Accounting Principles, 12th Edition Solutions Manual by Ace Test Banks

Accounting Principles, International Student Version, 10th Edition BY Weygandt, Kimmel, Kieso

CHAPTER 1 ACCOUNTING IN ACTION LEARNING OBJECTIVES 1. IDENTIFY THE ACTIVITIES AND USERS ASSOCIATED WITH ACCOUNTING. 2. EXPLAIN THE BUILDING BLOCKS OF ACCOUNTING: ETHICS, PRINCIPLES, AND ASSUMPTIONS. 3. STATE THE ACCOUNTING EQUATION, AND DEFINE ITS COMPONENTS. 4. ANALYZE THE EFFECTS OF BUSINESS TRANSACTIONS ON THE ACCOUNTING EQUATION. 5. DESCRIBE THE FOUR FINANCIAL STATEMENTS AND HOW THEY ARE PREPARED. *6. EXPLAIN THE CAREER OPPORTUNITIES IN ACCOUNTING.

1-1

CHAPTER REVIEW Accounting Defined 1.

(L.O. 1) Accounting is an information system that identifies, records, and communicates the economic events of an organization to interested users. a. The first part of the process, identifying, involves selecting those events that are considered evidence of economic activity relevant to a particular business organization. b. Recording is the keeping of a chronological diary of events, measured in dollars and cents. c. Communication occurs through the preparation and distribution of accounting reports.

The accounting process consists of: Identification  Recording  Communication.

Internal users of accounting information are managers who plan, organize, and run a business. These include marketing managers, production supervisors, finance directors, and company officers.

External users include investors, creditors, taxing authorities, regulatory agencies, labor unions, and customers.

Ethics 5.

(L.O. 2) The standards of conduct by which one’s actions are judged as right or wrong, honest or dishonest, fair or not fair, are ethics. The process of analyzing ethics cases and situations is to recognize an ethical situation and the ethical issues involved, identify and analyze the principal elements in the situation (especially those harmed or benefited), identify the alternatives and weigh the impact of each alternative on various stakeholders, then select the most ethical alternative.

GAAP and Measurement Principles 6.

Generally accepted accounting principles (GAAP) are a common set of guidelines (standards) used by accountants.

The Securities and Exchange Commission (SEC) is the agency of the United States government that oversees U.S financial markets and accounting standard-setting bodies.

The Financial Accounting Standards Board (FASB) is the primary accounting standard-setting body in the United States. Many countries outside of the U.S. have adopted the accounting standards issued by the International Accounting Standards Board (IASB).

The historical cost principle requires that companies record assets at their cost. The fair value principle states that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability).

1-2

The Monetary Unit and Economic Entity Assumptions 10.

The accounting profession has developed certain assumptions that serve as guidelines for the accounting process. a. The monetary unit assumption requires that only transaction data that can be expressed in money terms be included in the accounting records. b. The economic entity assumption requires that the activities of the entity be kept separate and distinct from (1) the activities of its owner and (2) all other economic entities.

Business Enterprises 11.

Three types of business enterprises are proprietorships, partnerships, and corporations. a. A proprietorship is a business owned by one person. b. A partnership is a business owned by two or more persons associated as partners. c. A corporation is a business organized as a separate legal entity under state corporation law with ownership divided into transferable shares of stock.

The Accounting Equation 12.

(L.O. 3) The basic accounting equation is: Assets = Liabilities + Owner’s Equity. The accounting equation applies to all economic entities regardless of size, nature of business, or form of business organization.

13.

The key components of the basic accounting equation are: a. Assets are resources owned. b. Liabilities are claims against assets. c. Owner’s equity is the claims of owners.

14.

In proprietorships, there are four subdivisions of owner’s equity: a. Investments by Owner are the assets put in the business by the owner. b. Revenues are the gross increase in owner’s equity resulting from business activities entered into for the purpose of earning income. c. Drawings are withdrawals of cash or other assets by the owner for personal use. d. Expenses are the cost of assets consumed or services used in the process of earning revenue.

15.

Revenues and expenses determine if a net income or net loss occurs as follows: a. Revenues > Expenses = Net Income. b. Revenues < Expenses = Net Loss.

1-3

Transactions 16.

(L.O. 4) Transactions are the economic events of the business recorded by accountants. Transactions may be identified as either external or internal transactions.

17.

Each transaction must be analyzed in terms of its effect on the components of the basic accounting equation. The analysis must also identify the specific items affected and the amount of the change in each item.

18.

Each transaction has a dual effect on the equation. For example, if an individual asset is increased, there must be a corresponding: a. decrease in another asset, or b. increase in a specific liability, or c. increase in owner’s equity.

19.

A tabular summary may be prepared to show the cumulative effect of transactions on the basic accounting equation. The summary demonstrates that: a. Each transaction must be analyzed in terms of its effect on (1) the three components of the equation and (2) specific types of items within each component. b. The two sides of the equation must always be equal. c. The causes of each change in the owner’s claim on assets must be indicated in the owners’ equity column.

The Financial Statements 20. (L.O. 5) Four financial statements are prepared from the summarized accounting data: a. An income statement presents the revenues and expenses and resulting net income or net loss of a company for a specific period of time. b. An owner’s equity statement summarizes the changes in owner’s equity for a specific period of time. c. A balance sheet reports the assets, liabilities, and owner’s equity at a specific date. d. A statement of cash flows summarizes information concerning the cash inflows (receipts) and outflows (payments) for a specific period of time. 21. The financial statements are interrelated because: a. Net income (or net loss) shown on the income statement is added (subtracted) to (from) the beginning balance of owner’s capital in the owner’s equity statement. b. Owner’s capital at the end of the reporting period shown in the owner’s equity statement is reported in the balance sheet. c. The amount of cash shown on the balance sheet is reported on the statement of cash flows. 22. In the income statement, revenues are listed first, followed by expenses. Then below expenses is the resulting amount of net income (or net loss). 23. The owner’s equity statement shows the owner’s capital at the beginning of the period, additional investments, net income (or net loss) for the period, owner’s drawings, and the owner’s capital at the end of the period. 24. In the balance sheet, assets are listed at the top, followed by liabilities and owner’s equity.

1-4

25. The statement of cash flows reports the sources, uses, and net increase or decrease in cash. Chapter 17 will examine in detail how the statement is prepared. *Careers in Accounting *26. (L.O. 6) Public accounting provides the services of auditing, taxation, and management consulting. a. Auditing involves examining financial statements of companies and expressing an opinion as to the fairness of their presentation. b. Taxation includes providing tax advice and planning, preparing tax returns, and representing clients before governmental agencies. c. Management consulting involves providing advice for managers on such matters as financial planning and control and the development of computer systems. *27. Private accounting involves the employment of accountants within individual companies. The private accountant performs a wide variety of duties such as general accounting, cost accounting, budgeting, accounting information systems, tax accounting, and internal auditing. *28. Opportunities in government are other options available such as employment with the Internal Revenue Service (IRS), Federal Bureau of Investigation (FBI) and the Securities and Exchange Commission (SEC). *29. Forensic accounting uses accounting, auditing, and investigative skills to conduct investigations into theft and fraud.

1-5

LECTURE OUTLINE A.

What Accounting Is. 1. Accounting consists of three basic activities—it identifies, records, and communicates the economic events of an organization to interested users. 2. Once a company identifies economic events, it records those events in order to provide a history of its financial activities. Recording consists of keeping a systematic, chronological diary of events, measured in dollars and cents. 3. A company communicates the collected information to interested users by means of accounting reports which are called financial statements. 4. A vital element in communicating economic events is the accountant’s ability to analyze and interpret the reported information. Interpretation involves explaining the uses, meaning, and limitations of reported data. 5. Bookkeeping usually involves only the recording of economic events and is therefore just one part of the accounting process. Accounting involves the entire process of identifying, recording, and communicating economic events.

Users and Uses of Accounting. 1. Internal users of accounting information are managers who plan, organize, and run a business. These include marketing managers, production supervisors, finance directors, and company officers.

1-6

2. External users are individuals and organizations outside of a company who are either: a.

Investors or creditors: Investors (owners) use accounting information to make decisions to buy, hold, or sell ownership shares of a company. Creditors (suppliers and bankers) use accounting information to evaluate the risks of granting credit or lending money.

Other external users: This includes taxing authorities (Internal Revenue Service), regulatory agencies (Securities and Exchange Commission), customers, and labor unions.

ACCOUNTING ACROSS THE ORGANIZATION Accounting can serve as a useful recruiting tool even for the human resources department. One company’s website includes the following: “operating results are posted and monthly group meetings inform all employees about what’s happening in the company.” What are the benefits to the company and to the employees of making the financial statements available to all employees? Answer: If employees can read and use financial reports, a company will benefit in the following ways. The marketing department will make better decisions about products to offer and prices to charge. The finance department will make better decisions about debt and equity financing and how much to distribute in dividends. The production department will make better decisions about when to buy new equipment and how much inventory to produce. The human resources department will be better able to determine whether employees can be given raises. Finally, all employees will be better informed about the basis on which they are evaluated, which will increase employee morale. C.

Ethics in Financial Reporting. 1. Ethics are the standards of conduct by which one’s actions are judged as right or wrong, honest or dishonest, fair or not fair. Effective financial reporting depends on sound ethical behavior.

1-7

2. In the process of analyzing ethics cases and situations, the following steps should be applied:

Recognize an ethical situation and the ethical issues involved.

Identify and analyze the principal elements in the situation.

Identify the alternatives, and weigh the impact of each alternative on various stakeholders.

Generally Accepted Accounting Principles. 1. Generally accepted accounting principles are a common set of standards used by accountants. 2. Two organizations are primarily responsible for establishing generally accepted accounting principles. a.

The Financial Accounting Standards Board (FASB) is the primary accounting standard–setting body in the United States.

The Securities and Exchange Commission (SEC) is the agency that oversees U.S. financial markets and accounting standard-setting bodies.

Many countries outside of the U.S. have adopted the accounting standards issued by the International Accounting Standards Board (IASB).

3. The historical cost principle (or cost principle) dictates that companies should record assets at their cost. This is also true over the time the asset is held. 4. The fair value principle states that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability).

1-8

Assumptions. 1. Monetary unit assumption. a.

Requires that companies include in the accounting records only transaction data that can be expressed in money terms. This assumption enables accounting to quantify (measure) economic events.

The monetary unit assumption is vital to applying the historical cost principle.

2. Economic entity assumption requires that the activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities. a.

A business owned by one person is generally a proprietorship.

A business owned by two or more persons associated as partners is a partnership.

A business organized as a separate legal entity under state corporation law and having ownership divided into transferable shares of stock is a corporation.

ACCOUNTING ACROSS THE ORGANIZATION The study of accounting should help students a great deal, because a working knowledge of accounting is desirable for virtually every field of business. How might accounting help a student? Answer: You will need to understand financial reports in any enterprise with which you are associated. Whether you become a manager, a doctor, a lawyer, a social worker, a teacher, an engineer, an architect, or an entrepreneur, a working knowledge of accounting is relevant.

1-9

The Basic Accounting Equation. 1. Assets = Liabilities + Owner’s Equity. 2. Equality of the equation must be preserved. 3. The expanded accounting equation is:

Assets = Liabilities + Owner’s Capital – Owner’s Drawings + Revenues – Expenses.

Assets, Liabilities, and Owner’s Equity. 1. Assets are resources a business owns. The business uses its assets in carrying out such activities as production and sales. 2. Liabilities are claims against assets. They are existing debts and obligations. 3. Owner’s equity is equal to total assets minus total liabilities; owner’s equity represents the ownership claim on total assets. The principal subdivisions of owner’s equity are capital, drawings, revenues, and expenses. a.

Capital is the owner’s investment in the business.

Drawings are the withdrawal of cash or other assets from a proprietorship for the personal use of the owner(s).

4. Revenues are the gross increase in owner’s equity resulting from business activities entered into for the purpose of earning income. 5. Expenses are the cost of assets consumed or services used in the process of earning revenue.

1-10 .

Using the Accounting Equation. 1. External transactions are economic events between the company and some outside enterprise. 2. Internal transactions are economic events that occur entirely within one company. 3. Each transaction must have a dual effect on the accounting equation.

Financial Statements. 1. An income statement presents the revenues and expenses and resulting net income or net loss for a specific period of time. 2. An owner’s equity statement summarizes the changes in owner’s equity for a specific period of time. 3. A balance sheet reports the assets, liabilities, and owner’s equity at a specific date. 4. A statement of cash flows summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period of time.

1-11

*J. Accounting Career Opportunities. 1. Individuals in public accounting offer expert service to the general public through the services they perform. a.

Auditing—A certified public accountant (CPA) examines company financial statements and provides an opinion as to how accurately the financial statements present the company’s results and financial position.

Taxation—Tax specialists provide tax advice and planning, prepare tax returns, and represent clients before governmental agencies.

Management Consulting—Management consultants assist in the installation of basic accounting software and perform support services for major marketing projects and merger and acquisition activities.

2. Private accountants are employees of a for-profit company and are involved in a number of activities including cost accounting, tax planning and preparation, accounting information system design and support, and internal auditing. 3. Governmental accounting opportunities include employment with the Internal Revenue Service, Federal Bureau of Investigation, and the Securities and Exchange Commission.

1-12 .

IFRS A Look at IFRS Most agree that there is a need for one set of international accounting standards. Here is why: Multinational corporations. Today’s companies view the entire world as their market. For example, Coca-Cola, Intel, and McDonald’s generate more than 50% of their sales outside the United States, and many foreign companies, such as Toyota, Nestlé, and Sony, find their largest market to be the United States. Mergers and acquisitions. The mergers between Fiat/Chrysler and Vodafone/Mannesmann suggest that we will see even more such business combinations in the future. Information technology. As communication barriers continue to topple through advances in technology, companies and individuals in different countries and markets are becoming more comfortable buying and selling goods and services from one another. Financial markets. Financial markets are of international significance today. Whether it is currency, equity securities (stocks), bonds, or derivatives, there are active markets throughout the world trading these types of instruments.

KEY POINTS Following are the key similarities and differences between GAAP and IRS as related to accounting fundamentals.

•

The basic techniques for recording business transactions are the same for U.S. and international companies.

•

Both international and U.S. accounting standards emphasize transparency in financial reporting. Both sets of standards are primarily driven by meeting the needs of investors and creditors.

•

The three most common forms of business organizations, proprietorships, partnerships, and corporations, are also found in countries that use international accounting standards.

1-13

•

International standards are referred to as International Financial Reporting Standards (IFRS), developed by the International Accounting Standards Board. Accounting standards in the United States are referred to as generally accepted accounting principles (GAAP), and are developed by the Financial Accounting Standards Board.

•

IFRS tends to be simpler in its accounting and disclosure requirements; some people say it is more “principles-based.” GAAP is more detailed; some people say it is more “rules-based.”

•

The internal control standards applicable to Sarbanes-Oxley (SOX) apply only to large public companies listed on U.S. exchanges. There is a continuing debate as to whether non-U.S. companies should have to comply with this extra layer of regulation.

LOOKING TO THE FUTURE Both the IASB and the FASB are hard at work developing standards that will lead to the elimination of major differences in the way certain transactions are accounted for and reported.

1-14 .

20 MINUTE QUIZ Circle the correct answer. True/False 1.

Accounting is the information system that identifies, records, and communicates the economic events of an organization to interested users. True

Bookkeeping deals with the record-keeping process and is only one aspect of accounting. True

1-15

False

Certified Public Accountants are only permitted to prepare audit reports and tax returns. True

False

Liabilities represent the ownership claim on total assets. True

*10.

False

An expense paid with cash would result in an equal decrease in liabilities and owner’s equity. True

False

Collection of an accounts receivable will increase both cash and accounts receivable. True

False

The economic entity assumption requires that the activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities. True

False

Net income is the excess of revenues over expenses for the accounting period. True

False

The Financial Accounting Standards Board is the primary accounting standard-setting body in the United States. True

False

Internal users are those who manage the business. True

False

Multiple Choice 1.

All of the following are external users of accounting information except a. labor unions. b. taxing authorities. c. regulatory agencies. d. company officers.

Recording consists of a. identifying and measuring economic events. b. preparing and distributing accounting reports. c. keeping a systematic, chronological diary of events, measured in dollars and cents. d. identifying, measuring, receiving, and communicating economic events to interested users.

The financial statement that summarizes information about the cash inflows and outflows during a period is the a. income statement. b. owner’s equity statement. c. balance sheet. d. statement of cash flows.

Which of the following is not an acceptable statement of the basic accounting equation? a. Assets – Liabilities = Owner’s equity b. Assets = Liabilities – Owner’s equity c. Assets = Liabilities + Owner’s equity d. Assets – Owner’s equity = Liabilities

*5.

Accountants involved with cost accounting, budgeting, and internal auditing are part of which broad category within the accounting profession? a. Governmental accounting b. Management consulting c. Public accounting d. Private accounting

1-16 .

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True True True True True

Multiple Choice 1. 2. 3. 4. *5.

1-17

d. c. d. b. d.

6. 7. 8. 9. *10.

True False False False False

CHAPTER 2 LEARNING OBJECTIVES

1. DESCRIBE HOW ACCOUNTS, DEBITS, AND CREDITS ARE USED TO RECORD BUSINESS TRANSACTIONS. 2. INDICATE HOW A JOURNAL IS USED IN THE RECORDING PROCESS. 3. EXPLAIN HOW A LEDGER AND POSTING HELP IN THE RECORDING PROCESS. 4. PREPARE A TRIAL BALANCE.

2-1

CHAPTER REVIEW The Account 1.

(L.O. 1) An account is an individual accounting record of increases and decreases in a specific asset, liability, or owner’s equity item.

In its simplest form, an account consists of (a) the title of the account, (b) a left or debit side, and (c) a right or credit side. The alignment of these parts resembles the letter T, and therefore the account form is called a T-account.

Debits and Credits 3.

The terms debit and credit mean left and right, respectively. a. The act of entering an amount on the left side of an account is called debiting the account and making an entry on the right side is crediting the account. b. When the debit amounts exceed the credits, an account has a debit balance; when the reverse is true, the account has a credit balance.

In a double-entry system, equal debits and credits are made in the accounts for each transaction. Thus, the total debits will always equal the total credits.

The effects of debits and credits on assets and liabilities and the normal balances are: Accounts Assets Liabilities

Debits Increase Decrease

Credits Decrease Increase

Normal Balance Debit Credit

Accounts are kept for each of the four subdivisions of owner’s equity: capital, drawings, revenues, and expenses.

The effects of debits and credits on the owner’s equity accounts and the normal balances are: Accounts Owner’s Capital Owner’s Drawings Revenues Expenses

Debits Decrease Increase Decrease Increase

Credits Increase Decrease Increase Decrease

Normal Balance Credit Debit Credit Debit

The expanded accounting equation is: Assets = Liabilities + Owner’s Capital – Owner’s Drawings + Revenues – Expenses

The Journal 9.

(L.O. 2) The basic steps in the recording process are: a. Analyze each transaction for its effect on the accounts. b. Enter the transaction information in a journal. c. Transfer the journal information to the appropriate accounts in the ledger.

2-2

10.

Transactions are initially recorded in a journal. a. A journal is referred to as a book of original entry. b. A general journal is the most basic form of journal.

11.

The journal makes several significant contributions to the recording process: a. It discloses in one place the complete effect of a transaction. b. It provides a chronological record of transactions. c. It helps to prevent or locate errors because the debit and credit amounts for each entry can be easily compared.

12.

Entering transaction data in the journal is known as journalizing. When three or more accounts are required in one journal entry, the entry is known as a compound entry.

The Ledger 13.

(L.O. 3) The ledger is the entire group of accounts maintained by a company. It keeps in one place all the information about changes in account balances and it is a source of useful data for management.

14.

The standard form of a ledger account has three columns and the balance in the account is determined after each transaction.

15.

Posting is the procedure of transferring journal entries to the ledger accounts. The following steps are used in posting: a. In the ledger, enter in the appropriate columns of the account(s) debited the date, journal page, and debit amount. b. In the reference column of the journal, write the account number to which the debit amount was posted. c. Perform the same steps in a. and b. for the credit amount.

The Chart of Accounts 16.

A chart of accounts is a listing of the accounts and the account numbers which identify their location in the ledger. The numbering system usually starts with the balance sheet accounts and follows with the income statement accounts.

2-3

The Basic Steps 17.

The basic steps in the recording process are illustrated as follows: Transaction

On September 4, Fesmire Inc. pays $3,000 cash to a creditor in full payment of the balance due.

Basic analysis

The liability Accounts Payable is decreased $3,000, and the asset Cash is decreased $3,000.

Debit-credit analysis

Debits decrease liabilities: debit Accounts Payable $3,000. Credits decrease assets: credit Cash $3,000.

The Trial Balance 18.

(L.O. 4) A trial balance is a list of accounts and their balances at a given time. The trial balance proves the mathematical equality of debits and credits after posting.

19.

A trial balance does not prove that the company has recorded all transactions or that the ledger is correct because the trial balance may balance even when a. a transaction is not journalized. b. a correct journal entry is not posted. c. a journal entry is posted twice. d. incorrect accounts are used in journalizing or posting. e. offsetting errors are made in recording the amount of a transaction.

2-4

LECTURE OUTLINE A.

The Account. An account is an individual accounting record of increases and decreases in a specific asset, liability, or owner’s equity item. An account consists of three parts: 1. A title. 2. A left or debit side. 3. A right or credit side.

Debits and Credits. The terms debit and credit are directional signals: Debit indicates left, and credit indicates right. 1. Assets, drawings, and expenses are increased by debits and decreased by credits.

2. Liabilities, owner’s capital, and revenues are increased by credits and decreased by debits.

Steps in the Recording Process. There are three basic steps in the recording process: 1. Analyze each transaction for its effects on the accounts. 2. Enter the transaction information in a journal.

2-5

3. Transfer the journal information to the appropriate accounts in the ledger.

The General Journal/Journalizing. Entering transaction data in the general journal is called journalizing. The general journal: 1. Discloses in one place the complete effects of a transaction. 2. Provides a chronological record of transactions. 3. Helps to prevent or locate errors because the debit and credit amounts for each entry can be easily compared. 4. A simple journal entry involves only two accounts (one debit and one credit) whereas a compound journal entry involves three or more accounts.

The Ledger. The ledger is the entire group of accounts maintained by a company. A general ledger contains all the assets, liabilities, and owner’s equity accounts. 1. The ledger provides the balance in each of the accounts as well as keeps track of changes in these balances. 2. Companies arrange the ledger in the sequence in which they present the accounts in the financial statements, beginning with the balance sheet accounts.

Posting/Chart of Accounts. 1. Posting is transferring journal entries to the ledger accounts. 2. Posting involves the following steps:

2-6

In the ledger, in the appropriate columns of the account(s) debited, enter the date, journal page, and debit amount shown in the journal.

In the reference column of the journal, write the account number to which the debit amount was posted.

In the ledger, in the appropriate columns of the account(s) credited, enter the date, journal page, and credit amount shown in the journal.

In the reference column of the journal, write the account number to which the credit amount was posted.

3. A chart of accounts lists the accounts and the account numbers that identify their location in the ledger. Accounts are usually numbered starting with the balance sheet accounts followed by income statement accounts.

Trial Balance. A trial balance is a list of accounts and their balances at a given time. 1. It proves the mathematical equity of debits and credits after posting. 2. It may also uncover errors in journalizing and posting. 3. It is useful the preparation of financial statements.

2-7

INVESTOR INSIGHT Bank regulators fined Bank One Corporation (Now Chase) $1.8 million because they felt the reliability of the bank’s accounting system caused it to violate regulatory requirements. The financial records of Waste Management Inc. were in such disarray that 10,000 employees were receiving pay slips that were in error. In order for these companies to prepare and issue financial statements, their accounting equations must have been in balance at year-end. How could these errors or misstatements have occurred? Answer: A company’s accounting equation (its books) can be in balance yet its financial statements have errors or misstatements because of the following: entire transactions were not recorded, transactions were recorded at wrong amounts; transactions were recorded in the wrong accounts; transactions were recorded in the wrong accounting period. Audits of financial statements uncover some, but not all, errors or misstatements.

2-8

IFRS A Look At IFRS International companies use the same set of procedures and records to keep track of transaction data. Thus, the material in Chapter 2 dealing with the account, general rules of debit and credit, and steps in the recording process—the journal, ledger, and chart of accounts—is the same under both GAAP and IFRS.

KEY POINTS Following are the key similarities and differences between GAAP and IFRS as related to the recording process: •

Transaction analysis is the same under IFRS and GAAP.

•

Both the IASB and FASB go beyond the basic definitions provided in the textbook for the key elements of financial statements, that is, assets, liabilities, equity, revenue, and expenses.

•

A trial balance under IFRS follows the same format as shown in the textbook.

•

As shown in the textbook, dollar signs are typically used only in the trial balance and the financial statements. The same practice is followed under IFRS, using the currency of the country where the reporting company is headquartered.

•

A trial balance under IFRS follows the same format as shown in the textbook.

•

IFRS relies less on historical cost and more on fair value than do FASB standards.

•

Internal controls are a system of checks and balances designed to prevent and detect fraud and errors. While most public U. S. companies have these systems in place, many non-U.S. companies have never completely documented the controls nor had an independent auditor attest to their effectiveness.

LOOKING TO THE FUTURE The basic recording process shown in this textbook is followed by companies across the globe. It is unlikely to change in the future. The definitional structure of assets, liabilities, equity, revenues, and expenses may change over time as the IASB and FASB evaluate their overall conceptual framework for establishing accounting standards.

2-9

20 MINUTE QUIZ Circle the correct answer. True/False 1.

Assets are increased by debits and liabilities are decreased by credits. True

The owner’s capital account is increased by credits. True

False

The double-entry system helps ensure the accuracy of the recorded amounts and helps to detect errors. True

False

When the columns of the trial balance equal each other, it proves no errors occurred in recording and posting. True

10.

False

In posting, one should enter “J2” in the Post. Ref. Column on page two of the journal. True

False

Assets = liabilities + owner’s capital – drawings + revenues – expenses is a correct form of the expanded basic accounting equation. True

False

Transferring journal entries to the ledger accounts is called posting and should be performed in chronological order. True

False

The basic steps in the recording process are (1) to analyze each transaction, (2) to enter the transaction in a journal, and (3) to transfer the journal entry to the appropriate ledger accounts. True

False

The ledger is the entire group of accounts maintained by a company. True

False

An account will have a credit balance if the total debit amounts exceed the total credit amounts. True

False

2-10

False

Multiple Choice

Transactions are initially recorded in the a. general ledger. b. general journal. c. trial balance. d. balance sheet.

The right side of an account is referred to as the a. footing. b. chart side. c. debit side. d. credit side.

A purchase of equipment for cash requires a credit to a. Equipment. b. Cash. c. Accounts Payable. d. Owner’s Capital.

The equality of the accounting equation can be proven by preparing a a. trial balance. b. journal. c. general ledger. d. T-account.

Which of the following accounts would be increased with a debit? a. Rent Payable b. Owner’s Capital c. Service Revenue d. Owner’s Drawings

2-11

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

False True False True True

Multiple Choice 1. 2. 3. 4. 5.

2-12

b. d. b. a. d.

6. 7. 8. 9. 10.

True True False False True

CHAPTER 3 LEARNING OBJECTIVES 1. EXPLAIN THE ACCRUAL BASIS OF ACCOUNTING AND THE REASONS FOR ADJUSTING ENTRIES. 2. PREPARE ADJUSTING ENTRIES FOR DEFERRALS. 3. PREPARE ADJUSTING ENTRIES FOR ACCRUALS. 4. DESCRIBE THE NATURE AND PURPOSE OF AN ADJUSTED TRIAL BALANCE. *5. PREPARE ADJUSTING ENTRIES FOR THE ALTERNATIVE TREATMENT OF DEFERRALS. *6. DISCUSS FINANCIAL REPORTING CONCEPTS.

3-1

CHAPTER REVIEW Accrual Basis Accounting 1.

(L.O. 1) The time period (or periodicity) assumption assumes that the economic life of a business can be divided into artificial time periods.

Accounting time periods are generally a month, a quarter, or a year. An accounting time period that is one year in length is a fiscal year.

The revenue recognition and expense recognition principles are used under the accrual basis of accounting. Under cash basis accounting, revenue is recorded only when cash is received and expenses are recorded only when paid.

Generally accepted accounting principles require accrual basis accounting rather than cash basis accounting because the cash basis of accounting often leads to misleading financial statements.

Revenue Recognition Principle 5.

The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied.

The Expense Recognition Principle 6.

The expense recognition principle requires that efforts (expenses) be matched with results (revenues).

Adjusting Entries 7.

Adjusting entries are made in order for: a. Revenues to be recorded in the period in which services are performed, and for expenses to be recognized in the period in which they are incurred. b. The revenue recognition and expense recognition principles are followed.

Adjusting entries are required every time financial statements are prepared. Adjusting entries can be classified as (a) deferrals (prepaid expenses or unearned revenues) or (b) accruals (accrued revenues or accrued expenses).

Adjusting Entries for Deferrals 9.

(L.O. 2) Prepaid expenses are expenses paid in cash before they are used or consumed. a. Prepaid expenses expire with the passage of time or through use and consumption. b. An asset-expense account relationship exists with prepaid expenses. c. Prior to adjustment, assets are overstated and expenses are understated. d. The adjusting entry results in a debit to an expense account and a credit to an asset account. e. Examples of prepaid expenses include supplies, insurance, and depreciation. f. To illustrate a prepaid adjusting entry, assume on October 1, Kubitz Company pays $2,400 cash to Sandy Insurance Co. for a one-year insurance policy effective October 1. The adjusting entry at October 31 is: Insurance Expense ($2,400 X 1/12) .................................. Prepaid Insurance ......................................................

3-2

200 200

10. Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner. a. The purchase of equipment or a building is viewed as a long-term prepayment of services and, therefore, is allocated in the same manner as other prepaid expenses. b. Depreciation is an estimate rather than a factual measurement of the cost that has expired. c. In recording depreciation, Depreciation Expense is debited and a contra asset account, Accumulated Depreciation—Equipment, is credited. d. In the balance sheet, Accumulated Depreciation is offset against the asset account. The difference between the cost of the asset and its related accumulated depreciation is referred to as the book value of the asset. e. To illustrate an adjusting entry for depreciation, assume Resch Co. purchases equipment for $6,000 cash on January 1, 2017. Assuming that annual depreciation is $1,200, the adjusting entry at December 31, 2017 is: Depreciation Expense .............................................. Accumulated Depreciation⎯Equipment ............

1,200 1,200

11. Unearned revenues are cash received before services are performed. a. Unearned revenues are subsequently recognized by performing the service for a customer. b. A liability-revenue account relationship exists with unearned revenues. c. Prior to adjustment, liabilities are overstated and revenues are understated. d. The adjusting entry results in a debit to a liability account and a credit to a revenue account. e. Examples of unearned revenues include rent, magazine subscriptions, and customer deposits for future service. f. To illustrate an unearned revenue adjusting entry, assume on October 1, Schoen Co. receives $3,000 cash from a renter in payment of monthly rent for the period October through December. At October 31, the adjusting entry to record the rent earned in October is: Unearned Rent Revenue ........................................... Rent Revenue ($3,000 X 1/3) ............................

1,000 1,000

Adjusting Entries for Accruals 12. (L.O. 3) Accrued revenues are revenues for services performed but not yet received in cash or recorded. a. Accrued revenues may accumulate with the passing of time as in the case of interest and rent, or through services performed but for which payment has not been collected. b. An asset-revenue account relationship exists with accrued revenues. c. Prior to adjustment, both assets and revenues are understated. d. The adjusting entry results in an increase (a debit) to an asset account and an increase (a credit) to a revenue account. e. To illustrate an accrued revenue adjusting entry, assume in October, Mayer, a dentist, performs $800 of services for patients for which payment has not been collected. The adjusting entry at October 31 is: Accounts Receivable ................................................. Service Revenue ...............................................

3-3

800 800

13. Accrued expenses are expenses incurred but not yet paid in cash or recorded. a. Accrued expenses result from the same causes as accrued revenues and include interest, rent, taxes, and salaries. b. A liability-expense account relationship exists with accrued expenses. c. Prior to adjustment, both liabilities and expenses are understated. d. The adjusting entry results in an increase (a debit) to an expense account and an increase (a credit) to a liability account. e. To illustrate an accrued expense adjusting entry, assume Schwenk Company incurs salaries and wages of $4,000 during the last week of October that will be paid in November. The adjusting entry on October 31 is: Salaries and Wages Expense .................................... Salaries and Wages Payable ............................

4,000 4,000

14. Each adjusting entry affects one balance sheet account and one income statement account. Adjusted Trial Balance 15. (L.O. 4) After all adjusting entries have been journalized and posted an adjusted trial balance is prepared. This trial balance shows the balances of all accounts, including those that have been adjusted, at the end of the accounting period. 16. The purpose of an adjusted trial balance is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments have been made. 17. The accounts in the adjusted trial balance contain all data that are needed for the preparation of financial statements. Alternative Treatment *18. (L.O. 5) Under the alternative treatment, at the time an expense is prepaid, an expense account is debited, and when unearned revenues are received a revenue account is credited. *19. The alternative treatment of prepaid expenses and unearned revenues has the same effect on the financial statements as the procedures described in the chapter. *20. When a prepaid expense is initially debited to an expense account, a. No adjusting entry will be required if the prepayment is fully expired or consumed before the next financial statement date. b. If the prepayment is not fully expired or consumed, an adjusting entry is required. c. Prior to adjustment an expense account is overstated and an asset account is understated. d. The adjusting entry results in a debit (increase) to an asset account and a credit (decrease) to an expense account. e. To illustrate the adjusting entry, assume Gonzalez Company purchases $1,200 of supplies and debits Supplies Expense. At the next financial statement date, $300 of supplies are on hand. The adjusting entry is: Supplies ................................................................... Supplies Expense .............................................

300 300

*21. When an unearned revenue is initially credited to a revenue account, the procedures are similar to those described above for prepaid expenses. In this case, however, 3-4

a. b.

Prior to adjustment, a revenue account is overstated and a liability account is understated. The adjusting entry results in a debit to a revenue account and a credit to a liability account.

Financial Reporting Concepts *22. (L.O.6) According to the FASB, to be useful, information should have two fundamental qualities: relevance and faithful representation. Accounting information has relevance if it makes a difference in a business decision. If relevant, accounting information has predictive value and confirmatory value. In addition, materiality is a company-specific aspect of relevance. Faithful representation means that accounting information accurately depicts what really happened. To provide this, information must be complete, neutral and free from error. *23. Accounting information is comparable when different companies use the same accounting principles. Accounting information is consistent when one company uses the same accounting principles and methods from year to year. If a company changes principles in order to produce more meaningful information, then it must disclose the change in the notes to the financial statements. *24. To be relevant, accounting information must be presented on a timely basis, meaning that it must be available to decision makers before it loses its capacity to influence decisions. Accounting information is understandable if it is presented in a clear and concise fashion so that a reasonably informed user can interpret and use it. Accounting information is verifiable if it can be proven to be free from error. *25. The monetary unit assumption states that only those things that can be expressed in monetary terms are included in the accounting records. The economic entity assumption states that every economic entity should be separately identified and accounted for. *26. The time period assumption states that the life of a business can be divided into artificial time periods and that reports covering those periods can be prepared for the business. Most companies report results at least annually and perhaps at other intervals during the year. The going concern assumption states that the business will remain in operation for the foreseeable future. *27. GAAP generally uses one of two measurement principles. The historical cost principle states that assets are record at their cost. Cost is used because it is easy to verify: usually there is documentation when an asset is purchased. The fair value principle indicates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). *28. The full disclosure principle requires that companies must disclose all circumstances and events that would make a difference to financial statement users. If a piece of information is not disclosed in one of the four financial statements, then it should be included in the notes to the statements. 29. The cost constraint relates to the fact that providing information is costly. In deciding what information companies should provide, accounting standard-setters weigh the cost of providing that information against the benefits users will have from having that information available.

3-5

LECTURE OUTLINE A.

Accrual Basis Accounting. 1. The assumption that the economic life of a business can be divided into artificial time periods. 2. Monthly and quarterly time periods are called interim periods. 3. An accounting time period that is one year in length is a fiscal year.

Accrual- vs. Cash-Basis Accounting. 1. Using the accrual basis to determine net income means companies recognize revenues when they actually perform the services (rather than when they receive cash). It also means recognizing expenses when incurred (rather than when paid). 2. Under cash-basis accounting, companies record revenue when they receive cash. They record an expense when they pay out cash.

Recognizing Revenues and Expenses. 1. The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. 2. The expense recognition principle requires that efforts (expenses) be matched with accomplishments (revenues). Expenses are matched with revenues in the period when efforts are expended to generate revenues.

3-6

ETHICS INSIGHT Allegations of abuse of the revenue recognition principle have become all too common in recent years. One company was accused of saying that a sale that occurred at the beginning of one quarter occurred at the end of the previous quarter in order to achieve the previous quarters sales targets. What motivates sales executives and finance and accounting executives to participate in activities that result in inaccurate reporting of revenues? Answer: Sales executives typically receive bonuses based on their ability to meet quarterly sales targets. In addition, they often face the possibility of losing their jobs if they miss those targets. Executives in accounting and finance are very aware of the earnings targets of Wall Street analysis and investors. If they fail to meet these targets, the company’s stock price will fall. As a result of these pressures, executives sometimes knowingly engage in unethical efforts to misstate revenues. As a result of the Sarbanes-Oxley Act, the penalties for such behavior are now much more severe. D.

The Need for Adjusting Entries. 1. In order for revenues and expenses to be reported in the correct period, companies make adjusting entries at the end of the accounting period. Adjusting entries ensure that revenues are recognized in the period in which services are performed, and that expenses are recognized in the period in which they are incurred. 2. A company must make adjusting entries every time it prepares financial statements. 3. Deferrals (prepaid expenses and unearned revenues). a.

3-7

Expenses paid in cash before they are used or consumed; they expire either with the passage of time or through use (supplies, insurance, rent).

Depreciation Adjustment. (1) Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner. (2) Depreciation expense is computed by dividing the cost of an asset by its useful life. (3) Accumulated depreciation is a contra-asset account that is offset against an asset account on the balance sheet.

When companies receive cash before services are performed, they record a liability called unearned revenues (magazine subscriptions, customer deposits).

ACCOUNTING ACROSS THE ORGANIZATION Gift cards are popular with marketing executives, but they create accounting questions. Should revenue be recorded at the time the gift card is sold, or when it is used by the customer? Suppose a customer purchases a $100 gift card at Best Buy on December 24, 2016, and gives it to his wife on December 25, 2016. On January 3, 2017, the customer’s wife uses the card to purchase CDs. When do you think Best Buy should recognize revenue, and why? Answer: According to the revenue recognition principle, companies should recognize revenue when the performance obligation is satisfied. In this case revenue is not recognized until Best Buy provides the goods. Thus, when Best Buy receives cash in exchange for the gift card on December 24, 2016 it should recognize a liability, Unearned Sales Revenue, for $100. On January 3, 2017 when the customer’s wife exchanges the card for merchandise, Best Buy should recognize revenue and eliminate $100 from the balance in the Unearned Sales Revenue account.

3-8

4. Accruals (accrued revenues and accrued expenses). a.

Revenues for services performed but not yet recorded at the statement date are accrued revenues (interest, rent, commissions).

Expenses incurred but not yet paid or recorded at the statement date are accrued expenses (interest, salaries, taxes).

5. Adjusting entries are recorded in the general journal and follow the last transaction entry. They are posted to the ledger accounts at the end of the accounting period.

The Adjusted Trial Balance and Financial Statements. 1. The adjusted trial balance is prepared after all adjusting entries have been journalized and posted. 2. The adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments. 3. Companies can prepare financial statements directly from the adjusted trial balance. Companies first prepare the income statement from the revenue and expense accounts. Companies then prepare the balance sheet from the asset and liability accounts and the ending owner’s capital balance as reported in the owner’s equity statement.

*F. Alternative Treatment of Prepaid Expenses and Unearned Revenue. 1. Companies may initially debit prepaid expenses to an expense account instead of an asset account. The adjusting entry requires recording an asset for the unexpired portion and crediting the expense account so that its balance will reflect the amount consumed.

3-9

2. Companies may initially credit revenues received in cash before being recognized to a revenue account instead of a liability account. The adjusting entry requires recording a liability for the portion still to be recognized and debiting the revenue account so that its balance will reflect the amount recognized.

*G. Discuss Financial Reporting Concepts. 1. To be useful, information should possess two fundamental qualities: relevance and faithful representation. a.

Relevance – if information has the ability to make a difference in a decision scenario, it is relevant.

Accounting information is considered relevant if it provides information that has predictive value – helps provide accurate expectations about the future, and has confirmatory value – confirms or corrects prior expectations.

Materiality is a company-specific aspect of relevance. An item is material when its size makes it likely to influence the decision of an investor or creditor.

Faithful Representation – information accurately depicts what really happened. To provide a faithful representation, information must be: (1) complete—nothing important has been omitted, (2) neutral—is not biased toward one position or another, and (3) free from error.

3-10 .

2. Enhancing Qualities – include comparability, consistency, verifiability, timeliness, and understandability. a.

Comparability—when different companies use the same accounting principles. (1) To make a comparison, companies must disclose the accounting methods used.

Consistency—when a company uses the same accounting principles and methods from year to year.

Verifiable—quality of information that occurs when independent measures obtain similar results.

Timely—information that is available to decision makers before it loses its capacity to influence decisions.

Understandability—information presented in a clear fashion so that users can interpret it and comprehend its meaning.

3. Monetary Unit Assumption – states that only transactions expressed in money are included in the accounting records. 4. Economic Entity Assumption ▪ Every economic entity can be separately identified and accounted for. ▪ Economic events can be identified with a particular unit of accountability. 5. Time Period Assumption – allows the business to be divided into artificial time periods that are useful for reporting. 6. Going Concern Assumption – Assumes the business will remain in operation for the foreseeable future. 7. Measurement Principles – GAAP generally uses one of two measurement principles: the historical cost principle or the fair value principle.

3-11

Historical Cost Principle – requires assets to be recorded at original cost because that amount is verifiable.

Fair Value Principle – requires that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability).

8. Full Disclosure Principle – requires that all circumstances and events that would make a difference to financial statement users should be disclosed. 9. Cost Constraint – determining whether the cost that companies will incur to provide the information will outweigh the benefit that financial statement users will gain from having the information available.

3-12 .

IFRS A Look at IFRS It is often difficult for companies to determine in what time period they should report particular revenues and expenses. Both the IASB and FASB are working on a joint project to develop a common conceptual framework that will enable companies to better use the same principles to record transactions consistently over time. KEY POINTS • In this chapter, you learned accrual-basis accounting applied under GAAP. Companies applying IFRS also use accrual-basis accounting to ensure that they record transactions that change a company’s financial statements in the period in which events occur. • Similar to GAAP, cash-basis accounting is not in accordance with IFRS. • IFRS also divides the economic life of companies into artificial time periods. Under both GAAP and IFRS, this is referred to as the time period assumption. • The general revenue recognition principles required by GAAP that are used in this textbook is similar to that under IFRS. • Revenue recognition fraud is a major issue in U.S. financial reporting. The same situation occurs in other countries, as evidenced by revenue recognition breakdowns at Dutch software company Baan NV, Japanese electronics giant NEC, and Dutch grocer Ahold NV. • Under IFRS, revaluation (using fair value) of items such as land and buildings is permitted. IFRS allows depreciation based on revaluation of assets, which is not permitted under GAAP. • The terminology used for revenues and gains, and expenses and losses, differs somewhat between IFRS and GAAP. For example, income under IFRS includes both revenues, which arise during the normal course of operating activities, and gains, which arise from activities outside of the normal sales of goods and services. The term income is not used this way under GAAP. Instead, under GAAP income refers to the net difference between revenues and expenses. Under IFRS, expenses include both those costs incurred in the normal course of operations as well as losses that are not part of normal operations. This is in contrast to GAAP, which defines each separately.

3-13

LOOKING TO THE FUTURE The IASB and FASB are completing a joint project on revenue recognition. The purpose of this project was to develop comprehensive guidance on when to recognize revenue. It is hoped that this approach will lead to more consistent accounting in this area.

3-14 .

20 MINUTE QUIZ Circle the correct answer. True/False 1.

Since companies find it desirable and necessary to report the results of their activities frequently, the time period assumption assumes that the economic life of a business can be divided into artificial time periods. True

The revenue recognition principle requires that companies recognize revenue in the period in which cash was received rather than when the performance obligation is satisfied. True

False

When accrual-basis accounting is applied, adjusting entries are not necessary. True

False

A contra-asset account is an account whose balance is deducted from a related asset in the financial statements. True

False

The adjusting entry for unearned revenues results in a debit to an asset account and a credit to a revenue account. True

False

Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner. True

False

Cost less accumulated depreciation is a measurement of the current value of an asset such as equipment or a building. True

False

Payments of expenses that will benefit more than one accounting period are referred to as prepaid expenses. True

False

Monthly and quarterly time periods are commonly referred to as fiscal periods. True

False

3-15

False

10.

Adjustments for accrued expenses are necessary to record the obligations that exist at the balance sheet date and to recognize the expenses that are applicable to the current accounting period. True

False

Multiple Choice 1.

The recording of salaries and wages earned but not yet paid is an example of an adjustment that a . recognizes an accrued expense. b. recognizes an unrecorded revenue. c . apportions revenues between two or more periods. d. apportions costs between two or more periods.

A list of the accounts and their balances after all adjustments have been made is known as a . adjusting entries. b. adjusted trial balance. c . book values. d. accrued accounts.

Prior to recording adjusting entries, revenues exceed expenses by $60,000. Adjusting entries for accrued salaries and wages of $10,000 and depreciation expense of $10,000 were made. Net income for the year would be a . $60,000. b. $50,000. c . $40,000. d. none of the above.

The adjustment for depreciation is an example of a . recognizing an accrued expense. b. apportioning costs between two or more periods. c . apportioning revenues between two or more periods. d. recognizing an unrecorded revenue.

Most businesses choose fiscal years which correspond to a . the calendar year. b. any twelve-month period. c . their natural business year. d. any of the above.

3-16 .

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

True False False True False True False True False True

Multiple Choice 1. 2. 3. 4. 5.

3-17

a. b. c. b. d.

CHAPTER 4 COMPLETING THE ACCOUNTING CYCLE LEARNING OBJECTIVES 1. PREPARE A WORKSHEET. 2. PREPARE CLOSING ENTRIES AND A POST-CLOSING TRIAL BALANCE. 3. EXPLAIN THE STEPS IN THE ACCOUNTING CYCLE AND HOW TO PREPARE CORRECTING ENTRIES. 4. IDENTIFY THE SECTIONS OF A CLASSIFIED BALANCE SHEET. *5. PREPARE REVERSING ENTRIES.

4-1

CHAPTER REVIEW Preparing a Worksheet 1.

(L.O. 1) The steps in preparing a worksheet are: a. Prepare a trial balance on the worksheet. b. Enter the adjustments in the adjustments columns. c. Enter adjusted balances in the adjusted trial balance columns. d. Extend adjusted trial balance amounts to appropriate financial statement columns. e. Total the statement columns, compute the net income (or loss), and complete the worksheet.

A worksheet is a multiple-column form that may be used in the adjustment process and in preparing financial statements. The basic form of a worksheet consists of the following columns:

Account Titles

Trial Balance Dr. Cr.

Adjustments Cr. Dr.

Adjusted Trial Balance Dr. Cr.

Income Statement Dr. Cr.

Balance Sheet Dr. Cr.

For each account in the worksheet, the amount in the adjusted trial balance columns is equal to the account balance that will appear in the ledger after the adjusting entries have been journalized and posted.

After the worksheet has been completed the statement columns contain all data that are required for the preparation of financial statements. The income statement is prepared from the income statement columns, and the owner’s equity statement and balance sheet are prepared from the balance sheet columns.

Using a worksheet accountants can prepare financial statements before adjusting entries are journalized and posted.

A worksheet is not a journal and it cannot be used as a basis for posting to ledger accounts.

Closing Entries 7.

(L.O. 2) Closing entries formally recognize in the ledger the transfer of net income (or loss) and owner’s drawings to owner’s capital as shown in the owner’s equity statement.

Journalizing and posting closing entries is a required step in the accounting cycle.

The drawing, revenue, and expense accounts are temporary (nominal) accounts. Asset accounts, liability accounts, and the owner’s capital account are permanent (real) accounts.

10.

A temporary account, Income Summary, is used in closing revenue and expense accounts to minimize the amount of detail in the permanent owner’s capital account.

11.

In closing the books of a proprietorship: a. Debit each revenue account for its balance, and credit Income Summary for total revenues. b. Debit Income Summary for total expenses, and credit each expense account for its balance. c. Debit Income Summary, and credit Owner’s Capital for the amount of net income; conversely, credit Income Summary and debit Owner’s Capital if a net loss exists. d. Debit Owner’s Capital for the balance in the Owner’s Drawings account and credit Owner’s Drawings for the same amount.

