impact on the daily operations of the business. In a vast number of such organizations, stockholders elect board of directors who in turn hires the members of management who run the business on a daily basis. 2.2.1—Board of Directors [PowerPoint 1-15] The Board of Directors is a representative group voted to this position by stockholders to oversee the management of a corporation. The board meets periodically (often quarterly) to review operating, investing, and financing results as well as to approve strategic policy initiatives. 2.2.2—Teaching Tip: Board of Directors on NPR If your classroom has internet and speaker capability, take a few minutes to listen to a story produced by National Public Radio on the roles played by a board of directors. It can be found at http://www.npr.org/templates/story/story.php?storyId=105576374 Running time: 4 minutes, 24 seconds 2.2.3—Company Operational Structure [PowerPoint 1-16] The following list demonstrates the hierarchy of authority and responsibility in a typical corporation. Ownership Board of Directors Management
Employees
Each capital share is the equivalent of one unit of ownership. Elected by shareholders to hire and oversee the management of the company and make policy decisions. Officials such as the president, the chief financial officer, and the director of marketing who are in charge of daily operations. All individuals who work for a company who are not deemed to be members of the management.
2.3—Predicting the Appreciation of Capital Stock Values [PowerPoint 1-17]
Capital shares of thousands of corporations trade each day on markets around the world such as the New York Stock Exchange or NASDAQ (National Association of Securities Dealers Automated Quotations). One party is looking to sell shares whereas another is seeking shares to buy. Stock markets match up these buyers and sellers so that a mutually agreed-upon price can be negotiated. Investors believe that a company is financially healthy and future prospects are good— stock price rises ©2012 Flat World Knowledge, Inc.
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Investors predict that company will not remain financially healthy—stock price drops Factors Affecting Stock Price [PowerPoint 1-18] • Perceived quality of management • Historical trends in profitability • Viability of company’s industry • Health of economy • Other factors 2.3.1—Financial Accounting and the Stock Market [PowerPoint 1-19] Investors attempt to assess the financial condition and prospects of various business organizations on an ongoing basis. Being able to understand and make use of reported financial data helps improve the investor’s knowledge of corporation and, thus, the chance of making wise decisions about the buying and selling of capital shares. Ignorance often leads to poor decisions and much less lucrative outcomes. 2.3.2—Long-term Capital Gain or Loss [PowerPoint 1-20] Gain or loss on sale of stock held for longer than one year. Significant tax savings may result over selling stock held for less than one year. 2.3.3—Teaching Tip: U.S. Tax Policy For those with time, you may want to give a brief introduction to the U.S. Tax System. Students may question why long-term stock gains are taxed differently than short-term ones. Discussing Congress’ wish to encourage investing so that businesses can get needed capital should give them an interesting connection between business and government about which they may never have thought.
2.4— The Receipt of Dividends [PowerPoint 1-21] Many corporations pay cash dividends to their stockholders periodically. Dividend: A dividend is a reward for being an owner of a business that is prospering. • Reward for being an owner • Distribution of income • Not required by law • Set by Board of Directors
2.5— Annual Rate of Return on an Investment in Capital Stock 2.5.1—Work through an example of computing annual rate of return on stock [PowerPoint 1-22, 23] January 1, Year One, Investor buys stock in both Company A and Company B ©2012 Flat World Knowledge, Inc.
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Price per share, 1/1: Dividend during year: Price per share, 12/31:
Company A Company B $100 $100 $1.00 per share $5.00 per share $108 $91
Value of Company A: $108 + $1 = $109 Annual Rate of Return = ($109 – $100)/$100 = 9% Value of Company B: $91 + $5 = $96 Annual Rate of Return = ($96 – $100)/$100 = –4% 2.5.2—Have students work through an example of computing annual rate of return on stock, either individually or in teams [PowerPoint 1-24, 25] January 1, Year One, Investor buys stock in both Company S and Company T
Price per share, 1/1: Dividend during year: Price per share, 12/31:
Company S $10 $.50 per share $12
Company T $10 $2.00 per share $7
Value of Company S: $12 + $.50 = $12.50 Annual Rate of Return = ($12.50 – $10)/$10 = 25% Value of Company T: $7 + $2 = $9 Annual Rate of Return = ($9 – $10)/$10 = –10% 2.5.3—Teaching Tip: Tie It All Together A good way to wrap up the first two sections is to point out that a careful analysis of the available data might have helped this investor to choose Company A rather than Company B. The data is a result of financial accounting. A careful analysis of it can only result when the user has knowledge of financial accounting. Estimating the annual rate of return is important for investors because it helps them select from among multiple investment opportunities. This computation provides a method for quantifying the financial benefit earned in the past and expected in the future.
3. USING FINANCIAL ACCOUNTING FOR WISE DECISION MAKING
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1. List the predictions that investors and potential investors want to make about a business organization. 2. List the predictions that creditors and potential creditors want to make about a business organization. 3. Explain the reporting of monetary amounts as a central focus of financial accounting. 4. Explain how financial accounting information is enhanced and clarified by verbal explanations. 5. Understand the function played by the annual report published by many businesses and other organizations. 3.1—Financial Accounting Information and Investments in Capital Stock [PowerPoint 1-28] Investors wish to estimate: 1. The future price of a corporation’s capital stock 2. The future amount of cash dividends that will be paid by the business
3.2— Financial Accounting Information and Other Interested Parties [PowerPoint 1-29] Sizeable portions of the parties that study the financial information reported by an organization are probably most interested in the likelihood that money will be available in the future to pay its debts. What information interests creditors and potential creditors? 1. Amount of debt company already has 2. When debt is coming due 3. Perceived ability of company to meet obligations as they come due Ultimately, creditors attempt to anticipate the organization’s future cash flows to measure the risk that debt principal and interest payments might not be forthcoming when due.
3.3—The Nature of Financial Information [PowerPoint 1-30] Financial information—data that can be measured in monetary terms Examples: • Company owes bank $400,000 • Company owns equipment worth $20,000 • Company made sales of $5,900,000 Not financial information: • Company has 7,890 employees ©2012 Flat World Knowledge, Inc.
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•
Company operates in 23 states
3.4—Financial Accounting and Verbal Explanations [PowerPoint 1-31] Although financial accounting starts by reporting balances as monetary amounts, the communication process does not stop there. Extensive verbal explanations as well as additional numerical data are also provided to clarify or expand the monetary information where necessary. Example: Company reports pending lawsuit with probable loss of $750,000. This is the communication of financial information. The company will also communicate verbal explanations, which provide the user with more information such as cause of the lawsuit and the likelihood of loss. Steps in Providing Information [PowerPoint 1-32] Step One: Financial information is provided in monetary terms Step Two: Further explanation is given to clarify and expand on those monetary balances
3.5—The Annual Report [PowerPoint 1-33] Most companies regardless of size prepare and distribute an annual report shortly after the end of each year.
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CHAPTER 2 What Should Decision Makers Know in Order to Make Good Decisions about an Organization? 1. CREATING A PORTRAIT OF AN ORGANIZATION THAT CAN BE USED BY DECISION MAKERS 1. Explain the comparison of financial accounting to the painting of a portrait. 2. Understand the reasons why financial accounting information does not need to be exact. 3. Define the term “material” and describe its fundamental role in financial accounting. 4. Define the term “misstatement” and differentiate between the two types of misstatements: errors and fraud.
1.1— Financial Statements: The Portrait of an Organization [PowerPoint 2-3]
The purpose of a portrait is to capture a likeness of the artist’s model. Similarly, financial accounting attempts to present a portrait of an organization that can be used by interested parties to assess its financial health and future prospects. In accounting, this portrait is most often presented in the form of financial statements. Financial statements are a representation of an organization’s operations, financial position, and cash flows.
1.2— A Likeness Does Not Have to Be Exact [PowerPoint 2-4] Like a portrait, financial statements are not an exact depiction of its subject. Just as the eyes in a portrait differ from the person’s actual eyes, the numbers in the financial statements are not exact. Financial accounting information is rarely an exactly accurate portrait. The accountant’s goal is to create financial statements that present a likeness of an organization that can be used to make decisions.
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Example: the reported cost of constructing a building may be off slightly because of the sheer volume of money being spent on the many different aspects of the project. No one expects the reported cost of a $50 million manufacturing plant to be accurate to the penny. 1.2.1—Usefulness of Financial Statements [PowerPoint 2-4] If financial information provides a fair representation, an interested party should be able to make use of it to arrive at desired projections such as future stock prices. A potential investor or creditor does not need numbers that are absolutely accurate in order to assert, “Based on the information available in the financial statements, I understand enough about this business to make informed decisions. Even if I could obtain figures that were more accurate, I believe that I would still take the same actions.” 1.2.1—IN-CLASS ACTIVITY Using Actual Financial Statements Description: Before class, require students to pull the income statement and balance sheet of a company that interests them, such as Starbucks or Target. These statements can be used to illustrate many of the points of this chapter. To begin, have the students examine the magnitude of the numbers on their financial statements. Many will be in the millions, and some in the billions, of dollars. It should make sense to them immediately that those types of numbers cannot be exact to the penny. 1.2.1—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
2 Minutes
Students will need to bring financial statements to class
1.3— Material Misstatements [PowerPoint 2-5] In financial accounting, the data presented to decision makers by an organization should never contain any misstatements that are deemed to be material. Financial statements must be free of material misstatements in order to be of use to decision makers.
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1.3.1—Two Types of Misstatements [PowerPoint 2-6] The two types of misstatements are errors and fraud. A misstatement is an error (made accidentally) or fraud (done intentionally) where reported figures or words actually differ from the underlying reality. In simple terms, the information is wrong. 1.3.2—Teaching tip Before giving students examples of errors and fraud, see if they can come up with example of their own. Ask if they know of any companies or individuals, which have been accused of fraud. They should come up with examples such as Enron or Madoff. This will allow for a good discussion of the difference between an error and fraud. 1.3.3—Material Misstatement [PowerPoint 2-6] A misstatement is deemed to be material if it is so significant that its presence would impact a decision made by an interested party. A financial accountant never claims that reported information is correct, accurate, or exact. However, the accountant must take all precautions necessary to ensure that reported data contain no material misstatements. All parties need to believe that reported information can be used with confidence because it presents a fair likeness of the organization as a whole. 1.3.3—IN-CLASS ACTIVITY Using Actual Financial Statements Description: Ask the students to look at their financial statements (see 1.2.1 above). Would a $100 misstatement make a difference to them if they were thinking of investing in this company’s stock? How about a $100 million misstatement? Call on one or two students to explain their answers. 1.3.3—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
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2 Minutes
Students will need to bring financial statements to class
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2.
DEALING WITH UNCERTAINTY
1. Discuss the challenge created for financial accountants by the presence of uncertainty. 2. List examples of uncertainty that an accountant might face in reporting financial information about an organization. 3. Explain how financial accounting resembles a language such as Spanish or Japanese. 2.1— Uncertainty, the True Challenge for Reporting [PowerPoint 2-8] Many of the figures reported by an organization do not lend themselves to accuracy. The primary reason that exactness is not a goal can be summed up in a single word: uncertainty. Financial accounting is a structured attempt to paint a fairly presented portrait of an organization’s overall operations, financial condition, and cash flows. This requires the reporting of many events where a final resolution might not occur for months or even years. Uncertainty keeps financial information from being precise. Examples of uncertainty faced by organizations include law suits, bonuses and warranties. Many of the most important accounting rules have been created to establish requirements for the reporting of uncertain situations. Because of the quantity and variety of such unknowns, exactness simply cannot be an objective of financial reporting. Whenever an organization encounters a situation of this type, the accountant must come to understand what has happened and then determine a logical method to communicate a fair representation of that information within the framework provided by financial accounting rules. Thus, reporting events in the face of uncertainty is surely one of the major challenges of being a financial accountant.
2.2— Accounting as the Language of Business [PowerPoint 2-9] Accounting is a language—one that enables an organization to communicate a portrait of its financial health and future prospects to interested parties by using words and numbers rather than oils and watercolors. 2.2.1—An Effective Communication [PowerPoint 2-9] An effective communication is possible in a language when: 1) set terminology exists and 2) structural rules and principles are applied.
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Financial accounting has its own terminology. Many words and terms (such as “LIFO” and “accumulated depreciation”) have specific meanings. In addition, a comprehensive set of rules and principles has been established over the decades to provide structure and standardization. They guide the reporting process so that the resulting information will be fairly presented and readily understood by all interested parties, both inside and outside the organization. For successful communication of financial information, both the terminology and the structural rules must be understood by all parties involved. 2.2.1—IN-CLASS ACTIVITY Using Actual Financial Statements Description: Ask the students to look at their financial statements (see 1.2.1 above). Are there terms they do not understand or recognize, much as if they were looking at foreign language? Ask one or two students to share a term they do not understand. Explain that the terminology will explained over the course of the term. They will be learning the language of business. 2.2.1—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
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2 Minutes
Students will need to bring financial statements to class
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3. THE NEED FOR ACCOUNTING STANDARDS 1. Describe the purpose of accounting standards such as U.S. Generally Accepted Accounting Principles (U.S. GAAP) and International Financial Reporting Standards (IFRS) and the benefits that these rules provide. 2. Explain the importance of accounting standards to the development of a capitalistic economy. 3. Understand the role played by the Financial Accounting Standards Board (FASB) in the ongoing evolution of accounting standards in the United States. 4. Discuss the advantages and the possibility that financial reporting will switch from U.S. GAAP to IFRS. 3.1— The Existence of Formal Accounting Standards [PowerPoint 212]
The existence of financial accounting standards is essential to ensure that all communicated information is understood properly. During the past ten years or so, as a truly global economy became a reality, two primary systems of accounting rules emerged. U.S. generally accepted accounting principles (U.S. GAAP) are applied to most financial information presented within the United States. International Financial Reporting Standards (IFRS) are now used almost exclusively in the rest of the world. Having two bodies of rules causes problems for decision makers. Not surprisingly, many corporate officials and decision makers would prefer to see one universal set of accounting standards. Over the past few years, extensive progress has been made in bringing these two sets of standards into alignment. However, a number of significant differences continue to exist. 3.1.1—How does GAAP keep pace with a changing business world? Some rules are older, but many have been developed in the last 20 to 30 years. Accounting principles evolve as the business world changes. Significant changes are made to GAAP every year.
3.2— The Development of Accounting Standards [PowerPoint 2-13]
The Financial Accounting Standards Board (FASB) has held the authority to develop U.S. GAAP since 1973. IFRS are produced by the London-based International ©2012 Flat World Knowledge, Inc.
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Accounting Standards Board (IASB). Whether U.S. GAAP or IFRS, accounting standards evolve quite quickly as the nature of business changes and new reporting issues, problems, and resolutions arise. Because standardization exists in most areas of the reporting process, any decision maker with an adequate knowledge of financial accounting—whether located in Phoenix, Arizona or in Portland, Maine—should be able to understand fairly presented information being conveyed by a wide variety of organizations. They all speak the same language. Put simply, the existence of accounting standards enables organizations and other interested parties to communicate successfully. 3.2.1—Teaching Tip: Value of GAAP [PowerPoint 2-14] Have a few students volunteer what they consider the greatest intellectual achievement of the 20th century. Then present this quote from the Wall Street Journal about the importance of GAAP: “When the intellectual achievements of the 20th century are tallied, GAAP should be on everyone's Top 10 list.”
3.3— The Importance of Accounting Standards [PowerPoint 2-14, 15] 3.3.1—IN-CLASS ACTIVITY Using Actual Financial Statements Description: Ask the students to look at their financial statements (see 1.2.1 above). Pair students and ask them to compare their two companies. Tell them that each company is allowed to do their accounting however they wish, that no actual rules exist. Ask what comparisons they can make. They should say none. Now say that in truth, the accounting for these statements is governed by U.S. GAAP, and that while some judgment is allowed, the companies follow the same basic rules for accounting. Now can they make any comparisons? This should demonstrate the value of GAAP. 3.3.1—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
√
3 Minutes
Students will need to bring financial statements to class
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operate and grow, these companies must convince investors and creditors to contribute huge amounts of their own money voluntarily. Not surprisingly, such financing is only forthcoming if the possible risks and rewards can be assessed and then evaluated with sufficient reliability. Bring back In-Class Activity 3.3.1 by asking them if they would be more comfortable investing their money in their company knowing that the company must follow certain accounting rules. Before handing over thousands or even millions of dollars, decision makers must believe that they are using reliable data to make reasonable estimations of future stock prices, cash dividends, and cash flows. Otherwise, buying stocks and granting credit is no more than gambling. U.S. GAAP enables outside parties to obtain the financial information they need to reduce their perceived risk to acceptable levels. Thus, money can be raised, and businesses can grow and prosper. If accounting standards did not exist, the development and expansion of thousands of the businesses that have become a central part of today’s society might be limited or impossible simply because of the lack of available resources. An expanding economy requires capital investment. That funding is more likely to be available when financial information can be understood because it is stated in a common language: U.S. GAAP.
3.4— The Evolution of Accounting Standards [PowerPoint 2-16] As indicated earlier, since 1973, FASB has served as the primary authoritative body in charge of producing U.S. GAAP for nongovernmental entities such as businesses and private not-for-profit organizations.. FASB is an independent group supported by the U.S. government, various accounting organizations, and many private businesses. Typically, accounting problems arise over time within the various areas of financial reporting. New types of financial events can be created, for example, that are not covered by U.S. GAAP or, perhaps, weaknesses in earlier rules start to become evident. If such concerns grow to be serious, FASB steps in to study the issues and alternatives. After a period of study, the board might pass new rules or make amendments to previous ones. The FASB and other standard setting bodies will be covered in more detail in Chapter 6.
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4. FOUR BASIC TERMS FOUND IN FINANCIAL ACCOUNTING 1. Define “asset” and provide examples found in financial reporting. 2. Define “liability” and provide examples found in financial reporting. 3. Define “revenue” and provide examples found in financial reporting. 4. Define “expense” and provide examples found in financial reporting. 4.1— Assets, Liabilities, Revenues, and Expenses [PowerPoint 2-18, 19]
Begin with basic terminology. Four fundamental terms will be introduced in this chapter asset, liability, revenue, and expense. Knowledge of these words is essential in gaining an understanding of accounting because they serve as the foundation for a significant portion of the financial information provided by any organization.
4.2— Definition of the Term “Asset” [PowerPoint 2-18] An asset is a probable future economic benefit that an organization either owns or controls. Every business has its own particular mix of assets. Virtually all have cash and accounts receivable (money due from customers). Many also have inventory (merchandise held for resale). The size and type of other assets will vary significantly based on the company and the industry in which it operates. 4.2.1—IN-CLASS ACTIVITY Using Actual Financial Statements Description: Ask the students to look at their financial statements (see 1.2.1 above). Point out the left-hand side or top of the balance sheet. Ask volunteers to read off assets listed there. Ask students to determine how that item can be used to benefit the business in the future. For example, if a student names “inventory,” its benefit could be that it can be sold for cash.
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4.2.1—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
3 Minutes
Students will need to bring financial statements to class
4.3— Definition of the Term “Liability” [PowerPoint 2-18] A more formal definition of a liability is that it is a probable future sacrifice of economic benefits arising from present obligations but, for simplicity sake, liabilities can be viewed as the debts of the organization. Another term that is often encountered in financial reporting is “net assets.” The net asset total for an organization is simply its assets (future benefits) less its liabilities (debts). This balance is also known as “equity” in reference to the owners’ rights to all assets in excess of the amount owed on liabilities. A business’s net assets will increase if assets go up or if liabilities decrease. Changes in net assets show growth (or shrinkage) in the size of the organization over time.
4.3.1—IN-CLASS ACTIVITY Using Actual Financial Statements Description: Ask the students to look at their financial statements (see 1.2.1 above). Point out the right-hand side or middle of the balance sheet. Ask volunteers to read off liabilities listed there. Ask students if it makes sense that that item is seen as a debt of the organization. For example, if a student names “accounts payable,” this makes sense because these are amounts owed to suppliers. 4.3.1—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
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Students will need to bring financial statements to class
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4.4— Definition of the Term “Revenue” [PowerPoint 2-19] The term “revenue” is a measure of the financial impact on an organization that results from a particular process. This process is a sale. For timing purposes, revenue is recognized when the earning process takes place. That is normally when the goods or services are delivered. 4.4.1—IN-CLASS ACTIVITY Using Actual Financial Statements Description: Ask the students to look at their financial statements (see 1.2.1 above). Point out the income statement. Point out that the top line is revenue.
4.4.1—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
1 Minute
Students will need to bring financial statements to class
4.5— Definition of the Term “Expense” [PowerPoint 2-19] An expense is an outflow or reduction in net assets that was incurred by an organization in hopes of generating revenues. In some ways, expenses are the opposite of revenues that measure the inflows or increases in net assets that are created by sales. Expense figures reflect outflows or decreases in net assets incurred in hopes of generating revenues. 4.5.1—IN-CLASS ACTIVITY Using Actual Financial Statements Description: Ask the students to look at their financial statements (see 1.2.1 above). Point out the income statement. Ask volunteers to read off some of the expenses listed. Many of these will not be familiar to students, i.e., cost of goods sold and depreciation. Inform them that they will be learning the meanings of all of these terms as they learn the “language of accounting.”
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4.5.1—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
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CHAPTER 3 How Is Financial Information Delivered to Decision Makers Such as Investors and Creditors? 1. CONSTRUCTION OF FINANCIAL STATEMENTS BEGINNING WITH THE INCOME STATEMENT 1. Understand that financial statements provide the physical structure for the financial information reported to decision makers by businesses and other organizations. 2. Identify each of the four financial statements typically produced by a reporting entity. 3. List the normal contents of an income statement. 4. Define “gains” and “losses” and explain how they differ from “revenues” and “expenses.” 5. Explain the term “cost of goods sold.” 6. Compute gross profit and the gross profit percentage.
1.1— Financial Statements Provide Physical Structure for Financial Reporting [PowerPoint 3-4] Businesses and other organizations periodically produce financial statements that provide a formal structure for conveying financial information to decision makers. An organization’s revenues, expenses, assets, liabilities, and other balances are reported to outsiders by means of financial statements. 1.1.1—Financial Statements and Accompanying Notes [PowerPoint 3-5] Typically, a complete set of financial statements produced by a business includes four separate statements along with pages of comprehensive notes. These four statements are the income statement, the statement of retained earnings, the balance sheet, and the statement of cash flows. Users sometimes ignore the notes, but they contain important information about the company.
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1.2— Reporting Revenues and Expenses on an Income Statement [PowerPoint 3-6] As indicated previously in Chapter 2, revenue figures disclose increases in net assets (assets minus liabilities) that were created by the sale of goods or services resulting from the primary operations of the organization. Expenses are decreases in net assets incurred by a reporting organization in hopes of generating revenues.
1.3— Reporting Gains and Losses [PowerPoint 3-7] Gains are increases in the net assets of an organization created by an occurrence that is outside its primary or central operations. Losses are decreases in net assets from a similar type of incidental event. 1.2—IN-CLASS ACTIVITY Using Actual Financial Statements Description: In Chapter 2, students were required to pull the income statement and balance sheet of a company that interests them, such as Starbucks or Target. These statements can again be used to illustrate the points of this chapter. Ask them to see if the company reported any gains or losses. Direct them to try and understand how the gain or loss they found may not be related to the company’s main operations (this will be too difficult with some gains and losses). Ask two or three volunteers to share their findings. 1.2—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
2 Minutes
Students will need to bring financial statements to class
1.4—Cost of Goods Sold and Gross Profit [PowerPoint 3-8 and 3-9] Cost of goods sold is an expense reflecting the cost of the merchandise that a company’s customers purchased during the period. The timing of cost of goods sold expense recognition is not tied to the payment of cash but rather to the loss of the asset.
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Students often struggle with the concept of cost of goods sold. The following In-Class Activity may help them understand it more quickly. 1.2.1—IN-CLASS ACTIVITY Using Actual Financial Statements Description: Ask the students to find cost of goods sold or cost of sales on their company’s income statement. Have them determine what would be the most likely component of cost of goods sold for their company. For instance, a student with a Papa John’s income statement should say the cost of making pizzas and the other foods the company sells. 1.2.1—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
1 Minute
Students will need to bring financial statements to class
Gross profit is the difference between revenue and cost of goods sold. It is often referred to as the company’s gross margin or markup. 1.4.1—Gross Profit Percentage [PowerPoint 3-10] A company’s gross profit percentage is its gross profit divided by its sales revenue. 1.4.2—Work through an example of computing gross profit and gross profit percentage [PowerPoint 3-11, 12] Davidson Groceries ended the year with sales revenue of $1,400,000 and cost of goods sold of $900,000. Determine Davidson’s gross profit and gross profit percentage for the year. Gross Profit = Sales Revenue – Cost of Goods Sold Gross Profit = $1,400,000 - $900,000 Gross Profit = $500,000 Gross Profit Percentage = Gross Profit Sales Revenue
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Gross Profit Percentage = $500,000 $1,400,000 Gross Profit Percentage = 35.7% 1.4.3—Have students work through an example of computing gross profit and gross profit percentage, either individually or in teams [PowerPoint 3-13, 14]
Max Company ended the year with sales revenue of $101,100 and cost of goods sold of $60,500. Determine Max’s gross profit and gross profit percentage for the year. Gross Profit = Sales Revenue – Cost of Goods Sold Gross Profit = $101,100 - $60,500 Gross Profit = $40,600 Gross Profit Percentage = Gross Profit Sales Revenue Gross Profit Percentage = $40,600 $101,100 Gross Profit Percentage =
40.16%
1.5— Placement of Income Taxes on an Income Statement [PowerPoint 3-15]
State, federal, and international income taxes cost businesses considerable sums of money each year. Income tax expense is reported at the bottom of income statement. The income tax figure is segregated in this manner because it is not an expense in a traditional sense. An expense is incurred in order to generate revenues. Income taxes do not create revenues. Instead, they are caused by a company’s revenues and related profitability. Because the financial impact is the same as an expense (an outflow or decrease in net assets), “income tax expense” is often used for labeling purposes. A more appropriate title would be something like “income taxes assessed by government.”
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1.5.1—Work through an example of preparing an income statement [PowerPoint 3-16, 17, 18]
Davidson Groceries is a small convenience store. The owners of Davidson Groceries want to know if they made a net income or a net loss for the year ended December 31, 2014. Given the following account balances, prepare an income statement for this company. Sales Revenue $1,400,000 Salary Expense 120,000 Cost of Goods Sold 900,000 Income Tax Expense 50,000 Loss on Sale of Land 15,000 Gain on Sale of Delivery Truck 5,000 Rent Expense 20,000 Advertising Expense 30,000 Insurance Expense 15,000 Other Expense 25,000
Davidson Groceries Income Statement for Year Ended December 31, 2014 Sales Revenue $1,400,000 Expenses: Cost of Goods Sold $900,000 Salary 120,000 Rent 20,000 Advertising 30,000 Insurance 15,000 Others 25,000 Total Expenses (1,110,000) Operating Income
290,000
Other Gains and Losses: Gain on Sale of Delivery Truck Loss on Sale of Land
5,000 (15,000)
(10,000)
Income Before Income Taxes
280,000
Income Tax Expense
(50,000)
Net Income
$
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230,000
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1.5.2—Have students work through an example of preparing an income statement, either individually or in teams [PowerPoint 3-19, 20, 21]
Max Company sells bicycles and related gear. The owners of Max Company want to know if they made a net income or a net loss for the year ended December 31, 2014. Given the following account balances, prepare an income statement for this company. Salary Expense $22,000 Advertising Expense 9,840 Cost of Goods Sold 60,500 Income Tax Expense 2,763 Sales Revenue 100,100 Gain on Sale of Equipment 1,450
Max Company Income Statement for Year Ended December 31, 2014 Sales Revenue $100,100 Expenses: Cost of Goods Sold $60,500 Salary 22,000 Advertising 9,840 Total Expenses (92,340) Operating Income
7,760
Other Gains And Losses: Gain on Sale Of Equipment
1,450
Income Before Income Taxes
9,210
Income Tax Expense
(2,763)
Net Income
$ 6,447
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2. REPORTED PROFITABILITY AND THE IMPACT OF CONSERVATISM 1. Describe the method used to differentiate assets from expenses. 2. Discuss the rationale for the practice of conservatism and its effect on financial reporting. 3. Explain the reason dividend distributions are not reported as expenses within net income. 4. Discuss the need for decision makers to study an entire set of financial statements rather than focus exclusively on one or two numbers such as net income or gross profit. 2.1— Differentiating between an Asset and an Expense [PowerPoint 3-23]
A cost is identified as an asset if the benefit clearly has value in generating future revenues for the company. An expense is a cost that has already helped to earn revenues in the past. An example is rent. If next month’s rent is paid, this is an asset because occupying the rented space will help generate revenues next month. If last month’s rent is paid, this is an expense because occupying the rented space helped generate revenues last month.
2.2— Conservatism in Financial Accounting [PowerPoint 3-24] When it seems impossible to determine if a cost is an asset or an expense, financial accounting has a long history of following the practice of conservatism. Conservatism holds that whenever an accountant faces two or more equally likely possibilities, the one that makes the reporting company look worse should be selected. In other words, financial accounting attempts to ensure that an organization never looks significantly better than it actually is. If a cost is incurred that might have either a future value (an asset) or a past value (an expense), the accountant always reports the most likely possibility. However, if neither scenario appears more likely to occur, the cost is classified as an expense rather than an asset because of conservatism.
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2.3— The Reason for Conservatism [PowerPoint 3-25] Accountants are well aware that the financial statements they produce are relied on by decision makers around the world to determine future actions that will place significant amounts of money at risk. Such decision makers face potential losses that can be substantial. Accountants take their role in this process quite seriously. As a result, financial accounting has traditionally held that the users of financial statements are best protected if the reporting process is never overly optimistic in picturing an organization’s financial health and future prospects. The practice of conservatism is simply an attempt by financial accounting to help safeguard the public. Teaching Tip: This would be an excellent time to discuss the downfall of WorldCom. A major cause of this accounting scandal, one of the biggest in history, was the fraudulent decision by members of the company’s management to record a cost of nearly $4 billion as an asset rather than as an expense. Although any future benefit resulting from those expenditures was highly doubtful, the cost was reported to outsiders as an asset. Conservatism was clearly not followed.
2.4—Reporting Dividend Distributions [PowerPoint 3-26] Dividends are not expenses and, therefore, are omitted in preparing an income statement. They are not related to generating revenues. A dividend is a sharing of profits with owners and not a cost incurred to create revenues. An income statement reports revenues, expenses, gains, and losses. Dividend distributions do not qualify and must be reported elsewhere in the company’s financial statements.
2.5—The Significance of Reported Net Income [PowerPoint 3-27] Financial statements present a vast array of data and the importance of any one balance should never be overemphasized. The analysis of all information conveyed by a set of financial statements enables an interested party to arrive at the most appropriate decisions about an organization. Some creditors and investors seek shortcuts when making business decisions rather than doing the detailed analysis that is appropriate. Those individuals often spend an exorbitant amount of time focusing on reported net income. Such a narrow view shows a fundamental misunderstanding of financial reporting and the depth and breadth of the information being conveyed.
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3. INCREASING THE NET ASSETS OF A COMPANY 1. Define “retained earnings” and explain its composition. 2. Define “capital stock” and explain the meaning of its reported account balance. 3. Explain the lack of financial impact that the exchange of ownership shares between investors has on a corporation. 3.1— The Meaning of Retained Earnings [PowerPoint 3-29] Retained earnings is the total amount of all net income earned by a business since it first began operations, less all dividends paid to stockholders during that same period of time. Retained earnings is a measure of the profits left in a business throughout its existence to create growth. Total net income since organization began operations Less: total of all dividends paid to owners Retained earnings balance When a business earns income, it becomes larger because net assets have increased. Even if a portion of the profits is later distributed to shareholders as a dividend, the company has grown in size as a result of its own operations. The retained earnings figure informs decision makers of the amount of that internally generated expansion.
3.1.1—IN-CLASS ACTIVITY Using Actual Financial Statements Description: Ask the students to find retained earnings on their company’s balance sheet. Most students will have comparative balance sheets, so have them locate retained earnings on the prior year’s balance sheet as well. Once they note the difference, point out that the reason it increased or decreased would be because the company earned net income or perhaps paid dividends.
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3.1.1—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead 1 Minute
√
Students will need to bring financial statements to class
3.2— The Reporting of Retained Earnings [PowerPoint 3-30] Company Name Statement of Retained Earnings for Year Ended December 31, Year Retained Earnings Balance, January 1, Year Net Income Reported for Year Dividends Distributed During Year Net Income Less Dividends for Year
XXX XXX XXX XXX
Retained Earnings Balance, December 31, Year
XXX
3.2.1—Work through an example of preparing a statement of retained earnings [PowerPoint 3-31, 32] Davidson Groceries is a small convenience store. The owners of Davidson Groceries would like to know the ending balance in their retained earnings account. Given the following account balances, prepare a statement of retained earnings for this company.
Net Income Retained Earnings, 1/1/14 Dividends Paid
$ 230,000 320,000 100,000
Davidson Groceries Statement of Retained Earnings for the Year Ended December 31, 2014 Retained Earnings Balance, January 1, 2014 $320,000 Net Income Reported for 2014 Dividends Distributed During 2014 Net Income Less Dividends for 2014
$230,000 100,000
Retained Earnings Balance, December 31, 2014
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130,000 $450,000
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3.2.2—Have students work through an example of preparing a statement of retained earnings, either individually or in teams [PowerPoint 3-33, 34] Max Company sells bicycles and related gear. The owners of Max Company would like to know the ending balance in their retained earnings account. Given the following account balances, prepare a statement of retained earnings for this company. Net Income Retained Earnings, 1/1/14 Dividends Paid
$ 6,447 15,900 2,000
Max Company Statement of Retained Earnings for the Year Ended December 31, 2014 Retained Earnings Balance, January 1, 2014 $15,900 Net Income Reported for 2014 Dividends Distributed During 2014 Net Income Less Dividends for 2014
$6,447 2,000
Retained Earnings Balance, December 31, 2014
4,447 $20,347
3.3— Assets Contributed to Gain Ownership Shares [PowerPoint 335]
In addition to retained earnings, a business accumulates net assets by receiving contributions from investors who become owners through the acquisition of capital stock. Capital stock is also known as common stock and contributed capital. The amount of a company’s net assets is the excess of its assets over its liabilities. For most businesses, two accounting balances indicate the primary sources of those net assets. •
Capital stock (or contributed capital). This is the amount invested in the business by individuals and groups to become owners.
•
Retained earnings. This figure is the total net income earned by the organization over its life less amounts distributed as dividends to owners.
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3.3.1—IN-CLASS ACTIVITY Using Actual Financial Statements Description: Ask the students to locate capital or common stock on their balance sheet. There should be a lot of information included (authorized shares, par value). Note that these will be explained as they progress further into the course. Have a volunteer put the number on their balance sheet into words (i.e., stockholders at Disney have invested X dollars into the company). 3.3.1—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
1 Minute
Students will need to bring financial statements to class
3.4—The Trading of Shares of Capital Stock [PowerPoint 3-36] A corporation issues (sells) ownership shares to investors to raise money. The source of the resulting inflow of assets into the business is reflected in financial accounting by the reporting of a capital stock (or contributed capital) balance. Purchases and sales on stock markets normally occur between two investors and not directly with the company. Therefore, a company does not receive money when its shares are sold each day on a stock exchange. Only the initial issuance of the ownership shares to a stockholder creates the inflow of assets reported by a capital stock or contributed capital account.
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4. REPORTING A BALANCE SHEET AND STATEMENT OF CASH FLOWS 1. List the types of accounts presented on a balance sheet. 2. Explain the difference between current assets and liabilities and noncurrent assets and liabilities. 3. Calculate working capital and the current ratio. 4. Provide the reason for a balance sheet to always balance. 5. Identify the three sections of a statement of cash flows and explain the types of events included in each. 4.1— Information Reported on a Balance Sheet [PowerPoint 3-38] The primary purpose of a balance sheet is to report a company’s assets and liabilities at a particular point in time. All assets are listed first—usually in order of liquidity—followed by the liabilities. A portrait is provided of each future economic benefit owned or controlled by the company (its assets) as well as its debts (liabilities). 4.1.1—IN-CLASS ACTIVITY Using Actual Financial Statements Description: To set up for the discussion of current vs. noncurrent assets and liabilities, have students examine their balance sheets. Ask a volunteer to express how assets are segregated. Use this to lead them into the next PowerPoint slide.
4.1.1—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
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Students will need to bring financial statements to class
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4.2—Classifying Assets and Liabilities [PowerPoint 3-39] Assets are divided between current (those expected to be used or consumed within the following year) and noncurrent (those expected to remain within the company for longer than a year). Likewise, liabilities are split between current (to be paid during the upcoming year) and noncurrent (not to be paid until after the next year). This labeling is common and aids financial analysis.
4.2—IN-CLASS ACTIVITY Using Actual Financial Statements Description: Continue the above activity by calling on students to list assets and liabilities which are listed as current and examples of those listed as noncurrent. Ask for volunteers to speculate why assets and liabilities are segregated this way. Use this to lead them into the current ratio (next slide). 4.2.1—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
2 Minutes
Students will need to bring financial statements to class
4.3—Current Ratio and Working Capital [PowerPoint 3-40] Current ratio = Current assets ÷ Current liabilities Current ratio is calculated by many decision makers as a useful measure of short-term operating strength. Working capital = Current assets – Current liabilities Working capital reflects short-term financial strength, the ability of a business or other organization to generate sufficient cash to pay debts as they come due.
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4.3.1—Work through an example of computing the current ratio and working capital [PowerPoint 3-41, 42] On December 31, Davidson Groceries has current assets of $161,000 and current liabilities of $57,000. Calculate Davidson’s current ratio and working capital. Current Ratio = Current Assets ÷ Current Liabilities Current Ratio = $161,000 ÷ $57,000 Current Ratio = 2.82 to 1 Working Capital = Current Assets – Current Liabilities Working Capital = $161,000 – $57,000 Working Capital = $104,000 4.3.2—Have students work through an example of computing current ratio and working capital, either individually or in teams [PowerPoint 3-43, 44] On December 31, Max Company has current assets of $23,685 and current liabilities of $9,000. Calculate Max’s current ratio and working capital. Current Ratio = Current Assets ÷ Current Liabilities Current Ratio = $23,685/$9,000 Current Ratio = 2.63 to 1 Working Capital = Current Assets – Current Liabilities Working Capital = $23,685 – $9,000 Working Capital = $14,685
4.4—The Accounting Equation [PowerPoint 3-45] The balance sheet will always balance unless a mistake is made. This is known as the accounting equation: Accounting Equation (Version 1): Assets = Liabilities + Stockholders’ Equity Or, if the stockholders’ equity account is broken down into its component parts: Accounting Equation (Version 2): Assets = Liabilities + Capital Stock + Retained Earnings
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This equation stays in balance for one simple reason: assets must have a source. If a business or other organization has an increase in its total assets, that change can only be caused by (a) an increase in liabilities such as money being borrowed, (b) an increase in capital stock such as additional money being contributed by stockholders, or (c) an increase created by operations such as a sale that generates a rise in net income. No other increases occur. One way to understand the accounting equation is that the left side (the assets) presents a picture of the future economic benefits that the reporting company holds. The right side provides information to show how those assets were derived (from liabilities, from investors, or from operations). Because no assets are held without a source, the equation (and, hence, the balance sheet) must balance. Accounting Equation (Version 3): Assets = The total of the sources of the assets 4.4.1—Work through an example of preparing a balance sheet [PowerPoint 3-46, 47, 48, 49, 50]
Davidson Groceries is a small convenience store. The owners of Davidson Groceries would like to know what assets, liabilities, and stockholders’ equity they have. Given the following account balances, prepare a balance sheet as of 2014 for this company. Accounts Payable Accounts Receivable Inventory Prepaid Rent Equipment (net) Land Buildings (net) Note Payable—Third National Bank Note Payable—State Bank Salaries Payable Insurance Payable Retained Earnings Cash Capital Stock
$ 33,000 24,000 103,000 12,000 155,000 210,000 680,000 300,000 220,000 9,000 15,000 450,000 22,000 179,000
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Davidson Groceries Balance Sheet, December 31, 2014 Assets Current Assets Cash Accounts Receivable Inventory Prepaid Rent Total Current Assets Noncurrent Assets Land Equipment (net) Buildings (net) Total Noncurrent Assets Total Assets Liabilities and Stockholders’ Equity Liabilities Current Liabilities Accounts Payable Salaries Payable Insurance Payable Total Current Liabilities Noncurrent Liabilities Note Payable—Third National Bank Note Payable—State Bank Total Noncurrent Liabilities Total Liabilities Stockholders’ Equity Capital Stock Retained Earnings Total Stockholders’ Equity Total Liabilities and Stockholders’ Equity
$ 22,000 24,000 103,000 12,000 $ 161,000 210,000 155,000 680,000 1,045,000 $1,206,000
$ 33,000 9,000 15,000 $
57,000
300,000 220,000 520,000 $ 577,000 $179,000 450,000 $ 629,000 $1,206,000
4.4.2—Have students work through an example of preparing a balance sheet, either individually or in teams [PowerPoint 3-51, 52, 53, 54, 55] Max Company sells bicycles and related gear. The owners of Max Company would like to know what assets, liabilities, and stockholders’ equity they have. Given the following account balances, prepare a balance sheet as of 2014 for this company.
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Retained Earnings $20,347 Accounts Receivable 9,230 Inventory 11,000 Building 48,937 Note Payable 25,475 Accounts Payable 9,000 Cash 3,455 Capital Stock 17,800 Max Company Balance Sheet, December 31, 2014 Assets Current Assets Cash Accounts Receivable Inventory Total Current Assets Noncurrent Assets Building Total Noncurrent Assets Total Assets Liabilities and Stockholders’ Equity Liabilities Current Liabilities Accounts Payable Total Current Liabilities Noncurrent Liabilities Note Payable Total Noncurrent Liabilities Total Liabilities Stockholders’ Equity Capital Stock Retained Earnings Total Stockholders’ Equity Total Liabilities and Stockholders’ Equity
$ 3,455 9,230 11,000 $23,685 48,937 48,937 $72,622
$9,000 $9,000 25,475 25,475 $34,475 $17,800 20,347 $38,147 $72,622
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4.5—The Statement of Cash Flows [PowerPoint 3-56] The statement of cash flows provides a portrait of the various ways the reporting company generated cash during the year and the uses that were made of it. Decision makers place considerable emphasis on a company’s ability to generate significant cash inflows and then make wise use of that money. Cash flows are divided into one of the three categories: (1) Operating activities (2) Investing activities (3) Financing activities 4.5.1—Operating Activities [PowerPoint 3-57] Cash flows listed as the result of operating activities relate to receipts and disbursements that arose in connection with the central activity of the organization. This section of the statement shows how much cash the primary business function generated during a period of time. 4.5.2—Investing Activities [PowerPoint 3-58] Investing activities report cash flows created by events that (1) are separate from the central or daily operations of the business and (2) involve an asset. Thus, the amount of cash collected when either equipment or land is sold is reported within this section. 4.5.3—Financing Activities [PowerPoint 3-59] Like investing activities, cash flows from financing activities are unrelated to daily business operations but, here, the transactions relate to either a noncurrent liability or a stockholders’ equity balance. Borrowing money from a bank meets these criteria as does distributing a dividend to shareholders. Issuing stock to new owners for cash is another financing activity as is payment of a noncurrent liability.
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4.5.4—Work through an example of preparing a statement of cash flows [PowerPoint 3-60, 61, 62, 63, 64]
Davidson Groceries is a small convenience store. The owners of Davidson Groceries would like to know their sources and uses of cash during the year 2014. Given the following items, prepare a statement of cash flows for this company.
Cash Balance, 1/1/2014 $39,000 Cash Paid to Owners as Dividends 100,000 Cash Collected From Customers 1,396,000 Cash Paid for Purchase of Building 280,000 Cash Paid For Inventory 935,000 Cash Paid For Income Taxes 50,000 Cash Received form Bank on a Loan 120,000 Cash Received From Sale of Delivery Truck 40,000 Cash Received from Sale of Land 35,000 Cash Paid For Salaries 138,000 Cash Paid For Rent 27,000 Cash Paid for Insurance 48,000 Cash Paid for Advertising 30,000 Davidson Groceries Statement of Cash Flows for Year Ended December 31, 2014 Cash Flows from Operating Activities Cash Collected from Customers Cash Paid for Inventory Cash Paid for Salaries Cash Paid for Rent Cash Paid for Advertising Cash Paid for Insurance Cash Paid for Income Taxes Total Cash Inflow from Operating Activities Cash Flows from Investing Activities Cash Received from Sale of Delivery Truck Cash Received from Sale of Land Cash Paid for Purchase of Building Total Cash Outflow from Investing Activities Cash Flows from Financing Activities Cash Paid to Owners as Dividends Cash Received from Bank on Loan Total Cash Inflow from Financing Activities Cash Reduction During Year Cash Balance—January 1, 2014 Cash Balance—December 31, 2014
$1,396,000 (935,000) (138,000) (27,000) (30,000) (48,000) (50,000) $168,000 40,000 35,000 (280,000) (205,000) (100,000) 120,000
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20,000 (17,000) 39,000 $ 22,000*
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*A good opportunity to show that this ending cash balance ties with the cash balance on the balance sheet
4.5.5—Have students work through an example of preparing a statement of retained earnings, either individually or in teams [PowerPoint 3-65, 66, 67, 68, 69]
Max Company sells bicycles and related gear. The owners of Max Company would like to know their sources and uses of cash during the year 2014. Given the following items, prepare a statement of cash flows for this company. Cash Balance, 1/1/2014 Cash Paid for Dividends Cash Paid for Building Cash Paid for Inventory Cash Paid for Income Taxes Cash Received from Bank Loan Cash Collected from Customers Cash Paid for Advertising
$2,188 2,000 20,760 12,840 2,763 20,970 28,500 9,840
Max Company Statement of Cash Flows for Year Ended December 31, 2014 Cash Flows from Operating Activities Cash Collected from Customers Cash Paid for Inventory Cash Paid for Advertising Cash Paid for Income Taxes Total Cash Inflow from Operating Activities Cash Flows from Investing Activities Cash Paid for Purchase of Building Total Cash Outflow from Investing Activities Cash Flows from Financing Activities Cash Received from Bank Loan Cash Paid to Owners as Dividends Total Cash Inflow from Financing Activities Cash Increase During Year
$28,500 (12,840) (9,840) (2,763) $ 3,057 (20,760) (20,760) 20,970 (2,000)
Cash Balance—January 1,2014 Cash Balance—December 31,2014
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18,970 1,267 2,188 $ 3,455
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CHAPTER 4 How Does an Organization Accumulate and Organize the Information Necessary to Create Financial Statements? 1. THE ESSENTIAL ROLE OF TRANSACTION ANALYSIS 1. Define “transaction” and provide several common examples. 2. Define “transaction analysis” and explain its importance to the accounting process. 3. Identify the account changes created by the purchase of inventory, the payment of a salary, and the borrowing of money. 4. Understand that corporate accounting systems can be programmed to record expenses such as salary automatically as they accrue.
1.1— The Nature of a Transaction [PowerPoint 4-3] The accounting process starts by analyzing the effect of transactions—any event that has an immediate financial impact on a company. Large organizations participate in literally millions of transactions each year. The resulting information must be gathered, sorted, classified, and turned into a set of financial statements that cover mere four or five pages. 1.1.1— Transactions Frequently Encountered by a Business [PowerPoint 4-4, 5, 6]
1) Buy inventory on credit for $2,000 2) Pay regular salary of $300 to an employee for work done during the past week; no amount had previously been recorded 3) Borrow $9,000 in cash from bank by signing a loan agreement 4) Make a sale of the inventory bought in (1) to a customer for $5,000 on credit
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5) Pay $700 for insurance coverage for the past few months; this amount has previously been recognized in the company’s accounting system as it was incurred 6) Buy a new automobile for the company for a price of $40,000 by paying $10,000 in cash and signing a note for the remainder 7) Issue ownership shares to a new stockholder for cash of $19,000 8) Collect cash from customer on earlier sale in (4) 9) Pay cash for the inventory acquired in (1) 10) Pay $4,000 to rent a building for the next four months All of the events listed above are typical transactions that any business might encounter. Each causes some measurable effect on a company’s assets, liabilities, revenues, expenses, gains, losses, capital stock, or dividends paid. The accounting process begins with an analysis of each transaction to determine the specific changes that took place. Was revenue earned? Did a liability increase? Has an asset been acquired? What changed as a result of this event?
1.2— Analyzing the Impact of a Transaction [PowerPoint 4-7] Transaction 1—A company buys inventory on credit for $2,000 Inventory, which is an asset, increases by $2,000 because of the purchase. The organization has more inventory than it did previously. Thus, inventory account is increased. Because no money was paid for these goods when bought, a liability for the same amount has been created. The term accounts payable is often used in financial accounting to represent debts resulting from the acquisition of inventory and supplies. Inventory (asset) increases by $2,000 Accounts Payable (liability) increases by $2,000
1.3— The Financial Impact of Paying an Employee [PowerPoint 4-8] Transaction 2—A company pays a salary of $300 to one of its employees for work performed during the past week. Cash (an asset) is decreased here by $300. The cash balance declined because salary was paid to an employee. As a result, assets reduce. That is a cost to the company. The person’s effort has already been carried out, generating revenues for the company in the previous week rather than in the future. Thus, a salary expense of $300 is reported. Salary Expense (expense) increases by $300 Cash (asset) decreased by $300
1.4—Recording Accrued Expense [PowerPoint 4-9] Costs such as salary, rent, or interest increase gradually over time and are often referred to as accrued expenses because the term “accrue” means “to grow.” An accounting system can be mechanically structured to record such costs in either of the two ways.
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Some companies simply ignore accrued expenses until paid. The expense is recognized and cash is reduced. No liability is entered into the accounting system or removed. Because the information provided specifies that nothing has been recorded to date, this approach was apparently used here. When financial statements are produced, any amount that is still owed must be recognized for a fair presentation.
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Other companies choose to program their computer systems so that both the expense and the related liability are recognized automatically as the amount grows.
A company can recognize an accrued expense as it is incurred or wait until payment is made. This decision depends on the preference of company officials. The end result is the same, but the recording procedures differ.
1.4— Borrowing Money from the Bank [PowerPoint 4-10] Transaction 3—A company borrows $9,000 from a bank on a long-term note. In this transaction, cash is increased by the amount of money received from the lender. The company is obligated to repay this balance and, thus, has incurred a new liability. Cash (asset) increases by $9,000 Note Payable (liability) increases by $9,000
2. UNDERSTANDING THE EFFECTS CAUSED BY COMMON TRANSACTIONS 1. Explain the reason that a minimum of two accounts are impacted by every transaction. 2. Identify the individual account changes that are created by the payment of insurance and rent, the sale of merchandise, the acquisition of a long-lived asset, a capital contribution, the collection of a receivable, and the payment of a liability. 3. Separate the two events that occur when inventory is sold and determine the financial effect of each. 2.1— Recording the Sale of Inventory [PowerPoint 4-12] Transaction 4—A company sells the inventory items bought in Transaction 1 for $2,000 are now sold to a customer for $5,000 on credit.
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Two connected events actually take place in the sale of inventory. First, revenue of $5,000 is generated by the sale. This account is frequently labeled as “Sales” or “Sales revenue.” In this example, because the money will not be collected until a later date, accounts receivable (an asset) is initially increased. The reporting of a receivable balance indicates that this amount of money is due from a customer and should be collected at some subsequent point in time. Accounts Receivable (asset) increases by $5,000 Sales (revenue) increases by $5,000 Second, the inventory is removed. Companies have an option in the method by which inventory balances are monitored. Here, a perpetual inventory system is utilized. This approach is extremely common due to the prevalence of computer systems in the business world. It maintains an ongoing record of the inventory held and the amount that has been sold to date. All changes in inventory are recorded immediately. Because a perpetual system is being used here, the reduction in inventory is recorded simultaneously with the sale. Inventory costing $2,000 is taken away by the customer. The company’s net assets are reduced by this amount. Therefore, a $2,000 expense is recognized. That inventory no longer provides a future benefit for the company but rather is a past benefit. Cost of goods sold (an expense) is reported to reflect this decrease in the amount of merchandise on hand. Cost of Goods Sold (expense) increases by $2,000 Inventory (asset) decreases by $2,000 The $3,000 difference between the sales revenue of $5,000 and the related cost of goods sold of $2,000 is known as the gross profit (or gross margin or mark up) on the sale. 2.1.1—Calculating Gross Profit [PowerPoint 4-13] Review from Chapter 3: Calculate gross profit on transaction number (4) above. Gross Profit = Sales Revenue − Cost of Goods Sold Gross Profit = $5,000 − $2,000 Gross Profit = $3,000
2.2— The Dual Effect of Transactions [PowerPoint 4-14] In every transaction, a cause and effect relationship is always present. No account balance can possibly change without some identifiable cause. Thus, every transaction must touch a minimum of two accounts. Many transactions actually affect more than two accounts but at least two are impacted by each of these financial events.