4-2

Post-Closing Trial Balance 12. After all closing entries have been journalized and posted, a post-closing trial balance is prepared. The purpose of this trial balance is to prove the equality of the permanent account balances that are carried forward into the next accounting period. Summary of the Accounting Cycle 13. (L.O. 3) The required steps in the accounting cycle are: a. Analyze business transactions. b. Journalize the transactions. c. Post to ledger accounts. d. Prepare a trial balance. e. Journalize and post adjusting entries: Deferrals/Accruals. f. Prepare an adjusted trial balance. g. Prepare financial statements: Income statement, Owner’s equity statement, Balance sheet. h. Journalize and post closing entries. i. Prepare a post-closing trial balance. 14. A reversing entry is the exact opposite of an adjusting entry. The preparation of reversing entries is an optional bookkeeping procedure that is not a required step in the accounting cycle. Correcting Entries 15. Errors that occur in recording transactions should be corrected as soon as they are discovered by preparing correcting entries. Correcting entries: a. are unnecessary if the records are free of errors. b. are journalized and posted whenever an error is discovered. c. may involve any combination of balance sheet and income statement accounts. 16. To determine the correcting entry, it is useful to compare the incorrect entry with the correct entry, and then make a correcting entry. Another approach is to reverse the incorrect entry and then prepare the correct entry. Classified Balance Sheet 17. (L.O. 4) Financial statements become more useful when the elements are classified into significant subgroups. A classified balance sheet generally has the following standard classifications: Assets Current assets Long-term investments Property, plant, and equipment Intangible assets

Liabilities and Owner’s Equity Current liabilities Long-term liabilities Owner’s equity

Assets 18. Current assets are assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer. Current assets are listed in the order of their liquidity. 19. The operating cycle of a company is the average time that it takes to purchase inventory, sell it on account, and then collect cash from customers.

4-3

20. Long-term investments are generally investments in stocks and bonds of other companies that are normally held for many years. 21. Property, plant, and equipment are assets with relatively long useful lives that a company is currently using in operating the business. 22. Intangible assets do not have physical substance yet often are very valuable. Liabilities 23. Current liabilities are obligations that the company is to pay within the coming year. 24. Long-term liabilities are obligations that a company expects to pay after one year. Owner’s Equity 25. The content of the owner’s equity section varies with the form of business organization. In a proprietorship, there is one capital account. In a partnership, there are separate capital accounts for each partner. For a corporation, owners’ equity is called stockholders’ equity and it consists of two accounts: Capital Stock and Retained Earnings. Reversing Entries *26. (L.O. 5) A reversing entry is made at the beginning of the next accounting period. The purpose of reversing entries is to simplify the recording of a subsequent transaction related to an adjusting entry. *27. Reversing entries are most often used to reverse two types of adjusting entries: accrued revenues and accrued expenses.

4-4

LECTURE OUTLINE A.

Using a Worksheet. 1. A worksheet is a multiple-column form used in the adjustment process and in preparing financial statements. 2. The steps in the preparation of a worksheet: a.

Step 1:

Prepare a trial balance on the worksheet.

Step 2:

Enter the adjustments in the adjustments columns.

Step 3: Enter adjusted balances in the adjusted trial balance columns.

Step 4: Extend adjusted trial balance amounts to the appropriate financial statement columns.

Step 5: Total the statement columns, compute the net income (or net loss), and complete the worksheet.

3. A worksheet facilitates the preparation of financial statements because it organizes the account balances and the statements can be prepared before the adjusting entries are journalized and posted. 4. The use of a worksheet is optional and it is essentially a working tool of the accountant. 5. A worksheet is not a journal, and it cannot be used as a basis for posting to ledger accounts. The company must record adjusting entries in the journal, and then post them to the ledger.

4-5

Preparing Closing Entries. 1. Closing entries formally recognize in the ledger the transfer of net income (or net loss) and owner’s drawings to owner’s capital. Journalizing and posting closing entries is a required step in the accounting cycle. 2. Closing entries produce a zero balance in each temporary account (revenue and expense accounts and the Owner’s Drawings account) so that each temporary account may be used to accumulate data in the next accounting period separate from the data of prior periods. 3. There are four closing entries: a.

Debit each revenue account for its balance, and credit Income Summary for total revenues.

Debit Income Summary for total expenses, and credit each expense account for its balance.

Debit Income Summary and credit Owner’s Capital for the amount of net income (assuming the company had net income).

Debit Owner’s Capital for the balance in the Owner’s Drawings account, and credit Owner’s Drawings for the same amount.

ACCOUNTING ACROSS THE ORGANIZATION Recent surveys have reported that the average company now takes only six to seven days to close, rather than 20 days. Knowing exactly where you are financially all the time allows the company to respond faster than competitors. Who else benefits from a shorter closing process?

4-6

Answer: Investors benefit from a shorter closing process. The shorter the closing, the sooner the company can report its financial results. This means that the financial information is more timely, and therefore more relevant to investors. C.

Preparing a Post-Closing Trial Balance. 1. The purpose of the post-closing trial balance is to prove the equality of the permanent account balances carried forward into the next accounting period. 2. The post-closing trial balance will contain only permanent—balance sheet—accounts since all temporary accounts will have zero balances.

Summary of the Accounting Cycle. 1. Analyze business transactions. 2. Journalize the transactions. 3. Post to ledger accounts. 4. Prepare a trial balance. 5. Journalize and post adjusting entries: Deferrals/Accruals. 6. Prepare an adjusted trial balance. 7. Prepare financial statements. 8. Journalize and post closing entries. 9. Prepare a post-closing trial balance.

Correcting Entries. 1. Companies should correct errors, as soon as they discover them, by journalizing and posting correcting entries. 2. Companies make correcting entries whenever they discover an error, not only at the end of an accounting period.

4-7

3. To determine the correcting entry, it is useful to compare the incorrect entry with the correct entry in order to identify the accounts and amounts that should—or should not—be corrected. 4. Errors may also be corrected by reversing the incorrect entry and then preparing the correct entry. ACCOUNTING ACROSS THE ORGANIZATION Yale Express, a short-haul trucking firm, turned over much of its cargo to local truckers to complete deliveries and waited 20 days to receive the local truckers’ bills. However, Republic Carloading, a nationwide, long-distance freight forwarder whom Yale merged with, frequently did not receive bills from truckers until months after the year-end. What might Yale Express have done to produce more accurate financial statements without waiting months for Republic’s outstanding transportation bills? Answer: Yale’s vice president could have engaged his accountants and auditors to prepare an adjusting entry based on an estimate of the outstanding transportation bills. (The estimate could have been made using past experience and the current volume of business.) F.

The Classified Balance Sheet. 1. Current assets are assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer. On the balance sheet, companies usually list current assets in the order in which they expect to convert them into cash (order of liquidity). 2. Long-term investments are generally investments in stocks and bonds of other companies that are normally held for many years. This category also includes long-term assets (land, buildings) not currently being used in operations, and long-term notes receivable. 3. Property, plant, and equipment are assets with relatively long useful lives that a company is currently using in operating the business.

4-8

4. Intangible assets are assets that do not have physical substance yet often are very valuable. 5. Current liabilities are obligations that the company is to pay within the coming year or its operating cycle, whichever is longer. 6. Long-term liabilities are obligations that a company expects to pay after one year. 7. The content of the owner’s equity section varies with the form of business organization. In a proprietorship, there is one capital account but corporations divide owner’s equity into Common Stock and Retained Earnings. *G. Reversing Entries. 1. Companies make reversing entries at the beginning of the next accounting period. Each reversing entry is the exact opposite of the adjusting entry made in the previous period. 2. The recording of reversing entries is an optional step in the accounting cycle. 3. The use of reversing entries does not change the amounts reported in the financial statements.

4-9

IFRS A Look at IFRS The classified balance sheet, although generally required internationally, contains certain variations in format when reporting under IFRS.

KEY POINTS The procedures of the closing process are applicable to all companies, whether they are using IFRS or GAAP. Following are the key similarities and differences between GAAP and IFRS related to the closing process and the financial statements. •

IFRS generally requires a classified statement of financial position similar to the classified balance sheet under GAAP.

•

IFRS follows the same guidelines as this textbook for distinguishing between current and noncurrent assets and liabilities.

•

IFRS recommends but does not require the use of the title “statement of financial position” rather than balance sheet.

•

The format of statement of financial position information is often presented differently under IFRS. Although no specific format is required, many companies that follow IFRS present statement of financial position information in this order: • • • • •

Non-current assets Current assets Equity Non-current liabilities Current liabilities

•

Under IFRS, current assets are usually listed in the reverse order of liquidity. For example, under GAAP cash is listed first, but under IFRS it is listed last.

•

IFRS has many differences in terminology from what are shown in your textbook. For example, in the investment category stock is called shares.

•

Both GAAP and IFRS are increasing the use of fair value to report assets. However, at this point IFRS has adopted it more broadly. As examples, under IFRS companies can apply fair value to property, plant, and equipment, and in some cases intangible assets.

LOOKING TO THE FUTURE The IASB and the FASB are working on a project to converge their standards related to financial statement presentation. A key feature of the proposed framework is that each of the statements will be organized in the same format, to separate an entity’s financing activities 4-10 .

from its operating and investing activities and, further, to separate financing activities into transactions with owners and creditors. Thus, the same classifications used in the statement of financial position would also be used in the income statement and the statement of cash flows. The project has three phases.

4-11

20 MINUTE QUIZ Circle the correct answer. True/False 1.

An important purpose of closing entries is to set permanent account balances to zero in order to begin the next period. True

The preparation of reversing entries is a required step in the accounting cycle. True

False

The relationship between current assets and current liabilities is important in evaluating a company’s liquidity. True

10.

False

The balance of Accumulated Depreciation will appear in the credit side of the worksheet’s Balance Sheet column. True

False

Long-term liabilities such as lease liabilities, mortgages payable, and bonds payable are expected to be paid from existing current assets. True

False

Current assets are resources that can be converted into cash, but are not expected to be converted within one year. True

False

Adjustments are journalized and posted only at the end of an accounting period, whereas correcting entries are journalized and posted whenever an error is discovered. True

False

The content of the owner’s equity section of a proprietorship is the same as the content of the owners’ equity section of a corporation. True

False

A worksheet can be used as a basis for posting the adjustments to the ledger. True

False

Intangible assets are not listed on the balance sheet because they do not have physical substance. True

4-12 .

False

Multiple Choice

The worksheet is a type of a. financial statement. b. permanent accounting record. c. working paper. d. journal.

In preparing closing entries, which of the following columns of the worksheet are the most helpful? a. The Adjustments column b. The Adjusted Trial Balance columns c. The Income Statement columns d. The Balance Sheet columns

The proper sequence for the accounting cycle is a. analyze, journalize, post, adjust, prepare statements, close. b. post, journalize, analyze, prepare statements, close, adjust. c. prepare statements, journalize, post, adjust, close, analyze. d. journalize, post, close, prepare statements, adjust, analyze.

After all the closing entries have been posted, the balance of the income summary will be a. a debit if a net income has occurred. b. a debit if a net loss has occurred. c. a credit if a net loss has occurred. d. zero.

The post-closing trial balance will a. be prepared before closing entries are posted to the ledger. b. contain both income statement and balance sheet accounts. c. contain only balance sheet accounts. d. contain only income statement accounts.

4-13

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

False False False False True

Multiple Choice 1. 2. 3. 4. 5.

4-14 .

c. c. a. d. c.

6. 7. 8. 9. 10.

False False True True False

CHAPTER 5 ACCOUNTING FOR MERCHANDISING OPERATIONS LEARNING OBJECTIVES 1. DESCRIBE MERCHANDISING OPERATIONS AND INVENTORY SYSTEMS. 2.

RECORD PURCHASES UNDER A PERPETUAL INVENTORY SYSTEM.

3. RECORD SALES UNDER A PERPETUAL INVENTORY SYSTEM. 4. APPLY THE STEPS IN THE ACCOUNTING CYCLE TO A MERCHANDISING COMPANY. 5. COMPARE A MULTIPLE-STEP AND A SINGLE-STEP INCOME STATEMENT. *6. PREPARE A WORKSHEET FOR A MERCHANDISING COMPANY. *7. RECORD PURCHASES AND SALES UNDER A PERIODIC INVENTORY SYSTEM.

5-1

CHAPTER REVIEW Merchandising Operations 1. (L.O. 1) A merchandising company is an enterprise that buys and sells merchandise as their primary source of revenue. Merchandising companies that purchase and sell directly to consumers are retailers, and those that sell to retailers are known as wholesalers. 2. The primary source of revenue for a merchandising company is sales revenue. Expenses are divided into two categories: (1) cost of goods sold and (2) operating expenses. 3. Sales less cost of goods sold is called the gross profit. For example, if sales are $5,000 and cost of goods sold is $3,000, gross profit is $2,000. 4. After gross profit is calculated, operating expenses are deducted to determine net income (or loss). 5. Operating expenses are expenses incurred in the process of recognizing sales revenue. Operating Cycles 6. The operating cycle of a merchandising company is as follows:

Flow of Costs 7. A merchandising company may use either a perpetual or a periodic inventory system in determining cost of goods sold. a. In a perpetual inventory system, detailed records of the cost of each inventory item are maintained and the cost of each item sold is determined from the records when the sale occurs. b. In a periodic inventory system, detailed inventory records are not maintained and the cost of goods sold is determined only at the end of an accounting period. Purchase Transactions 8. (L.O. 2) Under the perpetual inventory system, purchases of merchandise for sale are recorded in the Inventory account. For a cash purchase, Cash is credited; for a credit purchase, Accounts Payable is credited. 9. FOB shipping point means that goods are placed free on board the carrier by the seller, and the buyer must pay the freight costs. FOB destination means that goods are placed free on board at the buyer’s place of business, and the seller pays the freight.

5-2

10. When the purchaser pays the freight, Inventory is debited and Cash is credited. When the seller pays the freight, Freight-Out (Delivery Expense) is debited and Cash is credited. This account is classified as an operating expense by the seller. 11. A purchaser may be dissatisfied with the merchandise received because the goods may be damaged or defective, of inferior quality, or not in accord with the purchaser’s specifications. The purchaser may return the merchandise, or choose to keep the merchandise if the supplier is willing to grant an allowance (deduction) from the purchase price. When merchandise is returned, Inventory is credited. 12. When the credit terms of a purchase on account permit the purchaser to claim a cash discount for the prompt payment of a balance due, this is called a purchase discount. If a purchase discount has terms 3/10, n/30, then a 3% discount is taken on the invoice price (less any returns or allowances) if payment is made within 10 days. If payment is not made within 10 days, then there is no purchase discount, and the net amount of the bill is due within 30 days. 13. When an invoice is paid within the discount period, the amount of the discount is credited to Inventory. When an invoice is not paid within the discount period, then the usual entry is made with a debit to Accounts Payable and a credit to Cash. Sales Transactions 14. (L.O. 3) In accordance with the revenue recognition principle, companies record sales revenues when the performance obligation is satisfied. Typically the performance obligation is satisfied when the goods are transferred from the seller to the buyer. 15. All sales transactions should be supported by a business document. Cash register documents provide evidence of cash sales; sales invoices provide support for credit sales. 16. A sale on credit is recorded as follows: Accounts Receivable ...................................................................... Sales Revenue ........................................................................

XXXX

Cost of Goods Sold ........................................................................ Inventory .................................................................................

XXXX

After the cash payment is received by the seller, the following entry is recorded: Cash ............................................................................................... Accounts Receivable .............................................................

XXXX XXXX

A cash sale is recorded by a debit to Cash and a credit to Sales Revenue, and a debit to Cost of Goods Sold and a credit to Inventory. Sales Returns and Allowances 17. A sales return results when a customer is dissatisfied with merchandise and is allowed to return the goods to the seller for credit or for a cash refund. A sales allowance results when a customer is dissatisfied with merchandise and the seller is willing to grant an allowance (deduction) from the selling price.

5-3

18. To give the customer a sales return or allowance, the seller normally makes the following entry if the sale was a credit sale (the second entry is made only if the goods are returned): Sales Returns and Allowances .................................................... Accounts Receivable ............................................................

XXXX

Inventory...................................................................................... Cost of Goods Sold ..............................................................

XXXX

For a sales return or allowance on a cash sale, a cash refund is made and Cash is credited instead of Accounts Receivable. The second entry is the same as above. 19. Sales Returns and Allowances is a contra revenue account and the normal balance of the account is a debit. Sales Discounts 20. A sales discount is the offer of a cash discount to a customer for the prompt payment of a balance due. If a credit sale has terms 2/10, n/30, then a 2% discount is taken on the invoice price (less any returns or allowances) if payment is made within 10 days. If payment is not made within 10 days, then there is no sales discount, and the net amount of the bill, without discount, is due within 30 days. Sales Discounts is a contra revenue account and the normal balance of this account is a debit. 21. Both Sales Returns and Allowances and Sales Discounts are subtracted from Sales Revenue in the income statement to arrive at net sales. The Accounting Cycle 22. (L.O. 4) Each of the required steps in the accounting cycle applies to a merchandising company. Adjusting Entries and Closing Entries 23. A merchandising company generally has the same types of adjusting entries as a service company but a merchandiser using a perpetual inventory system will require an additional adjustment to reflect the difference between a physical count of the inventory and the accounting records. In addition, like a service company, a merchandising company closes all accounts that affect net income to Income Summary. Multiple-Step vs. Single-Step Income Statement 24. (L.O. 5) A multiple-step income statement shows several steps in determining net income: (1) cost of goods sold is subtracted from net sales to determine gross profit and (2) operating expenses are deducted from gross profit to determine net income. In addition, there may be nonoperating sections for: a. Revenues and expenses that result from secondary or auxiliary operations, and b. Gains and losses that are unrelated to the company’s operations.

5-4

Gross Profit and Operating Expenses 25. Gross profit is net sales less cost of goods sold. The gross profit rate is expressed as a percentage by dividing the amount of gross profit by net sales. Operating expenses are the third component in measuring net income for a merchandising company. 26. Nonoperating sections are reported in the income statement after income from operations and are classified as (a) Other revenues and gains and (b) Other expenses and losses. 27. The income statement is referred to as a single-step income statement when all data are classified under two categories: (a) Revenues and (b) Expenses, and only one step is required in determining net income or net loss. Classified Balance Sheet 28. A merchandising company generally has the same type of balance sheet as a service company except inventory is reported as a current asset. Using a Worksheet *29. (L.O. 6) As indicated in Chapter 4, a worksheet enables financial statements to be prepared before the adjusting entries are journalized and posted. The steps in preparing a worksheet for a merchandising company are the same as they are for a service company except the additional merchandising accounts are included. Determining Cost of Goods Sold Under a Periodic System

*30. (L.O. 7) Under a periodic system separate accounts are used to record freight costs, returns, and discounts. In addition, a running account of changes in inventory is not maintained. Instead, the balance in ending inventory, as well as cost of goods sold for the period, is calculated at the end of the period. The determination of cost of goods sold for Tsutsui Co. using a periodic inventory system, is as follows: TSUTSUI COMPANY Cost of Goods Sold For the Year Ended December 31, 2017 Cost of goods sold Inventory, January 1 ..................................... Purchases..................................................... Less: Purchases returns and allowances..... Purchase discounts ............................ Net purchases .............................................. Add: Freight-in ............................................. Cost of goods purchased .............................. Cost of goods available for sale .................... Inventory, December 31................................ Cost of goods sold ........................................

5-5

$ 28,000 $234,000 $8,200 4,600

12,800 221,200 10,800 232,000 260,000 30,000 $230,000

*31. To determine the cost of goods sold under a periodic inventory system, three steps are required: (1) Record purchases of merchandise; (2) Determine the cost of goods purchased; and (3) Determine the cost of goods on hand at the beginning and end of the accounting period. *32. In determining cost of goods purchased, (a) contra-purchase accounts are subtracted from purchases to produce net purchases, and (b) freight-in is then added to net purchases. *33. Cost of inventory on hand under the periodic inventory method is obtained from a physical inventory. *34. Cost of goods sold is determined by two steps: a. The cost of goods purchased is added to the cost of goods on hand at the beginning of the period to obtain the cost of goods available for sale. b. The cost of goods on hand at the end of the period is subtracted from the cost of goods available for sale. Recording Purchases and Sales of Merchandise *35. In a periodic inventory system revenues from the sale of merchandise are recorded when sales are made in the same way as in a perpetual system. But, no attempt is made on the date of sale to record the cost of the merchandise sold. Instead, a physical inventory count is taken at the end of the period to determine (1) the cost of the merchandise then on hand and (2) the cost of the goods sold during the period. *36. Under the periodic inventory system, purchases of merchandise for sale are recorded in a Purchases account. For a cash purchase, Cash is credited; for a credit purchase, Accounts Payable is credited. *37. A purchase return and allowance is recorded by debiting Accounts Payable or Cash and crediting the account Purchase Returns and Allowances. Purchase Returns and Allowances is a temporary account whose normal balance is a credit. *38. If payment is made within a discount period, the amount of the discount is credited to the account Purchases Discounts. When an invoice is not paid within the discount period, then the usual entry is made with a debit to Accounts Payable and a credit to Cash.

5-6

LECTURE OUTLINE A. Merchandising Operations. 1. The primary source of revenues for merchandising companies is the sale of merchandise, referred to as sales revenue or sales. 2. A merchandising company has two categories of expenses: a.

Cost of goods sold is the total cost of merchandise sold during the period.

Operating expenses are expenses incurred in the process of earning sales revenues.

3. Gross profit is the difference between sales revenue and cost of goods sold. INVESTOR INSIGHT Morrow Snowboards implemented a perpetual inventory system to improve its control over inventory. It also stated that it would perform a physical inventory count every quarter until it felt that the perpetual inventory system was reliable. If a perpetual system keeps track of inventory on a daily basis, why do companies ever need to do a physical count? Answer: A perpetual system keeps track of all sales and purchases on a continuous basis. This provides a constant record of the number of units in the inventory. However, if employees make errors in recording sales or purchases, the inventory value will not be correct. As a consequence, all companies do a physical count of inventory at least once a year.

5-7

B. Recording Purchases and Sales of Merchandise. 1. In a perpetual inventory system, companies keep detailed records of the cost of each inventory purchase and sale. These records continuously (perpetually) show the inventory that should be on hand for every item. 2. Under a perpetual inventory system: a.

Companies record purchases of merchandise for sale in the Inventory account. Companies record purchases of assets acquired for use, such as supplies and equipment, as increases to specific asset accounts rather than to Inventory.

The company debits the Inventory account for all purchases of merchandise and freight-in, and credits it for purchase discounts and purchase returns and allowances. Freight terms are expressed as either FOB shipping point or FOB destination. (1) FOB shipping point means that the seller places the goods free on board the common carrier, and the buyer pays the freight costs. (2) FOB destination means that the seller places the goods free on board to the buyer's place of business, and the seller pays the freight. Freight costs incurred by the seller on outgoing merchandise are an operating expense to the seller and are debited to FreightOut (Delivery Expense).

5-8

A purchaser may return goods to the seller for credit because the goods are damaged or defective, or of inferior quality. The return of goods to the seller is known as a purchase return.

The credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment. The buyer calls this cash discount a purchase discount.

(3) In accordance with the revenue recognition principle, companies record sales revenues when the performance obligation is satisfied. Typically the performance obligation is satisfied when goods transfer from the seller to the buyer. (4) Sales may be made on credit or for cash. Companies record sales by debiting Accounts Receivable (or Cash) and crediting Sales Revenue for the selling price of the merchandise. (5) The cost of goods sold is recognized for each sale by debiting Cost of Goods Sold and crediting Inventory. (6) Sales Returns and Allowances is a contra revenue account (offset against a revenue account) to Sales Revenue. Companies use a contra account, instead of debiting Sales Revenue, to disclose in the accounts and in the income statement the amount of sales returns and allowances. (7) Companies record the cost of goods returned by decreasing Cost of Goods Sold and increasing the Inventory account. (8) A sales discount occurs when the seller offers a cash discount for prompt payment of the balance due. (9) Like Sales Returns and Allowances, Sales Discounts is a contra revenue account to Sales Revenue and its normal balance is a debit.

5-9

ACCOUNTING ACROSS THE ORGANIZATION Costco Wholesale Corp. has always had a generous return policy, but adopted a new policy requiring that certain electronics be returned within 90 days of their purchase. The reason for the change was that returned electronics cut an estimated 8¢ per share off Costco’s earnings per share. If a company expects significant returns, what are the implications for revenue recognition? Answer: If a company expects significant returns, it should make an adjusting entry at the end of the year reducing sales by the estimated amount of sales returns. This is necessary so as not to overstate the amount of revenue recognized in the period. C. Adjusting Entries. 1. A merchandiser using a perpetual system will require one additional adjusting entry to make the records agree with the actual inventory on hand. 2. At the end of each period, for control purposes, a merchandising company that uses a perpetual system will take a physical count of its goods on hand. A company’s unadjusted balance in Inventory usually does not agree with the actual amount of inventory on hand. 3. The company may need to adjust the perpetual inventory records to make the recorded inventory amount agree with the inventory on hand. This involves debiting (or crediting) Inventory and crediting (or debiting) Cost of Goods Sold. D. Closing Entries. 1. The temporary accounts with credit balances are closed to Income Summary. 2. The temporary accounts with debit balances are closed to Income Summary. 3. Income Summary is closed to the Owner’s Capital account. 4. The Owner’s Drawings account is closed to the Owner’s Capital account. 5-10 .

E. Forms of Income Statements. Merchandising companies use one of two forms for the income statement: 1. Multiple-step income statement. a.

Includes sales revenues, cost of goods sold, and operating expenses.

Two nonoperating activities sections: Other revenues and gains and other expenses and losses.

2. The multiple-step income statement reports gross profit (net sales less cost of goods sold). a.

A company’s gross profit can be expressed as a percentage, called the gross profit rate.

The gross profit rate is computed by dividing the gross profit amount by net sales.

Analysts generally consider the gross profit rate to be more useful than the gross profit amount.

3. Single-step income statement. a.

All data are classified into two categories: (1) Revenues include both operating revenues and other revenues and gains. (2) Expenses include cost of goods sold, operating expenses, and other expenses and losses.

5-11

*F. Using a Worksheet. 1. The steps in preparing a worksheet for a merchandising company are the same as they are for a service company. 2. The Inventory account is extended from the adjusted trial balance column to the balance sheet debit column. 3. Sales Revenue, Sales Returns and Allowances, and Sales Discounts are extended from the adjusted trial balance column to the income statement columns. Sales Revenue is placed in the credit column while Sales Returns and Allowances and Sales Discounts are entered in the debit column. 4. Cost of Goods Sold is extended from the adjusted trial balance column to the income statement debit column.

*G. Determining Cost of Goods Sold Under a Periodic System. 1. Determining cost of goods sold is different under the periodic system than under the perpetual system. 2. Under a periodic system, the company uses separate accounts to record freight costs, returns, and discounts. 3. At the end of the period, a company calculates the balance in ending inventory, and cost of goods sold for the period.

5-12 .

4. The steps in determining cost of goods sold are: a.

Record the purchases of merchandise.

Determine the cost of goods purchased: Purchases less purchase returns and allowances and purchase discounts plus freight-in.

Determine the cost of goods on hand at the beginning and end of the accounting period.

*H. Periodic Inventory System. 1. Companies record revenues from the sale of merchandise when sales are made, just as in a perpetual system. But companies do not attempt on the date of sale to record the cost of the merchandise sold. 2. Companies record purchases of merchandise in the Purchases account rather than the Inventory account. 3. Freight costs are recorded in a Freight-In account which is a temporary account whose normal balance is a debit. 4. When a purchaser returns merchandise for credit or receives a discount for prompt payment, it is called purchase returns and allowances or purchase discounts. Purchase Returns and Allowances and Purchase Discounts are contra accounts to Purchases and have normal credit balances.

5-13

A Look at IFRS The basic accounting entries for merchandising are the same under both GAAP and IFRS. The income statement is a required statement under both sets of standards. The basic format is similar although some differences do exist.

KEY POINTS Following are the key similarities and differences between GAAP and IFRS related to inventories. • Under both GAAP and IFRS, a company can choose to use either a perpetual or periodic system. • The definition of inventrories is basically the same under GAAP and IFRS. • As indicated above, the basic accounting entries for merchandising are the same under both GAAP and IFRS. • Both GAAP and IFRS require that income statement information be presented for multiple years. For example, IFRS requires that 2 years of income statement information be presented, whereas GAAP requires 3 years. • Under GAAP companies generally classify income statement items by function. Classification by function leads to descriptions like administration, distribution, and manufacturing. Under IFRS, companies must classify expenses either by nature or function. Classification by nature leads to descriptions such as the following: salaries, depreciation expense, and utilities expense. If a company uses the functional-expense method on the income statement, disclosure by nature is required in the notes to the financial statements. • Presentation of the income statement under GAAP follows either a singlestep or multiple-step format. IFRS does not mention a single-step or multiple-step approach. • Under IFRS revaluation of land, buildings, and intangible assets is permitted. The initial gains and losses resulting from this revaluation are reported as adjustments to equity, often referred to as other comprehensive income. The effect of this difference is that the use of IFRS results in more transactions affecting equity (other comprehensive income) but not net income.

5-14 .

LOOKING TO THE FUTURE The IASB and FASB are working on a project that would rework the structure of financial statements. Specifically, this project will address the issue of how to classify various items in the income statement. A main goal of this new approach is to provide information that better represents how businesses are run. In addition, this approach draws attention away from just one number—net income. It will adopt major groupings similar to those currently used by the statement of cash flows (operating, investing, and financing), so that numbers can be more readily traced across statements. For example, the amount of income that is generated by operations would be traceable to the assets and liabilities used to generate the income. Finally, this approach would also provide detail, beyond that currently seen in most statements (either GAAP or IFRS), by requiring that line items be presented both by function and by nature. The new financial statement format was heavily influenced by suggestions from financial statement analysts.

5-15

20 MINUTE QUIZ Circle the correct answer. True/False 1. Measuring net income for a merchandising company is conceptually the same as for a service company. True

False

2. The cost of goods sold is determined only at the end of the accounting period under a perpetual inventory system. True

False

3. Under the perpetual inventory system, the purchase of merchandise is recorded with a debit to the Purchases account. True

False

4. Sales Discounts is a contra revenue account and has a debit balance. True

False

5. A customer may receive a sales discount for goods that are damaged or defective. True

False

6. In a single-step income statement, gross profit and operating income are shown on the income statement. True

False

7. In the balance sheet, inventory is reported as a current asset immediately below accounts receivable. True

False

8. Income from operations is determined by subtracting other expenses and losses from gross profit. True

False

9. Merchandising companies report nonoperating activities in the income statement immediately after the company’s primary operating activities. True

False

*10. In preparing a worksheet for a merchandising firm, all income statement column debits represent expenses. True 5-16 .

False

Multiple Choice

Sales Discounts a. is a contra revenue account. b. has a normal debit balance. c. appears on the income statement. d. all of the above.

When a company uses the perpetual method of accounting for inventories the a. Inventory account does not change until the end of the year. b. Inventory account is debited when inventory is purchased and Cost of Goods Sold is debited when inventory is sold. c. sale of inventory requires a credit to Cost of Goods Sold. d. acquisition of merchandise requires a debit to Purchases.

The recording of a sale requires a a. credit to a sales account and a debit to an asset account. b. debit to Cash and a credit to Owner’s Capital. c. debit to a sales account and credit to an asset account. d. credit to Sales Revenue and a debit to Sales Discounts.

Which of the following would not be considered an operating expense? a. Cost of goods sold b. Rent expense c. Freight-out d. Office expense

Which of the following is reported on both a multiple-step and a single-step income statement? a. Gross profit b. Income from operations c. Other revenues and gains d. Net sales

5-17

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True False False True False

Multiple Choice 1. 2. 3. 4. 5.

5-18 .

d. b. a. a. d.

6. 7. 8. 9. *10.

False True False True False

CHAPTER 6 INVENTORIES LEARNING OBJECTIVES 1. DISCUSS HOW TO CLASSIFY DETERMINE INVENTORY. 2. APPLY INVENTORY COST FLOW METHODS AND DISCUSS THEIR FINANCIAL EFFECTS. 3. INDICATE THE EFFECTS OF INVENTORY ERRORS ON THE FINANCIAL STATEMENTS. 4. EXPLAIN THE STATEMENT PRESENTATION AND ANALYSIS OF INVENTORY. *5. APPLY THE INVENTORY COST FLOW METHODS TO PERPETUAL INVENTORY RECORDS. *6. DESCRIBE THE TWO METHODS OF ESTIMATING INVENTORIES.

6-1

CHAPTER REVIEW Classifying Inventory 1.

(L.O. 1) Inventory has two common characteristics: (a) it is owned by the company and (b) it is in a form ready for sale in the ordinary course of business.

A manufacturer’s inventory is usually classified into three categories: a. Finished goods that are completed and ready for sale. b. Work in process that is in various stages of production but not yet completed. c. Raw materials that are on hand waiting to be used in production.

Determination of Inventory Quantities 3.

The determination of inventory quantities involves (a) taking a physical inventory of goods on hand and (b) determining the ownership of goods.

Taking a physical inventory involves counting, weighing or measuring each kind of inventory on hand. Internal control procedures should be followed in taking the inventory in order to minimize errors.

For goods in transit, legal title is determined by the terms of sale. When the terms are: a. FOB (free on board) shipping point, ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller. b. FOB destination, legal title to the goods remains with the seller until the goods reach the buyer.

Under a consignment arrangement, the holder of the goods (called the consignee) does not own the goods. Ownership remains with the shipper of the goods (consignor) until the goods are actually sold to a customer. Consigned goods should be included in the consignor’s inventory⎯not the consignee’s inventory.

Inventory Costing 7.

(L.O. 2) Inventory is accounted for at cost which includes all expenditures necessary to acquire goods and place them in a condition ready for sale. After a company has determined the quantity of units of inventory, it applies unit costs to the quantities to determine the total cost of the inventory and the cost of goods sold.

Specific Identification 8.

The specific identification method identifies the particular units sold so that the cost of the specific unit sold is charged to the cost of goods sold. This method is possible when a company sells a limited variety of high unit-cost items that can be clearly identified from the time of purchase through the time of sale.

The allocation of inventoriable costs may be made under any of the following assumptions as to the flow of costs (a) first-in, first-out (FIFO), (b) last-in, first-out (LIFO), or (c) average-cost.

FIFO 10.

The FIFO method assumes that the costs of the earliest goods purchased are the first to be sold. a. This method often parallels the actual physical flow of the merchandise. b. Under this method, the ending inventory is based on the latest units purchased.

6-2

LIFO 11.

The LIFO method assumes that the costs of the latest units purchased are the first to be sold. a. This method seldom coincides with the actual physical flow of inventory. b. Under this method, all goods purchased during the period are assumed to be available for the first sale, regardless of the date of purchase. c. The ending inventory is found by taking the unit cost of the oldest goods and working forward until all units of inventory are costed.

Average-Cost 12.

The average-cost method assumes that the goods available for sale are similar in nature. a. Under this method, the cost of goods available for sale is allocated on the basis of weightedaverage unit cost. b. The formula for determining the weighted-average unit cost is: Cost of goods available for sale divided by total units available for sale.

Financial Statement Effects 13.

In periods of rising prices, FIFO produces a higher net income, LIFO the lowest, and average cost falls in the middle. The reverse is true when prices are falling.

14.

Companies adopt different inventory costing methods because of: a. Balance sheet effects: the inventory costs are closer to current costs under FIFO than under LIFO. b. Income statement effects: in addition to the effects on net income in (13) above, LIFO enables the company to avoid reporting paper or phantom profit as economic gain. c. Tax effects: in a period of inflation LIFO results in the lowest income taxes.

Net Realizable Value 15.

The value of inventory for companies in certain industries can drop due to changes in technology or fashions. This situation requires valuing inventory at the lower-of-cost-or-net realizable value (LCNRV) in the period in which the price decline occurs.

16.

Net realizable value refers to the net amount that a company expects to realize (receive) from the sale of inventory.

Effects of Inventory Errors 17.

(L.O. 3) The effects of inventory errors on the current year’s income statement are: Inventory Error Beginning inventory understated Beginning inventory overstated Ending inventory understated Ending inventory overstated

18.

Net Income Overstated Understated Understated Overstated

The effects of ending inventory errors on the balance sheet are: Ending Inventory Overstated Understated

Cost of Goods Sold Understated Overstated Overstated Understated

6-3

Assets Overstated Understated

Liabilities No effect No effect

Owner’s Equity Overstated Understated

19. In the financial statements: a. Inventory is usually classified as a current asset after receivables in the balance sheet, and cost of goods sold is subtracted from sales in the income statement. b. There should be disclosure of (1) the major inventory classifications, (2) the basis of accounting, and (3) the costing method. Inventory Turnover 20. (L.O. 4) The inventory turnover measures the number of times on average the inventory is sold during the period. Cost of Goods Sold ÷ Average Inventory = Inventory Turnover *Applying Perpetual Inventory *21. (L.O. 5) Each of the inventory cost flow methods may be used in a perpetual inventory system. a. Under FIFO, the cost of the earliest goods on hand prior to each sale is charged to cost of goods sold. b. Under the LIFO method, the most recent purchase prior to sale is allocated to the units sold. c. When the moving-average method is used, a new average is computed after each purchase by dividing the cost of goods available for sale by the units on hand. Estimating Inventories *22. (L.O. 6) Inventories may have to be estimated when (a) management wants monthly or quarterly financial statements or (b) a fire or other type of casualty makes it impossible to take a physical inventory. Gross Profit Method *23. The gross profit method is widely used to estimate the ending inventory. Two steps are involved in using this method. a. The estimated cost of goods sold is determined by subtracting the estimated gross profit from net sales. b. The estimated cost of goods sold is subtracted from cost of goods available for sale to determine the estimated cost of the ending inventory. Retail Inventory Method *24. The retail inventory method is used by retail companies to estimate the cost of the inventory. The steps in using this method are:

6-4

Goods Available – for Sale at Retail

Net = Sales

Goods Available for Sale at Cost

Goods Available for Sale at Retail

Ending Inventory at Retail

Cost-toRetail Ratio

Ending Inventory at Retail =

Cost-toRetail Ratio

Estimated Cost of Ending Inventory

LECTURE OUTLINE A.

Classifying and Determining Inventory. 1. Inventory of a merchandising company has two common characteristics: a.

It is owned by the company.

It is in a form ready for sale to customers in the ordinary course of business.

2. In a manufacturing company, some inventory may not yet be ready for sale. As a result, manufacturers usually classify inventory into three categories: a.

Finished goods; manufactured items that are completed and ready for sale.

Work in process; the portion of manufactured inventory that has been placed into the production process but is not yet complete.

Raw materials; the basic goods that will be used in production but have not yet been placed into production.

ACCOUNTING ACROSS THE ORGANIZATION JIT can save a company a lot of money, but it isn’t without risk. An unexpected disruption in the supply chain can cost a company a lot of money. Japanese automakers experienced such a disruption when an earthquake damaged a company that supplies 50% of the automaker’s piston rings. What steps might companies take to avoid such a serious disruption in the future? Answer: The manufacturer of the piston rings should spread its manufacturing facilities across a few locations that are far enough apart that they would not all be at risk at once. In addition, the automakers might consider becoming less dependent on a single supplier as well as having weather contingency plans. .

6-5

Determining Inventory Quantities. 1. All companies need to determine inventory quantities at the end of the accounting period. Companies using a perpetual system take a physical inventory for the following reasons: a.

To check the accuracy of their perpetual inventory records.

To determine the amount of inventory lost due to wasted raw materials, shoplifting, or employee theft.

2. Determining inventory quantities involves two steps: (1) taking a physical inventory of goods on hand and (2) determining the ownership of goods. a.

Taking a physical inventory involves actually counting, weighing, or measuring each kind of inventory on hand.

Determining the ownership of goods. (1) Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of the sale: (a) When the terms are FOB (free on board) shipping point, ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller. (b) When the terms are FOB destination, ownership of the goods remains with the seller until the goods reach the buyer. (2) Consigned goods are goods held by one party although ownership of the goods is retained by another party. If an inventory count is taken, the goods would not be included in the holding party’s inventory.

Inventory Costing. 1. Inventory is accounted for at cost. 2. Cost includes all expenditures necessary to acquire goods and place them in condition ready for sale.

6-6

3. Cost of goods available for sale includes: a.

The cost of beginning inventory.

The cost of goods purchased.

4. Cost of goods available for sale is allocated to either ending inventory or to cost of goods sold. D.

Specific Identification. 1. Specific identification requires that companies keep records of the original cost of each individual inventory item. 2. Bar coding, electronic product codes, and radio frequency identification make it theoretically possible to do specific identification with nearly any type of product. 3. This method, however, may enable management to manipulate net income.

Cost Flow Assumptions—FIFO, LIFO, and Average-Cost. 1. The FIFO (first-in, first-out) method assumes that the earliest goods purchased are the first to be recognized in determining cost of goods sold. a.

FIFO often parallels the actual physical flow of merchandise because it generally is good business practice to sell the oldest units first.

Under FIFO, companies obtain the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed.

2. The LIFO (last-in, first-out) method assumes that the latest goods purchased are the first to be recognized in determining cost of goods sold. a.

6-7

LIFO seldom coincides with the actual physical flow of inventory. All goods purchased during the period are assumed to be available for the first sale, regardless of the date of purchase.

Under LIFO, companies obtain the cost of the ending inventory by taking the unit cost of the earliest goods available for sale and working forward until all units of inventory have been costed.

3. The average-cost method assumes that the goods are similar in nature.

Under this method, the cost of goods available for sale is allocated on the basis of the weighted-average unit cost.

The weighted-average unit cost is computed by dividing cost of goods available for sale by total units available for sale.

The company then applies the weighted-average unit cost to the units on hand to determine the cost of ending inventory.

Financial Statement and Tax Effects of Cost Flow Methods.

1. Income statement effects. a.

Each dollar of difference in ending inventory results in a corresponding dollar difference in income before income taxes.

In a period of inflation, FIFO produces a higher net income because the lower unit costs of the first units purchased are matched against revenues.

Some argue that the use of LIFO in a period of inflation enables the company to avoid reporting paper (or phantom) profit as economic gain.

2. Balance sheet effects. a.

6-8

A major advantage of the FIFO method is that in a period of inflation, the costs allocated to ending inventory will approximate their current cost.

A major shortcoming of the LIFO method is that in a period of inflation, the costs allocated to ending inventory may be significantly understated in terms of current cost.

3. Tax effects. LIFO results in lower income taxes, because of lower net income, than either FIFO or average cost in a period of rising prices. INTERNATIONAL INSIGHT ExxonMobil Corporation uses LIFO to value its inventory for financial reporting and tax purposes. International accounting standards do not allow the use of LIFO, which makes the net income of foreign oil companies such as BP not directly comparable to U.S. companies. What are the arguments for and against the use of LIFO? Answer: Proponents of LIFO argue that it is conceptually superior because it matches the most recent cost with the most recent selling price. Critics contend that it artificially understates the company’s net income and consequently reduces tax payments. Also, because most foreign companies are not allowed to use LIFO, its use by U.S. companies reduces the ability of investors to compare results across companies. G.

Lower-of-Cost-or-Net Realizable Value. 1. The value of inventory for companies in certain industries can drop very quickly due to changes in technology or fashions. This situation requires a departure from the cost basis of accounting. This is done by valuing the inventory at the lower-of-cost-or-net realizable value (LCNRV) in the period in which the price decline occurs. 2. Companies apply LCNRV to the items in inventory after they have used one of cost flow methods to determine cost. Under LCNRV, companies recognize the loss in the period in which the price decline occurs. a.

6-9

LCNRV is an example of the accounting concept of conservatism, which means that the best choice among accounting alternatives is the method that is least likely to overstate assets and net income.

Under the LCNRV basis, net realizable value refers to the net amount that a company expects to realize (receive) from the sale of inventory. Net realizable value is the estimated selling price in the normal course of………………………………………..

Inventory Errors. 1. The effects of inventory errors on net income of the current year are: a.

An error in beginning inventory will have a reverse effect on net income (overstatement of inventory results in understatement of net income).

An error in ending inventory will have a similar effect on net income (overstatement of inventory results in overstatement of net income).

If ending inventory errors are not corrected in the following period, their effect on net income for that period is reversed, and total net income for the two years will be correct.

2. Errors in ending inventory have no effect on liabilities and have the same effect on total assets and total owners’ equity (overstatement of inventory results in overstatement of total assets and owners’ equity). I.

Statement Presentation and Analysis. 1. Inventory is classified as a current asset immediately below receivables in the balance sheet. Cost of goods sold is subtracted from sales revenue in a multiple-step income statement. 2. There should be disclosure in the notes to the financial statements of: a.

the major inventory classifications.

the basis of accounting (cost, or lower of cost or market).

the costing method (FIFO, LIFO, or average cost).

3. Inventory turnover measures the number of times on average the inventory is sold during the period. 6-10 .

4. A variant of the inventory turnover is to compute the number of days inventory is held. It is computed by dividing 365 days by the inventory turnover. *J

Inventory Cost Flow Methods in Perpetual Inventory Systems. 1. Under FIFO, companies charge to cost of goods sold the cost of the earliest goods on hand prior to each sale. The results under FIFO in a perpetual system are the same as in a periodic system. 2. Under LIFO, companies charge to cost of goods sold the cost of the most recent purchase prior to sale. In a perpetual LIFO system, the company allocates the latest units purchased prior to each sale to cost of goods sold. 3. Under the moving-average (average cost) method and a perpetual system, companies compute a new average cost after each purchase. The average cost is computed by dividing the cost of goods available for sale by the units on hand.

6-11

Estimating Inventories—Gross Profit and Retail Inventory Methods. 1. Two circumstances explain why companies sometimes estimate inventories: a.

A casualty such as a fire, flood, or earthquake may make it impossible to take a physical inventory.

Managers may want monthly or quarterly financial statements, but a physical inventory is taken only annually.

2. There are two widely used methods of estimating inventories: a.

The gross profit method is used in preparing monthly financial statements under a periodic system. (1) Step 1: Net sales less estimated gross profit equals estimated cost of goods sold. (2) Step 2: Cost of goods available for sale less estimated cost of goods sold (from Step 1) equals the estimated cost of ending inventory. (3) The gross profit method is based on the assumption that the gross profit rate will remain constant. (4) Companies should not use the gross profit method to prepare financial statements at the end of the year.

When a store has many different types of merchandise at low unit costs, the retail inventory method is often used. (1) Under the retail inventory method, a company’s records must show both the cost and retail value of the goods available for sale. (2) Step 1: Goods available for sale at retail less net sales equals ending inventory at retail. (3) Step 2: Goods available for sale at cost divided by goods available for sale at retail equals the cost-to-retail ratio.

6-12 .

(4) Step 3: Ending inventory at retail multiplied by the cost-to-retail ratio equals the estimated cost of ending inventory. (5) The major disadvantage of the retail method is that it is an averaging technique. This may produce an incorrect inventory valuation if the mix of the ending inventory is not representative of the mix in the goods available for sale.

6-13

A Look at IFRS The major IFRS requirements related to accounting and reporting for inventories are the same as GAAP. The major difference is that IFRS prohibits the use of the LIFO cost flow assumption.

Relevant Facts • IFRS and GAAP account for inventory acquisitions at historical cost and value inventory at the lower-of-cost-or-net realizable value subsequent to acquisition. • Who owns the goods—goods in transit or consigned goods—as well as the costs to include in inventory are essentially accounted for the same under IFRS and GAAP. • The requirements for accounting for and reporting inventories are more principles based under IFRS. That is, GAAP provides more detailed guidelines in inventory accounting. • A major difference between IFRS and GAAP relates to the LIFO cost flow assumption. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost flow assumptions permitted under IFRS. Both sets of standards permit specific identification where appropriate.

LOOKING TO THE FUTURE One convergence issue that will be difficult to resolve relates to the use of the LIFO cost flow assumption. As indicated, IFRS specifically prohibits its use. Conversely, the LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages. In addition, many argue that LIFO from a financial reporting point of view provides a better matching of current costs against revenue and, therefore, enables companies to compute a more realistic income.

6-14 .

20 MINUTE QUIZ Circle the correct answer. True/False 1.

When prices are rising, FIFO results in a higher ending inventory than LIFO. True

We can use the LIFO inventory method only if we know that the newest units are always sold first. True

False

The retail inventory method and the gross profit method are both methods of inventory estimation. True

False

The gross profit method estimates the cost of ending inventory by applying a gross profit rate to net sales. True

*10.

False

The inventory turnover is computed by dividing the cost of goods sold by the ending inventory. True

*9.

False

The LIFO method assumes that the earliest goods purchased are the first to be sold. True

False

Cost of goods purchased less the ending inventory equals cost of goods sold. True

False

When beginning inventory is understated, net income will be understated. True

False

Under the LCNRV basis, net realizable value is the estimated selling price in the normal course of business. True

False

Goods in transit would be included in the ending inventory of the buyer and the seller. True

False

6-15

False

Multiple Choice 1.

The cost flow method that results in the lowest income taxes when prices are rising is a. average cost. b. FIFO. c. LIFO. d. specific identification.

The data below are for Parrett Enterprises: Beginning inventory 150 units at $2.00 Purchase—August 375 units at $1.50 Purchase—October 150 units at $3.00 A periodic inventory system is used; ending inventory is 330 units. What is the ending inventory under FIFO? a. $570 b. $743 c. $593 d. $720

Double-counting an inventory item at year end will result in a. understated tax liability. b. overstated cost of goods sold. c. overstated net income. d. understated beginning inventory for the next period.

*4.

A retail company has goods available for sale of $300,000 at retail and $210,000 at cost, and ending inventory of $80,000 at retail. What is the estimated cost of goods sold? a. $220,000 b. $154,000 c. $210,000 d. $56,000

*5.

Which method might be used to estimate inventory costs when physical inventories are not taken? a. First-in, first-out b. Last-in, first-out c. Average cost method d. Gross profit method

6-16 .

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True False False True False

Multiple Choice 1. 2. 3. *4. *5.

6-17

c. d. c. b. d.

6. 7. 8. *9. *10.

False False False True True

CHAPTER 7 ACCOUNTING INFORMATION SYSTEMS LEARNING OBJECTIVES 1. EXPLAIN THE BASIC CONCEPTS OF AN ACCOUNTING INFORMATION SYSTEM. 2. DESCRIBE THE NATURE AND PURPOSE OF A SUBSIDIARY LEDGER. 3. RECORD TRANSACTIONS IN SPECIAL JOURNALS IN JOURNALIZING.

7-1

CHAPTER REVIEW Accounting Information Systems 1.

(L.O. 1) The accounting information system collects and processes transaction data and communicates financial information to decision makers. It includes each step of the accounting cycle.

The basic principles of an accounting information system are: a. Cost-effectiveness. The system must be cost effective: the benefits of the information must outweigh the cost of providing it. b. Usefulness. To be useful the information must be understandable, relevant, reliable, timely, and accurate. c. Flexibility. The system should accommodate a variety of users and changing information needs.

Computerized Accounting Systems 3.

General ledger accounting systems are software programs that integrate the various accounting functions related to sales, purchases, receivables, payables, cash receipts and disbursements, and payroll. They also generate financial statements.

Companies with revenues of less than $5 million and up to 20 employees generally use entrylevel programs. Quality entry-level packages include easy data access and report preparation, provide an “audit trail,” have internal controls, enable customization, and provide networkcompatibility.

Enterprise resource planning (ERP) systems are typically used by manufacturing companies with more than 500 employees and $500 million in sales. ERP systems go far beyond the functions of an entry-level general ledger package by integrating all aspects of the organization, including accounting, sales, human resource management, and manufacturing.

Manual Systems 6.

In a manual accounting system, each of the steps in the accounting cycle is performed by hand.

Subsidiary Ledgers 7.

(L.O. 2) A subsidiary ledger is a group of accounts with a common characteristic, assembled together to facilitate the recording process by freeing the general ledger from details concerning individual balances. Two common subsidiary ledgers are: a.The accounts receivable (or customers’) ledger, which collects transaction data of individual customers. b.

7-2

The accounts payable (or creditors’) ledger, which collects transaction data of individual creditors.

The summary account in the general ledger is called a control account and the balance in the control account must equal the composite balance of the individual accounts in the subsidiary ledger at the end of the period.

10.

The advantages of using subsidiary ledgers are that they: a. Show in a single account transactions affecting one customer or one creditor, thus providing up-to-date information on specific account balances. b. Free the general ledger of excessive details. As a result, a trial balance of the general ledger does not contain vast numbers of individual account balances. c. Help locate errors in individual accounts by reducing the number of accounts in one ledger and by using control accounts. d. Make possible a division of labor in posting by having one employee post to the general ledger while a different employee posts to the subsidiary ledgers.

Special Journals 11.

(L.O. 3) To expedite journalizing and posting transactions, most companies use special journals in addition to the general journal. A special journal is used to group similar types of transactions, such as all sales of merchandise on account or all cash receipts.

12.

The following are types of special journals: a. Sales journal—all sales of merchandise on account. b. Cash receipts journal—all cash received (including cash sales). c. Purchases journal—all purchases of merchandise on account. d. Cash payments journal—all cash paid (including cash purchases).

13.

If a transaction cannot be recorded in a special journal, it is recorded in the general journal. Special journals permit greater division of labor and reduce the time necessary to complete the posting process.

Sales Journal 14.

For the sales journal, a. Each entry results in a debit to Accounts Receivable and a credit to Sales Revenue at selling price; and a debit to Cost of Goods Sold and a credit to Inventory at cost. b. Only one line is needed to record each transaction. c. All entries are made from sales invoices. d. Postings are made daily to the individual accounts receivable in the subsidiary ledger and monthly, in total, to Accounts Receivable, Sales Revenue, Cost of Goods Sold and Inventory in the general ledger.

Cash Receipts Journal 15.

The cash receipts journal is a columnar journal with debit columns for cash and sales discounts, and credit columns for accounts receivable, sales revenue, and “other” accounts. In addition there is a separate column for a debit to Cost of Goods Sold and a credit to Inventory. In journalizing cash receipts transactions: a. Only one line is needed for each entry. b. Each sale entry is accompanied by another entry that debits Cost of Goods Sold and credits Inventory for cost.

7-3

16.

The posting of a columnar journal such as the cash receipts journal involves the following procedures: a. All column totals except the total for the Other Accounts column are posted once at the end of the month to the account title or titles specified in the column heading. b. The total of the Other Accounts column is not posted. Instead, the individual amounts comprising the total are posted separately to the general ledger accounts specified in the Accounts Credited column. c. The individual amounts in a column, posted in total to a control account, are posted daily to the subsidiary ledger account specified in the Accounts Credited column.

Purchases Journal 17.

For the purchases journal, a. Each entry results in a debit to Inventory and a credit to Accounts Payable. b. Only one line is needed to record each transaction. c. All entries are made from purchase invoices. d. Postings are made daily to the individual creditor accounts in the accounts payable subsidiary ledger and monthly, in total, to Inventory and Accounts Payable in the general ledger.

18.

The purchases journal can be expanded into a columnar journal by adding columns for supplies and other accounts.

Cash Payments Journal 19.

The cash payments journal has multiple columns because cash payments may be made for a variety of purposes. a. The journalizing procedures are similar to those described earlier for the cash receipts journal. b. All entries are made from prenumbered checks. c. The posting procedures are similar to those described earlier for the cash receipts journal.

Effects of Special Journals on the General Journal 20.

Only transactions that cannot be entered in a special journal are recorded in the general journal. When the entry involves both control and subsidiary accounts the following modifications are required: a. In journalizing, both the control and subsidiary accounts must be identified. b. In posting, there must be a dual posting: once to the control account and once to the subsidiary account.

7-4

LECTURE OUTLINE A.

Basic Concepts of Accounting Information Systems. 1. Cost-effectiveness—the benefits of the information must outweigh the cost of providing it. 2. Usefulness—information must be understandable, relevant, reliable, timely, and accurate. 3. Flexibility—an accounting system should accommodate a variety of users and changing information needs.

Computerized Accounting Systems. 1. General ledger accounting systems are software programs that integrate the various accounting functions related to sales, purchases, receivables, payables, cash receipts and cash disbursements, and payroll. 2. Choosing the right software package is critical because installation of even a basic system is time-consuming, and learning a new system will require many hours of employee time. 3. Quality entry-level software packages usually involve more than recording transactions and preparing financial statements. Common features and benefits include: (a) Easy data access and report preparation, (b) Audit trail, (c) Internal controls, (d) Customization, and (e) Network-compatibility. 4. Enterprise resource planning (ERP) systems go far beyond the functions of an entry-level general ledger package. They integrate all aspects of the organization, including accounting, sales, human resource management, and manufacturing.

7-5

ETHICS INSIGHT The Sarbanes-Oxley Act requirements have created a huge market for software that can monitor and trace every recorded transaction and adjusting entry. This enables companies to pinpoint who used the accounting system and when they used it. Why might this software help reduce fraudulent activity by employees? Answer: By pinpointing who used the accounting system and when they used it, the software can hold employees more accountable for their actions. Companies hope that this will reduce efforts by employees to enter false accounting entries, change the dates of transactions, or create unauthorized expenditures. If employees do engage in these activities, there will be significant evidence of their activities. C.

Subsidiary Ledgers. 1. A subsidiary ledger is a group of accounts with a common characteristic (for example, all accounts receivable). 2. The subsidiary ledger facilitates the recording process by freeing the general ledger from the details of individual balances. 3. At the end of an accounting period, each general ledger control account balance must equal the composite balance of the individual accounts in the related subsidiary ledger. 4. The advantages subsidiary ledgers are that they:

7-6

Show in a single account transactions affecting one customer or one creditor, thus providing up-to-date information on specific account balances.

Free the general ledger of excessive details relating to individual accounts receivable and accounts payable.

Help locate errors in individual accounts by reducing the number of accounts in one ledger and by using control accounts.

Make possible a division of labor in posting to the general ledger and subsidiary ledgers.

ACCOUNTING ACROSS THE ORGANIZATION Rather than relying on customer or creditor names in a subsidiary ledger, a computerized system expands the account number of the control account in a prespecified manner. Why use numbers to identify names in a computerized system? Answer: Computerized systems process numbers faster than letters. Also, letters sometimes cause problems because you may have two people with the same name. Computerized systems avoid this problem by giving different customers, including those with the same names, different account numbers. D.

Special Journals. 1. Companies use special journals to record similar types of transactions. Special journals frequently used are: a.

Sales journal. Used for all sales of merchandise on account.

Cash receipts journal. Used for all cash received.

Purchases journal. Used for all purchases of merchandise on account.

Cash payments journal. Used for all cash paid.

2. In the sales journal, companies record sales of merchandise on account. Each entry in the sales journal results in a debit to Accounts Receivable and a credit to Sales Revenue at selling price and another entry at cost—a debit to Cost of Goods Sold and a credit to Inventory.

7-7

3. In the cash receipts journal, companies record all receipts of cash. a.

Companies use a multiple-column cash receipts journal because a two column journal would not have enough space for all possible cash receipts transactions.

Generally, a cash receipts journal includes debit columns for Cash and Sales Discounts, and credit columns for Accounts Receivable, Sales Revenue, and “Other” Accounts. A debit and credit column is also included to record debits to Cost of Goods Sold and credits to Inventory when a cash sale occurs.

4. In the purchases journal, companies record all purchases of merchandise on account. Each entry in this journal results in a debit to Inventory and a credit to Accounts Payable. 5. In a cash payments (cash disbursements) journal, companies record all disbursements of cash. 6. Only transactions that cannot be entered in a special journal are recorded in the general journal.

Posting of Multi-Column Journals. 1. Companies post all column totals except for the Other Accounts column once at the end of the month to the account title specified in the column heading. 2. Companies do not post the total of the Other Accounts column. Instead, the individual amounts comprising the total are posted separately to the general ledger accounts specified in the Account Credited (Debited) column. 3. The individual amounts in a column posted in total to a control account are posted daily to the subsidiary ledger accounts specified in the Account Credited (Debited) column.

7-8

A Look at IFRS As discussed in Chapter 1, IFRS is growing in acceptance around the world. For example, recent statistics indicate a substantial number of the Global Fortune 500 companies use IFRS. And the chairman of the IASB predicts that IFRS adoption will grow from its current level of 115 countries to nearly 150 countries in the near future. When countries accept IFRS for use as accepted accounting policies, companies need guidance to ensure that their first IFRS financial statements contain high-quality information. Specifically, IFRS 1 requires that information in a company’s first IFRS statements (1) be transparent, (2) provide a suitable starting point, and (3) have a cost that does not exceed the benefits. RELEVANT FACTS Following are the key similarities and differences between AAP and IFRS related to accounting information systems. • The basic concepts related to an accounting information system are the same under GAAP and IFRS. • The use of subsidiary ledgers and control accounts, as well as the system used for recording transactions, are the same under GAAP and IFRS. • Many companies will be going through a substantial conversion process to switch from their current reporting standards to IFRS. • Upon first-time adoption of IFRS, a company must present at least one year of comparative information under IFRS. LOOKING TO THE FUTURE The basic recording process shown in this textbook is followed by companies around the globe. It is unlikely to change in the future. The definitional structure of assets, liabilities, equity, revenues, and expenses may change over time as the IASB and FASB evaluate their overall conceptual framework for establishing accounting standards. In addition, high-quality international accounting requires both high-quality accounting standards and high-quality auditing. Similar to the convergence of U.S. GAAP and IFRS, there is a movement to improve international auditing standards.

7-9

20 MINUTE QUIZ Circle the correct answer. True/False 1.

The basic principles in developing an accounting information system are cost-effectiveness, useful output, and flexibility. True

Flexibility (the ability to accommodate a variety of users and changing information needs) is not important in designing and developing an efficient and effective accounting information system. True

False

The purchases journal is used to record all purchases of merchandise. True

10.

False

Companies record all receipts of cash in the cash receipts journal. True

False

Only transactions that cannot be entered in a special journal are recorded in the general journal. True

False

Each entry in the single-column purchases journal results in a debit to Inventory and a credit to Accounts Payable. True

False

In posting a multi-column journal, the total of the Other Accounts column is not posted. True

False

An advantage of using subsidiary ledgers is that they show transactions affecting one customer or one creditor in a single account, providing up-to-date information on specific account balances. True

False

The sales journal is used to record all sales of merchandise. True

False

When control and subsidiary accounts are involved, there must be a dual posting: once to the control account and once to the subsidiary account. True

7-10 .

False

Multiple Choice

To be useful, information must be all of the following except a. accurate. b. conservative. c. relevant. d. understandable.

The source for preparing the schedule of accounts receivable is the a. accounts receivable controlling account. b. sales journal. c. accounts receivable subsidiary ledger. d. trial balance.

A group of accounts with a common characteristic, such as all accounts receivable, is a a. cash receipts journal. b. subsidiary ledger. c. special journal. d. general ledger.

Sales of merchandise for cash would be recorded in the a. sales journal. b. general journal. c. purchases journal. d. cash receipts journal.

A purchase return for credit is recorded in the a. cash receipts journal. b. cash payments journal. c. general journal. d. sales journal.

7-11

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True False False True True

Multiple Choice 1. 2. 3. 4. 5.

7-12 .

b. c. b. d. c.

6. 7. 8. 9. 10.

True True True False True

CHAPTER 8 FRAUD, INTERNAL CONTROL, AND CASH LEARNING OBJECTIVES 1. DISCUSS FRAUD AND THE PRINCIPLES OF INTERNAL CONTROL. 2. APPLY INTERNAL CONTROL PRINCIPLES TO CASH. 3. IDENTIFY THE CONTROL FEATURES OF A BANK ACCOUNT. 4. EXPLAIN THE REPORTING OF CASH.

8-1

CHAPTER REVIEW Fraud and Internal Control 1.

(L.O. 1) Fraud is a dishonest act by an employee that results in personal benefit to the employee at a cost to the employer. The fraud triangle refers to the three factors that contribute to fraudulent activity by employees: opportunity, financial pressure, and rationalization.

Internal control consists of all the related methods and measures adopted within an organization to (a) safeguard assets, (b) enhance the reliability of accounting records, (c) increase efficiency of operations, and (d) ensure compliance with laws and regulations.

An essential characteristic of internal control is the establishment of responsibility to specific employees. Control is most effective when only one person is responsible for a given task.

The rationale for segregation of duties is this: The work of one employee should, without a duplication of effort, provide a reliable basis for evaluating the work of another employee.

The responsibility for related transactions should be assigned to different individuals, and the responsibility for establishing the accountability for an asset should be separate from the physical custody of that asset.

Documentation procedures provide evidence that transactions and events have occurred.

Physical controls relate primarily to the safeguarding of assets and include such measures as safes for the storage of cash prior to deposit, vaults for the deposit of cash, safety deposit boxes for the storage of important business papers, and locked warehouses for inventories. These controls also include alarms, television monitors, garment sensors and time clocks.

Most systems of internal control provide for independent internal verification. This principle involves the review of data prepared by employees.

In large companies, independent internal verification is often assigned to internal auditors. Internal auditors are company employees who continuously evaluate the effectiveness of the company’s internal control systems.

10.

Human resource control measures include bonding of employees who handle cash, rotating employees’ duties and requiring employees to take vacations, and conducting thorough background checks.

Limitations of Internal Control 11.

The concept of reasonable assurance rests on the premise that the costs of establishing control procedures should not exceed their expected benefits.

12.

The human element is also an important factor in every system of internal control. A good system can become ineffective through employee fatigue, carelessness, or indifference.

13.

Collusion may result when two or more individuals work together to get around prescribed controls and may significantly reduce the effectiveness of a system.

8-2

Cash Controls 14.

(L.O. 2) To safeguard cash and to assure the accuracy of the accounting records for cash, effective internal control over cash is critical.

Cash Receipts Controls 15.

The application of internal control principles to cash receipts transactions includes: (1) only designated personnel should be authorized to handle or have access to cash receipts; (2) different individuals should be assigned the duties of receiving cash, recording cash receipt transactions, and having custody of cash; (3) documents should include remittance advices, cash register tapes, and deposit slips; (4) cash should be stored in company safes and bank vaults, access to storage areas should be limited to authorized personnel, and cash registers should be used; (5) daily cash counts and daily comparisons of total receipts should be made; and (6) all personnel who handle cash receipts should be bonded and required to take vacations.

16.

Control of over-the-counter receipts is centered on cash registers that are visible to customers.

Cash Disbursements Controls 17.

(L.O. 4) Generally, internal control over cash disbursements is more effective when companies pay by check or electronic funds transfer (EFT), rather than by cash, except for incidental amounts that are paid out of petty cash.

18.

The application of internal control principles to cash disbursements transactions includes: (1) only designated individuals should be authorized to sign checks; (2) different individuals should be assigned the duties of approving an item for payment and paying it; (3) prenumbered checks should be used and each check should be supported by an approved invoice or other document; (4) blank checks should be stored in a safe and access should be restricted to authorized personnel, and a machine should be used to imprint the amount on the check in indelible ink; (5) each check should be compared with the approved invoice before it is issued; and (6) bonding personnel who handle cash, requiring employees to take vacations, and conducting background checks.

Voucher System 19.

Companies use a voucher system to enhance the internal control over cash disbursements. A voucher system is a network of approvals by authorized individuals, acting independently, to ensure that all disbursements by check are proper. A voucher system includes the use of authorization forms called vouchers which are recorded by the accounting department in the voucher register.

Petty Cash Fund 20.

A petty cash fund is a cash fund used to pay relatively small amounts. a. The operation of the fund, often called an imprest system, involves (1) establishing the fund, (2) making payments from the fund, and (3) replenishing the fund. b. Accounting entries are required when (1) the fund is established, (2) the fund is replenished, and (3) the amount of the fund is changed.

8-3

Control Features: Use of a Bank 21.

(L.O. 3) The use of a bank minimizes the amount of currency that must be kept on hand and therefore contributes significantly to good internal control over cash.

22.

A check is a written order signed by the depositor directing the bank to pay a specified sum of money to a designated recipient. The three parties to a check are as follows: a. The maker (or drawer) who issues the check. b. The bank (or payer) on which the check is drawn. c. The payee to whom the check is payable.

23.

A bank statement shows (a) checks paid and other debits charged against the account, (b) deposits and other credits made to the account, and (c) the account balance after each day’s transactions.

24.

A bank debit memorandum is usually included with the bank statement to indicate charges against the depositor’s account such as a bank service charge, cost of printing checks, issuing traveler’s checks, and when a previously deposited customer’s check “bounces” because of insufficient funds (NSF check).

25.

A bank credit memorandum shows such items as the collection of a note receivable for the depositor by the bank.

Reconciling the Bank Account 26.

A reconciliation of a bank account is necessary because the balance per bank and balance per books are seldom in agreement. The need for agreement may be the result of time lags and errors.

27.

To obtain maximum benefit from a bank reconciliation, the reconciliation should be prepared by an employee who has no other responsibilities pertaining to cash.

28.

In reconciling the bank statement, it is customary to reconcile the balance per books and balance per bank to their adjusted cash balances. The reconciliation schedule consists of two sections. The steps in preparing a bank reconciliation are: a. Determine deposits in transit. b. Determine outstanding checks. c. Note any errors discovered. d. Trace bank memoranda to the depositor’s records.

29.

Each reconciling item used in determining the adjusted cash balance per books should be recorded by the depositor.

Reporting Cash 30.

(L.O. 4) Cash on hand, cash in banks, and petty cash are often combined and reported simply as Cash. Because it is the most liquid asset, cash is listed first in the current assets section of the balance sheet under the title “Cash and cash equivalents.” Cash equivalents are short-term highly liquid investments that are both readily convertible to known amounts of cash, and so near their maturity that their market value is relatively insensitive to changes in interest rates. They include Treasury bills, Commercial paper, and money market funds.

8-4

LECTURE OUTLINE

Fraud. 1. A fraud is a dishonest act by an employee that results in personal benefit to the employee at a cost to the employer. 2. The fraud triangle refers to the three factors that contribute to fraudulent activity by employees:

Opportunity—occurs when the workplace lacks sufficient controls to deter and detect fraud.

Financial pressure—employees sometimes commit fraud because they want to lead a lifestyle that they cannot afford on their current salary.

Rationalization—employees sometimes justify fraud because they believe they are underpaid and the employer is making lots of money.

Internal Control. 1. Internal control consists of all the related methods and measures adopted within an organization to: a.

Safeguard assets, enhance the reliability of accounting records, increase efficiency of operations, and ensure compliance with laws and regulations.

2. Internal control systems have five primary components: a control environment, risk assessment, control activities, information and communication, and monitoring.

8-5

Principles of Internal Control Activities. 1. Establishment of responsibility: control is most effective when only one person is responsible for a given task, (i.e., cash register). 2. Segregation of duties: the work of one employee should, without a duplication of effort, provide a reliable basis for evaluating the work of another employee. a.

Related activities: making one individual responsible for related activities increases the potential for errors and irregularities. (1) Activities related to purchasing (ordering, receiving, and authorizing payment). (2) Activities related to sales (selling, shipping, and billing).

Record keeping separate from physical custody: The custodian of the asset is not likely to convert the asset to personal use when one employee maintains the record of the asset, and a different employee has physical custody of the asset.

3. Documentation procedures: documents provide evidence that transactions and events have occurred. a.

Prenumbering documents helps to prevent a transaction from being recorded more than once, or conversely, from not being recorded at all.

Companies should require that employees promptly forward source documents for accounting entries to the accounting department.

4. Physical controls: a.

8-6

Physical controls relate to the safeguarding of assets (safes, vaults, safety deposit boxes, and locked warehouses), and enhance the accuracy and reliability of the accounting records (alarms, television monitors, garment sensors, and time clocks).

5. Independent internal verification: the review of data prepared by employees. a.

Maximum benefit from independent internal verification is obtained when: (1) Companies verify records periodically or on a surprise basis. (2) An independent employee makes the verification. (3) Discrepancies and exceptions are reported and corrected.

Internal auditors review the activities of departments and individuals to determine whether prescribed internal controls are being followed and recommend improvements when needed.

6. Human resource controls:

8-7

Bonding employees who handle cash involves obtaining insurance protection against theft by employees.

Rotating employees’ duties and requiring employees to take vacations deters employees from attempting thefts since they will not be able to permanently conceal their improper actions.

Conducting thorough background checks is considered by many to be the most important and inexpensive measure any business can take to reduce employee theft and fraud.

ACCOUNTING ACROSS THE ORGANIZATION To ensure proper employee supervision and proper separation of duties, companies must develop and monitor an organizational chart. One corporation that did this found that out of 17,000 employees, there were 400 people who did not report to anyone, and 35 people who reported to each other. Why would unsupervised employees or employees who report to each other represent potential internal control threats? Answer: An unsupervised employee may have a fraudulent job (or may even be a fictitious person—e.g., a person drawing a paycheck without working). Or, if two employees supervise each other, there is no real separation of duties, and they can conspire to defraud the company. D.

Limitations of Internal Control. 1. The concept of reasonable assurance rests on the premise that the costs of establishing control procedures should not exceed their expected benefit. 2. It should also be recognized that the human element (employee fatigue, carelessness, or indifference) is an important factor as is collusion between two or more individuals to get around prescribed controls.

Cash Receipts Controls. 1. In retail businesses, control of over-the-counter receipts centers on cash registers that are visible to customers. 2. All mail receipts should be opened in the presence of at least two mail clerks and one of the clerks should endorse each check “For Deposit Only.” 3. By employing two clerks, the chance of fraud is reduced since they would have to collude to engage in fraud.

8-8

Cash Disbursements Controls. 1. Generally, internal control over cash disbursements is more effective when companies pay by check or electronic funds transfer (EFT), except for incidental amounts that are paid out of petty cash. 2. A voucher system is a network of approvals by authorized individuals, acting independently, to ensure that all disbursements by check are proper. 3. The use of a voucher system, whether done manually or electronically, improves internal control over cash disbursements and keeps track of the documents that back up each transaction.

Petty Cash Fund. 1. Companies use a petty cash fund to pay relatively small amounts. 2. The operation of a petty cash fund, called an imprest system, involves: a.

Establishing the fund: debit Petty Cash and credit Cash.

Making payments from the fund: payments must be documented by a prenumbered petty cash receipt.

Replenishing the fund: debit appropriate expense accounts and credit Cash.

ETHICS INSIGHT A recent study by the Association of Certified Fraud Examiners found that twothirds of all employee thefts involved a fraudulent disbursement by an employee. The most common form was fraudulent billing schemes. How can companies reduce the likelihood of fraudulent disbursements?

8-9

Answer: Some common-sense approaches are to make sure only certain designated individuals can sign checks. In addition, make sure that different personnel approve payments and make payments. The next chapter will provide even more sophisticated approaches to reduce fraudulent disbursements.

Control Features: Use of a Bank. 1. The use of a bank contributes significantly to good internal control by: a.

Providing physical controls for the storage of cash.

Minimizing the amount of currency that a company must keep on hand.

Creating a double record of a depositor’s bank transactions.

2. An authorized employee (i.e., head cashier) should make a company’s bank deposits, documented by a deposit slip (ticket). 3. A check is a written order signed by the depositor directing the bank to pay a specified sum of money to a designated recipient. 4. A bank statement shows: a.

Checks paid and other debits (i.e. debit card transactions) that reduce the balance in the depositor’s account.

Deposits and other credits that increase the balance in the depositor’s account.

The account balance after each day’s transactions.

5. A debit memorandum may identify a bank’s monthly service charge (SC) or a non-sufficient funds check (NSF). 6. A credit memorandum may identify notes receivable collected by the bank for the depositor and interest paid on checking account.

8-10

Reconciling the Bank Account.

1. Deposits recorded by the depositor that have not been recorded by the bank are deposits in transit and are added to the balance per bank. 2. Issued checks recorded by the company but that have not yet been paid by the bank are outstanding checks and are deducted from the balance per bank. 3. List any errors by the depositor or bank in the appropriate section of the reconciliation schedule. 4. List any unrecorded bank memoranda in the appropriate section of the reconciliation schedule.

Reporting Cash. 1. On the balance sheet, companies often combine cash on hand, cash in banks, and petty cash and report the total as Cash. 2. Cash equivalents are short-term, highly liquid investments that are both: a.

Readily convertible to known amounts of cash, and

So near their maturity that their market value is relatively insensitive to changes in interest rate.

3. Restricted cash is cash that is not available for general use but is restricted for a special purpose. It should be reported separately on the balance sheet as either a current or noncurrent asset.

8-11

A Look at IFRS Fraud can occur anywhere. Because the three main factors that contribute to fraud are universal in nature, the principles of internal control activities are used globally by companies. While Sarbanes-Oxley (SOX) does not apply to international companies, most large international companies have internal controls similar to those indicated in the chapter. IFRS and GAAP are also very similar in accounting for cash. IAS No. 1 (revised). “Presentation of Financial Statements,” is the only standard that discusses issues specifically related to cash. Relevant Facts Following are the key similarities and differences between GAAP and IFRS related to fraud, internal control, and cash. • The fraud triangle discussed in this chapter is applicable to all international companies. Some of the major frauds on an international basis are Parmalat (Italy), Royal Ahold (the Netherlands), and Satyam Computer Services (India). • Rising economic crime poses a growing threat to companies, with nearly one-third of all organizations worldwide being victims of fraud in a recent 12-month period. • Accounting scandals both in the United States and internationally have reignited the debate over the relative merits of GAAP, which takes a “rulesbased” approach to accounting, versus IFRS, which takes a “principlesbased” approach. The FASB announced that it intends to introduce more principles-based standards. • On a lighter note, at one time the Ig Nobel Prize in Economics went to the CEOs of those companies involved in the corporate accounting scandals of that year for “adapting the mathematical concept of imaginary numbers for use in the business world.” • The accounting and internal control procedures related to cash are essentially the same under both IFRS and this textbook. In addition, the definition used for cash equivalents is the same. • Most companies report cash and cash equivalents together under IFRS, as shown in this textbook. In addition, IFRS follows the same accounting policies related to the reporting of restricted cash. 8-12

• The SOX internal control standards apply only to companies listed on U.S. exchanges. There is continuing debate over whether foreign issuers should have to comply with this extra layer of regulation. LOOKING TO THE FUTURE Ethics has become a very important aspect of reporting. Different cultures have different perspectives on bribery and other questionable activities, and consequently penalties for engaging in such activities vary considerably across countries. High-quality international accounting requires both high-quality accounting standards and high-quality auditing. Similar to the convergence of GAAP and IFRS, there is movement to improve international auditing standards. The International Auditing and Assurance Standards Board (IAASB) functions as an independent standard-setting body. It works to establish high-quality auditing and assurance and quality-control standards throughout the world. Whether the IAASB adopts internal control provisions similar to those in SOX remains to be seen.

8-13

20 MINUTE QUIZ Circle the correct answer. True/False 1.

An effective system of internal control will segregate functions between individuals to reduce the potential for errors and fraud. True

When one individual is responsible for all of the related activities, the potential for errors and fraud is increased. True

False

A postage due expense of $4.75 would be paid out of petty cash and the entry to record the transaction would reduce the balance of the Petty Cash account by that amount. True

8-14

False

An outstanding check that was also outstanding the previous month should not be included in the reconciliation of the bank statement this month. True

10.

False

The lack of agreement between the balance per books and the balance per bank is due to time lags and errors by either party. True

False

Cash proceeds collected by the bank for a depositor would be identified in the bank statement by a credit memorandum to explain the entry. True

False

A check is a written order signed by the depositor directing the bank to pay a specified sum of money to a designated recipient. True

False

At the end of an accounting period, a debit balance of $99.00 in the Cash Over and Short account would be reported in the income statement as Miscellaneous Revenue. True

False

The duties of receiving cash, recording cash receipts transactions, and having custody of cash should be assigned to a single capable individual. True

False

Independent internal verification should be made periodically and should be done by an employee who is independent of the employee responsible for the information. True

False

Multiple Choice 1.

Which of the following is a primary concern of internal control? a. Promote training programs and control incentives b. Enhancing the reliability of accounting data c. Ensuring fairness of the financial statements d. Encouraging adherence to prescribed managerial performance

Each of the following is an attribute of internal control except a. segregation of duties. b. establishment of responsibility. c. independent internal verification. d. a sound marketing plan.

A company issues a check for $75 but records it incorrectly as $57. On the bank reconciliation, the $18 should be a. deducted from the balance per bank. b. added to the balance per bank. c. deducted from the balance per books. d. deducted from the balance per books and added to the balance per bank.

Irwin, Inc. has the following assets at the balance sheet date: Cash in bank—savings account $4,000 Amounts due from customers 7,000 Post-dated checks 2,000 Checking account balance 6,000 Which amount should be reported as cash in the balance sheet? a. $10,000 b. $6,000 c. $11,000 d. $13,000

A $100 petty cash fund has cash of $17 and valid receipts for $81. The journal entry upon replenishment would include a a. credit to Cash for $81. b. credit to Cash Over and Short for $2. c. debit to Cash for $81. d. debit to Cash Over and Short for $2.

8-15

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True True True False False

Multiple Choice 1. 2. 3. 4. 5.

8-16

b. d. c. a. d.

6. 7. 8. 9. 10.

True True True False False

CHAPTER 9 ACCOUNTING FOR RECEIVABLES LEARNING OBJECTIVES 1. EXPLAIN HOW COMPANIES RECOGNIZE ACCOUNTS RECEIVABLE. 2. DESCRIBE HOW COMPANIES VALUE ACCOUNTS RECEIVABLE AND RECORD THEIR DISPOSITION. 3. EXPLAIN HOW COMPANIES RECOGNIZE NOTES RECEIVABLE. 4. DESCRIBE HOW COMPANIES VALUE NOTES RECEIVABLE, RECORD THEIR DISPOSITION, AND PRESENT AND ANALYZE RECEIVABLES.

9-1

CHAPTER REVIEW Types of Receivables 1. 2.

(L.O. 1) Receivables are claims that are expected to be collected in cash. Receivables are usually classified as: (a) accounts receivable, (b) notes receivable, and (c) other receivables. Accounts receivable are amounts customers owe on account. Notes receivable are a written promise (as evidenced by a formal instrument) for amounts to be received. And other receivables include nontrade receivables such as interest receivable, loans to company officers, advances to employees, and income taxes refundable.

Recognizing Accounts Receivable 3.

When a business sells merchandise to a customer on credit, Accounts Receivable is debited and Sales Revenue is credited.

If a payment is received by a customer within the discount period, the following entry is made: Cash ........................................................................................ Sales Discounts ....................................................................... Accounts Receivable .........................................................

XXX XXX XXX

Valuing Accounts Receivable 5.

(L.O. 2) Companies record credit losses as debits to Bad Debt Expense (or Uncollectible Accounts Expense). Such losses are considered to be a normal and necessary risk of doing business. Two methods are used in accounting for uncollectible accounts: (a) the direct write-off method and (b) the allowance method.

Direct Write-off Method for Uncollectible Accounts 6.

Under the direct write-off method, bad debt losses are not anticipated and no allowance account is used. a. No entries are made for bad debts until an account is determined to be uncollectible at which time the loss is charged to Bad Debt Expense. b. This method makes no attempt to match bad debt expense to sales revenue in the income statement or to show the cash realizable value of the accounts receivable in the balance sheet. c. This method is not acceptable for financial reporting purposes, unless bad debt losses are insignificant.

The allowance method is required when bad debts are material in amount. Its essential features are: a. Uncollectible accounts are estimated and the expense for the uncollectible accounts is matched against sales revenue in the same accounting period in which the sales occurred. b. Estimated uncollectibles are debited to Bad Debt Expense and credited to Allowance for Doubtful Accounts through an adjusting entry at the end of each period. c. Actual uncollectibles are debited to Allowance for Doubtful Accounts and credited to Accounts Receivable at the time a specific account is written off.

When there is a recovery of an account that has been written off as uncollectible, it is necessary to: a. reverse the entry made when the account was written off, and b. record the collection in the usual manner.

There are two bases that are used to determine the amount of expected uncollectibles. One is the percentage-of-sales basis, and the other is the percentage-of-receivables basis.

9-2

Percentage-of-Sales Basis 10.

Under the percentage-of-sales basis, a. Management establishes a percentage relationship between the amount of credit sales and expected losses from uncollectible accounts. b. The expected bad debt losses are determined by applying the percentage to the sales base of the current period. c. This basis better matches expenses with revenues.

Percentage-of-Receivables Basis 11.

Under the percentage-of-receivables basis, a. The balance in the allowance account is derived from an analysis of individual customer accounts. The analysis is often called aging the accounts receivable. b. The amount of the adjusting entry is the difference between the required balance and the existing balance in the allowance account. c. This basis produces the better estimate of cash realizable value of the accounts receivable.

Disposing Accounts Receivable 12.

In order to accelerate the receipt of cash from receivables, owners frequently (1) sell to a factor such as a finance company or bank, or (2) make credit card sales.

13.

A factor buys receivables from businesses for a fee and then collects the payments directly from the customers. The entry for a sale to a factor is: Cash ......................................................................................... Service Charge Expense .......................................................... Accounts Receivable ..........................................................

14.

XXX XXX XXX

Credit cards are frequently used by retailers because the retailer does not have to be concerned with the customer’s credit history and the retailer can receive cash more quickly from the credit card issuer. However, the credit card issuer usually receives a fee of from 2–6% of the invoice price from the retailer.

Notes Receivable 15.

A promissory note is a written promise to pay a specified amount of money on demand or at a definite time. The party making the promise is called the maker; the party to whom payment is made is called the payee.

16.

When the life of a note is expressed in terms of months, the due date is found by counting the months from the date of issue. When the due date is stated in terms of days, it is necessary to count the days. In counting days, the date of issue is omitted but the due date is included.

17.

The basic formula for computing interest on an interest bearing note is:

Face Value of Note

9-3

Annual X Interest Rate

Time in Terms X of One Year

Interest

Recognizing Notes Receivable 18.

(L.O. 3) Entries for notes receivable are required when the note is received and at maturity. To illustrate, assume that on June 1, 2017, Raider Company receives a $2,000, 3-month, 12% note receivable from Paul Revere in settlement of an open account. The entry is: June 1

Notes Receivable ...................................................... Accounts Receivable ...........................................

2,000 2,000

Valuing Notes Receivable 19.

(L.O. 4) Like accounts receivable, short-term notes receivable are reported at their cash (net) realizable value and an Allowance for Doubtful Accounts is used.

Disposing of Notes Receivable 20.

On September 1, the maturity date, Paul Revere honors the note by paying the face amount, $2,000 plus interest of $60 ($2,000 X 12% X 3/12). Assuming that interest has not been accrued, the entry is: Sept. 1 Cash ......................................................................... Notes Receivable ................................................. Interest Revenue .................................................

2,060 2,000 60

Statement Presentation and Analysis 21.

In the balance sheet, short-term receivables are reported within the current assets section below short-term investments. Both the gross amount of receivables and the allowance for doubtful accounts should be reported. In a multiple-step income statement, Bad Debt Expense and Service Charge Expense are reported as selling expenses in the operating expenses section.

22.

The accounts receivable turnover is computed by dividing net credit sales (net sales less cash sales) by the average net accounts receivable during the year. The average collection period, a variant of the accounts receivable turnover, is computed by dividing the turnover ratio into 365 days. The average collection period should not greatly exceed the credit term period.

9-4

LECTURE OUTLINE A.

Types of Receivables. 1. Receivables refer to amounts due from individuals and companies that are expected to be collected in cash. 2. Receivables are classified as:

Accounts receivable are amounts customers owe on account. Companies generally expect to collect these receivables within 30 to 60 days.

Notes receivable are a written promise (as evidenced by a formal instrument) for amounts to be received. A note normally requires the collection of interest and extends for time periods of 60 to 90 days or longer.

Other receivables include nontrade receivables such as interest receivable, loans to company officers, advances to employees, and income taxes refundable.

Recognizing Accounts Receivable. 1. Accounts receivable are recognized when merchandise is sold on account, as explained in Chapter 5. 2. Recognizing accounts receivable also occurs when a company sells merchandise and a customer uses the company’s own credit card.

. 9-5

Credit card sales result in a debit to Accounts Receivable and a credit to Sales Revenue.

If customers fail to pay within a specified period (usually 30 days), the seller adds interest. The interest is debited to Accounts Receivable and credited to Interest Revenue.

Valuing Accounts Receivable. 1. Valuing receivables involves reporting receivables at their cash (net) realizable value. Cash (net) realizable value is the net amount expected to be received in cash. 2. Uncollectible Accounts Receivable. a.

Credit losses are a normal and necessary risk of doing business on a credit basis. Credit losses may be recognized under the allowance method or by the direct write-off method.

GAAP requires the allowance method for financial reporting purposes when bad debts are material in amount. Under this method: (1) Companies estimate uncollectible accounts receivable and match this estimate expense against revenues in the same accounting period in which they record the revenues. (2) Companies debit estimated uncollectibles to Bad Debt Expense and credit them to Allowance for Doubtful Accounts (a contraasset account) through an adjusting entry at the end of each period. (3) When companies write off a specific account, they debit actual uncollectibles to Allowance for Doubtful Accounts and credit that amount to Accounts Receivable.

3. Occasionally, a company collects from a customer after it has written off the account as uncollectible. The company

9-6

Reverses the entry made in writing off the account to reinstate the customer’s account.

Journalizes the collection in the usual manner.

4. Two bases are used to determine the amount of the expected uncollectibles: a.

Under the percentage-of-sales basis, management estimates what percentage of credit sales will be uncollectible. This percentage is based on past experience and anticipated credit policy, and is applied either to total credit sales or net credit sales of the current year. (1) This basis of estimating uncollectibles emphasizes the matching of expenses with revenues (income statement viewpoint). (2) When the company makes the adjusting entry, it disregards the existing balance in Allowance for Doubtful Accounts.

Under the percentage-of-receivables basis, management estimates what percentage of receivables will result in losses from uncollectible accounts. The company prepares an aging schedule, in which it classifies customer balances by the length of time they have been unpaid. (1) This method normally results in the better approximation of cash realizable value (balance sheet viewpoint). (2) An aging schedule is used to determine the required balance in the allowance account at the balance sheet date. (3) The amount of the bad debt expense adjusting entry is the difference between the required balance and the existing balance in the allowance account.

5. The direct write-off method may be used for financial reporting purposes only when bad debts are insignificant. Under this method:

9-7

Bad debt losses are not estimated and an allowance account is not used.

Bad debt losses are debited to Bad Debt Expense when they are determined to be uncollectible.

This method does not attempt to match bad debt expense with sales revenues or to show accounts receivable in the balance sheet at the amount the company actually expects to receive.

Disposing of Accounts Receivable. 1. In the normal course of events, companies collect accounts receivable in cash and remove receivables from the books. 2. Companies frequently sell their receivables to another company for cash, which shortens the cash-to-cash operating cycle. 3. A sale may be made to a factor which is a finance company or bank that buys receivables from businesses and then collects the payments directly from the customers. 4. A credit card sale occurs when a company accepts national credit cards, such as Visa, Mastercard, and American Express.

9-8

A retailer’s acceptance of a national credit card is another form of selling (factoring) the receivable.

The retailer generally considers sales from the use of national credit card sales as cash sales. The retailer must pay to the bank that issues the card a fee of 2 to 6% for processing the transactions.

ACCOUNTING ACROSS THE ORGANIZATION Assume you use a Visa card to purchase some new ties at Nordstrom. Visa acts as the clearing agent for the transaction and transfers funds from the bank that issued your Visa card to Nordstrom’s bank account. If Nordstrom prepares a bank reconciliation monthly and some credit card sales have not been processed by the bank, how should Nordstrom treat these transactions on its reconciliation? Answer: Nordstrom would treat the credit card receipts as deposits in transit. It has already recorded the receipts as cash. Its bank will increase Nordstrom’s cash account when it receives the receipts.

Notes Receivable. 1. A promissory note is a written promise to pay a specified amount of money on demand or at a definite time. Notes receivable give the payee a stronger legal claim to assets than accounts receivable. Promissory notes may be used: a.

When individuals and companies lend or borrow money.

When the amount of the transaction and the credit period exceed normal limits.

In settlement of accounts receivable.

2. Determining the maturity date. When the life of a note is expressed in terms of months, you find the date when it matures by counting the months from the date of issue. When the due date is stated in terms of days, you need to count the exact number of days to determine the maturity date. In counting, omit the date the note is issued but include the due date.

9-9

3. Computing interest. The formula for computing interest is face value of note times annual interest rate times time in terms of one year. For a note stated in months, a fraction of the year is used; when a note is stated in days, time factor is the number of days in the note divided by 360. 4. Recognizing notes receivable occurs when the note is received. The company records the note receivable at its face value by debiting Notes Receivable and crediting Accounts Receivable. 5. Valuing short-term notes receivable involves reporting notes receivable at their cash (net) realizable value. a.

The notes receivable allowance account is Allowance for Doubtful Accounts.

The estimations involved in determining cash realizable value and in recording bad debt expense and the related allowance are similar.

6. Disposing of notes receivable involves the honoring (paying) or dishonoring (not paying) of the note at maturity.

A note is honored when its maker pays it in full at its maturity date. If interest has been accrued prior to maturity, Interest Receivable is credited for the accrued interest at maturity.

A dishonored (defaulted) note is a note that is not paid in full at maturity. The entry to record the dishonor of a note depends on whether the payee expects eventual collection. If the debtor is expected to pay, Accounts Receivable is debited for the face value of the note plus accrued interest. If there is no hope of collection, the payee would write off the face value of the note by debiting Allowance for Doubtful Accounts.

Statement Presentation and Analysis. 1. Companies should identify in the balance sheet or in the notes to the financial statements each of the major types of receivables.

9-10 .

2. Short-term receivables appear in the current assets section of the balance sheet. Companies report both the gross amount of receivables and the allowance for doubtful accounts. 3. In a multiple-step income statement, companies report bad debt expense and service charge expense as selling expenses in the operating expenses section. Interest revenue appears under “Other revenues and gains” in the nonoperating activities section. 4. Investors and managers evaluate accounts receivable for liquidity by computing the accounts receivable turnover and an average collection period.

9-11

The accounts receivable turnover is computed by dividing net credit sales by the average net accounts receivable during the year. This ratio measures the number of times, on average, the company collects accounts receivable during the period.

The average collection period is computed by dividing the accounts receivable turnover into 365 days. Companies frequently use the average collection period to assess the effectiveness of a company’s credit and collection policies.

A Look at IFRS The basic accounting and reporting issues related to recognition, measurement, and disposition of receivables are essentially the same between IFRS and GAAP. KEY POINTS Similarities • The recording of receivables, recognition of sales returns and allowances and sales discounts, and the allowance method to record bad debts are the same between IFRS and GAAP. • Both IFRS and GAAP often use the term impairment to indicate that a receivable may not be collected. • The FASB and IASB have worked to implement fair value measurement (the amount they currently could be sold for) for financial instruments, such as receivables. Both Boards have faced bitter opposition from various factions. Differences • Although IFRS implies that receivables with different characteristics should be reported separately, there is no standard that mandates this segregation. • IFRS and GAAP differ in the criteria use to determine how to record a factoring transaction. IFRS uses a combination approach focused on risks and rewards and loss of control. GAAP uses loss of control as the primary criterion. In addition, IFRS permit partial derecognition of receivables; GAAP does not. Looking to the Future The question of recording fair values for financial instruments will continue to be an important issue to resolve as the Boards work toward convergence. Both the IASB and the FASB have indicated that they believe that financial statements would be more transparent and understandable if companies recorded and reported all financial instruments at fair value.

9-12 .

20 MINUTE QUIZ Circle the correct answer. True/False 1.

Receivables are classified as accounts, notes, or other. True

Financing charges added to a customer’s credit card balance with a retailer are recorded as a debit to Accounts Receivable and a credit to Interest Revenue. True

False

Short-term receivables are reported in the balance sheet immediately below cash. True

False

The principal amount of a 9%, 3-year, note receivable is $300,000 and is dated January 1, 2014. The interest revenue to be recognized on December 31, 2014, is $9,000. True

10.

False

The maturity value of a $5,000 note is $5,300. If $180 of the interest has been accrued prior to maturity, the entry to record the honoring of the note at maturity should include a credit to Interest Revenue for $120. True

False

The interest due at maturity of a two-month, 8%, $800 note is computed by multiplying $800 X .08 X 2/12. True

False

The maturity date of a 60-day note dated December 1 is January 31. True

False

Sale of receivables to a factor may result in a debit to Service Charge Expense at the time of sale. True

False

An aging schedule shows a required balance in Allowance for Doubtful Accounts of $8,600. If there is a credit balance in the allowance account of $2,000 prior to adjustment, the adjustment amount is $6,600. True

False

The allowance method for uncollectible accounts violates the expense recognition principle. True

False

9-13

False

Multiple Choice 1.

The sale of merchandise by a company on its own credit card may result in a a. debit to Service Charge Expense. b. debit to Interest Expense. c. credit to Interest Revenue. d. credit to Cash.

A company has net credit sales of $600,000 for the year and it estimates that uncollectible accounts will be 2% of sales. If Allowance for Doubtful Accounts has a credit balance of $1,000 prior to adjustment, its balance after adjustment will be a credit of a. $12,000. b. $13,000. c. $11,000. d. some other amount.

Under the allowance method, the entry to write-off an uncollectible account results in a debit to a. Bad Debt Expense and a credit to Accounts Receivable. b. Bad Debt Expense and a credit to Allowance for Doubtful Accounts. c. Allowance for Doubtful Accounts and a credit to Bad Debt Expense. d. Allowance for Doubtful Accounts and a credit to Accounts Receivable.

A company sells $400,000 of accounts receivable to a factor for cash less a 2% service charge. The entry to record the sale should not include a a. debit to Interest Expense for $8,000. b. debit to Cash for $392,000. c. debit to Service Charge Expense for $8,000. d. credit to Accounts Receivable for $400,000.