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2.3— Paying a Previously Recorded Expense [PowerPoint 4-15] Transaction 5—A company pays $700 for insurance coverage relating to the past few months. Cash declined by $700 as a result of the payment. This cost relates to a past benefit. Thus, an expense must be recorded. The company’s accounting system has already recorded an accrual for the insurance. Thus, $700 in insurance expense and the related liability were recognized as incurred. The expense cannot be recorded again or it will be double-counted. Instead, cash is reduced along with the liability that was established through the accrual process. The expense has already been recorded, so no additional change in that balance is needed. Insurance Payable (liability) decreases by $700 Cash (asset) decreases by $700
2.4— Acquisition of an Asset [PowerPoint 4-16] Transaction 6—A company acquires a truck for $40,000 but only $10,000 in cash is paid by the company. The other $30,000 is covered by signing a note payable. In this transaction, for the first time, three accounts are impacted. A truck is bought for $40,000 so the balance recorded for this asset is increased by that cost. Cash decreases by $10,000 while the notes payable balance rises by $30,000. Truck (asset) increases by $40,000 Cash (asset) decreases by $10,000 Notes Payable (liability) increases by $30,000
2.5— Recording a Capital Contribution Made by an Owner [PowerPoint 4-17]
Transaction 7—A company issues ownership shares to a new stockholder for cash of $19,000 When cash is contributed to a company for a portion of the ownership, cash obviously goes up by the amount received. This money was not generated by revenues or by liabilities but rather represents assets given freely so that new ownership shares could be obtained. This inflow is reflected in the financial accounting as increases in both the cash and capital stock accounts. Cash (asset) increases by $19,000 Capital Stock (stockholders’ equity) increases by $19,000
2.6— The Collection of an Account Receivable [PowerPoint 4-18] Transaction 8—A company collects cash from customer on earlier sale made in Transaction 4 for $5,000. ©2012 Flat World Knowledge, Inc.
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The revenue from this transaction was properly recorded in Transaction 4 when the sale originally took place. The account receivable balance was also established. Revenue should not be recorded again or it will be double-counted causing reported net income to be overstated. In simple terms, revenue is recorded when earned, and that has already taken place. Instead, for recording purposes, the accountant indicates that this increase in cash is caused by the decrease in the accounts receivable balance established in Transaction 4. Cash (asset) increases by $5,000 Accounts Receivable (asset) decreases by $5,000
2.7— Payment Made on an Earlier Purchase [PowerPoint 4-19] Transaction 9— A company makes a payment made for inventory bought in Transaction 1 for $2,000. As a result of the payment, cash is decreased by $2,000. The inventory was recorded previously when acquired. Therefore, this subsequent transaction does not replicate that effect. Instead, the liability established in Transaction 1 is now removed from the books. The company is not buying the inventory again but simply paying off the debt established for these goods when they were purchased. Accounts Payable (liability) decreases by $2,000 Cash (asset) decreases by $2,000
2.8— Payment of Rent in Advance [PowerPoint 4-20] Transaction 10— A company pays $4,000 to rent a building for the next four months In acquiring the use of this property, the company’s cash decreases by $4,000. The money was paid in order to utilize the building for four months in the future. The anticipated economic benefit is an asset, and that information should be reported to decision makers by establishing a prepaid rent balance. Money has been paid to use the property at a designated time in the future to help generate revenues. Prepaid Rent (asset) increases $4,000 Cash (asset) decreases by $4,000
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3. DOUBLE-ENTRY BOOKKEEPING 1. 2. 3. 4. 5.
Explain the history of double-entry bookkeeping. List the four steps followed in the accounting process. Indicate the purpose of a T-account. List the basic rules for making use of debits and credits. Describe the reason that debits and credits are always equal for every transaction.
3.1— Double-Entry Bookkeeping [PowerPoint 4-22] Over five hundred years ago, Venetian merchants in Italy developed a system that continues to serve in the twenty-first century as the basis for accumulating financial data throughout much of the world. The double-entry bookkeeping procedures that were first documented in 1494 by Fra Luca Bartolomeo de Pacioli remain virtually unchanged by time. Organizations, both small and large, use the fundamentals of double-entry bookkeeping to gather the monetary information needed to produce financial statements that are fairly presented according to the rules of U.S. GAAP or IFRS.
3.2— Analyze, Record, Adjust, and Report [PowerPoint 4-23] State-of-the-art computers and other electronic devices are designed to refine and accelerate the financial accounting process but the same basic organizing procedures have been utilized now for hundreds of years. Accounting systems are all created to follow four sequential steps: 1) Analyze 2) Record 3) Adjust 4) Report Financial accounting starts by analyzing each transaction to ascertain the changes created in accounts such as rent expense, cash, inventory, and dividends paid. Fortunately, a vast majority of any company’s transactions are repetitive so that many of the effects can be easily anticipated. Computer systems can be programmed to record the impact of these events automatically allowing the accountant to focus on analyzing more complex transactions.
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3.3— Debits, Credits, and T-Accounts [PowerPoint 4-24, 25, 26, 27, 28] An essential step in understanding double-entry bookkeeping is to realize that financial information is accumulated by accounts. Every balance to be reported in a set of financial statements is maintained in a separate account. Based on the original Venetian model, the balance for each account is monitored in a form known as a T-account. This structure provides room for recording on both the left side (known as the debit side) and the right side (the credit side). One side of each T-account records increases; the other side records decreases. For over five hundred years, the following rules have applied. In these accounts, debits indicate an increase and credits indicate a decrease. They are grouped together because they all refer to costs. • Expenses and losses • Assets • Dividends paid In these accounts, credits reflect an increase and debits reflect a decrease. They are grouped together because they all indicate sources of funding. • Liabilities • Capital stock • Revenues and gains • Retained earnings The debit and credit rules for these seven general types of accounts provide a short-hand method for recording the financial impact that a transaction has on any account. They were constructed in this manner so that the following will be true: Debits Must Always Equal Credits for Every Transaction
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4. RECORDING TRANSACTIONS USING JOURNAL ENTRIES 1. Describe the purpose and structure of a journal entry. 2. Identify the purpose of a journal. 3. Define “trial balance” and indicate the source of its monetary balances. 4. Prepare journal entries to record the effect of acquiring inventory, paying salary, borrowing money, and selling merchandise. 5. Define “accrual accounting” and list its two components. 6. Explain the purpose of the revenue realization principle. 7. Explain the purpose of the matching principle. 4.1—The Purpose of a Journal Entry [PowerPoint 4-31] After each event is analyzed, the financial changes caused by a transaction are initially recorded as a journal entry. A list of a company’s journal entries is maintained in a journal (also referred to as a general journal), which is one of the most important components within any accounting system. The journal is a financial diary for a company. It provides a history of the impact of all financial events, recorded as they took place. A journal entry is no more than an indication of the accounts and balances that were changed by a single transaction.
4.2—Practicing with Debits and Credits [PowerPoint 4-32, 33] A company keeps its T-accounts together in a ledger (or general ledger). A listing of the account balances found in the ledger is commonly referred to as a trial balance. A trial balance reports the individual balances for each T-account maintained in the company’s ledger. The Lawndale example from the beginning of the chapter will be redone, this time using journal entries. Lawndale has beginning balances in certain accounts, as demonstrated by the following trial balance:
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Lawndale Company Trial Balance (prior to recording new transactions) Account Debit Balance Credit Balance Cash $ 20,000 Accounts Receivable 50,000 Inventory 65,000 Insurance Payable $ 700 Accounts Payable 18,000 Notes Payable (long term) 40,000 Capital Stock 30,000 Retained Earnings (beginning of 32,000 year) Sales of Merchandise 250,000 Cost of Goods Sold 150,000 Rent Expense 12,000 Salary Expense 60,000 Utilities Expense 10,000 Insurance Expense 3,700 Totals $370,700 $370,700
4.3— Journal Entry for Acquisition of Inventory on Credit [PowerPoint 4-34]
In Transaction 1, inventory was bought on credit for $2,000 Inventory is an asset. An asset always uses a debit to note an increase. Accounts payable is a liability so that a credit indicates that an increase has occurred. Thus, the following journal entry is appropriate. Journal Entry 1— Inventory Acquired on Credit Inventory Accounts Payable
2,000 2,000
The word “inventory” is physically on the left of the journal entry and the words “accounts payable” is indented to the right. This positioning clearly shows which account is debited and which is credited. In the same way, the $2,000 numerical amount added to the Inventory total appears on the left (debit) side whereas the $2,000 change in accounts payable is clearly on the right (credit) side.
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4.4—Recording Payment of an Expense [PowerPoint 4-35] In Transaction 2, the Lawndale Company pays its employees salary of $300 for work performed during the past week. No entry has been recorded previously. Because the information provided indicates that no entry has yet been made, neither the $300 salary expense nor the related salary payable already exists in the accounting records. Apparently, the $1,000 salary expense appearing in the above trial balance reflects earlier payments made during the period to company employees. Payment is made here for past work so this cost represents an expense rather than an asset. Thus, the balance recorded as salary expense goes up by this amount while cash decreases. Increasing an expense is always shown by means of a debit. Decreasing an asset is reflected through a credit. Journal Entry 2— Salary Paid To Employees Salary Expense Cash
300 300
4.5— Journal Entry When Money Is Borrowed [PowerPoint 4-36] According to Transaction 3, $9,000 is borrowed from a bank when officials sign a note payable that will have to be repaid in several years. Cash—an asset—increases $9,000 which is shown as a debit. The company’s notes payable balance also goes up by the same amount. As a liability, this increase is recorded through a credit. Journal Entry 3—Money Borrowed from Bank Cash Notes Payable
9,000 9,000
4.6— Recording Sale of Inventory on Credit [PowerPoint 4-37, 38] In Transaction 1, inventory was bought for $2,000. That journal entry is recorded earlier. Now, in Transaction 4, these goods are sold for $5,000 to a customer with payment to be made at a later date. As discussed previously, two events happen when inventory is sold. First, the sale is made and, second, the customer takes possession of the merchandise from the company. Assuming again that a perpetual inventory system is in use, both the sale and the related expense are recorded immediately. In the initial part of the transaction, the accounts receivable balance goes up $5,000 because the money from the customer will not be collected until a future point in time. The increase in this asset is shown by means of a debit. The new receivable resulted from a sale. Thus, revenue is also recorded (through a credit) to indicate the cause of that effect. ©2012 Flat World Knowledge, Inc.
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Journal Entry 4(A)— Sale of Inventory Made on Account Accounts Receivable Sales of Merchandise
5,000 5,000
At the same time, inventory costing $2,000 is surrendered by the company. The reduction of any asset is recorded by means of a credit. The expense account that represents the outflow of inventory has been identified previously as “cost of goods sold.” Like any expense, it is entered into the accounting system through a debit. Journal Entry 4(B)—Merchandise Acquired by Customers Cost of Goods Sold Inventory
2,000 2,000
4.7— The Role of Accrual Accounting [PowerPoint 4-39, 40] One of the most important components of U.S. GAAP is accrual accounting. It serves as the basis for timing the recognition of revenues and expenses. The accountant must constantly monitor events as they occur to determine the appropriate point in time for reporting each revenue and expense. Accrual accounting provides standard guidance for that process. Accrual accounting is really made up of two distinct elements. The revenue realization principle provides authoritative direction as to the proper timing for the recognition of revenue. The matching principle establishes similar guidelines for expenses. Revenue realization principle. Revenue is properly recognized at the point that (1) the earning process needed to generate the revenue is substantially complete and (2) the amount eventually to be received can be reasonably estimated. Matching principle: Expenses are recognized in the same time period as the revenue they help to create. Thus, if specific revenue is to be recognized in the year 2019, all associated costs should be reported as expenses in that same year. Expenses are matched with revenues. However, when a cost cannot be tied directly to identifiable revenue, matching is not possible. In those cases, the expense is recognized in the most logical time period, in some systematic fashion, or as incurred—depending on the situation. Revenue reported in Journal Entry 4(A). Assuming that the Lawndale Company has substantially completed the work required of this sale and $5,000 is a reasonable estimate of the amount that will be collected, recognition at the time of sale is appropriate. Because the revenue is reported at that moment, the related expense (cost of goods sold) should also be recorded as can be seen in Journal Entry 4B.
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5. CONNECTING THE JOURNAL TO THE LEDGER 1. Prepare journal entries for basic transactions such as the payment of insurance, the acquisition of a long-lived asset, the contribution of capital by owners, the distribution of a dividend, and the like. 2. Explain the recording of a gain or loss. 3. Describe the recording of unearned revenue. 4. Understand the purpose within an accounting system of both the journal and the ledger. 5. Discuss the posting of journal entries to T-accounts in the ledger and describe the purpose of that process. 5.1— Payment of a Previously Recognized Expense [PowerPoint 4-43] In Transaction 5, the Lawndale Company paid $700 for insurance coverage received over the past few months. Because of the previous recognition, the expense should not be recorded a second time. Instead, this payment eliminates the liability that was established by the accounting system. Cash—an asset—is decreased, which is shown in accounting by means of a credit. At the same time, the previously recorded payable is removed. Any reduction of a liability is communicated by a debit. Journal Entry 5— Payment of Liability for Insurance Coverage Insurance Payable Cash
700 700
5.2— Acquisition of an Asset [PowerPoint 4-44, 45] In Transaction 6, a truck was acquired for $40,000 by paying $10,000 in cash and signing a note for the remainder. As has been discussed, every transaction changes at least two accounts because of the cause and effect relationship underlying all financial events. However, beyond that limit, any number of accounts can be impacted. Complex transactions often touch numerous balances. Here, the truck account (an asset) is increased and must be debited. Part of the acquisition was funded by paying cash (an asset) with that decrease recorded as a credit. The remainder of the cost was covered by signing a note payable (a liability). Any increase in a liability is recorded by means of a credit. Note that the debits do equal credits even when more than two accounts are affected by a transaction. ©2012 Flat World Knowledge, Inc.
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Journal Entry 6—Truck Acquired for Cash and by Signing a Note Truck Cash Note Payable
40,000 10,000 30,000
5.3— Issuance of Capital Stock [PowerPoint 4-46] In Transaction 7, the Lawndale Company issue ownership shares to a new stockholder for cash of $19,000 The asset cash is increased in this transaction, a change that is always shown as a debit. Capital stock also goes up because new shares are issued to company owners. As indicated in the debit and credit rules, the capital stock account increases by means of a credit. Journal Entry 7— Capital Stock Issued for Cash Cash Capital Stock
19,000 19,000
5.4— Collection Made on an Account Receivable [PowerPoint 4-47] In Transaction 8, cash was collected from customer on earlier sale made in Transaction 4 for $5,000. When a customer makes payment on a previous sale, cash increases and accounts receivable decrease. Both are assets; one balance goes up while the other is reduced. Journal Entry 8—Money Collected on Account Cash Accounts Receivable
5,000 5,000
Note that cash is collected here but no additional revenue is recorded. Based on the requirements of accrual accounting, revenue of $5,000 was recognized previously in Journal Entry 4A.
5.5— Paying for a Previous Purchase [PowerPoint 4-48] In Transaction 9, payment was made for inventory bought in Transaction 1 for $2,000. Inventory was bought at an earlier time and payment is now being made. Here, cash is reduced (a credit). The liability set up in Journal Entry 1 (accounts payable) is removed by means of a debit.
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Journal Entry 9—Money Paid for Previous Purchase Accounts Payable Cash
2,000 2,000
5.6— Prepayment of an Expense [PowerPoint 4-49] In Transaction 10, the company paid $4,000 to rent a building for the next four months. Cash is decreased by the payment made to rent this building. This rent provides a future value for Lawndale Company. The cost is not for past usage of the building but rather for the upcoming four months. Therefore, the amount paid creates an asset. When the $4,000 is paid, an asset—normally called prepaid rent—is recorded through a debit. Journal Entry 10—Money Paid for Future Rent Prepaid Rent Cash
4,000 4,000
5.7—Four additional common transactions [PowerPoint 4-50] 11) Purchase land for $8,000 cash 12) Sell land purchased in Transaction 11 almost immediately for $11,000 cash 13) Receive $3,000 in cash from a customer before work is performed 14) Distribute $600 cash dividend
5.8— Acquisition of Land [PowerPoint 4-51] Transaction 11—Purchased a small tract of land by paying $8,000 in cash. As an asset, land increases with a debit. The company’s cash balance goes down because of the acquisition. That drop is recorded using a credit. Journal Entry 11—Land Acquired for Cash Land Cash
8,000 8,000
5.9— Sale of an Asset other than Inventory [PowerPoint 4-52, 53] Transaction 12—Land purchased in Transaction 11 is sold almost immediately to an outside party for cash of $11,000. Because the sale of land is not viewed as a central portion of this company’s operations, neither revenue nor cost of goods sold is reported as in the sale of inventory. An $11,000 increase in cash is recorded along with the removal of the $8,000 cost of the land that has been conveyed to the new owner. However, to alert decision makers that a more
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incidental event has taken place, a gain (if the sales price is more than the cost of the land) or a loss (if the sales price is less than cost) is recognized for the difference. Journal Entry 12—Land Sold for Cash in Excess of Cost Cash 11,000 Land 8,000 Gain on Sale of Land 3,000
5.9— Receiving Cash before the Earning Process is Complete [PowerPoint 4-54]
Transaction 13—Lawndale Company received $3,000 in cash from a customer before work is performed. Although cash is received, accrual accounting dictates that revenue cannot be recognized until the earning process is substantially complete. Here, the earning process will not take place for some time in the future. As an asset, the cash account is increased (debit) but no revenue can yet be recorded. Instead, an unearned revenue account is established for the $3,000 credit. This balance is reported by the Lawndale Company as a liability. Because the money has been accepted, the company is obliged to provide the service or return the $3,000 to the customer. Recording a liability mirrors that responsibility. Journal Entry 13—Money Received for Work to be Done Later Cash Unearned Revenue
3,000 3,000
5.10— Distribution of a Dividend [PowerPoint 4-55] Transaction 14—The Lawndale Company distributes a cash dividend to all owners, a reward that totals $600. Cash is reduced by this payment to the company’s owners. The cause of the decrease in cash was a dividend. Hence, a “dividends paid” account is established to measure this particular outflow of net assets. According to the debit and credit rules, an increase in this account is shown through a debit. Journal Entry 14—Dividend Distributed to Owners Dividends Paid Cash
600 600
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5.11—Current T-Account Balances [PowerPoint 4-56, 57, 58, 59, 60] In an accounting system, the recording process is composed of two distinct steps. 1. After analyzing the financial impact of a transaction, journal entries are created to reflect the monetary impact on relevant accounts. 2. Then, each individual debit and credit is added to the specific T-account being altered, a process known as “posting.” A debit to cash in a journal entry is listed as a debit in the cash T-account. A credit made to notes payable is recorded as a credit within the corresponding T-account. After all entries are posted, the current balance for any account can be determined by adding the debit and the credit sides of the T-account and netting the two. Automated systems are designed so that the impact of each entry is simultaneously recorded in the proper T-accounts found in the ledger. Lawndale’s entries have been posted into ledger T-accounts shown below. Each account includes the previous balance (PB) found in the trial balance shown in section 4.2. The new debits and credits are then posted for each of the fourteen sample transactions. For cross-referencing purposes, the number of the corresponding journal entry is included.
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LAWNDALE COMPANY LEDGER CASH
ACCOUNTS RECEIVABLE
PB
20,000
(3)
9,000
(2)
300
(7)
19,000
(5)
700
(8) (12) (13)
5,000 11,000 3,000
(6) (9) (10) (11) (14)
10,000 2,000 4,000 8,000 600
67,000 CB
PB
50,000
4(A)
5,000
(8)
14,000 CB
5,000
INVENTORY PB
65,000
(1)
2,000
5,000
9,000
2,000
10,000 CB
2,000
65,000
25,600
41,400 PREPAID RENT
TRUCK
(10)
4,000
(6)
40,000
CB
4,000
CB
40,000
LAND (11)
INSURANCE PAYABLE PB
ACCOUNTS PAYABLE
700
700
(9)
700
700 CB
2,000
PB (1)
2,000
-0-
8,000
(12)
8,000
8,000 CB
(5)
(4 B)
CB
8,000
-0NOTES PAYABLE
18,000 2,000
PB (3)
40,000 9,000
4,600
(6)
6,000
18,000
CB
79,000
UNEARNED REVENUE (13)
3,000
CB
3,000
CAPITAL STOCK
RETAINED EARNINGS
DIVIDENDS PAID
PB
30,000
PB
32,000
(14)
600
(7)
19,000
CB
32,000
CB
600
CB
49,000
SALE OF MERCHANDISE
COST OF GOODS SOLD
RENT EXPENSE
PB 4(A)
250,000 5,000
PB 4(B)
150,000 2,000
PB
12,000
CB
225,000
CB
152,000
CB
12,000
SALARY EXPENSE
INSURANCE EXPENSE
GAIN ON SALE OF LAND
PB
60,000
PB
3.700
(12)
3,000
(2)
300
CB
3,700
CB
3,000
CB PB
60,300 UTILITIES EXPENSE 10,000
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5.12—End of Chapter Review Problem [PowerPoint 4-61 to 77] For practice, here is a problem which will review everything covered in this chapter. This can be worked by the students individually or in teams, with the instructor circulating the room to answer questions. This should help students to solidify the knowledge gained from the chapter and help them to see the “big picture.” Arcadia Snacks, Inc. had the following trial balance at the beginning of December, 20X1.
Account Cash Accounts Receivable Inventory Rent Payable Notes Payable (long term) Capital Stock Retained Earnings Totals
Arcadia Snacks, Inc. Trial Balance December 1, 20X1 Debit Balance
Credit Balance
$10,000 8,500 7,000
$25,500
$ 1,000 8,000 11,500 5,000 $25,500
1) The following transactions occurred during December. For each, record the proper journal entry. a) Purchased inventory for $3,000 on account b) Paid $200 towards salaries c) Borrowed $10,000 from the bank d) Sold the inventory purchased in Transaction (a) for $5,000 on account e) Paid $1,000 on rent payable f) Purchased equipment for $10,000, paying $4,000 cash and signing a note for the remainder g) Issued common stock for $4,000 cash h) Collected $5,000 on accounts receivable from (d) i) Paid $3,000 on accounts payable from (a) j) Paid $500 for advertising to be released in the next year k) Purchased land for $14,000 cash l) Sold the land purchased in Transaction k for $12,000 m) Received $3,000 cash for work to be performed next year n) Distributed $400 dividends to stockholders
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2) Prepare T-accounts to calculate the ending balance in each account. Don’t forget the beginning balances from the trial balance. 3) Prepare an ending trial balance for the month of December based on your T-accounts. SOLUTION: 1) The following transactions occurred during December. For each, record the proper journal entry. a) Purchased inventory for $3,000 on account Inventory Accounts Payable
3,000 3,000
b) Paid $200 towards salaries Salary Expense Cash
200 200
c) Borrowed $10,000 from the bank Cash Notes Payable
10,000 10,000
d) Sold the inventory purchased in Transaction a for $5,000 on account Accounts Receivable 5,000 Sales of Merchandise 5,000 Cost of Goods Sold Inventory
3,000 3,000
e) Paid $1,000 on rent payable Rent Payable Cash
1,000 1,000
f) Purchased equipment for $10,000, paying $4,000 cash and signing a note for the remainder Equipment Cash Note Payable
10,000 4,000 6,000
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g) Issued common stock for $4,000 cash Cash Capital Stock
4,000 4,000
h) Collected $5,000 on accounts receivable from (d) Cash 5,000 Accounts Receivable 5,000 i) Paid the $3,000 on accounts payable from (a) Accounts Payable Cash
3,000 3,000
j) Paid $500 for advertising to be released in the next year Prepaid Advertising Cash
500 500
k) Purchased land for $14,000 cash Land Cash
14,000 14,000
l) Sold the land purchased in (k) for $12,000 Cash Loss on Sale of Land Land
12,000 2,000 14,000
m) Received $3,000 cash for work to be performed next year Cash Unearned Revenue
3,000 3,000
n) Distributed $400 dividends to stockholders Dividends Paid Cash
400 400
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2)
PB (c) (g) (h) (l) (m)
CB
CASH 10,000 10,000 (b) 4,000 (e) 5,000 (f) 12,000 (i) 3,000 (j) (k) (n) 44,000 20,900
200 1,000 4,000 3,000 500 14,000 400 23,100
PREPAID ADVERTISING (j) 500 CB 500
ARCADIA CORPORATION LEDGER ACCOUNTS RECEIVABLE PB 8,500 (d) 5,000 (h) 5,000 13,500 5,000 CB 8,500
(f) CB
EQUIPMENT 10,000 10,000
PB (a) CB
(k) CB
(e)
RENT PAYABLE PB 1,000 1,000 1,000 1,000 CB -0-
ACCOUNTS PAYABLE (i) 3,000 (a) 3,000 3,000 3,000 CB -0-
INVENTORY 7,000 3,000 (d) 10,000 7,000
LAND 14,000 (l) 14,000 0
3,000 3,000
14,000 14,000
NOTES PAYABLE PB 8,000 (c) 10,000 (f) 6,000 CB 24,000
UNEARNED REVENUE (m) 3,000 CB 3,000 CAPITAL STOCK PB 11,500 (g) 4,000 CB 15,500 SALE OF MERCHANDISE (d) 5,000 CB 5,000
(b) CB
SALARY EXPENSE 200 200
RETAINED EARNINGS PB 5,000 CB 5,000
(d) CB
(n) CB
DIVIDENDS PAID 400 400
COST OF GOODS SOLD 3,000 3,000
LOSS ON SALE OF LAND (l) 2,000 CB 2,000
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Account Cash Accounts Receivable Inventory Prepaid Advertising Equipment Notes Payable (long term) Unearned Revenue Capital Stock Retained Earnings Sales of Merchandise Dividends Paid Cost of Goods Sold Salary Expense Loss on Sale of Land Totals
Arcadia Snacks, Inc. Trial Balance December 31, 20X1 Debit Balance $20,900 8,500 7,000 500 10,000
Credit Balance
$24,000 3,000 15,500 5,000 5,000 400 3,000 200 2,000 $52,500
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$52,500
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CHAPTER 5 Why Is Financial Information Adjusted Prior to the Production of Financial Statements? 1. THE NEED FOR ADJUSTING ENTRIES 1. Explain the purpose and necessity of adjusting entries. 2. List examples of several typical accounts that require adjusting entries. 3. Provide examples of adjusting entries for various accrued expenses. 1.1—Accounting for the Passage of Time [PowerPoint 5-3] Financial events take place throughout the year. Journal entries record the individual debit and credit effects that are then entered into the proper T-accounts. However, not all changes in these balances occur as a result of physical events. Some accounts increase or decrease because of the passage of time. The impact can be so gradual that producing individual journal entries is not reasonable. Unless an accounting system is programmed to record tiny incremental changes, none of these financial effects is captured as they occur. Prior to producing financial statements, the accountant must search for any changes that have not yet been recognized. These incremental increases or decreases must also be recorded in a debit and credit format (called adjusting entries rather than journal entries) with the impact then posted to the appropriate ledger accounts.
1.2—Examples of Adjusting Entries [PowerPoint 5-4, 5] These are the four general types of adjusting entries: • Accrued expenses (also referred to as accrued liabilities) • Prepaid expenses (including supplies) • Accrued revenue (earned but not recorded) • Unearned revenue (also referred to as deferred revenue) Usually, at the start of the adjustment process, the accountant prepares an updated trial balance to provide a visual, organized representation of all ledger account balances. This ©2012 Flat World Knowledge, Inc.
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listing aids the accountant in spotting figures that might need adjusting in order to be fairly presented. Therefore, Figure 5.1 shows the trial balance on December 31, Year Four, with account balances for the Lawndale Company determined at the end of Chapter 4, Section 5.11 of the instructor’s manual. All transactions have been recorded and posted, but no adjustments have yet been made. Figure 5.1 Lawndale Company Trial Balance (after recording all new transactions) Account Cash Accounts Receivable Inventory Prepaid Rent Truck Accounts Payable Notes Payable (long-term) Unearned Revenue Capital Stock Retained Earnings (beginning of year) Dividends Paid Sales of Merchandise Cost of Goods Sold Rent Expense Salary Expense Utilities Expense Insurance Expense Gain on Sale of Land Totals
Debit Balance $ 41,400 50,000 65,000 4,000 40,000
Credit Balance
$ 18,000 79,000 3,000 49,000 32,000 600 255,000 152,000 12,000 1,300 10,000 3,700 $ 439,000
3,000 $ 439,000
1.3—Adjusting Entry to Recognize Accrued Expense [PowerPoint 56]
If a reporting company’s accounting system recognizes an expense as it grows, no adjustment is necessary. The balances are recorded properly. They are ready to be included in financial statements. Thus, when statements are prepared, the accountant only needs to search for accrued expenses that have not yet been recognized. Numerous expenses do get slightly larger each day until paid including salary, rent, insurance, utilities, interest, advertising, income taxes, and the like. 1.3.1—Lawndale Company—Adjusting Entry 1 [PowerPoint 5-7]
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Assume that Lawndale Company currently owes $900 for utilities. The following adjustment is needed before financial statements can be created. It is an adjusting entry because no physical event took place. This liability simply grew over time and has not yet been paid. Adjusting Entry 1—Amount Owed for Utilities Utilities Expense Utilities Payable (or Accrued Liabilities)
2.
900 900
PREPARING VARIOUS ADJUSTING ENTRIES
1. Explain the need for an adjusting entry in the reporting of prepaid expenses and be able to prepare that adjustment. 2. Explain the need for an adjusting entry in the reporting of accrued revenue and be able to prepare that adjustment. 3. Describe the challenge of determining when the earning process for revenue is substantially complete and discuss possible resolutions. 4. Explain the need for an adjusting entry in the reporting of unearned revenue and be able to prepare that adjustment. 2.1—Recording and Adjusting Prepaid Expenses [PowerPoint 5-9, 10] A $4,000 payment was made by the Lawndale Company for four months of rent to use a building. An asset—prepaid rent—was recorded at that time through the normal accounting process. Assume, at the end of Year Four, the Lawndale Company’s accountant examines the invoice that was paid and determines that this $4,000 in rent covered the period from December 1, Year Four until March 31, Year Five. During these four months, the company will use the rented facility to help generate revenue. Over that time, the future economic benefit established by the payment gradually becomes a past benefit. The asset literally changes into an expense day by day. In this example, one month of the rent from this payment has now been consumed. The benefit provided by using this building during December to gain revenue no longer exists. That portion of the rent ($1,000 or $4,000/4 months) reflects a past benefit and should be reported as an expense in Year Four in accordance with the matching principle. Expenses are recognized in the same period as the revenue they help to generate. ©2012 Flat World Knowledge, Inc.
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As a preliminary step in preparing financial statements, an adjusting entry is needed to reclassify $1,000 from the asset (prepaid rent) into an expense (rent expense). This adjustment leaves $3,000 in the asset (for the remaining three months of rent on the building) while $1,000 is now reported as an expense (for the previous one month of rent). Adjusting Entry 2 (Version 1): Use Is Made of a Rented Facility (Original Entry to Prepaid Rent) Rent Expense 1,000 Prepaid Rent 1,000 After $1,000 is moved from asset to expense, the balances are presented fairly: an asset of $3,000 for the future benefit and an expense of $1,000 for the past. 2.1.1—Lawndale Company— Adjusting Entry 2 - Alternative [PowerPoint 511]
Assume that when the $4,000 payment was made, the company recorded a debit to rent expense rather than prepaid rent. Perhaps an error was made or, more likely, a computerized accounting system was programmed to record all money spent for rent as an expense. If a $4,000 expense was recorded here initially rather than a prepayment, an adjusting entry is still needed. The expense appearing on the income statement should be $1,000 (for the past one month) while the appropriate asset on the balance sheet should be $3,000 (for the subsequent three months). If the entire cost of $4,000 is located in rent expense, the following alternative is necessary to arrive at the proper balances. Adjusting Entry 2A (Version 2): Use Is Made of a Rented Facility (Original Entry to Rent Expense) Prepaid Rent 3,000 Rent Expense 3,000 This adjusting entry leaves the appropriate $1,000 in expense and puts $3,000 into the asset account.
2.2—Recognizing Accrued Revenue [PowerPoint 5-12, 13] Various types of revenue are earned as time passes rather than through a physical event such as the sale of inventory. To illustrate, assume that a customer visited the Lawndale Company five days before the end of Year Four to ask for assistance. The customer must be away from his ranch for the next 30 days and wanted company employees to feed, water, and care for his horses during the period of absence. Everything needed for the job is available in the customer’s barn. The Lawndale Company just provides the service. ©2012 Flat World Knowledge, Inc.
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The parties agreed that the company will receive $100 per day for this work with payment to be made upon the person’s return. No asset changes hands at the start of this task. Thus, the company’s accounting system is not likely to make any entry until payment is eventually received. However, after the first five days of this work, the Lawndale Company is ready to prepare Year Four financial statements. For that reason, the company needs to recognize all revenue earned to date. Service to this customer has been carried out for five days at a rate of $100 per day. The company has performed the work to earn $500 although the money will not be received until later. Consequently, a receivable and revenue for this amount should be recognized through an adjusting entry. The earning process for the $500 occurred in Year Four and should be recorded in this year. Adjusting Entry 3—Revenue Earned for Work Done Accounts Receivable Sales of Services
500 500
The $500 receivable will be removed in the subsequent period when the customer eventually pays Lawndale for the services rendered. No recognition is needed in this adjusting entry for cost of goods sold because a service, rather than inventory, is being sold.
2.3—The Earning Process [PowerPoint 5-14] The proper recognition of revenue is one of the most challenging tasks encountered in financial accounting. The revenue realization principle is established by U.S. GAAP, but practical issues remain. For example, when does an earning process become substantially complete? Here, the simplest way to resolve this accounting issue is to consider the nature of the task to be performed by the Lawndale Company. If the work is viewed as one large task like painting a house, then the earning process is only 5/30 finished at the moment and not substantially complete. No revenue should be recognized until the remainder of the work has been performed. In that case, the adjusting entry is not warranted. Conversely, if this assignment is actually 30 separate tasks, then five of them are substantially complete at the end of the year and revenue of $500 is properly recorded by the above adjustment. Unfortunately, the distinction is not always clear. Because accounting is conservative, revenue should never be recognized unless evidence predominates that the individual tasks are clearly separate events.
2.4—The Revenue Recognition Principle [PowerPoint 5-15]
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Accountants spend a lot of time searching for credible evidence as to the true nature of the events they encounter and report. Their goal is to ensure that all information included in financial statements is presented fairly according to U.S. GAAP (or IFRS). The timing of revenue recognition can be a special challenge that requires analysis and expertise. It is difficult to determine if a job is substantially complete so that revenue could be recognized or not. Here is one technique that might be applied in analyzing this particular example. Assume that after five days, Lawndale had to quit feeding the customer’s horses for some legitimate reason. Should the company be able to demand and collect all $500 for the work done to that point? If so, then those five days are distinct tasks that have been completed. However, if no money would be due based on working just five days, substantial completion has not been achieved by the services performed to date. Thus, revenue recognition would be inappropriate.
2.5—Unearned Revenue [PowerPoint 5-16, 17] Unearned revenue represents a liability recognized when money is received before work is done. After the required service is carried out so that the earning process is substantially complete, an appropriate amount is reclassified from unearned revenue on the balance sheet to revenue on the income statement. For example, in connection with the $3,000 payment collected by Lawndale, assume that all of the work necessary to recognize the first $600 was performed by the end of Year Four. Prior to preparing financial statements, an adjusting entry reduces the liability and recognizes the earned revenue. Adjusting Entry 4—Money Previously Received Has Now Been Earned Unearned Revenue Sales of Services
600 600
3. PREPARATION OF FINANCIAL STATEMENTS 1. Prepare an income statement, statement of retained earnings, and balance sheet based on the balances in an adjusted trial balance. 2. Explain the purpose and construction of closing entries. 3.1— Preparing Financial Statements [PowerPoint 5-19] After the adjusting entries are posted, the accountant should believe that all material misstatements have been removed from the accounts. Thus, they are presented fairly according to U.S. GAAP (or IFRS) and can be used by decision makers. As one final check, an adjusted trial balance is produced for a last, careful review. Assuming that no ©2012 Flat World Knowledge, Inc.
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additional concerns are uncovered, the accountant prepares an income statement, a statement of retained earnings, and a balance sheet. The basic financial statements are then completed by the production of a statement of cash flows. Cash flows are classified as resulting from operating activities, investing activities, or financing activities. The reporting process is then finalized by the preparation of explanatory notes that accompany a set of financial statements. Several aspects of this process should be noted: • The statements are properly identified by name of company, name of statement, and date. The balance sheet is for a particular day (December 31, Year Four) and the other statements cover a period of time (Year ending December 31, Year Four). • Each account in the trial balance appears within only one statement. • There is no T-account for net income. It is a composition of all revenues, gains, expenses, and losses for the year. The net income figure computed in the income statements is then used in the statement of retained earnings. In the same manner, there is no T-account for the ending retained earnings balance. It is a composition of the beginning retained earnings balance, net income, and dividends paid. The ending retained earnings balance computed in the statement of retained earnings is then used in the balance sheet. • The balance sheet does balance.
3.2— The Purpose of Closing Entries [PowerPoint 5-20] The final action performed each year by the accountant is the preparation of closing entries. Five types of accounts—specifically, revenues, expenses, gains, losses, and dividends paid—reflect the various increases and decreases that occur in a company’s net assets in the current period. These accounts are often deemed “temporary” because they only include changes for one year at a time. Consequently, the figure reported by a company as its revenue, measures only sales during that year. T-accounts for rent expense, insurance expense, and the like reflect just the current decreases in net assets. In order for the accounting system to start measuring the effects for each new year, these specific T-accounts must all be returned to a zero balance after the annual financial statements are produced. After these accounts are closed at year’s end, the resulting single figure is the equivalent of the net income reported for the year (revenues and gains less expenses and losses) reduced by any dividends paid. This net effect is recorded in the retained earnings Taccount. The closing process effectively moves the balance for every revenue, expense, gain, loss, and dividend paid into retained earnings. As a result, the beginning retained earnings balance for the year is updated to arrive at the ending total reported on the balance sheet. Assets, liabilities, capital stock, and retained earnings all start out each year with a balance that is the same as the ending figure reported on the previous balance sheet. ©2012 Flat World Knowledge, Inc.
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Those accounts are permanent; they are not designed to report an impact occurring during the current year. In contrast, revenues, expenses, gains, losses, and dividends paid all begin the first day of each year with a zero balance—ready to record the events of this new period.
3.3— Lawndale’s Adjusted Trial Balance and Financial Statements [PowerPoint 5-21, 22, 23, 24, 25] Lawndale’s adjusted trial balance is provided so that the instructor can walk the students through the preparation of the income statement, statement of retained earnings, and balance sheet from a trial balance. Lawndale Company Updated Trial Balance December 31, Year Four Account Cash Accounts Receivable Inventory Prepaid Rent Truck Accounts Payable Utilities Payable Unearned Revenue Notes Payable (long-term) Capital Stock Retained Earnings (beginning of year) Dividends Paid Sales of Merchandise Sales of Services Cost of Goods Sold Rent Expense Salary Expense Utilities Expense Insurance Expense Gain on Sale of Land Totals
Debit $41,400 50,500 65,000 3,000 40,000
Credit
$ 18,000 900 2,400 79,000 49,000 32,000 600 255,000 1,100 152,000 13,000 60,300 10,900 3,700 $440,400
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3,000 $440,400
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Lawndale Company Income Statement Year Ended December 31, Year Four Revenues: Sales of Merchandise Sales of Services Total Revenues Expenses: Cost of Goods Sold Rent Expense Salary Expense Utilities Expense Insurance Total Expenses Operating Income Other Gains and Losses: Gain on Sale of Land Net Income
$255,000 1,100 $256,100
152,000 13,000 60,300 10,900 3,700 (239,900)
Lawndale Company Statement of Retained Earnings Year Ended December 31, Year Four Retained Earnings Balance, January 1, Year Four Net Income, Year Four Dividends Paid Retained Earnings Balance, December 31, Year Four
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16,200
3,000 $ 19,200
$ 32,000 $19,200 (600)
18,600 $50,600
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Lawndale Company Balance Sheet December 31, Year Four Assets Current Assets Cash Accounts Receivable Inventory Prepaid Rent Total Current Assets Noncurrent Assets Truck Total Assets Liabilities and Stockholders' Equity Liabilities Current Liabilities Accounts Payable Utilities Payable Unearned Revenue Total Current Liabilities Noncurrent Liabilities Notes Payable Total Liabilities Stockholders' Equity Capital Stock Retained Earnings
$41,400 50,500 65,000 3,000 $ 159,900 40,000 $ 199,900
$ 18,000 900 2,400 $21,300 79,000 $100,300 $49,000 50,600
Total Stockholders’ Equity
$ 99,600
Total Liabilities And Stockholders’ Equity
$199,900
3.4—End of Chapter Review Problem [PowerPoint 5-26-43] For practice, here is a problem which will review everything covered in this chapter. This can be worked by the students individually or in teams, with the instructor circulating the room to answer questions. This should help students to solidify the knowledge gained from this chapter and help them to see the “big picture.” This is a continuation of the Arcadia Snacks problem begun in Chapter 4. Arcadia Snacks, Inc. had the following trial balance prior to any adjustments on December 31, 20X1.
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Arcadia Snacks, Inc. Trial Balance December 31, 20X1 Account Debit Balance Credit Balance Cash $20,900 Accounts Receivable 8,500 Inventory 7,000 Prepaid Advertising 500 Equipment 10,000 Notes Payable (long term) 24,000 Unearned Revenue 3,000 Capital Stock 15,500 Retained Earnings 5,000 Sales of Merchandise 5,000 400 Dividends Paid Cost of Goods Sold 3,000 Salary Expense 200 Loss on Sale Of Land 2,000 Totals $52,500 $52,500 1) The following adjustments need to be made. For each, record the proper journal entry. o) Arcadia owes $400 for utilities. p) One month of the prepaid advertising has been “used”— the ads ran during the month of December. The $500 covers 5 months of ads. q) Arcadia agrees to perform a service for a client over a period of 20 days for $40 per day. Arcadia has performed 10 days of this service, but will not be paid until January. Arcadia’s accountants believe that the earnings process is complete for the 10 days. r) Arcadia earns the $3,000 originally labeled unearned revenue.
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2) Prepare T-accounts to calculate the ending balance in each account. Unadjusted Taccounts from the end of Chapter 4 are given. Only the adjustments need to be posted.
PB (c) (g) (h) (l) (m)
CB
CASH 10,000 10,000 (b) 4,000 (e) 5,000 (f) 12,000 (i) 3,000 (j) (k) (n) 44,000 20,900
200 1,000 4,000 3,000 500 14,000 400 23,100
PREPAID ADVERTISING (j) 500 CB 500
Arcadia Snacks, Inc. Ledger ACCOUNTS RECEIVABLE PB 8,500 (d) 5,000 (h) 5,000 13,500 5,000 CB 8,500
(f) CB
EQUIPMENT 10,000 10,000
PB (a) CB
(k) CB
(e)
RENT PAYABLE PB 1,000 1,000 1,000 1,000 CB -0-
ACCOUNTS PAYABLE (i) 3,000 (a) 3,000 3,000 3,000 CB -0-
INVENTORY 7,000 3,000 (d) 10,000 7,000
LAND 14,000 (l) 14,000 -0-
3,000 3,000
14,000 14,000
NOTES PAYABLE PB 8,000 (c) 10,000 (f) 6,000 CB 24,000
UNEARNED REVENUE (m) 3,000 CB 3,000 CAPITAL STOCK PB 11,500 (g) 4,000 CB 15,500
RETAINED EARNINGS PB 5,000 CB 5,000
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(n) CB
DIVIDENDS PAID 400 400
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SALES OF MERCHANDISE (d) 5,000 CB 5,000
COST OF GOODS SOLD (d) 3,000 CB 3,000
SALARY EXPENSE 200 200
LOSS ON SALE OF LAND (l) 2,000 CB 2,000
(b) CB
3) Prepare an adjusted trial balance for the month of December based on your T-accounts. 4) Prepare an income statement, statement of retained earnings and balance sheet for Arcadia. SOLUTION: 1) The following adjustments need to be made. For each, record the proper journal entry. o) Arcadia owes $400 for utilities. Utilities Expense Utilities Payable
400 400
p) One month of the prepaid advertising has been “used”—the ads ran during the month of December. The $500 covers 5 months of ads. Advertising Expense Prepaid Advertising
100 100
q) Arcadia agrees to perform a service for a client over a period of 20 days for $40 per day. Arcadia has performed 10 days of this service, but will not be paid until January. Arcadia’s accountants believe that the earnings process is complete for the 10 days. Accounts Receivable Sales of Services
400 400
r) Arcadia earns the $3,000 originally labeled unearned revenue. Unearned Revenue Sales of Services
3,000 3,000
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2) Arcadia Snacks, Inc. Ledger—With Adjustments Posted CASH PB
10,000
(c)
10,000
(b)
(g)
4,000
(h)
ACCOUNTS RECEIVABLE PB
8,500
200
(d)
5,000
(e)
1,000
(q)
400
5,000
(f)
4,000
(l)
12,000
(i)
3,000
(m)
3,000
(j)
500
(k)
14,000
(n)
400
44,000 CB
(h)
PB
7,000
(a)
3,000
5,000
CB
3,000
7,000
8,900
20,900
(j)
500
CB
400
(p)
EQUIPMENT 100
(f)
10,000
CB
10,000
LAND (k)
RENT PAYABLE PB
ACCOUNTS PAYABLE 1,000
1,000
3,000
(a)
3,000
1,000
1,000 CB
(m)
3,000 CB
(l)
14,000
NOTES PAYABLE
3,000
PB
8,000
3,000
(c)
10,000
-0-
(f)
6,000
CB
24,000
CB
UTILITIES PAYABLE
3,000
(o)
400
3,000
CB
400
-0-
CAPITAL STOCK
14,000
-0-
-0-
UNEARNED REVENUE 3,000
(i)
14,000 14,000
CB
(r)
3,000
23,100
PREPAID ADVERTISING
(e)
(d)
10,000
13,900 CB
5,000
INVENTORY
RETAINED EARNINGS
DIVIDENDS PAID
PB
11,500
PB
5,000
(n)
400
(g)
4,000
CB
5,000
CB
400
CB
15,500
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SALES OF MERCHANDISE
SALES OF SERVICES
COST OF GOODS SOLD
(d)
5,000
(q)
400
(d)
3,000
CB
5,000
(r)
3,000
CB
3,000
CB
3,400
SALARY EXPENSE
LOSS ON SALE OF LAND
UTILITIES EXPENSE
(b)
200
(l)
2,000
(O)
400
CB
200
CB
2,000
CB
400
ADVERTISING EXPENSE (p)
100
CB
100
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3) Prepare an adjusted trial balance for the month of December based on your Taccounts. Arcadia Snacks, Inc. Adjusted Trial Balance December 31, 20X1 Account Debit Balance Cash $20,900 Accounts Receivable 8,900 Inventory 7,000 Prepaid Advertising 400 Equipment 10,000 Utilities Payable Notes Payable (long term) Capital Stock Retained Earnings Sales of Merchandise Sales of Services 400 Dividends Paid Cost of Goods Sold 3,000 Advertising Expense 100 Utilities Expense 400 Salary Expense 200 Loss on Sale of Land 2,000 Totals $53,300
Credit Balance
400 24,000 15,500 5,000 5,000 3,400
$53,300
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4) Prepare an income statement, statement of retained earnings and balance sheet for Arcadia. Arcadia Snacks, Inc. Income Statement Month Ended December 31, 20X1 Revenues: Sales of Merchandise Sales of Services Total Revenues
$5,000 3,400
Expenses: Cost of Goods Sold Advertising Salary Utilities Total Expenses
3,000 100 200 400
$ 8,400
(3,700)
Loss on Sale of Land
(2,000)
Net Income
$ 2,700
Arcadia Snacks, Inc. Statement of Retained Earnings Month Ended December 31, 20X1 Retained Earnings Balance, December 31, 2011 Net Income Reported for December 2011 Dividends Distributed During December 2011 Net Income Less Dividends for December 2011 Retained Earnings Balance, December 31, 2011
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$ 5,000 $2,700 400 2,300 $7,300
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Arcadia Snacks, Inc. Balance Sheet December 31, 20X1 Assets Current Assets Cash Accounts Receivable Inventory Prepaid Rent Total Current Assets Noncurrent Assets Equipment Total Assets Liabilities and Stockholders' Equity Liabilities Current Liabilities Utilities Payable Total Current Liabilities Noncurrent Liabilities Notes Payable Total Liabilities Stockholders' Equity Capital Stock Retained Earnings Total Stockholders’ Equity Total Liabilities And Stockholders’ Equity
$20,900 8,900 7,000 400 $ 37,200 10,000 $ 47,200
$400 $400 24,000 $24,400 $15,500 7,300
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$ 22,800 $47,200
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CHAPTER 6 Why Should Decision Makers Trust Financial Statements? 1. THE NEED FOR THE SECURITIES AND EXCHANGE COMMISSION 1. Understand the reasons that reported financial statements might not be presented fairly. 2. Describe the mission of the Securities and Exchange Commission (SEC). 3. Explain the purpose of the EDGAR (Electronic Data Gathering and Retrieval) system. 4. Discuss the times when state laws apply to corporate securities rather than the rules and regulations of the SEC. 5. Explain the relationship of the SEC and the Financial Accounting Standards Board (FASB).
1.1— Financial Reporting and the Need for Trust [PowerPoint 6-3] 1.1.1—IN-CLASS ACTIVITY Discussing fraud and the credit crunch Description: This chapter discusses the importance of regulation in the financial markets and in the development of financial statements. To facilitate discussion of the importance of these issues, assign this activity to the class ahead of time. Split the class in half. Have half find an article discussing the failure of a firm due to fraudulent financial statements (Enron and Madoff are two examples). Have the other half find an article dealing with the fallout from the credit crisis (the difficulty companies had in borrowing money would be an example).
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1.2.1—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
5-10 Minutes
Students will need to bring articles to the class
The possible presence of material misstatements (created either accidentally or on purpose) is a fundamental concern that should occur to every individual who studies a set of financial statements. (Here, bring in the articles found by the first half of the class dealing with fraudulent financial statements. Call on several students to discuss the situation surrounding the company they identified and possibly some repercussions). Over the decades, numerous laws have been passed in hopes of creating a system to ensure that all distributed financial statements fairly represent the underlying organization they profess to report. Because of the need for economic stability, this is an objective that governments take seriously. Under capitalism, the financial health of the entire economy depends on the ability of worthy businesses to gain external financing for both operations and expansion. Without trust in the reporting process, people simply will not invest so that the raising of large monetary amounts becomes difficult, if not impossible. (Here, bring in the articles found by the second half of the class dealing with the credit crisis.) 1.1.1—The Securities and Exchange Commission [PowerPoint 6-4] In the U.S., ultimate responsibility for the availability of complete and reliable information about every organization that issues publicly-traded securities lies with the Securities and Exchange Commission (SEC). The SEC is an independent agency within the federal government established by the Securities Exchange Act of 1934. Its mission as stated at its Web site (www.sec.gov) “is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” Virtually all U.S. companies of any significant size—as well as many foreign companies—fall under the jurisdiction of the SEC because their securities (either ownership shares or debt instruments such as bonds) are traded publicly within the U.S. Financial statements and other formal filings have to be submitted regularly to the SEC by these companies. A Form 10-K must be submitted each year which includes financial statements as well as a substantial amount of additional data. A Form 10-Q serves the same purpose each quarter. This information is then made available to the public through a system known as EDGAR (Electronic Data Gathering and Retrieval). All such statements and other released data must conform precisely to the extensive rules and regulations of the SEC.
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Teaching tip: PowerPoint Slide 6-4 contains a link to the EDGAR page of the SEC website. The instructor may choose to click on the link and visit the page to familiarize students with different ways to search for filings using EDGAR. 1.1.2—Non-publicly-traded companies [PowerPoint 6-5] Companies that do not issue even a minimum amount of securities to the public normally are required to comply with state laws rather than with the SEC and federal laws. The form and distribution of financial information by these companies must conform to state laws (often referred to as “blue sky laws”).
1.2— The Relationship of the SEC to Official Accounting Standards [PowerPoint 6-6] Legally, the SEC has the ability to establish accounting rules for all companies under its jurisdiction simply by specifying that certain information must be presented in a particular manner in the public filings that it requires. However, for decades the SEC has opted to leave the development of authoritative accounting principles to the Financial Accounting Standards Board (FASB). For nearly 40 years the FASB has had the primary authority for producing U.S. GAAP. FASB is a private (rather than government) organization. At present, FASB produces accounting rules to be applied by all for-profit and not-for-profit organizations in the U.S. Groups other than FASB also contribute to accounting standards but in a much less significant fashion: Emerging Issues Task Force (EITF)—created in 1984 to assist FASB. The EITF examines new problems when they initially arise in hopes of coming to a quick agreement as to an appropriate method of reporting based on existing U.S. GAAP. SEC—occasionally issues guidelines to ensure that adequate information are being disclosed to the public through its own rules and interpretive releases.
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2. THE ROLE OF THE INDEPENDENT AUDITOR IN FINANCIAL REPORTING 1. Understand the purpose of an independent audit. 2. List the two primary components of an independent audit. 3. Explain the function of an independent audit firm. 4. Describe the steps required to become a Certified Public Accountant (CPA). 5. List the various types of services provided by many public accounting firms. 6. Discuss the necessity for the creation of the Public Company Accounting Oversight Board (PCAOB) and describe its function. 2.1— The Need for an Independent Audit of Financial Statements [PowerPoint 6-8]
A detailed examination of the financial statements produced by thousands of publicly traded companies around the world would require a massive work force with an enormous cost. Therefore, this essential role in the financial reporting process has been left by the SEC to auditing (also known as public accounting) firms that operate both inside and outside the U.S. 2.1.1— Information Provided by Audit Report [PowerPoint 6-9] Before submitting financial statements to the SEC and then to the public, reporting companies must hire an independent auditing firm to: • •
perform audit (examination) of the company’s financial statements, provide a report stating whether sufficient supporting evidence was obtained. This enables the auditor to provide reasonable assurance that the statements are presented fairly because they contain no material misstatements according to U.S. GAAP.
In the U.S., independent auditing firms can only be operated by individuals who have been formally recognized by a state government as Certified Public Accountants (CPAs).
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2.2— Standards for a Proper Audit [PowerPoint 6-10] When an audit is performed on the financial statements of any organization that issues securities to the U.S. public, the examination and subsequent reporting is regulated by the Public Company Accounting Oversight Board (PCAOB). The PCAOB was brought into existence by the U.S. Congress through the Sarbanes-Oxley Act of 2002. The PCAOB was established under the oversight and enforcement authority of the SEC. If an audit is performed on financial statements that are produced by an organization that does not issue securities to the public, the PCAOB holds no authority. For such smaller engagements, the Auditing Standards Board (ASB) officially sets the rules for an appropriate audit. The ASB is a technical committee within the American Institute of Certified Public Accountants (AICPA), a national professional organization of CPAs. The rules for performing an audit on a large company can differ somewhat from those applied to a smaller private one.
2.3—Role of the SEC [PowerPoint 6-11] The SEC strives to make certain that the organizations that fall under its jurisdiction are in total compliance with all laws so that decision-makers have ready access to information that is viewed as relevant. It reviews the required filings submitted by each organization to ensure that the rules and regulations are followed. The SEC also has the power to enforce securities laws and punish companies and individuals who break them. If corporate officials provide false or misleading data, fines and jail time are also possible.
3. PERFORMING AN AUDIT 1. Describe the goal of an auditor in examining an account balance. 2. List the tests that might be performed in auditing a reported balance such as account receivable. 3. Understand the reason that an independent auditor only provides reasonable assurance and not absolute or perfect assurance. 3.1— Auditing a Reported Balance [PowerPoint 6-13] An independent audit is a complicated activity that often requires scores of experienced CPAs many months to complete. A general understanding of the process is important because of its relevance to almost all businesses as well as investors and creditors. ©2012 Flat World Knowledge, Inc.
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In preparing statements, company accountants should document the steps taken to arrive at each balance and the work performed to determine the appropriate method of reporting according to U.S. GAAP. The statements are the representation of the company; thus, the burden of proof is on that organization and its officials. The independent auditors then examine the available evidence to ascertain whether reliance on the reported information should be advised. 3.1.1—Auditing Accounts Receivable [PowerPoint 6-14, 15] Assume that a business presents a list of 1,000 customers and claims that the total amount due from them is $12.7 million. This figure is reported as “accounts receivable” under the asset section of the year-end balance sheet. The independent audit firm will seek to accumulate sufficient, competent evidence to substantiate that this reported balance is not materially misstated in accordance with U.S. GAAP. For these receivables, the auditor will carry out a number of possible testing procedures to gain the assurance needed. Such techniques might include: • •
•
•
Adding the individual account balances to ensure that the total really is $12.7 million. Examining sales documents for a sample of individual customers to determine that the amounts sold to them are equal to the figures listed within the receivable. For example, if the sales document indicates that Mr. A bought goods at a price of $1,544, is that same amount found in the company’s receivable balance? Examining cash receipts documents for a sample of individual customers to ensure that no unrecorded payments were collected prior to the end of the year. If Mr. A paid cash of $1,544 on December 30, was the corresponding receivable balance reduced by that amount prior to the end of the year? Contacting a sample of the customers directly to confirm that the balance shown is, indeed, appropriate. “Mr. A: Company records show that you owe $1,544. Is that amount correct?”
The actual quantity and type of testing varies considerably based on the nature of the account. Auditing $12.7 million in receivables requires different steps than investigating a building bought for that same amount. Not surprisingly, large monetary balances often require especially extensive testing. In addition, certain accounts (such as cash or inventory) where the risk of misstatement is particularly high will draw particular attention from the independent auditors. If the auditor eventually concludes that sufficient evidence has been obtained to reduce the risk of a material misstatement in the financial statements to an acceptably low level, an audit report can be issued with that opinion. Assuming no problems were encountered, reasonable assurance is provided by the independent auditor that the statements are presented fairly and, thus, contain no material misstatements according to U.S. GAAP. ©2012 Flat World Knowledge, Inc.
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3.2— Reasonable Assurance and Not Perfect Assurance [PowerPoint 6-16]
Independent auditors provide reasonable assurance, but not absolute assurance, that financial statements are presented fairly because they contain no material misstatements according to U.S. GAAP. A number of practical reasons exist as to why the level of assurance is limited in this manner. 1) Many of the figures found on any set of financial statements are no more than estimations. 2) Organizations often take part in so many transactions during a period (millions for many large companies) that uncovering every potential problem or issue during an audit is impossible. 3) An independent auditor visits a company for a few weeks or months each year to carry out testing procedures. Company officials who want to hide financial problems are sometimes successful at concealment. 4) Informed decision makers should understand that independent auditors can only provide reasonable assurance.
4. THE NEED FOR INTERNAL CONTROL 1. Define “internal control.” 2. Explain a company’s need for internal control policies and procedures. 3. Describe the effect that a company’s internal control has on the work of the independent auditor. 4.1—Internal Controls Within an Organization [PowerPoint 6-18] To be efficient and effective, a company’s systems must be carefully designed and maintained. Well-designed systems generate information with fewer errors which reduces the threat of material misstatements. However, simply having systems in place—even if they are properly designed and constructed—is not sufficient to guarantee both the effectiveness of the required actions and the reliability of the collected data. Thus, extra procedures should be built into each system by management to help ensure that every operation is performed as intended and the resulting financial information is reliable. All of the redundancies added to a system to make certain that it functions properly are known collectively as internal control. Internal control is made up of all the added procedures that are performed so that each system operates as intended. Systems cannot be considered well designed without the inclusion of adequate internal control. Management is responsible for the development of effective systems but also for all internal control rules and requirements created to ensure that these systems accomplish their stated objectives. ©2012 Flat World Knowledge, Inc.
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4.2—Internal Control and the Independent Audit [PowerPoint 6-19] As one of the preliminary steps in an audit examination, the CPA gains an understanding of the internal control procedures included within each of the systems that relates to reported financial accounts and balances. The auditor then makes an evaluation of the effectiveness of those policies and procedures. In cases where internal control is both well designed and appears to be functioning as intended, a reduction is possible in the amount of audit testing that is needed. This is because the likelihood of a material misstatement is reduced by the company’s own internal control.
5. THE PURPOSE AND CONTENT OF AN INDEPENDENT AUDITOR’S REPORT 1. Describe the purpose of the independent auditor’s report. 2. Identify the intended beneficiaries of an independent auditor’s report. 3. Discuss the contents of the introductory, scope, and opinion paragraphs in an independent auditor’s report. 4. List problems that might require a change in the contents of an independent auditor’s report. 5.1—The Structure of an Independent Auditor’s Report [PowerPoint 6-21, 22, 23, 24]
5.1.1—IN-CLASS ACTIVITY The audit report Description: Prior to class, ask students to print off a copy of the most recent audit report for a publicly traded company. They may wish to use the same company whose financial information they examined in Chapters 2 and 3. Ask them to follow along in their reports as you share information on its contents. Alternatively, the audit report for Proctor & Gamble is provided in the PowerPoint presentation should you prefer not to make this an assignment.
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1.2.1—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
5-10 Minutes
Students will need to bring audit report to class
1) The report is addressed to the board of directors (elected by the shareholders) and the shareholders. An audit is not performed for the direct benefit of the reporting company or its management but rather for any person or group studying the financial statements for decision-making purposes. The salutation stresses that external users (rather than the company itself) are the primary beneficiaries of the work carried out by the independent auditor. 2) To avoid any potential misunderstanding, the first (introductory) paragraph identifies the specific financial statements to which the report relates. In addition, both the responsibility of the management for those financial statements and the responsibility of the independent auditor for providing an opinion on those statements are clearly delineated. The statements are not created by the auditor; that is the job of management. The auditor examines the financial statements so that an expert opinion can be rendered.
3) The second (scope) paragraph provides information to explain the audit work. One key sentence in this paragraph is the second. It spells out the purpose of the audit by referring to the standards created by the PCAOB: “Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements.” This sentence clearly sets out the goal of an audit engagement and the level of assurance given by the auditor. No reader should expect absolute assurance. The remainder of the second paragraph describes in general terms the steps taken by the auditor such as the following: a. Examining evidence on a test basis to support reported amounts and disclosures b. Assessing the accounting principles that were applied c. Assessing significant estimations used in creating the statements d. Evaluating overall presentation 4) The third (opinion) paragraph provides the auditor’s opinion of the financial statements. Students may have differing opinions in the audit reports, but most are going to be unqualified opinions.
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5) The fourth (explanatory) paragraph provides an additional opinion by the auditor, this time in connection with the company’s internal control. Such an assessment is required when an audit is performed on a company that is subject to the rules of the PCAOB. Not only is the auditor asserting that the financial statements are presented fairly in conformity with U.S. GAAP (paragraph 3) but also gives an unqualified opinion on the company’s internal control over its financial reporting (paragraph 4).
5.2—Qualified Audit Opinions [PowerPoint 6-25] An independent auditor renders an opinion that is not unqualified in two general situations: •
Lack of evidence: The auditor was not able to obtain sufficient evidence during the audit to justify an unqualified opinion.
•
Presence of a material misstatement: The auditor discovered the existence of a material misstatement in the financial statements, a balance or disclosure that does not conform to U.S. GAAP.
The physical changes made in the report depend on the type of problem that is involved and its magnitude. The key method of warning is that a new paragraph is added between the scope and the opinion paragraphs to describe the auditor’s concern.
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CHAPTER 7 In Financial Reporting, What Information Is Conveyed about Receivables? 1. ACCOUNTS RECEIVABLE AND NET REALIZABLE VALUE 1. Understand that accounts receivable are reported at net realizable value. 2. Know that net realizable value is an estimation of the amount of cash to be collected from a particular asset. 3. Appreciate the challenge that uncertainty poses in the reporting of accounts receivable. 4. List the factors to be considered by officials when estimating the net realizable value of a company’s accounts receivable.
1.1—Reporting Accounts Receivable [PowerPoint 7-3] In previous chapters, the term “accounts receivable” was introduced to report monetary amounts owed to a reporting entity by its customers. Individual balances are generated by sales made on credit. Businesses sell on credit, rather than demanding cash, as a way to increase the number of customers and the related revenue. According to U.S. GAAP, the figure presented on a balance sheet for accounts receivable is its net realizable value—the amount of cash the company estimates will be collected over time from these accounts. The actual total of receivables is higher than the figure reported on the balance sheet. An estimated amount of doubtful accounts is subtracted recognizing that a portion of these debts will never be collected. For this reason, the asset is identified on the balance sheet as “accounts receivable, net” or, sometimes, “accounts receivable, net of allowance for doubtful accounts” to explain that future losses have already been anticipated and removed.
1.2—Lack of Exactness in Reporting Receivables [PowerPoint 7-4] ©2012 Flat World Knowledge, Inc.
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No one will ever be able to predict the precise amount of cash to be received from accounts receivable. Knowledgeable decision makers understand that a degree of uncertainty exists in reporting all such balances. However, a very specific figure does appear on the balance sheet for accounts receivable. By communicating this amount, company officials are asserting that they believe sufficient evidence is available to provide reasonable assurance that the amount collected will not be a materially different figure.
1.3—Determining Net Realizable Value [PowerPoint 7-5] To determine the net realizable value appropriate for accounts receivable, company officials consider many relevant factors such as: • Historical experience of the company in collecting its receivables • Efficiency of the company’s credit verification policy • Current economic conditions • Industry averages and trends • Percentage of overdue accounts at present • Efficiency of current collection procedures Teaching Tip: Determining Net Realizable Value Prior to giving your students this list, ask volunteers to think of factors companies can use. Students should be able to come up with at least a few of these such as historical experience and current economic conditions.
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2. ACCOUNTING FOR UNCOLLECTIBLE ACCOUNTS 1. Understand the reason for reporting a separate allowance account on the balance sheet in connection with accounts receivable. 2. Know that bad debt expenses must be anticipated and recorded in the same time period as the related sales revenue to conform to the matching principle. 3. Prepare the adjusting entry to reduce accounts receivable to net realizable value and recognize the resulting bad debt expense. 2.1—The Allowance For Doubtful Accounts [PowerPoint 7-7] Companies maintain two separate T-accounts for accounts receivables solely because of the uncertainty involved. If the balance to be collected was known, one account would suffice for reporting purposes. However, that level of certainty is rarely possible. • An Accounts Receivable T-account monitors the total due from all of a company’s customers. • A second account (often called the allowance for doubtful accounts or the allowance for uncollectible accounts) reflects the estimated amount that will eventually have to be written off as uncollectible. Whenever a balance sheet is produced, these two accounts are netted to arrive at net realizable value, the figure to be reported for this particular asset. The allowance for doubtful accounts is an example of a “contra account,” one that always appears with another account but as a direct reduction to lower the reported value. Here, the allowance decreases the receivable balance to its estimated net realizable value.
2.2—Anticipating Bad Debt Expense [PowerPoint 7-8] If receivables are recorded that will eventually have to be decreased because they cannot be collected, an expense must be recognized. In financial reporting, terms such as “bad debt expense,” “doubtful accounts expense,” or “the provision for uncollectible accounts” are often encountered for that purpose. The inherent uncertainty as to the amount of cash that will be received affects the physical recording process.
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2.3—Bad Debts and the Matching Principle [PowerPoint 7-9] The timing of expense recognition according to accrual accounting is based on the matching principle. The expected expense is the result of making sales to customers who ultimately will never pay. Because the revenue was reported at the time of sale, the related expense must also be recognized in that very year. Therefore, when the company produces financial statements at the end of Year One, an adjusting entry is made to: (a) reduce the receivables balance to its net realizable value and (b) recognize the expense in the same period as the related revenue. 2.3.1—Work through an example of computing bad debt expense [PowerPoint 7-10, 11, and 12]
A company makes sales on account to 100 different customers late in Year One for $1,000 each. Journal Entry—Year One—Sales Made on Credit Accounts Receivable Sales
100,000 100,000
Company’s past history and other relevant information lead officials to estimate that approximately 7 percent of all credit sales will prove to be uncollectible. Bad debt expense = 7% × $100,000 Bad debt expense = $7,000 Adjusting Entry—End of Year One—Recognition of Bad Debt Expense for the Period Bad Debt Expense Allowance for Doubtful Accounts
7,000 7,000
After this entry is made and posted to the ledger, the Year One financial statements contain the following information based on the T-account balances (assuming for convenience that no other sales were made during the year). Year One—Financial Statements Income Statement (Partial) for Year One Revenue Sales Operating Expenses Bad Debt Expense
$100,000
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Balance Sheet (Partial) at End of Year One Current Assets Accounts Receivable $100,000 Allowance for Doubtful Accounts 7,000 Accounts Receivable, Net $93,000
2.4—The Need for a Separate Allowance Account [PowerPoint 7-13] The actual accounts that will not be collected are unknown. Plus, on the balance sheet date, the company does hold all the receivables. The accounts receivable figure cannot be reduced directly until the specific identity of the accounts to be written off has been established. Therefore, utilizing a separate allowance allows the company to communicate the expected amount of cash while still maintaining a record of all balances in the accounts receivable T-account.
3. THE PROBLEM WITH ESTIMATIONS 1. Record the impact of discovering that a specific receivable is uncollectible. 2. Understand the reason an expense is not recognized when a receivable is deemed to be uncollectible. 3. Record the collection of a receivable that has previously been written off as uncollectible. 4. Recognize that estimated figures often prove to be erroneous but changes in previous year figures are not made if the reported balance was a reasonable estimate. 3.1—The Write-off of an Uncollectible Account [PowerPoint 7-15] When an account proves to be uncollectible, the receivable T-account is decreased. It is not viewed as an asset because it has no future economic benefit. Furthermore, the amount of bad accounts within the receivables will also be lowered. The following journal entry is shown to write off an account. Throughout the year, this entry is repeated whenever a balance is found to be worthless. No additional expense is recognized.
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Journal Entry during Year Two—Write-off of Specific Account as Uncollectible Allowance for Doubtful Accounts Accounts Receivable
1,000 1,000
Two basic steps in the recording of doubtful accounts: 1. Reporting of uncollectible accounts in the year of sale based on estimation. 2. Write-off an account judged to be uncollectible.
3.2—Collecting Accounts Previously Written-off [PowerPoint 7-16] Organizations always make every possible effort to recover money they are owed. Writing off an account simply means that the chances of collection are deemed to be slim. Efforts to force payment will continue, often with increasingly aggressive techniques. If money is ever received from a written off account, the company first reinstates the account by reversing the earlier entry. Then, the cash received is recorded in the normal fashion. 3.2.1—Work through an example of writing off a specific account and collecting the account at a later date [PowerPoint 7-17, 18] Assume that on March 13, Year Two, a $1,000 accounts receivable balance is judged to be worthless. The company will make the following journal entry. Journal Entry during Year Two—Write-off of Specific Account as Uncollectible Allowance for Doubtful Accounts Accounts Receivable
1,000 1,000
On a later date, the account is actually collected from this customer. Journal Entry—Reinstate Account Previously Thought to Be Worthless Accounts Receivable Allowance for Doubtful Accounts
1,000 1,000
Journal Entry—Collection of Reinstated Account Cash Accounts Receivable
1,000 1,000
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3.3—Reporting an Incorrect Estimation [PowerPoint 7-19] According to U.S. GAAP, if a number in an earlier year is reported based on a reasonable estimation, any subsequent differences with actual amounts are not handled retroactively. Reasons for accountant’s unwillingness to adjust previously reported estimations unless they were clearly unreasonable or fraudulent: 1. Most decision makers are well aware that many reported figures represent estimates. 2. Because an extended period of time often exists between issuing statements and determining actual balances, most parties will have already used the original information to make their decisions. Knowing the correct number will yield no discernable benefit to such parties. 3. Financial statements contain numerous estimations and nearly all will prove to be inaccurate to some degree. Correcting each of the previously reported figures would virtually become a never ending task for a company and its accountants. 4. At least theoretically, half of the differences between actual and anticipated results should make the reporting company look better and half make it look worse. If so, such errors will offset each other and have little overall impact on a company’s reported income and financial condition. However, differences that arise should be taken into consideration in creating current and subsequent statements.
3.4—Recording Receivable Transactions in Subsequent Years [PowerPoint 7-20 and 21]
Let us continue with the previous example. Assume that $400,000 in new credit sales are made during Year Two while cash of $330,000 is collected. Uncollectible receivables totaling $10,000 are written off in that year.
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End of Year Two—Sales, Receivables, and Bad Debt Balances Sales 0 400,000 400,000
Beginning Balance (Year Two)
Bad Debt Expense 0
Beginning Balance (Year Two) Credit Sales
Accounts Receivable 100,000 400,000 330,000
Ending Balance to Date
Accounts Written Off Ending Balance to Date
10,000 500,000 340,000 160,000
Beginning Balance (Year Two) Credit Sales Ending Balance to Date
Cash Collections Accounts Written Off
Allowance for Doubtful Accounts 7,000 Beginning Balance (Year Two) 10,000 10,000 7,000 3,000
3.5—Residual Balance in the Allowance for Doubtful Accounts [PowerPoint 7-22]
A debit balance in the Allowance for Doubtful Accounts indicates that the original estimate of bad debts was too low. Until the estimation for the current year is determined and recorded, the balance residing in the allowance account indicates a previous underestimation (an ending debit balance) or overestimation (a credit) of the amount of worthless accounts.
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4. THE ACTUAL ESTIMATION OF UNCOLLECTIBLE ACCOUNTS 1. Estimate and record bad debts when the percentage of sales method is applied. 2. Estimate and record bad debts when the percentage of receivables method is applied. 3. Explain the reason that bad debt expense and the allowance for doubtful accounts normally report different figures. 4. Understand the reason for maintaining a subsidiary ledger. 4.1—Two Methods for Estimating Uncollectible Accounts [PowerPoint 7-24]
Two approaches predominate when predicting the amount of uncollectible accounts. Percentage of sales method—computes the current period bad debt expense by anticipating the percentage of sales (or credit sales) that will eventually fail to be collected. The percentage of sales method is sometimes referred to as an income statement approach because the only number being estimated (bad debt expense) appears on the income statement. Percentage of receivables method—determines the proper balance for the allowance for doubtful accounts based on the percentage of ending accounts receivable that are presumed to be uncollectible. This method is identified as a balance sheet approach because the only figure being estimated (the allowance for doubtful accounts) is found on the balance sheet. A common variation applied by many companies is the “aging method” which first classifies all receivable balances by age and then multiplies each of those individual totals by a different percentage. Normally, a higher rate is used for accounts that are older because they are considered more likely to become uncollectible.
4.2—Applying the Percentage of Sales Method [PowerPoint 7-25, 26, 27] We will use the previous example to illustrate the two methods. The company generated $400,000 in credit sales during Year Two. Uncollectible accounts are estimated to be 8% of credit sales. Bad debt expense = 8% × $400,000 ©2012 Flat World Knowledge, Inc.
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Bad debt expense = $32,000 Adjusting Entry for Year Two – Uncollectible Accounts Estimated as a Percentage of Sales Bad Debt Expense Allowance for Doubtful Accounts
32,000 32,000
This adjustment increases the expense to the appropriate $32,000 figure, the proper percentage of the Sales figure. However, prior to adjustment, the allowance account held a residual $3,000 debit balance ($7,000 Year One estimation less $10,000 accounts written off.) Resulting T-Accounts, Based on Percentage of Sales Method
Beginning Balance Expense Adjustment Ending Balance
Accounts Written Off
Bad Debt Expense 0 32,000 32,000 Allowance for Doubtful Accounts 7,000 Beginning Balance 10,000 32,000 Expense Adjustment 10,000 39,000 29,000 Ending Balance
After this adjustment, the figures appearing in the financial statements for Year Two are as follows: Uncollectible Accounts Estimated Based on 8 Percent of Sales Income Statement (Partial) for Year Two Revenue Sales Operating Expenses Bad debt Expense
$400,000
32,000
Balance Sheet (Partial) at End of Year Two Current Assets Accounts Receivable $160,000 Allowance for Doubtful Accounts 29,000 Accounts Receivable, Net $131,000
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4.3—The Difference Between Bad Debt Expense and the Allowance for Doubtful Accounts [PowerPoint 7-28] The difference between the bad debt expense balance and the allowance for doubtful accounts balance is caused due to the failure of previous estimations to be accurate. Actual amount of worthless accounts is quite likely to be entirely different from either the balance of bad debt expense, or allowance for doubtful accounts. This difference should not be an issue if neither of the two reported balances is believed to be materially misstated
4.4—Applying the Percentage of Receivables Method [PowerPoint 729, 30, 31]
Assume that the Year Two adjusting entry has not yet been made so that bad debt expense remains at zero and the allowance for doubtful accounts still holds a $3,000 debit balance. Also assume that the company has chosen to use the percentage of receivables method. Officials have looked at all available evidence and come to the conclusion that 15 percent of ending accounts receivable are likely to prove to be uncollectible. Bad debt expense = 15% × $160,000 Bad debt expense = $24,000 The percentage of receivables method views the estimated figure of $24,000 as the proper total for the allowance for doubtful accounts. Thus, the accountant must turn the $3,000 debit balance residing in the contra asset account into the proper $24,000 credit. This change can only be accomplished by recognizing an expense of $27,000. Adjusting Entry for Year Two—Uncollectible Accounts Estimated as a Percentage of Receivables Bad Debt Expense Allowance for Doubtful Accounts
27,000 27,000
Resulting T-Accounts, Based on Percentage of Receivables Method
Accounts Written Off
Allowance for Doubtful Accounts 7,000 Beginning Balance 10,000 27,000 Expense Adjustment 10,000 34,000 24,000 Ending Balance
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Beginning Balance Expense Adjustment Ending Balance
Bad Debt Expense 0 27,000 27,000
After this adjusting entry has been posted, the balances appear in the financial statements for Year Two as follows: Uncollectible Accounts Estimated Based on 15 Percent of Receivables Income Statement (Partial) for Year Two Revenue Sales Operating expenses Bad debt expense
$400,000
27,000
Balance Sheet (Partial) at End of Year Two Current Assets Accounts receivable $160,000 Allowance for doubtful accounts 24,000 Accounts receivable, net $136,000
4.5—The Purpose of a Subsidiary Ledger [PowerPoint 7-32] A ledger account only reflects a single total at the present time. In many cases, as with accounts receivable, the composition of that balance is also essential information. For those T-accounts, the accounting system can be expanded to include a subsidiary ledger to maintain data about the various individual components making up the account total. When a subsidiary ledger is maintained, the accounting system can be programmed so that each entry into the general ledger T-account requires an immediate parallel increase or decrease to the appropriate individual account.
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5. REPORTING FOREIGN CURRENCY BALANCES 1. Recognize that transactions denominated in a foreign currency have become extremely common. 2. Understand the necessity of remeasuring the value of foreign currency balances into a company’s functional currency prior to the preparation of financial statements. 3. Appreciate the problem that fluctuations in exchange rates cause when foreign currency balances are reported in a set of financial statements. 4. Know which foreign currency balances are reported using a historical exchange rate and which balances are reported using the currency exchange rate in effect on the date of the balance sheet. 5. Understand that gains and losses are reported on a company’s income statement when foreign currency balances are remeasured using current exchange rates. 5.1—Reporting Balances Denominated in a Foreign Currency [PowerPoint 7-35]
Foreign currency balances are common in today’s world. Although a company will have a functional currency in which it normally operates (probably the U.S. dollar for a U.S. company), transactions often involve a number of currencies. For many companies, sales, purchases, expenses and the like can be denominated in dozens of different currencies. A company’s financial statements may report U.S. dollars because that is its functional currency but underlying amounts to be paid or received might be set in another currency such as the euro or the pound. Without standardization, a decision maker would likely face a daunting task trying to analyze similar companies if they employed different approaches for reporting foreign currency figures. Therefore, U.S. GAAP has long had an authoritative standard for this reporting. The basic problem with reporting foreign currency balances is that exchange rates are constantly in flux. The price of one euro in terms of U.S. dollars changes many times each day. Because such values float, the reporting of these foreign currency amounts poses a challenge with no easy resolution.
5.2—Accounting for Changes in Currency Exchange Rates [PowerPoint 7-36]
Exchange rates that vary over time create a reporting problem for companies operating in international markets. For over 25 years, U.S. GAAP has required that monetary assets and liabilities denominated in a foreign currency be reported at the current exchange rate ©2012 Flat World Knowledge, Inc.
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as of the balance sheet date. All other balances continue to be shown at the historical exchange rate in effect on the date of the original transaction. Because monetary assets and liabilities reflect current or future cash amounts, the current exchange rate is always viewed as the most relevant. Both the individuals who produce financial statements as well as the decision makers who use this information them should understand the rule that is applied to resolve this reporting issue. 5.2.1—Foreign Currency Example [PowerPoint 7-37] A U.S. based company makes a sale of a service to a Mexican company on December 9, Year One, for 100,000 Mexican pesos that will be paid at a later date. Assume also that the exchange rate on the day when the sale was made was 1 peso equal to $0.08. However, by the end of Year One when financial statements are to be produced, the exchange rate is different: 1 peso is now worth $0.09. Reporting at the time of the sale: Value in dollars = 100,000 pesos × $0.08 Value in dollars = $8,000 Journal Entry – December 9, Year One—Sale of Services Made for 100,000 Pesos Accounts Receivable 8,000 Sale of Services 8,000 By the end of the year, the exchange rate has changed so that 1 peso is equal to $0.09. Value in dollars = 100,000 pesos × $0.09 Value in dollars = $9,000 In the above example, the value of the receivable (a monetary asset) has changed in terms of U.S. dollars. The 100,000 pesos that will be collected have an equivalent value now of $0.09 each rather than $0.08. The reported receivable is updated to a value of $9,000 (100,000 pesos × $0.09). Cash, receivables, and payables denominated in a foreign currency must be adjusted for reporting purposes whenever exchange rates fluctuate. All other account balances (equipment, sales, rent expense, dividends, and the like) reflect historical events and not future cash flows. Thus, they retain the rate in effect at the time of the original transaction and no further changes are ever needed. Because the sales figure is not a monetary asset or liability so the $8,000 balance continues to be reported regardless of the relative value of the peso.
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5.3—The Income Effect of a Change in Currency Exchange Rates [PowerPoint 7-38]
In this example, the value of the 100,000-peso receivable is raised from $8,000 to $9,000. When the amount reported for monetary assets and liabilities increases or decreases because of changes in currency exchange rates, a gain or loss is recognized on the income statement. Adjusting Entry at December 31, Year One – Remeasurement of 100,000 Pesos Receivable Accounts Receivable Gain in Value of Foreign Currency Receivable
1,000 1,000
On its balance sheet, this company now reports a receivable as of December 31, Year One, of $9,000 while its income statement for that year shows sales revenue of $8,000 as well as the above gain of $1,000.
6. A COMPANY’S VITAL SIGNS—ACCOUNTS RECEIVABLE 1. Compute the current ratio, the amount of working capital, and other figures pertinent to the reporting of accounts receivable. 2. Describe the implications of a company’s current ratio. 3. Describe the implications of a company’s working capital balance. 4. Calculate the amount of time that passes before the average accounts receivable is collected and explain the importance of this information. 5. List techniques that a business can implement to speed up collection of its accounts receivable. 6.1—Current Ratio and Working Capital [PowerPoint 7-41] Financial statements are extremely complex and most analysts have certain preferred figures or ratios that they believe are especially significant when investigating a company. For example, in a previous chapter, both the current ratio and the amount of working capital were computed using the balance reported for current assets (those that will be used or consumed within one year) and current liabilities (those that will be paid ©2012 Flat World Knowledge, Inc.
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within one year): Current Ratio = Current Assets/Current Liabilities Working Capital = Current Assets − Current Liabilities These figures reflect a company’s liquidity, its ability to pay its debts as they come due and still have enough monetary resources available to generate profits in the near future. They are vital signs that help indicate the financial health of a business and its future prospects. Whether these numbers are impressive or worrisome almost always depends on a careful comparison with other similar companies and results from prior years. Note: These ratios are reviewed here, but were introduced in Chapter 3.
6.2—Computing the Age of Accounts Receivable [PowerPoint 7-42] One indication of a company’s financial health is its ability to collect receivables in a timely fashion. Money cannot be put to productive use until it is received. For that reason, companies work to encourage customers to make payments as quickly as possible. Furthermore, as stated previously, the older a receivable becomes the more likely it is to prove worthless. Thus, interested parties (both inside a company as well as external) frequently monitor the time taken to collect receivables. Age of Receivables = Receivables/Sales per Day A similar figure is referred to as the receivables turnover and is computed by the following formula: Receivables Turnover = Sales/Average Receivables 6.2.1—Work through an example of computing age of receivables [PowerPoint 7-43, 44]
A company reports sales for the current year of $7,665,000 and currently holds $609,000 in receivables. Determine the sales per day and age of receivables Sales per day = Sales/365 Sales per day = $7,665,000/365 = $21,000 Age of Receivables = Receivables/Sales per Day Age of Receivables = $609,000/$21,000 = 29 days
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6.2.2—Work through an example of computing age of receivables and receivables turnover [PowerPoint 7-45, 46] For the year ended January 28, 2011, Dell Inc. reported net revenue of $61.494 billion. The January 28, 2011, net accounts receivable balance for the company was $6.493 billion, which was up from $5.837 billion the year before. Determine the age of receivables and receivables turnover. Sales per day = Sales/365 Sales per day = $61.494 billion/365 = $168.5 million Age of Receivables = Receivables/Sales per Day Age of Receivables = $6.494 billion/$168.5 million = 38.5 days Receivables Turnover = Sales/Average Receivables Average Receivable = ([$6.493 billion + $5.837 billion]/2) = $6.165 billion Receivables Turnover = $61.494 billion/$6.165 billion = 9.97 times
6.3—Reducing the Time it Takes to Collect Receivables [PowerPoint 7-47]
A number of strategies can be used by astute officials to shorten the time between a sale being made and cash collected. 1) Stronger review of credit worthiness before selling on credit 2) Make accounting system more efficient to send bills in a timely manner 3) Offer discounts as incentive to customers to pay quickly 4) Send out second bills more quickly to remind customers 5) Pursue a more aggressive collection policy Teaching Tip: Ask students for other possible measures to shorten the time taken for cash collections. Some interesting responses will be to ask for upfront deposits, suggest the use of credit cards, and promote cash sales as much as possible.
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CHAPTER 8 How Does a Company Gather Information about Its Inventory? 1. DETERMINING AND REPORTING THE COST OF INVENTORY 1. Understand that inventory is recorded initially at historical cost. 2. Provide the guiding rule for identifying expenditures that are capitalized in the acquisition of inventory. 3. Explain the rationale for offering a discount for quick payments of cash as well as the accounting used to report such reductions. 1.1—The Reported Inventory Balance [PowerPoint 8-3] Accounting for inventory is more complicated because reporting is not as standardized as with accounts receivable. Under certain circumstances, the balance sheet amount shown by a company for inventory actually does reflect its net realizable value. However, several other meanings for that reported balance are more likely. The range of accounting alternatives emphasizes the need for a careful reading of financial statement notes rather than fixating on a few reported numbers alone.
1.2—Determining the Cost of Inventory [PowerPoint 8-4] In accounting for the acquisition of inventory cost is said to include all normal and necessary amounts incurred to get the item into condition and position to be sold. All such expenditures provide future value. Occasionally, costs arise where the “normal and necessary” standard may be difficult to apply. If an accountant cannot make a reasonable determination as to whether a particular cost qualifies as normal and necessary, the practice of conservatism that underlies financial accounting requires the cost be reported as an expense.
1.2.1—Example of determining the initial cost of inventory [PowerPoint 8-5, 6]
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Rider Inc. acquires a new bicycle (Model XY-7) to sell. A price of $250 was charged by the manufacturer (Builder Company) for the bicycle and the purchase was made by Rider on credit. The buyer then spent another $9 in cash to transport the item from the factory to one of its retail stores and another $6 to have the pieces assembled so that the bicycle could be displayed in the salesroom for customers to examine. What is the cost of the bicycle to Rider? Monitoring the Cost of an Inventory Item—Subsidiary Ledger Rider Inc. Bicycle – Model XY-7 Invoice price Transportation-in Assembly Cost of inventory (bicycle)
$250 9 ___6 $265
1.3—Offering Discounts for Quick Payment [PowerPoint 8-7] Sellers can offer a wide variety of discount terms to encourage speedy payment. One such as 2/10, n/45 is generally read “two ten, net 45.” It informs the buyer that a 2 percent discount is available if the invoice is paid by the tenth day. The net amount that remains unpaid (after merchandise returns or partial cash payments) is due on the fortyfifth day. Many companies automatically take all discounts as a matter of policy because of the high rate of interest earned. 1.3.1—Example of calculating a discount [PowerPoint 8-8] Continuing the above example, Rider receives an invoice from Buyer for $250 with the terms 2/10, n/45. If Rider pays within 10 days, what is its payment? Discount = $250 × 2% Discount = $5 Rider would pay $245 ($250 - $5) if it pays within 10 days.
2.
PERPETUAL AND PERIODIC INVENTORY SYSTEMS
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1. Identify the attributes as well as the advantages and disadvantages of a perpetual inventory system. 2. Identify the attributes as well as the advantages and disadvantages of a periodic inventory system. 3. Provide journal entries for a variety of transactions involved in the purchase of inventory using both a perpetual and a periodic inventory system. 2.1—Maintaining Inventory Cost in a Perpetual System [PowerPoint 8-10,11]
When a perpetual inventory system is in use, all additions and reductions are monitored in the inventory T-account. Here are the journal entries a company would make if it uses a perpetual system: Purchased Inventory Inventory Accounts Payable Paid for Inventory after Taking Discount Accounts Payable Cash Inventory Payment Made to Transport or Assemble Inventory Inventory Cash
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2.1.1—Example of perpetual inventory system [PowerPoint 8-12, 13, 14] What journal entries should Rider Inc. make for its purchase of a bicycle (Model XY7) if a perpetual inventory system is utilized? Assume that the 2 percent discount is availed. Rider Inc. – Journal Entries—Perpetual Inventory System Purchased Bicycle Inventory Accounts Payable
250 250
Paid for Bicycle after Taking 2 Percent Discount Accounts Payable Cash Inventory
250 245 5
Payment Made to Transport Bicycle to Retail Store Inventory Cash
9 9
Payment Made to Assemble Bicycle for Display Purposes Inventory Cash
6 6
2.1.2—Gross Method and Net Method [PowerPoint 8-15] The bicycle is recorded at the $250 invoice amount and then reduced by $5 at the time the discount is taken. This approach is known as the “gross method of reporting discounts.” As an alternative, companies can choose to anticipate taking the discount and simply make the initial entry for the $245 expected payment. This option is referred to as the “net method of reporting discounts.” Under that approach, if the discount is not actually taken, the additional $5 cost is recorded as a loss or an expense rather than as a capitalized cost of the inventory because it is not normal and necessary to pay the extra amount.
2.2—Recording Inventory Purchases in a Periodic System [PowerPoint 8-16, 17]
If a company uses a periodic system, no attempt is made to monitor either the cost or the quantity of the items on hand is monitored. Inventory amounts are unknown both in total and individually. Here are the journal entries a company would make if it uses a periodic
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system: Purchased Inventory Purchases of Inventory Accounts Payable Paid for Inventory after Taking Discount Accounts Payable Cash Purchases Discount Payment Made to Transport Inventory Transportation-in Cash Payment Made to Assemble Inventory Assembly of Inventory Cash 2.2.1—Example of periodic inventory system [PowerPoint 8-18, 19, 20, 21] What journal entries should Rider, Inc. make for its purchase of a bicycle (Model XY-7) if a periodic inventory system is utilized? Assume that the 2 percent discount is availed. Rider Inc. – Journal Entries—Periodic Inventory System Purchased Bicycle Purchases of Inventory Accounts Payable
250 250
Paid for Bicycle after Taking 2 Percent Discount Accounts Payable Cash Purchases Discount
250 245 5
Payment Made to Transport Bicycle To Retail Store Transportation-in Cash
9 9
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Payment Made to Assemble Bicycle For Display Purposes Assembly of Inventory Cash
6 6
Note that the choice between a perpetual and periodic system impacts: • • •
Information available to company officials on a daily basis Journal entries to be made Cost required to operate the accounting system (the technology required by a perpetual system is more expensive)
However, the figures reported in the financial statements are unaffected by the mechanical recording procedures applied. Regardless of the system in use, Rider holds one piece of inventory with a cost of $260.
2.3— Actual Use of Periodic Inventory Systems [PowerPoint 8-22] Perpetual inventory systems provide valuable and immediate information to company officials. However, some types of businesses are unlikely to ever change from the simplicity of a periodic system. Companies where services are rendered but a small amount of inventory is kept on hand for occasional sales, would certainly not need to absorb the cost of a perpetual system. Visual inspection can alert employees as to the quantity of inventory on hand. In such operations, the information provided by a perpetual system does not necessarily provide additional benefit. Some companies use a hybrid system where the units on hand and sold are monitored carefully with a perpetual system. However, to reduce accounting costs, the dollar amounts for inventory and cost of goods sold are determined using a periodic system when financial statements are to be prepared. In that way, the company gains valuable information (the number of units on hand) but still utilizes a cheaper system.
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3. THE CALCULATION OF COST OF GOODS SOLD 1. Explain the meaning of the FOB point in connection with an inventory purchase and its impact on the recording of this transaction. 2. Identify the time at which cost of goods sold is computed in a perpetual inventory system as well as the recording made at the time of sale. 3. Identify the time at which cost of goods sold is computed in a periodic inventory system as well as the recording made at the time of sale. 4. Compute cost of goods sold in a periodic inventory system and prepare the adjustment to enter the appropriate balances into the accounting system. 5. Understand the necessity of taking a physical inventory count. 3.1—Recording Purchases Based on the FOB Point [PowerPoint 8-25, 26]
Documents prepared in connection with inventory shipments are normally marked with an “FOB” point. FOB stands for “Free On Board” and indicates when legal title to property is transferred from seller to buyer. At that moment, ownership of inventory is conveyed. The FOB point signifies the appropriate date for recording. If the contract states that a transaction is made “FOB destination,” the seller maintains ownership until the inventory arrives at the store of the buyer. Neither party records the transaction until that date. The date of recognition is based on the FOB point. If the contract states that the transaction is made “FOB shipping point,” the buyer gains legal ownership when the inventory leaves the seller’s warehouse. The FOB point is often important for two other reasons besides knowing when to record an inventory purchase. • The party that holds legal title to merchandise during its delivery from seller to buyer normally incurs the transportation cost. • Any losses or damages that occur in route affect the party holding legal title.
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3.1.1—Example of FOB point [PowerPoint 8-27, 28] Builder Company and Rider Inc. agree that the sale of the bicycle is to be made “FOB shipping point.” The bicycle is ordered by Rider Inc. on December 27 of Year One. It is shipped by Builder Company from Wisconsin on December 29 of Year One and arrives at Rider’s retail store on January 4 of Year Two. When Rider Inc. produces its financial statements for Year One, should the cost and related payable be included even though the bicycle was not physically received until Year Two? Solution: The sale is made FOB shipping point. This means that the inventory belongs to Rider on December 29 when it leaves the seller’s warehouse. Rider should record the inventory in Year One even though it is not received until Year Two.
3.2—Recording Cost of Goods Sold: Perpetual and Periodic [PowerPoint 8-29, 32, 33]
In a perpetual system, the accounting records maintain current balances so that officials are cognizant of (a) the amount of merchandise on hand and (b) the cost of goods sold for the year to date. These figures are readily available in general ledger T-accounts. When a sale is made, the applicable cost is reclassified from the inventory account on the balance sheet to cost of goods sold on the income statement. Simultaneously, the corresponding balance in the subsidiary ledger is lowered. Journal entries for sale of inventory are as follows: Cash Sales Revenue—Merchandise Cost of Goods Sold Inventory 3.2.1—Example of Perpetual System [PowerPoint 8-30, 31] Rider Inc. begins the current year holding three Model XY-7 bicycles costing $260 each or $780 in total. During the period, another five units of this same model are acquired at $260 a piece or $1,300 in total. Eventually, a customer buys seven of these bicycles for her family and friends paying cash of $440 each or $3,080 in total. No further sales are made of this model. At the end of the period, a single bicycle remains. What journal entries should have been made at the time of sale of the seven bicycles? Journal Entry—Sale Made Of Seven Model XY-7 Bicycles for Cash of $440 Each Cash Sales Revenue—Merchandise
3,080
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Journal Entry—Seven Bicycles with a Cost of $260 A Piece are Sold Cost of Goods Sold Inventory
1,820 1,820
A periodic system monitors the various inventory expenditures but makes no attempt to maintain a record of the merchandise on hand or the cost of goods sold during the year. At the time of sale, the first journal entry shown above is still made to recognize the revenue. However, if a periodic system is in use, the second entry is omitted. Cost of goods sold is neither calculated nor recorded when a sale occurs. The inventory balance remains unadjusted throughout the year. Eventually, whenever financial statements are prepared, the amount to be reported for the asset (inventory) must be determined along with the expense (Cost of Goods Sold) for the entire period. When using a periodic system, cost of goods sold is computed as a prerequisite step in preparing financial statements. Inventory on hand is counted (a process known as a “physical inventory”) and all units that are no longer present are assumed to have been sold. The resulting figure is then reported as the company’s cost of goods sold for the period. Calculating cost of goods sold is done using the following formula: Beginning Inventory + Purchases for the Period Goods Available for Sale ‒ Ending Inventory Cost of Goods Sold 3.2.2—Example of Periodic System [PowerPoint 8-34, 35, 36] A physical inventory count is taken by the employees of Rider, Inc. on the last day of the year so that financial statements can be produced. Because eight bicycles (Model XY-7) were available during the year but seven have now been sold, one unit— costing $260—remains (if no accident or theft has occurred). Cost of goods sold would be: Beginning Inventory Purchases for the Period Goods Available for Sale Ending Inventory Cost of Goods Sold
$ 780 1,300 2,080 (260) $1,820
What journal entries should have been made at the time of sale of the seven bicycles? Journal Entry—Sale Of Seven Model XY-7 Bicycles for Cash of $440 Each Cash 3,080 Sales Revenue—Merchandise 3,080 ©2012 Flat World Knowledge, Inc.
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No entry is made at time of sale to record cost of goods sold
3.3—Periodic Inventory—Year-End Recording Process [PowerPoint 8-37]
Cost of goods sold and ending inventory are not recorded on an ongoing basis so the general ledger must be updated to agree with the reported balances. The following journal entry will be made: Inventory—Ending Cost of Goods Sold Purchases of Inventory Inventory—Beginning 3.3.1—Example of Periodic System [PowerPoint 8-38] Adjusting Entry—Recording Inventory and Cost of Goods Sold as Determined in Periodic Inventory System. Inventory—Ending Cost of Goods Sold Purchases of Inventory Inventory—Beginning
260 1,820 1,300 780
4. REPORTING INVENTORY AT LOWER OF COST OR MARKET 1. Explain the need for reporting inventory at lower of cost or market. 2. Differentiate between a reporting problem caused by a drop in the purchase value of inventory and one resulting from the sales value of the merchandise. 3. Understand the difference in applying the lower-of-costor-market rule under U.S. GAAP and IFRS. 4.1—Inventory—The Reporting of Cost or Market Value [PowerPoint 8-40]
Under normal conditions, market value is rarely relevant in the reporting of inventory. An exception to this rule becomes relevant if the value of inventory falls below cost. If market value remains greater than cost, no change is made in the reported balance until a ©2012 Flat World Knowledge, Inc.
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sale occurs. In contrast, if the value drops so that inventory is worth less than cost, a loss is recognized immediately. Whenever inventory appears to have lost value for any reason, the accountant compares the cost of the item to its market value and the lower figure then appears on the balance sheet.
4.2—Arriving at a Figure for Market Value [PowerPoint 8-41] There are several plausible ways to view the worth of any asset. For inventory, there is both a “purchase value” (replacement cost—the amount needed to acquire the same item again at the present time) and a “sales value” (net realizable value—the amount of cash expected from an eventual sale). When preparing financial statements, if either of these amounts is impaired, the possibility that a loss should be recognized is likely. Purchase Value. In some cases, often because of bad timing, a company finds that it has paid an excessive amount for inventory. Usually as the result of an increase in supply or a decrease in demand, replacement cost might drop after an item is acquired. When replacement cost for inventory drops below the amount paid, the lower (more conservative) figure is reported on the balance sheet and the related loss is recognized on the income statement. Sales Value. Inventory also has a sales value that is, frequently, independent of replacement cost. The sales value of an item can fall for any number of reasons, for example, technological innovation. For accounting purposes, the sales value of inventory is normally defined as its estimated net realizable value. Net realizable value is the anticipated sales price less any cost required to generate the sale. As with purchase value, if the sales value of an inventory item falls below its historical cost, the lower figure is reported along with a loss to mirror the impact of the asset reduction.
4.3—Applying Lower of Cost or Market [PowerPoint 8-42] As a preliminary step in preparing financial statements, a comparison of the cost and market value of the inventory is made. Assume that Rider Inc. is currently preparing financial statements and holds two bicycles in its ending inventory. Model XY-7 cost the company $260 while Model AB-9 cost $380. Model XY-7 now has a replacement cost of only $210. Because of market conditions, the exact sales value is uncertain. The other unit, Model AB-9, has been damaged and can only be sold for $400 after $50 is spent for necessary repairs. This inventory has a cost of $640 ($260 + $380). What should Rider report for its asset Inventory? 4.3.1—Lower of Cost or Market—Solution [PowerPoint 8-43] Although other alternatives exist, assume that Rider compares the cost to the market value for separate items. Market value used for the first item (XY-7) is its purchase value (replacement cost of $210) whereas the market value for the ©2012 Flat World Knowledge, Inc.
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second item (AB-9) is the item’s sales value of $350 (net realizable value of $400 minus $50). Recognition of a Loss on Impaired Inventory Value Model
Cost
Impaired Market Value
XY-7 AB-9 Total
$260 $380 $640
$210(replacement cost) $350(net realizable value)
Lower of cost or market value $210 $350 $560
Rider Inc. reports its inventory at the conservative $560 amount on its balance sheet with an $80 loss ($640 – $560) appearing in the income statement for this period.
4.4—Difference in Applying the Lower-of-Cost-or-Market Rule Under U.S. GAAP and IFRS? [PowerPoint 8-44] International Accounting Standards 2, Inventories (IAS 2) states that inventories should be measured at the lower of cost and net realizable value. Net realizable value is the anticipated sales price of the item (in the ordinary course of business) reduced by the estimated costs to complete the item and any estimated costs needed to make the sale. Replacement cost is not taken into consideration. Because most U.S. companies determine net realizable value when considering whether or not to decrease the cost of their inventory, there isn’t any significant differences in this area of financial reporting (with the exception of some very industry specific circumstances) when a switch to IFRS is made. However, IFRS does allow reversals of previous write-downs if appropriate, whereas this is not allowed under U.S. GAAP.