When an interest-bearing note is dishonored at maturity and ultimate collection is expected, the entry for the dishonoring, assuming no previous accrual of interest should include a. a debit to Allowance for Doubtful Accounts. b. only a credit to Notes Receivable. c. a credit to Notes Receivable and Interest Revenue. d. a credit to Notes Receivable and Interest Receivable.

9-14 .

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True True False True True

Multiple Choice 1. 2. 3. 4. 5.

9-15

c. b. d. a. c.

6. 7. 8. 9. 10.

False True True False False

CHAPTER 10 PLANT ASSETS, NATURAL RESOURCES, AND INTANGIBLE ASSETS LEARNING OBJECTIVES 1. EXPLAIN THE ACCOUNTING FOR PLANT ASSET EXPENDITURES. 2. APPLY DEPRECIATION ASSETS.

METHODS

PLANET

3. EXPLAIN HOW TO ACCOUNT FOR THE DISPOSAL OF PLANT ASSETS. 4. DESCRIBE HOW TO ACCOUNT FOR NATURAL RESOURCES AND INTANGIBLE ASSETS. 5. DISCUSS HOW PLANT ASSETS, NATURAL RESOURCES, AND INTANGIBLE ASSETS ARE REPORTED AND ANALYZED. *6. EXPLAIN HOW TO ACCOUNT FOR THE EXCHANGE OF PLANT ASSETS.

10-1

CHAPTER REVIEW Plant Assets 1.

(L.O. 1) Plant assets are resources that have a physical substance (a definite size and shape), are used in the operations of a business and are not intended for sale to customers. They are also called property, plant, and equipment; plant and equipment; or fixed assets.

Cost of Plant Assets 2.

Plant assets are recorded at cost in accordance with the historical cost principle. Cost consists of all expenditures necessary to (1) acquire the asset, and (2) make it ready for its intended use.

The cost of land includes the cash purchase price, closing costs such as title and attorney’s fees, real estate broker’s commission, and accrued property taxes and other liens on the land assumed by the purchaser. All necessary costs incurred in making land ready for its intended use are debited to the Land Account.

Land improvements are structural additions made to land, such as driveways, parking lots, fences, landscaping, and underground sprinklers. The cost of land improvements includes all expenditures needed to make the improvements ready for their intended use.

The cost of buildings includes all necessary costs related to the purchase or construction of a building: a. When a building is purchased, such costs include the purchase price, closing costs, and real estate broker’s commission. b. Costs to make the building ready for its intended use include expenditures for remodeling and replacing or repairing the roof, floors, wiring, and plumbing. c.

When a new building is constructed, cost consists of the contract price plus payments for architects’ fees, building permits, interest payments during construction, and excavation costs.

The cost of equipment consists of the cash purchase price, sales taxes, freight charges, and insurance paid by the purchaser during transit. Cost includes all expenditures required in assembling, installing, and testing the unit. Recurring costs such as licenses and insurance are expensed as incurred.

Depreciation

(L.O. 2) Depreciation is the process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner. a. The cost allocation is designed to provide for the proper matching of expenses with revenues in accordance with the expense recognition principle. b. During an asset’s life, its usefulness may decline because of wear and tear or obsolescence. c. Recognition of depreciation does not result in the accumulation of cash for the replacement of the asset.

Three factors that affect the computation of depreciation are (1) cost, (2) useful life, and (3) salvage value.

10-2

Three methods of recognizing depreciation are (a) straight-line, (b) units-of-activity, and (c) decliningbalance. a. Each method is acceptable under generally accepted accounting principles. b. Management selects the method it believes to be appropriate. c. Once a method is chosen, it should be applied consistently.

Straight-Line Method 10.

Under the straight-line method depreciation is the same for each year of the asset’s useful life. a. The formula for computing annual depreciation expense is: Depreciable Cost ÷ Useful Life (in years) = Depreciation Expense b.

c. d.

To illustrate the computation, assume that the Benson Company purchased a delivery truck for $11,000 on January 1 with an estimated salvage value of $1,000 at the end of its four-year service life. Annual depreciation is $2,500 [($11,000 – $1,000 ÷ 4)]. The straight-line method predominates in practice. This method is simple to apply and it matches expenses and revenues appropriately when the use of the asset is reasonably uniform throughout the service life.

Units-of-Activity Method 11.

Under the units-of-activity method, service life is expressed in terms of the total units of production or expected use from the asset, rather than time. a. The formulas for computing depreciation expense are:

c. d.

10-3

(1)

Depreciable Cost ÷ Total Units of Activity = Depreciable Cost per Unit

(2)

Depreciable Cost per Unit X Units of Activity During the Year = Depreciation Expense

To illustrate the computation, assume that Benson Company expects to drive the truck purchased in (10b) above for 100,000 miles and that 30,000 miles are driven in the first year. Depreciation for the first year is $3,000. (1)

$10,000 ÷ 100,000 = $.10 per mile.

(2)

$.10 X 30,000 = $3,000.

In using this method, it is often difficult to make a reasonable estimate of total activity. When the productivity of an asset varies significantly from one period to another, this method results in the best matching of expenses with revenues.

Declining-Balance Method 12.

The declining-balance method produces a decreasing annual depreciation expense over the useful life of the asset. a. The formula for computing depreciation expense is: Book Value at Beginning of Year X Declining-Balance Rate = Depreciation Expense b.

c. d.

13.

To illustrate the computation, assume that Benson Company uses a declining-balance rate that is double the straight-line rate of 25%. Depreciation in the first year is $5,500 ($11,000 X 50%). Under this method, the depreciation rate remains constant from year to year, but the book value to which the rate is applied declines each year. This method is compatible with the expense recognition principle because the higher depreciation in early years is matched with the higher benefits received in these years.

Taxpayers must use on their tax returns either the straight-line method or a special accelerated depreciation method called the Modified Accelerated Cost Recovery System (MACRS).

Revising Periodic Depreciation 14.

If wear and tear or obsolescence indicate that annual depreciation is inadequate or excessive, a change in the periodic amount should be made. a. When a change is made, (1) there is no correction of previously recorded depreciation expense, and (2) depreciation expense for current and future years is revised. b. To determine the new annual depreciation expense, the depreciable cost at the time of the revision is divided by the remaining useful life.

Expenditures During Useful Life 15.

Ordinary repairs are expenditures to maintain the operating efficiency and expected productive life of the plant asset. They are debited to Maintenance and Repairs Expense as incurred and are often referred to as revenue expenditures.

16.

Additions and improvements are costs incurred to increase the operating efficiency, productive capacity, or expected useful life of the plant asset. These expenditures are usually material in amount and occur infrequently during the period of ownership.

17.

Capital expenditures increase the company’s investment in productive facilities. These expenditures include additions and improvements.

Plant Asset Disposals 18.

(L.O. 3) Plant assets may be disposed of by (a) retirement, (b) sale, or (c) exchange.

19.

At the time of disposal, it is necessary to determine the book value of the plant asset. a. If the disposal occurs during the year, depreciation for the fraction of the year to the date of disposal must be recorded. b. The book value is then eliminated by debiting the Accumulated Depreciation account for the total depreciation to the date of disposal and crediting the asset account for the cost of the asset.

10-4

Retirement of Plant Assets 20.

In accounting for a disposal by retirement, a. if the asset is fully depreciated, the entry is a debit to Accumulated Depreciation and a credit to the plant asset account. b. if the asset is retired before it is fully depreciated and no scrap or salvage value is received, a loss on disposal of plant assets occurs. c. the loss on disposal of plant assets is reported in the Other expenses and losses section of the income statement.

Sale of Plant Assets 21.

In a disposal by sale, the book value of the asset is compared with the proceeds received from the sale. a. If the proceeds of the sale exceed the book value, a gain on disposal of plant assets occurs which is reported in the Other revenues and gains section of the income statement. b. If the proceeds of the sale are less than the book value of the asset, a loss on disposal of plant assets occurs which is reported in the Other expenses and losses section of the income statement.

Natural Resources 22.

(L.O. 4) Natural resources consist of standing timber and underground deposits of oil, gas, and minerals. These assets are frequently called wasting assets.

Acquisition Cost 23.

The acquisition cost of a natural resource is the price needed to acquire the resource and prepare it for its intended use.

Depletion 24.

Depletion is the systematic write-off of the cost of natural resources. The units-of-activity method is generally used to compute depletion because periodic depletion is generally a function of the units extracted during the year. The formulas for computing depletion expense are: a. Total Cost minus Salvage Value ÷ Total Estimated Units = Depletion Cost per Unit. b. Depletion Cost per Unit X Number of Units Extracted and Sold = Depletion Expense.

25.

To record depletion expense, Depletion Expense is debited and a contra asset account, Accumulated Depletion, is credited. a. Depletion expense is reported as a cost of producing the product. b. Accumulated Depletion is deducted from the cost of the natural resource in the balance sheet.

Intangible Assets 26.

Intangible assets are rights, privileges, and competitive advantages that result from the ownership of assets that do not possess physical substance. Intangibles may arise from government grants, acquisition of another business, and private monopolistic arrangements.

10-5

27.

In general, accounting for intangible assets parallels the accounting for plant assets. Intangible assets are (a) recorded at cost, (b) cost is written off over useful life in a rational and systematic manner, assuming the useful life is limited, and (c) at disposal, book value is eliminated and gain or loss, if any, is recorded. If the life of the intangible is indefinite, the cost of the intangible should not be allocated.

28.

Differences between the accounting for intangible assets and the accounting for plant assets include: a. The systematic write-off of an intangible asset is referred to as amortization. b. To record amortization, Amortization Expense is debited and the specific intangible asset is credited. c. Amortization is typically computed on a straight-line basis.

Patents 29.

A patent is an exclusive right issued by the U.S. Patent Office that enables the recipient to manufacture, sell, or otherwise control his or her invention for a period of twenty years from the date of grant. a. The initial cost of a patent is the cash or cash equivalent price paid when the patent is acquired. b. When legal costs are incurred in successfully defending the patent, they are added to the Patents account and amortized over the remaining useful life of the patent. c. The cost of the patent should be amortized over its legal life (20 years) or useful life, whichever is shorter.

Copyrights 30.

Copyrights are granted by the federal government, giving the owner the exclusive right to reproduce and sell an artistic or published work. Copyrights extend for the life of the creator plus 70 years.

Trademark or Trade name 31.

A trademark or trade name is a word, phrase, jingle, or symbol that distinguishes or identifies a particular enterprise or product.

Franchise 32.

A franchise is a contractual arrangement under which the franchisor grants the franchisee the right to sell certain products, to perform specific services, or to use certain trademarks or trade names, usually within a designated geographic area. Another type of franchise, commonly referred to as a license or permit, is entered into between a governmental body and a business enterprise and permits the enterprise to use public property in performing its services.

10-6

Goodwill 33. Goodwill is the value of all favorable attributes that relate to a business enterprise such as exceptional management, skilled employees, high-quality products, fair pricing policies, and harmonious relations with labor unions. a. Goodwill can be identified only with the business as a whole. b. Goodwill is recorded only when there is an exchange transaction that involves the purchase of an entire business. c. When an entire business is purchased, goodwill is the excess of cost over the fair value of the net assets (assets less liabilities) acquired. 34. Goodwill is not amortized because it is considered to have an indefinite life. Research and Development 35. Research and development costs are costs that are spent on developing new products and processes. Such costs are usually recorded as an expense when incurred. Financial Statement Presentation 36. (L.O. 5) In the balance sheet, plant assets and natural resources are usually combined under Property, Plant, and Equipment and intangibles are shown separately under Intangible Assets. a. There should be disclosure of the balances in the major classes of assets and accumulated depreciation of major classes of assets or in total. b. Depreciation and amortization methods used should be described and the amount of depreciation and amortization expense for the period disclosed. Exchanges of Plant Assets *37. (L.O. 6) Companies usually record a gain or loss on the exchange of plant assets because most exchanges have commercial substance. An exchange has commercial substance if the future cash flows change as a result of the exchange. *38. In recording an exchange at a loss (or gain), three steps are required: a. Eliminate the book value of the asset given up. b. Record the cost of the asset acquired. c. Recognize the loss or gain on disposal of plant assets.

10-7

LECTURE OUTLINE A.

Plant Assets. 1. Plant assets, also called property, plant, and equipment, or plant and equipment, are resources that have a physical substance (a definite size and shape), are used in the operations of a business, and are not intended for sale to customers. 2. Because plant assets play a key role in ongoing operations, companies: a.

Keep plant assets in good operating condition.

Replace worn-out or outdated plant assets.

Expand productive resources as needed.

3. Many companies have substantial investments in plant assets.

Determining the Cost of Plant Assets. 1. The historical cost principle requires that companies record plant assets at cost. 2. Cost consists of all expenditures necessary to acquire the asset and make it ready for its intended use. 3. Once cost is established, the company uses that amount as the basis of accounting for the plant asset over its useful life. 4. Application of the historical cost principle to the major classes of plant assets. a.

10-8

The cost of land includes (1) the cash purchase price, (2) closing costs such as title and attorney’s fees, (3) real estate brokers’ commissions, and (4) accrued property taxes and other liens assumed by the purchaser.

10-9

Land improvements are structural additions made to land such as driveways, parking lots, fences, landscaping, and underground sprinklers. The cost of land improvements includes all expenditures needed to make the improvements ready for their intended use. These improvements have limited useful lives and their maintenance and replacement are the responsibility of the company.

Costs related to the purchase of a building include the purchase price, closing costs, and real estate broker’s commission. Costs to make the building ready for its intended use include expenditures for remodeling and replacing or repairing the roof, floors, electrical wiring, and plumbing. Costs related to construction of a building include the contract price plus payments for architects’ fees, building permits, and excavation costs. Interest costs incurred to finance the project are included in the cost of the building when a significant period of time is required to get the asset ready for use.

The cost of equipment includes the cash purchase price, sales taxes, freight charges, and insurance during transit paid by the purchaser. It also includes expenditures required in assembling, installing, and testing the unit. Motor vehicle licenses and accident insurance on company vehicles are treated as expenses as incurred, because they represent annual recurring expenditures and do not benefit future periods.

ACCOUNTING ACROSS THE ORGANIZATION Leasing is a big business for U.S. companies. As an excellent example of the magnitude of leasing, leased planes account for nearly 40% of the U.S. fleet of commercial airlines. Why might airline managers choose to lease rather than purchase their planes? Answer: The reasons for leasing include favorable tax treatment, better financing options, increased flexibility, reduced risk of obsolescence, and low airline income. C.

Depreciation. 1. Depreciation is the process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner. 2. Cost allocation enables companies to properly match expenses with revenues in accordance with the expense recognition principle. 3. Depreciation is a process of cost allocation, not a process of asset valuation. 4. The book value (cost less accumulated depreciation) of a plant asset may be quite different from its fair value. 5. Revenue-producing ability of plant assets may decline because of: a.

Wear and tear.

Obsolescence, which is the process of becoming out of date before the asset physically wears out.

6. The balance in Accumulated Depreciation represents the total amount of the asset’s cost that the company has charged to expense; it is not a cash fund.

. 10-10

Factors in Computing Depreciation/Depreciation Methods. 1. The computation of depreciation expense is based on three factors: a.

Cost.

Useful life is an estimate of the expected productive life of the asset for its owner. Useful life may be expressed in terms of time, units of activity, or units of output.

Salvage value (residual value) is an estimate of the asset’s value at the end of its useful life.

2. There are three depreciation methods.

. 10-11

Under the straight-line method, companies expense the same amount of depreciation for each year of the asset’s useful life. The formula for computing annual depreciation expense is depreciable cost (cost less salvage value) divided by useful life. The straightline method is simple to apply, and it matches expenses with revenues when the use of the asset is reasonably uniform throughout the service life.

Under the units-of-activity method, useful life is expressed in terms of the total units of production or use expected from the asset. Annual depreciation expense is computed by multiplying depreciable cost per unit by the units of activity during the year. This method is not nearly as popular as the straight-line method because it is often difficult for companies to reasonably estimate total activity.

The declining-balance method produces a decreasing annual depreciation expense over the asset’s useful life. Companies compute annual depreciation expense by multiplying the book value at the beginning of the year by the constant declining-balance depreciation rate. This method is compatible with the expense recognition principle in that it matches the higher depreciation expense in early years with the higher benefits received in these years.

Depreciation and Income Taxes. 1. The Internal Revenue Service (IRS) does not require taxpayers to use the same depreciation method on the tax return that is used in preparing financial statements. 2. Taxpayers must use either the straight-line method or a special accelerateddepreciation method called the Modified Accelerated Cost Recovery System (MACRS) on their tax returns.

Revising Periodic Depreciation. 1. If wear and tear or obsolescence indicate that annual depreciation estimates are inadequate or excessive, the company should change the amount of depreciation expense. 2. Companies make revisions of periodic depreciation in current and future years, not in prior periods. 3. To determine the new annual depreciation expense, the company allocates the asset’s depreciable cost at the time of the revision to the remaining useful life.

Expenditures During Useful Life. 1. Companies incur revenue expenditures to maintain the operating efficiency and productive life of the asset. These expenditures are fairly small amounts that occur frequently and are debited to Maintenance and Repairs Expense as incurred. 2. Capital expenditures (additions and improvements) increase the operating efficiency, productive capacity, or expected useful life of the asset. These expenditures are usually material in amount and occur infrequently.

. 10-12

Plant Asset Disposals. 1. Disposal by retirement: the plant asset is scrapped or discarded a.

Eliminate the book value of the plant asset at the date of disposal by debiting Accumulated Depreciation and crediting the asset account for its cost.

Debit Cash to record any cash proceeds from scrap or salvage value.

Record the loss. (1) If a company retires a plant asset before it is fully depreciated, and no cash is received, a loss is recorded by debiting Loss on Disposal of Plant Assets. (2) Companies report a loss on disposal of plant assets in the “Other expenses and losses” section of the income statement.

2. Disposal by sale: the plant asset is sold to another party. a.

Eliminate the book value of the plant asset at the date of sale by debiting Accumulated Depreciation and crediting the asset account for its cost.

Debit Cash to record the cash proceeds from the sale.

Compute gain or loss. (1) If the cash proceeds exceed the book value, recognize a gain by crediting Gain on Disposal of Plant Assets for the difference. (2) If the cash proceeds are less than the book value, recognize a loss by debiting Loss on Disposal of Plant Assets for the difference.

Natural Resources. 1. Natural resources consist of standing timber and underground deposits of oil, gas, and minerals.

. 10-13

2. Natural resources have two distinguishing characteristics. a.

They are physically extracted in operations (mining, cutting, pumping).

They are replaceable only by an act of nature.

3. The acquisition cost of a natural resource is the price needed to acquire the resource and prepare it for its intended use. 4. The allocation of the cost of natural resources to expense in a rational and systematic manner over the resource’s useful life is called depletion. Companies generally use the units-of-activity method to compute depletion, because depletion generally is a function of the units extracted during the year. J.

Accounting for Intangible Assets. 1. The accounting for intangible assets and plant assets is much the same. a.

Companies record intangible assets at cost.

If an intangible has a limited life, companies allocate its cost over the asset’s useful life, using a process referred to as amortization.

2. There are several differences between accounting for intangible assets and accounting for plant assets.

. 10-14

The term used to describe the allocation of the cost of an intangible asset to expense is amortization, rather than depreciation.

To record amortization of an intangible asset, companies debit Amortization Expense and credit the specific intangible asset rather than a contra account.

Intangible assets with a limited life are normally amortized on a straightline basis. An indefinite-life intangible asset should not be amortized.

3. Patents are an exclusive right issued by the U.S. Patent Office that enables the recipient to manufacture, sell, or otherwise control an invention for a period of 20 years from the date of the grant. a.

The initial cost of a patent is the cash or cash equivalent price paid to acquire the patent.

If the owner incurs legal costs in successfully defending a patent in an infringement suit, such costs are considered necessary to establish the patent’s validity. The owner adds these costs to the Patents account and amortizes them over the remaining life of the patent.

The patent holder amortizes the cost of a patent over its 20-year legal life or its useful life, whichever is shorter.

4. The federal government grants copyrights which give the owner the exclusive right to reproduce and sell an artistic or published work. a.

Copyrights extend for the life of the creator plus 70 years.

The cost of a copyright is the cost of acquiring and defending it.

The useful life of a copyright is generally significantly shorter than its legal life; therefore, copyrights are amortized over a relatively short period of time.

5. A trademark or trade name is a word, phrase, jingle, or symbol that identifies a particular enterprise or product. a.

. 10-15

The creator or original user may obtain exclusive legal right to a trademark or trade name by registering it with the U.S. Patent Office, providing 20 years of protection. The registration may be renewed indefinitely as long as the trademark or trade name is in use.

If a company purchases the trademark or trade name, its cost is the purchase price. If a company develops and maintains the trademark or trade name, any costs related to these activities are expensed as incurred.

Because trademarks and trade names have indefinite lives, they are not amortized.

6. A franchise is a contractual arrangement between a franchisor and a franchisee that grants the franchisee the right to sell certain products, perform specific services, or use certain trademarks or trade names, usually within a designated geographic area. a.

When a company can identify costs with the purchase of a franchise or license, it should recognize an intangible asset.

Companies should amortize the cost of a limited-life franchise over its useful life.

If the life is indefinite, the cost is not amortized.

7. Goodwill represents the value of all favorable attributes that relate to a company. These include exceptional management, desirable location, good customer relations, skilled employees, high-quality products, and harmonious relations with labor unions.

. 10-16

Goodwill cannot be sold individually in the marketplace; it can be identified only with the business as a whole.

Companies record goodwill only when an entire business is purchased.

When an entire business is purchased, goodwill is the excess of cost over the fair value of the net assets (assets less liabilities) acquired.

Goodwill is not amortized because it is considered to have an indefinite life.

8. Research and development costs are expenditures that may lead to patents, copyrights, new processes, and new products. These costs are not intangible assets. Companies usually record R&D costs as an expense when incurred, whether the research and development is successful or not. K.

Statement Presentation and Analysis. 1. Usually companies combine plant assets and natural resources under “Property, plant, and equipment,” and show intangibles separately. 2. Companies disclose either in the balance sheet or the notes the balances of the major classes of assets, such as land, buildings, and equipment, and accumulated depreciation by major classes or in total. 3. They should describe the depreciation and amortization methods that were used, and disclose the amount of depreciation and amortization expense for the period. 4. The asset turnover is a measure of how efficiently a company uses its assets to generate sales. This ratio is computed by dividing net sales by average total assets for the period.

*L. Exchange of Plant Assets. 1. Usually companies record a gain or loss on the exchange of plant assets since most exchanges have commercial substance. An exchange has commercial substance if the future cash flows change as a result of the exchange. 2. Losses on the exchange of plant assets are recognized by debiting Loss on Disposal of Plant Assets.

. 10-17

The cost of the new asset received is equal to the fair value of the old asset exchanged plus any cash paid.

A loss results when the book value is greater than the fair value of the asset given up.

3. Gains on exchange of plant assets are recognized by crediting Gain on Disposal of Plant Assets.

. 10-18

The cost of the new asset received is equal to the fair value of the old asset exchanged plus cash paid.

A gain results when the fair value is greater than the book value of the asset given up.

A Look at IFRS IFRS follows most of the same principles as GAAP in the accounting for property, plant, and equipment. There are, however, some significant differences in the implementation. IFRS allows the use of revaluation of property, plant, and equipment, and it also requires the use of component depreciation. In addition, there are some significant differences in the accounting for both intangible assets and impairments. KEY POINTS The following are the key similarities and differences between GAAP and IFRS as related to the recording process for long-lived assets. • The definition for plant assets for both IFRS and GAAP is essentially the same. • Both IFRS and GAAP follow the historical cost principle when accounting for property, plant, and equipment at date of acquisition. Cost consists of all expenditures necessary to acquire the asset and make it ready for its intended use. • Under both IFRS and GAAP, interest costs incurred during construction are capitalized. Recently, IFRS converged to GAAP requirements in this area. • IFRS also views depreciation as an allocation of cost over an asset’s useful life. IFRS permits the same depreciation methods (e.g., straight-line, accelerated, and units-of-activity) as GAAP. • Under both GAAP and IFRS, changes in the depreciation method used and changes in useful life are handled in current and future periods. Prior periods are not affected. GAAP recently conformed to international standards in the accounting for changes in depreciation methods. • The accounting for subsequent expenditures, such as ordinary repairs and additions, are essentially the same under IFRS and GAAP.

. 10-19

• The accounting for plant asset disposals is essentially the same under IFRS and GAAP. • Initial costs to acquire natural resources are essentially the same under IFRS and GAAP. • The definition of intangible assets is essentially the same under IFRS and GAAP. • The accounting for exchanges of nonmonetary assets has recently converged between IFRS and GAAP. GAAP now requires that gains on exchanges of nonmonetary assets be recognized if the exchange has commercial substance. This is the same framework used in IFRS. • IFRS uses the term residual value, rather than salvage value, to refer to an owner’s estimate of an asset’s value at the end of its useful life for that owner. • IFRS allows companies to revalue plant assets to fair value at the reporting date. Companies that choose to use the revaluation framework must follow revaluation procedures. If revaluation is used, it must be applied to all assets in a class of assets. Assets that are experiencing rapid price changes must be revalued on an annual basis, otherwise less frequent revaluation is acceptable. • IFRS requires component depreciation. Component depreciation specifies that any significant parts of a depreciable asset that have different estimated useful lives should be separately depreciated. Component depreciation is allowed under GAAP but is seldom used.

. 10-20

• As in GAAP, under IFRS the costs associated with research and development are segregated into the two components. Costs in the research phase are always expensed under both IFRS and GAAP. Under IFRS, however, costs in the development phase are capitalized as Development Costs once technological feasibility is achieved. • IFRS permits revaluation of intangible assets (except for goodwill). GAAP prohibits revaluation of intangible assets.

LOOKING TO THE FUTURE The IASB and FASB have identified a project that would consider expanded recognition of internally generated intangible assets. IFRS permits more recognition of intangibles compared to GAAP. Thus, it will be challenging to develop converged standards for intangible assets, given the long-standing prohibition on capitalizing internally generated intangible assets and research and development costs in GAAP.

. 10-21

20 MINUTE QUIZ Circle the correct answer. True/False 1. The cost of equipment consists of the cash purchase price plus certain related costs such as sales taxes and freight charges. True

False

2. Cost to construct a plant includes the contract price, architect’s fees, building fees, excavation costs but not interest costs incurred to finance the project. True

False

3. The book value of an asset equals its cost less accumulated depreciation. True

False

4. Under the declining-balance method of depreciation, an asset may not be depreciated below its estimated salvage value. True

False

5. Ordinary repairs are expenditures to increase the operating efficiency, productive capacity, or expected useful life of a plant asset. True

False

6. The useful life of a copyright is generally shorter than its legal life. True

False

7. Unlike other assets that can be sold individually in the marketplace, goodwill can be identified only with the business as a whole. True

False

8. The process of allocating the cost of natural resources to expense is called amortization. True

False

*9. Gains on exchanges of plant assets are recorded in the period the exchange occurs. True

False

*10. When plant assets are exchanged, the cost of the new equipment is always equal to the fair value of the new equipment plus the cash paid. True

. 10-22

False

Multiple Choice 1.

The cost of a factory machine includes all of the following costs except a. invoice price less discount taken. b. sales tax and insurance during shipping. c. three-year insurance policy on the machine. d. testing and installation cost.

On January 1, a machine with a useful life of 5 years and a salvage value of $8,000 was purchased for $160,000. What is the depreciation expense in year 2 under the double declining-balance method? a. $38,400 b. $36,480 c. $25,600 d. $24,320

An asset that cost $80,000 and has accumulated depreciation of $60,000 is sold for $12,000. The journal entry would include a a. debit to Loss on Disposal of Plant Assets of $20,000. b. debit to Loss on Disposal of Plant Assets of $8,000. c. credit to Gain on Disposal of Plant Assets of $8,000. d. credit to Accumulated Depreciation for $60,000.

The exclusive right to reproduce and sell an artistic or published work is called a a. patent. b. trademark. c. license. d. copyright.

*5.

A company decides to exchange old equipment with a book value of $81,000 ($150,000 cost less accumulated depreciation of $69,000) plus $129,000 cash for new equipment (similar asset). The fair value of the old equipment is $90,000. The entry to record the new equipment would include a debit to a. Equipment (new) for $210,000. b. Equipment (old) for $150,000. c. Loss on Disposal of Plant Assets for $9,000. d. Equipment (new) for $219,000.

. 10-23

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True False True True False

Multiple Choice 1. 2. 3. 4. *5.

. 10-24

c. a. b. d. d.

6. 7. 8. *9. *10.

True True False True False

CHAPTER 11 CURRENT LIABILITIES AND PAYROLL ACCOUNTING LEARNING OBJECTIVES 1. EXPLAIN HOW TO ACCOUNT FOR CURRENT LIABILITIES. 2. DISCUSS HOW CURRENT LIABILITIES ARE REPORTED AND ANALYZED. 3. EXPLAIN HOW TO ACCOUNT FOR PAYROLL. *4. DISCUSS ADDITIONAL FRINGE BENEFITS ASSOCIATED WITH EMPLOYEE COMPENSATION.

11-1

CHAPTER REVIEW Current Liabilities 1.

(L.O. 1) A current liability is a debt that a company expects to pay within one year or the operating cycle, whichever is longer. Current liabilities include notes payable, accounts payable, unearned revenues, and accrued liabilities.

Notes Payable 2.

Notes payable are obligations in the form of written notes that usually require the borrower to pay interest. Notes due for payment within one year of the balance sheet date are usually classified as current liabilities.

When an interest-bearing note is issued, the assets received generally equal the face value of the note: a. During the term of the note, it is necessary to accrue interest expense. b. At maturity, Notes Payable is debited for the face value of the note and Interest Payable is debited for accrued interest.

Sales Taxes Payable 4.

A sales tax is expressed as a percentage of the sales price on goods sold to customers. The entry by the selling company to record sales taxes is as follows: Cash ................................................................................................ Sales Revenue ......................................................................... Sales Taxes Payable ................................................................

XXXX XXXX XXXX

When sales taxes are not rung up separately on the cash register, total receipts are divided by 100% plus the sales tax percentage to determine the sales. Unearned Revenues 5.

Unearned Revenues (advances from customers) are recorded by a debit to Cash and a credit to a current liability account identifying the source of the unearned revenue. When the revenue is recognized, an unearned revenue account is debited and a revenue account is credited.

Current Maturities of Long-Term Debt 6.

Another item classified as a current liability is current maturities of long-term debt. Current maturities of long-term debt are often identified on the balance sheet as long-term debt due within one year.

Statement Presentation and Analysis 7.

(L.O. 2) Current liabilities is the first category under liabilities on the balance sheet. a. Each of the principal types of current liabilities is listed separately. b. Current liabilities are usually reported in order of magnitude with the largest obligations being listed first. However, many companies, as a matter of custom, show notes payable first, and then accounts payable, regardless of amount.

The excess of current assets over current liabilities is working capital. The current ratio is current assets divided by current liabilities.

11-2 .

Contingent Liabilities 9.

A contingent liability is a potential liability that may become an actual liability in the future. The accounting guidelines require that: a. If the contingency is probable (likely to occur) and the amount can be reasonably estimated, the liability should be recorded in the accounts. b. If the contingency is only reasonably possible (could happen), then it needs to be disclosed only in the notes that accompany the financial statements. c. If the contingency is remote (unlikely to occur), it need not be recorded or disclosed.

10.

Product warranties are an example of a contingent liability. They are recorded by estimating the cost of honoring product warranty contracts and expensing the amount in the period in which the sale occurs. Warranty expense is reported under selling expenses in the income statement, and estimated warranty liability is classified as a current liability on the balance sheet.

Payroll Accounting 11.

(L.O. 3) The term payroll pertains to both salaries and wages of employees. Payments made to professional individuals who are independent contractors are called fees. Government regulations relating to the payment and reporting of payroll taxes apply only to employees.

Gross Earnings 12.

Gross earnings is the total compensation earned by an employee. It consists of wages or salaries, plus any bonuses and commissions. a. Total wages are determined by applying the hourly rate of pay to the hours worked. b. Most companies are required by law to pay a minimum of one and one-half times the regular hourly rate for overtime work.

Payroll Deductions 13.

Mandatory payroll deductions consist of FICA taxes and income taxes. a. These deductions do not result in payroll tax expense to the employer. b. FICA taxes are designed to provide workers with supplemental retirement, employment disability, and medical benefits. c. FICA taxes are also known as Social Security taxes.

14.

Income taxes are required to be withheld from employees each pay period and the amount is determined by three variables: (a) the employees’ gross earnings: (b) the number of allowances claimed by the employee; and (c) the length of the pay period.

15.

Voluntary deductions pertain to withholdings for charitable, retirement, and other purposes. Voluntary deductions are at the option of the employee.

16.

Net pay is determined by subtracting payroll deductions from gross earnings.

Recording the Payroll 17.

The employee earnings record provides a cumulative record of each employee’s gross earnings, deductions, and net pay during the year. This record is used by the employer in: a. Determining when an employee has earned the maximum earnings subject to FICA taxes. b. Filing state and federal payroll tax returns. c. Providing each employee with a statement of gross earnings and tax withholdings for the year.

11-3

18.

Many companies use a payroll register to accumulate the gross earnings, deductions, and net pay by employee for each period. In some companies, this record is a journal or book of original entry.

19.

The typical journal entry to record a payroll is as follows: Salaries and Wages Expense ............................................................. FICA Taxes Payable.................................................................... Federal Income Taxes Payable ................................................... State Income Taxes Payable ....................................................... United Fund Contributions Payable ............................................. Union Dues Payable .................................................................... Salaries and Wages Payable.......................................................

XXX XXX XXX XXX XXX XXX XXX

20. When the payroll is paid, Salaries and Wages Payable is debited and Cash is credited. Each payroll check is usually accompanied by a detachable statement of earnings document that shows the employee’s gross earnings, payroll deductions, and net pay. Employer Payroll Taxes 21. There are three taxes imposed on employers by government agencies that result in payroll tax expense. a. FICA Taxes. The employer must match each employee’s FICA contribution. b. Federal Unemployment Taxes. The employer is required to pay a tax on the first $7,000 of gross wages paid to each employee during a calendar year. c. State Unemployment Taxes. All states have unemployment compensation programs that require the employer to pay a tax on the first $7,000 of gross wages paid to each employee during a calendar year. 22. The typical entry for recording payroll tax expense is as follows: Payroll Tax Expense ........................................................................... FICA Taxes Payable.................................................................... Federal Unemployment Taxes Payable ....................................... State Unemployment Taxes Payable ...........................................

XXXX XXXX XXXX XXXX

23. Preparation of payroll tax returns is the responsibility of the payroll department; payment of the taxes is made by the treasurer’s department. 24. The employer is required to provide each employee with a Wage and Tax Statement (Form W-2) by January 31 following the end of a calendar year. This statement shows gross earnings, FICA taxes withheld, and income taxes withheld for the year. Internal Control for Payroll 25. The objectives of internal accounting control concerning payroll are (a) to safeguard company assets from unauthorized payments of payrolls, and (b) to ensure the accuracy and reliability of the accounting records pertaining to payrolls. 26. The payroll activities consist of four functions (a) hiring employees, (b) timekeeping, (c) preparing the payroll, and (d) paying the payroll. These four functions should be assigned to different departments or individuals. 11-4 .

Additional Fringe Benefits *27. (L.O. 4) When the payment for paid absences (paid vacations, sick pay benefits, and paid holidays) is probable and the amount can be reasonably estimated, a liability should be accrued. The entry to record the liability will include a debit to Vacation Benefits Expense and a credit to Vacation Benefits Payable. When the amount cannot be reasonably estimated, the potential liability should be disclosed. *28. Postretirement benefits are benefits that employers provide to retired employees for (a) pensions, and (b) health care and life insurance. *29. A pension plan is an agreement whereby employers provide benefits (payments) to employees after they retire. The most popular type of pension plan is the 401(k) plan. When a company makes a contribution to the 401(k) plan on behalf of the employee, it debits Pension Expense and credits Cash for the amount contributed. *30. A defined-contribution plan defines the contribution an employer will make but not the benefit that the employee will receive at retirement. A 401(k) plan is an example of a defined-contribution plan. In a defined-benefit plan, the employer agrees to pay a defined amount to retirees, based on employees meeting certain eligibility standards. *31. Companies estimate and expense postretirement costs during the working years of the employee because the company benefits from the employee’s services during this period. The company rarely sets up funds to meet the cost of the future benefits.

11-5

LECTURE OUTLINE A.

Accounting for Current Liabilities. 1. A current liability is a debt that a company expects to pay within one year or the operating cycle, whichever is longer. 2. Current liabilities include notes payable, accounts payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest payable. a.

Companies record obligations in the form of written notes as notes payable. Companies frequently issue notes payable to meet shortterm financing needs. Notes payable usually require the borrower to pay interest. Notes due for payment within one year of the balance sheet date are usually classified as current liabilities. When a company issues an interest-bearing note, the amount of assets it receives upon the issuance of the note generally equals the note’s face value. Interest accrues over the life of the note, and the company must periodically record that accrual.

11-6 .

Sales taxes are expressed as a percentage of the sales price. The selling company collects the tax from the customer when the sale occurs, and periodically (monthly) remits the collections to the state’s department of revenue.

Cash received from customers before goods are delivered or services are rendered is called unearned revenues. When a company receives the advance payment, it debits Cash, and credits a current liability account identifying the source of the unearned revenue. When the company recognizes revenue, it debits an unearned revenue account and credits a revenue account.

Companies often identify current maturities of long-term debt in the balance sheet as long-term debt due within one year. At the balance sheet date, all obligations due within one year are classified as current, and all other obligations are long-term.

3. Statement Presentation and Analysis. a.

Companies usually list current liabilities by order of magnitude, with the largest ones first.

As a matter of custom, many companies show notes payable first and then accounts payable, regardless of amount.

The excess of current assets over current liabilities is working capital, which is a measure of liquidity. Liquidity is the ability to pay maturing obligations and meet unexpected needs for cash.

The current ratio is also a measure of liquidity and permits analysts to compare the liquidity of different-sized companies. It is computed by dividing current assets by current liabilities.

4. A contingent liability is a potential liability that may become an actual liability in the future.

11-7

If the contingency is probable (likely to occur) and the amount can be reasonably estimated, the liability should be recorded in the accounts. (Both conditions required for recording.)

If the contingency is only reasonably possible (it could happen), then it needs to be disclosed only in the notes that accompany the financial statements.

If the contingency is remote (unlikely to occur), it need not be recorded or disclosed.

Product warranties are an example of a contingent liability that companies should record in the accounts. The accounting for warranty costs is based on the expense recognition principle; therefore, companies should recognize the estimated cost of honoring product warranty contracts as an expense in the period in which the sale occurs.

When it is probable that a company will incur a contingent liability but it cannot reasonably estimate the amount, or when the contingent liability is only reasonably possible, only disclosure of the contingency is required.

Contingencies that may require disclosures are: (1) Pending or threatened lawsuits. (2) Assessment of additional income taxes pending an IRS audit of the tax return.

11-8 .

ACCOUNTING ACROSS THE ORGANIZATION Contingent liabilities abound in the real world. Life and health insurance companies and their stockholders wonder how big the cost of diabetes, Alzheimer’s, and AIDS really are and what damage they might do in the future. Why do you think most companies disclose, but do not record, contingent liabilities? Answer: In many cases, it is probable that companies have a contingent liability but the amount of the liability is often difficult to determine. If it cannot be determined, the company is not required to accrue it as a liability. B.

Payroll Accounting. 1. Payroll accounting involves maintaining payroll records for each employee, filing and paying payroll taxes, and complying with state and federal employee compensation tax laws. 2. The term “payroll” refers to both salaries and wages of employees. It does not apply to payments made for services of professionals such as CPAs and attorneys. 3. Professionals such as CPAs are independent contractors and payment to them are not subject to payroll taxes.

Gross Earnings. 1. Gross earnings consist of: wages or salaries, plus any bonuses and commissions. 2. Companies determine total wages for an employee by multiplying the hourly rate of pay by the hours worked. An employee’s salary is generally based on a monthly or yearly rate rather than on an hourly basis. 3. Many companies have bonus agreements for employees. Bonus arrangements may be based on such factors as increased sales or net income.

11-9

Payroll Deductions and Net Pay. 1. Payroll deductions do not result in payroll tax expense to the employer because the company is merely a collection agent for the government. Mandatory deductions are required by law and consist of FICA taxes and income taxes. a.

FICA taxes are designed to provide workers with supplemental retirement, employment disability, and medical benefits. FICA taxes are commonly referred to as Social Security taxes.

Under the U.S. pay-as-you-go system of federal income taxes, employers are required to withhold income taxes from employees each pay period. Three variables determine the amount to be withheld: (1) The employee’s gross earnings. (2) The number of allowances claimed by the employee. (3) The length of the pay period.

2. Employees may voluntarily authorize withholdings for charitable, retirement, and other purposes. All voluntary deductions from gross earnings should be authorized in writing by the employee. 3. Companies determine net (or take-home) pay by subtracting payroll deductions from gross earnings. E.

Maintaining Payroll Department Records. 1. To comply with state and federal laws, an employer must keep a cumulative record of each employee’s gross earnings, deductions, and net pay during the year. 2. The record that provides employee information is the employee earnings record.

11-10 .

3. The employer uses the cumulative payroll data on the earnings record to: a.

Determine when an employee has earned the maximum earnings subject to FICA taxes.

File state and federal payroll tax returns.

Provide each employee with a statement of gross earnings and tax withholdings for the year.

4. The journal entry that companies make to record payroll includes a debit to Salaries and Wages Expense for the gross earnings and credits for the mandatory and voluntary deductions and Salaries and Wages Payable. F.

Employer Payroll Taxes. 1. Payroll tax expense results from three taxes that governmental agencies levy on employers. These taxes are FICA, federal unemployment tax (FUTA), and state unemployment tax (SUTA). 2. FICA, FUTA, SUTA, plus items such as paid vacations and pensions are collectively referred to as fringe benefits.

. 11-11

Employers must match each employee’s FICA contribution. Thus, the employer’s tax is subject to the same rate and maximum earnings as the employee’s.

The Federal Unemployment Tax Act (FUTA) is another feature of the federal Social Security program. Federal unemployment taxes provide benefits for a limited period of time to employees who lose their jobs through no fault of their own. The employer bears the entire federal unemployment tax.

All states have unemployment compensation programs under state unemployment tax acts (SUTA). This tax is levied only on the employer.

3. Companies usually record employer payroll taxes at the same time they record the payroll. Payroll Tax Expense is debited and the separate liability accounts are credited because these liabilities are payable to different taxing authorities at different dates. 4. Preparation of payroll tax returns is the responsibility of the payroll department; the treasurer’s department makes the tax payment. G.

Internal Control for Payroll. 1. The objectives of internal control for payrolls are: a.

To safeguard company assets against unauthorized payments of payrolls.

To ensure the accuracy and reliability of the accounting records pertaining to payrolls.

2. Payroll activities involve four functions: hiring employees, timekeeping, preparing the payroll, and paying the payroll. Companies should assign these four functions to different departments or individuals for effective internal control. 3. Posting job openings, screening and interviewing applicants, and hiring employees are responsibilities of the human resources department. 4. Another area in which internal control is important is timekeeping. Hourly employees are normally required to record time worked by “punching” a time clock. 5. The payroll is prepared in the payroll department on the basis of two inputs: human resources department authorizations and approved time cards.

11-12 .

6. The payroll is paid by the treasurer’s department. Payment by check minimizes the risk of loss from theft, and the endorsed check provides proof of payment. *H. Additional Fringe Benefits. 1. Additional fringe benefits associated with wages are paid absences (paid vacations, sick pay benefits, and paid holidays) and postretirement benefits (pensions and health care and life insurance). 2. Employees often are given rights to receive compensation for absences when certain conditions of employment are met. a.

When the payment for such absences is probable and the amount can be reasonably estimated, the company should accrue a liability for paid future absences.

When the amount cannot be reasonably estimated, the company should instead disclose the potential liability.

3. Postretirement benefits are benefits provided by employers to retired employees for pensions and health care and life insurance.

. 11-13

A pension plan is an arrangement whereby an employer provides benefits (payments) to employees after they retire. In a definedcontribution 401(K) plan, the plan defines the employer’s contribution but not the benefit that employee will receive at retirement.

Companies estimate and expense postretirement health-care costs during the working years of the employee because the company benefits from the employee’s services. Companies follow a pay-asyou-go basis for these costs since they do not receive a tax deduction until they actually pay the medical bill.

IFRS A Look at IFRS IFRS and GAAP have similar definitions of liabilities. The general recording procedures for payroll are similar although differences occur depending on the types of benefits that are provided in different countries. For example, companies in other countries often have different forms of pensions, unemployment benefits, welfare payments, and so on. KEY POINTS Following are the key similarities and differences between GAAP and IFRS related to current liabilities and payroll. • The basic definition of a liability under GAAP and IFRS is very similar. In a more technical way, liabilities are defined by the IASB as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. • Under IFRS, liabilities are classified as current if they are expected to be paid within 12 months. • Companies using IFRS sometimes show liabilities before assets. Also, they will sometimes show long-term liabilities before current liabilities. • Under IFRS, companies sometimes will net current liabilities against current assets to show working capital on the face of the statement of financial position. The accounting for current liabilities such as notes payable, unearned revenue, and payroll taxes payable is similar between IFRS and GAAP. • Under GAAP, some contingent liabilities are recorded in the financial statements, others are disclosed, and in some cases no disclosure is required. Unlike GAAP, IFRS reserves the use of the term contingent liability to refer only to possible obligations that are not recognized in the financial statements but may be disclosed if certain criteria are met. • For those items that GAAP would treat as recordable contingent liabilities, IFRS instead uses the term provisions. Provisions are defined as liabilities of uncertain timing or amount. Examples of provisions would be provisions for warranties, employee vacation pay, or anticipated losses. Under IFRS, the measurement of a provision related to an uncertain obligation is based on the best estimate of the expenditure required to settle the obligation.

11-14 .

. 11-15

20 MINUTE QUIZ Circle the correct answer. True/False 1. A current liability to the state arises when a business sells an item and collects a state sales tax on it. True

False

2. An unearned revenue arises when payment is accepted in advance of the goods being delivered. True

False

3. A refrigerator is sold in year 1, and a repair is made in year 2. The company’s entry upon making the repair would include a debit to Warranty Liability. True

False

4. The excess of current assets over current liabilities is called the current ratio. True

False

5. Current maturities of long-term debt are identified on the balance sheet as long-term debt due within one year. True

False

6. With an interest-bearing note, the amount of cash received upon issuance of the note will be less than the note’s face value. True

False

7. A contingent liability is recorded if it is reasonably possible and the amount can be reasonably estimated. True

False

8. The separation of the payroll activities of hiring, timekeeping, preparing payroll, and paying the payroll weakens internal control over the payroll transactions. True

False

9. Net pay is determined by applying the hourly rate of pay to the hours worked less payroll deductions. True

False

*10. Vacation pay is properly charged as an expense in the month in which the employee takes the vacation. True

11-16 .

False

Multiple Choice 1.

The account Unearned Subscription Revenue a. is considered a miscellaneous revenue account. b. has a normal debit balance. c. is a contra account to Subscription Revenue. d. is a current liability.

Which of the following is not a contingent liability? a. Product warranties b. Pending or threatened lawsuits c. Current maturities of long-term debt d. Assessment of additional income taxes pending an audit

Payroll Tax Expense includes all of the following except a. federal income tax payable. b. federal unemployment tax payable. c. FICA tax payable. d. state unemployment tax payable.

Which of the following is not an estimated liability? a. Vacation pay b. Sales taxes c. Product warranties d. Income taxes

Recording estimated warranty expense in the year of the sale best follows which accounting principle? a. Revenue recognition b. Full disclosure c. Expense recognition d. Historical cost

. 11-17

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True True True False True

Multiple Choice 1. 2. 3. 4. 5.

11-18 .

d. c. a. b. c.

6. 7. 8. 9. *10.

False False False True False

CHAPTER 12 ACCOUNTING FOR PARTNERSHIPS LEARNING OBJECTIVES 1. DISCUSS AND ACCOUNT FOR THE FORMATION OF A PARTNERSHIP. 2. EXPLAIN HOW TO ACCOUNT FOR NET INCOME OR NET LOSS OF A PARTNERSHIP. 3. EXPLAIN HOW TO ACOUNT FOR THE LIQUIDATION OF A PARTNERSHIP. *4. PREPARE JOURNAL ENTRIES WHEN A NEW PARTNER IS EITHER ADMITTED OR WITHDRAWS.

12-1

CHAPTER REVIEW Partnership Form of Organization 1.

A partnership is an association of two or more persons to carry on as co-owners of a business for a profit.

Characteristics of Partnerships 2.

The principal characteristics of the partnership form of business organization are (a) association of individuals, (b) mutual agency, (c) limited life, (d) unlimited liability, and (e) co-ownership of property.

The association of individuals in a partnership may be based on as simple an act as a handshake; however, it is preferable to state the agreement in writing. a. A partnership is a legal entity for certain purposes. b. A partnership is an accounting entity for financial reporting purposes. c. Net income of a partnership is not taxed as a separate entity.

Mutual agency means that each partner acts on behalf of the partnership when engaging in partnership business, and the act of any partner is binding on all other partners. This is true even when partners act beyond the scope of their authority, so long as the act appears to be appropriate for the partnership.

Partnerships have a limited life. Partnership dissolution occurs whenever a partner withdraws or a new partner is admitted.

Each partner has unlimited liability. a. Each partner is personally and individually liable for all partnership liabilities. b. Creditors’ claims attach first to partnership assets and then to the personal resources of any partner, irrespective of that partner’s capital equity in the company.

Partnership assets are co-owned by the partners. Once assets have been invested in the partnership they are owned jointly by all the partners.

Advantages and Disadvantages 8.

Organizations with partnership characteristics include limited partnerships, limited liability partnerships, limited liability companies, and S corporations.

The major advantages of a partnership are: a. Combining skills and resources of two or more individuals. b. Ease of formation. c. Freedom from governmental regulations and restrictions. d. Ease of decision-making.

10.

The major disadvantages of a partnership are a. mutual agency. b. limited life. c. unlimited liability.

Limited Partnerships 11.

Under limited partnerships, the liability of a limited partner is limited to the partners’ capital equity. However, there must always be at least one partner with unlimited liability, often referred to as the general partner.

12-2

Limited Liability Partnership 12.

Professionals such as lawyers, doctors, and accountants can be protected from malpractice or negligence claims of other partners by forming a limited liability partnership.

Limited Liability Companies 13.

A new hybrid form of business organization with certain features like a corporation and others like a limited partnership is a limited liability company.

The Partnership Agreement 14.

The written contract, often referred to as the partnership agreement, contains such basic information as the name and principal location of the firm, the purpose of the business, and the date of inception.

Forming a Partnership 15.

(L.O. 1) In the formation of a partnership, each partner’s initial investment in a partnership should be recorded at the fair value of the assets at the date of their transfer to the partnership.

Dividing Net Income or Net Loss 16.

(L.O. 2) Partnership net income or net loss is shared equally unless the partnership contract specifically indicates otherwise. a. A partner’s share of net income or net loss is recognized in the accounts through closing entries. b. Closing entries for a partnership are identical to the entries made for a proprietorship, except for the use of multiple capital and drawing accounts.

17.

The various income ratios that may be used include: a. A fixed ratio, expressed as a proportion (6:4), a percentage (70% and 30%), or a fraction (2/3 and 1/3). b. A ratio based either on capital balances at the beginning of the year or on average capital balances during the year. c. Salaries to partners and the remainder on a fixed ratio. d. Interest on partners’ capitals and the remainder on a fixed ratio. e. Salaries to partners, interest on partners’ capitals, and the remainder on a fixed ratio. The objective is to reach agreement on a basis that will equitably reflect the differences among partners in terms of their capital investment and service to the partnership.

18.

Provisions for salaries and interest must be applied before the remainder of net income or net loss is allocated on the specified fixed ratio. Detailed information concerning the division of net income or net loss should be shown at the bottom of the partnership’s income statement.

Partnership Financial Statements 19.

The financial statements of a partnership are similar to a proprietorship. The differences are generally related to the fact that a number of owners are involved in a partnership. The income statement for a partnership is identical to the income statement for a proprietorship except for the division of net income.

20.

The owners’ equity statement for a partnership is called the partners’ capital statement. It explains the changes in each partners’ equity during an accounting period. Changes in capital may result from additional capital investment, drawings, and net income or net loss.

12-3

Liquidation of a Partnership 21. (L.O. 3) The liquidation of a partnership terminates the business. In a liquidation, it is necessary to: a. Sell noncash assets for cash and recognize a gain or loss on realization. The journal entry to record this will include a debit to Cash for the amount received from the sale, debits to any contra-asset accounts, a debit for the loss on realization/or a credit for the gain on realization and credits to all asset accounts. b. Allocate gain/loss on realization to the partners based on their income ratios. The journal entry to record this will include a debit to Gain on Realization and credits to each partner’s capital account or debits to each partner’s capital account and a credit to Loss on Realization. c. Pay partnership liabilities in cash. The journal entry to record this will include debits to all liability accounts and a credit to Cash. d. Distribute remaining cash to partners on the basis of their remaining capital balances. The journal entry to record this will include debits to each partner’s capital account and a credit to Cash. Each of the steps must be performed in sequence. 22. The liquidation of a partnership may result in no capital deficiency (all partners have credit balances in their capital accounts) or in a capital deficiency (at least one partner’s capital account has a debit balance.) 23. A schedule of cash payments may be used to determine the distribution of cash to each partner. 24. When there is a capital deficiency, the partner with the deficiency may pay the amount owed and the deficiency is eliminated. 25. If a partner with a capital deficiency is unable to pay the amount owed to the partnership, the partners with credit balances must absorb the loss as follows: a. The cash distributed to each partner is the difference between the partner’s present capital balance and the loss that the partner may have to absorb if the capital deficiency is not paid. b. The allocation of the deficiency is made on the income ratios that exist between the partners with credit balances. The allocation is journalized and posted. Admission of a Partner *26. (L.O. 4) A new partner may be admitted either by (1) purchasing the interest of one or more existing partners, or (2) investing assets in the partnership. The former affects only partners’ capital accounts whereas the latter increases both net assets and total capital of the partnership. *27. When a new partner is admitted by purchase of an interest, a. The transaction is a personal one between one or more existing partners and the new partner. b. Any money or other consideration exchanged is the property of the participants and not the property of the partnership. c. Each partner’s capital account is debited for the ownership claims that have been relinquished, and the new partner’s capital account is credited with the capital equity purchased. d. Total assets, total liabilities, and total capital remain unchanged. *28. When a new partner is admitted by the investment of assets, both the total net assets and the total capital of the partnership increase. This is done by debiting Cash and crediting the new partner’s capital account. When the capital credit does not equal the investment of assets in the partnership, the difference is considered a bonus either to the existing partners or the new partner.

12-4

*29. A bonus to old partners results when the new partner’s capital credit on the date of admittance is less than the new partner’s investment in the firm. The procedure for determining the new partner’s capital credit and the bonus to the old partners is as follows: a. Determine the total capital of the new partnership by adding the new partner’s investment to the total capital of the old partnership. b. Determine the new partner’s capital credit by multiplying the total capital of the new partnership by the new partner’s ownership interest. c. Determine the amount of bonus by subtracting the new partner’s capital credit from the new partner’s investment. d. Allocate the bonus to the old partners on the basis of their income ratios. *30. A bonus to a new partner results when the new partner’s capital credit is greater than the partner’s investment of assets in the firm. The bonus results in a decrease in the capital balances of the old partners based on their income ratios before admission of the new partner. Withdrawal of a Partner *31. As in the case of the admission of a partner, the withdrawal of a partner legally dissolves the partnership. The withdrawal of a partner may be accomplished by (a) payment from partners’ personal assets or (b) payment from partnership assets. The former affects only the partners’ capital accounts, whereas the latter decreases total net assets and total capital of the partnership. *32. The withdrawal of a partner when payment is made from partners’ personal assets is the direct opposite of admitting a new partner who purchases a partner’s interest. a. Payment from partners’ personal assets is a personal transaction between the partners. b. Partnership assets are not involved and total capital does not change. c. The effect on the partnership is limited to a realignment of the partners’ capital balances. *33. Using partnership assets to pay for a withdrawing partner’s interest is the reverse of admitting a partner through the investment of assets in the partnership. a. Payment from partnership assets is a transaction that involves the partnership. b. Both partnership net assets and total capitals are decreased. c. Asset revaluations should not be recorded. *34. When the partnership assets paid are in excess of the withdrawing partner’s capital interest, a bonus to the retiring partner results. The bonus is deducted from the remaining partners’ capital balances on the basis of their income ratios at the time of the withdrawal. *35. When the partnership assets paid are less than the withdrawing partner’s capital interest, a bonus to the remaining partners results. The bonus is allocated to the capital accounts of the remaining partners on the basis of their income ratios. Death of a Partner *36. The death of a partner dissolves the partnership, but provision generally is made for the surviving partners to continue operations. When a partner dies it is necessary to determine the partner’s equity at the date of death.

12-5

LECTURE OUTLINE A.

Characteristics of Partnerships. 1. A partnership is an association of two or more persons to carry on as co-owners of a business for profit. 2. The principal characteristics of partnerships are:

Association of individuals. A partnership is a legal entity that can own property and can sue or be sued. A partnership is also an accounting entity.

Mutual agency. Each partner acts on behalf of the partnership when engaging in partnership business. The act of any partner is binding on all other partners, even when partners act beyond the scope of their authority, so long as the act appears to be appropriate for the partnership.

Limited life. Corporations have unlimited life, but partnerships do not. A partnership may be ended voluntarily any time through the acceptance of a new partner or the withdrawal of a partner. Partnership dissolution occurs whenever a partner withdraws or a new partner is admitted.

Unlimited liability. Each partner is personally and individually liable for all partnership liabilities. Creditors’ claims attach first to partnership assets. If these are insufficient, the claims then attach to the personal resources of any partner, irrespective of that partner’s equity in the partnership.

Co-ownership of property. Partners jointly own partnership assets. If the partnership is dissolved, each partner has a claim on total assets equal to the balance in his/her respective capital account.

Organizations with Partnership Characteristics. 1. Special forms of business organizations with partnership characteristics are often used to provide protection from unlimited liability for people who want to work together in some activity.

12-6

2. The special partnership forms are: a.

Limited partnership. One or more partners have unlimited liability and one or more partners have limited liability for the debts of the firm. Those with limited liability are responsible for partnership debts up to the limit of their investment in the firm.

Limited liability partnership (LLP). The LLP is designed to protect innocent professionals (lawyers, doctors) from malpractice or negligence claims resulting from the acts of another partner.

Limited liability companies (LLC). The LLC is a hybrid form of business organization with certain features like a corporation and others like a limited partnership. The owners (members) have limited liability like owners of a corporation.

ACCOUNTING ACROSS THE ORGANIZATION Whenever a group of individuals wants to form a partnership, the limited liability company is usually the popular choice. One other form of business organization is a subchapter S corporation, but it is losing its popularity. Why do you think that the use of the limited liability company is gaining in popularity? Answer: The LLC is gaining in popularity because owners in such companies have limited liability for business debts even if they participate in management. As a result, the LLC form has a distinct advantage over regular partnerships. In addition, the other limited type partnerships are restrictive as to their use.

12-7

Advantages and Disadvantages of Partnerships. 1. Advantages of partnerships are: a.

Combining skills and resources of two or more individuals.

Ease of formation and freedom from governmental regulations and restrictions.

Ease of decision-making.

2. Major disadvantages of a partnership are:

Mutual agency.

Limited life.

Unlimited liability.

The Partnership Agreement. 1. The partnership contract, called the partnership agreement, or articles of co-partnership, contains such basic information as the name and principal location of the firm, the purpose of the business, and date of inception. 2. The partnership agreement should specify relationships among the partners, such as rights and duties of partners, provision for withdrawals of assets, and procedures for the withdrawal or addition of a partner.

12-8

ACCOUNTING ACROSS THE ORGANIZATION What should you do when you and your business partner do not agree on things, to the point where you are no longer on speaking terms? Unfortunately, in many instances the partners do everything they can to undermine the other partner, eventually destroying the business. How can partnership conflicts be minimized and more easily resolved? Answer: First, it is important to develop a business plan that all parties agree to. Second, it is vital to have a well-thought-out partnership agreement. Third, it can be useful to set up a board of mutually agreed upon and respected advisors to consult when making critical decisions. E.

Forming a Partnership. 1. Each partner’s initial investment in a partnership is entered in the partnership records. The partnership should record these investments at the fair value of the assets at the date of their transfer to the partnership. 2. All partners must agree to the values assigned. 3. After formation of the partnership, the accounting for transactions is similar to any other type of business organization.

Dividing Net Income or Net Loss. 1. Partners equally share partnership net income or net loss unless the partnership contract indicates otherwise. 2. The same basis of division usually applies to both net income and net loss, and is referred to as the income ratio, or the profit and loss (P&L) ratio. 3. Typical income ratios are:

12-9

A fixed ratio, expressed as a proportion, a percentage, or a fraction.

A ratio based either on capital balances at the beginning of the year or on average capital balances during the year.

Salaries to partners and the remainder on a fixed ratio.

Interest on partners’ capital balances and the remainder on a fixed ratio.

Salaries to partners, interest on partners’ capital, and the remainder on a fixed ratio.

4. The objective is to settle on a basis that will equitably reflect the partners’ capital investment and service to the partnership. G.

Partnership Financial Statements. 1. The financial statements of a partnership are similar to those of a proprietorship. 2. The partnership’s income statement shows the division of net income at the bottom of the income statement. 3. The owners’ equity statement is called the partners’ capital statement. It explains the changes in each partner’s capital account and in total partnership capital during the year. 4. The partnership reports each partner’s capital balance on the balance sheet.

Liquidation of a Partnership. 1. Liquidation may result from the sale of the business by mutual agreement of the partners, from the death of a partner, or from bankruptcy.

2. To liquidate a partnership, it is necessary to: a.

. 12-10

Sell noncash assets for cash and recognize a gain (loss) on realization.

Allocate any gain (loss) on realization to the partners based on their income ratios.

Pay partnership liabilities in cash.

Distribute remaining cash to the partners on the basis of their capital balances.

3. Each of the steps must be performed in sequence because the partnership must pay creditors before partners receive any cash distributions. 4. A cash payments schedule is sometimes prepared to determine the distribution of cash to the partners in the liquidation of a partnership. 5. A partner’s capital deficiency may result from recurring net losses, excessive drawings, or losses from realization suffered during liquidation.

*I.

The partner with a capital deficiency is obligated to pay the partnership the amount owed.

If a partner with a capital deficiency is unable to pay the amount owed to the partnership, the partners with credit capital balances must absorb the loss on the basis of their income ratios.

Admission of a Partner. 1. The admission of a new partner results in the legal dissolution of the existing partnership and the beginning of a new one. 2. A new partner may be admitted either by:

. 12-11

Purchasing the interest of one or more existing partners. The partnership debits each partner’s capital account for the ownership claims that have been sold, and credits the new partner’s capital account with the capital equity purchased.

Investment of assets in a partnership. When a partner is admitted by investment, both the total net assets and the total capital change. When the new partner’s investment differs from the capital equity acquired, the difference is considered a bonus either to:

(1) The existing (old) partners or (2) The new partner. c.

The partnership allocates a bonus to the old partners on the basis of their income ratios before the admission of the new partner.

A bonus to a new partner results in a decrease in the capital balances of the old partners based on their income ratios before the admission of the new partner.

*J. Withdrawal of a Partner. 1. A partner may withdraw from a partnership voluntarily, by selling his or her equity in the firm. Or he/she may withdraw involuntarily, by reaching mandatory retirement age or by dying. 2. The withdrawal of a partner may be accomplished by: a.

Payment from partners’ personal assets, or

Payment from partnership assets.

3. The entry to record the withdrawal of a partner when the partners pay from their personal assets only affects the partners’ capital accounts. It is the direct opposite of admitting a new partner who purchases a partner’s interest. 4. Using partnership assets to pay for a withdrawing partner’s interest decreases both partnership net assets and total capital. In accounting for a withdrawal by payment from partnership assets:

. 12-12

The partnership should not record asset revaluations.

The partnership should consider any difference between the amount paid and the withdrawing partner’s capital balance as a bonus to the retiring partner or to the remaining partners.

5. A partnership may pay a bonus to a retiring partner when: a.

The fair value of partnership assets is more than their book value,

There is unrecorded goodwill resulting from the partnership’s superior earnings record, or

The remaining partners are eager to remove the partner from the firm.

6. The retiring partner may give a bonus to the remaining partners when: a.

Recorded assets are overvalued,

The partnership has a poor earnings record, or

The partner is eager to leave the partnership.

7. Death of a partner: when a partner dies, it is usually necessary to determine the partner’s equity at the date of death by:

. 12-13

Determining the net income or loss for the year to date,

Closing the books,

Preparing financial statements.

20 MINUTE QUIZ Circle the correct answer. True/False 1. A partner can bind the partnership to outside contracts without receiving permission from the other partners. True

False

2. In a limited partnership, one or more partners have limited liability for the debts of the firm. True

False

3. A partner is never liable for more than his or her capital investment in the partnership. True

False

4. In a partnership, when the division of profits and losses is based on salaries, interest, and a fixed ratio, if the salary and interest allocation exceeds net income, then a net loss has in fact occurred. True

False

5. A partnership is considered an accounting entity for financial reporting purposes. True

False

6. When the partnership contract does not specify the manner in which net income and net loss are to be divided, profits and losses are distributed based on the average capital balances of each partner during the year. True

False

7. The partners’ capital statement explains the changes in each partner’s capital account and in total partnership capital during the year. True

False

8. Upon the sale of assets in liquidation, gains and losses are always divided equally among partners. True

False

*9. If a partnership is admitting a new partner to the existing partnership and the existing partners are to receive a bonus, this bonus would be allocated on the basis of their income ratios before the admission of the new partner. True

False

*10. Admission of a new partner to the partnership does not result in the dissolution of the existing partnership. True . 12-14

False

Multiple Choice 1.

Which one of the following is not a feature of partnerships? a. Limited life b. Limited liability c. Mutual agency d. Voluntary association

Selling partnership assets and paying the proceeds to creditors and owners refers to a. dissolution. b. unlimited liability. c. mutual agency. d. liquidation.

Partners A and B receive a salary allowance of $63,000 and $81,000, respectively, and share the remainder equally. If the company earned $90,000 during the period, what is the effect on A’s capital? a. $63,000 increase b. $36,000 decrease c. $36,000 increase d. $45,000 increase

*4.

A invests $60,000 for a one-fifth interest in a partnership in which the other partners have capital totaling $180,000 before admitting A. After distribution of the bonus, what would A’s capital be? a. $32,000 b. $36,000 c. $60,000 d. $48,000

*5.

B invests $120,000 for a 20 percent interest in a partnership that has total capital of $400,000 after admitting B. Which of the following is true? a. B’s capital is $120,000 b. B’s capital is $56,000 c. B received a bonus of $40,000 d. The original partners received a bonus of $40,000.

. 12-15

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True True False False True

Multiple Choice 1. 2. 3. *4. *5.

. 12-16

b. d. c. d. d

6. 7. 8. *9. *10.

False True False True False

CHAPTER 13 CORPORATIONS: ORGANIZATION AND CAPITAL STOCK TRANSACTIONS LEARNING OBJECTIVES 1. DISCUSS THE MAJOR CHARACTERISTICS OF A CORPORATION. 2. EXPLAIN HOW TO ACCOUNT FOR THE ISSUANCE OF COMMON AND PREFERRED STOCK. 3. EXPLAIN THE ACCOUNTING FOR TREASURY STOCK. 4. PREPARE A STOCKHOLDERS’ EQUITY SECTION.

13-1

CHAPTER REVIEW The Corporate Form of Organization 1.

(L.O. 1) A corporation is an entity created by law that is separate and distinct from its owners and its continued existence is dependent upon the corporate statutes of the state in which it is incorporated.

The characteristics that distinguish a corporation from proprietorships and partnerships are: a. The corporation has separate legal existence from its owners. b. The stockholders have limited liability. c. Ownership is shown in shares of capital stock, which are transferable units. d. It is relatively easy for a corporation to obtain capital through the issuance of stock. e. The corporation can have a continuous life. f. The management in the corporation’s organizational structure is at the discretion of the board of directors who are elected by the stockholders. g. The corporation is subject to numerous government regulations. h. The corporation must pay an income tax on its earnings, and the stockholders are required to pay taxes on the dividends they receive: the result is double taxation of distributed earnings.

Forming a Corporation 3.

A corporation is formed by grant of a state charter. Upon receipt of its charter from the state of incorporation the corporation establishes by-laws which are the internal rules and procedures for conducting the affairs of the corporation. a. Costs incurred in forming a corporation are called organization costs. b. These costs include legal and state fees, and promotional expenditures. c. Organization costs are expensed as incurred.

Stockholder Rights 4.

When chartered, the corporation may begin selling ownership rights in the form of shares of stock. Each share of common stock gives the stockholder the following ownership rights: a. To vote for the board of directors and in corporate actions that require stockholder approval. b. To share in corporate earnings through the receipt of dividends. c. To maintain the same percentage ownership when additional shares of common stock are issued (preemptive right). d. To share in assets upon liquidation (residual claim).

Stock Issue Considerations 5.

Authorized stock is the amount of stock a corporation is allowed to sell as indicated by its charter. a. The authorization of capital stock does not result in a formal accounting entry. b. The difference between the shares of stock authorized and the shares issued is the number of unissued shares that can be issued without amending the charter.

A corporation has the choice of issuing common stock directly to investors or indirectly through an investment banking firm (brokerage house). Direct issue is typical in closely held companies, whereas indirect issue is customary for a publicly held corporation.

Par value stock is capital stock that has been assigned a value per share in the corporate charter. It represents the legal capital per share that must be retained in the business for the protection of corporate creditors.

13-2

No-par stock is capital stock that has not been assigned a value in the corporate charter. In many states the board of directors can assign a stated value to the shares which becomes the legal capital per share. When there is no assigned stated value, the entire proceeds are considered to be legal capital.

Corporate Capital 9.

Owner’s equity in a corporation is identified as stockholders’ equity, shareholders’ equity, or corporate capital. The stockholders’ equity section of a corporation’s balance sheet consists of: (a) paid-in (contributed) capital, and (b) retained earnings (earned capital).

10.

Paid-in capital is the total amount of cash and other assets paid into the corporation by stockholders in exchange for capital stock.

11.

Retained earnings is net income retained in a corporation. a. Net income is recorded in Retained Earnings by a closing entry with a debit to Income Summary and a credit to Retained Earnings. b. Retained earnings is part of the stockholders’ equity section of a corporation.

12.

(L.O. 2) The primary objectives in accounting for the issuance of common stock are to (a) identify the specific sources of paid-in capital and (b) maintain the distinction between paid-in capital and retained earnings.

13.

When par value common stock is issued for cash, the par value of the shares is credited to Common Stock and the portion of the proceeds that is above or below par value is recorded in a separate paid-in capital account.

14.

When no-par common stock has a stated value, the stated value is credited to Common Stock. When the selling price exceeds the stated value, the excess is credited to Paid-in Capital in Excess of Stated Value—Common Stock. When no-par stock does not have a stated value, the entire proceeds are credited to Common Stock.

Issuing Common Stock for Services or NonCash Assets 15.

When common stock is issued for services or noncash assets, cost is either the fair value of the consideration given up or the consideration received, whichever is more clearly determinable.

Treasury Stock 16.

(L.O. 3) Treasury stock is a corporation’s own stock that has been issued and subsequently reacquired from shareholders but not retired. a. Under the cost method, Treasury Stock is debited at the price paid for the shares and the same amount is credited to Treasury Stock when the shares are reissued. b. When the Treasury Stock is resold and the selling price of the shares is greater than cost, the difference is credited to Paid-in Capital from Treasury Stock. c. When the selling price is less than cost, the excess of cost over selling price is usually debited to Paid-in Capital From Treasury Stock. When there is no remaining balance in Paid-in Capital From Treasury Stock, the remainder is debited to Retained Earnings.

Preferred Stock 17.

Preferred stock has contractual claims that give it some preference or priority over common stock. Preferred stockholders usually have a priority to distributions of earnings (dividends) and assets in the event of liquidation. However, they usually do not have voting rights.

13-3

18.

When a corporation has more than one class of stock, each paid-in capital account title should identify the stock to which it relates (e.g., Preferred Stock, Paid-in Capital in Excess of Par— Preferred Stock). Preferred stock is shown first in the stockholders’ equity section.

Cumulative Dividend 19.

A cumulative dividend provides that preferred stockholders must be paid both current and prioryear dividends before common stockholders receive any dividends. a. Preferred dividends not declared in a given period are called dividends in arrears. b. Dividends in arrears are not considered a liability, but the amount of the dividends in arrears should be disclosed in the notes to the financial statements.

Statement Presentation 20.

(L.O. 4) In the stockholders’ equity section, paid-in capital and retained earnings are reported and the specific sources of paid-in capital are identified. Within paid-in capital, two classifications are recognized. a. Capital stock, which consists of preferred and common stock. Preferred stock appears before common stock because of its preferential rights. Information as to the par value, shares authorized, shares issued, and shares outstanding is reported for each class of stock. b. Additional paid-in capital, which includes the excess of amounts paid in over par or stated value and paid-in capital from treasury stock.

13-4

LECTURE OUTLINE A.

The Corporate Form of Organization. 1. The prevailing legal interpretation of a corporation is an entity separate and distinct from its owners. 2. A corporation may be organized for the purpose of making a profit, or it may be not-for-profit. 3. Classification by ownership differentiates publicly held and privately held corporations.

A publicly held corporation may have thousands of stockholders, and its stock is regularly traded on a national securities exchange.

A privately held corporation, also referred to as a closely held corporation, usually has only a few stockholders, and does not offer its stock for sale to the general public.

Characteristics of a Corporation. 1. Separate legal existence. As an entity separate and distinct from its owners, the corporation acts under its own name rather than in the name of its stockholders. 2. Limited liability of stockholders. Since a corporation is a separate legal entity, creditors have recourse only to corporate assets to satisfy their claims. 3. Transferable ownership rights. Shares of capital stock, which are transferable units, give ownership in a corporation. 4. Ability to acquire capital. Obtaining capital is relatively easy for a corporation because stockholders have limited liability and shares of stock are readily transferable.

13-5

5. Continuous life. The life of a corporation is stated in its charter. It may be perpetual, or it may be limited to a specific number of years. 6. Corporation management. Stockholders legally own the corporation, but they manage the corporation indirectly through a board of directors they elect. The board, in turn, formulates operating policies and also selects officers to execute policy and to perform daily management functions. 7. Government regulations. A corporation is subject to numerous state and federal regulations that are designed to protect the owners of the corporation. 8. Additional taxes. Corporations must pay federal and state income taxes as a separate legal entity. These taxes can be substantial; they can amount to as much as 40% of taxable income. C.

Forming a Corporation. 1. A corporation is formed by grant of a state charter that describes the name and purpose of the corporation, the types and number of shares of stock that are authorized to be issued, and the names of the individuals that formed the company. 2. It is to a company’s advantage to incorporate in a state whose laws are favorable to the corporate form of business organization. 3. Corporations engaged in interstate commerce must obtain a license from each state in which they do business. 4. Costs incurred in the formation of a corporation are called organization costs. These costs include legal and state fees, and promotional expenditures involved in the organization of the business and are expensed as incurred.

13-6

D. Stockholder Rights. 1. Each share of common stock gives the stockholder the following ownership rights: a.

Each share of stock entitles the owner to vote in the election of the board of directors and in corporate actions that require stockholder approval.

Stockholders share in corporate earnings through the receipt of dividends.

Common stockholders are granted the right (preemptive right) to keep the same ownership percentage when new shares of stock are issued.

Common stockholders have a claim (residual claim) on corporate assets in proportion to their holdings if the corporation is liquidated.

2. Proof of stock ownership is evidenced by a form known as a stock certificate. E.

Stock Issue Considerations. 1. Authorized stock. The charter indicates the amount of stock that a corporation is authorized to sell. 2. Issuance of stock. A corporation can issue common stock directly to investors. Alternatively, it can issue the stock indirectly through an investment banking firm that specializes in bringing securities to the attention of prospective investors. 3. Market price of stock. The stock of publicly held companies is traded on organized exchanges. The interaction between buyers and sellers determines the prices per share.

13-7

4. Par and no-par value stocks. Par value stock is capital stock to which the charter has assigned a value per share. No-par value stock is capital stock to which the charter has not assigned a value. In many states the board of directors assigns a stated value to no-par shares. INVESTOR INSIGHT Shares in excess of a billion are often traded daily on the New York Stock Exchange. For each listed stock, the Wall Street Journal reports the total volume of stock traded for a given day, the high and low price for the day, the closing market price, and the net change for the day. How are the dollar prices per share established for stocks traded on organized stock exchanges? What factors might influence the price of shares in the marketplace? Answer: The dollar prices per share are established by the interaction between buyers and sellers of the shares. The price of shares is influenced by a company’s earnings and dividends as well as by factors beyond a company’s control, such as changes in interest rates, labor strikes, scarcity of supplies or resources, and politics. The number of willing buyers and sellers (demand and supply) also plays a part in the price of shares.

13-8

Corporate Capital. 1. Owners’ equity in a corporation is identified as stockholders’ equity, shareholders’ equity, or corporate capital. 2. The stockholders’ equity section of a corporation’s balance sheet consists of:

Paid-in (contributed) capital. Paid-in capital is the total amount of cash and other assets paid in to the corporation by stockholders in exchange for capital stock. When a corporation has only one class of capital stock, it is common stock.

Retained earnings. Retained earnings is net income that a corporation retains for future use. It is also referred to as earned capital.

Accounting for Issues of Common Stock. 1. The primary objectives in accounting for the issuance of common stock are to: a.

Identify the specific sources of paid-in capital.

Maintain the distinction between paid-in capital and retained earnings.

2. When the company records issuance of common stock for cash, it credits the par value of the shares to Common Stock. It also records in a separate paid-in capital account the portion of the proceeds that is above or below par value. 3. When no-par common stock has a stated value, the entries are similar to those for par value stock. 4. When no-par common stock does not have a stated value, the corporation credits the entire proceeds to Common Stock. 5. When stock is issued for services (compensation to attorneys or consultants) or for noncash assets (land, buildings, and equipment), the cost is either the fair value of the consideration given up, or the fair value of the consideration received, whichever is more clearly determinable. .

13-9

Accounting for Treasury Stock. 1. Treasury stock is a corporation’s own stock that it has issued and subsequently reacquired from shareholders but not retired. 2. Companies generally account for treasury stock by the cost method. Under this method, companies debit Treasury Stock for the price paid to reacquire the shares, and when they dispose of the shares, they credit Treasury Stock for the same amount paid to reacquire the shares. 3. When the selling price of treasury stock is greater than its cost, the company credits the difference to Paid-in Capital from Treasury Stock. When a company sells treasury stock below its cost, it debits Paid-in Capital from Treasury Stock for its remaining balance and debits Retained Earnings for any additional excess of cost over selling price.

ACCOUNTING ACROSS THE ORGANIZATION Reebok at one time bought back nearly a third of its shares which dramatically reduced its available cash. Critics suggested that Reebok’s management was repurchasing shares to make it less likely that another company would acquire Reebok. What signal might a large stock repurchase send to investors regarding management’s belief about the company’s growth opportunities? Answer: When a company has many growth opportunities it will normally conserve its cash in order to be better able to fund expansion. A large use of cash to buy back stock (and essentially shrink the company) would suggest that management was not optimistic about its growth opportunities. I.

Accounting for Preferred Stock. 1. To appeal to a larger segment of potential investors, a corporation may issue an additional class of stock, called preferred stock.

13-10 .

2. Preferred stock has contractual provisions that give it some preference or priority over common stock. Typically, preferred stockholders have a priority as to: a.

Distributions of earnings (dividends).

Assets in the event of liquidation.

3. Preferred stock dividend preferences may be classified as:

Cumulative—preferred stockholders must be paid both current-year dividends and any unpaid prior-year dividends before common stockholders receive any dividends. Preferred dividends not declared in a given period are called dividends in arrears. Dividends in arrears are not considered a liability, but companies should disclose in the notes to the financial statements the amount of dividends in arrears.

Participating – preferred stock may have the right to receive dividends in addition to their stated rate after the Common shareholders have received a similar percentage return.

Statement Presentation and Analysis. Within paid-in capital, companies use the following classifications: 1. Capital stock. This category consists of preferred and common stock. Preferred stock appears before common stock because of its preferential rights. Companies report par value, shares authorized, shares issued, and shares outstanding for each class of stock. 2. Additional paid-in capital. This category includes the excess of amounts paid in over par or stated value and paid-in capital from treasury stock.

. 13-11

20 MINUTE QUIZ Circle the correct answer. True/False 1.

The cost method derives its name from the fact that the Treasury Stock account is maintained at the cost of shares purchased. True

When treasury stock is sold for an amount greater than its cost, the difference should be credited to Gain on Sale of Treasury Stock and reported as other income on the income statement. True

False

Preferred stockholders have a priority as to dividends but not to assets in the event of liquidation. True

10.

False

Dividends in arrears are not considered a liability because no obligation exists until the dividend is declared by the board of directors. True

False

The cumulative feature of stock applies to preferred stock. True

False

Issued shares of stock less outstanding shares equals treasury stock. True

False

A corporation is bound to a contract entered into by one of its stockholders. True

False

Retained earnings is net income retained in a corporation and is often referred to as earned capital. True

False

Stockholders’ liability is generally unlimited; therefore, creditors have recourse to stockholders’ personal assets as well as corporate assets. True

False

Treasury stock should be listed as an asset in the balance sheet. True

13-12 .

False

Multiple Choice 1.

Par value a. represents what a share of stock is worth. b. represents the original selling price for a share of stock. c. is the legal capital established for a share of stock. d. is established for a share of stock after it is issued.

If a company has 900,000 shares of common stock authorized, and has 750,000 shares issued, and holds 30,000 shares of common stock as treasury stock, the general ledger account for common stock, $1 par value would have a balance of a. $870,000. b. $750,000. c. $720,000. d. $150,000.

All of the following balances are normally found in a corporation’s stockholders’ equity section except a. common stock. b. paid-in capital in excess of par. c. retained earnings. d. dividends in arrears.

Preferred stock would least likely have which characteristic? a. The right of the holder to vote at stockholders’ meetings. b. The right of the corporation to redeem or retire the stock. c. Preference as to assets upon liquidation of the corporation. d. Preference as to dividends.

A company purchases 1,500 shares of its $25 par value stock at $35 per share. It then reissues 500 shares at $40 per share. The entry upon reissue of the stock would include a credit to a. Cash for $2,500. b. Treasury Stock for $2,500. c. Retained Earnings for $2,500. d. Paid-in Capital from Treasury Stock for $2,500.

. 13-13

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True False False True False

Multiple Choice 1. 2. 3. 4. 5.

13-14 .

c. b. d. a. d

6. 7. 8. 9. 10.

True True True False False

CHAPTER 14 CORPORATIONS: DIVIDENDS, RETAINED EARNINGS, AND INCOME REPORTING LEARNING OBJECTIVES 1. EXPLAIN HOW TO ACCOUNT FOR CASH DIVIDENDS. 2. EXPLAIN HOW TO ACCOUNT FOR STOCK DIVIDENDS AND SPLITS 3. PREPARE AND ANALYZE A COMPREHENSIVE STOCKHOLDERS’ EQUITY SECTION. 4. DESCRIBE THE FORM AND CONTENT OF CORPORATION INCOME STATEMENTS.

13-1

CHAPTER REVIEW Dividends 1.

(L.O. 1) A dividend is a distribution by a corporation to its stockholders on a pro rata (proportional) basis. Dividends may be in the form of cash, property, scrip, or stock.

A cash dividend is a pro rata distribution of cash to stockholders. For a corporation to pay a cash dividend, it must have (a) retained earnings, (b) adequate cash, and (c) declared dividends.

Three dates are important in connection with dividends: a. Declaration date—the date on which the board of directors formally declares a cash dividend and the liability is recorded. b. Record date—the date that marks the time when ownership of outstanding shares is determined from the stockholders’ records maintained by the corporation. c. Payment date—the date dividend checks are mailed to the stockholders and the payment of the dividend is recorded.

Preferred stockholders must be paid dividends before common stockholders receive dividends. a. When preferred stock is cumulative, any dividends in arrears must be paid to preferred stockholders before allocating any dividends to common stockholders. b. When preferred stock is not cumulative, only the current year’s dividend must be paid to preferred stockholders before paying any dividends to common stockholders.

Stock Dividend 5.

(L.O. 2) A stock dividend is a pro rata (proportional to ownership) distribution of the corporation’s own stock to stockholders. A stock dividend results in a decrease in retained earnings and an increase in paid-in capital. At a minimum, the par or stated value must be assigned to the dividend shares; in most cases, however, fair value is used.

When the fair value of the stock is used, the following entry is made at the declaration date: Stock Dividends .................................................................................... Common Stock Dividends Distributable ....................................... Paid-in Capital in Excess of Par—Common Stock ........................ a. b.

XXX XXX XXX

Common Stock Dividends Distributable is reported in paid-in capital as an addition to common stock issued. Common Stock Dividends Distributable is debited and Common Stock is credited when the dividend shares are issued.

Stock dividends change the composition of stockholders’ equity because a portion of retained earnings is transferred to paid-in capital. However, total stockholders’ equity and the par or stated value per share remain the same.

Stock Split 8.

A stock split involves the issuance of additional shares of stock to stockholders according to their percentage ownership. a. In a stock split, the number of shares is increased/decreased in the same proportion that par or stated value per share is decreased/increased.

13-2

b. c.

A stock split has no effect on total paid-in capital, retained earnings, or total stockholders’ equity. It is not necessary to formally journalize a stock split.

Retained Earnings 9.

Retained earnings is net income that is retained in the business. The balance in retained earnings is part of the stockholders’ claim on the total assets of the corporation. a. A net loss is recorded in Retained Earnings by a closing entry in which Retained Earnings is debited and Income Summary is credited. b. A debit balance in Retained Earnings is identified as a deficit and is reported as a deduction in the stockholders’ equity section.

10.

In some cases there may be retained earnings restrictions that make a portion of the balance currently unavailable for dividends. Restrictions result from one or more of the following causes: legal, contractual or voluntary. Retained earnings restrictions are generally disclosed in the notes to the financial statements.

11.

A prior period adjustment is the correction of a material error in reporting net income in previously issued financial statements. The correction is: a. made directly to Retained Earnings. b. reported in the current year’s retained earnings statement as an adjustment of the beginning balance of Retained Earnings.

12.

Many corporations prepare a retained earnings statement to explain the changes in retained earnings during the year.

Stockholders’ Equity Statement 13.

(L.O. 3) Instead of presenting a detailed stockholders’ equity section in the balance sheet and a retained earnings statement, many companies prepare a stockholders’ equity statement.

Form of Income Statement 14.

(L.O. 4) The income statement for a corporation includes essentially the same sections as in a proprietorship or a partnership. The major difference is a section for income taxes.

Earnings Per Share 15.

Earnings per share (EPS) indicates the net income earned by each share of outstanding common stock. a. The formula for computing earnings per share is: Net Income Available to Common b. c.

Weighted-Average Common Shares Outstanding

Earnings per Share

Most companies are required to report earnings per share on the income statement. When there has been a change in the number of shares outstanding during the year, the denominator in the formula becomes the weighted-average shares outstanding.

16.

When a corporation has both preferred and common stock outstanding, dividends declared on preferred stock are subtracted from net income in determining earnings per share. If the preferred stock is cumulative, the dividend for the current year is deducted whether or not it is declared.

13-3

LECTURE OUTLINE A.

Dividends. 1. A dividend is a corporation’s distribution of cash or stock to its stockholders on a pro rata (proportional) basis. 2. Dividends can take four forms:

Cash.

Property.

Scrip (a promissory note to pay cash).

Stock.

Cash Dividends. 1. A cash dividend is a pro rata distribution of cash to stockholders. 2. For a corporation to pay a cash dividend, it must have the following:

13-4

Retained earnings.

Adequate cash.

Declared dividends.

3. Three dates are important in connection with dividends: a.

The declaration date: the date the board of directors formally declares (authorizes) the cash dividend and announces it to stockholders. The company makes an entry to recognize the increase in Cash Dividends and the increase in the liability Dividends Payable.

The record date: the date when the company determines ownership of the outstanding shares for dividend purposes. The records maintained by the corporation supply this information.

The payment date: the date the company mails the dividend checks to the stockholders and records the payment of the dividend.

4. Preferred stock has priority over common stock in regard to dividends. Owners of cumulative preferred stock must be paid any unpaid prioryear dividends and their current year’s dividend before common stockholders receive dividends. ACCOUNTING ACROSS THE ORGANIZATION The decision whether to pay a dividend, and how much to pay, is a very important management decision. From 2002–2007, many companies substantially increased their dividends, and total dividends paid by U.S. companies hit record levels. What factors must management consider in deciding how large a dividend to pay? Answer: Management must consider the size of its retained earnings balance, the amount of available cash, its expected near-term cash needs, its growth opportunities, and what level of dividend it will be able to sustain based upon its expected future earnings.

13-5

Stock Dividends. 1. A stock dividend is a pro rata (proportional to ownership) distribution of the corporation’s own stock to stockholders. 2. A stock dividend results in a decrease in retained earnings and an increase in paid-in capital. Unlike a cash dividend, a stock dividend does not decrease total stockholders’ equity or total assets. 3. If a company issues a small stock dividend (less than 20–25% of the corporation’s issued stock), the value assigned to the dividend is the fair value per share. If a company issues a large stock dividend (greater than 20–25%) the value assigned to the dividend is the par or stated value. 4. Stock dividends have no effect on the par or stated value per share, but the number of shares outstanding increases.

Stock Splits. 1. A stock split, like a stock dividend, involves issuance of additional shares to stockholders according to their ownership percentage. 2. A stock split results in a reduction in the par or stated value per share. 3. The purpose of a stock split is to increase the marketability of the stock by lowering its market price per share. 4. It is not necessary to journalize a stock split since it does not affect the balances in any stockholders’ equity accounts.

13-6

Retained Earnings. 1. Retained earnings is net income that a company retains for use in the business and is part of the stockholders’ claim on the total assets of the corporation. 2. When a company has a net loss, it closes this amount to Retained Earnings. 3. A debit balance in Retained Earnings is identified as a deficit and is reported as a deduction in the stockholders’ equity section.

Retained Earnings Restrictions. 1. Retained earnings restrictions make a portion of the retained earnings balance currently unavailable for dividends. 2. Restrictions result from one or more of the following causes: a.

Legal restrictions. Many states require a corporation to restrict retained earnings for the cost of treasury stock purchased.

Contractual restrictions. Long-term debt contracts may restrict retained earnings as a condition for a loan.

Voluntary restrictions. The board of directors may voluntarily create retained earnings restrictions for specific purposes (i.e. future plant expansion).

3. Companies generally disclose retained earnings restrictions in the notes to the financial statements. G.

Prior Period Adjustments. 1. A prior period adjustment is the correction of an error in previously issued financial statements. 2. Companies report prior period adjustments in the current year’s retained earnings statement. They add (or deduct) these adjustments from the beginning retained earnings balance, resulting in the adjusted beginning balance.

13-7

Retained Earnings Statement. 1. The retained earnings statement shows the changes in retained earnings during the year. The company prepares the statement from the retained earnings account. 2. Prior period adjustments may either increase or decrease retained earnings, while both cash dividends and stock dividends decrease retained earnings.

Statement Presentation and Analysis. 1. A comprehensive stockholders’ equity section includes all stockholders’ equity accounts. It consists of two sections: paid-in capital and retained earnings. Instead of presenting a detailed stockholders’ equity section in the balance sheet and a retained earnings statement, many companies prepare a stockholders’ equity statement. This statement shows the changes in each stockholders’ equity account and in total that have occurred during the year. 2. The return on common stockholders’ equity measures profitability and shows how many dollars of net income the company earned for each dollar invested by the stockholders. It is computed by dividing net income minus preferred stock dividends by average common stockholders’ equity.

Corporation Income Statement. 1. Income statements for corporations are the same as the statements for proprietorships or partnerships except for the reporting of income taxes. Corporations report income tax expense in a separate section of the corporation income statement, before net income. 2. Companies record income tax expense and the related liability for income taxes payable as part of the adjusting process.

Earnings Per Share. 1. A convenient measure of earnings is earnings per share (EPS), which indicates the net income earned by each share of outstanding common stock.

13-8

2. The formula for computing earnings per share is net income available to common divided by the weighted-average of common shares outstanding during the period.

Preferred stock dividends.

When a corporation has both preferred and common stock, the company must subtract the current year’s preferred dividend from net income, to arrive at income available to common stockholders.

If the preferred stock is cumulative, the company deducts the dividend for the current year whether or not it is declared.

13-9

20 MINUTE QUIZ Circle the correct answer. True/False 1.

The cumulative effect of the declaration and payment of a cash dividend is to decrease both stockholders’ equity and total assets. True

A stock split does not have any effect on total paid-in capital, retained earnings, or total stockholders’ equity. True

False

Three important dates when cash dividends are involved are: date of declaration, date of record, and date of payment. True

False

The accounting effects of a restriction on retained earnings is limited entirely to the retained earnings section of stockholders’ equity. True

10.

False

A restriction on retained earnings is described as a cash fund established for a specific future purpose. True

False

A prior period adjustment always includes a credit to Retained Earnings. True

False

The return on common stockholders’ equity shows how many dollars of net income were earned for each dollar invested by stockholders. True

False

Income tax expense is reported in a separate section of the corporation income statement before net income. True

False

Earnings per share is reported for both common and preferred stock. True

False

A stock dividend results in a decrease in retained earnings and a decrease in total stockholders’ equity. True

False

13-10

False

Multiple Choice

A company had outstanding 80,000 shares of $10 par value common stock. During the period a 10% stock dividend was declared and distributed. The market price was $25 a share. As a result of this stock dividend, retained earnings should increase (decrease) by an amount of a. $(120,000). b. $( 80,000). c. $(200,000). d. $80,000.

For a corporation to pay a cash dividend, it must have all of the following except a. retained earnings. b. net income. c. adequate cash. d. a declaration of dividends.

Which one of the following decreases total stockholders’ equity? a. Stock splits. b. Small stock dividends. c. Large stock dividends. d. Cash dividends.

A prior period adjustment a. may be recorded for a computational error of a prior period that was discovered this period. b. is disclosed in the balance sheet. c. may be recorded for an additional tax assessment for a prior year. d. may be recorded for a lawsuit that was initiated two years ago but was settled this year.

The return on common stockholders’ equity is computed by dividing a. net income by ending common stockholders’ equity. b. net income by average common stockholders’ equity. c. net income less preferred dividends by ending common stockholders’ equity. d. net income less preferred dividends by average common stockholders’ equity.

13-11

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True True False False True

Multiple Choice 1. 2. 3. 4. 5.

c. b. d. a. d.

13-12

6. 7. 8. 9. 10.

True False False True True

CHAPTER 15 LONG-TERM LIABILITIES Learning Objectives 1. DESCRIBE BONDS.

THE

2. EXPLAIN HOW TRANSACTIONS.

MAJOR TO

CHARACTERISTICS

ACCOUNT

FOR

BOND

3. EXPLAIN HOW TO ACCOUNT FOR LONG-TERM NOTES PAYABLE. 4. DISCUSS HOW LONG-TERM REPORTED AND ANALYZED.

LIABILITIES

ARE

*5. APPLY THE STRAIGHT-LINE METHOD OF AMORTIZING BOND DISCOUNT AND BOND PREMIUM. *6. APPLY THE EFFECTIVE-INTEREST METHOD OF AMORTIZING BOND DISCOUNT AND BOND PREMIUM.COMPUTE THE MARKET PRICE OF A BOND.

15-1

CHAPTER REVIEW Bonds 1.

(L.O. 1) Long-term liabilities are obligations that are expected to be paid after one year. Long-term liabilities include bonds, long-term notes, and lease obligations.

Bonds offer the following advantages over common stock: a. Stockholder control is not affected. b. Tax savings result. c. Return on common stockholders’ equity of common stock may be higher.

The major disadvantages resulting from the use of bonds are that interest must be paid on a periodic basis, and the principal (face value) of the bonds must be paid at maturity.

Types of Bonds 4.

Secured bonds have specific assets of the issuer pledged as collateral for the bonds. A mortgage bond is secured by real estate. Unsecured bonds are issued against the general credit of the borrower; they are also called debenture bonds.

Bonds that mature at a single specified future date are called term bonds. In contrast, bonds that mature in installments are called serial bonds.

Registered bonds are issued in the name of the owner and have interest payments made by check to bondholders of record. Bearer or coupon bonds are not registered; thus bondholders must send in coupons to receive interest payments.

Convertible bonds permit bondholders to convert the bonds into common stock at their option. Callable bonds are subject to call and redemption at a stated dollar amount prior to maturity at the option of the issuer.

State laws grant corporations the power to issue bonds. a. Within the corporation, formal approval by both the board of directors and stockholders is usually required before bonds can be issued. b. In authorizing a bond issue, the board of directors must stipulate the total number of bonds to be authorized, total face value, and the contractual interest rate. c. The terms of the bond issue are set forth in a formal legal document called a bond indenture.

Market Price of Bonds 9.

The market price (present value) of a bond is a function of three factors: (a) the dollar amounts to be received, (b) the length of time until the amounts are received, and (c) the market rate of interest. The process of finding the present value is referred to as discounting the future amounts.

Bond Issues 10.