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5. DETERMINING INVENTORY ON HAND 1. Understand the necessity of taking a physical inventory count even in a perpetual inventory system. 2. Estimate the amount of inventory on hand using historic gross profit percentages and identify situations when this computation might be necessary. 5.1—Counting Inventory in a Perpetual System [PowerPoint 8-46, 47] A physical inventory is necessary even if a company has invested the effort and cost to install a perpetual system. Merchandise can be lost, broken, or stolen. Errors can occur in the record keeping. Thus, a count is taken on a regular basis simply to ensure that subsidiary and general ledger balances are kept in alignment with the actual items held. An adjustment is necessary when the count does not agree with perpetual inventory figures. If the physical count shows fewer items on hand than the account balance, the Inventory account must be reduced. The other half of the adjusting entry depends on the perceived cause of the shortage. For example, officials might have reason to believe that errors took place in the accounting process during the period. When merchandise is being bought and sold, recording miscues do occur. This type of mistake means that the cost of goods sold figure is too low. Adjusting Entry—To Bring Perpetual Inventory Records in Line with Physical Count, a Recording Error is Assumed Cost of Goods Sold Inventory Conversely, if differences between actual and recorded inventory amounts occur because of damage, loss, or theft, the reported balance for cost of goods sold should not bear the cost of these items. They were not sold. Instead, a loss occurred. The following alternative adjustment is appropriate: Adjusting Entry—To Bring Perpetual Inventory Records in Line with Physical Count, Theft or Loss is Assumed Loss on Inventory Shortage Inventory Whether a loss is reported or a change is made in reporting cost of goods sold, the impact on net income is the same. The construction of the adjustment is at the discretion of
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company officials. Normally, consistent application from year to year is the major objective 5.1.1—Example of Inventory Error [PowerPoint 8-48, 49, 50, 51] A ski apparel company’s records indicate that 65 ski jackets are currently in stock costing $70 apiece. The physical inventory finds only 63 items are actually on hand. On a busy afternoon, a clerk failed to reclassify the sale of two jackets from inventory to expense. What journal entry is necessary? Cost of Goods Sold Inventory
140 140
If instead, two jackets were stolen, what would be the journal entry? Loss on Inventory Shortage Inventory
140 140
5.2—Estimating the Amount of Inventory on Hand [PowerPoint 8-52, 53, 54]
One entire branch of accounting—known as “forensic accounting”—specializes in investigations where information is limited or not available (or has even been purposely altered to be misleading). A hurricane or tornado may hit a company’s warehouse and destroy a portion of its inventory. In trying to determine the resulting loss, the amount of inventory in the building prior to the storm needs to be calculated. A forensic accountant might be hired, by either the owner of the store or the insurance company, to produce a reasonable estimation of the merchandise on hand. Obviously, if the company had used a perpetual rather than a periodic system, the services of an accounting expert are less likely to be needed unless fraud is suspected. In some cases, arriving at a probable inventory balance is not extremely complicated even if periodic inventory procedures were utilized. When historical trends can be determined with assurance, a valid estimation of the goods on hand is possible at any point in time without the benefit of perpetual records. A company should start with the amount of inventory it had on hand before the disaster. This can be found by adding the beginning inventory to the purchases made during the year. The company will then use its sales figure to help determine cost of goods sold. First, the markup the company uses must be estimated. This can be found by looking at historical trends such as cost of goods sold percentage (cost of goods sold divided by sales). This percentage is then multiplied by sales for the period to arrive at an estimate for cost of goods sold. Cost of goods sold is subtracted from inventory available for sale to determine the approximate inventory on hand before the disaster. An identical set of procedures could also be used if the company was preparing financial
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statements for a period of time of less than a year (for example, a month or a quarter). For such interim reporting, companies often determine inventory and cost of goods sold based on estimations to avoid the cost of frequent physical counts. The biggest obstacle in this type calculation is the validity of the cost and markup percentages. 5.2.1—Example of Inventory Estimation [PowerPoint 8-55, 56, 57, 58, 59] A hurricane floods a retail clothing store in Charleston, South Carolina. Only merchandise costing $80,000 can be saved. The general ledger is located after the disaster and the T-account balances provide the following information from the periodic system in use: General Ledger Balances Inventory Available for Sale Inventory, Beginning of Year Purchases of Inventory for Current Period Cash Discounts on Purchases Transportation-in Cost to Date
$165,000 378,000 (6,000) 34,000 $571,000
Sales
$480,000
Last year, sales were $500,000 and cost of goods sold was $300,000. Sales Cost of Goods Sold % Cost of Goods Sold
$480,000 60%* $288,000
Inventory Available for Sale Cost of Goods Sold Inventory, before Disaster Inventory, after Disaster Loss
$571,000 (288,000) $283,000 (80,000) $203,000
*Cost of Goods Sold Percentage = $300,000/$500,000 = 60%
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CHAPTER 9 Why Does a Company Need a Cost Flow Assumption in Reporting Inventory? 1. THE NECESSITY OF ADOPTING A COST FLOW ASSUMPTION 1. Understand that accounting rules tend to be standardized so that companies must often report events according to one set method. 2. Know that the selection of a particular cost flow assumption is necessary when inventory items are bought at more than one cost. 3. Apply each of the following cost flow assumptions to determine reported balances for ending inventory and cost of goods sold: specific identification, FIFO, LIFO, and averaging. 1.1— Accounting for Inventory When Costs Vary Over Time [PowerPoint 9-3]
Standardized accounting rules help to ensure understandable communication and enhance the ability of decision-makers to compare results from one year to the next and or from one company to another. For example, inventory—except in unusual circumstances— appears on a balance sheet at historical cost unless its value is lower. Consequently, experienced decision-makers should be well aware of the normal meaning of a reported inventory figure. Exceptions do exist to standardization, such as the choice companies have in the method they use to cost their inventory.
1.2— Applying Cost Flow Assumptions [PowerPoint 9-4] In Chapter 8, it was assumed that the cost of inventory items never change. This is not a realistic assumption—considering gas prices or electronic gadgets price. If inventory items are acquired at different costs, then a cost flow assumption must be selected by company officials to identify the cost that remains in inventory and the cost that moves to cost of goods sold. This choice can have a significant and ongoing impact on both income statement and balance sheet figures. ©2012 Flat World Knowledge, Inc.
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1.2—IN-CLASS ACTIVITY Using Actual Financial Statements Description: Prior to class, instruct students to find the financial statement notes of a company—perhaps the company they used in Chapter 3. Tell them to print out Note 1. During class, ask students to find the inventory note and have a few volunteers share which cost allocation method their company uses. You may wish to spend a few minutes discussing how this could impact comparability between companies before getting into the specifics of each method. 1.2—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
5 Minutes
Students will need to bring Note 1 from the financial statements to class
1.3— Example to be followed for all three cost assumptions [PowerPoint 9-5, 6]
Assume a men’s retail clothing store holds $120 in cash. December 2, Year One—purchase 1 blue dress shirt for $50 in cash December 29, Year One—purchase 1 blue dress shirt for $70 in cash December 31, Year One—sell 1 shirt for cash of $110. Regardless of the cost flow assumption, the company retains one blue dress shirt in inventory at the end of the year and cash of $110. It also reports sales revenue of $110. From an accounting perspective, only two questions must be resolved: (1) What is the cost of goods sold to be reported for the one shirt that was sold, and (2) What is the cost retained in inventory for the one item shirt on hand? 1.3.1—Specific Identification [PowerPoint 9-7] Specific identification is not a cost flow assumption. Companies that use this method are not making an assumption because they know which item was sold. In some way, the inventory conveyed to the customer can be identified so that the actual cost is reclassified to expense to reflect the sale. ©2012 Flat World Knowledge, Inc.
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For some types of inventory, such as automobiles held by a car dealer, specific identification is relatively easy to apply. Each vehicle tends to be somewhat unique and can be tracked through identification numbers. Thus, if the men’s retail store maintains a system where individual shirts are coded when acquired, it will be possible to know whether the $50 shirt or the $70 shirt was actually conveyed to the first customer. That cost can then be moved from inventory to cost of goods sold. However, for identical items like shirts, the idea of maintaining such precise records is ludicrous. In most cases, unless merchandise items are both expensive and unique, the cost of creating such a meticulous record-keeping system far outweighs any potential advantages. 1.3.2—First-In, First-Out (FIFO) [PowerPoint 9-8, 9, 10] The FIFO cost flow assumption is based on the premise that selling the oldest item first is most likely to mirror reality. The oldest items are often displayed on top in hopes that they will sell before becoming stale or damaged. Therefore, although the identity of the actual item sold is rarely known, the assumption is made in FIFO that the first (or oldest) cost is moved from inventory to cost of goods sold when a sale occurs. The first shirt costs $50, so the following entry is made to reduce the inventory and record the expense. Journal Entry—Reclassification of the Cost of One Piece of Inventory Using FIFO Cost of Goods Sold 50 Inventory 50 FIFO Cost of Goods Sold (one unit sold—the cost of the first one) Gross Profit ($110 sales price less $50 cost) Ending Inventory (one unit remains—the cost of the last one)
$50 $60 $70
In a period of rising prices, the earliest (cheapest) cost moves to cost of goods sold and the latest (more expensive) cost remains in ending inventory. For this reason, in inflationary times, FIFO is associated with a higher reported net income as well as a higher reported inventory total on the balance sheet. 1.3.3—Last-In, First-Out (LIFO) [PowerPoint 9-11, 12, 13] LIFO is the opposite of FIFO: the most recent costs are moved to expense as sales are made. Theoretically, the LIFO assumption is often justified as more in line with the matching principle. Shirt One was bought on December 2 whereas Shirt Two was not acquired until December 29. The sales revenue was generated on December 31. ©2012 Flat World Knowledge, Inc.
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Proponents of LIFO argue that matching the December 29 cost with the December 31 revenue is more appropriate than using a cost incurred several weeks earlier. According to this reasoning, income is properly determined with LIFO because a relatively current cost is shown as cost of goods sold rather than a figure that is outof-date. The difference in reported figures is especially apparent in periods of high inflation which makes this accounting decision even more important. The last cost incurred in buying blue shirts was $70, so this amount is reclassified to expense at the time of the first sale. Journal Entry—Reclassification of the Cost of One Piece of Inventory Using LIFO Cost of Goods Sold 70 Inventory 70 LIFO Cost of Goods Sold (one unit sold—the cost of the last one) Gross Profit ($110 sales price less $70 cost) Ending Inventory (one unit remains—the cost of the first one)
$70 $40 $50
Characteristics commonly associated with LIFO can be seen in this example. When prices rise, LIFO companies report lower net income (the most recent and, thus, the most costly purchases are moved to expense) and a lower inventory balance on the balance sheet (the earlier, cheaper costs remain in the Inventory T-account). 1.3.4—Averaging [PowerPoint 9-14, 15, 16] Because the identity of the items conveyed to buyers is unknown, this final cost flow assumption holds that using an average of all costs is the most logical solution. In the shirt example, the two units cost a total of $120 ($50 plus $70) so the average is $60 ($120/2 units). Journal Entry—Reclassification of the Cost of One Piece of Inventory Using Averaging Cost of Goods Sold 60 Inventory 60 Averaging Cost of Goods Sold (one unit sold—the cost of the average one) $60 Gross Profit ($110 sales price less $60 cost) $50 Ending Inventory (one unit remains—the cost of the average $60 one) Averaging has many supporters. However it can be a rather complicated system to implement especially if inventory costs change frequently. In addition, it does not offer the benefits that make FIFO (higher reported income) and LIFO (lower taxes in the United States) so appealing. ©2012 Flat World Knowledge, Inc.
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2. THE SELECTION OF A COST FLOW ASSUMPTION FOR REPORTING PURPOSES 1. Appreciate that reported inventory and cost of goods sold balances are not intended to be right or wrong but rather in conformity with U.S. GAAP, which permits the use of several different cost flow assumptions. 2. Recognize that three cost flow assumptions (FIFO, LIFO, and averaging) are particularly popular in the United States. 3. Understand the meaning of the LIFO conformity rule and realize that use of LIFO in the U.S. largely stems from the presence of this tax law. 4. Know that U.S. companies prepare financial statements according to U.S. GAAP but their income tax returns are based on the Internal Revenue Code so that significant differences often exist. 2.1—Presenting Inventory Balances Fairly [PowerPoint 9-19] Specific identification maintains an item’s cost through a system, but it is nearly impossible to apply unless easily distinguishable differences exist between similar inventory items. For a vast majority of companies, that leaves FIFO, LIFO, and averaging. Arguments over their merits and their problems have raged for decades. Ultimately, information in financial statements must be presented fairly based on the cost flow assumption that is utilized. In a previous chapter, it was learned that the auditor states that financial statements “presented fairly…in conformity with accounting principles generally accepted in the United States of America.” That is a substantially more objective standard. Thus, for the men’s clothing store, the cost of goods sold and ending inventory figures are presented fairly but only in conformity with the specific cost flow assumption that was being applied.
2.2—Most Popular Cost Flow Assumptions [PowerPoint 9-20] To help interested parties gauge the usage of various accounting methods and procedures, a survey is carried out annually of the financial statements of 600 large companies in the U.S. The resulting information helps accountants, auditors, and decision makers weigh the validity of a particular presentation. For 2009, this survey found the following frequency for the various cost flow assumptions. Some companies actually use multiple ©2012 Flat World Knowledge, Inc.
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assumptions, and 98 of the surveyed companies did not report having inventory or mention a cost flow assumption. Inventory Cost Flow Assumptions—600 Companies Surveyed First-in, First-out (FIFO) 325 Last-in, First-out (LIFO) 176 Averaging 147 Other
18 2.2—IN-CLASS ACTIVITY Using Actual Financial Statements Description: Since students have pulled this information prior to class (see In-Class Activity 1.2), take an informal poll of the class to see which method is most popular among the companies chosen. 1.2—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
1 Minutes
Students will need to bring Note 1 from the financial statements to class
2.3—The LIFO Conformity Rule [PowerPoint 9-21, 22] In periods of inflation, FIFO reports a higher gross profit (and, hence, net income) and a higher Inventory balance than LIFO. Averaging presents figures that usually fall between these two extremes. However, a U.S. income tax requirement known as the LIFO conformity rule makes LIFO attractive to some companies. If costs are increasing, companies prefer to apply LIFO for tax purposes because this assumption reduces reported income and, hence, the required cash payments to the government. However, if a company uses LIFO for income tax purposes it must use LIFO for financial reporting also. Actual use of LIFO has remained popular for decades. For many companies, the money saved in income tax dollars outweighs the problem of having to report numbers that make the company look weaker.
FIFO LIFO
Advantages* Company looks financially stronger Company pays less tax ©2012 Flat World Knowledge, Inc.
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FIFO LIFO
Disadvantages* Company pays more tax Company looks financially weaker
*Assume a period of rising prices.
2.3—Two Sets of Books [PowerPoint 9-23] The existence of separate accounting records for tax purpose and financial reporting is a practical necessity. One set is based on applicable tax laws while the other enables the company to prepare financial statements according to U.S. GAAP. In filing income taxes with the U.S. government, a company must follow the regulations of the Internal Revenue Code. Those laws have several underlying objectives that influence their development. 1) Income tax laws are designed to raise money for the operation of the federal government 2) Income tax laws enable the government to help regulate the health of the economy 3) Income tax laws enable the government to assist certain members of society who are viewed as deserving help In contrast, in the United States, external financial reporting is governed by U.S. GAAP (Generally Accepted Accounting Principles), a system designed to achieve the fair presentation of accounting information. Because their goals are different, financial data reported according to U.S. GAAP will not necessarily correspond to the tax figures submitted by the same company to the Internal Revenue Service (IRS).
3. PROBLEMS WITH APPLYING LIFO 1. Recognize that theoretical and practical problems with LIFO have led the creators of IFRS rules to prohibit its use. 2. Explain that the most obvious problem associated with LIFO is an inventory balance that can show costs from years (or even decades) earlier, costs that are totally irrelevant today. 3. Identify the cause of a LIFO liquidation and the reason that it is viewed as a theoretical concern by accountants. 3.1—Reporting Ending Inventory Using LIFO [PowerPoint 9-25] LIFO costing method is not allowed in most countries outside of the U.S. Although LIFO can be supported as providing a better matching of expenses (cost of goods sold) with ©2012 Flat World Knowledge, Inc.
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revenues, a number of serious problems arise from its application. The most common accusation made against LIFO is that it often presents a balance sheet figure that is outof-date and completely useless. When applying this assumption, the latest costs are moved to cost of goods sold so that earlier costs remain in the Inventory account— possibly for years and even decades. After some period of time, this asset balance is likely to report a number that has no relevance to today’s prices. Example: On December 31, 2013, ExxonMobil reported inventory on its balance sheet of $13.0 billion based on applying the LIFO cost flow assumption. In the notes to those financial statements, the company disclosed that the current cost to acquire this same inventory was actually $21.3 billion higher than the number reported. The asset figure was shown as $13.0 billion but the price to obtain that merchandise on the balance sheet date was $34.3 billion ($13.0 billion plus $21.3). The essential problem attributed to LIFO is that it reports an asset (one that is being held for sale) at an amount way below its current replacement cost.
3.2—LIFO Liquidation [PowerPoint 9-26] Costs from much earlier years often remain in the inventory account over a long period of time if LIFO is applied. If the quantity of inventory is ever allowed to decrease (accidently or on purpose), some or all of those early costs will be moved to cost of goods sold. Costs from earlier years are matched with revenue earned in the current year. That is a LIFO liquidation and can artificially inflate reported earnings if those earlier costs are especially low.
4. MERGING PERIODIC AND PERPETUAL INVENTORY SYSTEMS WITH A COST FLOW ASSUMPTION 1. Merge a cost flow assumption (FIFO, LIFO, and averaging) with a method of monitoring inventory (periodic or perpetual) to arrive at six different systems for determining reported inventory figures. 2. Understand that a cost flow assumption is only applied when determining the cost of ending inventory in a periodic system but is used for each reclassification from inventory to cost of goods sold in a perpetual system. 3. Calculate ending inventory and cost of goods sold using both a periodic and a perpetual FIFO system. 4. Recognize that periodic and perpetual FIFO systems will arrive at identical account balances.
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4.1—Cost Flow Assumptions and Inventory [PowerPoint 9-29, 30] Each company that holds inventory must develop a mechanism to both (a) monitor the balances and (b) allow for the preparation of financial statements. Companies also select a cost flow assumption to specify the cost that is transferred from inventory to cost of goods sold (and, hence, the cost that remains in the Inventory T-account). For a periodic system, the cost flow assumption is applied only when the physical inventory count is taken and the cost of that ending inventory is determined. In a perpetual system, the cost flow assumption is used each time a sale is made to identify the cost to be reclassified to cost of goods sold. That can occur thousands of times each day. Therefore, companies normally choose one of six systems to monitor merchandise balances and determine the cost assignment between cost of goods sold and ending inventory: Periodic FIFO Perpetual FIFO Periodic LIFO Perpetual LIFO Periodic Averaging (also called Weighted Averaging) Perpetual Averaging (also called Moving Averaging) 4.1.1— Example: Mayberry Home Improvement Store [PowerPoint 9-31, 32]
Mayberry Home Improvement Store starts the new year with four bathtubs (Model WET-5) in its inventory, costing $110 each ($440 in total). The following events then take place during the current year. • Beginning inventory: 4 bathtubs, $110 each •
February 2: Sold 3 bathtubs for $200 each
•
February 6: Purchased 3 bathtubs for $120 each
•
June 8: Sold 3 bathtubs for $250 each
•
June 13: Purchased 3 bathtubs for $130 each
•
September 9: Sold 2 bathtubs for $300 each
•
September 22: Purchased 2 bathtubs for $149 each
At the end of the year, on December 31, a physical inventory count shows four bathtubs, Model WET-5, are in stock. Regardless of the inventory system in use, several pieces of information are established in this example. These figures are factual, not impacted by accounting. ©2012 Flat World Knowledge, Inc.
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The Facts—Purchase and Sale of WET-5 Bathtubs Revenue: 8 units were sold for $1,950 ($600 + $750 + $600) Beginning inventory: 4 units costing $110 each or $440 in total Purchases: 8 units were bought during the year costing a total of $1,048 ($360 + $390 + $298) Ending inventory: 4 units are still held according to the physical inventory
4.2—Periodic and Perpetual FIFO [PowerPoint 9-33, 34, 35, 36] Periodic FIFO. In a periodic system, the cost of all new purchases is the focus of the record keeping. Then, at the end of the period, accountants must count and also determine the cost of the items held in ending inventory. When using FIFO, the first costs are transferred to cost of goods sold so the cost of the last four bathtubs stay in the Inventory T-account. That is the FIFO assumption. PERIODIC FIFO—BATHTUB MODEL WET-5 Beginning Inventory: 4 units at $110 each $ 440 Purchases: 8 units 1,048 Goods Available for Sale (12 units in total) $1,488 Ending Inventory (physical count): Based FIFO: 2 units at $149 each and 2 units at $130 each (558) Cost of Goods Sold $ 930
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Perpetual FIFO. Perpetual accounting systems are constructed so that costs can be moved from inventory to cost of goods sold at the time of each new sale. PERPETUAL FIFO—BATHTUB MODEL WET-5 Inventory Inventory on Hand Cost of Goods Sold Acquired 1/1 – Beg. Balance 4 Units @ $110 2/2 – 3 Units Sold 1 Unit @ $110 3 Units @ $110 = $330 2/6 – 3 Units Bought 3 units @ $120 1 Unit @ $110 3 Units @ $120 6/8 – 3 Units Sold 1 Unit @ $120 1 Unit @ $110 + 2 Units @ $120 = $350 6/13 – 3 Units Bought 3 units @ $130 1 Unit @ $120 3 Units @ $130 9/9 – 2 Units Sold 2 Units @ $130 1 Unit @ $120 + 1 Unit @ $130 = $250 9/22 – 2 Units Bought 2 units @ $149 2 Units @ $130 2 Units @ $149 Totals $260 + $298 = $558 $330 + $350 + $250 =$930 The first cost incurred in a period (to expense under FIFO) is the same regardless of the date of sale. Thus, the resulting amounts will always be identical under either FIFO system. For that reason, many companies that apply FIFO maintain perpetual records to track the units on hand throughout the period but ignore the costs.
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4.3—Have students work through an example of periodic and perpetual FIFO, either individually or in teams [PowerPoint 9-37, 38, 39, 40, 41]
GameStart sells video games and systems, including the YBox. GameStart currently uses the periodic FIFO method of inventory costing, but is considering implementing a perpetual system. It will cost a good deal of money to start and maintain perpetual system, so GameStart would like to see the difference, if any, between the two and is using its YBox inventory to do so. Here is YBox’s information for the first quarter: Date Beginning Balance: January 1 January 5 January 29 February 19 February 21 March 10 March 30
Number of items 5 Purchased 4 Sold 6 Purchased 8 Sold 10 Purchased 9 Sold 5
Cost per item $190 $191 $193 $194
Each YBox sells for $250. Determine GameStart’s cost of goods sold and ending inventory under periodic FIFO. Beginning Inventory: 5 units @ $190 Purchase: 4 units @ $191 Purchase: 8 units @ $193 Purchase: 9 units @ $194 Cost of Goods Available for Sale Ending Inventory: 5 @ $194 Cost of Goods Sold
$ 950 764 1,544 1,746 $5,004 (970) $4,034
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Determine GameStart’s cost of goods sold and ending inventory under perpetual FIFO. Inventory Acquired 1/1 – Beginning Balance 1/5 – 4 Units Purchased
4 Units @ $191
1/29 – 6 Units Sold
2/19 – 8 Units Purchased
8 Units @ $193
2/21 – 10 Units Sold
3/10 – 9 Units Purchased
9 Units @ $194
Inventory on Hand 5 Units @ $190 5 Units @ $190 4 Units @ $191 3 Units @ $191
3 Units @ $191 8 Units @ $193 1 Unit @ $193
3/30 – 5 units sold
1 Unit @ $193 9 Units @ $194 5 Units @ $194
Totals
$970
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Cost of Goods Sold
5 Units @ $190 1 Unit @ $191 = $1,141
3 Units @ $191 7 Units@ $193=$1,924
1 Units @ $193 4 Units @ $194 =$969 $1,141 + $1,924 + $969 = $4,034
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5. APPLYING LIFO AND AVERAGING TO DETERMINE REPORTED INVENTORY BALANCES 1. Determine ending inventory and cost of goods sold using a periodic LIFO system. 2. Monitor inventory on an ongoing basis through a perpetual LIFO system. 3. Understand the reason that periodic LIFO and perpetual LIFO usually arrive at different figures. 4. Use a weighted average system to determine the cost of ending inventory and cost of goods sold. 5. Calculate reported inventory balances by applying a moving average inventory system. 5.1—Applying LIFO [PowerPoint 9-43, 44, 45, 46] Periodic LIFO. In a periodic system, only the computation of the ending inventory is directly affected by the choice of a cost flow assumption. The figure that changes is the cost of the ending inventory. According to LIFO, the last (most recent) costs are transferred to cost of goods sold. So, only the cost of the first four units remains in ending inventory. PERIODIC LIFO—BATHTUB MODEL WET-5 Beginning Inventory: 4 units at $110 each $ 440 Purchases: 8 units 1,048 Goods Available for Sale (12 units in total) $ 1,488 Ending Inventory (physical count): 4 units at $110 each Based on Applying LIFO (440) Cost of Goods Sold $ 1,048 Perpetual LIFO. The mechanical structure for a perpetual LIFO system is the same as for perpetual FIFO except that the most recent costs are moved into cost of goods sold at the time of each sale.
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1/1 – Beginning balance 2/2 – 3 units sold
PERPETUAL LIFO—BATHTUB MODEL WET-5 Inventory Acquired Inventory on Hand Cost of Goods Sold 4 units @ $110
2/6 – 3 units bought
1 unit @ $110 3 units @ $120
6/8 – 3 units sold 6/13 – 3 units bought 9/9 – 2 units sold
3 units @ $130
9/22 – 2 units bought
2 units @ $149
Totals
1 unit @ $110 3 units @ $120 1 unit @ $110 1 unit @ $110 3 units @ $130 1 unit @ $110 1 unit @ $130 1 unit @ $110 1 unit @ $130 2 units @ $149 $110 + $130 + $298 = $538
3 units @ $110 = $330
3 units @ $120 = $360
2 units @ $130 = $260
$330 + $360 +$260= $950
Although periodic and perpetual FIFO always arrive at the same results, balances reported by periodic and perpetual LIFO frequently differ. The first cost incurred in a period (the cost transferred to expense under FIFO) is the same regardless of the date of sale. However, the identity of the last or most recent cost (expensed according to LIFO) depends on the perspective.
5.2—Have students work through an example of periodic and perpetual LIFO, either individually or in teams [PowerPoint 9-47,48, 49] Refer to GameStart example and determine its cost of goods sold and ending inventory under periodic LIFO inventory system.
Beginning Inventory: 5 units @ $190 Purchase: 4 units @ $191 Purchase: 8 units @ $193 Purchase: 9 units @ $194 Cost of Goods Available for Sale Ending Inventory: 5 units @ $190 Cost of Goods Sold
$ 950 764 1,544 1,746 $5,004 (950) $4,054
Determine GameStart’s cost of goods sold and ending inventory under perpetual LIFO.
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Inventory Acquired 1/1 – Beginning Balance 1/5 – 4 Units Purchased 1/29 – 6 Units Sold
Inventory on Hand
Cost of Goods Sold
5 Units @ $190 4 Units @ $191
5 Units @ $190 4 Units @ $191 3 Units @ $190
2/19 – 8 Units 8 Units @ $193 Purchased 2/21 – 10 Units Sold
3 Units @ $190 8 Units @ $193 1 Unit @ $190
3/10 – 9 Units Purchased 3/30 – 5 Units Sold
1 Unit @ $190 9 Units @ $194 1 Unit @ $190 4 Units @ $194 $966
9 Units @ $194
Totals
4 Units @ $191 2 Units @ $190 = $1,144
2 Units @ $190 + 8 Units@ $193 =$1,924
5 Units @ $194 =$970 $1,144 + $1,924 + $970 = $4,038
5.3—Applying Averaging as a Cost Flow Assumption [PowerPoint 9-50, 51, 52]
Refer to Mayberry Home Improvement Store example. Periodic (Weighted) Averaging. Mayberry Home Improvement Store eventually held 12 bathtubs. Four of these units were on hand at the start of the year and the other eight were acquired during the period. The beginning inventory cost $440 and the new purchases were bought for a total of $1,048. Cost of goods available for sale = $1,488 ($440 + $1,048) Average cost = $1,488/12 units = $124 per bathtub When applying a weighted average system, this single average is the basis for the entire period for both the ending inventory and cost of goods sold to be reported in the financial statements.
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PERIODIC (WEIGHTED) AVERAGE —BATHTUB MODEL WET-5 Beginning Inventory: 4 units at $110 each $ 440 Purchases: 8 units 1,048 Goods Available for Sale (12 units in total) $1,488 Ending Inventory (physical count): 4 units at $124 each Based on Applying Periodic Averaging (496) Cost of Goods Sold (can also be determined as 8 units at an average cost of $124 each) $ 992 Perpetual (Moving) Average. Each time that a company buys inventory at a new price, the average cost is recalculated. Below, a new average is computed at each purchase point. PERPETUAL (MOVING) AVERAGE—BATHTUB MODEL WET-5 Inventory Acquired 1/1 – Beginning Balance 2/2 – 3 Units Sold 2/6 – 3 Units Bought
1 Unit @ $110 = $110 3 Units @ $120
3 Units @ $130 New average
9/9 – 2 Units Sold 9/22 – 2 Units Bought
2 Units @ $149 New average
Totals
Cost of Goods Sold
4 Units @ $110 = $440
New average 6/8 – 3 Units Sold 6/13 – 3 Units Bought
Inventory on Hand
1 Unit @ $110.00 = $110 3 Units @ $120.00 = $360 4 Units @ $117.50 = $470 1 Unit @ $117.50 1 Unit @ $117.50 = $117.50 3 Units @ $130.00 = $390.00 4 Units @ $126.88 = $507.50 2 Units @ $126.88 = $253.76 2 Units @ $126.88 = $253.76 2 Units @ $149.00 = $298.00 4 Units @ $137.94 = $551.76 $551.76
3 Units @ $110 = $330
3 Units @ $117.50 = $352.50
2 Units @ $126.88 = $253.76
$330 + $352.50 + $253.76 = $936.26
5.4—Have students work through an example of periodic and perpetual averaging, either individually or in teams [PowerPoint 9-53, 54, 55]
Refer to GameStart example and determine GameStart’s cost of goods sold and ending inventory under periodic averaging. ©2012 Flat World Knowledge, Inc.
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Cost of goods available for sale = $5,004 ($950 + $4,054) Average cost = $5,004/26 units = $192.46 per YBox Beginning Inventory: 5 units @ $190 Purchase: 4 units @ $191 Purchase: 8 units @ $193 Purchase: 9 units @ $194 Cost of Goods Available for Sale Ending Inventory: 5 units @ $192.46 each Based on Applying Periodic Averaging Cost of Goods Sold (can also be determined as 21 units at an average cost of $192.46 each)
$
$
950 764 1,544 1,746 5,004 (952.30)
$4,041.70
Determine GameStart’s cost of goods sold and ending inventory under perpetual averaging. 1/1 – Beginning Balance 1/5 – 4 Units Purchased
Inventory Acquired
Inventory on Hand 5 Units @ $190
4 Units @ $191 New Average
5 Units @ $190 = $950 4 Units @ $191 = $764 9 Units @ $190.44 = $1,714 3 Units @ $190.44
1/29 – 6 Units Sold 2/19 – 8 Units Purchased
8 Units @ $193 New Average
2/21 – 10 Units Sold 3/10 – 9 Units Purchased
9 Units @ $194
3 Units @ $190.44 = $571.32 8 Units @ $193 = $1,544 11 Units @ $192.30 = $2,115.32 1 Unit @ $192.30
3/30 – 5 units sold
1 Unit @ $192.30 = $192.30 9 Units @ $194 = $1,746 10 Units @ $193.83 = $1,938.30 5 Units @ $193.83
Totals
$969.15
New Average
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Cost of Goods Sold
6 Units @ $190.44= $1,142.64
10 Units @ $192.30= $1,923
5 Units @ $193.83 = $969.15 $1,142.64 + $1,923 + $969.15 = $4,034.79
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6. ANALYZING REPORTED INVENTORY FIGURES 1. Use information found in the financial statement disclosure notes to convert LIFO income statement numbers into their FIFO or current cost equivalents. 2. Compute a company’s gross profit percentage and explain the relevance of this figure. 3. Calculate the average number of days that inventory is held and provide reasons why companies worry if this figure starts to rise unexpectedly. 4. Determine the inventory turnover and explain its meaning. 6.1— Making Comparisons when LIFO is Applied [PowerPoint 957, 58, 59]
Significant variations in reported balances frequently result from the application of different cost flow assumptions. Because of the potential detrimental effects, companies that use LIFO often provide additional information to help decision-makers understand the impact of this choice. For example, in discussing the use of LIFO, a note to the financial statements for Rite Aid explains (numbers are in thousands): “At February 26, 2011 and February 27, 2010, inventories were $875,012 and $831,113, respectively, lower than the amounts that would have been reported using the first-in, first-out (‘‘FIFO’’) method.” Rite Aid: LIFO inventory FIFO inventory February 26, 2011 $3,158,145,000 $4,033,157,000 February 27, 2010 $3,238,644,000 $4,069,757,000 Decision makers can use this information to compare Rite Aid to a company that uses FIFO. Restatement of financial statements in this manner is a common technique relied on by investment analysts to make available information more usable. Restating the company’s income statement to numbers in line with FIFO is a bit more challenging. Rite Aid reported an overall net loss for the year ended 2011, of $555,424,000. The Cost of Goods Sold equation can be used. Cost of Goods Sold = Beginning Inventory + Purchases – Ending Inventory
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LIFO: Cost of goods sold = $3,238,644,000 + Purchases − $3,158,145,000 = $80,499,000 + Purchase FIFO: Cost of goods sold = $4,069,757,000 + Purchases − $4,033,157,000 = $36,600,000 + Purchases The purchase figure is the same in both equations. Thus, using FIFO reduces the reported cost of goods sold by $43,899,000 ($80,499,000 – $36,600,000), so that net income is $43,899,000 higher. If FIFO had been used, Rite Aid’s net loss for the period would have been $511,525,000 instead of $555,424,000.
6.2— Analyzing Vital Signs For Inventory [PowerPoint 9-60, 61, 62] The first vital sign is the gross profit percentage which is found by dividing the gross profit for the period by net sales. Sales − Sales Returns and Discounts = Net Sales Net Sales − Cost of Goods Sold = Gross Profit Gross Profit/Net Sales = Gross Profit Percentage Gross profit is the difference between the amount paid to buy (or manufacture) inventory and the amount received from an eventual sale. The gross profit percentage is often used to compare one company to another or one time period to the next. The gross profit percentage is also watched closely from one year to the next. For example, if this figure falls, analysts will be quite interested in the reason. Are costs rising more quickly than the sales price of the merchandise? Has a change occurred in the types of inventory being sold? Was the reduction in the gross profit offset by an increase in sales? A second vital sign is the number of days inventory is held on the average. Companies want to turn their merchandise into cash as quickly as possible. Holding inventory for a length of time can have several unfortunate repercussions. The longer it sits in stock the more likely the goods are to get damaged, stolen, or go out of fashion. Such losses can be avoided through quick sales. Furthermore, as long as the merchandise sits on the shelves, it is not earning any profit. Money is tied up with no return until a sale takes place. The number of days inventory is held on the average is found in two steps. First, the cost of inventory that is sold each day on the average is determined. Cost of Goods Sold/365 Days = Cost of Inventory Sold Per Day Second, this daily cost figure is divided into the average amount of inventory held during ©2012 Flat World Knowledge, Inc.
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the period. The average amount of inventory can be based on beginning and ending totals, monthly balances, or other available figures. Average Inventory/Cost of Inventory Sold Per Day = Number of Days Inventory Is Held A third vital sign that is often analyzed is the inventory turnover, which is simply another way to measure the speed by which a company sells inventory. Cost of Goods Sold/Average Inventory = Inventory Turnover 6.2.1—Work through an example of computing gross profit percentage, number of days inventory is held and inventory turnover [PowerPoint 9-63, 64, 65, 66]
Patterson, Inc. began the year with $225,500 in Inventory, and ended the year with $176,000 in Inventory, $4,000,000 in Sales, and $2,007,500 in Cost of Goods Sold. Determine Patterson’s gross profit percentage, number of days inventory is held, and inventory turnover. Gross Profit Percentage = Gross Profit/Net Sales Gross Profit Percentage = ($4,000,000 − $2,007,500)/$4,000,000 Gross Profit Percentage = $1,992,500/$4,000,000 Gross Profit Percentage = 49.8% Number of Days Inventory is Held = Average Inventory/Cost of Inventory Sold per Day Number of Days Inventory is Held = (($225,500 + $176,000)/2)/($2,007,500/365) Number of Days Inventory is Held = $200,750/$5,500 Number of Days Inventory is Held = 36.5 days Inventory Turnover = Cost of Goods Sold/Average Inventory Inventory Turnover = $2,007,500/(($225,500 + $176,000)/2) Inventory Turnover = 10 times 6.2.2—Have students work through an example of computing gross profit percentage, number of days inventory is held and inventory turnover, either individually or in teams [PowerPoint 9-67, 68, 69, 70] Hager Corporation began the year with $195,000 in Inventory, and ended the year with $168,000 in Inventory, $4,500,000 in Sales and $2,190,000 in Cost of Goods Sold. Determine Hager’s gross profit percentage, number of days inventory is held, and inventory turnover. Gross Profit Percentage = Gross Profit/Net Sales Gross Profit Percentage = ($4,500,000 − $2,190,000)/$4,500,000 Gross Profit Percentage = $2,310,000/$4,500,000 Gross Profit Percentage = 51.3% ©2012 Flat World Knowledge, Inc.
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Number of Days Inventory is Held = Average Inventory/Cost of Inventory Sold per Day Number of Days Inventory is Held = (($195,000 + $168,000)/2)/($2,190,000/365) Number of Days Inventory is Held = $181,500/$6,000 Number of Days Inventory is Held = 30.25 days Inventory Turnover = Cost of Goods Sold/Average Inventory Inventory Turnover = $2,190,000/(($195,000 + $168,000)/2) Inventory Turnover = 12.07 times
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CHAPTER 10 In a Set of Financial Statements, What Information Is Conveyed about Property and Equipment? 1. THE REPORTING OF PROPERTY AND EQUIPMENT 1. Recognize that tangible operating assets with lives of over one year (such as property and equipment) are initially reported at historical cost. 2. Understand the rationale for assigning the cost of these operating assets to expense over time if the item has a finite life. 3. Recognize that these assets are normally reported on the balance sheet at net book value, which is their cost less accumulated depreciation. 4. Explain the reason for not reporting property and equipment at fair value except in certain specified circumstances. 1.1— Initially Reporting Property and Equipment at Historical Cost [PowerPoint 10-4] The starting basis in reporting property and equipment, and any other tangible operating assets with a life of over one year is historical cost. The amount sacrificed to obtain land, machinery, buildings, furniture, and the like is determined when an arm’s length acquisition takes place: a willing buyer and a willing seller, both acting in their selfinterests, agree on an exchange price. Cost indicates the amount management chose to sacrifice in order to gain the use of a specific asset. However, after the date of acquisition, the figure reported on the balance sheet will probably never again reflect the actual value of the asset. Subsequently, if the asset has a finite life (most pieces of property and equipment assets other than land do have finite lives), the matching principle necessitates that the historical cost be allocated to expense over the anticipated years of service. This expense is recognized systematically each period as the company utilizes the asset to generate revenue. This accounting is resembles the handling of a prepaid rent and other similar expenses. The cost is first recorded as an asset and then moved to expense over time in ©2012 Flat World Knowledge, Inc.
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some logical fashion as the utility is consumed. At any point, the reported net book value for the asset is the original cost less the amount that has been reclassified to expense.
1.2—The Reporting of Accumulated Depreciation [PowerPoint 10-5, 6] One important mechanical distinction does exist when comparing the accounting for prepayments and any plant and equipment that has a finite life. With a prepaid expense (such as rent), the asset is directly reduced over time as the cost is assigned to expense. In accounting for property and equipment, the asset does not physically shrink. As the utility is consumed, buildings and equipment do not get smaller; they only get older. To reflect that reality, a separate Accumulated Depreciation account is created to represent the total amount of asset’s cost that has been reclassified to expense. Through this approach, information about the original cost continues to be available. Example: An equipment account is reported as $30,000 and the related accumulated depreciation currently holds a $10,000 balance. Users will know that the asset cost $30,000, but $10,000 of that amount has been expensed since the date of acquisition. If the asset has been used for two years to generate revenue, $6,000 might have been moved to expense in the first year and $4,000 in the second. The $20,000 net book value appearing on the balance sheet is the cost that has not yet been expensed because the asset still has future value.
1.3— Failure of Accounting to Reflect the Fair Value of Property and Equipment [PowerPoint 10-7, 8] The debate among accountants, company officials, investors, creditors, and others over whether various assets should be reported based on historical cost or fair value has raged for many years. However, U.S. GAAP has remained relatively unchanged for many decades regarding reporting for property and equipment. It states unless the value of one of these assets has been impaired or it is going to be sold in the near future, historical cost less accumulated depreciation remains the basis for balance sheet presentation. The fair value of property and equipment is a reporting alternative preferred by some decision makers, but only if the reported amount is objective and reliable. That is where the difficulty begins. Historical cost is both an objective and a reliable measure, determined through a transaction between a willing buyer and a willing seller. In contrast, any gathering of “experts” could assess the value of a large building or an acre of land at widely different figures with equal certitude. No definitive value can possibly exist until sold. What is the informational benefit of a number that is so subjective? Furthermore, the value might change radically on a daily basis rendering previous assessments useless. For that reason, historical cost, as adjusted for accumulated depreciation, remains the accepted method for reporting property and equipment on an owner’s balance sheet.
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Use of historical cost is supported by the going concern assumption that underlies financial reporting. Companies do not plan to sell their property and equipment prematurely but rather to utilize them for their entire lives. Consequently, financial statements are constructed assuming that the organization will function until all of its assets are consumed. Unless impaired or a sale is anticipated in the near future, the fair value of these assets is not truly of significance to the operations of a business.
2. DETERMINING HISTORICAL COST AND DEPRECIATION EXPENSE 1. Make use of the guiding accounting rule to ascertain which costs are capitalized and which are expensed when acquiring property and equipment. 2. List the variables that impact the amount of depreciation to be expensed each period in connection with the property and equipment owned by a company. 3. Recognize that the straight-line method for assigning depreciation predominates in practice but any system that provides a rational approach can be used to create a pattern for this cost allocation. 2.1—Assets Classified as Property and Equipment [PowerPoint 10-11] To be classified within the property and equipment category, an asset must have tangible physical substance and be expected to help generate revenues for longer than a single year. In addition, it must function within the normal operating activities of the business. However, it cannot be held for immediate resale, like inventory. Examples include the following: a building used as a warehouse, machinery operated in the production of inventory, computers, furniture, fixtures, and equipment. Conversely, land acquired as a future plant site and a building held for speculative purposes are both classified as investments (or, possibly, “other assets”) rather than as property and equipment. Neither of these assets is being used at the current time to help generate operating revenues.
2.2—Determining Historical Cost [PowerPoint 10-12, 13] All expenditures are included within the cost of property and equipment if the amounts are normal and necessary to get the asset into condition and position to assist the company in generating revenues. Example: ©2012 Flat World Knowledge, Inc.
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The cost of a new cash register might well include shipping charges, installation fees, and training sessions to teach employees to use the asset. These costs all meet the criterion for capitalization. They are normal and necessary payments to permit use of the equipment for its intended purpose. Hence, a new cash register bought at a price of $4,100 might actually be reported as an asset by its owner at $5,300 as follows: Invoice Price—Charged by Seller Shipping Costs from Manufacturer Installation Employee Training Sessions Cost of Machine
$4,100 300 400 500 $5,300
2.3—Straight-Line Method of Determining Depreciation [PowerPoint 10-14]
Depreciation is based on a mathematically derived system that allocates the asset’s cost to expense over the expected years of use. It does not mirror the actual loss of value over that period. The specific amount of depreciation expense recorded each year for buildings, machinery, furniture, and the like is determined using four variables: • The historical cost of the asset • Its expected useful life • Any residual (or salvage) value anticipated at the end of the expected useful life • An allocation pattern After total cost is computed, officials estimate the useful life based on company experience with similar assets or on other sources of information such as guidelines provided by the manufacturer. In a similar fashion, officials arrive at the expected residual value—an estimate of the likely worth of the asset at the end of its useful life. US GAAP does not require any specific computational method for determining the annual allocation of the asset’s cost to expense. Any method can be used to determine annual depreciation if it provided an expense in a “systematic and rational manner.” Consequently, a vast majority of reporting companies have chosen to adopt the straightline method to assign the cost of property and equipment to expense over their useful lives. The estimated residual value is subtracted from cost to arrive at the asset’s depreciable base. This figure is then expensed evenly over the expected life. Straight-line depreciation allocates an equal expense to each period in which the asset is used to generate revenue. 2.3.1—Work through an example of calculating depreciation expense using straight-line [PowerPoint 10-15, 16]
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Assume a building is purchased by a company on January 1, Year One, for cash of $600,000. Based on experience with similar properties, officials believe that this structure will be worth only $30,000 at the end of an expected five-year life. Depreciable base = Cost − Estimated residual value Depreciable base = $600,000 − $30,000 Depreciable base = $570,000 Annual Depreciation = Depreciable base Expected useful life Depreciation Expense = $570,000/5 years Depreciation Expense = $114,000 per year
2.4—Recording Depreciation Expense [PowerPoint 10-17] An adjusting entry is prepared at the end of each period to move the assigned cost from the asset account on the balance sheet to expense on the income statement. 2.4.1—Work through an example of recording depreciation expense over the life of an asset [PowerPoint 10-18, 19, 20] In reference to the example provided above, the entries to record the cost of acquiring this building and the annual depreciation expense over the five-year life are as follows: Acquisition of Building 1/1/1 Building 600,000 Cash 600,000 Recording Depreciation Expense over the Life of the Building 12/31/1
12/31/2
12/31/3
12/31/4
Depreciation Expense Accumulated Depreciation—Building
114,000
Depreciation Expense Accumulated Depreciation—Building
114,000
Depreciation Expense Accumulated Depreciation—Building
114,000
Depreciation Expense Accumulated Depreciation—Building
114,000
114,000
114,000
114,000
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114,000
5
12/31/5
Depreciation Expense Accumulated Depreciation—Building
114,000 114,000
Because the straight-line method is applied, depreciation expense is a consistent $114,000 each year. As a result, the net book value reported on the balance sheet drops during the asset’s useful life from $600,000 to $30,000. 2.4.2— Have students work through an example of recording depreciation expense over the life of an asset, either individually or in teams [PowerPoint 10-21, 22, 23, 24] Assume a machine is purchased on January 1, Year One, for cash of $40,000. Based on experience with properties, officials believe that the machine will be worth only $7,000 at the end of an expected three-year life. Make all necessary journal entries to record depreciation throughout the machine’s life. Also determine book value at the end of the machine’s life. Depreciable base = Cost – Estimated residual value Depreciable base = $40,000 − $7,000 Depreciable base = $33,000 Depreciation Expense per Year =
Depreciable base Expected useful life
Depreciation Expense = $33,000/3 years Depreciation Expense = $11,000 per year Recording Depreciation Expense over the Life of the Building 12/31/1
12/31/2
12/31/3
Depreciation Expense Accumulated Depreciation—Machine
11,000
Depreciation Expense Accumulated Depreciation—Machine
11,000
Depreciation Expense Accumulated Depreciation—Machine
11,000
11,000
11,000
11,000
Year 3: Building $40,000 Less: Accumulated Depreciation (33,000)
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Net book value * Salvage value
$ 7,000*
3. RECORDING DEPRECIATION EXPENSE FOR A PARTIAL YEAR 1. Understand the need to record depreciation for each period of use even when property and equipment are disposed of prior to the end of the year. 2. Construct the journal entry to record the disposal of property or equipment and the recognition of a gain or loss. 3. Explain the half-year convention and the reason that it is frequently used by companies for reporting purposes. 3.1—Recording the Disposal of Property or Equipment [PowerPoint 10-26]
First, to establish account balances that are appropriate as of the date of sale, depreciation is recorded for the period of use during the current year. In this way, the expense is matched with the revenues earned in the current period. Second, the amount received from the sale is recorded while the net book value of the asset (both its cost and accumulated depreciation) is removed. If the owner receives less for the asset than net book value, a loss is recognized for the difference. If more is received than net book value, the excess is recorded as a gain so that net income increases. 3.1.1—Work through an example of selling an asset prior to the conclusion of its useful life [PowerPoint 10-27, 28, 29, 30] Assume a building is purchased by a company on January 1, Year One, for cash of $600,000. Based on experience with similar properties, officials believe that this structure will be worth only $30,000 at the end of an expected five-year life. Depreciation expense is $114,000 per year. After the adjusting entry for depreciation is made on December 31, Year Two, the building is sold for $290,000 cash. Record this sale. Cost Accumulated depreciation Book value
$600,000 (228,000) $372,000
Sales price Book value
$290,000 (372,000) ©2012 Flat World Knowledge, Inc.
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Loss on sale
$ 82,000
Sale of Building at a Loss 12/31/2 Cash Accumulated Depreciation—Building Loss on Sale of Building Building
290,000 228,000 82,000 600,000
Assume that the building was sold for $440,000 rather than $290,000. Sales price Book value Gain on sale
$440,000 (372,000) $ 68,000
Sale of Building at a Gain 12/31/2 Cash Accumulated Depreciation—Building Building Gain on Sale of Building
440,000 228,000 600,000 68,000
3.1.2—Have students work through an example of selling an asset prior to the conclusion of its useful life, either individually or in teams [PowerPoint 10-31, 32, 33]
Assume a machine is purchased on January 1, Year One, for cash of $40,000. Based on experience with similar properties, officials believe that the machine will be worth only $7,000 at the end of an expected three-year life. Depreciation expense per year is $11,000. On December 31, Year 1, after the adjusting entry for depreciation is recorded, the company sells the machine for $30,000. Record the necessary journal entry for sale. Cost Accumulated depreciation Book value
$40,000 (11,000) $29,000
Sales price Book value Gain on sale
$30,000 (29,000) $ 1,000
Sale of Machine at a Gain 12/31/1 Cash Accumulated Depreciation—Machine Machine Gain on Sale of Machine
30,000 11,000 40,000 1,000
3.2— Recognizing Depreciation When Asset is Used for a Partial Year [PowerPoint 10-34] ©2012 Flat World Knowledge, Inc.
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The recording of depreciation follows the matching principle. If an asset is owned for less than a full year, it does not help generate revenues for all twelve months. The amount of expense should be reduced accordingly. If the asset is sold on a day other than December 31, less than a full year’s depreciation is assigned to expense in the year of sale. Revenue is not generated for the entire period; therefore, depreciation must also be recognized proportionally. 3.2.1—Work through an example of selling an asset prior to the conclusion of its useful life when the asset was not purchased at the beginning of the year [PowerPoint 10-35, 36, 37, 38] Assume a building is purchased by a company on April 1, Year One, for cash of $600,000. Based on experience with similar properties, officials believe that this structure will be worth only $30,000 at the end of an expected five-year life. The building is sold on September 1, Year Three for $350,000. Record all necessary journal entries for this building. Depreciation Expense = ($600,000 − $30,000)/5 years Annual Depreciation Expense = $114,000 per year Purchase of Building 4/1/1 Building Cash
600,000 600,000
Year 1 depreciation = $114,000 × 9/12 = $85,500 Depreciation Expense for Year One 12/31/1 Depreciation Expense Accumulated Depreciation—Building
85,500
Depreciation Expense for Year Two 12/31/2 Depreciation Expense Accumulated Depreciation—Building
114,000
85,500
114,000
Year 3 depreciation = $114,000 × 8/12 = $76,000 Depreciation Expense for Year Three 8/31/3 Depreciation Expense Accumulated Depreciation—Building
76,000
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76,000
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Cost Accumulated depreciation Book value
$600,000 (275,500) $ 324,500
Sales price Book value Gain on sale
$350,000 (324,500) $ 25,500
Sale of Building at a Gain 9/1/3 Cash Accumulated Depreciation—Building Building Gain on Sale of Building
350,000 275,500 600,000 25,500
3.2.2— Have students work through an example of selling an asset prior to the conclusion of its useful life when the asset was not purchased at the beginning of the year, either individually or in teams [PowerPoint 10-39, 40, 41, 42]
Assume a machine is purchased on July 1, Year One, for cash of $40,000. Based on experience with similar properties, officials believe that the machine will be worth only $7,000 at the end of an expected 3-year life. The machine was sold on April 1, Year Two for $29,000. Make all journal entries for the machine. Depreciation Expense = ($40,000 −$7,000)/3 years Depreciation expense = $11,000 per year Year 1 depreciation = $11,000 × 6/12 Year 1 depreciation = $5,500 Purchase of Machine 6/1/1 Machine Cash
40,000
Depreciation Expense for Year One 12/31/1 Depreciation Expense Accumulated Depreciation—Machine
5,500
40,000
5,500
Year 2 depreciation = $11,000 × 3/12 Year 2 depreciation = $2,750
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Recording Depreciation Expense for Year Two 3/31/2 Depreciation Expense Accumulated Depreciation—Building
Cost Accumulated depreciation Book value
$40,000 (8,250) $31,750
Sales price Book value Loss on sale
$29,000 (31,750) $ 2,750
Sale of Machine at a Loss 4/1/2 Cash Accumulated Depreciation—Building Loss on Sale of Machine Machine
2,750 2,750
29,000 8,250 2,750 40,000
3.3—The Half-Year Convention [PowerPoint 10-43] Most companies hold a great many depreciable assets, often thousands. Depreciation is nothing more than a mechanical cost allocation process. It is not an attempt to mirror current value. Cost is mathematically assigned to expense in a systematic and rational manner. Consequently, company officials often prefer not to invest the time and effort needed to keep track of the specific number of days or weeks of an asset’s use during the years of purchase and sale. As a result, depreciation can be calculated to the nearest month when one of these transactions is made. A full month of expense is recorded if an asset is held for fifteen days or more whereas no depreciation is recognized in a month where usage is less than fifteen days. As another accepted alternative, many companies apply the half-year convention (or some variation). When property or equipment is owned for any period less than a full year, a half year of depreciation is automatically assumed. The costly maintenance of exact records is not necessary. Long-lived assets are typically bought and sold at various times throughout each period so that, on the average, one-half year is a reasonable assumption.
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4. ALTERNATIVE DEPRECIATION PATTERNS AND THE RECORDING OF A WASTING ASSET 1. Explain the justification for accelerated methods of depreciation. 2. Compute depreciation expense using the doubledeclining balance method. 3. Realize that the overall impact on net income is not affected by a particular cost allocation pattern. 4. Describe the units-of-production method, including its advantages and disadvantages. 5. Explain the purpose and characteristics of MACRS. 6. Compute depletion expense for a wasting asset such as an oil well or a forest of trees. 7. Explain the reason that depletion amounts are not directly recorded as an expense. 4.1—Accelerated Depreciation [PowerPoint 10-46, 47] The most common alternative to the straight-line method is accelerated depreciation, which records a larger expense in the initial years of an asset’s service. The primary rationale for this pattern is that property and equipment frequently produce higher amounts of revenue earlier in their lives because they are newer. A second justification for accelerated depreciation is that some types of property and equipment lose value more quickly in their first few years than they do in later years. The most common accelerated method is the double-declining balance method (DDB). When using DDB, annual depreciation is determined by multiplying the current net book value of the asset times two divided by the expected years of life. As the net book value drops, the annual expense drops. Although residual value is not utilized in this computation, the final amount of depreciation recognized must be manipulated to arrive at this ending balance. 4.1.1—Work through an example of calculating depreciation expense using double-declining balance [PowerPoint 10-48, 49, 50, 51, 52] Assume a building is purchased by a company on January 1, Year One, for cash of $600,000. Based on experience with similar properties, officials believe that this structure will be worth only $30,000 at the end of an expected five-year life.
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Depreciation expense for period = (Cost – accumulated depreciation) × 2 expected life Year One: ($600,000 − $0); $600,000 × 2/5 = $240,000 depreciation expense Year Two: ($600,000 − $240,000); $360,000 × 2/5 = $144,000 depreciation expense Year Three: ($600,000 − $384,000); $216,000 × 2/5 = $86,400 depreciation expense Year Four: ($600,000 − $470,400); $129,600 × 2/5 = $51,840 depreciation expense Year Five: ($600,000 − $522,240); $77,760 However, depreciation for Year Five must be set at $47,760 to reduce the $77,760 net book value to the expected residual value of $30,000. Purchase of Building 1/1/1 Building Cash
600,000
Depreciation Expense for Year One 12/31/1 Depreciation Expense Accumulated Depreciation—Building
240,000
Depreciation Expense for Year Two 12/31/2 Depreciation Expense Accumulated Depreciation—Building
144,000
Depreciation Expense for Year Three 12/31/3 Depreciation Expense Accumulated Depreciation—Building
86,400
Depreciation Expense for Year Four 12/31/4 Depreciation Expense Accumulated Depreciation—Building
51,840
Depreciation Expense for Year Five 12/31/5 Depreciation Expense Accumulated Depreciation—Building
47,760
600,000
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240,000
144,000
86,400
51,840
47,760
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4.1.2— Have students work through an example of recording depreciation expense using DDB, either individually or in teams [PowerPoint 10-53, 54, 55, 56]
Assume a building is purchased on January 1, Year One, for cash of $400,000. Based on experience with similar properties, officials believe that the building will be worth only $30,000 at the end of an expected four-year life. Make all necessary journal entries to record depreciation throughout the building’s life. Depreciation expense for period = (Cost – accumulated depreciation) × 2 expected life Year One: ($400,000 − $0) = $400,000 × 2/4 = $200,000 depreciation expense Year Two: ($400,000 − $200,000) = $200,000 × 2/4 = $100,000 depreciation expense Year Three: ($400,000 − $300,000) = $100,000 × 2/4 = $50,000 depreciation expense Year Four: ($400,000 − $350,000) = $50,000 So, depreciation for Year Four is set at $20,000 to reduce the $50,000 net book value to arrive at the expected residual value of $30,000. Purchase of Building 1/1/1 Building Cash
400,000
Depreciation Expense for Year One 12/31/1 Depreciation Expense Accumulated Depreciation – Building
200,000
Depreciation Expense for Year Two 12/31/2 Depreciation Expense Accumulated Depreciation—Building
100,000
Depreciation Expense for Year Three 12/31/3 Depreciation Expense Accumulated Depreciation—Building
50,000
Depreciation Expense for Year Four 12/31/4 Depreciation Expense Accumulated Depreciation—Building
20,000
400,000
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200,000
100,000
50,000
20,000
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4.1.3—Work through an example of selling an asset prior to the conclusion of its useful life [PowerPoint 10-57, 58, 59] Assume a building is purchased by a company on January 1, Year One, for cash of $600,000. Based on experience with similar properties, officials believe that this structure will be worth only $30,000 at the end of an expected five-year life. Depreciation expense is $240,000 for Year One and $144,000 for Year Two. After the adjusting entry for depreciation is made on December 31, Year Two, the building is sold for $290,000 cash. Record this sale. Cost Accumulated depreciation Book value
$600,000 (384,000) $216,000
Sales price Book value Gain on sale
$290,000 (216,000) $ 74,000
Sale of Building at a Gain 12/31/2 Cash Accumulated Depreciation—Building Building Gain on Sale of Building
290,000 384,000 600,000 74,000
4.1.4 — Work through an example to show overall impact on net income using different depreciation methods [PowerPoint 10-60, 61] For example, assume a company buys a building for $600,000 at the beginning of Year One and sells it for $290,000 at the end of Year Two. If the company uses straight line depreciation method, it will report depreciation expense of $114,000 for both the years and a loss on sale of $82,000. If the company uses double –declining balance method for depreciation, it will report depreciation expense of $240,000 for Year One and $144,000 for Year Two. Also it will recognize a gain of $74,000 for sale of building. The impact of different method on net income is shown below:
Year One Depreciation Expense Year Two Depreciation Expense Loss on Sale of $290,000 Gain on Sale of $290,000 Overall Impact on Net Income
Straight-Line Method ($114,000) (114,000) (82,000) ($310,000)
Double-Declining Balance Method ($240,000) (144,000) +74,000 ($310,000)
Although the annual depreciation amounts are quite different under different depreciation methods, the overall net income is never affected by the allocation pattern. The net
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income for the entire period of use is reduced by $310,000 difference regardless of the approach applied.
4.2—Units-Of-Production Method [PowerPoint 10-62] Depreciation does not have to be based on time; it only has to be computed in a systematic and rational manner. Thus, the units-of-production method (UOP) is another alternative that is occasionally encountered. UOP is justified because the periodic expense is matched with the work actually performed. 4.2.1—Work through an example of calculating depreciation expense using units of production [PowerPoint 10-63, 64, 65] Assume that a limousine company buys a new vehicle for $90,000 to serve as an addition to its fleet. Company officials expect this limousine to be driven for 300,000 miles and then have no residual value. Determine the depreciation rate using the units-of-production method. Depreciation Rate = ($90,000 less $0) / 300,000 miles = $0.30 per mile Assume that the vehicle is driven 80,000 miles in Year One, 120,000 miles in Year Two, and 100,000 miles in Year Three. Purchase of Vehicle 1/1/1 Vehicle Cash
90,000
Depreciation Expense for Year One 12/31/1 Depreciation Expense Accumulated Depreciation—Vehicle
24,000
Depreciation Expense for Year Two 12/31/2 Depreciation Expense Accumulated Depreciation—Vehicle
36,000
Depreciation Expense for Year Three 12/31/3 Depreciation Expense Accumulated Depreciation—Vehicle
30,000
90,000
24,000
36,000
30,000
This vehicle will not likely be driven exactly 300,000 miles. If used for less and then retired, both the cost and accumulated depreciation are removed. A loss is recorded equal to the remaining book value unless some cash or other asset is received. If driven more than the anticipated number of miles, depreciation stops at 300,000 miles.
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4.2.2—Have students work through an example of calculating depreciation expense using units of production, either individually or in groups [PowerPoint 10-66, 67, 68] Antez Company purchases a machine which is expected to produce 1,600,000 bagels over its four-year life. The machine cost $360,000 and has a salvage value of $40,000. Determine the depreciation rate using units of production. Depreciation Rate = ($360,000 − $40,000)/1,600,000 bagels = $0.20 per bagel If 500,000 bagels were produced in Year One, and 600,000 in Year Two, record the depreciation expense. Also, record the purchase of the machine. Purchase of Machine 1/1/1 Machine Cash
360,000
Depreciation Expense for Year One 12/31/1 Depreciation Expense Accumulated Depreciation – Machine
100,000
Depreciation Expense for Year Two 12/31/2 Depreciation Expense Accumulated Depreciation – Machine
120,000
360,000
100,000
120,000
4.2—IN-CLASS ACTIVITY Using Actual Financial Statements Description: Prior to class, instruct students to find the financial statement notes of a company–perhaps the company they used in Chapter 3. Tell them to print out Note 1 (they may still have it from Chapter 9). During class, ask students to find the depreciation note and have a few volunteers share which depreciation method their company uses. 4.2—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
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Students will need to bring Note 1 from the financial statements to class
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4.3— Modified Accelerated Cost Recovery System (MACRS) [PowerPoint 10-69]
In most cases, the government wants businesses to buy more machinery, equipment, and the like because such purchases help stimulate the economy and create jobs. Consequently, for federal income tax purposes, companies are required to use a designed method known as Modified Accelerated Cost Recovery System (MACRS). MACRS has several built-in tax incentives inserted to encourage businesses to acquire more depreciable assets. Greater depreciation expense is allowed especially in the earlier years of use so that the purchase reduces tax payments. Each depreciable asset must be placed into one of 8 classes based upon its type and life. Every asset within a class is depreciated by the same method and over the same life. For most of these classes, the number of years is relatively short so that the benefit of the expense is received quickly for tax purposes. Residual value is ignored completely. For six of the 8 classes, accelerated depreciation is required which, again, creates more expense in the initial years.
4.4—Determining Depletion [PowerPoint 10-70] Oil, timber, gold and the like are “wasting assets.” They are taken from land over time, a process referred to as depletion. Value is literally removed from the asset rather than being consumed through use as with the depreciation of property and equipment. The same mechanical calculation demonstrated above for the units-of-production (UOP) method is applied. Because the value is separated rather than used up, depletion initially leads to the recording of inventory (such as oil or gold, for example). An expense is recognized only at the eventual point of sale. As with other types of property and equipment, historical cost is the sum of all normal and necessary expenditures to get the wasting asset into condition and position to generate revenues. For depreciation, expense is recognized immediately as the asset’s utility is consumed. With depletion, no expense is recorded until the inventory is eventually sold.
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4.4.1—Work through an example of calculating depletion expense [PowerPoint 10-71, 72, 73]
At the beginning of Year One, land is acquired for $1.6 million cash while another $400,000 is spent to construct a mining operation. Total cost is $2 million. The land is estimated to hold 10,000 tons of ore to be mined and sold. The land will be worth an estimated amount of only $100,000 after all ore is removed. Depletion = ($2,000,000 − $100,000)/10,000 tons Depletion = $190 per ton Assume that 3,000 tons of ore are extracted in Year One and sold in Year Two for $1 million cash. Another 3,600 tons are removed in the second year for sale at a later time. Acquisition of Land 1/1/1 Land with Mineral Rights Cash
1,600,000 1,600,000
1/1/1
Land with Mineral Rights Cash Extraction of Ore in Year One 12/31/1 Inventory of Ore Accumulated Depletion Sale of the Extracted Ore Year Two Cash Revenue from Sale of Ore
400,000 400,000 570,000 570,000
1,000,000
Cost of Goods Sold Inventory of Ore Extraction of Ore in Year Two 12/31/2 Inventory Accumulated Depletion
1,000,000 570,000 570,000
684,000 684,000
After two years, this land is reported on the company’s balance sheet at a net book value of $746,000 based on its historical cost of $2 million and accumulated depletion to date of $1,254,000 ($570,000 + $684,000). The remaining inventory of ore is reported as an asset at $684,000 because it has not yet been sold.
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4.4.2—Have students work through an example of calculating depletion expense, either individually or as a team [PowerPoint 10-74, 75, 76, 77, 78] At the beginning of Year One, land is acquired for $2.4 million cash while another $600,000 is spent to construct a mining operation. Total cost is $3 million. The land is estimated to hold 30,000 tons of minerals to be mined and sold. The land will be worth an estimated amount of only $60,000 after all minerals are removed. Depletion = ($3,000,000 − $60,000) / 30,000 tons Depletion = $98 per ton Assume that 10,000 tons of ore are extracted in Year One. 5,000 tons are sold in Year One for $700,000 cash. The other 5,000 tons are sold in Year 2 for $750,000 cash. Another 13,000 tons are removed in Year 2. 7,000 tons sold in Year 2 for $1,950,000. Acquisition of Land 1/1/1 Land with Mineral Rights Cash 1/1/1
2,400,000 2,400,000
Land with Mineral Rights Cash
600,000 600,000
Extraction of Minerals in Year One 12/31/1 Inventory of Minerals Accumulated Depletion
980,000 980,000
Sale of the Extracted Minerals Year One Cash Revenue from Sale of Minerals
700,000 700,000
Cost of Goods Sold Inventory of Minerals
490,000 490,000
Sale of the Extracted Ore Year Two Cash Revenue from Sale of Minerals
750,000 750,000
Cost of Goods Sold Inventory of Minerals Extraction of Minerals in Year Two 12/31/2 Inventory of Minerals Accumulated Depletion
490,000 490,000
1,274,000
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1,274,000
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Sale of Extracted Minerals Year Two Cash Revenue from Sale of Minerals
1,950,000
Cost of Goods Sold Inventory of Minerals
1,950,000 686,000 686,000
5. RECORDING ASSET EXCHANGES AND EXPENDITURES THAT AFFECT OLDER ASSETS 1. Record the exchange of one asset for another and explain the rationale for this method of accounting. 2. Explain when the fair value of an asset received must be used for recording an exchange rather than the fair value of the property surrendered. 3. Compute the allocation of cost between assets when more than one asset is acquired in a single transaction. 4. Determine which costs are capitalized when incurred in connection with an asset that has already been in use for some time and explain the impact on future depreciation expense calculations. 5.1— Exchanging One Asset for Another [PowerPoint 10-81] In virtually all cases, fair value is the accounting basis used to record items received in an exchange. The net book value of the old asset is removed from the accounts and the new model is reported at fair value. Fair value is added; net book value is removed. A gain or loss is recognized for the difference. 5.1.1—Work through an example of an exchange of assets [PowerPoint 1082, 83, 84, 85]
Assume that a limousine company buys a new vehicle for $90,000 to serve as an addition to its fleet. Company officials expect this limousine to be driven for 300,000 miles and then have no residual value. So the depreciation rate is $0.30 per mile. Assuming that the vehicle is driven 80,000 miles in Year One, 120,000 miles in Year Two. The accumulated depreciation at the end of Year Two is (80,000 + $120,000) × $0.30 per mile = $60,000 This limousine is traded to an automobile manufacturer for a new model on
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December 31, Year Two. Because company employees have taken excellent care of the vehicle during those two years, fair value is actually $45,000. The vehicle being acquired is worth $100,000 so the company also pays $55,000 in cash ($100,000 value received less $45,000 value surrendered) to the manufacturer to complete the trade. Record this exchange. Vehicle (Cost) Accumulated Depreciation Net book value
$90,000 (60,000) $30,000
Fair value of assets surrendered = $45,000 (Vehicle) + $55,000 (Cash) = $100,000 Net book value of assets surrendered = $30,000 (Vehicle) + $55,000 (Cash) = $85,000 Fair value of assets surrendered Net book value of assets surrendered Gain on exchange
$100,000 (85,000) $ 15,000
The gain results because the old limousine had not lost as much value as the depreciation process had expensed. The net book value was reduced to $30,000 but the vehicle was actually worth $45,000. Vehicle (New) Accumulated depreciation Vehicle (Old) Cash Gain on Exchange of Limousines
100,000 60,000 90,000 55,000 15,000
5.1.2—Have students work through an example of an exchange of assets, either individually or in teams [PowerPoint 10-86, 87, 88, 89] Antez Company purchases a machine, which is expected to produce 1,600,000 bagels over its 4-year life. The machine cost $360,000 and has a salvage value of $40,000. So the depreciation rate using units-of-production method is $0.20 per bagel. If 500,000 bagels were produced in Year One and 600,000 in Year Two, the accumulated depreciation at the end of Year Two will be : (500,000 + $600,000) × $0.20 per mile = $220,000 This machine is traded for a newer model on December 31, Year Two. This machine has been a hot seller for the past two years, so its fair value is actually $160,000. The machine being acquired is worth $200,000 so Antez also pays $40,000 in cash ($200,000 value received less $160,000 value surrendered) to the manufacturer to
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complete the trade. Record this exchange. Machine (Cost) Accumulated Depreciation Net book value
$360,000 (220,000) $140,000
Fair value of assets surrendered = $160,000 (Machine) + $40,000 (Cash) = $200,000 Net book value of assets surrendered = $140,000 (Machine) + $40,000 (Cash) = $100,000 Fair value of assets surrendered Net book value of assets surrendered Gain on exchange Machine (New) Accumulated depreciation Machine (Old) Cash Gain on exchange
$200,000 (180,000) $ 20,000 200,000 220,000 360,000 40,000 20,000
5.2—Determining the Fair Value to Record in an Exchange [PowerPoint 10-90]
To stay consistent with the historical cost principle, the new asset received in a trade is recorded at the fair value of the item or items surrendered. Giving up the previouslyowned property is the sacrifice made to obtain the new asset. That is the cost to the new buyer. Generally, the fair value of the items sacrificed equals the fair value of the items received. However, that is not always the case. Thus, if known, the fair value of the assets given up always serves as the basis for recording the asset received. Only if the value of the property traded away cannot be readily determined is the new asset recorded at its own fair value.
5.3— Allocating a Purchase Price Between Two Assets [PowerPoint 10-91]
Companies do commonly purchase more than one asset at a time. This is sometimes referred to as a basket purchase. The cost assigned to each asset should be based on their relative values.
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5.3.1—Work through an example of a basket purchase of assets [PowerPoint 10-92, 93, 94, 95, 96, 97]
A business pays $5.0 million for three acres of land along with a five-story building. The land and building have been appraised at $4.5 million and $1.5 million, respectively, for a total of $6.0 million. Perhaps the owner needed cash immediately and was willing to accept a price of only $5.0 million. Relative fair value % of land = Fair value of land / (Fair value of land + Fair value of building) Relative fair value % of land = $4,500,000 / ($4,500,000 + $1,500,000) Relative fair value % of land = 75% Relative net book value of land = 75% × $5,000,000 Relative net book value of land = $3,750,000 Relative fair value % of building = Fair value of building / (Fair value of land + Fair value of building) Relative fair value % of building = $1,500,000 / ($4,500,000 + $1,500,000) Relative fair value % of building = 25% Relative net book value of building = 25% × $5,000,000 Relative net book value of building = $1,250,000 Allocation of cost between Land and Building with Both Values Known Land 3,750,000 Building 1,250,000 Cash 5,000,000 Occasionally, in a basket purchase, the value can be determined for one of the assets, but not for all. As an example, the above land might be worth $4.6 million but no legitimate value is available for the building. In such cases, the known value is used for that asset with the remainder of the cost assigned to the other property. If the land is worth $4.6 million but no reasonable value can be ascribed to the building, the excess $400,000 ($5,000,000 cost less $4,600,000 assigned to the land) is arbitrarily assigned to the second asset. Allocation of Cost Based on Known Value of Land Only Land 4,600,000 Building 400,000 Cash
5,000,000
The possibility of bias exists in these allocations. If the buyer assigns more of the cost of a basket purchase to land, future depreciation will be less and reported net income will be higher. In contrast, if more of the cost is allocated to the building, depreciation expense is
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higher and taxable income and income tax payments are reduced.
5.4— Subsequent Expenditures for Property and Equipment [PowerPoint 10-98, 99, 100, 101]
In many cases, additional money is spent simply to keep the asset operating with no change in expected life or improvement in future productivity. Such costs are recorded as maintenance expense if anticipated or repair expense if unexpected. A company spends an additional $150,000 on routine maintenance on a building. Recording of Cost to Maintain or Repair Assets Maintenance (or Repair) Expense Cash
150,000 150,000
However, if the $150,000 cost increases the future operating capacity of the asset, the amount should be capitalized. Cost Capitalized Because of Increase in Operating Capacity Building 150,000 Cash
150,000
The $150,000 will be depreciated along with the building over the remainder of its life. Another possibility does exist. The $150,000 might extend the building’s life without creating any other improvement. Because the building will now generate revenue for a longer period of time than previously expected, this cost is capitalized. The building is not increased directly but, instead, accumulated depreciation is reduced. Recording Cost Capitalized Because Expected Life Is Extended Accumulated Depreciation 150,000 Cash
150,000
Assume the $150,000 payment extends the remaining useful life of the building from 12 years to 18 years with no accompanying change in residual value. The cost of the building was $1,250,000. Accumulated depreciation amounts to $500,000 before this expenditure. Reduced accumulated depreciation: $500,000 − $150,000 = $350,000 Adjusted net book value: $1,250,000 − $350,000 = $900,000 Annual depreciation: $900,000 / 18 years = $50,000
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6. REPORTING LAND IMPROVEMENTS AND IMPAIRMENTS IN THE VALUE OF PROPERTY AND EQUIPMENT 1. Identify assets that qualify as land improvements and understand that the distinction between land and land improvements is not always clear. 2. Perform the two tests used in financial accounting to determine the necessity of recognizing a loss because of an impairment in the value of a piece of property or equipment. 3. Explain the theoretical justification for capitalizing interest incurred during the construction of property and equipment. 6.1—Recognition of Land Improvements [PowerPoint 10-103] Any asset that is attached to land but has a finite life is recorded in a separate account, frequently referred to as Land Improvements. This cost is, then depreciated over the estimated life in the same way as equipment or machinery. The cost of a parking lot or sidewalk, for example, is capitalized and then reclassified to expense in a systematic and rational manner. In some cases, a distinction between land and improvements is difficult to draw. For example, trees, shrubbery, and sewer systems might be viewed as normal and necessary costs to get land into the condition and position to generate revenues rather than serving as separate assets.
6.2—Property and Equipment with Impaired Value [PowerPoint 10-104] Accounting is influenced by conservatism. Concern should always arise when any piece of property or equipment is thought to be worth less than its normal net book value. Because temporary swings in value can happen frequently and often have no long term impact, they do not require accounting modification. Permanent declines in the worth of an asset, though, are a problem for the owner that needs to be recognized in some appropriate manner. Consequently, two tests have been created by FASB to determine if the value of property or equipment has been impaired in such a serious fashion that a loss must be recognized. If a possible impairment of the value of property or equipment is suspected, the owner must estimate the total amount of cash that will be generated by the asset during its ©2012 Flat World Knowledge, Inc.
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remaining life. The resulting cash figure is then compared with the asset’s current net book value (cost less accumulated depreciation). A reporting problem exists if the company does not anticipate receiving even enough cash to recover the net book value of the asset. At that point, the asset is a detriment to the company rather than a benefit. This recoverability test highlights situations that are so dire that immediate recognition of a loss must be considered. If expected future cash flows exceed the current net book value of a piece of property or equipment, no reporting is necessary. The asset can still be used to recover its net book value. No permanent impairment has occurred according to the rules of U.S. GAAP. Conversely, if an asset cannot even generate sufficient cash to recover its own net book value, the accountant performs a second test (the fair value test) to determine the amount of loss, if any, to be reported. Net book value is compared to present fair value, the amount for which the asset could be sold. For property and equipment, the lower of these two figures is then reported on the balance sheet. Any reduction in the reported asset balance creates a loss to be recognized on the income statement. 6.2.1—Work through an example of asset impairment [PowerPoint 10-105, 106, 107]
A company constructs a plant for $3 million to manufacture widgets. Shortly thereafter, the global market for widgets falls precipitously so that the owner of this structure has little use for it. The building has been used for a short time so that it now has a net book value of $2.8 million. Also assume that because of the change in demand for its product, this building is now expected to generate a net positive cash flow of only $200,000 during each of the next five years or a total of $1.0 million. No amount of cash is expected after that time. Has impairment occurred? The Recoverability Test. The expected future cash flow of $1 million is far below the net book value of $2.8 million. The company will not be able to recover the asset’s net book value through these cash flows. Thus, the building has failed the recoverability test. The fair value test must now be applied to see if a reported loss is necessary. The Fair Value Test. Assuming that a real estate appraiser believes this building could be sold for only $760,000. Fair value ($760,000) < Net book value ($2,800,000) Fair value $ 760,000 Net book value (2,800,000) Loss $2,040,000 Loss on Impaired Value of Building Loss on Impaired Value of Building Building
2,040,000
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6.2.2—Have students work through an example asset impairment, either individually or in teams [PowerPoint 10-108, 109, 110] A company purchases a machine for $70,000. It is designed to make the most popular electronic gadget of 2012. Unfortunately, after one year (and $15,000 in depreciation), a fatal flaw is discovered in the gadget and it becomes virtually unsellable. There is not much else this machine can do, so the estimate of future cash flows is limited to 3 years at around $10,000 per year. Should a loss on impairment be taken on this machine? The Recoverability Test. The expected future cash flow of $30,000 is below the net book value of $55,000. The company will not be able to recover the asset’s net book value through these cash flows. Thus, the building has failed the recoverability test. The fair value test must now be applied to see if a reported loss is necessary. The Fair Value Test. Assuming that an expert in the field believes this machine could only be sold for scrap of $12,000. Fair value ($12,000) < Net book value ($55,000) Fair value Net book value Loss
$12,000 (55,000) $43,000
Loss on Impaired Value of Machine Loss on Impaired Value of Machine Machine
43,000 43,000
6.3—Capitalizing the Cost of Interest During Construction [PowerPoint 10-111]
If an asset is purchased, it can be used immediately to generate revenue. Borrowing the money and paying an interest charge allows the company to use the asset to generate revenues immediately. The matching principle requires this cost to be reported as interest expense for Year One. Expense is matched with the revenue it helps to create. In contrast, if company officials choose to construct an asset, no revenue is generated until it is completed. Because of the decision to build rather than buy, revenues are postponed until completion of construction. Without any corresponding revenues, expenses are not normally recognized. Choosing to build the asset means that the interest paid during construction is a normal and necessary cost to get the asset ready to use. Thus, if the asset is constructed, all the interest is capitalized rather than expensed until revenues are generated.
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6.3.1—Work through an example interest capitalization [PowerPoint 10-112, 113, 114]
A company is debating between purchasing and constructing a building. Either will cost $1,000,000. The money can be borrowed with a 10% annual interest rate. The building is expected to generate revenues for 20 years with no residual value and that the straight-method is used for depreciation purposes. How will reported numbers differ over the first two years of the building if it is purchased versus constructed? Store Bought on January 1, Year One—Revenues Generated Immediately Historical cost: $1 million Interest expense reported for Year One: $100,000 Interest expense reported for Year Two: $100,000 Depreciation expense reported for Year One: $50,000 ($1 million/20 years) Depreciation expense reported for Year Two: $50,000 Net book value at end of Year Two: $900,000 ($1 million less $50,000 and $50,000) Store Constructed during Year One—No Revenues Generated until Year Two Historical cost: $1.1 million (includes Year One interest) Interest expense reported for Year One: -$0- (no revenues earned) Interest expense reported for Year Two: $100,000 Depreciation expense reported for Year One: -$0- (no revenues earned) Depreciation expense reported for Year Two: $55,000 ($1.1 million/20 years) Net book value at end of Year Two: $1,045,000 ($1.1 million less $55,000)
6.4—Fixed Asset Turnover [PowerPoint 10-115] The fixed asset turnover indicates the efficiency by which a company uses its property and equipment to generate sales revenues. If a company holds large amounts of fixed assets but fails to generate an appropriate amount of revenue balances, the ability of management to make good use of those assets should be questioned. This figure is calculated by taking net sales for a period and dividing it by the average net book value of the company’s property and equipment (fixed assets). Net Sales/Average Net Fixed Assets
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6.4.1—Work through an example of calculating fixed asset turnover [PowerPoint 10-116, 117]
A company reports $1 million in property and equipment on its balance sheet at the beginning of the year but $1.2 million at the end. During the year, the company generates $6.16 million in net sales. Calculate the fixed asset turnover. Average net fixed assets = ($1 million + $1.2 million)/2 = $1.1 million Fixed assets turnover = Net Sales/Average Net Fixed Assets $6,160,000/$1,100,000 5.6 Times 6.4.2—Have students work through an example of calculating fixed asset turnover, either individually or in teams [PowerPoint 10-118, 119] Orion Company reports $2.4 million in property and equipment on its balance sheet at the beginning of the year but $2.6 million at the end. During the year, the company generates $10 million in net sales. Calculate the fixed asset turnover. Average net fixed assets = ($2.4 million + $2.6 million)/2 = $2.5 million Net Sales/Average Net Fixed Assets $10,000,000/$2,500,000 4 Times
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CHAPTER 11 In a Set of Financial Statements, What Information Is Conveyed about Intangible Assets? 1. IDENTIFYING AND ACCOUNTING FOR INTANGIBLE ASSETS 1. List the characteristics of intangible assets and provide several common examples. 2. Understand that intangible assets are becoming more important to businesses and, hence, are gaining increased attention in financial accounting. 3. Record the acquisition of an intangible asset. 4. Describe the amortization process for intangible assets. 5. Explain the accounting used to report an intangible asset that has increased in value since acquisition. 1.1— The Rise in the Importance of Intangible Assets [PowerPoint 11-3, 4] An intangible asset is one that lacks physical substance. It cannot be touched but is expected to provide future benefits for longer than one year. Except for a few slight variations, intangible assets are reported in the same manner as a building or equipment. For example, historical cost serves as the basis for reporting. If the intangible has a finite life, the depreciation process (although the term “amortization” is normally applied in reporting intangibles) reclassifies this cost from asset to expense over that estimated period. U.S. GAAP provides structure for the reporting process by placing all intangibles into six major categories: 1. 2. 3. 4. 5. 6.
Artistic-related (such as copyrights) Technology-related (patents) Marketing-related (trademarks) Customer-related (a database of customer information) Contract-related (franchises) Goodwill
In all of these categories (except for goodwill which will be explained later in this chapter), each intangible asset is actually an established right of usage. Intangible assets represent a legal right that helps the owner to generate revenues.
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1.1—IN-CLASS ACTIVITY Intangibles Description: Before class, ask students to pull the balance sheet from a company of their choice. Many may still have the financial statements that they used in other chapters. During class, have volunteers name some of the intangibles they find on their balance sheet. Discuss what these assets seem to have in common. 1.1—Appropriate In-Class Use Pages Discussion Team Class Assign Activity Time Ahead √
3-5 Minutes
Students will need to bring a balance sheet to class
1.2—The Acquisition of an Intangible [PowerPoint 11-5, 6, 7, 8] The buyer of an intangible asset prepares a journal entry that is basically identical to the acquisition of inventory, land or a machine. Example: An automobile company is creating a series of television commercials for one of its new models. On January 1, Year One, the company pays $1 million cash to a famous musical group for the right to use a well-known song. The band holds the legal copyright on the piece of music and has agreed to share that right with the automobile company so that the song can be played in one or more commercials. As with all those other assets, the intangible is recorded initially at historical cost. January 1, Year One—Acquisition of Right to Use Copyrighted Song Copyright 1,000,000 Cash 1,000,000 Many intangible assets have defined legal lives. For example, copyrights last for 70 years beyond the creator’s life. Acquired intangibles often have lives legally limited by contractual agreement. Amortization of the cost to expense should extend over the shorter of the asset’s useful life or its legal life.
Example:
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Assume that this piece of music is expected to be included by the automobile company in its television commercials for the next four years. After that, a different advertising campaign will likely be started. Annual amortization = $1 million cost/4 year life Annual amortization = $250,000 December 31, Year One—First Year Amortization of Copyright Cost Amortization Expense 250,000 Copyright 250,000 At the end of the first year, the copyright appears on the automobile company’s balance sheet as $750,000, the remainder of its historical cost. The credit in the adjusting entry directly decreases the asset account. Although establishing a separate contra account (such as accumulated amortization) is permitted, most companies simply reduce the intangible asset balance because the utility is literally shrinking. The automobile company went from holding a copyright to play the music in its commercials for an expected four years to a copyright that will likely only be used for three more years. A direct reduction of the cost is more appropriate.
1.3—Intangible Assets and Fair Value [PowerPoint 11-9] Depending on the specific terms of the contract, the creator often continues to possess the copyright and maintain that asset on its own balance sheet. In many cases, the original artist only conveys permission to a buyer to use this music (or other intellectual work) for specific purposes or a set period of time. However, the copyright is not adjusted on the creator’s books to its fair value; rather, it remains at historical cost less any amortization to date. The reported amount shown for copyrights and other similar intangibles contains all normal and necessary costs such as attorney fees and money spent for legal filings made with appropriate authorities. Subsequently, such intangible assets sometimes become the subject of lawsuits if other parties assert claims to the same ideas and creations. The cost of a successful defense is also capitalized and then amortized over the shorter of the remaining legal life or the estimated useful life of the asset. If the defense proves unsuccessful, the remaining asset balance is written off as a loss.
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2. BALANCE SHEET REPORTING OF INTANGIBLE ASSETS 1. Explain the theoretical rationale for using historical cost as the basis for reporting intangible assets as well as long-lived assets such as equipment. 2. Understand that using historical cost as the accounting basis means that a company’s intangible assets can actually be worth much more than is shown on the balance sheet. 3. Recognize that intangible assets with large monetary balances can result from acquisition either individually or through the purchase of an entire company that holds valuable intangible assets. 4. Describe the method of recording intangible assets when the company that owns them is acquired by another company. 2.1— Reporting Historical Cost for Intangible Assets Rather than Fair Value [PowerPoint 11-12] Internally developed trademarks and other intangibles often have little actual cost despite the possibility of gaining immense value. Figures reported for intangible assets, such as trademarks, may indeed be vastly understated on a company’s balance sheet when compared to fair values. Decision makers who rely on financial statements need to understand what they are seeing. U.S. GAAP requires that companies follow the historical cost principle in reporting many assets. Financial accounting tends to be conservative. Reporting an asset at a balance in excess of its historical cost basis is much less common. As discussed in earlier chapters, cost can be reliably and objectively determined. It does not fluctuate from day to day throughout the year. It is based on an agreed-upon exchange price and reflects a resource allocation judgment made by management. Cost is not a guess so it is less open to manipulation. Although fair value may appear to be more relevant, various parties might arrive at significantly different estimates of worth. Even though fair value accounting seems quite appealing to many decision makers, accountants have proceeded slowly because of potential concerns. For example, the 2001 collapse of Enron Corporation was the most widely discussed accounting scandal to
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occur in recent decades. Many of Enron’s reporting problems began when the company got special permission (due to the unusual nature of its business) to report a number of assets at fair value (a process referred to as “mark to market”). Because fair value was not easy to determine for many of those assets, Enron officials were able to manipulate reported figures to make the company appear especially strong and profitable. Investors then flocked to the company only to lose billions when Enron eventually filed for bankruptcy. A troubling incident of this magnitude makes accountants less eager to embrace the reporting of fair value except in circumstances where very legitimate amounts can be determined. For intangible assets as well as property and equipment, fair value is rarely so objective that the possibility of manipulation can be eliminated.
2.2— Acquiring a Company to Gain Control of its Intangibles [PowerPoint 11-13, 14, 15, 16]
Two possible reasons exist for a company’s intangible asset figures to grow to incredible size. First, instead of being internally developed, assets such as copyrights and patents are often acquired from outside owners. Reported asset balances then represent the historical costs of these purchases which were based on fair value at the time of the transaction. Second, a company could have bought one or more entire companies so that title to a multitude of assets (including a possible plethora of intangibles) is obtained in a single transaction. In fact, such acquisitions often occur specifically because one company wants to gain valuable intangibles owned by another. If a company buys a single intangible asset directly from its owner, the financial reporting follows the pattern previously described. Whether the asset is a trademark, franchise, copyright, patent, or the like, it is reported at the amount paid. That cost is then amortized over the shorter of its estimated useful life or legal life. Reporting the assigned cost of intangible assets acquired when one company (often referred to as “the parent”) buys another company (“the subsidiary”) is a complex issue. In simple terms, the subsidiary’s assets (inventory, land, buildings, equipment and the like) are valued and recorded at that amount by the parent as the new owner. The subsidiary’s assets and liabilities are consolidated with those of the parent. In this process, each intangible asset held by the subsidiary that meets certain requirements is identified and recorded by the parent at its fair value. The assumption is that a portion of the price conveyed to purchase the subsidiary is being paid to obtain these intangible assets. Example: Big Company pays $10 million in cash to buy all the capital stock of Little Company. Consolidated financial statements will now be necessary. Little owns three intangibles (perhaps a copyright, patent, and trademark) that are each worth $1 million. Little also holds land worth $7 million but has no liabilities. Little’s previous net book value for these assets is not relevant to Big, the new owner. Following the takeover of Little, Big reports each of the intangibles on its balance sheet at its cost of $1 million (and the land
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at $7 million). The acquisition price is assumed to be the historical cost paid by Big to obtain these assets. When Big purchases Little Company, it is gaining control of all these assets and records the transaction as follows.
Big Company Buys Little Company Which Holds Assets With These Values Copyrights 1,000,000 Patents 1,000,000 Trademarks 1,000,000 Land 7,000,000 Cash 10,000,000
3. RECOGNIZING INTANGIBLE ASSETS OWNED BY A SUBSIDIARY 1. Understand that only subsidiary intangible assets that meet either of two specific criteria are recognized separately by a parent following an acquisition. 2. Explain the meaning of the asset goodwill. 3. Compute and record the amount to be reported as goodwill on a consolidated balance sheet when a parent acquires another company as a subsidiary. 4. Understand that amounts attributed to goodwill are not amortized to expense but rather are checked periodically for impairment of value. 3.1—Criteria for Recognizing Intangible Assets [PowerPoint 11-18] The rules for reporting intangible assets are best demonstrated through the acquisition of a subsidiary by a parent because large amounts are often spent for numerous items that might qualify as assets. In establishing rules for consolidated financial statements, FASB has stated that a parent company must identify all intangible assets held by a subsidiary on the date of acquisition. The fair value of each of these intangibles is recorded by the parent as an asset but only if one of the following two specific criteria is met: 1. contractual or other legal rights have been gained or 2. the intangible can be separated from the subsidiary and sold. Patents, copyrights, trademarks, and franchises clearly meet the first of these criteria. Legal rights are held for patents, copyrights, and trademarks while contractual rights allow the owner to operate franchises. By acquiring the subsidiary, the parent now control these same rights and should record them on the consolidated balance sheet at fair value.
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Other intangibles that can be separated from the subsidiary and sold, should also be consolidated at fair value. For example, an acquired company might have a database containing extensive information about its customers. After purchasing the subsidiary, this information could be separated from that company and sold. Thus, on the date the subsidiary is purchased, the parent recognizes this database as an intangible asset at fair value to reflect the portion of the acquisition price paid to obtain it.
3.2— Recognition of Goodwill [PowerPoint 11-19, 20, 21] When one company buys another, payment amounts will likely be negotiated to compensate the seller for intangibles where contractual or legal rights are held or where the asset can be separated and then sold. However, some intangibles have significant value but fail to meet either of the criteria required for recognition of goodwill. Customer loyalty, for example, is vitally important to the future profitability of a business but neither contractual nor legal rights are present and loyalty cannot be separated from a company and sold. Hence, customer loyalty is not reported as an intangible asset regardless of its worth. Much the same can be said for brilliant and creative employees. A value exists but neither rule for recognition is met. During negotiation, the owners of a company that is being acquired will argue for a higher price if attributes such as these are in place because they provide increased profitability in the future. Every subsidiary intangible (such as patents, copyrights and databases) that meets either of the official criteria is consolidated by the parent as an asset at fair value. Any excess price paid over the total fair value of these recorded assets is also reported as an asset, known as goodwill. Example: Giant Corporation pays $16 million to acquire Tiny Corporation. The subsidiary owns property and equipment worth $4 million. It also holds patents worth $6 million, a database worth $2 million, and copyrights worth $3 million. The total value of these four assets is only $15 million. For convenience, assume Tiny has no liabilities. Assume that Giant agrees to pay an extra $1 million because the subsidiary has customer loyalty valued at $600,000 and a talented workforce worth $400,000. Record this purchase. Giant Company Buys Tiny Company—$1 Million Paid in Excess of Fair Value of Identifiable Assets Property and Equipment Patents Database Copyrights Goodwill Cash
4,000,000 6,000,000 2,000,000 3,000,000 1,000,000 16,000,000
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3.3— Excess Payment for a Subsidiary Not Identified with an Intangible [PowerPoint 11-22] The acquisition of one company by another can require months of bargaining between the parties. In most cases, the parent has to pay more than the sum of the value of all individual assets to entice the owners of the other company to sell. Sometimes, as in the initial example, the reason for the added payment is apparent (customer loyalty and talented workforce). More likely, the increased amount is simply necessary in order to make the deal happen. Whenever an extra cost must be expended to gain control of a subsidiary, it is labeled by the parent as an asset known as goodwill.
3.4— Accounting for Goodwill Over Time [PowerPoint 11-23] Because goodwill is the one asset on a balance sheet that is not tied to an identifiable benefit, no attempt is ever made to determine an anticipated life. Consequently, the assigned cost is not amortized to expense. A goodwill balance can remain unchanged on a consolidated balance sheet for decades after a subsidiary is purchased. However, the reported figure is reduced immediately if its value is ever judged to be impaired. Attributes such as customer loyalty or a talented workforce might continue in place for years or disappear completely in a short period of time. If goodwill is merely a premium paid to acquire a subsidiary, the justification for that excess amount could vanish because of poor management decisions or environmental factors. The value of all assets is tentative, but probably none is more so than goodwill. Although a cost recorded as goodwill is not amortized over time, its ongoing worth is not assumed. Instead, a test to check for any loss of that value is performed periodically. In the event that the goodwill associated with a subsidiary is ever found to be worth less than its reported balance, an impairment loss is recorded. Although not identical, the accounting is similar in some ways to the impairment test for land, buildings, and equipment demonstrated previously.
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4. ACCOUNTING FOR RESEARCH AND DEVELOPMENT 1. Define the terms “research” and “development.” 2. Explain the problem that uncertainty creates for accountants in reporting research and development costs. 3. Understand the required method of reporting research and development costs according to U.S. GAAP. 4. Discuss the advantages of reporting research and development costs in the manner required by U.S. GAAP. 5. Recognize that many companies report asset totals that are vastly understated as a result of the authoritative handling of research and development costs. 4.1— Reporting Research and Development Costs [PowerPoint 11-26, 27, 28]
Research is any attempt made to find new knowledge with the hope that those results will eventually be useful in creating new products or services or significant improvements in existing products or services. Development is the natural next step. It is the translation of that new knowledge into actual products or services or into significant improvements in existing products or services. However, the reporting of research and development costs poses incredibly difficult challenges for the accountant. The quantity of these expenditures is often massive because of the essential role that new ideas and products play in the future success of many organizations. Unfortunately, significant uncertainty is inherent in virtually all such endeavors. The probability that any research and development cost will eventually lead to a successful product is impossible to determine for years. Furthermore, any estimation of the outcome of such work is open to manipulation. Often, the only piece of information that is known with certainty is the amount that has been spent. Thus, except for some relatively minor exceptions, all research and development costs are expensed as incurred according to U.S. GAAP. The total cost incurred each period for research and development appears on the income statement as an expense regardless of the chance for success. Two major advantages are provided by this approach. First, the amount spent by a company on research and development each period is easy to determine and then compare with previous years and with other similar businesses. Most decision makers are interested in the amount invested in the search for new ideas and products and that
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information is readily apparent. Second, the possibility for manipulation is virtually eliminated. No distinction is drawn between a likely success and a probable failure.
4.2—Research And Development Costs and the Impact on the Balance Sheet [PowerPoint 11-29] Companies in technology, pharmaceutical, and many other industries must exclude items of significant value from their balance sheets by following U.S. GAAP. While this approach is conservative, consistent, and allows for comparability, the rationale is confusing. The balance sheet hardly paints a fair portrait of the assets being held. Expensing research and development costs also violates the matching principle. These expenditures are made in the hopes of generating future revenues but the expense is recorded immediately before any revenues have been earned. Capitalizing these costs so that they are reported as assets is logical but measuring the value of future benefits is extremely challenging. Without authoritative guidance, the extreme uncertainty of such projects would leave the accountant in a precarious position. The temptation would be to tailor the reporting to make the company look as good as possible. U.S. GAAP “solves” the problem by eliminating the need for any judgment by the accountant. All costs are expensed. Consequently, any decision maker evaluating a company that invests heavily in research and development needs to recognize that the assets appearing on the balance sheet are incomplete.
4.3— Accounting for Research and Development Costs Under IFRS [PowerPoint 11-30] If specified criteria are met, IFRS requires the capitalization of development costs. These guidelines help determine when a project moves from the research stage into the development stage. However, once the development stage commences, the costs are capitalized and amortized over the anticipated useful life.
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5. ACQUIRING AN ASSET WITH FUTURE CASH PAYMENTS 1. Realize that if payments to acquire an asset are delayed into the future, part of the total cash amount is attributed to the purchase of the asset with the rest deemed to be interest. 2. Recognize that a reasonable rate of interest on a longterm debt can be stated explicitly in the contract and paid when due so that no present value computation is needed. 3. Record the acquisition of an intangible asset based on a present value computation whenever payments are made over a period of years and no explicit interest is included in those payments. 4. Define the term “compounding.” 5. Compute interest to be recognized each period when a long-term debt was recorded using a present value computation. 6. Differentiate between an annuity due and an ordinary annuity. 5.1— Purchases Made with Future Cash Payments [PowerPoint 11-33, 34]
When cash is paid for a purchase over an extended period of time two distinct reasons for the payments always exist. The first is obviously the acquisition of the property, such as the patent. The second is interest. Interest is the charge for the use of money over time. A theoretical problem arises if interest is not identified in the contract. According to U.S. GAAP, interest is still present and must be recognized because the conveyance of cash has been delayed. This means that only part of the payment is actually paid for the intangible purchased with the rest serving as interest. Authoritative accounting rules hold that an interest charge is always present when payment is put off into the future. The specific allocation of the payment between intangible asset and interest is not readily apparent. To calculate the interest included within the price, present value computation is necessary.
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The present value of future cash flows is the amount left after all future interest is removed (hence the term “present value”). The present value is the portion within the payment that is being paid for the intangible. The remainder will be recognized as interest expense over the period until payment is made. To determine the present value of future cash flows, a reasonable interest rate is needed. Then, the amount of interest for the period can be mathematically calculated and removed. An appropriate interest rate is often viewed as the one that the buyer would be charged if the money were borrowed from a local bank. A reasonable annual interest rate must be assumed. Present value is then determined which is equal to the payment amount with all interest removed. Using a PV table, a factor can be determined. The factor is then multiplied by the actual cash payment to determine its present value. 5.1.1—Teaching Tip: Using Present Value Tables Here, it might be a good idea to pull up a copy of a Present Value of $1 table for the students to see. It can be used to find the PV factor in the two example problems. Present value tables are also available online or the link from the chapter can be used. Those who choose to may also want to demonstrate to students how to find a present value on Excel. 5.1.2—Work through an example of recording a delayed payment without an explicit interest rate [PowerPoint 11-35, 36, 37, 38, 39, 40] A company offers to pay $1 million to purchase a patent, but not until 5 years have passed. The purchase is made now but payment is delayed. The contract to buy this patent requires payment of $1 million after 5 years. Interest is not mentioned. Assume that a 10 percent interest rate is appropriate. Using the table, a factor of .62092 is found for a 10 percent interest rate for 5 years. (See Teaching Tip 5.1.1) Principal Principal Principal
= Factor × Payment = .62092 × $1,000,000 = $620,920
Interest Expense, Year 1 Interest Expense, Year 1 Interest Expense, Year 1
= Principal × Interest Rate = $620,920 × 10% = $62,092
Record the note payable and interest expense for year 1.
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Present Value—Acquisition of Patent with Future Payment of Cash and Recognition of Year One Interest 1/1/1
12/31/1
Patent Notes Payable
620,920
Interest Expense Notes Payable
62,092
620,920
62,092
Because interest was recognized in Year One but not paid, the amount of the liability (the principal) has grown. Increasing a debt to reflect the accrual of interest is referred to as “compounding.” Whenever interest is recognized but not paid, it is compounded, which means that it is added to the principal of the liability. In the second year, the expense to be recognized is higher because the principal has increased from $620,920 to $683,012 ($620,920 plus $62,092) as a result of compounding the Year One interest. The ongoing compounding raises the principal each year so that the expense also increases. Interest Expense, Year 2 = (Principal + Prior years’ interest) × Interest Rate Interest Expense, Year 2 = ($620,920 + $62,092) × 10% Interest Expense, Year 2 = $68,301 Present Value—Recognition and Compounding of Interest 12/31/2
12/31/3
12/31/4
12/31/5
12/31/5
Interest Expense Notes Payable
68,301
Interest Expense Notes Payable
75,131
Interest Expense Notes Payable
82,644
Interest Expense Notes Payable
90,912
Notes Payable Cash
68,301
75,131
82,644
90,912 1,000,000 1,000,000
5.1.3—Have students work through an example of delayed payment without an explicit interest rate, either individually or in teams [PowerPoint 11-41, 42, 43]
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mentioned. Assume that a 5 percent interest rate is appropriate. Using the table, a factor of .86384 is found for a 5 percent interest rate for 3 years. Principal Principal Principal
= Factor × Payment = .86384 × $100,000 = $86,384
Interest Expense, Year 1 Interest Expense, Year 1 Interest Expense, Year 1 1/1/1
12/31/1
12/31/2
12/31/3
12/31/3
= Principal × Interest Rate = $86,384 × 5% = $4,319
Trademark Notes Payable
86,384
Interest Expense Notes Payable
4,319
Interest Expense Notes Payable
4,535
Interest Expense Notes Payable
4,762
Notes Payable Cash
86,384
4,319
4,535
4,762 100,000 100,000
Record the acquisition of trademark, adjusting entry to recognize interest expense for all years and payment of notes payable.
5.2— The Present Value of Cash Flows Paid as an Annuity [PowerPoint 11-44]
Assume a company acquires a copyright from an artist by paying a certain amount on January 1, Year One, and agreeing to pay that same amount at the beginning of each subsequent year until January 1, Year Five. No separate interest is paid. Cash is conveyed over an extended period of time in this purchase. However, a reasonable rate of interest is not being explicitly paid to compensate for the delay in payments. Once again, accounting believes that interest exists within the cash amounts. A present value computation is necessary to pull out the appropriate amount of interest and leave just the cost of the newly-acquired asset. Cash is not conveyed as a single amount but rather as an annuity—an equal amount paid at equal time intervals. An annuity can be either an ordinary annuity, with payments made at the end of each period, or an annuity due, with payments starting immediately at the beginning of each period.
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5.2.1—Teaching Tip: Using Present Value Tables Here, it might be a good idea to pull up a copy of a Present Value of an Annuity Due table for the students to see. It can be used to find the PV factor in the two example problems. Present value tables are also available online or the link from the chapter can be used. Those who choose to may also want to demonstrate to students how to find a present value of an annuity on Excel. It may also be beneficial for students to see a Present Value of an Ordinary Annuity table. 5.2.2—Work through an example of recording a series of equal payments without an explicit interest rate [PowerPoint 11-45, 46, 47, 48, 49] A company acquires a copyright from an artist by paying $10,000 on January 1, Year One, and agreeing to pay an additional $10,000 at the beginning of each subsequent year until January 1, Year Five. No separate interest is paid. Assume an interest rate of 12 percent per year is appropriate. The present value of a $1 per year annuity due for five periods is 4.03735. (This factor can be used to demonstrate in Teaching Tip 5.2.1.) Record all journal entries for the first 2 years. Acquisition of Intangible Asset—Present Value of an Annuity Due 1/1/1
Copyright Cash Notes Payable
40,374 10,000 30,374
At the end of the first year, amortization of the cost of the copyright must be recognized along with interest expense on the liability. Assuming a life of 10 years and no residual value, annual amortization is $40,374 divided by ten years or $4,037. Interest for the period is the $30,374 principal of the liability times the 12 percent reasonable rate or $3,645 (rounded). Intangible Asset—Recognition of Interest and Amortization for Year One 12/31/1
Interest Expense Notes Payable
3,645
Amortization Expense Copyright
4,037
3,645
4,037
Second Payment for Copyright—Start of Year Two
1/1/2
Notes Payable Cash
10,000
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Computation of Liability Principal at End of Year Two Liability Principal—January 1, Year Two ($30,374 plus Year One interest of $3,645) Payment on January 1, Year Two Liability Principal—December 31, Year Two
$34,019 (10,000) $24,019
Intangible Asset—Recognition of Interest and Amortization for Year Two 12/31/2
Interest Expense Notes Payable
2,882
Amortization Expense Copyright
4,037
2,882
4,037
5.2.3—Have students work through an example of recording a series of equal payments without an explicit interest rate, either individually or in teams [PowerPoint 11-50, 51, 52] Kansas Corporation acquires a patent from an inventor by paying $20,000 on January 1, Year One, and agreeing to pay an additional $20,000 at the beginning of each subsequent year with the final payment on January 1, Year Three. No separate interest is paid. Assume an interest rate of 10 percent is appropriate. The present value of a $1 per year annuity due for three periods is 2.73554. Record the journal entries for all 3 years. Assume the patent has a life of 10 years with no residual value.