(L.O. 2) The issuance of bonds at face value results in a debit to Cash and a credit to Bonds Payable. a. Over the term of the bonds, entries are required for bond interest. b. At the maturity date, it is necessary to record the final payment of interest and payment of the face value of the bonds.

11.

Bonds may be issued below or above face value.

15-2

a. b.

If the market (effective) rate of interest is higher than the contractual (stated) rate, the bonds will sell at less than face value, or at a discount. If the market rate of interest is less than the contractual rate on the bonds, the bonds will sell above face value, or at a premium.

Bond Issues at a Discount 12.

When bonds are issued at a discount, a. The discount is debited to a contra account, Discount on Bonds Payable, and it is deducted from Bonds Payable in the balance sheet to show the carrying (or book) value of the bonds. b. Bond discount is an additional cost of borrowing that should be recorded as interest expense over the life of the bonds.

Bond Issues at a Premium 13.

When bonds are issued at a premium, a. The premium is credited to the account, Premium on Bonds Payable, and it is added to Bonds Payable in the balance sheet to show the carrying (or book) value of the bonds.. b. Bond premium is a reduction in the cost of borrowing that should be credited to Interest Expense over the life of the bonds.

Bond Redemptions 14.

When bonds are redeemed before maturity it is necessary to (a) eliminate the carrying value of the bonds at the redemption date, (b) record the cash paid, and (c) recognize the gain or loss on redemption.

15.

In recording the conversion of bonds into common stock the current market prices of the bonds and the stock are ignored. Instead, the carrying value of the bonds is transferred to paid-in capital accounts and no gain or loss is recognized.

Long-term Notes Payable 16.

(L.O. 3) A long-term note payable may be secured by a document called a mortgage that pledges title to specific assets as security for a loan. a. Typically, the terms require the borrower to make installment payments consisting of (1) interest on the unpaid balance of the loan and (2) a reduction of loan principal. b. Mortgage notes payable are recorded initially at face value; each installment payment results in a debit to Interest Expense, a debit to Mortgage Payable, and a credit to Cash.

Leases 17.

A lease is a contractual agreement between a lessor (owner) and a lessee (renter) that grants the right to use specific property for a period of time in return for cash payments.

Operating Leases 18.

In an operating lease the intent is temporary use of the property by the lessee with continued ownership of the property by the lessor. The lease (or rental) payments are recorded as an expense by the lessee and as revenue by the lessor.

15-3

Capital Leases 19.

A capital lease transfers substantially all the benefits and risks of ownership from the lessor to the lessee. a. The lessee is required to record an asset and the related liability at the present value of the future lease payments. b. The leased asset is reported on the balance sheet under plant assets. c. The portion of the lease liability to be paid in the next year is a current liability, and the remainder is classified as a long-term liability.

20. Criteria for a capital lease are as follows – only one needs to be met a. The lease transfers ownership of the property to the lessee b. The lease contains a bargain purchase option. c. The lease term is equal to 75% or more of the economic life of the leased asset d. The present value of the lease payments equals or exceeds 90% of the fair value of the leased asset. Presentation and Analysis 21. (L.O. 4) Long-term liabilities are reported in a separate section of the balance sheet immediately following current liabilities. 22. The debt to assets ratio measures the percentage of the total assets provided by creditors. It is computed by dividing debt (both current and long-term liabilities) by assets. 23. Times interest earned provides an indication of the company’s ability to meet interest payments as they become due. It is computed by dividing income before interest expense and income taxes by interest expense. Present Value Concepts *24. The present value is based on three variables: (1) the dollar amount to be received (future amount), (2) the length of time until the amount is received (number of periods), and (3) the interest rate (the discount rate). PV = FV  (1 + i) PV = present value FV = future value i = interest rate *25. The present value of 1 may also be determined through tables that show the present value of 1 for n periods. Present Value of an Annuity *26. In computing the present value of an annuity, it is necessary to know (1) the discount rate, (2) the number of interest periods, and (3) the amount of the periodic receipts or payments. When the future receipts are the same in each period, there are two other ways to compute the present value. First, the annual cash flow can be multiplied by the sum of the three present value factors. Second, annuity tables may be used.

15-4

Time Periods and Discounting *27. Present value computations may also be done over shorter periods of time such as monthly, quarterly, or semiannually. When the time frame is less than one year, it is necessary, to convert the annual interest rate to the applicable time frame. Computing the Present Value of a Bond 28.

The current market price present value of a bond is a function of three variables: (1) the payment amounts, (2) the length of time until the amounts are paid, and (3) the interest (discount) rate. When the investor’s interest (discount) rate is equal to the bond’s contractual interest rate, the present value of the bonds will equal the face value of the bonds.

Straight-Line Method *29. (L.O. 5) The straight-line method of amortization allocates the same amount of bond discount each interest period. The formula is: Bond Discount ÷ Number of Interest Periods = Bond Discount Amortization Bond discount amortization is recorded by debiting Interest Expense and crediting Discount on Bonds Payable. 30.

The straight-line method of amortization allocates the same amount of bond premium each interest period. The formula is: Bond Premium ÷ Number of Interest Periods = Bond Premium Amortization Bond premium amortization is recorded by debiting Premium on Bonds Payable and crediting Interest Expense.

Effective-Interest Method *31. (L.O. 6) The effective-interest method of amortization is an alternative to the straight-line method. Under this method, a. Interest Expense is computed first by multiplying the carrying value of the bonds at the beginning of the period by the effective interest rate. b. The credit to Cash (or Interest Payable) is computed by multiplying the face value of the bonds by the contractual interest rate. c. The bond discount or premium amortization amount is then determined by comparing bond interest expense with the interest paid or accrued. 32.

The effective-interest method produces a periodic interest expense equal to a constant percentage of the carrying value of the bonds. When the amounts of bond interest expense are materially different under the two methods, the effective-interest method is required under generally accepted accounting principles.

15-5

LECTURE OUTLINE A.

Why Issue Bonds? 1. Bonds are sold in relatively small denominations (usually $1,000), and as a result, they attract many investors. 2. From the standpoint of the corporation seeking long-term financing, bonds offer the following advantages over common stock: a.

Stockholder control is not affected.

Tax savings result.

Return on common stockholder's equity may be higher.

3. One disadvantage in using bonds is that the company must pay interest on a periodic basis. Also, the company must repay the principal at the due date. B.

Types of Bonds. 1. Bonds may be classified by certain features. Some types of bonds commonly issued include:

15-6

Secured bonds have specific assets of the issuer pledged as collateral for the bonds. Unsecured bonds are issued against the general credit of the borrower.

Bonds that mature—are due for payment—at a single specified future date are term bonds. Bonds that mature in installments are serial bonds.

Bonds issued in the name of the owner are registered bonds. Bonds not registered are bearer (coupon) bonds.

Bonds that can be converted into common stock at the bondholder’s option are convertible bonds. Bonds that the issuing company can redeem (buy back) at a stated dollar amount prior to maturity are callable bonds.

2. Issuing procedures. a.

In authorizing the bond issue, the board of directors must stipulate the number of bonds to be authorized, total face value, and contractual interest rate.

The terms of the bond issue are set forth in a legal document called a bond indenture. The indenture shows the terms and summarizes the rights of the bondholders and their trustees, and the obligations of the issuing company.

3. Determining the market price of a bond. a.

Present value is the amount that must be invested today at a given interest rate to have a specified sum of money at a specified date.

The current market price (present value) of a bond is the value at which it should sell in the marketplace. Market price is a function of the three factors that determine present value: (1) The dollar amounts to be received. (2) The length of time until the amounts are received. (3) The market rate of interest.

Issuing Bonds at Face Value. 1. When bonds are issued, Cash is debited for the cash proceeds and Bonds Payable is credited for the face value of the bonds. 2. The entry for payment of interest includes a debit to Interest Expense and a credit to Cash.

15-7

3. The entry to accrue bond interest includes a debit to Interest Expense and a credit to Interest Payable. D.

Issuing Bonds at a Discount or Premium. 1. If the market interest rate is higher than the contractual (stated) rate, the bonds will sell at a discount (less than face value). 2. If the market interest rate is lower than the contractual (stated) rate on the bonds, the bonds will sell at a premium (more than face value). 3. The entry to record bonds issued at a discount includes a debit to Cash for the cash proceeds, a credit to Bonds Payable for the face value of the bonds, and a debit to Discount on Bonds Payable for the difference. a.

Discount on Bonds Payable is a contra liability account which is deducted from Bonds Payable on the balance sheet.

The discount is an additional cost of borrowing and the company records this additional cost as interest expense over the life of the bonds.

4. The entry to record bonds issued at a premium includes a debit to Cash for the cash proceeds, a credit to Bonds Payable for the face value of the bonds, and a credit to Premium on Bonds Payable for the difference.

Companies add the premium on bonds payable to the bonds payable amount on the balance sheet.

The bond premium is considered to be a reduction in the cost of borrowing and companies credit the premium to Interest Expense over the life of the bonds.

Redeeming Bonds Before Maturity. 1. Bonds may be redeemed before maturity because a company may decide to reduce interest cost and to remove debt from its balance sheet.

15-8

2. When a company redeems bonds before maturity, it is necessary to:

Eliminate the carrying value of the bonds at the redemption date.

Record the cash paid.

Recognize the gain or loss on redemption.

Converting Bonds into Common Stock. 1. Convertible bonds give bondholders an opportunity to benefit if the market price of the common stock increases substantially. For the issuer of convertible bonds, the bonds sell at a higher price and pay a lower rate of interest than nonconvertible bonds. 2. When the issuing company records a conversion, the company ignores the current market prices of the bonds and stock. The company transfers the carrying value of the bonds to paid-in capital accounts and no gain or loss is recognized.

Long-Term Notes Payable. 1. Long-term notes payable are similar to short-term interest-bearing notes payable except that the term of the notes exceeds one year. 2. A long-term note may be secured by a mortgage that pledges title to specific assets as security for a loan.

Lease Liabilities. 1. In an operating lease, the intent is temporary use of the property by the lessee while the lessor continues to own the property. 2. In an operating lease, the lessee records the lease (rental) payments as an expense. The lessor records the payments as revenue.

15-9

3. In a capital lease the company capitalizes the present value of the cash payments for the lease and records that amount as an asset. A capital lease is in substance an installment purchase by the lessee. 4. If any one of the following conditions exists, the lessee must record a lease as an asset (a capital lease):

The lease transfers ownership of the property to the lessee.

The lease contains a bargain purchase option.

The lease term is equal to 75% or more of the economic life of the leased property.

The present value of the lease payments equals or exceeds 90% of the fair value of the leased property.

Statement Presentation and Analysis. 1. Companies should report the nature and amount of each long-term debt in the balance sheet or in the notes accompanying the financial statements. 2. Companies may present summary data in the balance sheet, with detailed data (interest rates, maturity dates, conversion privileges, and assets pledged as collateral) shown in a supporting schedule. 3. Companies report the current maturities of long-term debt under current liabilities if they are to be paid within one year or the operating cycle, whichever is longer. 4. The long-run solvency of a company may be analyzed by computing the debt to assets ratio and the times interest earned.

15-10 .

The debt to assets ratio measures the percentage of the total assets provided by creditors. It is computed by dividing debt (both current and long-term liabilities) by assets.

Times interest earned indicates the company’s ability to meet interest payments as they come due. It is computed by dividing income before income taxes and interest expense by interest expense.

INVESTOR INSIGHT In many corporate loans the lending agreement specifies debt convenants— specific financial measures that a company must maintain during the life of the loan. Covenants protect lenders because they enable lenders to step in and try to get their money back before the borrower gets too deep into trouble. How can financial ratios such as those covered in this chapter provide protection for creditors? Answer: Financial ratios such as the current ratio, debt to total assets ratio, and the times interest earned ratio provide indications of a company’s liquidity and solvency. By specifying minimum levels of liquidity and solvency, as measured by these ratios, a creditor creates triggers that enable it to step in before a company’s financial situation becomes too dire. *J. Present Value a Single Amount. 1. The present value of the future amount is the value today of a future amount to be received (or paid), assuming compound interest. 2. The present value of the future amount can be computed using the following formula: PV = FV ÷ (1 + i)n FV = future amount; i = interest rate; n = number of periods. 3. Another way to compute the present value of a single future amount is to use Table 1, which shows the present value of 1 for n periods. 4. Using Table 1, the present value of a single future amount is computed by multiplying the future amount by the appropriate present value of 1 factor. *K.

Present Value of Interest Payments (Annuities). 1. The present value of an annuity is the value today of a series of future amounts to be received (or paid), assuming compound interest.

. 15-11

2. In order to compute the present value of an annuity, one needs to know the: a.

interest rate.

number of interest periods.

amount of the periodic receipts of payments.

3. The present value of an annuity can be computed by using Table 2, which shows the present value of 1 to be received periodically for a given number of periods. *L. Computing the Present Value of a Bond. 1. The present value (or market price) of a bond is a function of the: a.

payment amounts.

length of time until the amounts are paid.

interest (discount) rate.

2. The payment amounts (dollars to be paid) are made up of two elements: a.

a series of interest payments (an annuity).

the principal amount (a single sum).

3. To compute the present value of the bond, one must discount both the interest payments and the principal amount.

15-12 .

Multiply the principal amount by the appropriate present value factor from Table 1.

Multiply the amount of the interest payments by the appropriate present value factor from Table 2.

Add the present value of the principal amount to the present value of the interest payments to determine the present value of the bond.

*M.

Straight-Line Amortization. 1. The straight-line method of amortization results in a constant amount of amortization and interest expense per period. 2. Bond interest expense is computed by adding (subtracting) the bond discount (premium) amortization per period to (from) the interest to be paid. 3. The bond discount or premium amortization each period is computed by dividing the total bond discount (premium) by the number of interest periods. 4. Over the term of the bonds, the balance in Discount (Premium) on Bonds Payable will decrease annually by the same amount until it has a zero balance at the bonds’ maturity date.

*N.

Effective-Interest Method of Bond Amortization. 1. Under the effective-interest method of amortization, the amortization of bond discount or bond premium results in periodic interest expense equal to a constant percentage of the bonds’ carrying value. 2. The effective-interest method results in varying amounts of amortization and interest expense per period. Companies compute: a.

bond interest expense by multiplying the carrying value of the bonds at the beginning of the interest period by the effective-interest rate.

the bond discount or premium amortization by determining the difference between the bond interest expense and the bond interest paid.

3. When the difference between the straight-line method and the effectiveinterest method of amortization is material, GAAP requires the use of the effective-interest method.

. 15-13

IFRS A Look at IFRS IFRS and GAAP have similar definitions of liabilities. IFRSs related to reporting and recognition of liabilities are found in IAS I (revised) (“Presentation of Financial Statements”) and IAS 37 (“Provisions, Contingent Liabilities, and Contingent Assets”).

KEY POINTS • As indicated in Chapter 11, in general GAAP and IFRS define liabilities similarly. • IFRS requires that companies classify liabilities as current or noncurrent on the face of the statement of financial position (balance sheet), except in industries where a presentation based on liquidity would be considered to provide more useful information (such as financial institutions). When current liabilities (also called short-term liabilities) are presented, they are generally presented in order of liquidity. • Under IFRS, liabilities are classified as current if they are expected to be paid within 12 months. • Similar to GAAP, items are normally reported in order of liquidity. Companies sometimes show liabilities before assets. Also, they will sometimes show noncurrent (long-term) liabilities before current liabilities. • Under both GAAP and IFRS, preferred stock that is required to be redeemed at a specific point in time in the future must be reported as debt, rather than being presented as either equity or in a “mezzanine” area between debt and equity. • The basic calculation for bond valuation is the same under GAAP and IFRS. In addition, the accounting for bond liability transactions is essentially the same between GAAP and IFRS. • IFRS requires use of the effective-interest method for amortization of bond discounts and premiums. GAAP also requires the effective-interest method, except that it allows use of the straight-line method where the difference is

15-14 .

not material. Under IFRS, companies do not use a premium or discount account but instead show the bond at its net amount. • The accounting for convertible bonds differs between IFRS and GAAP. Unlike GAAP, IFRS splits the proceeds from the convertible bond between an equity component and a debt component. The equity conversion rights are reported in equity. • The IFRS leasing standard is IAS 17. Both Boards share the same objective of recording leases by lessees and lessors according to their economic substance—that is, according to the definitions of assets and liabilities. However, GAAP for leases is much more “rules-based” with specific bright-line criteria (such as the “90% of fair value” test) to determine if a lease arrangement transfers the risks and rewards of ownership; IFRS is more conceptual in its provisions. Rather than a 90% cut-off, it asks whether the agreement transfers substantially all of the risks and rewards associated with ownership.

LOOKING TO THE FUTURE The FASB and IASB are currently involved in two projects, each of which has implications for the accounting for liabilities. One project is investigating approaches to differentiate between debt and equity instruments. The other project, the elements phase of the conceptual framework project, will evaluate the definitions of the fundamental building blocks of accounting. The results of these projects could change the classification of many debt and equity securities. In addition to these projects, the FASB and IASB have also identified leasing as one of the most problematic areas of accounting. A joint project is now focused on lessee accounting. One of the first areas studied is, “What are the assets and liabilities to be recognized related to a lease contract?” Should the focus remain on the leased item or the right to use the leased item? This question is tied to the Boards’ joint project on the conceptual framework—defining an “asset” and a “liability.”

. 15-15

20 MINUTE QUIZ Circle the correct answer. True/False 1.

A bond that matures at a single specified future date is called a secured bond. True

Transactions between a bondholder and other investors are journalized by the issuing corporation. True

False

Under the straight-line method of amortization, the amortization of a bond premium will increase each year over the life of the bond. True

*10.

False

Under a capital lease, Rent Expense should be recorded each period. True

*9.

False

The sale of bonds above face value causes the total cost of borrowing to be more than the bond interest paid. True

False

Bonds with a higher contractual interest rate than the market rate for similar bonds will sell at a discount. True

False

When bonds are issued at face value, the debit to Cash is equal to the credit to Bonds Payable. True

False

The amount that must be invested today at current interest rates in order to receive a specified sum of money at a specified date is the present value. True

False

Bondholders have voting rights and retain full control of the company. True

False

Under the effective-interest method, the amortization of a bond discount will result in an increasing interest expense each year over the life of the bond. True

15-16 .

False

Multiple Choice 1.

The total cost of borrowing on a 10-year, 9%, $1,000 bond that is sold for $960 is a. $960. b. $940. c. $860. d. $870.

A $2,000,000 bond issue with a carrying value of $2,080,000 is called at 103 and retired. Which of the following is true? a. A gain of $80,000 is recorded. b. A loss of $20,000 is recorded. c. A gain of $20,000 is recorded. d. No gain or loss is recorded.

If bonds payable are issued at a discount, the contractual interest rate is a. higher than the market rate of interest. b. lower than the market rate of interest. c. equal to the market rate of interest. d. changed to reflect the market rate of interest.

*4.

Caldwell Company issued 8%, 10-year bonds that pay interest semiannually. The market rate of interest for such bonds is 10%. In computing the market price of these bonds, the appropriate interest rate is a. 10%. b. 8%. c. 5%. d. 4%.

*5.

When the effective-interest method is used, the interest expense for the period is calculated by multiplying the a. face value of the bonds at the beginning of the period by the contractual interest rate. b. carrying value of the bonds at the beginning of the period by the contractual interest rate. c. face value of the bonds at the beginning of the period by the effective rate. d. carrying value of the bonds at the beginning of the period by the effective rate.

. 15-17

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

False False False True True

Multiple Choice 1. 2. 3. *4. *5.

15-18 .

b. c. b. c. d.

6. 7. 8. *9. *10.

False False False False True

CHAPTER 16 INVESTMENTS Learning Objectives 1. EXPLAIN HOW INVESTMENTS.

ACCOUNT

FOR

DEBT

2. EXPLAIN HOW INVESTMENTS.

ACCOUNT

FOR

STOCK

3. DISCUSS HOW DEBT AND STOCK INVESTMENTS ARE REPORTED IN FINANCIAL STATEMENTS.

16-1

CHAPTER REVIEW Why Corporations Invest 1.

Corporations purchase investments because (1) they may have excess cash, (2) they generate earnings from investment income, and (3) for strategic reasons.

Accounting for Debt Investments 2.

(L.O. 1) Debt investments are investments in government and corporation bonds. At acquisition, debt investments are recorded at cost and all expenditures necessary to acquire these investments are included in the cost (e.g., brokerage fees). At acquisition, Debt Investments is debited and Cash is credited for the cost of the investment.

Interest revenue must also be recorded on debt investments. Assume Bodhi Company (fiscal year ends December 31) receives $2,000 interest every six months on a debt investment purchased April 1, 2014. The following entries are required: Oct.

Dec. 31 Apr.

Cash ......................................................................... Interest Revenue ...............................................

2,000

Interest Receivable ................................................... Interest Revenue ...............................................

1,000

Cash ......................................................................... Interest Receivable ............................................ Interest Revenue ...............................................

2,000

2,000 1,000 1,000 1,000

When bonds are sold, it is necessary to credit the Investment account for the cost of the bonds, debit Cash, and any difference between the sale price and cost of bonds is recorded as a gain or loss. The gain or loss on the sale of debt investments is reported under Other revenues and gains or Other expenses and losses, respectively, in the income statement.

Accounting for Stock Investments 5.

(L.O. 2) Stock investments are investments in the capital stock of corporations. The accounting for stock investments differs depending on the degree of influence the investor has over the issuing corporation. The presumed influences based on the investor’s ownership interest and the accounting guidelines that are to be used are as follows: Investor’s Ownership Interest in Investee’s Common Stock Less than 20%

Presumed Influence on Investee Insignificant

Between 20% and 50%

Significant

Equity Method

More than 50%

Controlling

Consolidated financial statements

Accounting Guidelines Cost Method

Holdings Less than 20% 6.

In accounting for stock investments of less than 20%, the cost method is used. Under the cost method, the investment is recorded at cost and revenue is recognized only when cash dividends are received.

16-2

a. b. c.

At acquisition, stock investments are recorded at cost. Stock Investments is debited and Cash is credited. When dividends are received, Cash is debited and Dividend Revenue is credited. When stock is sold, Cash is debited, Stock Investments is credited, and any difference between the two is debited or credited to Loss or Gain on Sale of Stock Investments, respectively. The loss or gain is reported under Other Expenses and Losses or Other Revenues and Gains in the income statement.

Holdings Between 20% and 50% 7.

When an investor owns between 20% and 50% of the common stock of a corporation, it is generally presumed that the investor has a significant influence over the financial and operating activities of the investee; and therefore the equity method is used. Under the equity method, the investor does not record its share of the investee income until the investee has earned income. a. At acquisition, the investor records the investment at cost. Stock Investments is debited and Cash is credited. b. Each year, the investor records its share of the investee’s income (investee’s income X % of ownership in investee) with a debit to Stock Investments and a credit to Revenue from Stock Investments (if the investee incurred a loss, then the opposite entry is made). c. Upon receiving dividends from the investee, the investor makes a debit to Cash and a credit to Stock Investments.

Holdings of More Than 50% 8.

(L.O. 4) A company that owns more than 50% of the common stock of another entity is known as the parent company. The entity whose stock is owned by the parent company is called the Subsidiary (affiliated) company. Because of its stock ownership, the parent company has a controlling interest in the subsidiary company.

When a company owns more than 50% of the common stock of another company, consolidated financial statements are usually prepared. Consolidated financial statements present the assets and liabilities controlled by the parent company and the aggregate profitability of the subsidiary companies.

Valuation and Reporting of Investments 10.

(L.O. 3) For purposes of valuation and reporting at a financial statement date, debt and stock investments are classified into the following three categories. a. Trading securities are securities bought and held primarily for sale in the near term to generate income on short-term price differences. b. Available-for-sale securities are securities the company may sell sometime in the future. c. Held-to-maturity securities are debt securities that the investor has the intent and ability to hold to maturity.

11.

The valuation guidelines for the above securities are as follows: Trading At fair value with changes reported in net income

16-3

Available-for-sale At fair value with changes reported in the stockholders’ equity section

Held-to-maturity At amortized cost

Trading Securities 12.

When the trading securities are not sold, the difference between the total cost of the securities and their total fair value is reported as unrealized gains or losses in the income statement. The adjusting entry to record an unrealized gain would include a debit to Fair Value Adjustment— Trading and a credit to Unrealized Gain—Income. The adjusting entry to record an unrealized loss would include a debit to Unrealized Loss—Income and a credit to Fair Value Adjustment— Trading. The unrealized gains or losses are reported in the income statement under Other revenues and gains or Other expenses and losses, respectively.

Available-for-Sale 13.

If available-for-sale securities are held with the intent to sell them within the next year or operating cycle, the securities are classified as current assets in the balance sheet. Otherwise, they are classified as long-term assets in the investments section of the balance sheet.

14.

The available-for-sale securities adjusting entry is made in the same way as the trading securities adjusting entry except that the unrealized gain or loss is reported in the stockholders’ equity section of the balance sheet. This balance is then adjusted with the Fair Value Adjustment account to show the difference between the cost and fair value at that time.

15.

Short-term investments are securities held by a company that are (a) readily marketable and (b) intended to be converted into cash within the next year or operating cycle, whichever is longer. Investments that do not meet both criteria are classified as long-term investments.

16.

An investment is readily marketable when it can be sold easily whenever the need for cash arises. Intent to convert means that management intends to sell the investment within the next year or the operating cycle, whichever is longer.

Balance Sheet Presentation 17.

Short-term investments are listed immediately below cash in the current assets section of the balance sheet. Short-term investments are reported at fair value. Long-term investments are generally reported in a separate section of the balance sheet immediately below current assets; and available-for-sale securities are reported at fair value, and investments in common stock accounted for under the equity method are reported at equity.

18.

In the income statement, the following items are reported in the nonoperating activities section: Other Revenue and Gains Interest Revenue Dividend Revenue Gain on Sale of Investments Unrealized Gain—Income

Other Expenses and Losses Loss on Sale of Investments Unrealized Loss—Income

The unrealized gain or loss on available-for-sale securities is reported as a separate component of stockholders’ equity.

16-4

LECTURE OUTLINE A.

Why Corporations Invest. 1. Corporations purchase investments in debt or stock securities for several different reasons. 2. To house excess cash until needed. 3. To generate earnings from investments. 4. To meet strategic goals (i.e., gaining control of a competitor).

Accounting for Debt Investments. 1. Companies record investments in debt securities when they purchase bonds, receive or accrue interest, and sell the bonds. 2. At acquisition, debt investments are recorded at cost. Cost includes all expenditures necessary to acquire the investment, such as the price paid plus brokerage fees (commissions). 3. When a company sells debt investments, it records as a gain or loss any difference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the investment.

Accounting for Stock Investments. 1. The accounting for investments in common stock depends on the extent of the investor’s influence over the operating and financial affairs of the issuing corporation (the investee). The general guidelines for stock investments are: TEACHING TIP

Emphasize that evidence of the extent of investor influence is the determining factor in choosing the proper accounting method.

16-5

Investor’s Ownership Interest in Investee

Presumed Influence on Investee

Accounting Guidelines

Less than 20%

Insignificant

Cost method

Between 20 and 50%

Significant

Equity method

More than 50%

Controlling

Consolidated financial statements

2. Companies record common stock investments of less than 20% when they purchase the stock, receive dividends, and sell the stock. a.

Companies record the receipt of dividends with a debit to Cash and a credit to Dividend Revenue.

When a company sells a stock investment, it recognizes as a gain or a loss the difference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the investment.

3. When an investor owns between 20% and 50% of the common stock of a corporation, it is presumed that the investor has significant influence over the financial and operating activities of the investee, and the investment should be accounted for by the equity method. a.

Under the equity method, the investor company initially records the investment in common stock at cost, and it annually adjusts the investment account to show the investor’s equity in the investee.

Each year, the investor debits the investment account and credits revenue for its share of the investee’s net income.

The investor records dividends received with a debit to Cash and a credit to the investment account.

4. A company that owns more than 50% of the common stock of another entity is known as the parent company and has a controlling interest in the subsidiary (affiliated) company. When a company owns more than 50% of the common stock of another company, it usually prepares consolidated financial statements. 16-6

5. Consolidated financial statements present the total assets and liabilities controlled by the parent company. They also present the total revenues and expenses of the subsidiary companies. Consolidated statements are useful to the stockholders, board of directors, and management of the parent company because they indicate the magnitude and scope of operations of the companies under common control. ACCOUNTING ACROSS THE ORGANIZATION Recently, Procter & Gamble acquired Gillette Company for $53.4 billion. The common stockholders of Procter & Gamble are in a position to elect the board of directors of Gillette and, in effect, control its operations. Where on Procter & Gamble’s balance sheet will you find its investment in Gillette Company? Answer: Because Procter & Gamble owns 90% of Gillette, P&G does not report Gillette in the investment section of its balance sheet. Instead, Gillette’s assets and liabilities are included and commingled with the assets and liabilities of Procter & Gamble. D.

Valuing and Reporting Investments. 1. Companies classify all debt securities and stock investments in which the holdings are less than 20% into three categories for valuation and reporting purposes: (1) trading securities, (2) available-for-sale securities, and (3) held-to-maturity securities.

16-7

Trading securities are bought and held primarily for sale in the near term to generate income on short-term price differences.

Available-for-sale securities are held for purposes other than trading. Companies may sell these securities sometime in the future.

Held-to-maturity securities are debt securities that the investor has the intent and ability to hold to maturity.

2. Fair value is the amount for which a security could be sold in a normal market. 3. Companies report trading securities at fair value with the unrealized gains or losses reported as part of net income. Companies report the unrealized gain (or loss) in the Other revenues and gains (or Other expenses and losses) section in the income statement. ACCOUNTING ACROSS THE ORGANIZATION Many companies have equity investments of some type. For example, the total amount of equity-method investments appearing on company balance sheets is approximately $403 billion. Why might the use of the equity method not lead to full disclosure in the financial statements? Answer: Under the equity method, the investment in common stock of another company is initially recorded at cost. After that, the investment account is adjusted at each reporting date to show the investor’s equity in the investee. However, on the investor’s balance sheet, only the investment account is shown. The pro-rata share of the investee’s assets and liabilities are not reported. Because the pro-rata share of the investee’s assets and liabilities are not shown, some argue that the full disclosure principle is violated. 4. Companies report available-for-sale securities at fair value and the unrealized gains or losses as a separate component of stockholders’ equity. 5. Companies use a Fair Value Adjustment account to adjust the securities to their fair value. Companies add (deduct) the Fair Value Adjustment debit (credit) balance to (from) the cost of the investments to arrive at the securities’ fair value. E.

Short-Term and Long-Term Investments. 1. Short-term investments (marketable securities) are securities held by a company that are (1) readily marketable and (2) intended to be converted into cash within the next year or operating cycle, whichever is longer.

16-8

2. Investments that do not meet both criteria are classified as long-term investments.

An investment is readily marketable when it can be sold easily whenever the need for cash arises. Short-term paper (CDs, money market certificates, Treasury bills) meets this criterion as do stocks and bonds traded on organized securities exchanges (i.e., New York Stock Exchange).

Intent to convert means that management intends to sell the investment within the next year or operating cycle, whichever is longer.

Short-term investments appear immediately below Cash in the “Current assets” section of the balance sheet and are reported at fair value.

Companies generally report long-term investments in a separate section of the balance sheet immediately below “Current assets”.

Presentation of Realized and Unrealized Gain or Loss. 1. Companies must report in the income statement in the nonoperating activities section gains and losses on trading securities, whether realized or unrealized. 2. Companies report an unrealized gain or loss on available-for-sale securities as a separate component of stockholders’ equity.

16-9

IFRS A Look at IFRS Until recently, when the IASB issued IFRS 9, the accounting and reporting for investments under IFRS and GAAP were for the most part very similar. However, IFRS 9 introduces new investment classifications and increases the situations when investments are accounted for at fair value, with gains and losses recorded in income. KEY POINTS • The basic accounting entries to record the acquisition of debt securities, the receipt of interest, and the sale of debt securities are the same under IFRS and GAAP. • The basic accounting entries to record the acquisition of stock investments, the receipt of dividends, and the sale of stock securities are the same under IFRS and GAAP. • Both IFRS and GAAP use the same criteria to determine whether the equity method of accounting should be used—that is, significant influence with a general guide of over 20% ownership, IFRS uses the term associate investment rather than equity investment to describe its investment under the equity method. • Under IFRS, both the investor and an associate company should follow the same accounting policies. As a result, in order to prepare financial information, adjustments are made to the associate’s policies to conform to the investor’s books. GAAP does not have that requirement. • The basis for consolidation under IFRS is control. Under GAAP, a bipolar approach is used, which is a risk-and-reward model (often referred to as a variable-entity approach) and a voting-interest approach. However, under both systems, for consolidation to occur, the investor company must generally own 50% of another company.

16-10 .

• In general, IFRS requires that companies determine how to measure their financial assets based on two criteria: ♦ The company’s business model for managing their financial assets; and ♦ The contractual cash flow characteristics of the financial asset. If a company has (1) a business model whose objective is to hold assets in order to collect contractual cash flows and (2) the contractual terms of the financial asset gives specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding, then the company should use cost (often referred to as amortized cost). For example, assume that Mitsubishi purchases a bond investment that it intends to hold to maturity (heldfor-collection). Its business model for this type of investment is to collect interest and then principal at maturity. The payment dates for the interest rate and principal are stated on the bond. In this case, Mitsubishi accounts for the investment at cost. If, on the other hand, Mitsubishi purchased the bonds as part of a trading strategy to speculate on interest rate changes (a trading investment), then the debt investment is reported at fair value. As a result, only debt investments such as receivables, loans, and bond investments that meet the two criteria above are recorded at amortized cost. All other debt investments are recorded and reported at fair value. • Equity investments are generally recorded and reported at fair value under IFRS. Equity investments do not have a fixed interest or principal payment schedule and therefore cannot be accounted for at amortized cost. In general, equity investments are valued at fair value, with all gains and losses reported in income. • GAAP classifies investments as trading, available-for-sale (both debt and equity investments), and held-to-maturity (only for debt investments). IFRS uses heldfor-collection (debt investments), trading (both debt and equity investments), and non-trading equity investment classifications. GAAP classifications are based on management’s intent with respect to the investment. IFRS classifications are based on the business model used to manage the investments and the type of security. • The accounting for trading investments is the same between GAAP and IFRS. Held-to-maturity (GAAP) and held-for-collection (IFRS) investments are accounted for at amortized cost. Gains and losses related to available-for-sale

. 16-11

securities (GAAP) and non-trading equity investments (IFRS) are reported in other comprehensive income. • Unrealized gains and losses related to available-for-sale securities are reported in other comprehensive income under GAAP and IFRS. These gains and losses that accumulate are then reported in the balance sheet. • IFRS does not use “Other revenues and gains” or “Other expenses and losses” in its income statement presentation. It will generally classify these items as unusual items or financial items. LOOKING TO THE FUTURE As indicated earlier, both the FASB and IASB have indicated that they believe that all financial instruments should be reported at fair value and that changes in fair value should be reported as part of net income. It seems likely, as more companies choose the fair value option for financial instrument, that we will eventually arrive at fair value measurement for all financial instruments.

16-12 .

20 MINUTE QUIZ True/False 1. To be considered a short-term investment, the investment must be readily marketable and management should intend to convert the investment into cash within the next year or operating cycle, whichever is longer. True 2.

Accounting for short-term investments involves entries for the acquisition, interest and dividend revenue, and the sale. True

False

Companies report both realized and unrealized gains and losses on trading securities in the income statement. True

10.

False

Under the fair value method, companies report the unrealized gain in the income statement for available-for-sale securities. True

False

The Fair Value Adjustment balance could be added to the cost of the investments to arrive at their fair value. True

False

Consolidated financial statements are useful to parent company stockholders and managers because they indicate the magnitude and scope of operations of the companies under common control. True

False

A parent/subsidiary relationship exists only when the parent company has a controlling interest in the subsidiary company. True

False

Under the equity method of accounting, the investment account is credited for the investor’s share of investee earnings and is debited for dividends received from the investee. True

False

The accounting guidelines for long-term investments in stock are based on the extent of the investor’s influence over the operating affairs of the issuing corporation. True

False

Pension funds and banks regularly invest in equity securities for strategic reasons. True

. 16-13

False

Multiple Choice 1.

Ross Corporation purchased 6,000 shares of Hunter common stock at $60 per share plus $7,200 brokerage fees as a short-term investment. The shares were subsequently sold at $65 per share less $8,400 brokerage fees. The cost of the securities purchased and gain or loss on the sale were Cost Gain or Loss a. $360,000 $30,000 gain b. $360,000 $14,400 gain c. $367,200 $14,400 gain d. $367,200 $14,400 loss

A company pays $600,000 for 30% of the common stock of X, Inc. In the first year, X, Inc. reports net income of $120,000 and pays a cash dividend of $45,000. The balance in Stock Investments-X, at year end under the equity method is: a. $577,500. b. $622,500. c. $636,000. d. $675,000.

The equity method is used when the investor a. makes long-term investments in stocks. b. plans to sell the investments within one year. c. owns less than 20% of the investee’s common stock. d. owns between 20% and 50% of the investee’s common stock.

At the end of its first year, the trading securities portfolio consisted of the following securities: Cost Fair Value Magnum Corp. $38,000 $40,000 Spencer Inc. 49,000 43,000 $87,000 $83,000 The unrealized loss to be recognized is a. $2,000. b. $6,000. c. $4,000. d. none of the above.

Which of the following would not appear in an income statement? a. Unrealized gain on trading securities. b. Realized gain on available-for-sale securities. c. Unrealized loss on available-for-sale securities. d. Realized loss on trading securities.

16-14 .

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True True True False True

Multiple Choice 1. 2. 3. 4. 5.

. 16-15

c. b. d. c. c.

6. 7. 8. 9. 10.

True True False True False

CHAPTER 17 STATEMENT OF CASH FLOWS

Learning Objectives 1. DISCUSS THE USEFULNESS AND FORMAT OF THE STATEMENT OF CASH FLOWS. 2. PREPARE A STATEMENT OF CASH FLOWS USING THE INDIRECT METHOD. 3. ANALYZE THE STATEMENT OF CASH FLOWS. *4. PREPARE A STATEMENT OF CASH FLOWS USING THE DIRECT METHOD. *5. USE A WORKSHEET TO PREPARE THE STATEMENT OF CASH FLOWS. *6. USE THE T-ACCOUNT APPROACH TO PREPARE A STATEMENT OF CASH FLOWS.

17-1

CHAPTER REVIEW Usefulness of the Statement of Cash Flows 1.

(L.O. 1) The fourth basic financial statement is the statement of cash flows. The primary purpose of the statement is to provide information about an entity’s cash receipts and cash payments during a period.

The information in the statement of cash flows should help investors to assess the a. entity’s ability to generate future cash flows. b. entity’s ability to pay dividends and meet obligations. c. reasons for the difference between net income and net cash provided (used) by operating activities. d. cash investing and financing transactions during the period.

Classification of Cash Flows 3.

The statement of cash flows classifies cash receipts and cash payments by: a. Operating activities which include cash effects of transactions that create revenues and expenses and thus enter into the determination of net income. b. Investing activities which include (1) acquiring and disposing of investments and (2) lending money and collecting the loans. c. Financing activities which involve liability and stockholders’ equity items and include (1) obtaining cash from issuing debt and repaying the amounts borrowed, and (2) obtaining cash from stockholders, repurchasing shares, and paying dividends.

Significant noncash transactions will include the conversion of bonds into common stock and the acquisition of assets through the issuance of bonds or capital stock. These transactions are individually reported at the bottom of the statement of cash flows or they may appear in a separate note or supplementary schedule to the financial statements.

Format of the Statement of Cash Flows 5.

The three classes of activities constitute the general format of the statement with the operating activities section appearing first, followed by the investing activities and financing activities sections. a. The net cash provided or used by each activity is totaled to show the net increase (decrease) in cash for the period. b. The net change in cash for the period is then added to or subtracted from the beginning-ofthe-period cash balance. c. Finally, any significant noncash investing and financing activities are reported in a separate schedule at the bottom of the statement.

The statement of cash flows is not prepared from the adjusted trial balance. The information to prepare this statement usually comes from three sources: (a) comparative balance sheets, (b) the current income statement, and (c) additional information.

17-2 .

The Major Steps 7.

The major steps in preparing the statement are: Step 1: Determine net cash provided/used by operating activities. This step involves analyzing not only the current year’s income statement, but also comparative balance sheets and selected additional data. Step 2: Analyze changes in noncurrent asset and liability accounts and record as investing and financing activities, or disclose as noncash transactions. This step involves analyzing not only the current year’s income statement, but also comparative balance sheets and selected additional data. Step 3: Compare the net change in cash on the statement of cash flows with the change in the Cash account reported on the balance sheet to make sure the amounts agree.

8. In performing step 1, the operating activities section must be converted from an accrual basis to a cash basis. This may be done by either the indirect method or the direct method. a. Both methods arrive at the same total amount for “net cash provided by operating activities” but they differ in how they arrive at the amount. b. The indirect method is used extensively in practice. c. The FASB has expressed a preference for the direct method. The Indirect Method 9. (L.O. 2) The following points 10 through 15 explain and illustrate the indirect method. The First Step—Indirect 10. The first step is to determine net cash provided/used by operating activities. a. Under generally accepted accounting principles the accrual basis of accounting is used which results in recording revenues when recognized and expenses when incurred. b. In order to determine net cash provided from operating activities it is necessary to report revenues and expenses on a cash basis. This is determined by adjusting net income for items that did not affect cash. 11. The operating section of the statement of cash flows should (a) begin with net income, (b) add (or deduct) items not affecting cash, and (c) show net cash provided by operating activities. 12. In determining net cash provided by operating activities, a. increases in specific current assets other than cash are deducted from net income, and decreases are added to net income. b. increases in specific current liabilities are added to net income, and decreases are deducted from net income. c. expenses for depreciation, amortization, and depletion and a loss on disposal of equipment are added back to net income, and a gain on disposal of equipment is deducted from net income. The Second Step—Indirect 13. The second step, analyze changes in noncurrent asset/liability accounts and record as investing and financing activities is generally determined from changes in noncurrent accounts reported in comparative balance sheets and selected additional data. a. If the account, Land, increases $50,000 and the transaction data indicates that land was purchased for cash, a cash outflow from an investment activity has occurred.

17-3

If the account, Common Stock, increases $100,000 and the transaction data indicates that additional capital stock was issued for cash, a cash inflow from a financing activity has resulted.

14. The redemption of debt and the retirement or reacquisition of capital stock are cash outflows from financing activities. The Third Step—Indirect 15. The third step is to determine the net change in Cash on the statement of cash flows with the change in the Cash account reported on the balance sheet to make sure the amounts agree. Analysis of the Statement of Cash Flows 16. (L.O. 3) Free cash flow describes the net cash provided by operating activities after adjustment for capital expenditures and dividends. The formula for free cash flow is: Free Cash Flow = Net Cash Provided by Operating Activities – Capital Expenditures – Cash Dividends. Preparing the Statement of Cash Flows— The Direct Method *17. (L.O. 4) The following points 18 through 23 explain and illustrate the direct method. The First Step—Direct *18. The first step is to determine net cash provided/used by operating activities by adjusting each item in the income statement from the accrual basis to the cash basis. a. If the income statement shows sales revenue of $120,000 and accounts receivable (net) increased $20,000 during the year, cash receipts are $100,000 ($120,000 – $20,000). b. If the income statement reports operating expenses of $60,000 but accounts payable have increased $12,000 during the year, cash operating expenses are $48,000 ($60,000 – $12,000). *19. In the operating activities section, only major classes of cash receipts and cash payments are reported as follows: a. Cash receipts from (1) sales of goods and services to customers and (2) interest and dividends on loans and investments. b. Cash payments (1) to suppliers, (2) to employees, (3) for operating expenses, (4) for interest, and (5) for taxes. *20. The formula for computing cash receipts from customers is: Sales Revenue

+ Decrease in Accounts Receivable or – Increase in Accounts Receivable

*21. The formula for computing cash payments to suppliers is: Cost of Goods Sold

17-4 .

+ Increase in Inventory + Decrease in Accounts Payable or or – Decrease in Inventory – Increase in Accounts Payable

*22.

The formula for computing cash payments for operating expenses is: Operating Expenses

+ Increase in Prepaid Expenses + Decrease in Accrued Expenses Payable or or – Decrease in Prepaid Expenses – Increase in Accrued Expenses Payable

*23. The formula for computing cash payments for income taxes is: Income Tax Expense

+ Decrease in Income Taxes Payable or – Increase in Income Taxes Payable

The Second Step—Direct *24. The second step, analyze changes in noncurrent asset/liability accounts and record as investing and financing activities is generally determined from changes in noncurrent accounts reported in comparative balance sheets and selected additional data. This is the same as under the indirect method. The Third Step—Direct *25. The third step is to determine the net increase or decrease in cash by determining the difference between cash at the beginning of the year and cash at the end of the year. This is the same as under the indirect method. Use of a Worksheet *26. (L.O. 5) A worksheet may be used to assemble and classify the data that will appear on the statement of cash flows. The worksheet is divided into two parts: a. Balance sheet accounts with columns for (1) end of last year balances, (2) reconciling items (debit and credit), and end of current year balances. b. Statement of cash flows effects with debit and credit columns. This part of the worksheet consists of the operating, investing, and financing sections. *27. The following guidelines are important in using a worksheet. a. In the balance sheet section, accounts with debit balances are listed separately from those with credit balances. b. In the cash flow effects section, inflows of cash are entered as debits in the reconciling columns and outflows of cash are entered as credits in the reconciling columns. c. The reconciling items shown in the worksheet are not entered in any journal or posted to any account. *28. The steps in preparing a worksheet are: a. Enter the balance sheet accounts and their beginning and ending balances in the balance sheet accounts section. b. Enter the data that explains the changes in the balance sheet accounts (other than cash) and their effects on the statement of cash flows in the reconciling columns of the worksheet. c. Enter the increase or decrease in cash on the Cash line and at the bottom of the worksheet. This entry should enable the totals of the reconciling columns to be in agreement. *29. The statement of cash flows is prepared entirely from the data that appears in the worksheet under Statement of Cash Flows Effects. .

17-5

LECTURE OUTLINE A.

Usefulness of the Statement of Cash Flows. 1. The statement of cash flows reports the cash receipts, cash payments, and net change in cash resulting from operating, investing, and financing activities during a period. 2. The information in a statement of cash flows should help investors, creditors, and others assess:

The entity’s ability to generate future cash flows.

The entity’s ability to pay dividends and meet obligations.

The reasons for the difference between net income and net cash provided (used) by operating activities.

The cash investing and financing transactions during the period.

Classification of Cash Flows. 1. The statement of cash flows classifies cash receipts and cash payments as operating, investing, and financing activities.

17-6 .

Operating activities include the cash effects of transactions that create revenues and expenses. They enter into the determination of net income.

Investing activities include (1) acquiring and disposing of investments and property, plant, and equipment, and (2) lending money and collecting the loans.

Financing activities include (1) obtaining cash from issuing debt and repaying the amounts borrowed, and (2) obtaining cash from stockholders, repurchasing shares, and paying dividends.

2. Note that (1) operating activities involve income statement items, (2) investing activities involve cash flows resulting from changes in investments and long-term asset items, and (3) financing activities involve cash flows resulting from changes in long-term liability and stockholders’ equity items. C.

Significant Noncash Activities. 1. Companies do not report in the body of the statement of cash flows significant financing and investing activities that do not affect cash. 2. They report these activities in either a separate schedule at the bottom of the statement of cash flows or in a separate note or supplementary schedule to the financial statements. 3. Examples of significant noncash activities are:

17-7

Direct issuance of common stock to purchase assets.

Conversion of bonds into common stock.

Direct issuance of debt to purchase assets.

Exchanges of plant assets.

ACCOUNTING ACROSS THE ORGANIZATION Net income is not the same as net cash provided by operating activities. Net cash provided by operating activities is usually significantly larger than net income. In general, why do differences exist between net income and net cash provided by operating activities? Answer: The differences are explained by differences in the timing of the reporting of revenues and expenses under accrual accounting versus cash. Under accrual accounting, companies report revenues when earned, even if cash hasn’t been received, and they report expenses when incurred, even if cash hasn’t been paid. D.

Format of the Statement of Cash Flows. 1. The cash flows from operating activities section always appears first, followed by the investing activities and then the financing activities sections. 2. Companies report the individual inflows and outflows from investing and financing activities separately. 3. The reported operating, investing, and financing activities result in either net cash provided or used by each activity. Companies total the amounts of net cash provided (used) by each activity, resulting in the net increase or decrease in cash for the period. This amount is then added to or subtracted from the beginning-of-period cash balance to obtain the end-of-period cash balance.

Preparing the Statement of Cash Flows. 1. Companies prepare the statement of cash flows differently from the three other basic financial statements. It is not prepared from an adjusted trial balance because the trial balance will not provide the necessary data. The information to prepare the statement of cash flows usually comes from three sources: a.

17-8 .

Comparative balance sheets.

Current income statement.

Additional information.