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1/1/1
12/31/1
1/1/2
12/31/2
1/1/3
12/31/3
Patent Cash Notes Payable
54,711
Interest Expense Notes Payable
3,471
Amortization Expense Patent
5,471
Note Payable Cash
20,000
Interest Expense Notes Payable
1,818
Amortization Expense Patent
5,471
Note Payable Cash
20,000
Amortization Expense Patent
5,471
20,000 34,711
3,471
5,417
20,000
1,818
5,417
20,000
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CHAPTER 12 In a Set of Financial Statements, What Information Is Conveyed about Equity Investments? 1. ACCOUNTING FOR INVESTMENTS IN TRADING SECURITIES 1. Realize that the financial reporting of investments in the ownership shares of another company depends on the purpose of the acquisition. 2. Explain the characteristics of investments that are classified as trading securities. 3. Account for changes in the value of investments in trading securities and understand the rationale for this handling. 4. Record dividends received from investments that are classified as trading securities. 5. Determine the gain or loss to be recorded on the sale of a trading security. 1.1—The Reasons Why One Company Buys Ownership Shares of Another [PowerPoint 12-4,5] Potentially, many benefits can accrue from obtaining shares of the capital stock issued by another business. Interestingly, the specific method of financial reporting depends on the owner’s purpose for holding such investments. In contrast, the accounting process used to report the ownership of stock in another company falls within one of several methods based solely on the reason for the investment. Company officials seek greater profit by using surplus money to buy the ownership shares of other organizations. The hope is that the market price of these shares will appreciate in value and/or dividends will be received before the cash is needed for operations. When equity shares are bought solely as a way to store cash and increase profits, the investor has no desire to influence or control the decisions of the other company. That is not the reason for the purchase; the ownership interest is much too small. Investors, though, may also embrace a strategy of acquiring enough shares to gain some ©2012 Flat World Knowledge, Inc.
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degree of influence over the other organization. Often, profitable synergies can be developed by having two companies connected in this way. Finally the investor may seek to obtain a controlling interest in the other company (in U.S. GAAP that is viewed as being over 50 percent of the outstanding capital stock). In many cases, the parent company chooses to buy 100 percent ownership of the other business to gain complete control. Such acquisitions are common as large companies attempt to (a) move into new industries or geographical areas, (b) become bigger players in their current markets, (c) gain access to valuable assets, or (d) eliminate competitors.
1.2—Trading Securities [PowerPoint 12-6] If management intends to sell the equity shares of another company shortly after buying them, the purchase is classified on the balance sheet as an investment in trading securities. On the acquisition date, the asset is recorded by the purchasing company at historical cost. 1.2.1—Work through an example of recording transactions for a trading security [PowerPoint 12-7, 8] Note: This problem will be used to illustrate each step in accounting for trading securities and then a comprehensive review problem will appear at the end of the section. Valente Corporation is holding $25,000 in cash that it will not need for several weeks. In hopes of generating a profit, the president of Valente has studied the financial statements of Bayless Corporation, a company with capital stock trading on the New York Stock Exchange for $25 per share. On November 30, Year One, Valente uses $25,000 to acquire 1,000 shares of stock in Bayless that will be held for only a few weeks or months. Prepare a journal entry to record this purchase. Purchase of Ownership Shares Classified as Trading Securities Investment in Trading Securities 25,000 Cash 25,000 1.2.2—Cash Dividend [PowerPoint 12-9] As an owner, even if the shares are only held for a short time, a company might receive a cash dividend from its trading security. Many companies distribute dividends to their stockholders periodically as a way of sharing a portion of any income that has been earned. 1.2.3—Work through an example of recording transactions for a trading security [PowerPoint 12-10, 11] Assume that Bayless has been profitable and, as a result, a $.20 per share cash dividend is declared by its board of directors and paid in December, Year One.
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Prepare a journal entry to record receipt of dividend from investment in stock. Receipt of Dividend from Investment in Stock Cash 200 Dividend Revenue 200
1.3—The Value of Trading Securities at Year’s End [PowerPoint 12-12] U.S. GAAP requires investments in trading securities to be reported on the owner’s balance sheet at fair value. Therefore, the reporting company must record a gain on the date the financial statements are prepared. The gain is labeled as “unrealized” to indicate that the value of the asset has appreciated but no final sale has yet taken place. Therefore the gain is not guaranteed; the value might go back down before the shares are sold. However, the unrealized gain is reported on the owner’s Year One income statement, so that the net income is affected. 1.3.1—Work through an example of recording transactions for a trading security [PowerPoint 12-13] The shares of Bayless are worth $28,000 at December 31, Year One. Prepare a journal entry to record any unrealized gain or loss. Shares of Bayless Adjusted to Fair Value at End of Year Investment in Trading Securities 3,000 Unrealized Gain—Trading Securities 3,000
1.4—Reporting Trading Securities at Fair Value [PowerPoint 12-14] Changes in the value of trading securities are recognized and the resulting gains or losses are included within current net income for several reasons: • Shares sell on a stock exchange and, thus, their reported value can be objectively determined. • The stock can be sold immediately; the owner does not even have to find a buyer. • As a trading security, a sale is anticipated in the near term.
1.5—The Sale of a Trading Security [PowerPoint 12-15] Following the fair value adjustments, the investments are recorded in the general ledger at their fair value rather than historical cost. When eventually sold, any difference between the sales price and its carrying amount is recorded as a gain or a loss on the income statement.
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1.5.1—Work through an example of recording transactions for a trading security [PowerPoint 12-16] The Bayless shares are subsequently sold by Valente on February 3, Year Two, for $27,000. Sale of Shares of Bayless for $27,000 in Year Two Cash 27,000 Loss on Sale of Trading Investment 1,000 Investment in Trading Securities
28,000
1.5.2—Have students work through an example of recording transactions for a trading security, either individually or in teams [PowerPoint 12-17, 18, 19]
On October 4, 2016, Olive Corporation purchased 500 shares of Bluto Company when Bluto was selling for $5 per share. Olive plans to hold this stock for a short time and sell it for a profit. Prepare journal entries for the following transactions: 1) The purchase of 500 shares of Bluto Company. 2) On December 31, 2016, Bluto was selling for $3 per share. 3) On January 15, 2017, Bluto paid a dividend of $.25 per share. 4) On March 22, 2017, Olive sold all its shares in Bluto for $6 per share. Solution: 1) The purchase of 500 shares of Bluto Company Investment in Trading Securities Cash
2,500
2) On December 31, 2016, Bluto was selling for $3 per share Unrealized Loss—Trading 1,000 Securities Investment in Trading Securities
2,500
1,000
3) On January 15, 2017, Bluto paid a dividend of $.25 per share Cash 1 25 Dividend Revenue 1 25 4) On March 22, 2017, Olive sold all its shares in Bluto for $6 per share Cash 3,000
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Investment in Trading Securities Gain on Sale of Trading Securities
1,500 1,500
2. ACCOUNTING FOR INVESTMENTS IN SECURITIES THAT ARE CLASSIFIED AS AVAILABLE-FOR-SALE 1. Identify the types of investments classified as availablefor-sale. 2. Record the receipt of dividends from an investment that is viewed as available-for-sale. 3. Explain the financial reporting of changes in the fair value of investments in available-for-sale securities. 4. Calculate the gain or loss to be reported when availablefor-sale securities are eventually sold. 5. Understand the need for reporting comprehensive income as well as net income. 6. Explain the adjustment made to net income in order to arrive at comprehensive income. 2.1—Reporting Available-For-Sale Investments [PowerPoint 12-22]
Not all investments in stock are bought for quick sale. Although the stock could be sold at any time, an investor may believe that the investment might well be retained for years. Because the owner’s intention is to retain these shares for an indefinite period, they will be classified on the company’s balance sheet as an investment in available-for-sale securities rather than as trading securities. Despite the difference in the plan for holding these shares, they are—once again—recorded at historical cost when acquired. The receipt of the dividend is also reported in the same manner as before with the dividend revenue increasing the owner’s net income. No difference is created between the accounting for trading securities and accounting for available-for-sale securities as a result of a dividend. The difference in reporting between trading securities and available-for-sale securities begins at the end of the year. U.S. GAAP requires available-for-sale investments to be included on the investor’s balance sheet at fair value (in the same manner as trading securities). 2.1.1—Work through an example of recording transactions for an available-for-sale security [PowerPoint 12-23, 24] Note: This problem will be used to illustrate each step in accounting for trading securities and then a comprehensive review problem will appear at the end of
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the section. Valente Corporation buys 1,000 shares of Bayless Corporation for $25 in Year One but does not anticipate selling the investment in the near term. Company officials intend to hold these shares for the foreseeable future until the money is clearly needed. Although the stock could be sold at any time, the president of Valente believes this investment might well be retained for years. During Year One, a $200 cash dividend is received from the Bayless shares. Prepare journal entries to record these transactions. Purchase of Ownership Shares Classified as Available-for-Sale Securities Investment in Available-for-sale Securities 25,000 Cash 25,000 Receipt of Dividend from Investment in Stock Cash Dividend Revenue
200 200
2.2—Accumulated Other Comprehensive Income [PowerPoint 12-25] When no sale is anticipated in the near term, the fair value of available-for-sale shares will possibly go up and down numerous times before being sold. Hence, the current gain is not viewed as “sure enough.” As a result of this uncertainty, a change in the owner’s reported net income is not considered appropriate. Instead, any unrealized gain (or loss) in the value of an investment that is classified as available-for-sale is reported within the stockholders’ equity section of the balance sheet. The figure is listed either just above or below the Retained Earnings account. A few other unrealized gains and losses are handled in this manner and are combined and reported as “accumulated other comprehensive income.” Interestingly, in 2007, FASB passed a rule that allows companies to elect to report available-for-sale investments as trading securities. This option must be selected when the investment is purchased.
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2.2.1—Work through an example of recording transactions for an available-for-sale security [PowerPoint 12-26, 27] The shares of Bayless are worth $28,000 at December 31, Year One. Prepare a journal entry to record any unrealized gain or loss. Shares of Bayless (an Available-for-Sale Security) Adjusted to Fair Value at End of Year Investment in Available-for-Sale-Securities 3,000 Unrealized Gain on Available-for-Sale-Securities 3000 Stockholders’ Equity Including Accumulated Other Accumulated Comprehensive Income Contributed Capital (or Capital Stock) Retained Earnings Accumulated Other Comprehensive Income: Unrealized Gain on Available-for-Sale Securities
XXX XXX $3,000
2.3—The Sale of Available-For-Sale Securities [PowerPoint 12-28] When available-for-sale securities are sold, the difference between the original cost and the selling price appears as a realized gain (or loss) on the owner’s income statement. Because no change in net income was reported in the previous year, the entire amount has to be recognized at the date of sale. When the investment is sold, both the asset and the unrealized gain reported in stockholders’ equity section must be removed. 2.3.1—Work through an example of recording transactions for an available-for-sale security [PowerPoint 12-29] The Bayless shares are subsequently sold by Valente on February 3, Year Two, for $27,000. Sale of Available-for-Sale Security in Year Two Cash Unrealized Gain on Available-for-Sale Securities Investment in Available-for-Sale Securities Gain on Sale of Available-for-Sale Securities
27,000 3,000 28,000 2,000
2.4—The Reporting of Comprehensive Income [PowerPoint 12-30] Changes in the value of available-for-sale securities create unrealized gains or losses that appear in the stockholders’ equity section of the balance sheet but not in net income. The completeness of reported net income in such situations can be questioned. To help
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decision makers better evaluate reporting companies with such unrealized items, a second income figure is presented that does include these gains or losses. The resulting balance, known as comprehensive income, is shown within a company’s financial statements. Comprehensive income includes all changes in stockholders’ equity other than (a) amounts contributed by stockholders and (b) dividend distributions made to stockholders. Unrealized gains and losses on available-for-sale securities are common but several other unrealized gains and losses are also included in moving from net income to comprehensive income.
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2.4.1—Work through an example of recording transactions for an available-for-sale security [PowerPoint 12-31] Valente earned net income of $80,000 during the year. Determine Valente’s comprehensive income. Net income Unrealized gain in available-for-sale securities Comprehensive income
$80,000 3,000 $83,000
2.4.2—Have students work through an example of recording transactions for an available-for-sale security, either individually or in teams [PowerPoint 12-32, 33, 34, 35] On October 4, 2016, Olive Corporation purchased 500 shares of Bluto Company when Bluto was selling for $5 per share. Olive plans to hold this stock indefinitely. Record journal entries for the following transactions: 1) The purchase of 500 shares of Bluto Company. 2) On December 31, 2016, Bluto was selling for $3 per share. 3) Determine Olive’s comprehensive income for 2016 assuming that its net income was $30,000. 4) On January 15, 2017, Bluto paid a dividend of $.25 per share. 5) On March 22, 2017, Olive sold all its shares in Bluto for $6 per share. Solution: 1) The purchase of 500 shares of Bluto Company Investment in Available-for-Sale Securities Cash
2,500
2) On December 31, 2016, Bluto was selling for $3 per share Unrealized Loss—Available-for-Sale Securities 1,000 Investment in Available-for-Sale Securities
2,500
1,000
3) Determine Olive’s comprehensive income for 2016 assuming that its net income was $30,000 Net income $30,000 Unrealized loss in available-for-sale securities (1,000) Comprehensive income $29,000
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4) On January 15, 2017, Bluto paid a dividend of $.25 per share Cash 125 Dividend Revenue
125
5) On March 22, 2017, Olive sold all its shares in Bluto for $6 per share Cash 3,000 Investment in Available-for-Sale Securities 1,500 Gain on Sale of Available-for-Sale Securities 500 Unrealized Loss − Available-for-Sale Securities 1,000
3. ACCOUNTING FOR INVESTMENTS BY MEANS OF THE EQUITY METHOD 1. Describe the theoretical criterion for applying the equity method to an investment in stock and explain the practical standard that is often used. 2. Compute the amount of income to be recognized when using the equity method and make the journal entry for its recording. 3. Understand the handling of dividends that are received when the equity method is applied and make the journal entry. 4. Indicate the impact that a change in fair value has on the reporting of an equity method investment. 5. Prepare the journal entry to record the sale of an equity method security. 3.1— The Need To Apply The Equity Method [PowerPoint 12-38,39] When one company holds a sizable portion of another company, the accounting for the investment as either an available-for-sale or trading security depends on the size of ownership. As the percentage of shares being held grows, the investor gradually moves from having little or no authority over the investee to a position where significant influence can be exerted. At that point, for financial reporting purposes, the investment no longer qualifies as a trading security or an available-for-sale security. Instead, the shares are reported by means of the equity method. The owner’s rationale for holding the investment has changed. The equity method is applied when the investor has the ability to apply significant influence to the operating and financing decisions of the investee. Unfortunately, the precise point at which one company gains that ability is impossible to ascertain. A bright line distinction simply does not exist. Although certain clues such as membership on the board of directors and the comparative size of other ownership interests can be helpful, ©2012 Flat World Knowledge, Inc.
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the degree of influence is a nebulous criterion. When a question arises as to whether the ability to apply significant influence exists, the percentage of ownership can be used to provide an arbitrary standard. According to U.S. GAAP, unless signs of significant influence are present, an investor owning less than 20 percent of the outstanding shares of another company reports the investment as either a trading security or available-for-sale security. In contrast, an investor holding 20 percent or more but less than or equal to 50 percent of the shares of another company is assumed to possess the ability to exert significant influence. Consequently, unless evidence is present that significant influence does not exist, the equity method is applied by the investor to report all investments in this 20-50 percent range of ownership.
3.2— The Reporting Of Investments When Applying The Equity Method [PowerPoint 12-40] When applying the equity method, the investor does not wait until dividends are received to recognize profit from its investment. Because of the close relationship between the two companies, the investor reports income as it is earned by the investee. The investor also increases its investment account by the same amount to reflect the growth in the size of the investee company. Because income is recognized by the investor as earned by the investee, it cannot be reported again when a subsequent dividend is collected. That would double-count the impact. Eventual payment of a dividend actually shrinks the size of the investee company because it has less assets. To reflect the change in size, the investor decreases the investment account when a dividend is received if the equity method is applied. Because of the fair value option, companies are also allowed to report equity investments as if they were trading securities. However, few investors seem to have opted to make this election. If chosen, the investment is reported at fair value despite the degree of ownership with gains and losses in the change of fair value reported within net income. 3.2.1—Work through an example of recording transactions for an equity method security [PowerPoint 12-41, 42, 43] Big Company buys 40 percent of the outstanding stock of Little Company on January 1, Year One, for $900,000. No evidence is present to indicate that Big lacks the ability to exert significant influence over the financing and operating decisions of Little. Thus, application of the equity method is appropriate. During Year One, Little reports net income of $200,000 and distribute a total cash dividend to its stockholders of $30,000. Prepare all necessary journal entries for Year One. Also determine the ending balance in investment account appearing on Big’s balance sheet. Acquisition of Shares of Little to Be Reported Using the Equity Method Investment in Little 900,000 Cash 900,000 ©2012 Flat World Knowledge, Inc.
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Income of Investee Recognized by Investor Using the Equity Method Investment in Little 80,000 Investment Income—Little 80,000 Dividend Received from Investment Accounted for by the Equity Method Cash 12,000 Investment in Little 12,000 At the end of Year One, the Investment account appearing on Big’s balance sheet reports a total of $968,000 ($900,000 + 80,000 ‒ 12,000). This balance does not reflect fair value as was appropriate with investments in trading securities and available-for-sale securities. Unless impaired, fair value is ignored in reporting an equity method investment. The reported amount also does not disclose historical cost. Rather, the asset figure determined under the equity method is an unusual mixture. It is the original cost of the shares plus the investor’s share of the investee’s subsequent income less any dividends received since the date of acquisition. Under the equity method, the investment balance is a conglomerate of amounts. 3.2.2—Have students work through an example of recording transactions for an equity method security, either individually or in teams [PowerPoint 12-44,45, 46] Trefold Corporation is looking to enter into a new market. It purchases 30 percent of the stock of Jamora Company on January 1, 2019 for $350,000. This investment qualifies as an equity method security. During 2019, Jamora earns net income of $90,000 and pays dividends of $20,000. Prepare all necessary journal entries for Year One. Also determine the ending balance in Investment account appearing on Trefold’s balance sheet. Acquisition of Shares of Jamora to Be Reported Using the Equity Method Investment in Jamora 350,000 Cash 350,000 Income of Investee Recognized by Investor Using the Equity Method Investment in Jamora 27,000 Investment Income—Jamora 27,000 Dividend Received from Investment Accounted for by the Equity Method Cash 6,000 Investment in Jamora 6,000
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Ending balance in investment account appearing on Big’s balance sheet Investment in Jamora 350,000
6,000
27,000 371,000
3.3— Selling An Investment Reported By Means Of The Equity Method [PowerPoint 12-47] Any investment reported using the equity method quickly moves away from historical cost as income is earned and dividends received. If the shares are sold for more than their carrying value, a gain on the sale is recognized. If they are sold for less than their carrying value, a loss is recognized. 3.3.1—Work through an example of recording transactions for an equity method security [PowerPoint 12-48] Big sells all of its shares in Little for $950,000. This can be recorded as: Sale of Investment Reported Using the Equity Method Cash 950,000 Loss on Sale of Equity Method Securities 18,000 Investment in Little
968,000
3.3.2—Have students work through an example of recording transactions for an equity method security, either in teams or individually [PowerPoint 12-50] Trefold sells all of its shares in Jamora for $380,000. This can be recorded as: Sale of Investment Reported Using the Equity Method Cash 380,00 Investment in Jamora Gain on Sale of Equity Method Securities
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4. REPORTING CONSOLIDATED FINANCIAL STATEMENTS 1. List various reasons for one company to seek to gain control over another. 2. Recognize that consolidated financial statements must be prepared if one company has control over another which is normally assumed at the point when ownership is over 50 percent of the other company’s outstanding stock. 3. Explain the reporting of a subsidiary’s revenues and expenses when consolidated financial statements are prepared at the date of acquisition. 4. Explain the reporting of a subsidiary’s assets and liabilities when consolidated financial statements are prepared at the date of acquisition. 4.1— Accounting For Mergers And Acquisitions [PowerPoint 12-52, 53, 54]
For external reporting purposes, consolidated financial statements are required. The parent company does not report an investment in its subsidiary account on its balance sheet as with the other accounting methods described above. Instead, the individual account balances from each organization are put together in a prescribed fashion to represent the single economic entity that has been created. In simple terms, the assets, liabilities, revenues, and expenses of the subsidiary are consolidated with those of the parent to reflect the united business. Subsidiary revenues and expenses: The revenues and expenses reported by each subsidiary are included in consolidated figures, but only for the period of time after control is obtained. Subsidiary assets and liabilities: On the date of the takeover, a total acquisition price is determined based on the fair value surrendered by the parent to gain control. A search is then made to identify all of the individual assets and liabilities held by the subsidiary at that time. The parent recognizes subsidiary assets (a) that provide contractual or legal rights or (b) that can be separated from the subsidiary and then sold. Fair value is established and recorded for each of these assets as if the parent were acquiring them individually. Also, if the acquisition price is more than the total fair value of these identifiable assets and liabilities, the intangible asset goodwill is reported for the excess. As a going concern, a total value is usually attributed to a company that exceeds the individual values of its assets and liabilities. ©2012 Flat World Knowledge, Inc.
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4.2—Consolidation of Financial Information [PowerPoint 12-55, 56, 57] Giant wishes to purchase 100% of the stock of Tiny Company. Tiny has earned revenues of $800,000 and incurred expenses of $500,000 during the year to date. In addition, the company reports a single asset, land costing $400,000 but with a $720,000 fair value. The only liability is a $300,000 note payable. Thus, the company’s net book value is $100,000. Tiny also owns the rights to a well-known trademark which has no book value, but is now estimated to be worth $210,000. The assets and liabilities held by Tiny have a net fair value of $630,000.Because the company has been extremely popular and developed a large customer base, Giant agrees to pay $900,000 to acquire all of the outstanding stock. How will these items be reported? At the date of acquisition, revenues and expenses of Tiny are not included in the consolidated statements. Tiny’s land is added to Giant’s own totals at its fair value of $720,000. Tiny’s trademark is consolidated at its fair value of $210,000. Tiny’s note payable is included in the consolidated figure at $300,000. Acquisition price Net fair value of Tiny Goodwill
$900,000 (630,000) $270,000
4.3— Analyzing a Company’s Use of It’s Assets [PowerPoint 12-58] A company controls a specific amount of assets. Investors and other decision makers are interested in knowing how effectively management is able to make use of these resources. Individuals who study specific companies search for signs that an appropriate level of income was generated from the assets on hand. Total asset turnover: Total asset turnover indicates management’s efficiency at generating sales revenue. Sales must occur before profits can be earned from normal operations. If assets are not well used to create sales, profits are unlikely to arise. Total Asset Turnover =
Sales Revenue Average Total Assets
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4.3.1—Work through an example of calculating total asset turnover [PowerPoint 12-59, 60]
Following is the information reported by PepsiCo, Inc for the year 2010. Based on these figures, compute the total asset turnover for Pepsi. Total Assets Beginning of Year End of Year Average for Year Net Sales Revenue Net Income
$39.8 billion $68.2 billion $54.0 billion $57.8 billion $ 6.3 billion
Total Asset Turnover for Pepsi = $57.8 billion/$54.0 billion Total Asset Turnover for Pepsi = 1.07 times 4.3.2—Have students work through an example of calculating total asset turnover, either individually or in teams [PowerPoint 12-61, 62] Following is the information reported by The Coca-Cola Company for the year 2013. Based on these figures, compute the total asset turnover for Coca-Cola. Total Assets Beginning of Year End of Year Average for Year Net Sales Revenue Net Income
$48.7 billion $72.9 billion $60.8 billion $35.1 billion $11.8 billion
Total Asset Turnover for Coca-Cola = $35.1 billion/$60.8 billion Total Asset Turnover for Coca-Cola = 0.58 times Return on assets: ROA is net income divided by average total assets and is viewed by many as an appropriate means of measuring management’s efficiency in using company resources. Return on Assets (ROA) = Net Income/Average Total Assets 4.3.3—Work through an example of calculating return on assets [PowerPoint 12-64]
Refer to the information reported by PepsiCo, Inc for the year 2010. Based on these figures , compute the ROA for Pepsi. ROA = $6.3 billion/$54.0 billion ROA = 11.7%
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4.3.4—Have students work through an example of calculating return on assets, either individually or in teams [PowerPoint 12-65] Refer to the information reported for 2010 by The Coca-Cola Company. Based on this information, compute the ROA for Coca-Cola. ROA = $11.8 billion/$60.8 billion ROA = 19.4%
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CHAPTER 13 In a Set of Financial Statements, What Information Is Conveyed about Current and Contingent Liabilities? 1. The BASIC REPORTING OF LIABILITIES 1. Define a “liability” by listing its essential characteristics. 2. Differentiate a current liability from a noncurrent liability. 3. Explain the significance that current liabilities have for investors and creditors who are studying the financial health and future prospects of an organization. 4. Compute the current ratio. 5. Identify the appropriate timing for the recognition of a liability. 1.1— Current and Noncurrent Liabilities [PowerPoint 13-3] A liability is an obligation owed to a party outside of the reporting organization—a debt that can be stated in monetary terms. Liabilities normally require the payment of cash but might at times be settled by the conveyance of other assets or the delivery of services. The distinction between current and noncurrent liabilities is a function of time. A debt that is expected to be satisfied within one year from the balance sheet date is normally classified as a current liability. Amounts owed for rent, insurance, utilities, inventory purchases, and the like usually fall into this category. If payment will not be made until after that one-year interval, the liability is reported as noncurrent. Bonds and notes payable are common examples of noncurrent debts as are liabilities for employee pensions, long-term leases, and deferred income taxes. Current liabilities are listed before noncurrent liabilities on a balance sheet.
1.2— The Importance of Information about Liabilities [PowerPoint 134]
Liabilities represent claims to a company’s assets. Debts must be paid as they come due or the entity risks serious consequences. Missed payments might damage a company’s ability to obtain additional credit in the future. Unfortunately, even bankruptcy can quickly become a possibility if obligations are not met. To stay viable, organizations have to manage their liabilities carefully. They must be able to generate sufficient cash on an ongoing basis to meet all required payments. In general, the larger a liability total is in comparison to the reported amount of assets, the ©2012 Flat World Knowledge, Inc.
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riskier the financial position. The amount reported as current liabilities is especially significant because those debts must be satisfied in the near future. Decision makers become concerned when the reported total for current liabilities is high in comparison with current assets because the organization might not be able to meet those obligations as they come due. As mentioned in an earlier chapter, one vital sign monitored by decision makers in judging the present level of risk posed by a company’s liability requirements is the current ratio: current assets divided by current liabilities. The current ratio is a simple benchmark that can be easily computed using available balance sheet information. Although many theories exist as to an appropriate standard, any current ratio below 1.00 to 1.00 signals that the company’s current liabilities exceed its current assets.
1.3— Characteristics of a Liability [PowerPoint 13-5] FASB Statement of Financial Accounting Concepts No. 6 defines many of the elements found in a set of financial statements. According to this guideline, a liability should be recognized when all of the following characteristics exist: a) there is a probable future sacrifice b) the sacrifice involves the reporting entity’s assets or services c) the sacrifice arises from a present obligation resulting from on past event or transaction. Often, in deciding whether a liability should be recognized, the accountant must address two key questions: what event actually obligates the company and when did that event occur?
2. REPORTING CURRENT LIABILITIES SUCH AS GIFT CARDS 1. Define and record “accrued liabilities.” 2. Report the sale and redemption of gift cards. 3. Account for gift cards that are not expected to be redeemed. 2.1— Recognizing all of a Company’s Current Liabilities [PowerPoint 13-7, 8, 9]
As discussed in a previous chapter, the timing for the recognition of a purchase is guided by the FOB point specified by the seller or negotiated by the parties. If marked “FOB shipping point,” the liability is reported by the buyer when the goods leave the seller’s place of business. “FOB destination” delays recording until the merchandise is received by the buyer. Many other liabilities are not created by a specific event but rather grow gradually day by ©2012 Flat World Knowledge, Inc.
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day. Interest and rent are common examples but salaries, payroll taxes, and utilities also accrue in the same manner. They increase based on the passage of time. Interest on a loan or the amount due an employee gets larger on a continual basis until paid. Adjusting entries are required at the end of a period to recognize any accrued liabilities that have been omitted from the general ledger. Example 1: A large group of employees earns total wages of $10,000 per day. They work Monday through Friday with payment made on the final day of each week. If the company’s fiscal year ends on a Wednesday, an adjustment is necessary so that both the expense on the income statement and the liability on the balance sheet are both presented fairly for the three days that have passed without payment, Year-end Adjusting Entry to Recognize Debt to Employees for Three Days’ Work Wages Expense 30,000 Wages Payable 30,000 Example 2: A company borrows $100,000 from a bank on December 1 with payment to be made in six months. The bank has to earn a profit and charges 6 percent annual interest rate. Make the necessary adjusting entry. Year-end Adjusting Entry to Recognize Interest for One Month Interest Expense 500 Interest Payable 500
2.2— Reporting the Sale of Gift Cards as a Liability [PowerPoint 13-10] A liability represents a probable future sacrifice of an asset or service. By selling a gift card, a company has created an obligation to the customer that must be reported. Businesses such as Best Buy or Barnes & Noble accept cash but then have to be willing to hand over inventory items such as cameras or books whenever the gift card is presented. Or, perhaps, some service is due to the cardholder such as the repair of a computer or a massage. To the seller, a gift card reflects a liability but one that is not normally settled with cash. When a seller sells a gift card, revenue cannot be reported at the time of sale; the earnings process is not yet substantially complete. Instead, a liability (labeled “unearned revenue” or “gift card revenue”) is recognized to indicate that the company has an obligation to the holder of the card. Over time, customers will present their gift cards for selected merchandise. Upon redemption, the liability is satisfied and the revenue is recognized. 2.2.1—Work through an example of recording gift cards [PowerPoint 13-11, 12]
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A company sells 10,000 gift cards with a redemption value of $50 each. Later, a person uses the first $50 card to buy goods which had originally cost the company only $32. Record these transactions assuming a perpetual inventory system is in use. Sale of Ten Thousand $50 Gift Cards for Cash Cash 500,000 Unearned Revenue Redemption of Gift Card Unearned Revenue Revenue Cost of Goods Sold Inventory
500,000
50 50 32 32
2.2.2—Have students work through an example of recording gift cards, either individually or in teams [PowerPoint 13-13, 14] Toys R U sells 25,000 gift cards with a redemption value of $10 each. Later, a person uses the first $10 card to buy a toy which cost the company $6. Record these transactions assuming a perpetual inventory system is in use. Sale of Twenty-five Thousand $10 Gift Cards for Cash Cash 250,000 Unearned Revenue Redemption of Gift Card Unearned Revenue Revenue Cost of Goods Sold Inventory
250,000
10 10 6 6
2.3— Accounting for Gift Cards that are Never Redeemed [PowerPoint 13-15]
One reason that gift cards have become so popular with businesses is that some percentage will never be redeemed. They will be misplaced, stolen or the holder will move away or die. Perhaps the person simply does not want the merchandise that is available. In such cases, the seller received money but never had to fulfill the obligation. The entire amount of cash from the sale of the gift card is profit. For the accountant, a question arises as to the appropriate timing of revenue recognition from such anticipated defaults. The earning process is never substantially completed by a redemption. In theory, a company recognizes this revenue when reasonable evidence exists that the card will never be used by the customer. Practically, though, determining ©2012 Flat World Knowledge, Inc.
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this precise point is a matter of speculation. Companies typically report the revenue from unused gift cards at one of three possible times: 1. When the cards expire if a time limit is imposed. 2. After the passage of a specified period of time, such as 18 months or two years. 3. In proportion to the cards that are actually redeemed.
3. ACCOUNTING FOR CONTINGENCIES 1. Define a “commitment” and explain the method by which it is reported. 2. Define a “contingency” and explain the method by which it is reported. 3. Explain the criteria that guide the reporting of a contingent loss. 4. Describe the appropriate accounting for contingent losses that do not qualify for recognition at the present time. 5. Describe the handling of a contingent loss that ultimately proves to be different from the originally estimated and recorded balance. 6. Compare the reporting of contingent losses and contingent gains. 3.1— Commitments and Contingencies [PowerPoint 13-18, 19, 20, 21] Commitments represent unexecuted contracts. A contract has been created (either orally or in writing) and all parties have agreed to the terms. However, the listed actions have not yet been performed. For example, assume that a business places an order with a truck company for the purchase of a large truck. The business has made a commitment to pay for this new vehicle but only after delivery has been received. Although a cash payment will be required in the future, the specified event (conveyance of the truck) has not occurred. No transaction has taken place; so no journal entry is needed. The liability does not yet exist. Information about such commitments is still of importance to decision makers because future cash payments will be required of the reporting company. However, events have not reached the point where all of the characteristics of a liability are present. Thus, an extensive explanation about commitments (as found in the notes for DuPont) is included in the notes to financial statements but no amounts are reported on either the income statement or the balance sheet.
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A contingency poses a different reporting quandary for the accountant. A past event has already occurred but the amount of the present obligation (if any) cannot yet be determined. With a contingency, the uncertainty is about the ultimate outcome of an action that took place in the past. Because companies prefer to avoid (or at least minimize) the recognition of losses and liabilities, authoritative guidelines are necessary to guide the appropriate reporting of contingencies. According to U.S. GAAP loss contingency is recognized if 1) the loss is deemed to be probable, and 2) the amount of that loss can be reasonably estimated. As soon as both of these criteria are met, the expected impact of the loss contingency must be recorded. Example: Wysocki Corporation commits an act that is detrimental to the environment. The federal government files a lawsuit for damages in Year One. Wysocki officials assess the situation. They believe that a loss is probable and that $800,000 is a reasonable estimation of the amount that will eventually have to be paid as a result of this litigation. Although this balance is only an estimate and the case may not be finalized for some time, the contingent loss is recognized. Year One—Expected Loss from Lawsuit (Contingency) Loss from Lawsuit—Estimated 800,000 Estimated Liability from Lawsuit
800,000
FASB has identified a number of examples of loss contingencies that are evaluated and reported in this same manner including: • Collectability of receivables • Obligations related to product warranties and product defects • Risk of loss or damage of enterprise property by fire, explosion, or other hazards • Threat of expropriation of assets • Pending or threatened litigation • Actual or possible claims and assessments • Guarantees of indebtedness of others
3.2— Accounting Rules Used to Record Contingent Losses [PowerPoint 13-22]
If a contingent loss is only reasonably possible (rather than probable) or if the amount of a probable loss does not lend itself to a reasonable estimation, only disclosure in the notes to the financial statements is necessary rather than actual recognition. Furthermore, a contingency where the chance of loss is viewed as merely remote can be omitted entirely from the financial statements. Unfortunately, as discussed above, official guidance provides little specific detail about ©2012 Flat World Knowledge, Inc.
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what constitutes a probable, reasonably possible, or remote loss. At best, each of those terms seems vague. For example, within U.S. GAAP, “probable” is described as “likely to occur.” Thus, the professional judgment of the accountants and auditors must be relied on to determine the exact point in time when a contingent loss moves from reasonably possible to probable. Not surprisingly, many companies contend that any future adverse effects from loss contingencies are only reasonably possible so that no actual amounts are reported on the balance sheet.
3.3— Fixing an Incorrect Estimate [PowerPoint 13-23, 24, 25] By the time the exact amount of loss is determined, investors and creditors would have already incorporated the original information reported into their decisions including the uncertainty of the outcome. Restating the estimations provided in the past does not allow them to undo and change decisions that were made in the past. Consequently, no alteration is made in the contingent figures reported previously; any additional gain or loss is recorded in the current year. The adjustment is recognized as soon as a better estimation (or final figure) is available. This approach is required to correct any reasonable estimate. Example: Wysocki Corporation recognized an estimated loss of $800,000 in Year One because of a lawsuit involving environmental damage. Assume the case is eventually settled in Year Two for $900,000. How is the additional loss of $100,000 reported? Year Two—Settlement of Lawsuit at an Amount $100,000 More than Originally Reported Estimated Liability from Lawsuit 800,000 Additional Loss on Lawsuit 100,000 Cash 900,000
One important exception to this handling does exist. If the initial estimate is viewed as fraudulent, reported contingency is physically restated. From a journal entry perspective, restatement of a previously reported income statement balance is accomplished by adjusting retained earnings. Revenues and expenses (as well as gains, losses, and any dividend paid figures) are closed into retained earnings at the end of each year. Thus, this account is where the previous year error now resides.
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Upon discovery that the actual loss from this lawsuit is $900,000, this amount is reported by one of the two approaches: Two Ways to Fix an Estimation Original Estimation Was Reasonable, Made in Good Faith Year One Year Two Income Statement Income Statement Loss on Lawsuit $800,000 $100,000
Original Estimation Was Not Made in Good Faith (Restatement Required) Year One Year Two Income Statement Income Statement Loss on Lawsuit $900,000 -0However, use of the second method is rare because accounting mistakes do not often reach this level of deceit or incompetence. An announcement that a company has had to “restate its earnings” is never a good sign.
3.4—Gain Contingencies [PowerPoint 13-26] As a result of the conservatism inherent in financial accounting, the timing used in the recognition of gains does not follow the same rules applied to losses. Losses are anticipated when they become probable; that has long been a fundamental rule of financial reporting. The recognition of gains is delayed until they actually occur (or, at least until they reach the point of being substantially complete). Disclosure in the notes is still important but the decision as to whether the outcome is probable or reasonably possible is irrelevant in reporting a gain. Gains are not anticipated for reporting purposes. Reporting a Gain Contingency Year One Year Two Income Statement Income Statement Gain on Lawsuit -0$900,000
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4. ACCOUNTING FOR PRODUCT WARRANTIES 1. Explain the difference between an embedded and an extended product warranty. 2. Account for the liability and expense incurred by a company that provides customers with an embedded warranty on a purchased product. 3. Account for the amount received on the sale of an extended warranty and any subsequent costs incurred as a result of this warranty. 4. Compute the average age of accounts payable. 4.1—Accounting for Embedded Product Warranties [PowerPoint 1328]
In accounting for warranties, cash rebates, the collectability of receivables and other similar contingencies, the likelihood of loss is rarely an issue. These losses are almost always probable. For the accountant, the challenge is in arriving at a reasonable estimate of that loss. Many companies look at data from previous offers to help determine the amount of the expected loss. However, historical trends cannot be followed blindly. Officials still have to be alert for any changes that could impact previous patterns. 4.1.1—Work through an example of recording embedded warranties [PowerPoint 13-29, 30, 31, 32, 33, 34, 35]
Note: This problem will be used to illustrate each step in accounting for warranties and then a comprehensive review problem will appear at the end of the section. A retail store sells 10,000 compact refrigerators during Year One for $400 cash each. The product is covered by a warranty that extends until the end of Year Three. No claims are made in Year One but similar programs in the past have resulted in repairs having to be made on 3 percent of the refrigerators at an average cost of $90. Estimated costs under warranty = 10,000 units × 3% = 300 claims; 300 claims × $90 each Estimated costs under warranty = $27,000 Although no repairs are made in Year One, the $27,000 is reported in that period. Immediate recognition is appropriate because the loss is both probable and subject to reasonable estimation. In addition, the matching principle states that expenses should be ©2012 Flat World Knowledge, Inc.
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reported in the same period as the revenues they help to generate. Year One—Sale of Ten Thousand Compact Refrigerators for $400 each Cash 4,000,000 Sales of Inventory 4,000,000 Year One—Recognize Expected Cost of Warranty Claims Warranty Expense 27,000 Warranty Payable
27,000
This warranty is in effect until the end of Year Three. Assume that repairs made in the year following the sale (Year Two) cost the company $13,000 but are made for these customers at no charge. When a refrigerator breaks, it is fixed as promised. Because the expense has already been recognized in the year of sale these payments reduce the recorded liability. They actual cost creates no additional impact on net income. Year Two—Payment for Repair Work Covered by Embedded Warranty Warranty Payable 13,000 Cash 13,000 Warranty Payable (end of Year 2) 27,000 13,000 14,000 Because the warranty has not expired, company officials need to evaluate whether this $14,000 liability is still a reasonable estimation of the remaining costs to be incurred. If so, no further adjustment is made. However, the original $27,000 was merely an estimate. More information is now available, some of which might suggest that $14,000 is no longer the best number to be utilized for the final year of the warranty. To illustrate, assume that a flaw has been found in the refrigerator’s design and that $20,000 (rather than $14,000) is now a better estimate of the costs to be incurred in the final year of the warranty. The $14,000 balance is no longer appropriate. December 31, Year Two—Adjust Warranty Liability from $14,000 to Newly Expected $20,000 Warranty Expense 6,000 Warranty Payable 6,000 4.1.2—Have students work through an example of recording embedded warranties, either individually or in teams [PowerPoint 13-36, 37, 38] A retail store sells 8,000 dryers during Year One for $500 cash each. The product is covered by a warranty that extends until the end of Year Three. No claims are made ©2012 Flat World Knowledge, Inc.
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in Year One but similar programs in the past have resulted in repairs having to be made on 5 percent of the dryers at an average cost of $50. No repairs are made in Year One. Record all necessary entries. Estimated costs under warranty = 8,000 units × 5% = 400 claims; 400 claims × $50 each Estimated costs under warranty = $20,000 Cash Sales of Inventory
4,000,000
Warranty Expense Warranty Payable
20,000
4,000,000
20,000
In Year Two, repairs costing $7,000 are made. Record this. Warranty Payable Cash
7,000 7,000
4.2— Accounting for Extended Product Warranties [PowerPoint 13-39] Extended warranties, which are quite popular in many industries, are simply insurance policies. If the customer buys the coverage, the product is insured against breakage or other harm for the specified period of time. The seller hopes that the money received for the extended warranty will outweigh the eventual repair costs. Therefore, the accounting differs here from the process demonstrated previously for an embedded warranty that was provided to encourage the sale of the product. By accepting money for an extended warranty, the seller agrees to provide services in the future. This contract is much like a gift card. The revenue cannot be recognized until the earning process is substantially complete. Thus, the amounts received for an extended warranty are initially recorded as “unearned revenue.” 4.2.1—Work through an example of recording extended warranties [PowerPoint 13-40, 41, 42]
Note: This problem will be used to illustrate each step in accounting for warranties and then a comprehensive review problem will appear at the end of the section. A seller offers an extended 3-year warranty on its televisions for $50. The goods have an embedded 1-year warranty, so the extended warranty covers Years 2 through 4. January 1, Year One—Sale of Extended Warranty Covering Years Two through Four Cash 50 Unearned Revenue 50 ©2012 Flat World Knowledge, Inc.
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Because of the terms specified, this extended warranty does not become active until January 1, Year Two. The television is then covered for a 3-year period. The revenue is recognized, most likely on a straight-line basis, over that time. Consequently, the $50 is reported at the rate of 1/3 per year or $16.66. December 31, Year Two (as well as Three and Four)—Recognition of Revenue from Extended Warranty Unearned Revenue 16.66 Revenue from Extended Warranty 16.66 In any period in which a repair must be made, the expense is recognized as incurred because revenue from this warranty contract is also being reported. For example, assume that on August 8, Year Two, a slight adjustment must be made to the television at a cost of $9. The product is under warranty so the customer is not charged for this service. The Year Two expense shown below is being matched with the Year Two revenue recognized above. August 8, Year Two—Repair of Television under Warranty Contract Warranty Expense 9 Cash 9 4.2.2—Have students work through an example of recording extended warranties, either individually or in teams [PowerPoint 13-43, 44, 45, 46] Crabees’ sells appliances. One particular dishwasher comes with a one-year embedded warranty. Crabees’ sells an extended warranty on the dishwasher for an additional two years at a cost of $100. A customer purchases the dishwashers and the extended warranty. Record the purchase of the extended warranty. Cash
100 Unearned Revenue
100
Assume that Crabees’ recognizes the revenue from the extended warranty using straight-line over the two years. Record the revenue Crabees’ earns in Year 2. Unearned Revenue Revenue from Extended Warranty
50 50
In year 3, the dishwasher is repaired at a cost of $40. Record this. Warranty Expense Cash
40 40
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4.3— Computing the Age of Accounts Payable [PowerPoint 13-47, 48] In studying current liabilities, the number of days a business takes to pay its accounts payable is usually a figure of interest. If a business begins to struggle, the time of payment tends to lengthen because of the difficulty in generating sufficient cash amounts. Therefore, an unexpected jump in this number is often one of the first signs of financial distress and warrants concern. To determine the age of accounts payable (or the number of days in accounts payable), the amount of inventory purchased during the year is first calculated. cost of goods sold = beginning inventory + purchases – ending inventory purchases = cost of goods sold – beginning inventory + ending inventory Using this computed purchases figure, the number of days that a company takes to pay its accounts payable on the average can be determined. Either the average accounts payable for the year can be used or just the ending balance. purchases/365 = average purchases per day accounts payable/average purchases per day = average age of accounts payable 4.3.1—Work through an example of calculating age of accounts payable [PowerPoint 13-49, 50]
The following information comes from the 2010 financial statements for Safeway Inc. Beginning Inventory Ending Inventory Cost of Goods Sold Ending Accounts Payable
$2.509 billion $2.623 billion $29.443 billion $2.533 billion
Determine the age of accounts payable for Safeway. purchases = cost of goods sold – beginning inventory + ending inventory purchases = $29.443 billion – $2.509 billion + $2.623 billion purchases = $29.557 billion purchases/365 $29.557/365 = $80.978 million accounts payable/average daily purchases $2.533 billion/$80.978 million = 31.28 days
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4.3.2—Have students work through an example of calculating age of accounts payable, either individually or in teams [PowerPoint 13-51, 52] Foster Corporation showed the following for 2019: Beginning Inventory $400 Ending Inventory $270 Cost of Goods Sold $3,780 Ending Accounts Payable $280 Determine Foster’s age of accounts payable. purchases = cost of goods sold – beginning inventory + ending inventory purchases = $3,780 – $400 + $270 purchases = $3,650 purchases/365 $3,650/365 = $10 accounts payable/average daily purchases $280/$10 = 28 days
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CHAPTER 14 In a Set of Financial Statements, What Information Is Conveyed about Noncurrent Liabilities Such as Bonds? 1. DEBT FINANCING 1. List and explain the advantages of debt financing. 2. List and explain the disadvantages of debt financing. 3. Describe and illustrate the use of financial leverage. 4. Define “notes” and “bonds” as used in debt financing. 1.1—The Cost and Risk of Debt [PowerPoint 14-3] The most obvious problem with financing an organization through debt is that it has a cost. A bank or other creditor will demand interest in exchange for the use of its money. The rate of interest charged on debt will vary based on economic conditions and the perceived financial health of the debtor. As should be expected, strong companies are able to borrow money at a lower rate than weaker ones. In addition, debt brings risk. A business must be able to generate enough surplus cash to satisfy its creditors as liabilities come due. Those funds might be generated by profitable operations or contributed by investors. Or, a company may simply borrow more money to pay off debts as they mature. The most serious risk associated with debt financing is the possibility of bankruptcy. As has become unfortunate commonplace during the recent economic crisis, organizations that are unable to pay their liabilities can be forced into legal bankruptcy. The end result of bankruptcy is frequently the liquidation of company assets with the distribution of those proceeds to creditors. However, under U.S. law, financial reorganization and continued existence is also a possibility. Given the cost and risk associated with owing large amounts of debt, the desire of decision makers to receive adequate and clear information is understandable. Few areas of financial accounting have been more discussed over the decades than the reporting of noncurrent liabilities.
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1.2— The Benefits of Debt Financing [PowerPoint 14-4] One advantage of borrowing money is that interest expense is tax deductible. A company will essentially recoup a significant portion of all interest costs from the government. Another advantage associated with debt financing is that it can be eliminated. If the economic situation changes, a company can rid itself of all debt by making payments as each balances comes due. In contrast, if money is raised by issuing capital stock, the new shareholders can maintain their ownership indefinitely. However, the biggest advantage commonly linked to debt is the benefit provided by financial leverage. This term refers to an organization’s ability to increase its reported net income by earning more money on borrowed funds than the associated cost of interest. Example: For example, if a company borrows $1 million on a debt that charges interest of 5 percent per year, annual interest is $50,000. If the $1 million that is received can be used to generate profit of $80,000 (added revenue minus added operating expenses), net income has gone up $30,000 ($80,000 minus $50,000) using funds provided solely by creditors.
1.3—Raising Funds by Issuing Notes and Bonds [PowerPoint 14-5] Both notes and bonds are written contracts (often referred to as indentures) that specify the payment of designated amounts of cash by the debtors on stated dates. The term “note” is used when a contract is negotiated directly between two parties. The term “bond” is used to describe a contract or group of contracts created by a debtor and then issued for money, often to members of the general public. Typically, the issuance of debt to multiple parties enables a company to raise extremely large amounts of money. If securities are being issued to the public in this way, the legal rules and regulations of the U.S. Securities and Exchange Commission must be followed which adds another layer of cost to the raising of funds.
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2. THE ISSUANCE OF NOTES AND BONDS 1. Identify common terms found in a note or bond contract such as face value, stated cash interest rate, and various types of security agreements or covenants. 2. Record notes and bonds that are issued at face value where periodic interest payments are made on dates other than the year-end. 3. Explain the handling of notes and bonds that are sold between interest dates and make the journal entries for both the issuance and the first interest payment. 2.1—Debt Contracts [PowerPoint 14-7, 8, 9] The specific terms written into a loan indenture vary considerably depending on what a debtor is willing to promise in hopes of enticing a creditor to turn over needed financial resources. Some of the most common are as follows. Face Value or Maturity Value. The note or bond will specify the amount to be repaid at the end of the contract term. A $1,000 bond, for example, has a face value of $1,000—the payment to be made on a designated maturity date. Payment Pattern. With some debts, no part of the face value is scheduled for repayment until conclusion of the contract period. These loans are often referred to as term notes or term bonds. Other loans, known as serial debts, require many individual payments of the face value to be made periodically over time. Notes and bonds can also be set up to allow the debtor the choice of repaying part or all of the face value prior to the due date. Such debts are referred to as “callable.” Interest Rate. Creditors require the promise of interest before they are willing to risk loaning money to a debtor. Therefore, within the debt contract, a stated cash interest rate is normally included. A loan that is identified as having a $100,000 face value with a stated annual interest rate of 5% informs both parties that $5,000 in interest ($100,000 × 5%) will be conveyed from debtor to creditor each year. Interest Payment Dates. The stated amount of interest is paid at the times identified in the contract. Payments can range from monthly to quarterly to semiannually to annually to the final day of the debt term. Security. Many companies are not able to borrow money (or cannot borrow money without paying a steep rate of interest) unless some additional security is provided for the creditor. Any reduction of risk makes a note or bond instrument more appealing to potential lenders. A debenture is a debt contract that does not contain any security. The ©2012 Flat World Knowledge, Inc.
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debtor is viewed as so financially strong that money can be obtained at a reasonable interest rate without having to add extra security agreements to the contract. Covenants and Other Terms. Notes and bonds can contain an almost infinite list of other agreements. In legal terms, a covenant is a promise to do a certain action or a promise not to do a certain action. Most loan covenant promises made by the debtor to help ensure that adequate money will be available to make required payments when they come due.
2.2—Recording a Note Issued at Face Value 2.2.1—Work through an example of debt that is issued a face value [PowerPoint 14-10, 11, 12, 13]
Note: This problem will be used to illustrate each step in accounting for debt that is issued at face value. Brisbane Company borrows $400,000 in cash from a local bank on May 1, Year One. The face value of this loan is to be repaid in exactly 5 years. In the interim, interest payments at an annual rate of 6% will be made every 6 months beginning on November 1, Year One. May 1, Year One—Cash of $400,000 Borrowed on Long-term Note Payable Cash 400,000 Note Payable 400,000 The first semiannual interest payment will be made on November 1, Year One. Semi-annual interest expense = 6% × $400,000 × 6/12 Semi-annual interest expense = $12,000 November 1, Year One—Payment of Interest for Six Months Interest Expense 12,000 Cash 12,000 By December 31, Year One, when financial statements are to be prepared, interest for two additional months (November and December) has accrued. Accrued interest expense, 11/1-12/31 = 6% × $400,000 × 2/12 Accrued interest expense, 11/1-12/31 = $4,000 December 31, Year One—Accrual of Interest for Two Months Interest Expense 4,000 Interest Payable 4,000
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When the next $12,000 interest payment is made by Brisbane on May 1, Year Two, the recorded $4,000 liability is extinguished and interest for four additional months (January through April) is recognized. Accrued interest expense, 1/1-4/30 = 6% × $400,000 × 4/12 Accrued interest expense, 1/1-4/30 = $8,000 May 1, Year Two—Payment of Interest for Six Months Interest Expense 8,000 Interest Payable 4,000 Cash 12,000 Interest payments and the recording process will continue in this same way until all 5 years have passed and the face value is paid.
2.3—Issuance of Bonds between Interest Dates [PowerPoint 14-14] The issuance of bonds between interest dates is common. Such bonds are normally issued for a stated amount plus accrued interest. The accrued interest is measured from the previous interest payment date to the present and is charged to the buyer. Later, when the first payment is made, the net effect reflects just the time that the bond has been outstanding. 2.3.1—Work through an example of a bond that is issued between issue dates [PowerPoint 14-15, 16, 17] Note: This problem will be used to illustrate each step in accounting for a bond that is issued between interest dates. Brisbane Company plans to issue bonds with a face value of $400,000 to a consortium of 20 wealthy individuals. These bonds pay a 6% annual interest rate with payments every May 1 and November 1. Assume that the creditors buy these bonds on October 1, Year One, for face value plus accrued interest. Because five months have passed since the previous interest date (May 1), interest accrued on the bonds as of the issuance date is $10,000. Thus, the creditors pay $400,000 for the bond and an additional $10,000 for the interest that has accrued to that date. Accrued interest expense, 5/1-10/1 = $400,000 × 6% × 5/12 Accrued interest expense, 5/1-10/1 = $10,000 Issuance of Bond on October 1 at Face Value plus Accrued Interest Recognized for Five Months Cash 410,000 Bonds Payable 400,000 Interest Payable 10,000
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One month later, Brisbane makes the first interest payment of $12,000. However, interest expense of only $2,000 is actually recognized in the entry below. Interest expense, 10/1-10/31 = $400,000 × 6% × 1/12 Interest expense, 10/1-10/31 = $2,000 November 1, Year One—Payment of First Interest Payment Interest Payable 10,000 Interest Expense 2,000 Cash 12,000 After this entry, the recording of interest follows the process demonstrated previously.
3. ACCOUNTING FOR ZERO-COUPON BONDS 1. Identify the characteristics of a zero-coupon bond. 2. Explain how interest is earned by a creditor on a zerocoupon bond. 3. Understand the method of arriving at an effective interest rate for a bond. 4. Calculate the price of a zero-coupon bond and list the variables that affect this computation. 5. Prepare journal entries for a zero-coupon bond using the effective rate method. 6. Explain the term “compounding.” 7. Describe the theoretical problems associated with the straight-line method and identify the situation in which this method can be applied. 3.1— The Issuance of a Zero-Coupon Bond [PowerPoint 14-20] No investor would buy a note or bond that did not pay interest. Because zero-coupon bonds are widely issued, some form of interest must be included. These bonds are sold at a discount below face value with that reduction serving as interest. Often, the actual exchange price for a bond is the result of a serious negotiation process to establish the interest rate to be earned. An investor who wishes to earn a certain annual interest rate can mathematically compute the exact amount to bid for the contract. The debtor could then counter by suggesting a lower rate. After some discussion, the two parties might compromise by settling on a price that provides an annual interest rate somewhere in the middle. After the effective rate (also called the yield or negotiated rate) has been agreed on by both the parties, the actual price of the bond is simply a mathematical computation.
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3.2— Agreeing on a Price for a Bond [PowerPoint 14-21] Calculation of the price of a bond is based on the present value of cash payments in the same manner as demonstrated previously in the coverage of intangible assets. Future cash payments are first identified and then valued by the mathematical removal of interest (the present value computation). Here, a single cash payment is to be made by the debtor in a certain number of years. In a present value computation, interest at the designated rate is calculated and subtracted to leave the principal amount of those payments. That is the price of the bond. 3.2.1—Teaching Tip: Using Present Value Tables Here, it might be a good idea to pull up a copy of a Present Value of $1 table for the students to see and use. It can be used to find the table factor in the two example problems below. There are many available online or the link from the chapter can be used. 3.2.2—Work through an example of computing the issuance cost of a zero-coupon bond [PowerPoint 14-22, 23, 24] Note: This problem will be used to illustrate each step in accounting for a zerocoupon bond. A comprehensive problem will appear at the end of this section. On January 1, Year One, a company offers a $20,000 2-year zero coupon bond to the public. A single payment of $20,000 will be made to the holder of this bond on December 31, Year Two. The parties have negotiated an annual 6% effective interest rate. Thus, a portion of the future cash ($20,000) serves as interest at an annual rate of 6% for this two-year period of time. The present value of $1 in two years at an annual rate of interest of 6% is $0.8900. The present value of the cash flows from this bond (its price) can be found as follows: Present Value = Future Cash Payment × $0.8900 Present Value = $20,000 × $0.8900 Present Value = $17,800 Bond prices are often stated as a percentage of face value. Thus, this bond is sold to the investor at “89” ($17,800/$20,000) which indicates that the price is 89% of the $20,000 face value. If the investor pays $17,800 today and the debtor returns $20,000 in two years, the additional $2,200 is the interest.
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The issuance is recorded through the following entry. January 1, Year One—Zero-Coupon Bond Issued at Effective Annual Interest Rate of 6 Percent Cash 17,800 Bond Payable 17,800
3.3—Recognizing Interest on a Zero-Coupon Bond 3.3.1—Work through an example of recording a zero-coupon bond after issuance using the effective interest rate method [PowerPoint 14-25, 26] Note: This problem will be used to illustrate each step in accounting for a zerocoupon bond. Interest for Year One = $17,800 × 6% Interest for Year One = $1,068 However, no cash interest payment is made for this zero-coupon interest bonds. Thus, this interest is compounded—added to the principal of the debt. Interest that is recognized but not paid at that time is compounded, included in the balance of the liability. December 31, Year One—Interest on Zero-Coupon Bond at 6 Percent Rate is Recognized and Compounded Interest Expense 1,068 Bond Payable 1,068 The balances to be reported in the financial statements at the end of Year One are as follows: Year One—Interest Expense (Income Statement) December 31, Year One—Bond Payable (Balance Sheet)
$ 1,068 $18,868
Interest for Year Two = $18,868 × 6% Interest for Year One = $1,132 December 31, Year Two—Interest on Zero-Coupon Bond at 6 Percent Rate Is Recognized and Compounded Interest Expense 1,132 Bond Payable 1,132 Note that the Bond Payable balance has now been raised to $20,000 as of the date of payment ($17,800 + $1,068 + $1,132). In addition, interest expense of $2,200 ($1,068 + $1,132) has been recognized over the two years ©2012 Flat World Knowledge, Inc.
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3.4—Recognizing Interest using the Straight-Line Method [PowerPoint 14-27]
When a zero-coupon bond is issued at a discount, interest to be reported each year can also be calculated by a simpler approach known as the straight-line method. According to this technique, an equal amount of the discount is assigned to interest each period over the life of the bond. 3.4.1—Work through an example of recording a zero-coupon bond after issuance using the straight-line interest rate method [PowerPoint 14-27, 28] Note: This problem will be used to illustrate each step in accounting for a zerocoupon bond. Interest = $2,200/2 Interest = $1,100 December 31, Years One —Interest on Zero-Coupon Bond at 6 Percent Rate— Straight-Line Method Interest Expense 1,100 Bond Payable 1,100 December 31, Years Two—Interest on Zero-Coupon Bond at 6 Percent Rate— Straight-Line Method Interest Expense 1,100 Bond Payable 1,100 Once again, the bond payable balance has been raised to $20,000 by the end of the second year ($17,800 + $1,100 + $1,100) and total interest expense over the life of the bond equals the $2,200 discount ($1,100 + $1,100). However, a theoretical question should be raised as to whether the information reported under this method is a fairly presented portrait of the events that took place. Although the bond was sold to earn 6% annual interest, this rate is not reported for either period. Year One: $1,100 interest/$17,800 principal = 6.2% Compounding of the interest raises the principal by $1,100 to $18,900 Year Two: $1,100 interest/$18,900 principal = 5.8% Although, the straight-line method creates some theoretical concerns, it can still be applied according to U.S. GAAP but only if the reported results are not materially different from those derived using the effective rate method.
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3.4.2—Have students work through an example of accounting for a zerocoupon bond, either individually or in teams [PowerPoint 14-29, 30, 31, 32] South Corporation issues $50,000 in zero-coupon bonds on January 1, 2014. South and the bondholders agree to a 5% interest rate. The bond will be repaid on January 1, 2016. Make the necessary journal entries to record the issuance of the bond and interest on December 31, 2014 and December 31, 2015. South uses the effective interest rate method. Issuance price: Present Value = Future Cash Payment × $0.90703 Present Value = $50,000 × $0.90703 Present Value = $45,352 January 1, 2014—Zero-Coupon Bond Issued at Effective Annual Interest Rate of 5 Percent Cash 45,352 Bond Payable 45,352 Interest expense, Year One: Interest for Year One = $45,352 × 5% Interest for Year One = $2,268 December 31, 2014—Interest on Zero-Coupon Bond at 5 Percent Rate is Recognized and Compounded Interest Expense 2,268 Bond Payable 2,268 Interest expense, Year Two: Interest for Year Two = $47,619 × 5% Interest for Year One = $2,381 December 31, 2015—Interest on Zero-Coupon Bond at 5 Percent Rate is Recognized and Compounded Interest Expense 2,381 Bond Payable 2,381
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4. PRICING AND REPORTING TERM BONDS 1. Understand the difference between a stated cash interest rate in a debt contract and an effective interest rate negotiated by the debtor and creditor. 2. Compute the price of a term bond when the stated cash interest rate is different from the effective interest rate. 3. Determine the amount of interest to be compounded each period when the stated cash interest rate specified on a bond contract is different from the effective interest rate established by the parties. 4. Prepare all journal entries for a term bond when the stated cash interest rate is different from the effective interest rate. 4.1—Determining the Price of a Term Bond [PowerPoint 14-35, 36, 37] Most bonds pay a stated rate of cash interest, one that is specified in the contract. If the buyer and the seller negotiate an effective rate of interest that is the same as this stated rate, an amount equal to face value is paid for the bond. No discount or premium results. However, the negotiated rate often differs from the cash rate stated in the bond contract. Market interest rate conditions change quickly. Term bonds are those where interest is conveyed periodically by the debtor but the entire face value is not due until the end of the term. The pricing of a term bond always begins by identifying the cash flows specified by the contract. These amounts are set and will not be affected by the eventual sales price. The cash flows include interest payments determined by multiplying the principal by the interest rate stated in the contract and the principal to be repaid at the end of the contract term. After the cash flows are identified, the present value of each is calculated based on the negotiated yield rate. These present values are then summed to arrive at the price to be paid for the bond. 4.1.1—Teaching Tip: Using Present Value Tables Here, it might be a good idea to pull up a copy of a Present Value of $1 and a Present Value of an Ordinary Annuity table for the students to see and use. They can be used to find the table factors in the two example problems below. There are many available online or the link from the chapter can be used.
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4.1.2—Work through an example of computing the issuance cost of a term bond [PowerPoint 14-38, 39, 40, 41] Note: This problem will be used to illustrate each step in accounting for a term bond. A comprehensive problem will appear at the end of this section. Smith Corporation decides to issue $1 million in term bonds to the public on January 1, Year One. The face value of these bonds comes due in 4 years. During the interim, annual interest at a stated cash rate of 5% will be paid each year starting on December 31, Year One. No investors can be found who want to purchase Smith Corporation bonds with only a 5% annual return. Therefore, in setting an issuance price, annual interest of 6% is negotiated. The $50,000 annual interest payments form an annuity— since equal amounts are paid at equal time intervals. Because interest is paid at the end of each period starting on December 31, Year One, these payments constitute an ordinary annuity. As determined by table, formula, or Excel spreadsheet, the present value of an ordinary annuity of $1 at an effective annual interest rate of 6% over 4 years is $3.46511. Present value of interest payments = $50,000 × $3.46511 Present value of interest payments = $173,256 The second part of the cash flows promised by this bond is a single payment of $1 million in 4 years. The present value of $1 in 4 years at a 6% annual rate is $0.79209. Present value of principal = $1,000,000 × $0.79209 Present value of principal = $792,090 Total present value of the cash flows = $173,256 + $792,090 Total present value of the cash flows = $965,346 January 1, Year One—Term Bonds Issued at an Effective Rate of 6 Percent Cash 965,346 Bonds Payable 965,346 The $34,654 discounted price ($1 million less $965,346) was accepted by Smith (the debtor) as a means of increasing the actual annual rate of return from 5 % per year to 6%.
4.2—Calculating Interest when a Term Bond is Issued at a Discount 4.2.1—Work through an example of recording journal entries over the life of a term bond [PowerPoint 14-42] At the end of Year One, Smith Corporation pays $50,000 cash interest to the ©2012 Flat World Knowledge, Inc.
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bondholders ($1 million face value times the 5% stated rate) as specified in the contract. However, reported interest on this debt must be recognized at the agreed upon rate of 6%. Interest expense = $965,346 × 6% Interest expense = $57,921 The $7,921 difference between the effective interest expense of $57,921 and the cash interest payment of $50,000 will eventually be paid but not until the end of the fouryear term when $1 million rather than $965,346 is conveyed to the bondholders. Therefore, at the end of Year One, this extra $7,921 is compounded. Only the portion of this interest that is not being paid is added to the principal. December 31, Year One— Payment of Cash Interest at 5 Percent Rate Interest Expense 50,000 Cash 50,000 Compounding Adjustment to Bring Interest to Effective Annual Rate of 6% Percent Interest Expense 7,921 Bonds Payable 7,921 Reported figures for the remaining 3 years of this bond contract can be computed to verify that the ending balance does grow to $1 million by the time of payment.
Beginning Bond Principal Effective Rate Interest Expense (rounded)
Year Two $973,267 6% $58,396
Year Three $981,663 6% $58,900
Year Four $990,563 6% $59,437
Through the use of the effective rate method, interest expense of 6% is recognized each period and the principal balance of the liability gradually grows to equal the face value of the bond. 4.2.2—Have students work through an example of accounting for a term bond, either individually or in groups [PowerPoint 14-43, 44, 45, 46, 47] Giardili Corporation issues $100,000 in term bonds on January 1, 2014. The bonds have a stated rate of interest of 8%, but a negotiated effective rate of interest of 9%. The bonds will be repaid at the end of 2 years, but interest is paid every December 31. Record all journal entries over the life of the bonds. Issuance price: Present value of interest payments = $100,000 × 8% × $1.75911 Present value of interest payments = $14,073
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Present value of principal = $100,000 × $0.84168 Present value of principal = $84,168 Total present value of the cash flows = $14,073 + $84,168 Total present value of the cash flows = $98,241 January 1, Year One—Term Bonds Issued at an Effective Rate of 8 Percent Cash 98,241 Bonds Payable 98,241 Interest, year one: Cash interest paid = $100,000 × 8% Cash interest paid = $8,000 December 31, Year One—Payment of Cash Interest at 8 Percent Rate Interest Expense 8,000 Cash 8,000 Interest expense = $98,241 × 9% =$8,842; Interest recognized = $8,842 – $8,000 = $842 Compounding Adjustment to Bring Interest to Effective Annual Rate of 9 Percent Interest Expense 842 Bonds Payable 842 Interest, Year Two: Cash interest paid = $100,000 × 8% Cash interest paid = $8,000 December 31, Year Two— Payment of Cash Interest at 8 Percent Rate Interest Expense 8,000 Cash 8,000 Interest expense = $99,083 × 9% = $8,917; Interest recognized = $8,917 –$8,000 = $917 Compounding Adjustment to Bring Interest to Effective Annual Rate of 9 Percent Interest Expense 917 Bonds Payable 917 Balance in Bond Payable account is now equal to face value of $100,000.
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5. ISSUING AND ACCOUNTING FOR SERIAL BONDS 1. Define a “serial bond.” 2. Identify the steps to calculate the price of a serial bond and provide the proper accounting for the issuance. 3. Record the interest and payments on a serial bond over its life. 4. Explain the determination of interest expense for a serial bond and the amount that must be compounded each period. 5.1—Recording the Issuance of a Serial Bond [PowerPoint 14-49]
The same process that was used to account for a term bond is applied when a serial bond is issued. The sole difference is that regular payments are also made to reduce the face value of the debt overtime. 5.1.1—Teaching Tip: Using Present Value Tables Here, it might be a good idea to pull up a copy of a Present Value of $1 and a Present Value of an Ordinary Annuity table for the students to see and use. They can be used to find the table factors in the two example problems below. There are many available online or the link from the chapter can be used. 5.1.2—Work through an example of accounting for a serial bond [PowerPoint 14-50, 51, 52, 53, 54, 55]
Note: This problem will be used to illustrate each step in accounting for a serial bond. A comprehensive problem will appear at the end of this section. Smith Corporation issues a 4-year, $1 million serial bond on January 1, Year One. This will pay a 5% stated interest rate at the end of each year on the unpaid face value for the period. The indenture further specifies that $250,000 of the face value is also to be paid annually at the same time as the interest. Smith officials negotiate with potential investors and finally agree on a 6% annual effective rate. Identify Cash Flows Specified in the Bond Contract. As a serial bond, Smith is required to make annual $250,000 payment to reduce the face value of this serial bond. In addition, interest must be paid each year. During Year One, the unpaid face value is original $1 million. The stated rate is 5% necessitating a $50,000 year-end interest payment ($1,000,000 × 5%).
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Following the $250,000 payment on December 31, Year One, the face value of the bond drops to $750,000 throughout the second year. Consequently, the interest payment at the end of Year Two is only $37,500 ($750,000 × 5 percent). As a serial bond, the annual payments cause the face value to get smaller so that the interest payments are less each year. Based on the terms of the contract, the cash flows required by this bond are identified as follows. Principal: Must repay $250,000 in principal each year Cash interest paid year 1: $1,000,000 × 5% = $50,000 Cash interest paid year 2: $750,000 × 5% = $37,500 Cash interest paid year 3: $500,000 × 5% = $25,000 Cash interest paid year 4: $250,000 × 5% = $12,500 Determine Present Value of the Cash Flows. These required cash flows can be organized in either of two ways. •
•
First, they can be viewed as an ordinary annuity of $250,000 per year for 4 years plus 4 separate single amounts of $50,000 (1 year), $37,500 (2 years), $25,000 (3 years) and $12,500 (4 years). The pattern is that of an ordinary annuity rather than an annuity due because the payments are at the end of each period. Second, the payments of the face value and interest can be combined into 4 separate single amounts of $300,000 (1 year), $287,500 (2 years), $275,000 (3 years), and $262,500 (4 years).
The same cash flows are being described in both cases. Thus, the resulting present value of both patterns will be the identical ($977,714) regardless of the approach that is followed. Computation of Present Value of Serial Bond—Second Pattern of Cash Flows Present value of four different single amounts at a 6% annual interest rate in each of the next 4 years: $300,000 (in 1 year) × 0.94340 = $283,020 $287,500 (in 2 year) × 0.89000 = $255,875 $275,000 (in 3 year) × 0.83962 = $230,895 $262,500 (in 4 year) × 0.79209 = $207,924 Total present value of cash flows $977,714
Record the Principal Amount Received in the Issuance of the Bond. Based on either of these computations, if $977,714 in cash is exchanged for this 4-year $1 million serial bond with an annual stated rate of 5%. That payment amount creates an effective rate of interest of 6% per year. The issuance of the bond is recorded through the following journal entry.
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January 1, Year One—Issuance of $1 Million Serial Bonds Paying 5 Percent Annual Interest with Effective Negotiated Rate of 6 Percent Cash 977,714 Bonds Payable 977,714 Payment of Stated Cash Interest at 5 Percent Annual Rate. Because of the terms specified in the bond contract, interest of $50,000 will be paid at the end of Year One, $37,500 at the end of Year Two, and so on as the face value is also paid. The Year One payment is recorded as follows: December 31, Year One—Payment of 5 Percent Interest on Serial Bond Interest Expense 50,000 Cash 50,000 Effective Rate Method is Applied to Recognize the Interest Rate that was Negotiated by the Two Parties. For the first year, the principal balance of this debt is the original issuance price of $977,714. The yield rate agreed on by the two parties was 6%. Thus, the interest to be recognized for Year One is $58,663 ($977,714 × 6 percent). As shown in the above entry, the cash interest paid is only 5% of the face value or $50,000. The $8,663 in extra interest for the period ($58,663 less $50,000) is compounded—added to the principal of the bond payable. December 31, Year One—Adjustment of Interest from Cash Rate to Effective Rate Interest Expense 8,663 Bonds Payable 8,663 In addition, as a serial bond, the first payment of the face value is made at the end of Year One. December 31, Year One—Payment on Face Value of Serial Bond Bonds Payable 250,000 Cash 250,000 5.1.3—Have students work through an example of accounting for a serial bond, either individually or in groups [PowerPoint 14-56, 57, 58, 59, 60, 61,]
Giardili Corporation issues $100,000 in serial bonds on January 1, 2014. The bonds have a stated rate of interest of 8%, but a negotiated effective rate of interest of 9%. The bonds will be repaid at a rate of $50,000 each year for 2 years. Record all journal entries over the life of the bonds. Issuance price: Principal: Must repay $50,000 in principal each year Cash interest paid year 1: $100,000 × 8%=$8,000 Cash interest paid year 2: $50,000 × 8%=$4,000 ©2012 Flat World Knowledge, Inc.
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$58,000 (in 1 year) × .91743 $54,000 (in 2 year) × .84168 Total present value of cash flows
$53,211 $45,451 $98,662
January 1, 2014—Issuance of $1 Million Serial Bonds Paying 8 Percent Annual Interest with Effective Negotiated Rate of 9 Percent Cash 98,662 Bonds Payable 98,662 Interest, 2014: Cash interest paid = $100,000 × 8% Cash interest paid = $8,000 December 31, 2014—Payment of 8% Interest on Serial Bond Interest expense 8,000 Cash 8,000 Interest expense = $98,662 × 9% = $8,880; Interest recognized = $8,880 – $8,000 = $880 December 31, 2014—Adjustment of Interest from Cash Rate to Effective Rate Interest expense 880 Bonds payable 880 Repayment of principal, 2014: December 31, 2014—Payment on Face Value of Serial Bond Bonds payable 50,000 Cash 50,000 Interest, 2015: Cash interest paid = $50,000 × 8% Cash interest paid = $4,000 December 31, 2015—Payment of 8% Interest on Serial Bond Interest expense 4,000 Cash 4,000 Interest expense = $49,542 × 9% = $4,459; Interest recognized = $4,459 – $4,000 = $459
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December 31, 2015—Adjustment of Interest from Cash Rate to Effective Rate Interest expense 459 Bonds payable 459 Repayment of principal, 2015: December 31, 2015—Payment on Face Value of Serial Bond Bonds payable 50,000 Cash 50,000 Balance in Bond payable account = $0
6. BONDS WITH OTHER THAN ANNUAL INTEREST PAYMENTS 1. Realize that cash interest payments are often made more frequently than once a year such as each quarter or semiannually. 2. Determine the stated interest rate, the effective interest rate, and the number of time periods to be used in a present value computation when interest payments cover a period of time of less than a year. 3. Compute the stated cash interest payments and the effective interest rate when interest is paid on a bond more frequently than once each year. 4. Prepare journal entries for a bond when the interest payments are made for a period of time shorter than a year. 6.1—Determining the price of a bond and the reporting debt when interest payments occur more often than once each year [PowerPoint 14-64]
None of the five basic steps for issuing and reporting a bond is affected by a change in the frequency of interest payments. However, both the stated cash rate and the effective rate must be set to agree with the time interval between payment dates. 6.1.1—Teaching Tip: Using Present Value Tables Here, it might be a good idea to pull up a copy of a Present Value of $1 and a Present Value of an Ordinary Annuity table for the students to see and use. They can be used to find the table factors in the two example problems below. There are many available online or the link from the chapter can be used. ©2012 Flat World Knowledge, Inc.
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6.1.2—Work through an example of accounting for a bond with differing interest payment time periods [PowerPoint 14-65, 66, 67, 68, 69, 70, 71, 72,] Note: This problem will be used to illustrate each step in accounting for a bond where interest is paid more frequently than once a year. A comprehensive problem will appear at the end of this section. On January 1, Year One, an entity issues term bonds with a face value of $500,000 that will come due in 6 years. Cash interest payments at a 6% annual rate are required by the contract. However, the actual disbursements are made every 6 months on June 30 and December 31. In setting a price for these bonds, the debtor and the creditor negotiate an effective interest rate of 8% per year. In this example, interest is paid semiannually so each time period is only 6 months in length. Stated interest rate = 6/12 × 6% Stated interest rate = 3% Effective interest rate = 6/12 × 8% Effective interest rate = 4% Over the 6 years until maturity, the bond is outstanding for 12 of these 6-month periods of time. Thus, for this bond, the cash flows will be the interest payments followed by settlement of the face value. Interest Payments = $500,000 face value × 3% stated rate Interest Payments = $15,000 every 6 months for 12 periods Present value of the cash interest payments every 6 months = $15,000 × $9.38507 Present value of the cash interest payments every 6 months = $140,776 Face Value = $500,000 at the end of these same 12 periods Present value of the face value cash payment = $500,000 × $0.62460 Present value of the face value cash payment = $312,300 Total present value of the cash flows = $312,300 + $140,776 Total present value of the cash flows =$453,076
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January 1, Year One—Issuance of $500,000 Bond to Yield Effective Rate of 4 Percent Semiannually Cash 453,076 Bonds Payable 453,076 On June 30, Year One, the first $15,000 interest payment is made. June 30, Year One—Cash Interest Paid on Bond for Six-Month Period Interest Expense 15,000 Cash 15,000 Interest expense, first 6 months: Interest expense = $453,076 × 4% = $18,123; Interest recognized = $18,123 – $15,000 = $3,123 June 30, Year One—Interest on Bond Adjusted to Effective Rate Interest Expense 3,123 Bonds Payable 3,123 For the second 6-months in Year One, the compound interest recorded above raises the bond’s principal to $456,199 ($453,076 principal for first 6 months plus $3,123 in compound interest). The principal is gradually moving to the $500,000 face value. Another $15,000 in cash interest is paid on December 31, Year One. December 31, Year One—Cash Interest Paid on Bond for Six-Month Period Interest Expense 15,000 Cash 15,000 Interest expense, second 6 months: Interest expense = $456,199 × 4% = $18,248; Interest recognized = $18,248 – $15,000 = $3,248
December 31, Year One—Interest on Bond Adjusted to Effective Rate Interest Expense 3,248 Bonds Payable 3,248 The Year One income statement will report interest expense of $18,123 for the first 6 months and $18,248 for the second, giving a total for the year of $36,371. The second amount is larger than the first because of compounding.
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The December 31, Year One, balance sheet reports the bond payable as a noncurrent liability of $459,447. That is the original principal (present value) of $453,076 plus compound interest of $3,123 (first 6 months) and $3,248 (second 6 months). 6.1.3—Have students work through an example of accounting for a bond with semiannual interest payments, either individually or in groups [PowerPoint 14-73, 74, 75, 76, 77,]
Giardili Corporation issues $100,000 in term bonds on January 1, 2014. The bonds have a stated rate of interest of 8%, but a negotiated effective rate of interest of 10%. The bonds will be repaid at the end of 2 years, but interest is paid every June 30 and December 31. Record all journal entries over the first year of the life of the bonds. Issuance price: Present value of interest payments = $4,000 × 4% × $3.54595 Present value of interest payments = $14,184 Present value of principal = $100,000 × $0.82270 Present value of principal = $82,270 Total present value of the cash flows = $14,184 + $82,270 Total present value of the cash flows = $96,454 January 1, 2014—Issuance of $100,000 Bond to Yield Effective Rate of 4% Semiannually Cash 96,454 Bonds Payable 96,454 Interest, first 6 months: Cash interest paid = $100,000 × 8% × 6/12 Cash interest paid = $4,000 June 30, 2014—Cash Interest Paid on Bond for Six-Month Period Interest Expense 4,000 Cash 4,000 Interest expense = $96,454 × 5% = $4,823; Interest recognized = $4,823 – $4,000 = $823 June 30, 2014—Interest on Bond Adjusted to Effective Rate Interest Expense 823 Bonds Payable 823
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Interest, second 6 months: Cash interest paid = $100,000 × 8% × 6/12 Cash interest paid = $4,000 December 31, 2014—Cash Interest Paid on Bond for Six-Month Period Interest expense 4,000 Cash 4,000 Interest expense = $97,277 × 5% = $4,864; Interest recognized = $4,864 – $4,000 = $864 December 31, 2014—Interest on Bond Adjusted to Effective Rate Interest Expense Bonds Payable
864 864
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CHAPTER 15 In A Set of Financial Statements, What Information Is Conveyed about Other Noncurrent Liabilities? 1. ACCOUNTING FOR LEASES 1. Understand the theoretical difference between an operating lease and a capital lease. 2. Recognize that a lessee will be required to account for a lease as either an operating lease or a capital lease based on the specific terms of the contract. 3. Understand the concept of off-balance sheet financing. 4. Explain the term “substance over form” and how it applies to the financial reporting of a capital lease. 1.1— Reporting a Liability for Leased Property [PowerPoint 15-3] When a lessee (the party that will make use of the asset) signs a lease agreement, the lease transaction is recorded in one of two ways based on the terms of the contract. • If the lease is an operating lease, it is like a rental arrangement. Liability is recognized only for the current amount due. In financial accounting, the future payments on an operating lease are viewed as a commitment rather than a liability. Thus, information about those payments are disclosed in the notes to the financial statements but not formally reported. • A capital lease is viewed as the equivalent of buying asset. In a capital lease, a liability is reported by the lessee for the present value for future payments.
1.2—Does a Lessee Prefer to Report an Operating or Capital Lease? [PowerPoint 15-4] In financial accounting, a lessee prefers to report operating lease over capital lease to reduce the reported debt total. If an option exists between reporting a larger liability (capital lease) or a smaller one (operating lease), officials for the lessee are inclined to take whatever measures necessary to classify each contract as an operating lease. Financial accounting is supposed to report events and not influence them. However, at times, authoritative reporting standards impact the method by which companies design the transactions in which they engage.
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The term “off-balance sheet financing” is commonly used when a company is obligated for more money than the reported debt. Operating leases are one of the primary examples of “off-balance sheet financing.”
1.3—Differentiating an Operating Lease from a Capital Lease [PowerPoint 15-5, 6]
In form, all lease agreements are rental arrangements. One party (the lessor) owns legal title to property while the other (the lessee) rents the use of that property for a specified period of time. However, in substance, a lease agreement may go beyond a pure rental agreement. Financial accounting has long held that a fairly presented portrait of an entity’s financial operations and economic health is only achieved by looking past the form of a transaction in order to report the actual substance of what is taking place. “Substance over form” is a mantra often heard in financial accounting. Over 30 years ago, U.S. GAAP was created (by FASB) to provide authoritative guidance for the financial reporting of leases. An official pronouncement released at that time states that “a lease that transfers substantially all of the benefits and risks incident to the ownership of property should be accounted for as the acquisition of an asset and the incurrence of an obligation by the lessee.” When the transaction is more like a purchase, it is recorded as a capital lease. When the transaction is more like a rental, it is recorded as an operating lease. • Capital lease—The lessee gains substantially all of the benefits and risks of ownership. Although legal form is still that of a lease arrangement, the transaction is reported as a purchase at the present value of the future cash flows. • Operating lease—The lessee does have not obtain substantially all of the benefits and risks of ownership. The transaction is reported as a rental arrangement.
1.4— Criteria for a Capital Lease [PowerPoint 15-7] In establishing reporting guidelines in this area, FASB created four specific criteria to serve as the line of demarcation between the two types of leases. If any one of these criteria is met, the lease is automatically recorded by the lessee as a capital lease. In that case, both the asset and liability are reported as if an actual purchase took place. Criteria to Qualify as a Capital Lease (only one must be met): 1) If the lease contract specifies that title to the property will be conveyed to the lessee by the end of the lease term, it is a capital lease. 2) If the contract allows the lessee to buy the property at a specified time at an amount sufficiently below expected fair value (so that purchase is reasonably assured), it is a capital lease. 3) If the lease contract is for a term that is equal to 75 percent or more of the estimated life of the property, it is a capital lease. 4) The fourth criterion is too complicated to cover in an introductory textbook. The ©2012 Flat World Knowledge, Inc.
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general idea is that the lessee is paying approximately the same amount as would have been charged to buy the asset.
2. OPERATING LEASES VERSUS CAPITAL LEASES 1. Account for an operating lease, realizing that the only liability to be reported is the amount that is currently due. 2. Understand that the only asset reported in connection with an operating lease is prepaid rent if payments are made in advance. 3. Record the initial entry for a capital lease with both the asset and the liability calculated at the present value of the future cash flows. 4. Explain the interest rate to be used by the lessee in determining the present value of a capital lease and the amount of interest expense to be recognized each period. 5. Determine and recognize the depreciation of an asset recorded as the result of a capital lease. 2.1— The Financial Reporting of an Operating Lease 2.1.1—Work through an example of an operating lease [PowerPoint 15-10, 11, 12]
Note: This problem will be used to illustrate each step in accounting for an operating lease. Abilene Company has agreed to pay $100,000 per year for seven years to lease an airplane. Assume that legal title will not be received by Abilene and no purchase option is mentioned in the contract. Assume also that the life of the airplane is judged to be ten years and that the payments do not approximate the fair value of the item. The contract is signed on December 31, Year One, with the first annual payment made immediately. Based on the description of the agreement none of the four criteria for a capital lease have been met. Thus, Abilene has an operating lease. The first annual payment was made immediately to cover the subsequent year. December 31, Year One—Payment of First Installment of Operating Lease Prepaid Rent 100,000 Cash 100,000 Because the first payment has been made, no liability is reported on Abilene’s ©2012 Flat World Knowledge, Inc.
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balance sheet although the contract specifies that an additional $600,000 in payments will be required over the subsequent six years. In addition, the airplane itself is not shown as an asset by the lessee. The operating lease is viewed as the equivalent of a rent and not a purchase. During Year Two, as time passes, the future value provided by the first prepayment gradually becomes a past value. The asset balance is reclassified as an expense. At the end of that period, the second payment will also be made. December 31, Year Two—Adjustment to Record Rent Expense for Year 2 Rent Expense 100,000 Prepaid Rent 100,000 December 31, Year Two—Payment of Second Installment of Operating Lease Prepaid Rent 100,000 Cash 100,000
2.2 - Accounting for a Capital Lease 2.2.1—Teaching Tip: Using Present Value Tables Here, it might be a good idea to pull up a copy of a Present Value of an Annuity Due table for the students to see and use. They can be used to find the table factors in the two example problems below. There are many available online or the link from the chapter can be used. 2.2.2—Work through an example of recording a capital lease [PowerPoint 15-13, 14, 15, 16, 17]
Note: This problem will be used to illustrate each step in accounting for a capital lease. Abilene Company has agreed to pay $100,000 per year for seven years to lease an airplane. Assume that legal title will not be received by Abilene and no purchase option is mentioned in the contract. Assume also that the life of the plane is judged to be nine years and that the payments do not approximate the fair value of the item. The contract is signed on December 31, Year One, with the first annual payment made immediately. This is now a capital lease because the lease term is over 77.8 percent of the asset’s useful life. As a capital lease, the transaction is reported in the same manner as a purchase. Abilene has agreed to pay $100,000 per year for 7 years but no part of this amount is specifically identified as interest. According to U.S. GAAP, if a reasonable rate of interest is not explicitly paid each period, a present value computation is required to split the contractual payments between principal (the amount paid for the airplane) and interest (the amount paid to extend payment over this 7-year period). ©2012 Flat World Knowledge, Inc.
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Before the lessee computes the present value of the future cash flows, one issue must be resolved. A determination is needed of the appropriate rate of interest to be applied. According to U.S GAAP, the lessee should use its own incremental borrowing rate. That is the interest rate the lessee would be forced to pay to borrow this same amount of money from a bank or other lending institution. Assume here that the incremental borrowing rate for Abilene is 10 percent per year. Abilene will pay $100,000 annually over these seven years. Because the first payment is made immediately, these payments form an annuity due. Present value of an annuity due of $1 per year for seven years at a 10% annual interest rate is $5.35526. The present value of 7 payments of $100,000 is $535,526. Present Value = $100,000 × $5.35526 Present Value = $535,526 December 31, Year One—Capital Lease Recorded at Present Value Leased Airplane 535,526 Lease Liability 535,526 December 31, Year One—Initial Payment on Capital Lease Lease Liability 100,000 Cash 100,000
2.3 - Accounting for a Capital Lease over Time Depreciation. The airplane will be used by Abilene for the seven-year life of the lease. The recorded cost of the asset is depreciated over this period to match the expense recognition with the revenue that the airplane helps to generate. Assuming the straightline method is applied: Annual depreciation = $535,526/7 years Annual depreciation = $76,504 December 31, Year Two—Depreciation of Airplane Obtained in Capital Depreciation Expense 76,504 Accumulated Depreciation 76,504
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Interest. The principal of the lease liability during Year 2 is $435,526. That is the initial $535,526 present value less the first payment of $100,000. Interest expense = $435,526 × 10% Interest expense = $43,553 December 31, Year Two—Interest on Lease Liability from Capital Lease Interest Expense 43,553 Lease Liability 43,553 December 31, Year Two—Second Payment on Capital Lease Lease Liability 100,000 Cash 100,000 2.3.1—Have students work through an example of recording a capital lease, either individually or in teams [PowerPoint 15-18, 19, 20, 21] On January 1, 2012, Weston Corporation leases a building for payments of $14,000 per year for the next twenty years. The expected life of the building is twenty-four years. Weston’s incremental borrowing rate is 5 percent. Payments start on January 1, 2012, and are made on January 1 each year. Record all necessary entries until the second payment is made on January 1, 2013. Present Value = $14,000 × $13.08532 Present Value = $183,194 December 31, Year One—Capital Lease Recorded at Present Value Leased Building 183,194 Lease Liability 183,194 December 31, Year One—Initial Payment on Capital Lease Lease Liability 14,000 Cash 14,000 Annual depreciation = $183,194/20 years Annual depreciation = $9,160 December 31, Year Two—Depreciation of Building Obtained in Capital Lease Depreciation Expense 9,160 Accumulated Depreciation 9,160 Interest expense = $169,194 × 5% Interest expense = $8,460
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December 31, Year Two—Interest on Lease Liability from Capital Lease Interest Expense 8,460 Lease Liability 8,460 December 31, Year Two—Second Payment on Capital Lease Lease Liability 14,000 Cash 14,000
3. RECOGNITION OF DEFERRED INCOME TAXES 1. Understand that the recognition of revenues and expenses under U.S. GAAP differs at many critical points from the taxation rules established by the Internal Revenue Code. 2. Explain the desire by corporate officials to defer the payment of income taxes. 3. Determine the timing for the reporting of a deferred income tax liability and explain the connection of this process to the matching principle. 4. Calculate taxable income as well as the related deferred income tax liability when the installment sales method is used. 3.1—The Reporting of Deferred Tax Liabilities [PowerPoint 15-24, 25] The reporting of deferred income tax liabilities is, indeed, quite prevalent. One recent survey found that approximately 70 percent of businesses included a deferred tax balance within their noncurrent liabilities. In the U.S., financial information is presented based on the requirements of U.S. GAAP (created by FASB) whereas income tax reporting is determined according to the Internal Revenue Code (written by Congress). At many places, these two sets of guidelines converge. However, at a number of critical junctures, the recognized amounts can be quite different. Where legal, companies frequently exploit these differences for their own benefit by delaying tax payments. The deferral of income taxes is usually considered a wise business strategy because the organization is able to use its cash for a longer period of time and, hence, generate additional revenues. When paid, the money is gone but, until then, it can be used to raise net income. Businesses commonly attempt to reduce their current taxable income by moving reported gains and revenue into the future. That is one prevalent method for deferring tax ©2012 Flat World Knowledge, Inc.
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payments. Revenue or a gain might be recognized this year for financial reporting purposes although deferred until an upcoming time period for tax purposes. Consequently, the payment of tax on this income is pushed into that future year. As long as the tax laws are obeyed, such deferral is legal. Taxable income is reduced in the current period (revenue is moved out) but increased at a later time (the revenue is moved back into taxable income). Because a larger tax will have to be paid in the subsequent period, a deferred income tax liability is created. 3.1.1—Work through an example of the creation of a deferred income tax liability [PowerPoint 15-26, 27] Assume that a business reports revenue of $10,000 on its Year One income statement. Because of tax rules and regulations, assume that this amount will not be subject to income taxation until Year Six. The $10,000 is referred to as a temporary tax difference. It is reported for both financial accounting and tax purposes but in two different time periods. If the effective tax rate for this business is 40 percent, it reports a $4,000 ($10,000 × 40 percent) deferred income tax liability on its December 31, Year One, balance sheet. The revenue was earned in Year One so the related expense and liability are also recorded in Year One. This amount will be paid to the government but not until Year Six when the revenue becomes taxable. A deferred income tax liability is created when an event occurs now that will lead to a higher amount of income tax payment in the future.
3.2— The Installment Sales Method and Deferred Income Taxes [PowerPoint 15-28]
One of the most common methods for deferring income tax payments is application of the installment sales method. For financial reporting purposes, any gain is recorded immediately as is the related income tax expense. However, according to tax laws, recognition of the profit can be delayed until cash is collected. In the interim, a deferred tax liability is reported to alert decision makers to the eventual payment that will be required. 3.2.1—Work through an example of the accounting for a deferred income tax liability [PowerPoint 15-29, 30, 31, 32] Assume that the Hill Company buys an asset (land, for example) for $150,000. Later, this asset is sold for $250,000 during Year One. The earning process is substantially complete at that point. Hill reports a gain on its Year One income statement of $100,000. Because of the terms of the sales contract, this money will not be collected from the buyer until Year Five. The buyer is financially strong and should be able to pay at the required times. Hill’s effective tax rate for this transaction is 30 percent. According to U.S. GAAP, this $100,000 gain is recognized on Hill Company’s income statement in Year One based on accrual accounting. However, if certain ©2012 Flat World Knowledge, Inc.
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conditions are met, income tax laws permit taxpayers to report such gains using the installment sales method. In simple terms, the installment sales method allows a seller to delay reporting a gain for tax purposes until cash is collected. No cash is received in Year One so no taxable income is reported. The tax will be paid in Year Five when Hill collects the cash. Thus, the income is reported now on the financial statements but not until Year Five for tax purposes. Year One Gain on Sale of Asset
Financial Accounting Income Tax Return $100,000 (accrual accounting) 0 (installment sales method)
The eventual tax to be paid on the gain will be $30,000 ($100,000 x 30 percent). How is this $30,000 reported in Year One if payment to the government is not required until Year Five? First, because of the matching principle, the income tax expense of $30,000 must be recorded in Year One. The $100,000 gain is reported on the income statement in that year; therefore, any related expense is recognized in the same period. That is the basic premise of the matching principle. Second, the $100,000 gain creates a temporary difference. The amount will become taxable when the cash is collected in Year Five. At that time, a tax payment of $30,000 is required. A deferred income tax liability is recorded in Year one. Consequently, the following adjusting entry is prepared at the end of Year One so that both the expense and the liability are properly reported. December 31, Year One—Recognition of Deferred Income Tax on Gain Income Tax Expense—Deferred 30,000 Deferred Income Tax Liability 30,000
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4. REPORTING POSTRETIREMENT BENEFITS 1. Define the term “postretirement benefits.” 2. Explain the accounting problems associated with the recognition of accrued postretirement benefits. 3. List the steps that are followed to determine a company’s reported obligation for postretirement benefits. 4. Identify the role of the actuary in accounting for postretirement benefits. 5. Calculate a company’s debt-to-equity ratio and explain its meaning. 6. Calculate the times interest earned ratio and explain its meaning. 4.1— Liability for Postretirement Benefits [PowerPoint 15-35] Postretirement benefits cover a broad array of promises that companies make to their employees to boost morale and keep them from seeking other jobs. Two of the most common insurance are health care insurance and life insurance. After a person retires, the company continues to pay a portion of insurance costs as a reward for years of employee service.
4.2— Determining a Liability for Postretirement Benefits [PowerPoint 15-36, 37, 38]
Postretirement benefits are estimated and reported according to U.S. GAAP while employees work. Because of the length of time involved and the large number of variables (some of which, such as future health care costs, are quite volatile), a precise determination of this liability is impossible. Work through the following example to understand the computation and reporting of postretirement benefits. An overview of the basic steps, is useful in helping decision makers understand the information that is provided. Example: Assume that one of the employees for the Michigan Company is currently thirty-four years old and is entitled to certain postretirement benefits starting at the age of sixty-five. The company has promised to continue paying health care and life insurance premiums for all retirees as long as they live. For this employee, no postretirement benefits will be paid for the next thirty-one years (65 less 34). After that, an unknown payment amount will begin and continue for an unknown period of time. Payments may continue for decades and neither their amount nor their duration is more than a guess.
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The employee is helping the company generate revenues currently so that, as always, the related expense should be recognized now according to the matching principle. Although this obligation might not be paid for many years, both the expense and related liability are recorded when the person is actually working for the company and earning these benefits. How is the amount of this liability determined? To arrive at the liability to be reported for postretirement benefits that are earned now but only paid after retirement; the Michigan Company takes two primary steps. First, an actuary calculates an estimation of the cash amounts that will eventually have to be paid as a result of the terms promised to employees. An actuary is a mathematical expert who computes the likelihood of future events. To make a reasonable guess at the amount of postretirement benefits, the actuary has to make a number of difficult estimations, such as the average length of the time employees will live and the future costs of health care and life insurance (and any other benefits provided to retirees). The future payments to be made by the company are estimated by an actuary but they are projected decades into the future. Thus, as the second step in this process, the present value of these amounts is calculated to derive the figure to be reported currently on the balance sheet. Once again, as in previous chapters, interest for this period of time is determined mathematically and removed to leave just the principal of the obligation as of the balance sheet date. That is the amount reported by the employer within noncurrent liabilities.
4.3—The Consequences of Having to Report a Liability [PowerPoint 15-39]
Organizations typically prefer not to report balances that appear to weaken the portrait of their economic health and vitality. However, better decisions are made by all parties when relevant information is readily available. Transparency is a primary goal of financial accounting. As the result of the evolution of U.S. GAAP, decision makers (both inside and outside the company) can now better see the costs associated with postretirement benefits. Not surprisingly, once disclosed, some companies opted to cut back on the amounts promised to retirees. For the employees directly impacted, these decisions may have been understandably alarming. However, by forcing the company to recognize this liability, U.S. GAAP has helped draw attention to the costs of making such promises.
4.4—Vital Signs Studied in Connection with Liabilities [PowerPoint 15-40]
One vital sign that is often studied by decision makers is the debt-to-equity ratio. This figure is simply the total liabilities reported by a company divided by total stockholders’ equity. The resulting number indicates whether most of a company’s assets have come from borrowing and other debt or from its own operations and owners. A high debt-to ©2012 Flat World Knowledge, Inc.
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equity ratio indicates that a company is highly leveraged. 4.4.1—Work through an example of calculating the debt-to-equity ratio [PowerPoint 15-41, 42]
At the end of 2015, Collins Corporation has assets of $400,000 and liabilities of $150,000. What is Collins’ debt-to-equity ratio? Stockholders’ equity = Assets − Liabilities Stockholders’ equity = $400,000 − $150,000 Stockholders’ equity = $250,000 Debt-to-equity ratio = Liabilities/ Stockholders’ equity Debt-to-equity ratio = $150,000/$250,000 Debt-to-equity ratio = 0.60 to 1 4.4.2—Have students work through an example of calculating the debtto-equity ratio, either individually or in teams [PowerPoint 15-43, 44] At the end of 2015, Dalton Corporation has liabilities of $900,000 and stockholders’ equity of $600,000. What is Dalton’s debt-to-equity ratio? Debt-to-equity ratio = Liabilities/ Stockholders’ equity Debt-to-equity ratio = $900,000/$600,000 Debt-to-equity ratio = 1.5 to 1 [PowerPoint 15-45]
Another method to evaluate the potential problem posed by a company’s debts is to compute the times interest earned (TIE) ratio. Normally, debt only becomes a risk if interest cannot be paid when due. This calculation helps measure how easily a company has been able to meet its interest obligations through current operations. Times interest earned begins with the company’s net income before both interest expense and income taxes are removed (a number commonly referred to as “EBIT” or “earnings before interest and taxes”). Interest expense for the period is then divided into this income figure. 4.4.3—Work through an example of calculating times interest earned [PowerPoint 15-46, 47]
Anerton Corporation ended the year with net income of $500,000. Interest expense totaled $70,000 and taxes were $130,000. Determine Anerton’s times interest earned. EBIT = Net Income + Interest Expense + Tax Expense EBIT = $500,000 + $70,000 + $130,000 EBIT = $700,000
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Times Interest Earned = EBIT/Interest Expense Times Interest Earned = $700,000/$70,000 Times Interest Earned = 10 times 4.4.4—Have students work through an example of calculating times interest earned, either individually or in teams [PowerPoint 15-48, 49] Utopia Corporation ended the year with EBIT of $500,000 and interest expense of $75,000. Determine Utopia’s times interest earned. Times Interest Earned = EBIT/Interest Expense Times Interest Earned = $500,000/$75,000 Times Interest Earned = 6.67 times
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CHAPTER 16 In a Set of Financial Statements, What Information Is Conveyed about Shareholders’ Equity? 1. SELECTING A LEGAL FORM FOR A BUSINESS 1. Describe the three primary legal forms available for a business in the United States. 2. Discuss the advantages and disadvantages of incorporating a business rather than maintaining it as a sole proprietorship or partnership. 3. Explain the double taxation that is inherent in operating a corporate organization. 4. Describe the impact that issuing capital stock has on a corporation. 1.1— Creating a Corporation [PowerPoint 16-3, 4, 5] In the U.S., business and other organizations must operate as one of three legal forms. A proprietorship has a single owner whereas a partnership is started and owned by two or more parties. In both of these cases, establishing the business is often an unstructured process. For example, a partnership can be created by a mere handshake or other informal agreement. The third legal form of organization is a corporation which is brought into existence by means of a formal request made to a state government. Organizers only need to satisfy the incorporation process in one state regardless of their entity’s size. To start, they submit articles of incorporation to that government along with any other necessary information. After necessary documents have been filed and all other requirements met, the state government issues a corporate charter that recognizes the organization as a legal entity separate from its owners. This separation of the business from its owners is what differentiates a corporation from a partnership or proprietorship. As mentioned in an earlier chapter, ownership of a corporation is physically represented by shares of stock that are issued to raise funds. In general, these shares are referred to as capital stock and the owners as shareholders or stockholders. After being issued by a corporation, shares can be resold dozens or even hundreds of times. Thus, a corporation is able to continue in existence even after owners die or decide to switch to other investments. In partnerships and proprietorships, capital stock does not exist. Consequently, transfer of an ownership interest is much more complicated. ©2012 Flat World Knowledge, Inc.
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Partnerships and proprietorships often operate only for as long as the original owners are willing and able to continue being actively involved. As a result of the legal separation of ownership and business, shareholders have no personal liability for the debts of the corporation. Thus, the maximum loss a shareholder can suffer is the amount contributed to the corporation (or paid to a previous owner) in acquiring capital stock. In contrast, the owners of a partnership or proprietorship are liable personally for all business debts. Such potential losses are especially worrisome in a partnership because of the legal concept of mutual agency where each partner serves as an agent for the entire organization. Thus, a partner can obligate the partnership and, if the debt is not paid when due, the creditor can seek redress from any partner.