2. Preparing the statement of cash flows from these data sources involves three major steps: a.

Determine net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis. Determining net cash provided/used by operating activities involves analyzing not only the current year’s income statement but also comparative balance sheets and selected additional data.

Analyze changes in noncurrent asset and liability accounts and record as investing and financing activities, or disclose as noncash transactions. This step involves analyzing comparative balance sheet data and selected additional information for their effects on cash.

Compare the net change in cash on the statement of cash flows with the change in the cash account reported on the balance sheet to make sure the amounts agree.

3. A company must convert net income from an accrual basis to a cash basis to determine net cash provided/used by operating activities by using either (1) the indirect method or (2) the direct method. F.

Preparing the Statement of Cash Flows—Indirect Method. 1. Step 1: Determine net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis.

17-9

Under the accrual basis of accounting, net income is not the same as net cash provided by operating activities.

Companies must adjust net income to convert certain items to the cash basis.

Noncash charges (depreciation expense, amortization, depletion) and losses in the income statement are added back to net income and gains are deducted which results in net cash provided by operating activities.

A final adjustment in reconciling net income to net cash provided by operating activities involves examining all changes in current asset and current liability accounts.

Deduct from net income increases in current asset accounts, and add to net income decreases in current asset accounts, to arrive at net cash provided by operating activities. (1) When the Accounts Receivable balance increases, cash receipts are lower than revenue recognized under the accrual basis. The company deducts from net income the amount of the increase in accounts receivable, to arrive at net cash provided by operating activities.

Increases in current liability accounts are added to net income, and decreases in current liability accounts are deducted from net income, to arrive at net cash provided by operating activities. (1) When the Accounts Payable balance increases, operating expenses on an accrual basis are higher than they are on a cash basis because expenses are incurred for which payment has not taken place. The company adds to net income the amount of the increase in accounts payable to arrive at net cash provided by operating activities.

2. Step 2: Analyze changes in noncurrent asset and liability accounts and record as investing and financing activities, or as noncash investing and financing activities. a.

17-10 .

Increases in any noncurrent asset (Land, Buildings, Equipment and Long-Term Investments) represent outflows of cash from investing activities. Decreases represent inflows of cash from investing activities.

Increases in long-term debt (Bonds Payable) or paid-in capital (Common Stock) accounts represent cash inflows from financing activities. Decreases in long-term debt or paid-in capital accounts represent cash outflows from financing activities as does the payment of dividends.

3. Step 3: Compare the net change in cash on the statement of cash flows with the change in the Cash account reported on the balance sheet to make sure the amounts agree. G.

Using Cash Flows to Evaluate a Company. 1. In the statement of cash flows, net cash provided by operating activities is intended to indicate the cash-generating capability of the company. 2. Net cash provided by operating activities fails to take into account that a company must invest in new fixed assets just to maintain its current level of operations. 3. Free cash flow is a measurement that provides additional insight regarding a company’s cash generating ability. 4. Free cash flow is calculated as net cash provided by operating activities less capital expenditures and cash dividends.

*H. Statement of Cash Flows—Direct Method. 1. Step 1: Determine the net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis. a.

Companies compute net cash provided by operating activities by adjusting each item in the income statement from the accrual basis to the cash basis. (1) Increase in accounts receivable: when accounts receivable increase during the year, sales revenue on an accrual basis is higher than cash receipts from customers.

. 17-11

(2) Increase in accounts payable: when accounts payable increase during the year, purchases on an accrual basis are higher than they are on a cash basis. b.

Companies report only major classes of operating cash receipts and cash payments; the difference between cash receipts and cash payments is the net cash provided by operating activities.

2. Step 2: Analyze changes in noncurrent asset and liability accounts and record as investing and financing activities, or as significant noncash activities. a.

Increases in any noncurrent assets (Land, Buildings, Equipment and Long-Term Investments) represent outflows of cash from investing activities. Decreases represent inflows of cash from investing activities.

Increases in long-term debt (Bonds Payable) or paid-in capital accounts (Common Stock) represent cash inflows from financing activities. Decreases in long-term debt or paid-in capital accounts represent cash outflows from financing activities as does the payment of dividends.

3. Step 3: Compare the net change in cash on the statement of cash flows with the change in the Cash account reported on the balance sheet to make sure the amounts agree. *I.

Preparing the Worksheet—Indirect Method. The steps in preparing a worksheet are: a. b.

17-12 .

Enter in the balance sheet accounts section the balance sheet accounts and their beginning and ending balances. Enter in the reconciling columns of the worksheet the data that explain the changes in the balance sheet accounts other than cash and their effects on the statement of cash flows. Enter on the cash line and at the bottom of the worksheet the increase or decrease in cash. This entry should enable the totals of the reconciling columns to be in agreement.

A Look at IFRS

As in GAAP, the statement of cash flows is a required statement for IFRS. In addition, the content and presentation of an IFRS statement of cash flows is similar to the one used for GAAP. However, the disclosure requirements related to the statement of cash flows are more extensive under GAAP. IAS 7 (“Cash Flow Statements”) provides the overall IFRS requirements for cash flow information.

KEY POINTS • Companies preparing financial statements under IFRS must prepare a statement of cash flows as an integral part of the financial statements. • Both IFRS and GAAP require that the statement of cash flows should have three major sections—operating, investing, and financing activities—along with changes in cash and cash equivalents. • Similar to GAAP, the statement of cash flows can be prepared using either the indirect or direct method under IFRS. In both U.S. and international settings, companies choose for the most part to use the indirect method for reporting net cash flows from operating activities. • The definition of cash equivalents used in IFRS is similar to that used in GAAP. A major difference is that in certain situations, bank overdrafts are considered part of cash and cash equivalents under IFRS (which is not the case in GAAP). Under GAAP, bank overdrafts are classified as financing activities in the statement of cash flows and are reported as liabilities on the balance sheet. • IFRS requires that noncash investing and financing activities be excluded from the statement of cash flows. Instead, these noncash activities should be reported elsewhere. This requirement is interpreted to mean that noncash investing and financing activities should be disclosed in the notes to the financial statements instead of in the financial statements. Under GAAP, companies may present this information on the face of the statement of cash flows.

. 17-13

• One area where there can be substantial differences between IFRS and GAAP relates to the classification of interest, dividends, and taxes. • Under IFRS, some companies present the operating section in a single line item, with a full reconciliation provided in the notes to the financial statements. This presentation is not seen under GAAP. • Similar to GAAP, under IFRS companies must disclose the amount of taxes and interest paid. Under GAAP, companies disclose this in the notes to the financial statements. Under IFRS, some companies disclose this information in the notes, but others provide individual line items on the face of the statement. In order to provide this information on the face of the statement, companies first add back the amount of interest expense and tax expense (similar to adding back depreciation expense) and then further down the statement they subtract the cash amount paid for interest and taxes. This treatment can be seen in the statement of cash flows provided for Zetar in Appendix F.

LOOKING TO THE FUTURE Presently, the FASB and the IASB are involved in a joint project on the presentation and organization of information in the financial statements. One interesting approach, revealed in a published proposal from that project, is that in the future the income statement and balance sheet would adopt headings similar to those of the statement of cash flows. That is, the income statement and balance sheet would be broken into operating, investing, and financing sections. With respect to the statement of cash flows specifically, the notion of cash equivalents will probably not be retained. That is, cash equivalents will not be combined with cash but instead will be reported as a form of highly liquid, lowrisk investment. The definition of cash in the existing literature would be retained, and the statement of cash flows would present information on changes in cash only. In addition, the FASB favors presentation of operating cash flows using the direct method only. However, the majority of IASB members express a preference for not requiring use of the direct method of reporting operating cash flows. The two Boards will have to resolve their differences in this area in order to issue a converged standard for the statement of cash flows. 17-14 .

20 MINUTE QUIZ Circle the correct answer. True/False 1.

Inflows and outflows from investing and financing activities should be reported separately on the statement of cash flows. True

In addition to the adjusted trial balance, information for the statement of cash flows is taken from comparative balance sheets, the current income statement and other transactional information. True

False

The amortization of a patent is added back to net income to arrive at net cash provided by operating activities. True

10.

False

The only use of a statement of cash flows is to help investors, creditors, and others assess the reasons for the difference between net income and net cash provided by operating activities. True

False

A statement of cash flows starts with net income and adds (or deducts) items that did not affect cash to arrive at net cash provided by operating activities if the indirect method is used. True

False

Cash outflows to purchase property, plant, and equipment would be reported in the investing section of the statement of cash flows. True

False

When accounts receivable increases during the year, revenues on a cash basis are higher than revenues on an accrual basis. True

False

An increase in equipment will increase net cash provided by operating activities. True

False

The purchase of inventory and investments in property, plant, and equipment are considered cash outflows from operations. True

False

The issuance of shares of stock for plant assets is a significant noncash transaction. True

. 17-15

False

Multiple Choice 1.

A company has credit sales of $900,000 and cash sales of $540,000 during the same year that the Accounts Receivable account decreased by $120,000. What was the total of cash receipts from sales? a. $1,320,000. b. $1,560,000. c. $1,020,000. d. $780,000.

Cash inflows from investing activities include a. sale of common stock. b. purchase of equipment. c. sale of land. d. issuance of long-term debt.

Operating activities do not include cash a. inflows from revenue. b. inflows from sale of equipment. c. outflows for income taxes. d. outflows for wages.

Which of the following would decrease net cash provided by operating activities? a. Decrease in short-term notes payable. b. Depreciation expense. c. Decrease in inventory. d. Loss on disposal of equipment.

Noncash investing and financing activities a. may represent significant investing and financing activities. b. do not involve cash receipts or cash payments. c. are disclosed on a separate schedule. d. All of the answer choices are correct.

17-16 .

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True False False False False

Multiple Choice 1. 2. 3. 4. 5.

. 17-17

b. c. b. a. d.

6. 7. 8. 9. 10.

True True False True True

CHAPTER 18 FINANCIAL STATEMENT ANALYSIS

Learning Objectives 1. APPLY HOIRIZONTAL AND VERTICAL ANALYSIS TO FINANCIAL STATEMENTS. 2. ANALYZE A COMPANY’S PERFORMANCE USING RATIO ANALYSIS. 3. APPLY THE CONCEPT OF SUSTAINABLE INCOME.

18-1

CHAPTER REVIEW Need for Comparative Analysis 1.

Financial statement analysis enables the financial statement user to make informed decisions about a company.

When analyzing financial statements, three major characteristics of a company are generally evaluated: (a) liquidity, (b) profitability, and (c) solvency.

Comparative analysis may be made on a number of different bases. a. Intracompany basis—Compares an item or financial relationship within a company in the current year with the same item or relationship in one or more prior years. b. Industry averages—Compares an item or financial relationship of a company with industry averages. c. Intercompany basis—Compares an item or financial relationship of one company with the same item or relationship in one or more competing companies.

Tools of Financial Analysis 4.

(L.O. 1) There are three basic tools of analysis: (a) horizontal, (b) vertical, and (c) ratio.

Horizontal Analysis 5.

Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time to determine the increase or decrease that has taken place, expressed as either an amount or a percentage. In horizontal analysis, a base year is selected and changes are expressed as percentages of the base year amount.

Vertical Analysis 6.

Vertical analysis, also called common size analysis, expresses each item within a financial statement as a percentage of a base amount. Generally, the base amount is total assets for the balance sheet, and net sales for the income statement. For example, it may be determined that current assets are 22% of total assets, and selling expenses are 15% of net sales.

Ratio Analysis 7.

(L.O. 2) A ratio expresses the mathematical relationship between one quantity and another as either a percentage, rate, or proportion. Ratios can be classified as: a. Liquidity ratios—measures of the short-term debt-paying ability. b. Profitability ratios—measures of the income or operating success of a company for a given period of time. c. Solvency ratios—measures of the ability of the company to survive over a long period of time.

There are four liquidity ratios: the current ratio, the acid-test ratio, accounts receivable turnover, and inventory turnover.

18-2

The current ratio expresses the relationship of current assets to current liabilities. It is a widely used measure for evaluating a company’s liquidity and short-term debt paying ability. The formula for this ratio is: Current Ratio =

10.

The acid-test or quick ratio relates cash, short-term investments, and net accounts receivable to current liabilities. This ratio indicates a company’s immediate liquidity. It is an important complement to the current ratio. The formula for the acid-test ratio is:

Acid-Test Ratio =

11.

Current Assets Current Liabilities

Cash + Short-Term Investments + Accounts Receivable (net) Current Liabilities

Accounts receivable turnover is used to assess the liquidity of the accounts receivable. This ratio measures the number of times, on average, accounts receivable are collected during the period. The formula for the ratio is: Accounts Receivable = Turnover

Net Credit Sales Average Net Accounts Receivable

Average net accounts receivable can be computed from the beginning and ending balances of the net accounts receivable. A popular variant of the accounts receivable turnover is to convert it into an average collection period in terms of days. This is done by dividing the turnover ratio into 365 days. 12.

Inventory turnover measures the number of times, on average, the inventory is sold during the period. It indicates the liquidity of the inventory. The formula for the ratio is: Cost of Goods Sold Average Inventory

Inventory Turnover =

Average inventory can be computed from the beginning and ending inventory balances. A variant of the inventory turnover is to compute the average days in inventory. This is done by dividing the inventory turnover into 365 days. 13.

There are seven profitability ratios: the profit margin, asset turnover, return on assets, return on common stockholders’ equity, earnings per share, price-earnings ratio, and the payout ratio.

14.

Profit margin is a measure of the percentage of each sales dollar that results in net income. The formula is: Profit Margin =

15.

Asset turnover measures how efficiently a company uses its assets to generate sales. The formula for this ratio is: Asset Turnover =

Net Income Net Sales

18-3

Net Sales Average Assets

16.

Return on assets is an overall measure of profitability. It measures the rate of return on each dollar invested in assets. The formula is: Return on Assets =

17.

Net Income Average Assets

Return on common stockholders’ equity measures profitability from the common stockholders’ viewpoint. The ratio shows the dollars of income earned for each dollar invested by the owners. The formula is: Net Income available to common Return on Common = Stockholders’ Equity Average Common Stockholders’ Equity a.

18.

When preferred stock is present, preferred dividend requirements are deducted from net income to compute income available to common stockholders. Similarly, the par value of preferred stock (or call price, if applicable) must be deducted from total stockholders’ equity to arrive at the amount of common stock equity used in this ratio. Leveraging or trading on the equity at a gain means that the company has borrowed money through the issuance of bonds or notes at a lower rate of interest than it is able to earn by using the borrowed money. A comparison of the rate of return on total assets with the rate of interest paid for borrowed money indicates the profitability of trading on the equity.

Earnings per share measures the amount of net income earned on each share of common stock. The formula is:

Earnings per Share =

Net Income Weighted-Average Common Shares Outstanding

Any preferred dividends declared for the period must be subtracted from net income. 19.

The price-earnings ratio measures the ratio of market price per share of common stock to earnings per share. It is an oft-quoted statistic that reflects investors’ assessments of a company’s future earnings. The formula for the ratio is: Price-Earnings Ratio =

20.

Market Price per Share of Stock Earnings per Share

The payout ratio measures the percentage of earnings distributed in the form of cash dividends. The formula is: Payout Ratio =

Cash Dividends Net Income

Companies with high growth rates generally have low payout ratios because they reinvest most of their income into the business. 21.

There are two solvency ratios: debt to assets and times interest earned.

18-4

22.

The debt to assets ratio measures the percentage of total assets provided by creditors. The formula for this ratio is: Debt to Assets

Debt Assets

The adequacy of this ratio is often judged in the light of the company’s earnings. Companies with relatively stable earnings, such as public utilities, have higher debt to assets ratios than cyclical companies with widely fluctuating earnings, such as many high-tech companies. 23.

Times interest earned measures a company’s ability to meet interest payments as they come due. The formula is:

Times Interest = Earned

Income before Income Taxes and Interest Expense Interest Expense

Discontinued Operations 24.

Discontinued operations refers to the disposal of a significant component of a business, such as eliminating an entire activity or eliminating a major class of customers. a. When the disposal occurs, the income statement should report both income from continuing operations and income (loss) from discontinued operations. b. The income (loss) from discontinued operations consists of (1) income (loss) from operations and (2) gain (loss) on disposal of the component. c. Both components are reported net of applicable taxes in a section entitled Discontinued Operations, which follows income from continuing operations.

Extraordinary Items 25.

Extraordinary items are events and transactions that meet two conditions: (a) unusual in nature and (b) infrequent in occurrence. a. To be “unusual,” the item should be abnormal and only incidentally related to customary activities of the entity. b. To be “infrequent,” the item should not be reasonably expected to recur in the foreseeable future. c. Extraordinary items are reported net of taxes in a separate section of the income statement immediately below discontinued operations.

Changes in Accounting Principle 26.

A change in an accounting principle occurs when the principle used in the current year is different from the one used in the preceding year. Companies report most changes in accounting principle retroactively. That is, they report both the current period and previous periods using the new principle.

Income Statement with Irregular Items 27.

A partial income statement showing the additional sections and the material items not typical of regular operations is as follows: Income Statement (partial)

18-5

Income before income taxes ................................................................ Income tax expense............................................................................. Income from continuing operations ...................................................... Discontinued operations: Loss from operations of discontinued division, net of $XXX income tax savings ................................................ Gain on disposal of division, net of $XXX income taxes ................. Income before extraordinary item ........................................................ Extraordinary item: Gain or loss, net of $XXX income taxes ................................... Net Income .......................................................................................... 28.

$XXX XXX XXX

$XXX XXX

XXX XXX XXX $XXX

Comprehensive income includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders. Certain items by bypass income and are reported directly in stockholders’ equity.

NOTE – AUTHORS NEED TO CHANGE THIS SECTION TO SUSTAINABLE INCOME Quality of Earnings 29.

In evaluating the financial performance of a company, the quality of a company’s earnings is of extreme importance to analysts. A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of financial statements.

30.

Variations among companies in the application of generally accepted accounting principles— alternative accounting methods—may hamper comparability and reduce quality of earnings.

31.

In recent years, many companies have also been reporting a second measure of income called pro forma income—which excludes items that the company thinks are unusual or nonrecurring. Because many companies have abused the flexibility that pro forma numbers allow, it is an area that will probably result in new rule-making.

18-6

LECTURE OUTLINE A.

Basics of Financial Statement Analysis. 1. Analyzing financial statements involves evaluating three characteristics: a company’s liquidity, profitability, and solvency. a.

A short-term creditor (a bank) is primarily interested in liquidity—the ability of the borrower to pay obligations when they come due.

A long-term creditor (a bondholder) looks to profitability and solvency measures that indicate the company’s ability to survive over a long period of time.

Stockholders look at the profitability and solvency of the company. They want to assess the likelihood of dividends and the growth potential of the stock.

2. Comparison of financial information can be made on a number of different bases.

Intracompany basis: compares an item or financial relationship within a company in the current year with the same item or relationship in prior years.

Industry averages: compares an item or financial relationship of a company with industry averages (norms) published by Dun & Bradstreet, Moody’s, and Standard & Poor’s.

Intercompany basis: compares an item or financial relationship of one company with the same item or relationship in one or more competing companies.

Tools of Financial Statement Analysis. 1. Horizontal analysis (trend analysis) is a technique for evaluating a series of financial statement data over a period of time to determine the increase or decrease that has taken place, expressed as either an amount or a percentage.

18-7

2. Vertical analysis (common-size analysis) is a technique that expresses each financial statement item as a percentage of a base amount. A benefit of vertical analysis is that it enables one to compare companies of different sizes. 3. Ratio analysis expresses the relationship among selected items of financial statement data. The relationship is expressed in terms of either a percentage, a rate, or a simple proportion. 4. Ratios can be classified as follows: a.

Liquidity ratios: measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.

Profitability ratios: measure the income or operating success of a company for a given period of time.

Solvency ratios: measure the ability of a company to survive over a long period of time.

5. Liquidity ratios.

18-8

The current ratio is a widely used measure for evaluating a company’s liquidity and short-term debt paying ability. It is computed by dividing current assets by current liabilities.

The acid-test (quick) ratio is a measure of a company’s immediate short-term liquidity. This ratio is computed by dividing the sum of cash, short-term investments, and net accounts receivable by current liabilities.

Accounts receivable turnover is used to assess the liquidity of accounts receivable. Companies compute this ratio by dividing net credit sales by the average net accounts receivable during the year. The average collection period in days is computed by dividing accounts receivable turnover into 365 days.

Inventory turnover measures the number of times, on average, the inventory was sold during the period. Companies compute the inventory turnover by dividing cost of goods sold by the average inventory during the year. The average days in inventory is computed by dividing inventory turnover into 365 days.

6. Profitability ratios. a.

Profit margin is a measure of the percentage of each dollar of sales that results in net income. It is computed by dividing net income by net sales.

Asset turnover measures how efficiently a company uses its assets to generate sales. It is computed by dividing net sales by average assets.

An overall measure of profitability is return on assets. This ratio is computed by dividing net income by average assets.

Return on common stockholders’ equity shows how many dollars of net income the company earned for each dollar invested by the owners. Companies compute it by dividing net income by average common stockholders’ equity. (1) When a company has preferred stock, it must deduct preferred dividend requirements from net income to compute income available to common stockholders. (2) Companies deduct the par value of preferred stock (or call price) from total stockholders’ equity to determine the amount of common stock equity used in the denominator. (3) Trading on the equity at a gain is borrowing money at a lower rate of interest than can be earned by using the borrowed money.

18-9

Earnings per share is a measure of the net income earned on each share of common stock. It is computed by dividing net income by the number of weighted-average common shares outstanding during the year.

The price-earnings ratio is a measure of the ratio of the market price of each share of common stock to the earnings per share. It is computed by dividing the market price per share of the stock by earnings per share.

The payout ratio measures the percentage of earnings distributed in the form of cash dividends. Companies compute it by dividing cash dividends by net income.

7. Solvency ratios.

The debt to assets ratio measures the percentage of the total assets that creditors provide. It is computed by dividing debt (both current and long-term liabilities) by assets.

Times interest earned (interest coverage) provides an indication of the company’s ability to meet interest payments as they come due. Companies compute it by dividing income before interest expense and income taxes by interest expense.

Earning Power and Irregular Items. Earning power means the normal level of income to be obtained in the future. Irregular items include (a) discontinued operations, and (b) extraordinary items. 1. Discontinued operations refers to the disposal of a significant component of a business. Examples involve stopping an entire activity or eliminating a major class of customers. a.

18-10 .

The income (loss) from discontinued operations consists of the income (loss) from operations and the gain (loss) on disposal of the component.

The discontinued operations section reports both the operating income (loss) and the gain (loss) on disposal net of applicable income taxes.

Extraordinary items are events and transactions that are: a.

Unusual in nature.

Infrequent in occurrence. (1) To be “unusual,” the item should be abnormal and only incidentally related to the company’s customary activities. (2) To be “infrequent,” the item should not be reasonably expected to recur in the foreseeable future.

Companies report extraordinary items net of taxes in a separate section of the income statement, immediately below discontinued operations.

INVESTOR INSIGHT Many companies incur restructuring charges as they attempt to reduce costs. They often label these items in the income statement as “non-recurring” charges to suggest that they are isolated events which are unlikely to occur in future periods. If a company takes a large restructuring charge, what is the effect on the company’s current income statement versus future ones? Answer: The current period’s net income can be greatly diminished by a large restructuring charge, while the net income in future periods can be enhanced because they are relieved of costs (i.e., depreciation and labor expenses) that would have been charged to them. 3. A change in accounting principle occurs when the principle used in the current year is different from the one used in the preceding year. Accounting rules permit a change when management can show that the new principle is preferable to the old principle. . 18-11

4. Companies report most changes in accounting principle retroactively. They report both the current period and previous periods using the new principle. 5. Comprehensive income includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders.

Quality of Earnings. 1. In evaluating the financial performance of a company, the quality of a company’s earnings is of extreme importance to analysts. A high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements. Factors affecting quality of earnings are: a.

Alternative accounting methods. Variations among companies in the application of generally accepted accounting principles may hamper comparability and reduce quality of earnings.

Improper recognition. Due to pressure from investors to continually increase earnings, some managers have manipulated the earnings numbers to meet these expectations. The most common abuse is the improper recognition of revenue.

2. Pro forma income. Pro forma income usually excludes items that the company thinks are unusual or non-recurring. Many analysts are critical of using pro forma income because these numbers often make companies look better than they really are.

18-12 .

IFRS A Look at IFRS

The tools of financial statement analysis, covered in the first section of this chapter, are the same throughout the world. Techniques such as vertical and horizontal analysis, for example, are tools used by analysts regardless of whether GAAP- or IFRS-related financial statements are being evaluated. In addition, the ratios provided in the textbook are the same ones that are used internationally. The latter part of this chapter relates to the income statement and irregular items. As in GAAP, the income statement is a required statement under IFRS. In addition, the content and presentation of an IFRS income statement is similar to the one used for GAAP. IAS 1 (revised), “Presentation of Financial Statements,” provides general guidelines for the reporting of income statement information. In general, the differences in the presentation of financial statement information are relatively minor.

IFRS ADDITIONS TO THE TEXTBOOK • The tools of financial statement analysis covered in this chapter are universal and therefore no significant differences exist in the analysis methods used. • The basic objectives of the income statement are the same under both GAAP and IFRS. As indicated in the textbook, a very important objective is to ensure that users of the income statement can evaluate the earning power of the company. Earning power is the normal level of income to be obtained in the future. Thus, both the IASB and the FASB are interested in distinguishing normal levels of income from irregular items in order to better predict a company’s future profitability. • The basic accounting for discontinued operations is the same under IFRS and GAAP.

. 18-13

• Under IFRS, there is no classification for extraordinary items. In other words, extraordinary item treatment is prohibited under IFRS. All revenue and expense items are considered ordinary in nature. Disclosure, however, is extensive for items that are considered material to the financial results. Examples are writedowns of inventory or plant assets, or gains and losses on the sale of plant assets. • The accounting for changes in accounting principles and changes in accounting estimates are the same for both GAAP and IFRS. • Both GAAP and IFRS follow the same approach in reporting comprehensive income. The statement of comprehensive income can be prepared under the one-statement approach or the two statement approach. • The issues related to quality of earnings are the same under both GAAP and IFRS. It is hoped that by adopting a more principles-based approach, as found in IFRS, that many of the earning quality issues will disappear. LOOKING TO THE FUTURE The FASB and the IASB are working on a project that would rework the structure of financial statements. Recently, the IASB decided to require a statement of comprehensive income, similar to what was required under GAAP. In addition, another part of this project addresses the issue of how to classify various items in the income statement. A main goal of this new approach is to provide information that better represents how businesses are run. In addition, the approach draws attention away from one number—net income.

18-14 .

20 MINUTE QUIZ Circle the correct answer. True/False 1.

Intercompany comparison refers to comparison with other companies to provide insight into competitive position. True

Vertical analysis determines the percentage increase or decrease that has taken place over a period of time. True

False

Extraordinary gains and losses should be disclosed in the income statement immediately below discontinued operations net of taxes. True

10.

False

The debt to assets ratio measures the percentage of total assets provided by long-term creditors. True

False

The formula for computing times interest earned is income before income taxes and interest expense divided by interest expense. True

False

Profit margin, return on assets, and return on common stockholders’ equity are profitability ratios. True

False

Accounts receivable turnover, inventory turnover, and asset turnover are all common measures of liquidity. True

False

Liquidity ratios measure the ability of a company to survive over a long period of time. True

False

A base year is determined when performing horizontal analysis. True

False

To compute pro forma income, companies generally can exclude any items they deem inappropriate for measuring their performance. True

. 18-15

False

Multiple Choice 1.

Sales (in millions) for a three year period are: Year 1 $6, Year 2 $6.9, and Year 3 $7.5. Using Year 1 as the base year the percentage increase in sales in Years 2 and 3 are, respectively a. 115% and 125%. b. 115% and 109%. c. 115% and 130%. d. 87% and 80%.

An incorrect formula is a. current ratio = current assets ÷ current liabilities. b. accounts receivable turnover = net credit sales ÷ average net accounts receivable. c. asset turnover = net income ÷ average assets. d. payout ratio = cash dividends ÷ net income.

The acid-test ratio a. is a solvency ratio. b. measures immediate short-term liquidity. c. includes inventory in the numerator of the formula. d. includes total liabilities in the denominator of the formula.

The ratio that measures the overall profitability of assets is a. profit margin. b. asset turnover. c. return on common stockholders’ equity. d. return on assets.

Which of the following would least likely be considered an extraordinary item? a. Loss from fire destruction. b. Loss from meteorite destruction. c. Gain on sale of company vehicle. d. Gain on property taken over by a foreign government.

18-16 .

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True False True False False

Multiple Choice 1. 2. 3. 4. 5.

. 18-17

a. c. b. d. c.

6. 7. 8. 9. 10.

True True False True True

CHAPTER 19 MANAGERIAL ACCOUNTING LEARNING OBJECTIVES 1. IDENTIFY THE FEATURES ACCOUNTING AND THE MANAGEMENT.

OF MANAGERIAL FUNCTIONS OF

2. DEFINE THE CLASSES OF MANUFACTURING COSTS AND THE DIFFERENCES BETWEEN PRODUCT AND PERIOD COSTS. 3. DETERMINE HOW TO COMPUTE COST OF GOODS MANUFACTURED AND PREPARE FINANCIAL STATEMENTS FOR A MANUFACTURER. 4. DISCUSS TRENDS IN MANAGERIAL ACCOUNTING.

19-1

CHAPTER REVIEW Managerial Accounting Basics 1.

(L.O. 1) Managerial accounting is a field of accounting that provides economic and financial information for managers and other internal users. Managerial accounting applies to all types of businesses—service, merchandising, and manufacturing—and to all forms of business organizations—proprietorships, partnerships and corporations. Moreover, managerial accounting is needed in not-for-profit entities as well as in profit-oriented enterprises.

Comparing Managerial and Financial Accounting 2.

There are both similarities and differences between managerial and financial accounting. a. Both fields of accounting deal with the economic events of a business and require that the results of that company’s economic events be quantified and communicated to interested parties. b. The principal differences are the (1) primary users of reports, (2) types and frequency of reports, (3) purpose of reports, (4) content of reports, and (5) verification process.

The role of the managerial accountant has changed in recent years. Whereas in the past their primary concern used to be collecting and reporting costs to management, today they also evaluate how well the company is using its resources and providing information to crossfunctional teams comprised of personnel from production, operations, marketing, engineering, and quality control.

Management Functions 4.

Managers perform three broad functions within an organization: a. Planning requires managers to look ahead and to establish objectives. b. Directing involves coordinating a company’s diverse activities and human resources to produce a smooth-running operation. c. Controlling is the process of keeping the firm’s activities on track.

Organizational Structure 5.

In order to assist in carrying out management functions, most companies prepare organization charts to show the interrelationships of activities and the delegation of authority and responsibility with the company. Stockholders own the corporation but manage the company through a board of directors. The chief executive officer (CEO) has overall responsibility for managing the business. The chief financial officer (CFO) is responsible for all of the accounting and finance issues the company faces. The CFO is supported by the controller and the treasurer.

Manufacturing Costs

(L.O. 2) Manufacturing consists of activities and processes that convert raw materials into finished goods.

Manufacturing costs are typically classified as either (a) direct materials, (b) direct labor or (c) manufacturing overhead.

19-2

Direct materials are raw materials that can be physically and directly associated with the finished product during the manufacturing process. Indirect materials are materials that (a) do not physically become a part of the finished product or (b) cannot be traced because their physical association with the finished product is too small in terms of cost. Indirect materials are accounted for as part of manufacturing overhead.

The work of factory employees that can be physically and directly associated with converting raw materials into finished goods is considered direct labor. In contrast, the wages of maintenance people, timekeepers, and supervisors are usually identified as indirect labor because their efforts have no physical association with the finished product, or it is impractical to trace the costs to the goods produced. Indirect labor is classified as manufacturing overhead.

10.

Manufacturing overhead consists of costs that are indirectly associated with the manufacture of the finished product. Manufacturing overhead includes items such as indirect materials, indirect labor, depreciation on factory buildings and machines, and insurance, taxes, and maintenance on factory facilities.

Product Versus Period Costs 11.

Product costs are costs that are a necessary and integral part of producing the finished product. Period costs are costs that are matched with the revenue of a specific time period rather than included as part of the cost of a salable product. These are nonmanufacturing costs. Period costs include selling and administrative expenses.

Manufacturing Income Statement 12.

(L.O. 3) The income statements of a merchandising company and a manufacturing company differ in the cost of goods sold section.

13.

The cost of goods sold section of the income statement for a manufacturing company shows: Beginning Finished Goods + Inventory

Cost of Goods Manufactured

–

Ending Finished Goods Inventory

Cost of Goods Sold

Determining Cost of Goods Manufactured 14.

(L.O. 3) The determination of the cost of goods manufactured consists of the following: a.

15.

Beginning Work in Process + Inventory Total Cost of Work in Process

Total Current Manufacturing Costs

Ending – Work in Process = Inventory

Total Cost of Work in Process

Cost of Goods Manufactured

The costs assigned to the beginning work in process inventory are the manufacturing costs incurred in the prior period.

19-3

16.

Total manufacturing costs is the sum of the direct materials costs, direct labor costs, and manufacturing overhead incurred in the current period.

17.

Because a number of accounts are involved, the determination of cost of goods manufactured is presented in a Cost of Goods Manufactured Schedule. The cost of goods manufactured schedule shows each of the cost factors above. The format for the schedule is: Beginning work in process ....................................................... Direct materials used ............................................................... Direct labor .............................................................................. Manufacturing overhead .......................................................... Total manufacturing costs ........................................................ Total cost of work in process ................................................... Less: Ending work in process ................................................. Cost of goods manufactured ....................................................

$XXXX $XXXX XXXX XXXX XXXX XXXX XXXX $XXXX

Manufacturing Balance Sheet 18.

The balance sheet for a manufacturing company may have three inventory accounts: finished goods inventory, work in process inventory, and raw materials inventory.

19.

The manufacturing inventories are reported in the current assets section of the balance sheet. The remainder of a manufacturer’s balance sheet is similar to a merchandising company’s balance sheet.

20.

Each step in the accounting cycle for a merchandising company is applicable to a manufacturing company. a. For example, prior to preparing financial statements, adjusting entries are required. b. Adjusting entries are essentially the same as those of a merchandising company. c. The closing entries for a manufacturing company are also similar to those of a merchandising company.

Product Costing for Service Industries 21.

Since service companies do not produce inventory, they use a subset of the accounts used by manufacturers. However, just like manufacturers, service companies also need to keep track of the costs of each service in order to know whether the service generates a profit.

Focus on the Value Chain 22.

(L.O. 4) The business environment and regulations are always changing, managerial accounting must continue to innovate in order to provide managers with the information they need. The value chain refers to all business processes associated with providing a product or service.

23.

Many companies have significantly lowered inventory levels and costs using just-in-time (JIT) inventory methods. Under a just-in-time method, goods are manufactured or purchased just in time for use. In addition, many companies have installed total quality management (TQM) systems to reduce defects in finished products.

24.

Activity-based costing (ABC) is a popular method for allocating overhead that obtains more accurate product costs. The theory of constraints is a specific approach used to identify and manage constraints in order to achieve the company goals. The balanced scorecard is a performance-measurement approach that uses both financial and nonfinancial measures to evaluate all aspects of a company’s operations in an integrated fashion.

19-4

Business Ethics 25. All employees are expected to act ethically in their business activities and an increasing number of organizations provide their employees with a code of business ethics. 26. Due to many fraudulent activities in recent years, U.S. Congress passed the Sarbanes-Oxley Act which resulted in many implications for managers and accountants. CEOs and CFOs must certify the fairness of financial statements, top management must certify they maintain an adequate system of internal controls, and other matters.

19-5

LECTURE OUTLINE A.

Managerial Accounting Basics. 1. Managerial accounting, also called management accounting, is a field of accounting that provides economic and financial information for managers and other internal users. 2. Managerial accounting applies to all types of businesses: service, merchandising, and manufacturing. It also applies to all forms of business organizations: proprietorships, partnerships, and corporations.

Comparing Managerial and Financial Accounting.

1. The distinguishing features of managerial accounting are:

19-6

Primary users of reports—internal users: officers and managers.

Types and frequency of reports—internal reports issued as frequently as needed.

Purpose of reports: special-purpose information for a specific decision.

Content of reports—pertains to subunits of the business and may be very detailed; extends beyond double-entry accounting to any relevant data; the standard is relevance to decisions.

Verification process—no independent audits.

Management Functions. 1. Manager’s activities and responsibilities can be classified into three broad functions: a.

Planning requires managers to look ahead and to establish objectives.

Directing involves coordinating a company’s diverse activities and human resources to produce a smooth-running operation.

Controlling is the process of keeping the company’s activities on track.

MANAGEMENT INSIGHT Louis Vuitton is a French manufacturer of high-end handbags, wallets, and suitcases. Luxury-goods manufacturers used to consider stock-outs to be a good thing, but Louis Vuitton recently changed its attitude. What are some of the steps that Louis Vuitton has taken in order to ensure that production meets demand? Answer: The company has organized flexible teams, with jobs arranged by the amount of time a task takes. Employees now are multiskilled, so they can switch between tasks and products. Also, the stores now provide sales data more quickly to the manufacturing facility, so that production levels can be changed more quickly to respond to demand. D.

Organizational Structure. 1. Most companies prepare organization charts to show the interrelationships of activities and the delegation of authority and responsibility within the company. 2. Stockholders own the corporation, but they manage it indirectly through a board of directors they elect. 3. The chief executive officer (CEO) has overall responsibility for managing the business, but delegates responsibility to other officers.

19-7

4. Responsibilities within a company are classified as either: line positions— employees directly involved in the company’s primary revenue-generating operating activities, or staff positions—employees involved in activities that support line employees’ efforts. 5. The chief financial officer (CFO) is responsible for all of the company’s accounting and finance issues, and is supported by the controller and the treasurer. Also serving the CFO is the internal audit staff who review the reliability and integrity of financial information provided by the controller and treasurer. E.

Manufacturing Costs. Manufacturing costs are classified as (1) direct materials, (2) direct labor, or (3) manufacturing overhead. 1. Direct materials are raw materials that can be physically and directly associated with the finished product during the manufacturing process. a.

Indirect materials: (1) Do not physically become part of the finished product or, (2) Cannot be traced because their physical association with the finished product is too small in terms of cost (i.e. lock washers).

Companies account for indirect materials as part of manufacturing overhead.

2. Direct labor is the work of factory employees that can be physically and directly associated with converting raw materials into finished goods.

19-8

Indirect labor has no physical association with the finished product, or it is impractical to trace the costs to the goods produced.

Companies classify indirect labor as manufacturing overhead.

MANAGEMENT INSIGHT Prior to 2010, U. S. manufacturing employment decreased every year for 60 years. However, during 2010, manufacturing jobs in the U.S. increased by 1.2%. What are some of the reasons attributed to this increase in manufacturing jobs? Answer:

Companies like Whirlpool, Caterpillar, and Dow are building huge new efficient plants in the U.S. to replace old, inefficient facilities. Also, companies that produce and sell products in the U.S. save on shipping costs. Finally, companies producing domestically are able to draw from an experienced workforce.

3. Manufacturing overhead consists of costs that are indirectly associated with the manufacture of the finished product. a.

Manufacturing overhead includes indirect materials, indirect labor, depreciation on factory buildings and machines, and insurance, taxes, and maintenance on factory facilities.

Product Versus Period Costs. 1. Product costs are costs that are a necessary and integral part of producing the finished product. 2. Product costs do not become expenses until the company sells the finished goods inventory. 3. Period costs are costs that are matched with the revenue of a specific time period rather than included as part of the cost of a salable product. 4. Period costs include selling and administrative expenses and companies deduct them from revenues in the period in which they are incurred.

19-9

Manufacturing Costs in Financial Statements. 1. The principal differences in a manufacturer’s financial statements occur in the cost of goods sold section in the income statement and the current assets section in the balance sheet. 2. Manufacturers compute cost of goods sold by adding the beginning finished goods inventory to the cost of goods manufactured and subtracting the ending finished goods inventory. 3. To determine the cost of goods manufactured, companies add the cost of the beginning work in process to the total manufacturing costs for the current year to find the total cost of work in process for the year. Companies then subtract the ending work in process from the total cost of work in process to find the cost of goods manufactured. 4. The balance sheet for a manufacturing company may have three inventory accounts: a.

Finished Goods Inventory, which shows the cost of completed goods on hand.

Work in Process Inventory, which shows the cost applicable to units that have been started into production but are only partially completed. Raw Materials Inventory, which shows the cost of raw materials on hand.

SERVICE COMPANY INSIGHT Allegiant Airlines must know something because while other airlines are losing money, it is generating profits. As a low-budget airline, it focuses on controlling costs. It flies out of small towns, so wages are low and competition is nonexistent. If a route isn’t filling up, it quits flying it as often or cancels it altogether. What are some of the line items that would appear in the cost of service schedule of an airline?

. 19-10

Answer: Some of the cost items that would appear in the cost of service schedule of an airline would be fuel, flight crew salaries, maintenance wages, depreciation on equipment, airport gate fees, and food-service costs. H.

Managerial Accounting Today. 1. Managerial accounting has experienced many changes in recent years including a shift toward addressing the needs of service companies and improving practices to better meet the needs of managers. 2. The value chain refers to all activities associated with providing a product or service (i.e. research and development, production, delivery, etc.). Analysis of the value chain has made companies far more responsive to customer needs and has improved profitability. 3. Many companies have significantly lowered inventory levels and costs using just-in-time (JIT) inventory methods. Under a just-in-time method, goods are manufactured or purchased just in time for use. 4. Many companies have installed total quality management (TQM) systems to reduce defects in finished products. These systems require timely data on defective products, rework costs, and the cost of honoring warranty contracts. 5.

All companies have constraints that limit their potential profitability. The theory of constraints is a specific approach used to identify and manage constraints in order to achieve the company goals.

Many companies now employ enterprise resource planning (ERP) software systems to manage their value chain. ERP systems provide a comprehensive, centralized, integrated source of information that companies can use to manage all major business processes, from purchasing to manufacturing to recording human resources.

. 19-11

7. In order to obtain more accurate product costs, many companies now allocate overhead using activity-based costing (ABC). Under ABC, companies allocate overhead based on each product’s use of activities in making the product.

The balanced scorecard is now used by many companies in order to attain a more comprehensive view of the company’s operations. The balanced scorecard is a performance-measurement approach that uses both financial and nonfinancial measures to evaluate all aspects of a company’s operations in an integrated fashion.

Many companies have begun to evaluate not just corporate profitability but also corporate social responsibility. Corporate social responsibility considers a company’s efforts to employ sustainable business practices with regard to its employees, society, and the environment. The reporting of sustainable business practices has no agreed upon standard setter, but guidelines published by the Global Reporting Initiative are among the most widely recognized and followed.

Business Ethics. 1. Companies use complex systems to control and evaluate managers’ actions. Unfortunately these systems and controls unwittingly create incentives for managers to sometimes take unethical actions. 2. Ethical business scandals involving fraudulent activities of managers caused the U.S. Congress to enact the Sarbanes-Oxley Act of 2002. This act requires that CEOs and CFOs certify that the financial statements give a fair presentation of the company’s operating results and its financial condition. 3. Top managers must certify that the company maintains an adequate system of internal controls to safeguard the company’s assets and ensure accurate financial reports. 4. The Institute of Management Accountants (IMA) has developed a code of ethical standards to provide guidance for managerial accountants. This code states that management accountants should not commit acts or condone acts by others in violation of these standards.

. 19-12

CHAPTER 20 JOB ORDER COSTING LEARNING OBJECTIVES 1. DESCRIBE COST SYSTEMS AND THE FLOW OF COSTS IN A JOB ORDER SYSTEM. 2. USE A JOB COST SHEET TO ASSIGN COSTS TO WORK IN PROCESS. 3. DEMONSTRATE HOW TO DETERMINE AND USE THE PREDETERMINED OVERHEAD RATE. 4. PREPARE ENTRIES FOR MANUFACTURING AND SERVICE JOBS COMPLETED AND SOLD. 5. DISTINGUISH BETWEEN UNDER- AND OVERAPPLIED MANUFACTURING OVERHEAD.

20-1

CHAPTER REVIEW Cost Accounting Systems 1.

(L.O. 1) Cost accounting involves the measuring, recording, and reporting of product costs. From the data accumulated, both the total cost and unit cost of each product is determined.

A cost accounting system consists of accounts for the various manufacturing costs. These accounts are fully integrated into the general ledger of a company. An important feature of a cost accounting system is the use of a perpetual inventory system. Such a system provides information immediately on the cost of a product. The two basic types of cost accounting systems are (a) a job order cost system and (b) a process cost system.

Under a job order cost system, costs are assigned to each job or to each batch of goods.

A process cost system is used when a large volume of similar products are manufactured. Process costing accumulates product-related costs for a period of time instead of assigning costs to specific products or job orders.

Job Order Cost Flow 5.

The flow of costs in job order cost accounting parallels the physical flow of the materials as they are converted into finished goods. There are two major steps in the flow of costs: (a) accumulating the manufacturing costs incurred and (b) assigning the accumulated costs to the work done.

A company accumulates manufacturing costs incurred by debits to Raw Materials Inventory, Factory Labor, and Manufacturing Overhead..

The assignment of manufacturing costs involves entries to Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold.

The cost of raw materials purchased is debited to Raw Materials Inventory when materials are received.

Factory labor costs are debited to Factory Labor when they are incurred. The cost of factory labor consists of (1) gross earnings of factory workers, (2) employer payroll taxes on the earnings, and (3) fringe benefits incurred by the employer.

10.

Manufacturing overhead costs are recognized as incurred and periodically through adjusting entries. The costs are debited to Manufacturing Overhead.

Assigning Manufacturing Costs to Work in Process 11.

(L.O. 2) The assignment of manufacturing overhead costs to work in process involves debits to Work in Process Inventory and credits to Raw Materials Inventory, Factory Labor, and Manufacturing Overhead.

Weygandt, Managerial Accounting, 7/e, Instructor’s Manual

(For Instructor Use Only)

20-2

12. A job cost sheet is a form used to record the costs chargeable to a specific job and to determine the total and unit cost of the completed job. A separate job cost sheet is kept for each job. A subsidiary ledger consists of individual records for each individual item (each job). The Work in Process account is referred to as a control account because it summarizes the detailed data regarding specific jobs contained in the job cost sheets. Each entry to Work in Process Inventory must be accompanied by a corresponding posting to one or more job cost sheets. 13. Raw materials costs are assigned when the materials are issued by the storeroom. Work in Process Inventory is debited for direct materials used, Manufacturing Overhead is debited for indirect materials used, and Raw Materials Inventory is credited. 14. Factory labor costs are assigned to jobs on the basis of time tickets prepared when the work is performed. Work in Process Inventory is debited for direct labor costs, Manufacturing Overhead is debited for indirect labor costs, and Factory Labor is credited. Manufacturing Overhead Costs 15. (L.O. 3) Manufacturing overhead relates to production operations as a whole and therefore cannot be assigned to specific jobs on the basis of actual costs incurred. Instead, manufacturing overhead is assigned to work in process and to specific jobs on an estimated basis through the use of a predetermined overhead rate. 16. The predetermined overhead rate is based on the relationship between estimated annual overhead costs and expected annual operating activity. This relationship is expressed in terms of a common activity base such as direct labor costs, direct labor hours, or machine hours. a. The formula for the predetermined overhead rate is: Estimated Annual Overhead Costs

Expected Annual Operating Activity

Predetermined Overhead Rate

b. The use of a predetermined overhead rate enables the company to determine the approximate total cost of each job when the job is completed. c. In recent years, more companies are using machine hours as the activity base due to increased reliance on automation in manufacturing operations. 17. At the end of each month, the balance in Work in Process Inventory should equal the sum of the costs shown on the job cost sheets for unfinished jobs. Assigning Costs to Finished Goods 18. (L.O. 4) When a job is completed, the total cost is debited to Finished Goods Inventory and credited to Work in Process Inventory. Finished Goods Inventory is a control account that controls individual finished goods records in a finished goods subsidiary ledger. 19. Cost of goods sold is recognized when a sale occurs by a debit to Cost of Goods Sold and a credit to Finished Goods Inventory (the sale is recorded with a debit to Accounts Receivable or Cash and a credit to Sales Revenue).

20-3

Job Order Costing for Service Companies 20. While service companies do not have inventory, the techniques of job order costing are still quite useful in many service industry environments. Many service organizations bill their customers using cost-plus contracts, which means that the customer’s bill is the sum of the costs incurred on the job, plus a profit amount that is calculated as a percentage of the costs incurred. 21. At the end of a period, financial statements are prepared that present aggregate data on manufactured and sold.

all jobs

a. The cost of goods manufactured schedule has one new feature: in determining total manufacturing costs, manufacturing overhead applied is used instead of actual overhead costs. b. The cost of goods manufactured schedule is prepared directly from the Work in Process Inventory account. Advantages and Disadvantages of Job Order Costing 22.