1.2— The Double Taxation of Corporations [PowerPoint 16-6, 7, 8] Incorporation is often a time consuming and costly legal process. However, in most states, proprietorships and partnerships can be created informally with little effort. The most obvious problem associated with corporations is the double taxation of income. As noted, proprietorships and partnerships are not deemed to be separate entities. Therefore, the owners (but not the business) must pay a tax when any income is generated. However, the income is taxed only that one time, when earned by the business. In contrast, as separate legal entities, corporations pay their own taxes by reporting all taxable income on Form 1120. However, when any dividends are eventually distributed from those earnings, this transfer is also viewed as taxable income to the stockholders. Example: To illustrate, assume that income tax rates are 30 percent except for the 15 percent tax on dividends. A proprietorship (or partnership) earns a profit of $100. For this type business, the $100 is only taxable to the owner or owners when earned. Payment of the resulting $30 income tax ($100 × 30 percent) leaves $70 as the remaining disposal income. If a corporation reports income of $100, a tax of $30 is assessed to the business so that only $70 remains. This residual amount can then be conveyed to owners as a dividend. However, if distributed, another tax must be paid, this time by the stockholder. The second income tax is $70 times 15 percent or $10.50. The owner is left with only $59.50 ($70.00 less $10.50) in disposal income. The government has collected a total of $40.50 ($30.00 plus $10.50). The increase in the amount taken by the government is significant enough to reduce the inclination of many owners to incorporate their businesses.
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2. THE ISSUANCE OF COMMON STOCK 1. Identify the legal rights normally held by the owners of a corporation’s common stock. 2. Describe the responsibilities of a board of directors. 3. Explain the terms “authorized,” “outstanding,” “issued,” and “par value” in relationship to common stock. 4. Record the issuance of common stock for cash. 5. Record the issuance of common stock for a service or for an asset other than cash. 2.1—Common Stock[PowerPoint 16-10] Common stock represents the basic ownership of a corporation. Obtaining shares of a company’s common stock provides several distinct rights. •
• • • •
Based on state laws and the corporation’s own rules, the owners of common stock are allowed to vote on a few specified issues. By far the most prevalent is the election of the board of directors. As mentioned previously, these individuals represent the ownership of the corporation in overseeing the management. The responsibilities of the board of directors can vary rather significantly from company to company. One of the most important decisions for any board of directors is the declaration of dividends. Management cannot pay dividends to shareholders without specific approval by the board. If dividends are paid on common stock, all stockholders share in them proportionally. Should the company ever be liquidated, the common stock shareholders are entitled to share proportionally in any assets that remain after all liabilities and other claims are settled.
2.2— Capital Stock Terminology [PowerPoint 16-11,12] Authorized. In applying to the state government as part of the initial incorporation process, company officials indicate the maximum number of capital shares they want to be allowed to issue. This approved limit is the authorized total. Issued. The number of issued shares is simply the quantity that has been sold or otherwise conveyed to owners. Outstanding. The total amount of stock currently in the hands of the public is referred to as the shares “outstanding.” Shares are often bought back by a corporation from its stockholders and recorded as treasury stock. Thus, originally issued shares are not always
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still outstanding. Par Value. Decades ago, the requirement was established in many states that a par value had to be set in connection with the issuance of stock. This par value is printed on the face of each stock certificate and indicates (depending on state law) the minimum amount of money that owners must legally leave in the business. By requiring a par value to be specified, lawmakers hoped to prevent the declaration of cash dividend that was so large that it would bankrupt the company, leaving creditors with no chance of repayment. The owners had to leave the set par value in the company. Traditionally, companies have gotten around this limitation by setting the par value at an extremely low number.
2.3—Reporting the Issuance of Common Stock [PowerPoint 16-13] A potential stockholder contributes assets to a company to obtain an ownership interest. The contribution of monetary capital is an expansion of both the company and its ownership. As a result, no gain, loss, or other income effect is ever reported by an organization as a result of transactions occurring in its own stock. Consequently, a second shareholders’ equity balance is created to report the amount received from owners above par value. Titles such as “capital in excess of par value” or “additional paid-in capital” are used to report amount received above par value. 2.3.1—Work through an example of issuing common stock [PowerPoint 1614]
Kellogg Corporation issued a share of $0.25 par value common stock for $46 in cash. Issuance of a Share of Common Stock for Cash Cash 46.00 Common Stock Capital in Excess of Par Value
0.25 45.75
On a balance sheet, within the stockholders’ equity section, the amount owners put into a corporation when they originally bought stock is the summation of the common stock and capital in excess of par value accounts. This total reflects the assets conveyed to the business to gain in exchange for capital stock.
2.4— Issuing Common Stock in Noncash Exchanges [PowerPoint 1615]
The issuance of stock for a service or an asset is not technically a trade but merely an expansion of the ownership. However, the accounting rules are the same. The asset or the service received by the corporation is recorded at the fair value of the capital stock surrendered. If the fair value of the shares of stock is not available (which is often the case for both new and small corporations), the fair value of the property or services received becomes the basis for reporting.
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2.4.1—Work through an example of recording common stock issued for an asset or service [PowerPoint 16-16, 17] A potential investor is willing to convey land with a fair value of $125,000 to the Maine Company in exchange for an ownership interest. During negotiations, officials for Maine offer to issue ten thousand shares of $1 par value common stock for this property. The shares are currently selling on a stock exchange for $12 each. The investor decides to accept this proposal rather than go to the trouble of trying to sell the land. The “sacrifice” made by the Maine Company to acquire this land is $120,000 ($12 per share × 10,000 shares). Those shares could have been sold to the public to raise that much money. Instead, Maine issues them directly in exchange for the land and records the transaction as follows. Issue Ten Thousand Shares of Common Stock Worth $12 per Share for Land Land 120,000 Common Stock 10,000 Capital in Excess of Par Value 110,000
3. ISSUING AND ACCOUNTING FOR PREFERRED STOCK AND TREASURY STOCK 1. Explain the difference between preferred stock and common stock. 2. Discuss the distribution of dividends to preferred stockholders. 3. Record the issuance of preferred stock. 4. Provide reasons for a corporation to spend its money to reacquire its own capital stock as treasury stock. 5. Account for the purchase and resale of treasury stock when both gains and losses occur. 3.1— Differentiating Preferred Stock from Common Stock [PowerPoint 16-19]
Preferred stock is another version of capital stock where the rights of those owners are set by the contractual terms of the stock certificate rather than state law. The term “preferred stock” comes from the preference that is conveyed to these owners. They are being allowed to step in front of common stockholders when specified rights are applied. If a corporation issues preferred stock with a stipulated dividend, that amount must be paid ©2012 Flat World Knowledge, Inc.
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before any money is conveyed to the owners of common stock. No dividend is ever guaranteed, not even on preferred shares. But, if declared, the preferred stock dividend normally must be paid before any common stock dividend. Common stock is often referred to as a residual ownership because these shareholders are entitled to all that remains after other claims have been settled including those of preferred stock. 3.1.1—Recording the Issuance of Preferred Stock [PowerPoint 16-20] The issuance of preferred stock is accounted for in the same way as common stock. Par value, though, often serves as the basis for stipulated dividend payments. Thus, the par value listed for a preferred share frequently approximates fair value. 3.1.2—Work through an example of recording the issuance of preferred stock [PowerPoint 16-21, 22] A corporation issues ten thousand shares of preferred stock. A $100 per share par value is printed on each stock certificate. If the annual dividend is listed as 4 percent, cash of $4 per year ($100 par value × 4%) must be paid on preferred stock before any distribution is made on common stock. If ten thousand shares of this preferred stock are each issued for $101 in cash ($1,010,000 in total), the company records the following journal entry. Issue Ten Thousand Shares of $100 Par Value Preferred Stock for $101 per Share Cash 1,010,000 Preferred Stock (par value) 1,000,000 Capital in Excess of Par Value 10,000
3.2— The Acquisition of Treasury Stock [PowerPoint 16-23] Numerous possible reasons exist to justify spending money to reacquire an entity’s own stock. • As a reward for service, businesses often give shares of their stock to key employees or sell shares to them at a relatively low price. Thus, some corporations acquire treasury shares to have available as needed for compensation purposes. • Acquisition of treasury stock can be used as a tactic to push up the market price of a company’s stock in order to please the remaining stockholders. Usually, a large scale repurchase indicates that management believes the stock is undervalued at its current market price. Buying treasury stock reduces the supply of shares in the market and, according to economic theory, forces the price to rise. • Corporations can also repurchase shares of stock to reduce the risk of a hostile takeover. If another company threatens to buy sufficient shares to gain control, the board of directors of the target company must decide if acquisition is in the best ©2012 Flat World Knowledge, Inc.
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interest of the stockholders. If not, the target company might attempt to buy up shares of its own stock in hopes of reducing the number of owners in the market who are willing to sell their shares. Here, repurchase is a defensive strategy designed to make the takeover more difficult to accomplish.
3.3—Reporting the Purchase of Treasury Stock [PowerPoint 16-24] Under U.S. GAAP, several methods are allowed for reporting the purchase of treasury stock. Most companies use the cost method because of its simplicity. Because the money spent on treasury stock represents assets that have left the business, this balance is shown within stockholders’ equity as a negative value, reflecting a decrease in net assets instead of an increase. Except for possible legal distinctions, treasury stock held by a company is the equivalent of unissued stock. The shares do not receive dividends and have no voting privileges. 3.3.1—Work through an example of recording the purchase of treasury stock [PowerPoint 16-25, 26] Chauncey Company has been in business for over 20 years. During that time, the company has issued ten million shares of its $1 par value common stock at an average price of $3.50 per share. The company now reacquires three hundred thousand of these shares for $4 each. Purchase of Three Hundred Thousand Shares of Treasury Stock at a Cost of $4 Each Treasury Stock 1,200,000 Cash 1,200,000
3.4— Reporting the Reissuance of Treasury Stock Above Cost [PowerPoint 16-27]
If treasury stock is reissued at a price higher than its purchase price, no gain is recorded. Instead, Capital in excess of cost—treasury stock is credited for the excess. Treasury stock is credited at its original cost. 3.4.1—Work through an example of reissuing treasury stock [PowerPoint 16-28, 29]
Chauncey Company subsequently sells one hundred thousand shares of its treasury stock for $5.00 each. That is $1.00 more than the reacquisition cost of these shares. Sale of One Hundred Thousand Shares of Treasury Stock Costing $4 Each for $5 per Share Cash 500,000 Treasury Stock 400,000 Capital in Excess of Cost—Treasury Stock 100,000
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3.5— Reporting the Reissuance of Treasury Stock below Cost [PowerPoint 16-30]
The most common approach is to first remove any capital in excess of cost recorded by reissuance of earlier shares of treasury stock at above cost. If that balance is not large enough to absorb the entire reduction, a decrease is then made in retained earnings. The $100,000 balance in capital in excess of cost-treasury stock was created in the previous reissuance. 3.5.1—Work through an example of reissuing treasury stock [PowerPoint 16-31, 32]
Chauncey subsequently sells another one hundred thousand of treasury shares but, this time, for only $2.60 each. The proceeds in this transaction are below the acquisition cost of $4 per share. Sale of One Hundred Thousand Shares of Treasury Stock Costing $4 Each for $2.60 per Share Cash 260,000 Capital in Excess of Cost—Treasury Stock 100,000 Retained Earnings 40,000 Treasury Stock 400,000 3.5.2—Have students work through an example of treasury stock, either individually or in teams [PowerPoint 16-33, 34, 35] Randall Corporation repurchases ten thousand shares of its own stock for the first time on May 14 for $10 each. On July 20, it reissues four thousand shares for $12 each. On September 3, it reissues three thousand shares for $7 each. Record the correct journal entry on each of these three dates. May 14; Purchase of Ten Thousand Shares of Treasury Stock at a Cost of $10 Each Treasury Stock Cash
100,000 100,000
July 20; Sale of Four Thousand Shares of Treasury Stock Costing $10 Each for $12 per Share Cash 48,000 Treasury Stock 40,000 Capital in Excess of Cost–Treasury Stock
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September 3; Sale of Three Thousand Shares of Treasury Stock Costing $10 Each for $7 per Share Cash Capital in Excess of Cost–Treasury Stock Retained Earnings Treasury Stock
21,000 8,000 1,000 30,000
4. THE ISSUANCE OF CASH AND STOCK DIVIDENDS 1. Identify the various dates associated with a dividend distribution. 2. Prepare journal entries to report a cash dividend declaration and payment to stockholders. 3. Define the characteristics of a cumulative dividend. 4. Explain a company’s rationale for issuing a stock dividend or stock split. 5. Record the issuance of a stock dividend. 4.1— Reporting Dividend Distributions [PowerPoint 16-37] Chronologically, accounting for dividends involves several dates with approximately two to five weeks passing between each: • The date of declaration • The date of record (and the related ex-dividend date) • The date of payment (also known as the date of distribution) 4.1.1—Work through an example of paying dividends [PowerPoint 16-38, 39] To illustrate, assume that the Hurley Corporation has: Authorized 1 million shares Issued 300,000 shares Treasury stock 20,000 shares Outstanding 280,000 shares In the current year, Hurley earned a reported net income of $780,000. After some deliberations, the board of directors votes to distribute a $1.00 cash dividend to the owner of each share of common stock. The day on which Hurley’s board of directors formally decides on the payment of this dividend is known as the date of declaration. Legally, this action creates a liability for
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the company that must be recognized as shown below. Dividends are only paid on shares that are outstanding so the liability balance is $280,000. $1.00 per Share Dividend Declared by Board of Directors, 280,000 Shares Outstanding Retained Earnings 280,000 Dividends Payable 280,000 When the dividend is declared by the board, the date of record is also set. Only the shareholders who own the stock on that day qualify for receipt. The ex-dividend date is the first day on which an investor is not entitled to the dividend. No journal entry is recorded by a corporation on either the date of record or the exdividend date because they do not represent an event or transaction. On the date of payment, the corporation mails checks to the appropriate recipients. This event is recorded as follows. Payment of $1.00 per Share Cash Dividend Dividends Payable 280,000 Cash
280,000
4.2— Cumulative Preferred Stock [PowerPoint 16-40] Preferred stock dividends are often identified on the stock certificate as “cumulative.” This term indicates that any obligation for unpaid dividends on these shares must be met before dividends can be distributed to the owners of common stock. Cumulative dividends are referred to as “in arrears” when past due. 4.2.1—Show an example of preferred dividends [PowerPoint 16-41, 42] Wington Company issues 1,000 shares of $100 par value preferred stock to an investor on January 1, Year One. The preferred stock certificate specifies an annual dividend rate of 8 percent. Dividend payment = $100 × 8 percent Dividend payment = $8 per share each year At the end of Year One, Wington faces a cash shortage and the board of directors chooses not to pay this dividend. If the dividend on the preferred shares of Wington is cumulative, the $8 per share is in arrears at the end of Year One. In the future, this (and any other) missed dividend will have to be paid before any distribution to the owners of on common stock can be considered. Conversely, if a preferred stock is noncumulative, a missed dividend is simply lost to those owners. It has no impact on the future allocation of dividends between preferred and common shares. The existence of a cumulative preferred stock dividend in arrears is information that
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must be disclosed through a note to the financial statements. However, the balance is not reported as a liability. Only dividends that have been formally declared by the board of directors are recorded through a journal entry.
4.3—Distribution of Stock Dividends [PowerPoint 16-43] When a stock dividend (or stock split) is issued, the number of shares held by every investor increases but their percentage of the ownership stays the same. Their interest in the corporation remains proportionally unchanged. They have gained nothing. 4.3.1—Work through an example of a stock dividend [PowerPoint 16-44, 45, 46]
Red Company reports net assets of $5 million. Janis Samples owns one thousand of the ten thousand shares of this company’s outstanding common stock. Thus, she holds a 10 percent interest (1,000 shares/10,000 shares) in a business with net assets of $5 million. The board of directors then declares and distributes a 4 percent stock dividend. New shares = 4% × 10,000 New shares = 400 Total shares outstanding = 10,400 Janis Samples’ new shares = 4% × 1,000 Janis Samples’ new shares = 40 Janis Samples’ holdings = 1,040 shares After this stock dividend, she still owns 10 percent of the outstanding stock of Red Company (1,040/10,400) and the company still reports net assets of $5 million. The investor’s financial position has not improved. She has gained nothing as a result of the stock dividend. The corporation makes a journal entry to record the issuance of a stock dividend although distribution creates no impact on either assets or liabilities. The retained earnings balance is decreased by the fair value of the shares issued while contributed capital (common stock and capital in excess of par value) is also increased by this same amount. Fair value is used here because the company could have issued those new shares for that amount of cash and then paid the money out as a dividend. Issuing a stock dividend creates the same overall impact. One exception to this method of reporting is applied. According to U.S. GAAP, if a stock dividend is especially large (in excess of 20-25 percent of the outstanding shares), the change in retained earnings and contributed capital is recorded at par value rather than fair value. When the number of shares issued becomes this large, fair value is no longer
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viewed as a reliable indicator of the financial effect of the distribution.
4.4—Why Issue a Stock Dividend [PowerPoint 16-47] The primary purpose served by a stock dividend (or a stock split) is a reduction in the market price of the corporation’s capital stock. When the price of a share rises to a relatively high level, fewer investors are willing to make purchases. By issuing a large quantity of new shares, the price falls, often precipitously. Stock dividends also provide owners with the possibility of other benefits. For example, cash dividend payments usually drop after a stock dividend but not always in proportion to the change in the number of outstanding shares.
5. THE COMPUTATION OF EARNINGS PER SHARE 1. Compute and explain return on equity. 2. Discuss the reasons that earnings per share (EPS) figures are so closely watched by investors. 3. Calculate basic EPS with or without the existence of preferred stock. 4. Explain the relevance of the P/E ratio. 5. Identify the informational benefit provided by diluted EPS.
5.1—The Calculation of Return on Equity [PowerPoint 16-49] Return on equity reflects the profitability of a business based on the size of the owners’ claim to net assets. It is simply the reported net income divided by the average stockholders’ equity for the period. Return on equity = Net Income/Average Stockholders’ Equity 5.1.1—Work through an example of calculating return on equity [PowerPoint 16-50, 51]
PPG Industries, Inc. began 2010 with total stockholders’ equity of $3,922 million. Partly because of a large acquisition of treasury stock and the payment of a $360 million cash dividend, the company ended that year with stockholders’ equity of only $3,833 million. For the year ended December 31, 2010, PPG reported net income of $880 million. Determine PPG’s return on equity for 2010.
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Average Stockholders’ Equity = ($3,922 million + $3,833 million)/2 = $3,877.5 million return on equity = $880 million/$3,877.5 million = 22.7%
5.1.2—Have students work through an example of calculating return on equity, either individually or in teams [PowerPoint 16-52, 53] White Industries reported sales of $4,000,000 and expenses of $3,200,000 during 2019. White began the year with stockholders’ equity of $3,800,000 and ended the year with stockholders’ equity of $4,200,000. Determine White’s ROE. Net income = Sales – Expenses Net income = $4,000,000 – $3,200,000 Net income = $800,000 Average Stockholders’ Equity = ($3,800,000 + $4,200,000)/2 = $4,000,000 ROE = Net Income/Average Stockholders’ Equity ROE = $800,000/$4,000,000 ROE = 20%
5.2— Earnings Per Share and the P/E Ratio PowerPoint 16-54] The simple reason for the public fascination with EPS is that this number is generally considered to be linked to the market price of a company’s capital stock. Therefore, constant and wide-scale speculation takes place about future EPS figures as a technique for forecasting future stock prices. If analysts merely predict an increase in EPS, this forecast alone can lead to a surge in the traded price of a company’s shares. A price-earnings ratio (P/E ratio) is even computed to help quantify this relationship. The P/E ratio is the current price of the stock divided by the latest EPS figure. It enables investors to anticipate movements in the price of a stock based on projections of earnings per share. If a company’s P/E ratio is twenty and is expected to remain constant, then an increase in EPS of $1 should lead to a $20 rise in stock price.
5.3—Calculating Earnings Per Share [PowerPoint 16-55] EPS is a common stock computation designed to measure operating results after all other claims have been satisfied. In simplest form, EPS (often referred to as basic EPS) is the net income for the period divided by the weighted average number of outstanding shares of common stock. The computation allocates a company’s income equally to each of its shares. Because EPS only relates to common stock, this computation is altered slightly if any ©2012 Flat World Knowledge, Inc.
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preferred stock shares are also outstanding. Preferred stock is normally entitled to a specified dividend before common stock has any claim. However, most preferred stocks get nothing other than that dividend. Therefore, in determining basic EPS, any preferred stock dividend must be removed to arrive at the portion of income that is attributed to the ownership of common stock. Basic EPS = (Net Income – Preferred Stock Dividend)/Average Number of Common Shares Outstanding 5.3.1—Work through an example of calculating EPS and the P/E ratio [PowerPoint 16-56, 57]
Maris Company reports its most recent net income as $700,000. If the company has a weighted average of 200,000 shares of common stock outstanding for this period of time, what is the company’s EPS? EPS = $700,000/200,000 EPS = $3.50 per share If the market price of Maris Company stock is $35, what is the company’s P/E ratio? P/E ratio = $35/$3.50 P/E ratio = 10 5.3.2—Have students work through an example of calculating EPS and the P/E ratio, either individually or in teams [PowerPoint 16-58, 59] Aberdeen Corporation finished the year with a net income of $350,000. It also paid preferred dividends of $25,000. The company began the year with 50,000 common shares outstanding. It sold an additional 20,000 shares on April 1. The company’s stock price is $45. Determine EPS and the P/E ratio for this company. Weighted average common shares outstanding = 50,000 + 20,000 (9/12) Weighted average common shares outstanding = 65,000 EPS = ($350,000 – $25,000)/65,000 EPS = $5 per share P/E ratio = $45/$5 P/E ratio = 9
5.4—Diluted Earnings Per Share [PowerPoint 16-60] All publicly traded companies must disclose basic EPS. Income reported for the period (after removal of any preferred stock dividends) is allocated evenly over the weighted average number of shares of outstanding common stock. Basic EPS is a mechanically derived figure based on the historically reported income and number of shares ©2012 Flat World Knowledge, Inc.
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outstanding. Many corporations also have other contractual obligations outstanding that could become common stock and, therefore, potentially affect this computation. Stock options, convertible bonds, and convertible preferred stock can each be exchanged in some manner for common stock shares. The decision to convert is usually up to the holder and out of the control of the company. If these conversions ever take place, the additional shares could cause EPS to drop—possibly by a significant amount. This potential reduction should be brought to the attention of investors. Diluted EPS provides a “worst case scenario” by setting up a hypothetical computation to give weight to the possibility of such conversions. Stock options, convertible bonds, convertible preferred stocks, and the like could become common stock and reduce a company’s reported EPS. Thus, U.S. GAAP requires that this possible impact is calculated and shown by the reporting of a lower diluted EPS.
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CHAPTER 17 In a Set of Financial Statements, What Information Is Conveyed by the Statement of Cash Flows? 1. THE STRUCTURE OF A STATEMENT OF CASH FLOWS 1. Describe the purpose of a statement of cash flows. 2. Define “cash” and “cash equivalents.” 3. Identify the three categories disclosed within a statement of cash flows. 4. Indicate the type of transactions that are reported as operating activities and provide common examples. 5. Indicate the type of transactions that are reported as investing activities and provide common examples. 6. Indicate the type of transactions that are reported as financing activities and provide common examples. 1.1—The Importance of a Statement of Cash Flows [PowerPoint 17-4, 5]
Some decision makers view the statement of cash flows as the most important of the financial statements. They are able to see how corporate officials managed to get and then make use of the ultimate asset: cash. Presentation of a statement of cash flows is required by U.S. GAAP for every period in which an income statement is reported. The income statement and the statement of cash flows connect the balance sheets from the beginning of the year to the end. During that time, total reported net assets either increase or decrease as does the entity’s cash balance. The individual causes of those changes are explained by means of the income statement and the statement of cash flows. The purpose of the statement of cash flows is virtually self-evident: It reports the cash receipts (cash inflows) and the cash disbursements (cash outflows) to explain the changes in cash that took place during the year.
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1.2—Cash And Cash Equivalents [PowerPoint 17-6] Cash consists of coins, currencies, bank deposits (both checking accounts and savings accounts) and some negotiable instruments (money orders, checks, and bank drafts). Cash equivalents are short-term, highly liquid investments that are readily convertible into known amounts of cash. Only securities with original maturities of ninety days or fewer are classified as cash equivalents. Cash equivalents held by most companies include treasury bills, commercial paper, and money market funds.
1.3—Cash Flows from Operating Activities [PowerPoint 17-7] Operating activities generally involve producing and delivering goods and providing services to customers. These events are those that transpire on virtually a daily basis as a result of the organization’s primary function. Typical Operating Activity Cash Inflows and Outflows Cash Inflows Receipts from the Sale of Goods or Services Cash Outflows Payments for Inventory Payments to Employees Payments for Taxes Payments for Rents, Insurance, Advertising, and the Like The net number for the period (the inflows compared to the outflows) is presented as the cash flows generated from operating activities. This figure is viewed by many decision makers as a good measure of a company’s ability to prosper. Investors obviously prefer to see a positive number, one that increases from year to year.
1.4—Investing Activity Cash Flows [PowerPoint 17-8] Investing activities encompass the acquisition and disposition of assets in transactions that are separate from the central activity of the reporting organization. In simple terms, these cash exchanges do not occur as part of daily operations. Typical Investing Activity Cash Inflows and Outflows Cash Inflows Receipts from the Sale of Property, Equipment Receipts from the Sale of Intangibles Receipts from the Sale of Investments ©2012 Flat World Knowledge, Inc.
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Cash Outflows Payments for Property, Equipment Payment for Intangibles Payment for Investments Healthy, growing companies normally expect cash flows from investing activities to be negative (a net outflow) as money is invested by management especially in new noncurrent assets.
1.5—Financing Activity Cash Flows [PowerPoint 17-9] Financing activities are transactions separate from the central, day-to-day activities of an organization that involve either liabilities or shareholders’ equity accounts. Typical Financing Activity Cash Inflows and Outflows Cash Inflows: Issuances of Common Stock Borrowing Money Cash Outflows: Payment of Dividends Repayment of Loan Acquisition of Treasury Stock The net result reported for financing activities is frequently positive in some years and negative in others. When a company borrows money or sells capital stock, an overall positive inflow of cash is likely. In years when a large dividend is distributed or debt is settled, the net figure for financing activities is more likely to be negative.
1.6—Disclosure of Noncash Transactions [PowerPoint 17-10] All investing and financing transactions need to be reported in some manner because of the informational value. They represent choices made by the organization’s management. Even if no cash is involved, such events must still be disclosed in a separate schedule (often attached to the statement of cash flows) or explained in the notes to the financial statements. Stock dividends and stock splits are omitted entirely in creating a statement of cash flows. They are viewed as techniques to reduce the price of a corporation’s stock and are not decisions that impact the allocation of financial resources.
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2. CASH FLOWS FROM OPERATING ACTIVITIES: THE DIRECT METHOD 1. Identify the two methods available for reporting cash flows from operating activities. 2. Indicate the method of reporting cash flows from operating activities that is preferred by FASB as well as the one that is most commonly used in practice. 3. List the steps to be followed in determining cash flows from operating activities. 4. List the income statement accounts that are removed entirely in computing cash flows from operating activities and explain this procedure when the direct method is applied. 5. Identify common “connector accounts” that are used to convert accrual accounting figures to the change taking place in the cash balance as a result of these transactions. 6. Compute the cash inflows and outflows resulting from common revenues and expenses such as sales, cost of goods sold, rent expense, salary expense, and the like. 2.1— The Handling of Noncash and Nonoperating Transactions by the Direct Method [PowerPoint 17-14, 15] The net cash inflow or outflow generated by operating activities can be presented within the statement of cash flows by either of two approaches: the direct method and the indirect method. FASB has indicated a preference for the direct method. In contrast, reporting companies (by an extremely wide margin) continue to use the more traditional indirect method. The direct method starts with the entire income statement for the period. Then, each of the separately reported figures is converted into the amount of cash received or spent in carrying on this operating activity. “Sales,” for example, is turned into “cash collected from customers.” “Salary expense” and “rent expense” are recomputed as “cash paid to employees” and “cash paid to rent facilities.”
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2.1.1—Work through an example of preparing the operating section in a statement of cash flows using the direct method [PowerPoint 1716 through 26]
Note: This problem will be used to illustrate each step in preparing the operating section in a statement of cash flows using the direct method and then a comprehensive review problem will appear at the end of the section. For illustration purposes, assume that that Liberto Company prepared its income statement for the year ended December 31, Year One. This statement has been kept rather simple so that the conversion to cash flows from operating activities is not unnecessarily complex. For example, income tax expense has been omitted. Liberto Company Income Statement Year Ended December 31, Year One Revenues: Sales to Customers $480,000 Expenses: Cost of Goods Sold $250,000 Salary Expense 60,000 Rent Expense 30,000 Depreciation Expense 80,000 420,000 Operating Income 60,000 Other Gains and Losses: Gain on Sale of Equipment 40,000 Net Income $100,000 To transform a company’s income statement into its cash flows from operating activities, three distinct steps must be taken. These steps are basically the same regardless of whether the direct method or the indirect method is applied. 1) Eliminate any income statement account that does not involve cash. Although such balances are important in arriving at net income, they are not relevant to the cash generated and spent in connection with daily operations. By far the most obvious example is depreciation. In determining cash flows from operating activities, it is omitted because depreciation is neither a source nor use of cash. It is an allocation of a historical cost to expense over an asset’s useful life. To begin the calculation of the cash flows resulting from Liberto’s operating activities, the $80,000 depreciation expense must be removed. 2) Remove any gains and losses that resulted from investing or financing activities. Although cash was likely involved in these transactions, this inflow or outflow is reported elsewhere in the statement of cash flows and not within the company’s operating activities. For example, Liberto’s $40,000 gain on the sale of equipment is germane to the ©2012 Flat World Knowledge, Inc.
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reporting of investing activities, not operating activities. After all noncash and nonoperating balances are deleted, Liberto is left with four income statement accounts: 1. 2. 3. 4.
Sales to Customers – $480,000 Cost of Goods Sold – $250,000 Salary Expense – $60,000 Rent Expense – $30,000
These balances all relate to operating activities. However, the numbers reflect the application of U.S. GAAP and accrual accounting rather than the amount of cash exchanged. The cash effects must be determined individually for these accounts. 3) Individually convert to cash all of the remaining income statement accounts. By this process, accrual accounting figures are converted to cash balances. For these balances, a difference usually exists between the time of recognition as specified by accrual accounting and the exchange of cash. Each income statement account (other than the noncash and nonoperating numbers that have already been eliminated) has at least one asset or liability that is recorded between the time of accounting recognition and the exchange of cash. In this textbook, these interim accounts will be referred to as “connector accounts” because they connect the recording mandated by accrual accounting with the cash transaction. The changes in these connector accounts can be used to convert the individual income statement figures to their cash equivalents. Basically, the increase or decrease is removed to revert the reported number back to the amount of cash involved. Connector accounts are mostly receivables, payables, and prepaid expenses. Common Connector Accounts for Liberto’s Four Income Statement Balances Income Statement Account Sales to Customers Cost of Goods Sold Salary Expense Rent Expense
Balance Sheet Connector Account Accounts Receivable Inventory and Accounts Payable Salary Payable Prepaid Rent and Rent Payable
Increase in connector account that is an asset → Lower cash balance Decrease in connector account that is an asset → Higher cash balance
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Increase in connector account that is a liability → Higher Cash balance Decrease in connector account that is a liability → Lower Cash balance Liberto has one revenue and three expenses left on its income statement after removal of noncash and nonoperating items. To arrive at the net cash flows from operating activities, the cash inflow or outflow relating to each must be determined. Assume that the following changes took place during this year in the related balance sheet connector accounts: • • • • • •
•
•
•
Accounts receivable: up $19,000 Inventory: down $12,000 Prepaid rent: up $4,000 Accounts payable: up $9,000 Salary payable: down $5,000
Sales to customers were reported on the income statement as $480,000. During that same period, accounts receivable increased by $19,000. Thus, less money was collected than the amount of the company’s credit sales. That is the cause for a rise in receivables. To reflect the collection of less cash, a reduction is needed. Consequently, the cash received from customers was only $461,000 ($480,000 less $19,000). Salary expense was reported as $60,000. During that time period, salary payable went down by $5,000. More cash must have been paid to cause this drop in the liability. The amount actually paid to employees was $65,000 ($60,000 plus $5,000). Rent expense was reported as $30,000. Prepaid rent increased by $4,000 from the first of the year to the end. This connector account is an asset. Because this asset increased, Liberto must have paid an extra amount for rent. Cash paid for rent was $34,000 ($30,000 plus $4,000). Cost of goods sold has been left to last because it requires an extra step. The company first determines the quantity of inventory bought during this period. Only then can the cash payment made for those acquisitions be determined. o Cost of goods sold is reported as $250,000. However, the balance held in inventory fell by $12,000. Thus, the company bought $12,000 less inventory than it sold. Fewer purchases cause a drop in inventory. The amount of inventory acquired during the period was only $238,000 ($250,000 less $12,000). o Next, the cash paid for those purchases is calculated. As indicated, accounts payable went up $9,000. Liabilities increase because less money is paid. Although $238,000 of merchandise was acquired, only $229,000 in cash payments were made ($238,000 less $9,000).
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After each of these four income statement accounts is converted to the amount of cash received or paid this period, the operating activity section of the statement of cash flows can be created by the direct method. Liberto Company Statement of Cash Flows for Year One, Operating Activities Reported by Direct Method Cash Collected from Customers $461,000 Cash Paid to Acquire Inventory (229,000) Cash Paid to Employees (65,000) Cash Paid for Rent (34,000) Cash Generated by Operating Activities $133,000 2.1.2—Have students work through an example of preparing the operating section in a statement of cash flows using the direct method, either individually or in teams [PowerPoint 17-27 to 32] Breeze Corporation presents the following income statement at the end of 2016: Breeze Company Income Statement Year Ended December 31, 2016 Revenues: Sales to Customers $50,000 Expenses: Cost of Goods Sold $30,000 Salary Expense 4,000 Interest Expense 2,000 Depreciation Expense 7,000 43,000 Operating Income 7,000 Other Gains and Losses: Gain on Sale of Equipment 2,000 Net Income $ 9,000 Breeze presents the following connector account changes for the year: • • • • •
Accounts receivable: down $4,000 Inventory: up $1,000 Accounts payable: up $900 Salary payable: down $400 Interest payable: down $500
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Prepare the operating section of Breeze’s cash flow statement using the direct method. Sales $50,000 Decrease in Accounts Receivable 4,000 Cash Collected from Customers $54,000 Salary Expense Decrease in Salary Payable Cash Paid for Salaries
$4,000 400 $4,400
Interest Expense Decrease in Interest Payable Cash Paid for Interest
$2,000 500 $2,500
First step: Calculate purchases Cost of Goods Sold Increase in Inventory Purchases
$30,000 1,000 $31,000
Second step: Calculate Cash Paid for Purchases Purchases $31,000 Increase in Accounts Payable (900) Cash Paid for Purchases $30,100 Breeze Company Statement of Cash Flows for 2016, Operating Activities Reported by Direct Method Cash Collected from Customers $54,000 Cash Paid to Acquire Inventory (30,100) Cash Paid to Employees (4,400) Cash Paid for Interest (2,500) Cash Generated by Operating Activities $17,000
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3. CASH FLOWS FROM OPERATING ACTIVITIES: THE INDIRECT METHOD 1. Explain the difference in the start of the operating activities section of the statement of cash flows when the indirect method is used rather than the direct method. 2. Demonstrate the removal of both noncash items and nonoperating gains and losses in the application of the indirect method. 3. Determine the effect caused by the change in the various connector accounts when the indirect method is used to present cash flows from operating activities. 4. Identify the reporting classification for interest revenues, dividend revenues, and interest expense in creating a statement of cash flows and explain the controversy that resulted from this handling. 3.1—The Steps Followed in Applying the Indirect Method [PowerPoint 17-35]
The indirect method actually follows the same set of procedures as the direct method except that it begins with net income rather than the business’s entire income statement. After that, the same three steps demonstrated previously to determine the net cash flows from operating activities are followed although the mechanical application here is different. 1. Noncash items are removed. 2. Nonoperational gains and losses are removed. 3. Adjustments are made, based on the monetary change occurring during the period in the various balance sheet connector accounts, to switch all remaining revenues and expenses from accrual accounting to cash accounting.
3.2—Removing Noncash And Nonoperating Items – The Indirect Method [PowerPoint 17-36] First, all noncash items within net income are eliminated. Depreciation is the example included here. As an expense, it is a negative component found within net income. To remove a negative, it is offset by a positive. Thus, adding back depreciation serves to remove their impact from the reporting company’s net ©2012 Flat World Knowledge, Inc.
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income. Second, all nonoperating items within net income are eliminated. A gain on sale of a noncurrent asset is reported within reported income as a positive figure. It helped to increase profits this period. To eliminate this gain, the amount must be subtracted from net income. The cash flows resulting from this transaction came from an investing activity and not an operating activity. Similarly, a loss on the sale of a noncurrent asset would be added to eliminate it. 3.2.1—Work through an example of preparing the operating section in a statement of cash flows using the indirect method [PowerPoint 17-37 to 42]
Note: This problem will be used to illustrate each step in preparing the operating section in a statement of cash flows using the indirect method and then a comprehensive review problem will appear at the end of the section. For illustration purposes, assume that that Liberto Company prepared itsthe following income statement for the year ended December 31, Year One. Liberto Company Income Statement Year Ended December 31, Year One Revenues: Sales to Customers Expenses: Cost of Goods Sold Salary Expense Rent Expense Depreciation Expense Operating Income Other Gains and Losses: Gain on Sale of Equipment Net Income
$480,000 $250,000 $60,000 $30,000 $80,000
420,000 60,000 40,000 $100,000
The first portion of the statement of cash flows begins with the two eliminations discussed above: Net income Eliminate: Depreciation Expense Gain on Sale of Equipment
$100,000 +80,000 (40,000)
After all noncash and nonoperating items are removed from net income, only the changes in the balance sheet connector accounts must be utilized to complete the conversion to cash. For Liberto, those balances were shown ©2012 Flat World Knowledge, Inc.
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previously. • • • • •
Accounts receivable: up $19,000 Inventory: down $12,000 Prepaid rent: up $4,000 Accounts payable: up $9,000 Salary payable: down $5,000
Although the procedures appear to be different, the same logic is applied in the indirect method as in the direct method. The change in each of the above connector accounts discloses the difference in the accrual accounting amounts recognized in the income statement and the actual changes in cash. Here, though, the effect is measured on net income as a whole rather than on the individual revenue and expense accounts. Accounts receivable increased by $19,000. This rise in the receivable balance shows that less money was collected than the sales made by Liberto during the period. Receivables go up because customers are slow to pay. This change results in a lower cash balance. Thus, the $19,000 is subtracted in arriving at the cash flow amount generated by operating activities. The cash received was actually less than the figure reported for sales that appears within the company’s net income. Subtract $19,000. Inventory decreased by $12,000. A drop in the amount of inventory on hand indicates that less merchandise was purchased during the period. Buying less requires a smaller amount of cash to be paid. That leaves the cash balance higher. The $12,000 is added in arriving at the operating activity change in cash. Add $12,000. Prepaid rent increased by $4,000. An increase in any prepaid expense shows that more of the asset was acquired during the year than was consumed. This additional purchase requires the use of cash; thus, the resulting cash balance is lower. The increase in prepaid rent necessitates a $4,000 subtraction in the operating activity cash flow computation. Subtract $4,000. Accounts payable increased by $9,000. Any jump in a liability means that Liberto paid less cash during the period than the debts that were incurred. Postponing liability payments is a common method for saving cash to keep the reported balance high. In determining cash flows from operating activities, the $9,000 liability increase is added. Add $9,000. Salary payable decreased by $5,000. Liability balances fall when additional payments are made. Such cash transactions are reflected in applying the indirect method by a $5,000 subtraction from net income. Subtract $5,000. Therefore, if Liberto Company uses the indirect method to report its cash flows from operating activities, the information will be presented to decision makers ©2012 Flat World Knowledge, Inc.
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as: Liberto Company Statement of Cash Flows for Year One, Operating Activities Reported by Indirect Method Net income Eliminate: Depreciation Expense Gain on Sale of Equipment Adjust Revenues and Expenses from Accrual Accounting to Cash: Increase in Accounts Receivable Decrease in Inventory Increase in Prepaid Rent Increase in Accounts Payable Decrease in Salary Payable Cash Generated by Operating Activities
$100,000 +80,000 (40,000)
(19,000) +12,000 (4,000) + 9,000 (5,000) $133,000
3.3—The Reporting of Dividends and Interest on the Statement of Cash Flows [PowerPoint 17-43] When FASB issued its official standard on cash flows in 1987, three of the seven board members voted against passage. Their opposition, at least in part, came from the handling of interest and dividends. They believed that interest and dividends received are returns on investments in debt and equity securities that should be classified as cash inflows from investing activities. They believe that interest paid is a cost of obtaining financial resources that should be classified as a cash outflow for financing activities. The other board members were not convinced. Thus, inclusion of dividends collected, interest collected, and interest paid within an entity’s operating activity cash flow became a requirement of U.S. GAAP. The majority of the board apparently felt that—because these transactions occur on a regular ongoing basis— a better portrait of the organization’s cash flows is provided by inclusion within operating activities.
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3.3.1—Have students work through an example of preparing the operating section in a statement of cash flows using the indirect method, either individually or in teams [PowerPoint 17-44,45,46] Breeze Corporation’s income statement at the end of 2016 : Breeze Company Income Statement Year Ended December 31, 2016 Revenues: Sales to Customers $50,000 Expenses: Cost of Goods Sold $30,000 Salary Expense 4,000 Interest Expense 2,000 Depreciation Expense 7,000 43,000 Operating Income 7,000 Other Gains and Losses: Gain on Sale of Equipment 2,000 Net Income $ 9,000 Breeze presents the following connector account changes for the year: Accounts receivable: down $4,000 Inventory: up $1,000 Accounts payable: up $900 Salary payable: down $400 Interest payable: down $500
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Prepare the operating section of Breeze’s cash flow statement using the indirect method. Breeze Company Statement of Cash Flows for Year 2016, Operating Activities Reported by Indirect Method Net income Depreciation Expense Gain on Sale of Equipment Adjust Revenues and Expenses from Accrual Accounting to Cash: Decrease in Accounts Receivable Increase in Inventory Increase in Accounts Payable Decrease in Salary Payable Decrease in Interest Payable Cash Generated by Operating Activities
$9,000 +7,000 (2,000)
+4,000 (1,000) +900 (400) (500) $17,000
4. CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES 1. Analyze the changes in assets that are not operating assets to determine cash inflows and outflows from investing activities. 2. Analyze the changes in liabilities (that are not operating liabilities) and stockholders’ equity accounts to determine cash inflows and outflows from financing activities. 3. Recreate journal entries to determine the individual effects on ledger accounts where several cash transactions have occurred. 4.1—Determining Cash Flows from Investing Activities [PowerPoint 17-48]
Here, the accountant is not interested in assets such as inventory, accounts receivable, and prepaid rent because they are included within operating activities. Instead, each of the other asset accounts (land, buildings, equipment, patents, trademarks, and the like) is investigated to determine the individual transactions that took place during the year.
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The difficulty in this process frequently comes from having to sort through multiple purchases and sales to compute the exact amount of cash involved in each transaction. Often, the journal entries that were made originally must be replicated. Even then, the cash portion of these transactions may have to be determined by mathematical logic. 4.1.1—Work through an example of preparing the investing section of a statement of cash flows [PowerPoint 17-49 through 55] Note: This problem will be used to illustrate each step in preparing the investing section of a statement of cash flows and then a comprehensive review problem will appear at the end of the section. Hastings Company reports the following account balances. January 1, Year One
December 31, Year One
Equipment
$730,000
$967,000
Accumulated Depreciation
300,000
450,000
Balance Sheet:
Income Statement: Depreciation Expense
230,000
Gain on Sale of Equipment
74,000
In looking through the financial records maintained by this business, assume, the accountant finds two additional pieces of information about the accounts: • Equipment costing $600,000 was sold this year for cash. • Other equipment was acquired, also for cash. Sale of Equipment. This transaction is analyzed first because the cost of the equipment is already provided. However, the accumulated depreciation relating to the disposed asset is not known. The accountant must study the available data to determine that missing number because that balance is also removed when the asset is sold. Accumulated depreciation at the start of the year was $300,000 but depreciation expense of $230,000 was then reported as shown above. This expense was recognized through the following year-end adjustment. Assumed Adjusting Entry for Depreciation Depreciation Expense Accumulated Depreciation
230,000 230,000
The depreciation entry increases the accumulated depreciation account to ©2012 Flat World Knowledge, Inc.
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$530,000 ($300,000 plus $230,000). However, the end-of-year balance is not $530,000 but only $450,000. Here, the accountant knows equipment was sold. Although the amount of accumulated depreciation relating to that asset is unknown, the assumption can be made that the sale caused this reduction of $80,000. Accumulated Depreciation ? 300,000 230,000 450,000 Thus, the accountant believes equipment costing $600,000 but with accumulated depreciation of $80,000 (and, hence, a net book value of $520,000) was sold. The amount received must have created the $74,000 gain that is shown in the reported balance presented above. A hypothetical journal entry can be constructed from this information. Assumed Journal Entry for Sale of Equipment Cash Accumulated Depreciation Equipment Gain on Sale of Equipment
??? 80,000 600,000 74,000
This journal entry only balances if the cash received is $594,000. Equipment with a book value of $520,000 was sold during the year at a reported gain of $74,000. Apparently, $594,000 was the cash received. Purchase of Equipment. According to the information provided, another asset was acquired this year but its cost is not provided. Once again, the accountant must puzzle out the amount of cash involved in the transaction. The equipment account began the year with a $730,000 balance. The sale of equipment costing $600,000 was just discussed. This transaction should have dropped the ledger account to $130,000 ($730,000 less $600,000). However, at the end of the period, the amount reported for this asset is actually $967,000. Equipment 730,000 600,000 ? 967,000 How did the cost of equipment rise from $130,000 to $967,000? If no other transaction is mentioned, the most reasonable explanation is that equipment was acquired at a cost of $837,000 ($967,000 less $130,000). Unless information is available indicating that part of this purchase was made on credit, the journal ©2012 Flat World Knowledge, Inc.
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entry that was recorded originally must have been: Assumed Journal Entry for Purchase of Equipment Equipment Cash
837,000 837,000
At this point, the changes in all related accounts (equipment, accumulated depreciation, depreciation expense, and the gain on sale of equipment) have been used to determine the two transactions for the period and their related cash inflows and outflows. In the statement of cash flows for this company, the investing activities are listed as follows. Statement of Cash Flows Investing Activities Sold Equipment Purchased Equipment Net Cash Outflow—Investing Activities
$594,000 (837,000) ($243,000)
4.2— Determining Cash Flows from Financing Activities [PowerPoint 17-56]
As has been indicated, financing activities reflect transactions that are not part of a company’s central operations and involve either a liability or a stockholders’ equity account. The procedures used in determining the cash amounts to be reported as financing activities are the same as demonstrated above for investing activities. The change in each relevant balance sheet account is analyzed to determine cash payments and receipts. In starting this process, many liabilities such as accounts payable, rent payable, and salaries payable are ignored because they relate only to operating activities. However, the remaining liabilities and all stockholders’ equity accounts must be studied.
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4.2.1—Work through an example of preparing the financing section of a statement of cash flows [PowerPoint 17-57 through 65] Note: This problem will be used to illustrate each step in preparing the financing section of a statement of cash flows and then a comprehensive review problem will appear at the end of the section. To illustrate, various account balances for the Hastings Corporation are presented in the following schedule. January 1, Year One
December 31, Year One
$680,000 (400,000) 120,000 454,000
$876,000 (300,000) 160,000 619,000
Balance Sheet: Note Payable Treasury Stock Capital in Excess of Cost Retained Earnings Income Statement: Loss on Early Extinguishment of Debt Net Income
25,000 200,000
In examining the financial records for the Hastings Corporation for this year, the accountant finds several additional pieces of information: 1. Cash of $400,000 was borrowed by signing a note payable with a local bank. 2. Another note payable was paid off prior to its maturity date because of a drop in interest rates. 3. Treasury stock was reissued to the public for cash. 4. A cash dividend was declared and distributed. Once again, the various changes in each account balance can be analyzed to determine the cash flows, this time to be reported as financing activities. Borrowing on Note Payable. Complete information about this transaction is available. Hastings Corporation received $400,000 in cash from a bank by signing a note payable. The journal entry to record the incurrence of this liability is: Assumed Journal Entry for Signing of Note Payable Cash Note Payable
400,000 400,000
On a statement of cash flows, this transaction is listed within the financing activities as a $400,000 cash inflow. ©2012 Flat World Knowledge, Inc.
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Paying Note Payable. Incurring the above $400,000 debt raises the note payable balance from $680,000 to $1,080,000. By the end of the year, this account only shows a total of $876,000. The company’s notes payable have decreased in some way by $204,000 ($1,080,000 less $876,000). According to the information gathered by the accountant, a debt was paid off this year prior to maturity. In addition, the general ledger reports a $25,000 loss on the early extinguishment of a debt. When a bond or note is settled before its maturity, a penalty payment is often required. Once again, the journal entry for this transaction can be recreated by logical reasoning. Note Payable ? 680,000 400,000 876,000
Assumed Journal Entry for Extinguishment of Debt Note Payable Loss on Extinguishment of Debt Cash
204,000 25,000 ???
To balance this entry, cash of $229,000 must have been paid. Spending this amount of money to extinguish a $204,000 liability creates the $25,000 reported loss. The cash outflow of $229,000 relates to a liability and is, thus, listed on the statement of cash flows as a financing activity. Issuance of Treasury Stock. This equity balance reflects the cost of all repurchased shares. During the year, the total in the T-account fell by $100,000 from $400,000 to $300,000. Apparently, $100,000 was the cost of the company’s shares reissued to the public. At the same time, the capital in excess of cost balance rose from $120,000 to $160,000. That $40,000 increase in contributed capital must have been created by this issuance since no other stock transaction is mentioned. The shares were sold for more than their purchase price. Treasury Stock 400,000 ? 300,000
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Capital in Excess of Cost—Treasury Stock 120,000 ? 160,000 Assumed Journal Entry for Sale of Treasury Stock Cash Treasury Stock Capital in Excess of Cost
??? 100,000 40,000
If the original cost of the treasury stock was $100,000 and $40,000 was added to the capital in excess of cost, the cash inflow from this transaction had to be $140,000. Cash received from the issuance of treasury stock is reported as a financing activity of $140,000 because it relates to a stockholders’ equity account. Distribution of Dividend. A dividend has been paid to the company’s stockholders but the amount is not shown in the information provided. However, other information is available. Net income for the period was reported as $200,000. Those profits increase retained earnings. As a result, the beginning balance of $454,000 increases to $654,000. Instead, retained earnings only rose to $619,000 by the end of the year. The unexplained drop of $35,000 ($654,000 less $619,000) must have resulted from the payment of the dividend. No other possible reason is given for this reduction. Hence, a cash dividend distribution of $35,000 is shown within the statement of cash flows as a financing activity. Retained Earnings ? 454,000 200,000 619,000 Assumed Journal Entry for Payment of Dividend Retained Earnings (or Dividend Paid) Cash
35,000
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In this example, four specific financing activity transactions have been identified as created changes in cash. Statement of Cash Flows - Financing Activities Borrowed on Note Payable Extinguishment of Note Payable Issuance of Treasury Stock Distribution of Cash Dividend Net Cash Outflow – Financing Activities
$400,000 (229,000) 140,000 (35,000) $276,000
4.2.2—Work through an example of preparing the financing section of a statement of cash flows [PowerPoint 17-66, 67, 68, 69, 70]
Equipment Accumulated Depreciation Note Payable Loss on Sale of Equipment
January 1, Year One $120,000 debit 50,000 credit 150,000 credit -
December 31, Year One $160,000 debit 70,000 credit 100,000 credit 24,000 debit
Here’s some other information: • A payment on a note was made this year. • Equipment was bought this year by paying cash. • Equipment costing $100,000 but with a $60,000 book value was sold for cash. a) Identify the two cash flows from investing activities. 1.Sale of equipment: Cash Accumulated depreciation Loss on sale of equipment Equipment
36,000 40,000 24,000 100,000 Equipment 120,000 100,000 ? 160,000
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2. Purchase of equipment must have been for $140,000. Equipment Cash
140,000 140,000
b) Identify the one cash flow from financing activities. 1.Payment made on Note Payable: Note Payable Cash
50,000 50,000
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