An advantage of job order costing is it is more precise in assignment of costs to projects than process costing. One disadvantage of job order costing is that it requires a significant amount of data entry.

Under- or Overapplied Manufacturing Overhead 23.

(L.O. 5) Manufacturing overhead may be under- or overapplied. When Manufacturing Overhead has a debit balance, overhead is said to be underapplied. Underapplied overhead means that the overhead assigned to work in process is less than the overhead incurred. When manufacturing overhead has a credit balance, overhead is overapplied. Overapplied overhead means that the overhead assigned to work in process is greater than the overhead incurred.

24.

At the end of the year, any balance in Manufacturing Overhead is eliminated through an adjusting entry, usually to Cost of Goods Sold. a. Underapplied overhead is debited to Cost of Goods Sold. b. Overapplied overhead is credited to Cost of Goods Sold.

Weygandt, Managerial Accounting, 7/e, Instructor’s Manual

(For Instructor Use Only)

20-4

LECTURE OUTLINE A.

Cost Accounting Systems. 1. Cost accounting involves the measuring, recording, and reporting of product costs. From the data accumulated, companies determine both the total cost and the unit cost of each product. 2. A cost accounting system consists of accounts for the various manufacturing costs. These accounts are fully integrated into the general ledger of a company. An important feature of a cost accounting system is the use of a perpetual inventory system that provides immediate, up-to-date information on the cost of a product. 3. There are two basic types of cost accounting systems: a.

A job order system, where the company assigns costs to each job or to each batch of goods, and

A process cost system, used when a company manufactures a large volume of similar products.

MANAGEMENT INSIGHT Many companies suffer from poor cost accounting and sometimes make products they should not be selling. The managers of a diversified company thought they were making money, but a consulting firm found that the company had seriously underestimated costs. What type of costs do you think the company had been underestimating?

20-5

Answer: It is most likely that the company failed to estimate and track overhead. In a highly diversified company, overhead associated with the diesel locomotive jobs may have been “lost” in the total overhead pool for the entire company. B.

Job Order Cost Flow. 1. The flow of costs (direct materials, direct labor, and manufacturing overhead) in job order cost accounting parallels the physical flow of the materials as they are converted into finished goods. 2. There are two major steps in the flow of costs: a.

Accumulating the manufacturing costs incurred; these costs are accumulated in three accounts: Raw Materials Inventory, Factory Labor, and Manufacturing Overhead, and

Assigning the accumulated costs to Work in Process Inventory and eventually to Finished Goods Inventory and Cost of Goods Sold.

3. Three entries are made to accumulate the manufacturing costs incurred. a.

When the company receives the raw materials it has purchased, it debits the cost of the materials to Raw Materials Inventory. Raw Materials Inventory is a control account. The subsidiary ledger consists of individual records for each item of raw materials.

The cost of factory labor consists of gross earnings of factory workers, employer payroll taxes, and fringe benefits (sick pay, pensions, and vacation pay) incurred by the employer. Companies debit labor costs to Factory Labor as they incur those costs. Factory labor is assigned to work in process and manufacturing overhead at the end of the period.

Weygandt, Managerial Accounting, 7/e, Instructor’s Manual

(For Instructor Use Only)

20-6

A company may record overhead costs periodically through adjusting entries by debiting Manufacturing Overhead. Manufacturing Overhead is a control account and the subsidiary ledger consists of individual accounts for each type of cost (factory utilities, factory repairs, etc.).

Assigning Manufacturing Costs to Work in Process. 1. A job cost sheet is a form used to record the costs chargeable to a specific job and to determine the total and unit costs of the completed job. The job cost sheets constitute the subsidiary ledger for the Work in Process Inventory account. 2. Each entry to Work in Process Inventory must be accompanied by a corresponding posting to one or more job cost sheets. 3. Three entries are made in assigning the manufacturing costs to work in process.

20-7

Materials requisition slips indicate the quantity and type of materials withdrawn and the account to be charged. Companies charge direct materials to Work in Process Inventory and indirect materials to Manufacturing Overhead.

Companies assign factory labor costs to jobs on the basis of time tickets prepared when the work is performed. The time ticket indicates the hours worked, the account and job to be charged, and the total labor cost. Companies debit the Work in Process Inventory account for direct labor, and Manufacturing Overhead for indirect labor.

Companies assign manufacturing overhead to work in process and to specific jobs on an estimated basis through the use of a predetermined overhead rate. Using a predetermined overhead rate enables a cost to be determined for a job immediately.

MANAGEMENT INSIGHT Competitors often want to know the cost of a competing product. For a price, a company called iSuppli will disassemble sophisticated electronics and tell you what it would cost to replicate the product. The difference between the cost of the parts and the cost of the labor to assemble the parts isn’t all profit. There are nonproduction costs such as research, design, marketing, patent fees, and selling costs. What type of costs are research, design, marketing, patent fees, and selling costs, and how are they treated for accounting purposes? Answer: Product costs include materials, labor, and overhead. Costs not related to production, such as research, design, marketing, patent fees, and selling costs, are period costs which are expensed in the period that they are incurred. 4. The predetermined overhead rate is based on the relationship between estimated annual overhead costs and expected annual operating activity, expressed in terms of a common activity base. a.

The company may state the activity in terms of direct labor costs, direct labor hours, machine hours, or any other measure that will provide an equitable basis for applying overhead costs to jobs.

The predetermined overhead rate is established at the beginning of the year.

5. Using a predetermined overhead rate enables the company to determine the approximate total cost of each job when it completes the job. 6. At the end of each month, the balance in Work in Process Inventory should equal the sum of the costs shown on the job cost sheets of unﬁnished jobs.

Weygandt, Managerial Accounting, 7/e, Instructor’s Manual

(For Instructor Use Only)

20-8

Assigning Costs to Finished Goods and Cost of Goods Sold. 1. When a job is completed, the company summarizes the costs in the applicable job cost sheet and debits Finished Goods Inventory. Finished Goods Inventory is a control account that controls individual finished goods records in a finished goods subsidiary ledger. Postings to the finished goods records are made directly from completed job cost sheets. 2. Companies recognize cost of goods sold when each sale occurs. Each sale requires an entry debiting Cash or Accounts Receivable and crediting Sales Revenue for the selling price and a second entry debiting Cost of Goods Sold and crediting Finished Goods Inventory for the cost of the goods. 3. Job cost sheets for a service company keep track of materials, labor, and overhead used on a particular job similar to a manufacturer.

SERVICE COMPANY INSIGHT Jet engines are one of the many products made by the industrial operations division of General Electric. At prices as high as $30 million per engine GE does its best to keep track of costs. Because of the high product costs, both the engines themselves and the subsequent service are most likely accounted for using job order costing. GE needs good cost records for its service jobs in order to control its costs. Explain why GE would use job order costing to keep track of the cost of repairing a malfunctioning engine for a major airline. Answer: GE operates in competitive environment. Other companies offer competing bids to win service contracts on GE airplane engines. GE needs to know what it costs to repair engines, so that it can present competitive bids while still generating a reasonable profit.

20-9

Reporting Job Cost Data. 1. At the end of a period, companies prepare financial statements that present data on all jobs manufactured and sold. 2. The cost of goods manufactured schedule is the same as for companies that do not use job order costing with one exception: manufacturing overhead applied, rather than actual overhead costs, is added to direct materials and direct labor to determine total manufacturing costs.

Under- or Overapplied Manufacturing Overhead. 1. Underapplied overhead means that the overhead assigned to work in process is less than the overhead incurred (when Manufacturing Overhead has a debit balance). 2. Overapplied overhead means that the overhead assigned to work in process is greater than the overhead incurred (when Manufacturing Overhead has a credit balance). 3. At the end of the year, the company eliminates any balance in Manufacturing Overhead by an adjusting entry. Under- or overapplied overhead is generally considered to be an adjustment to cost of goods sold. 4. The company debits underapplied overhead to Cost of Goods Sold and it credits overapplied overhead to Cost of Goods Sold.

Weygandt, Managerial Accounting, 7/e, Instructor’s Manual

(For Instructor Use Only) 20-10

20 MINUTE QUIZ Circle the correct answer. True/False 1.

Under a job order system, the company assigns costs to each job, or each batch of goods, to fill a specific customer order or replenish inventory. True

Manufacturing costs incurred in a job order system are accumulated by debits to Purchases, Factory Labor, and Manufacturing Overhead. True

False

In preparing the costs of goods manufactured schedule in job order costing, manufacturing costs include direct materials used, direct labor used, and manufacturing overhead applied. True

10.

False

A debit balance in the Manufacturing Overhead Account at the end of the period indicates that overhead has been overapplied. True

False

The entry to record the cost of goods sold includes a debit to Finished Goods Inventory. True

False

Actual overhead costs are debited to the Manufacturing Overhead account. True

False

The requisition of factory supplies to production requires a debit to the Manufacturing Overhead account. True

False

Manufacturing overhead costs cannot be traced directly to a specific job. True

False

Each debit to Work in Process Inventory must be accompanied by a corresponding posting to one or more job cost sheets. True

False

A job cost sheet is a form used to record the costs chargeable to a specific job and to determine the total and unit cost of the completed job. True

. 20-11

False

Multiple Choice 1.

A job order cost sheet includes a. the selling price of the job. b. a total when a job is completed and transferred to cost of goods sold. c. all manufacturing costs for a job. d. all manufacturing overhead costs for the period.

Companies assign raw materials costs to jobs a. By debiting Raw Materials Inventory and crediting Work in Process. b. Based on a predetermined rate. c. In response to verbal requests for indirect materials such as supplies. d. Using any of the inventory costing methods (FIFO, LIFO, or average-cost).

In a job order cost system, debits to Work in Process Inventory originate from all of the following except a. applying the predetermined overhead rate. b. assigning direct labor from time tickets. c. assigning actual manufacturing overhead costs to jobs. d. assigning direct materials from requisition slips.

The predetermined overhead rate is computed by dividing estimated a. level of activity by estimated overhead costs. b. level of activity by expected overhead costs. c. overhead costs by estimated cost of jobs. d. overhead costs by expected activity base.

If annual overhead costs are expected to be $1,000,000 and 200,000 total labor hours are anticipated (80% direct, 20% indirect), the overhead rate based on direct labor hours is a. $6.25. b. $5.00. c. $25.00. d. $4.00.

Weygandt, Managerial Accounting, 7/e, Instructor’s Manual

(For Instructor Use Only) 20-12

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True False True True True

Multiple Choice 1. 2. 3. 4. 5.

. 20-13

c. d. c. d. a

6. 7. 8. 9. 10.

True False False True True

CHAPTER 21 PROCESS COSTING LEARNING OBJECTIVES 1.

DISCUSS THE USES OF A PROCESS COST SYSTEM AND HOW IT COMPARES TO A JOB ORDER SYSTEM.

EXPLAIN THE FLOW OF COSTS IN A PROCESS COST SYSTEM AND THE JOURNAL ENTRIES TO ASSIGN MANUFACTURING COSTS.

COMPUTE EQUIVALENT UNITS.

COMPLETE THE FOUR STEPS TO PREPARE A PRODUCTION COST REPORT.

*5. COMPUTE EQUIVALENT UNITS USING THE FIFO METHOD.

21-1

CHAPTER REVIEW Process Cost Systems 1.

(L.O. 1) Process cost systems are used to apply costs to similar products that are mass produced in a continuous fashion, such as the production of ice cream, steel or soft drinks. In comparison, costs in a job order cost system are assigned to a specific job, such as the construction of a customized home, the making of a motion picture, or the manufacturing of a specialized machine.

Job order cost and process cost systems are similar in that (a) both use the same three manufacturing cost elements of direct materials, direct labor, and manufacturing overhead; (b) both accumulate costs of raw materials by debiting Raw Materials Inventory, factory labor by debiting Factory Labor, and manufacturing overhead costs by debiting Manufacturing Overhead; and (c) both assign costs to the same accounts of Work in Process, Finished Goods Inventory, and Cost of Goods Sold.

The major differences between a job order cost system and a process cost system are as follows: Job Order Cost System One for each job

Process Cost System One for each process

Documents used

Job cost sheets

Production cost reports

Determination of total manufacturing costs

Each job

Each period

Unit-cost computations

Cost of each job ÷ Units produced for the job

Total manufacturing costs ÷ Equivalent units produced during the period

Feature Work in process accounts

Process Cost Flow

(L.O. 2) In the Tyler Company example in the text book, manufacturing consists of two processes: machining and assembly. In the Machining Department, the raw materials are shaped, honed, and drilled. In the Assembly Department, the parts are assembled and packaged.

Materials, labor, and manufacturing overhead can be added in both the Machining and Assembly Departments. When the Machining Department finishes its work, the cost of the partially completed units is transferred to the Assembly Department. In the Assembly Department, the goods are finished and the cost is then transferred to the finished goods inventory. Upon sale, the cost of the goods sold is removed from the finished goods inventory.

21-2

Assigning Manufacturing Costs 6.

All raw materials issued for production are a materials cost to the producing department. Materials requisition slips may be used in a process cost system, but fewer requisitions are generally required than in a job order cost system, because the materials are used for processes rather than for specific jobs. In the case of the Tyler Company, the entry to record the materials used is: Work in Process—Machining .......................................... Work in Process—Assembly........................................... Raw Materials Inventory.........................................

XXXX XXXX XXXX

The basis for allocating the overhead costs to the production departments in an objective and equitable manner is the activity that “drives” or causes the costs. A primary driver of overhead costs in continuous manufacturing operations is machine time used, not direct labor. Thus, machine hours are widely used in allocating manufacturing overhead costs. In the case of the Tyler Company, the entry to allocate overhead is: Work in Process—Machining .......................................... Work in Process—Assembly........................................... Manufacturing Overhead........................................

XXXX

Time tickets may be used in determining the cost of labor assignable to the production departments. The labor cost chargeable to a process can be obtained from the payroll register or departmental payroll summaries. All labor costs incurred within a producing department are a cost of processing the raw materials. In the case of the Tyler Company, the entry to assign the labor costs is: Work in Process—Machining .......................................... Work in Process—Assembly........................................... Factory Labor.........................................................

XXXX XXXX

XXXX XXXX XXXX

At the end of the period, the following transfer entries are needed for the Tyler Company to transfer units to the Assembly department from the Machining department; to transfer from the Assembly department to Finished Goods; and, to transfer from Finished Goods to Cost of Goods Sold: Work in Process—Assembly........................................... Work in Process—Machining .................................

XXXX

Finished Goods Inventory ............................................... Work in Process—Assembly ..................................

XXXX

Cost of Goods Sold ........................................................ Finished Goods Inventory ......................................

XXXX

Equivalent Units 10.

(L.O. 3) A major step in process cost accounting is the calculation of equivalent units. Equivalent units of production measure the work done during the period, expressed in fully completed units. This concept is used to determine the cost per unit of completed product.

21-3

11.

The formula to compute equivalent units of production under the weighted-average method is as follows: Units Completed and + Transferred Out

Equivalent Units of Ending Work in Process

Equivalent Units of Production

12.

The method of computing equivalent units here is referred to as the weighted-average method. It considers the degree of completion (weighting) of the units completed and transferred out and the units in ending work in process. A lesser used method, called the FIFO method, is discussed in the appendix to this chapter.

13.

To illustrate the computation of equivalent units using the weighted-average method, assume that materials are entered at the beginning of the process, conversion costs include both labor and overhead costs, and the following information is provided for the Processing Department of Silva Company:

Work in process, Beg. Started into production Total units Units transferred out Work in process, End. Total units 14.

Percentage Complete Materials Conversion Costs 100% 80%

Physical Units 2,500 4,500 7,000 6,000 1,000 7,000

100%

60%

The two equivalent unit computations are as follows:

Units transferred out Work in process, End 1,000 X 100% 1,000 X 60% Total equivalent units

Equivalent Units Conversion Materials Costs 6,000 6,000 1,000 7,000

600 6,600

Production Cost Report 15.

(L.O. 4) A production cost report is the key document used by management to understand the activities in a department because it shows the production quantity and cost data related to that department. In order to be ready to complete a production cost report, the company must perform four steps: a. Compute the physical unit flow. b. Compute the equivalent units of production. c. Compute unit production costs. d. Prepare a cost reconciliation schedule.

21-4

16.

The computation of physical units involves: a. adding the units started (or transferred) into production during the period to the units in process at the beginning of the period to determine the total units to be accounted for; and b. accounting for these units by determining the output for the period⎯which consists of units transferred out during the period and units in process at the end of the period. In the example above, the total units to be accounted for and the units accounted for are both equal to 7,000 units for the Silva Company.

17.

In computing unit costs, production costs are expressed in terms of equivalent units of production. When equivalent units are different for materials and conversion costs, the formulas for computing unit costs are as follows: Total Materials ÷ Cost

18.

Equivalent Units of Materials

Unit Materials Cost

Total Conversion Costs

Equivalent Units of Conversion Costs

Unit Conversion Cost

Unit Materials Cost

Unit Conversion Cost

Total Manufacturing Cost per Unit

The cost reconciliation schedule shows that the total costs accounted for equal the total costs to be accounted for as follows: Costs to be accounted for Transferred out .......................................... Work in process, End Materials................................................ Conversion costs ................................... Total costs ....................................................

19.

$XXXX $XXXX XXXX

XXXX $XXXX

Assume the Processing Department of Silva Company has the following additional cost information: Work in process, Beg. Direct materials: 100% complete ....................... Conversion costs: 80% complete ...................... Cost of work in process, Beg. ...................................

$ 24,000 19,620 $ 43,620

Costs incurred during production Direct materials ................................................. Conversion costs ............................................... Costs incurred ..........................................................

$200,000 150,000 $350,000

21-5

20.

Silva Company’s Processing Department Production Cost Report at the end of the period is as follows: Processing Department Production Cost Report For the Period Ended

Physical Units QUANTITIES Units to be accounted for Work in process, Beg. Started into production Total units Units accounted for Transferred out Work in process, End. Total units

COSTS Unit costs Costs during the period Equivalent units Unit costs [(a) ÷ (b)]

Equivalent Units Conversion Materials Costs

2,500 4,500 7,000 6,000 1,000 7,000

6,000 1,000 7,000

6,000 600 (1,000 X 60%) 6,600

Materials

Conversion Costs

(a) $224,000 (b) 7,000 $32.00

$169,620 6,600 $25.70

Costs to be accounted for Work in process, Beg. Started into production Total costs Cost Reconciliation Schedule Costs accounted for Transferred out (6,000 X $57.70) Work in process, End. Materials (1,000 X $32.00) Conversion costs (600 X $25.70) Total costs

Total

$393,620 $57.70

$ 43,620 350,000 $393,620

$346,200 $32,000 15,420

47,420 $393,620

Operations Costing 21.

Companies often use a combination of a process cost and a job order cost system, called operations costing. Operations costing is similar to process costing in that standardized methods are used to manufacture the product. At the same time, the product may have some customized, individual features that require the use of a job order cost system.

21-6

Equivalent Units Using the FIFO Method *22. (L.O. 5) To illustrate the computation of equivalent units using the FIFO method, assume that materials are entered at the beginning of the process and the following information is provided for the Processing Department of Silva Company:

Work in process, Beg. Started into production Total units Units transferred out Work in process, End. Total units

Physical Units 2,500 4,500 7,000 6,000 1,000 7,000

Percentage Complete Materials Conversion Costs 100% 80%

100%

60%

*23. The equivalent units for material costs of the Processing Department under the FIFO method are computed as follows:

Production Data Work in process, Beg. Started and finished Work in process, End. Total

Processing Department Work Added Physical Units This Period 2,500 0 3,500 100% 1,000 100% 7,000

Equivalent Units 3,500 1,000 4,500

*24. The equivalent units for conversion costs of the Processing Department under the FIFO method are computed as follows:

Production Data Work in process, Beg. Started and completed Work in process, End. Total

Processing Department Work Added Physical Units This Period 2,500 20% 3,500 100% 1,000 60% 7,000

Equivalent Units 500 3,500 600 4,600

Production Cost Report Using the FIFO Method *25. Assume the Processing Department of Silva Company has the following additional cost information:

Work in process, Beg. Direct materials: 100% complete ....................................... Conversion costs: 80% complete ....................................... Cost of work in process, Beg. ..............................................

$ 24,000 19,620 $ 43,620

Costs incurred during the production Direct materials.................................................................. Conversion costs ............................................................... Costs incurred .....................................................................

$200,000 150,000 $350,000

21-7

*26. Silva Company’s Processing Department Production Cost Report at the end of the period using the FIFO method is as follows: Processing Department Production Cost Report For the Period Ended

Physical Units QUANTITIES Units to be accounted for Work in process, Beg. Started into production Total units Units accounted for Completed and transferred out Work in process, Beg. Started and completed Work in process, End. Total units

COSTS Unit costs Costs during the period Equivalent units Unit costs [(a)/(b)]

Equivalent Units Conversion Materials Costs

2,500 4,500 7,000

2,500 3,500 1,000 7,000

(a) (b)

0 3,500 1,000 4,500

500 3,500 600 4,600

Materials

Conversion Costs

$200,000 4,500 $44.444

$150,000 4,600 $ 32.609

Costs to be accounted for Work in process, Beg. Started into production Total costs

Total costs

21-8

$350,000 $77.053

$ 43,620 350,000 $393,620

Cost Reconciliation Schedule Costs accounted for Transferred out Work in process, Costs to complete beg. work in process Conversion costs (500 X $32.609) Total costs Units started and completed (3,500 X $77.053) Total costs transferred out Work in process, End Materials (1,000 X $44.444) Conversion costs (600 X $32.609)

Total

$ 43,620 16,305 59,925 269,686 329,611 $44,444 19,565

64,009 $393,620

LECTURE OUTLINE A.

Uses of Process Cost Systems. 1. Process cost systems are used to apply costs to similar products that are mass-produced in a continuous fashion. 2. Once production begins, it continues until the finished product emerges, and each unit of finished product is like every other unit.

Similarities and Differences Between Job Order Cost and Process Cost Systems. 1. In a process cost system, costs are tracked through a series of connected manufacturing processes or departments, rather than by individual jobs as in a job order cost system. 2. Companies use process cost systems when they produce a large volume of relatively homogeneous products. 3. Job order cost and process cost systems are similar in three ways: a.

Both systems track the same manufacturing cost elements—direct materials, direct labor, and manufacturing overhead.

Both accumulate costs in the same accounts—Raw Materials Inventory, Factory Labor, and Manufacturing Overhead.

Both assign accumulated costs to the same accounts—Work in Process, Finished Goods Inventory, and Cost of Goods Sold.

4. There are four main differences between the two cost systems: a.

21-9

In a job order cost system, only one work in process account is used while separate accounts are maintained for each department or manufacturing process in a process cost system.

In a job order cost system, costs are charged to individual jobs and summarized in a job cost sheet; in a process cost system, costs are summarized in a production cost report for each department.

Costs are totaled at the completion of a job in a job cost system but at the end of a time period (i.e. a month or year) in a process cost system.

In a job cost system, the unit cost is the total cost per job ÷ by the units produced. In a process cost system, the unit cost is total manufacturing costs for the period ÷ by the units produced during the period.

Process Cost Flow. 1. The company can add materials, labor, and manufacturing overhead in each production department. 2. The costs of units completed are transferred from one department to another as those units move through the manufacturing process. 3. The costs of completed work are transferred to Finished Goods Inventory. 4. When inventory is sold, costs are transferred to Cost of Goods Sold.

Assigning Manufacturing Costs. 1. The accumulation of the costs of materials, labor, and manufacturing overhead is the same in a process cost system as in a job order cost system. 2. Entries to assign the costs of raw materials, factory labor, and overhead consist of a debit to Work in Process for each department and a credit to Raw Materials Inventory, Factory Labor, and Manufacturing Overhead. 3. The assignment of the three manufacturing cost elements to Work in Process in a process cost system is different from a job order cost system.

. 21-10

All raw materials issued for production are a materials cost to the producing department. A process cost system may use materials requisition slips, but fewer requisitions are generally required than in a job order system, because the materials are used for processes rather than specific jobs.

Companies may use time tickets to determine the cost of factory labor assignable to production departments. Since labor costs are assigned to a process rather than a job, the labor cost chargeable to a process can be obtained from the payroll register or departmental payroll summaries.

The objective in assigning overhead in a process cost system is to allocate the overhead costs to the production departments on an objective and equitable basis. A primary driver of overhead costs in continuous manufacturing operations is machine time used, not direct labor. Companies widely use machine hours in allocating manufacturing overhead costs.

4. The entry to record units completed and transferred to the warehouse is a debit to Finished Goods Inventory and a credit to Work in Process. 5. The entry to record the sale of goods is a debit to Cost of Goods Sold and a credit to Finished Goods Inventory. MANAGEMENT INSIGHT Some companies continue to assign manufacturing overhead on the basis of direct labor despite the fact that there is no cause-and-effect relationship between labor and overhead. In such cases, the overhead rates may be misleading. What is the result if a company uses the wrong “cost driver” to assign manufacturing overhead? Answer: Incorrect application of manufacturing overhead will result in some products receiving too much overhead and others receiving too little.

. 21-11

Equivalent Units. 1. Equivalent units of production measure the work done during the period, expressed in fully completed units. 2. Companies use this measure to determine the cost per unit of completed product. 3. Equivalent units of production are the sum of:

. 21-12

Units completed and transferred out.

Equivalent units of ending work in process.

4. The weighted-average method is most commonly used to compute equivalent units of production. 5. This method considers the degree of completion (weighting) of the units completed and transferred out and the ending work in process. 6. In computing equivalent units, the beginning work in process is not part of the equivalent-units-of-production formula. 7. For the example company in the textbook, the company needs to make two equivalent unit computations: one for materials, and the other for conversion costs (labor plus overhead costs). This is necessary because ending work in process is fully complete as to materials, but only partially complete as to conversion costs. MANAGEMENT INSIGHT In recent years more companies have been remanufacturing a wide variety of products including cell phones, car parts, and medical equipment. Rising commodity prices and regulations requiring that certain electronic items be recycled has fueled this trend. In what ways might the relative composition (materials, labor, and overhead) of a remanufactured product’s cost differ from that of a newly made product? Answer: We would expect that the materials costs would be substantially reduced since the bulk of the physical product is being reused. The labor component might increase, and the level of automation might decrease, since remanufacturing a product requires identification and replacement of malfunctioning components. This process might not be as easily automated as the production of a new product.

. 21-13

Production Cost Report.

1. In order to complete a production cost report, the company must perform four steps: a.

Compute the physical unit flow.

Compute the equivalent units of production.

Compute unit production costs.

Prepare a cost reconciliation schedule.

2. The first step in completing a production cost report requires computing physical unit flow. a.

The physical units are computed by adding the units started (or transferred) into production during the period to the units in process at the beginning of the period. This amount is called the total units to be accounted for.

These units then are accounted for by the output of the period, which consists of units transferred out during the period and any units in process at the end of the period.

3. The second step in completing a production cost report requires computing equivalent units of production.

. 21-14

Each processing department adds materials at the beginning of the process, and incurs conversion costs uniformly during the process.

Two computations of equivalent units are required—one for materials and one for conversion costs.

4. The third step in completing a production cost report requires computing unit production costs. a.

Unit production costs are costs expressed in terms of equivalent units of production.

When equivalent units of production are different for materials and conversion costs, companies compute three unit costs: (1) materials, (2) conversion, and (3) total manufacturing.

Total manufacturing cost per unit is computed as the sum of unit materials cost + unit conversion cost.

5. The fourth step in completing a production cost report requires preparing a cost reconciliation schedule.

The company prepares a cost reconciliation schedule to assign total costs to (1) units transferred out to the next department and (2) ending work in process.

The total manufacturing cost per unit is used in costing the units completed and transferred out.

The cost reconciliation schedule shows that the total costs accounted for equal the total costs to be accounted for.

Preparing the Production Cost Report. 1. The production cost report contains both quantity and cost data for a production department. a.

. 21-15

This report is an internal document for management that shows production quantity and cost data for a production department.

There are four steps in preparing a production cost report: (1) Prepare a physical unit schedule. (2) Compute equivalent units. (3) Compute unit costs. (4) Prepare a cost reconciliation schedule.

Production cost reports provide a basis for evaluating the productivity of a department. Managers can use the cost data to assess whether unit costs and total costs are reasonable.

*H. Equivalent Units Under FIFO. 1. Under the FIFO method, companies compute equivalent units on a firstin, first-out basis. 2. Companies assume that the beginning work in process is completed before new work is started under the FIFO method. 3. Equivalent units are the sum of the work performed to: a.

Finish the units of beginning work in process inventory.

Complete the units started into production during the period (units started and completed).

Start, but only partially complete, the units in ending work in process inventory.

4. The units started and completed during the current period are the units transferred out minus the units in beginning work in process. 5. Companies often expand the physical units schedule to ensure reporting of the beginning work in process and the units started and completed.

. 21-16

6. As with the weighted-average method, once companies determine the physical flow of units, they need to compute the equivalent units of production. a.

When companies add materials at the beginning of the process, no additional materials costs are required to complete the beginning work in process. However, sometimes companies add materials evenly throughout the process. When this occurs, computations for materials would mirror those for conversion costs.

Equivalent units for materials are the sum of: (1) Units started and finished. (2) Equivalent units of ending work in process.

Equivalent units for conversion costs are the sum of: (1) Equivalent units to complete beginning work in process. (2) Units started and finished. (3) Equivalent units of ending work in process.

7. The unit production costs are based entirely on the production costs incurred during the month. The costs in the beginning work in process are ignored because they were incurred on work done in the preceding month. 8. In preparing a cost reconciliation schedule under the FIFO method: a.

The cost of the beginning work in process is always assigned to the goods transferred to the next department (or finished goods, if processing is complete).

The ending work in process will be assigned only the production costs incurred in the current period.

9. The weighted-average method of computing equivalent units is simple to understand and apply. It will be very similar to the FIFO method when prices do not fluctuate significantly from period to period. . 21-17

10. Conceptually, the FIFO method is superior to the weighted-average method because it measures current performance using only costs incurred in the current period. It provides current cost information, which the company can use to establish more accurate pricing strategies for goods manufactured and sold in the current period.

. 21-18

20 MINUTE QUIZ Circle the correct answer. True/False 1. Costs are assigned to each specific job in a process cost system. True

False

2. In a process cost system, total costs are determined at the end of a period of time, such as a month. True

False

3. In a process cost system, the unit cost is total manufacturing costs divided by the equivalent units produced during the period. True

False

4. The accumulation of the costs of materials, labor, and manufacturing overhead is the same in a process cost system as in a job order cost system. True

False

5. More materials requisitions are generally required in a process cost system than in a job order cost system. True

False

6. Equivalent units of production equals units completed and transferred out + units in beginning work in process. True

False

7. Two equivalent unit computations are necessary—one for materials and the other for conversion costs. True

False

8. The first step in preparing a production cost report is to compute the equivalent units of production. True

False

9. The cost reconciliation schedule shows that the total costs accounted for equal the total costs to be accounted for. True

False

*10. Units in work in process at the beginning of the period are included in units “started and completed” under the FIFO method. True

. 21-19

False

Multiple Choice 1.

Which of the following is not a step in preparing a production cost report? a. Prepare a cost reconciliation schedule. b. Compute equivalent units of production. c. Compute the physical unit flow. d. Assign costs to particular jobs.

A department has no beginning work in process, has started 80,000 units and completed 50,000 units. Its ending work in process is 30,000 units, 60% complete as to conversion costs and fully complete as to materials. Its equivalent units for conversion costs are a. 50,000. b. 80,000. c. 68,000. d. 44,000.

In process costing, the computation of unit production costs requires a. the accumulation of material and conversion costs in work in process for each department or process. b. the computation of equivalent units for material and conversion costs. c. both a and b. d. neither a nor b.

Which of the following is not included in a production cost report? a. Costs accounted for. b. Entries to assign cost. c. Units accounted for. d. Units to be accounted for.

Unit costs for materials and conversion costs amount to $4 and $5 respectively. The ending work in process costs for 8,000 units (100% complete as to material and 70% complete as to conversion costs) amount to a. $60,000. b. $72,000. c. $44,000. d. $40,000.

. 21-20

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

False True True True False

Multiple Choice 1. 2. 3. 4. 5.

. 21-21

d. c. c. b. a.

6. 7. 8. 9. *10.

False True False True False

CHAPTER 22 COST-VOLUME-PROFIT Learning Objectives 1. EXPLAIN VARIABLE, FIXED, AND MIXED COSTS AND THE RELEVANT RANGE. 2. APPLY THE HIGH-LOW METHOD TO DETERMINE THE COMPONENTS OF MIXED COSTS. 3. PREPARE A CVP INCOME STATEMENT TO DETERMINE CONTRIBUTION MARGIN. 4. COMPUTE THE BREAK-EVEN POINT USING THREE APPROACHES. 5. DETERMINE THE SALES REQUIRED TO EARN TARGET NET INCOME AND DETERMINE MARGIN OF SAFETY. 6. USE CVP ANALYSIS TO RESPOND TO CHANGES IN THE BUSINESS ENVIRONMENT. *7. EXPLAIN THE DIFFERENCE BETWEEN ABSORPTION COSTING AND VARIABLE COSTING.

22-1

CHAPTER REVIEW Cost Behavior Analysis 1.

Cost behavior analysis is the study of how specific costs respond to changes in the level of business activity. A knowledge of cost behavior helps management plan operations and decide between alternative courses of action.

The activity index identifies the activity that causes changes in the behavior of costs; examples include direct labor hours, sales dollars, and units of output. Once an appropriate activity index is chosen, costs can be classified as variable, fixed or mixed.

Variable and Fixed Costs 3.

(L.O. 1) Variable costs are costs that vary in total directly and proportionately with changes in the activity level. Examples of variable costs include direct materials and direct labor, cost of goods sold, sales commissions, and freight out. A variable cost may also be defined as a cost that remains the same per unit at every level of activity.

Fixed costs are costs that remain the same in total regardless of changes in the activity level. Examples include property taxes, insurance, rent, supervisory salaries, and depreciation. Fixed costs per unit vary inversely with activity; as volume increases, unit cost declines and vice versa.

Mixed Costs 5.

Mixed costs are costs that contain both a variable element and a fixed element; they increase in total as the activity level increases, but not proportionately. For purposes of CVP analysis, mixed costs must be classified into their fixed and variable elements.

Relevant Range 6.

The range over which a company expects to operate during the year is called the relevant range. Within the relevant range a linear (straight-line) relationship exists for both variable and fixed costs.

(L. O. 2) The high-low method uses the total costs incurred at the high and low levels of activity. The difference in costs represents variable costs, since only the variable cost element can change as activity levels change.

The steps in computing fixed and variable costs under the high-low method are: a. Determine variable cost per unit from the following formula: High minus High minus Low Variable Cost per Low Total ÷ = Activity Level Unit Costs b.

Determine the fixed cost by subtracting the total variable cost at either the high or the low activity level from the total cost at that activity level.

Cost-Volume-Profit Analysis

22-2

Cost-volume-profit (CVP) analysis is the study of the effects of changes in costs and volume on a company’s profits. It is a critical factor in such management decisions as profit planning, setting selling prices, determining the product mix, and maximizing use of production facilities.

10.

CVP analysis considers the interrelationships among the following components: (a) volume or level of activity, (b) unit selling prices, (c) variable cost per unit, (d) total fixed costs, and (e) sales mix.

Basic CVP Components 11.

The following assumptions underlie each CVP analysis: a. The behavior of both costs and revenues is linear throughout the relevant range of the activity index. b. Costs can be classified accurately as either variable or fixed. c. Changes in activity are the only factors that affect costs. d. All units produced are sold. e. When more than one type of product is sold, the sales mix will remain constant.

CVP Income Statement 12.

(L.O. 3) The cost-volume-profit (CVP) income statement classifies costs and expenses as variable or fixed and specifically reports contribution margin in the body of the statement.

Contribution Margin 13.

Contribution margin is the amount of revenue remaining after deducting variable costs. The formula for contribution margin per unit is: Unit Selling Unit Variable Contribution – = Price Cost Margin per Unit

14.

Contribution margin per unit indicates the amount available to cover fixed costs and contribute to income. The formula for the contribution margin ratio is: Contribution Unit Selling Contribution ÷ = Margin per Unit Price Margin Ratio The ratio indicates the portion of each sales dollar that is available to apply to fixed costs and to contribute to income.

Break-Even Analysis 15.

(L.O. 4) The break-even point is the level of activity at which total revenue equals total costs both fixed and variable. Knowledge of the break-even point is useful to management when it decides whether to introduce new product lines, change sales prices on established products, or enter new market areas.

16.

A common equation used for CVP analysis is as follows: Sales = Variable Costs + Fixed Costs + Net Income

17.

Under the contribution margin technique, the break-even point can be computed by using either the contribution margin per unit or the contribution margin ratio.

22-3

18.

The formula, using unit contribution margin, is: Fixed Contribution Break-even ÷ = Costs Margin per Unit Point in Units

19.

The formula using the contribution margin is: Fixed Contribution Break-Even ÷ = Costs Margin Ratio Point in Dollars

20.

A chart (or graph) can also be used as an effective means to determine and illustrate the break-even point. A cost-volume-profit (CVP) graph is as follows: Dollars (000)

Sales Line

900 Total Cost Line

800 700 600 Break-even Point

Variable Costs

500 400 300 200

Fixed Cost Line

100

Fixed Costs

200 400 600 800 1000 1200 1400 1600 1800 Units of Sales

Target Net Income 21.

(L.O. 5) Target net income is the income objective for individual product lines. The following equation is used to determine required sales to meet target net income: Required Sales = Variable Costs + Fixed Costs + Target Net Income

Margin of Safety 22.

Margin of safety is the difference between actual or expected sales and sales at the break-even point. a. The formula for stating the margin of safety in dollars is: Actual Break-Even Margin of Safety (Expected) – = Sales in Dollars Sales b.

22-4

The formula for determining the margin of safety ratio is:

Actual Margin of Safety in Margin of Safety ÷ (Expected) = Dollars Ratio Sales The higher the dollars or the percentage, the greater the margin of safety. NOTE – I AM NOT SURE HOW YOU WANT TO INCORPORATE L. O. 6 Absorption and Variable Costing *23. (L.O. 7) There are two approaches to product costing. a. Under full or absorption costing all manufacturing costs are charged to the product. b. Under variable costing, only direct materials, direct labor, and variable manufacturing overhead costs are product costs; fixed manufacturing overhead costs are treated as period costs (expenses) when incurred. *24. The income statement under variable costing is prepared in the cost-volume-profit format. *25. The effects of the alternative costing methods on income from operations are:

Circumstance Units produced exceed units sold

Effects on Income From Operations Income under absorption costing is higher than under variable costing

Units produced are less than units sold

Income under absorption costing is lower than under variable costing

Units produced equal units sold

Income will be equal under both approaches

*26. The use of variable costing is acceptable only for internal use by management. It cannot be used in determining product costs in financial statements prepared in accordance with generally accepted accounting principles because it understates inventory costs.

22-5

LECTURE OUTLINE A.

Cost Behavior Analysis. 1. Cost behavior analysis is the study of how specific costs respond to changes in the level of business activity. 2. The activity index identifies the activity that causes changes in the behavior of costs. With an appropriate activity index, companies can classify the behavior of costs into three categories: variable, fixed, or mixed. 3. Variable costs are costs that vary in total directly and proportionately with changes in the activity level. A variable cost remains the same per unit at every level of activity. 4. Fixed costs are costs that remain the same in total regardless of changes in the activity level. a.

Because total fixed costs remain constant as activity changes, it follows that fixed costs per unit vary inversely with activity.

Examples of fixed costs include property taxes, insurance, rent, supervisory salaries, and depreciation on buildings and equipment.

5. The relevant range is the range of activity in which a company expects to operate during a year. It is important in CVP analysis because the behavior of costs is assumed to be linear (straight-line) throughout the relevant range. Although the linear (straight-line) relationship may not be completely realistic, the linear assumption produces useful data for CVP analysis as long as the level of activity remains within the relevant range.

22-6

6. Mixed costs are costs that contain both a variable element and a fixed element. Mixed costs change in total but not proportionately with changes in the activity level. a.

For purposes of CVP analysis, mixed costs must be classified into their fixed and variable elements. One method that management may use is the high-low method.

The high-low method uses the total costs incurred at the high and low levels of activity. The difference in costs between the high and low levels represents variable costs, since only the variable cost element can change as activity levels change. Fixed costs are determined by subtracting the total variable cost at either the high or low activity level from the total cost at that activity level.

MANAGEMENT INSIGHT The recession that started in 2008 produced a surprise for some manufacturers— the number of jobs lost was actually lower than in previous recessions. Between 2000 and 2008 many factories adopted lean manufacturing practices that relied less on large numbers of low skilled workers, and more on machines and a few highly skilled workers. Because the employees are highly skilled, employers are reluctant to lose them. Would you characterize labor costs as being a fixed cost, a variable cost, or something else in this situation? Answer: Because these labor costs are essentially unchanged for most levels of production, they are primarily fixed. However, it could be described as being a “step function.” If production gets too far outside the normal range, workers’ hours will change. If production goes too low, hours are cut, and if it goes too high, overtime hours are needed. B.

Cost-Volume-Profit Analysis. 1. Cost-volume-profit (CVP) analysis is the study of the effects of changes in costs and volume on a company’s profits. CVP analysis is important in profit planning. It is useful in setting selling prices, determining product mix, and maximizing use of production facilities.

22-7

2. CVP analysis considers the interrelationships among the following components: a.

Volume or level of activity.

Unit selling prices.

Variable cost per unit.

Total fixed costs.

Sales mix.

3. The following assumptions underlie each CVP analysis:

The behavior of both costs and revenues is linear throughout the relevant range of the activity index.

Costs can be classified accurately as either variable or fixed.

Changes in activity are the only factors that affect costs.

All units produced are sold.

When more than one type of product is sold, the sales mix will remain constant (the percentage that each product represents of total sales will stay the same).

CVP Income Statement. The CVP income statement classifies costs and expenses as variable or fixed. It also reports contribution margin in the body of the statement 4. Contribution margin is the amount of revenue remaining after deducting variable costs. It can be expressed as a per unit amount or as a ratio.

22-8

Contribution Margin per Unit = Unit Selling Price – Unit Variable Costs.

Contribution Margin Ratio = Contribution Margin per Unit ÷ Unit Selling Price.

Break-even Analysis. 1. At the break-even point, the company will realize no income but will suffer no loss. 2. Knowledge of the break-even point is useful to management when it decides whether to introduce new product lines, change sales prices on established products, or enter new market areas. 3. The break-even point can be: a.

Computed from a mathematical equation: Break-even Point in Dollars = Total Variable Costs + Total Fixed Costs. The break-even point in units can be computed by using unit selling prices and unit variable costs.

Computed by using contribution margin: Break-even Point in Units = Fixed Costs ÷ Contribution Margin per Unit. Break-even Point in Dollars = Fixed Costs ÷ Contribution Margin Ratio.

Derived from a CVP graph at the intersection of the total-cost line and the total-revenue line.

4. The income objective set by management is called target net income. To meet target net income, required sales must be determined.

22-9

Mathematical equation: Required Sales = Variable Costs + Fixed Costs + Target Net Income. Required sales may be expressed in either sales units or sales dollars.

Contribution margin technique: Fixed Costs + Target Net Income ÷ Contribution Margin Ratio = Required Sales in Dollars.

Graphic presentation: In the profit area of the CVP graph, the distance between the sales line and the total cost line at any point equals net income. A company can find required sales by analyzing the differences between the two lines until the desired net income is found.

SERVICE COMPANY INSIGHT FlightServe, a chartered aircraft company, decided to match up executives with charter flights in small “private jets”. The company noted that the average charter jet had eight seats, but it would break even at an average of 3.3 seats per flight. How did FlightServe determine that it would break even with 3.3 seats full per flight? Answer: FlightServe determined its break-even point with the following formula: Fixed costs ÷ Contribution margin per seat occupied = Break-even point in seats. 5. Margin of safety is the difference between actual or expected sales and sales at the break-even point. The margin of safety can be expressed in dollars or as a ratio. a.

Margin of Safety in Dollars = Actual (Expected) Sales – Break-even Sales.

Margin of Safety Ratio = Margin of Safety in Dollars ÷ Actual (Expected) Sales.

6. CVP analysis can help management respond to changes in business conditions. MANAGEMENT INSIGHT The promoter for the Rolling Stones’ tour guaranteed $1.2 million to the group. In addition, 20% of the gross goes to the stadium where the performance is staged and another $400,000 for other expenses such as ticket takers and advertising. What amount of sales dollars are required for the promoter to break even? Answer: Fixed costs = $1,200,000 + $400,000 = $1,600,000 Contribution margin ratio = 80%. Break-even sales = $1,600,000 ÷ .80 = $2,000,000.

22-10 .

*E. Variable Costing. 1. Under absorption costing (full costing), all manufacturing costs are charged to, or absorbed by, the product. 2. Under variable costing, only direct materials, direct labor, and variable manufacturing overhead costs are considered product costs. In this approach, companies recognize fixed manufacturing overhead costs as period costs (expenses) when incurred. 3. Selling and administrative expenses are period costs under both absorption and variable costing. 4. The CVP income statement format is used with variable costing. 5. When units produced exceed units sold, income under absorption costing is higher than under variable costing (because fixed overhead costs are included in the inventory rather than expensed). When units produced are less than units sold, income under absorption costing is lower than under variable costing (because the ending inventory cost will be higher under absorption costing than under variable costing). 6. The use of variable costing is acceptable only for internal use by management. Companies must use absorption costing in determining product costs in financial statements and for income tax purposes.

. 22-11

20 MINUTE QUIZ Circle the correct answer. True/False 1.

The range over which a company is expected to operate is called the relevant range of the activity index. True

A mixed cost contains both selling and administrative cost elements. True

False

In a CVP income statement, contribution margin is reported in the body of the statement. True

10.

False

If the unit contribution margin is $300 and fixed costs are $240,000 then the break-even point in units would be 800 units. True

False

Sales mix is the relative combination in which a company’s products are sold. True

False

The contribution margin is the amount of revenue remaining after deducting fixed costs. True

False

If revenue = $80 and variable cost = 40% of revenue, then contribution margin = $48. True

False

If a salesperson incurs $2,000 of expenses in servicing two customers and $4,000 of expenses in servicing four customers, the fixed costs are $1,000. True

False

Variable costs are costs that remain the same per unit at every level of activity. True

False

Margin of safety is the difference between actual sales and contribution margin. True

22-12 .

False

Multiple Choice 1.

Which of the following is a false statement regarding assumptions of CVP analysis? a. Total fixed costs remain constant over the relevant range. b. Unit selling prices are constant. c. Changes in volume or level of activity increase variable costs per unit. d. All units produced are sold.

Mixed costs may be separated into fixed costs and variable costs by using a. the variable costing method. b. the high-low method. c. the contribution margin method. d. all of the above.

If the unit selling price is $500, the unit variable cost is $300, and the total monthly fixed costs are $300,000, then the contribution margin ratio is a. 30%. b. 40%. c. 50%. d. 60%.

If activity level increases 25% and a specific cost increases from $40,000 to $50,000, this cost would be classified as a a. variable cost. b. mixed cost. c. fixed cost. d. none of the above.

If total fixed costs are $900,000 and variable costs as a percentage of unit selling price are 40%, then the break-even point in dollars is a. $1,500,000. b. $360,000. c. $2,250,000. d. not determinable with the information given.

. 22-13

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True False True False True

Multiple Choice 1. 2. 3. 4. 5.

22-14 .

c. b. b. a. a.

6. 7. 8. 9. 10.

False True True True False

CHAPTER 23 BUDGETARY PLANNING

Learning Objectives

STATE THE ESSENTIALS OF EFFECTIVE BUDGETING AND THE COMPONENTS OF THE MASTER BUDGET.

PREPARE BUDGETS FOR SALES, PRODUCTION AND DIRECT MATERIALS.

PREPARE BUDGETS FOR DIRECT LABOR, MANUFACTURING OVERHEAD, AND SELLING AND ADMINISTRATIVE EXPENSES, AND A BUDGETED INCOME STATEMENT.

PREPARE A CASH BUDGET AND A BUDGETED BALANCE SHEET.

APPLY BUDGETING PRINCIPLES NONMANUFACTURING COMPANIES.

23-1

CHAPTER REVIEW Budgeting Basics 1.

A budget is a formal written statement of management’s plans for a specified time period, expressed in financial terms.

The role of accounting during the budgeting process is to (a) provide historical data on revenues, costs, and expenses, (b) express management’s plans in financial terms, and (c) prepare periodic budget reports.

Benefits of Budgeting 3.

The primary benefits of budgeting are as follows: a. It requires all levels of management to plan ahead and to formalize goals on a recurring basis. b. It provides definite objectives for evaluating performance at each level of responsibility. c. It creates an early warning system for potential problems so that management can make changes. d. It facilitates the coordination of activities within the business. e. It results in greater management awareness of the entity’s overall operations and the impact on operations of external factors. f. It motivates personnel throughout the organization to meet planned objectives.

Essentials of Effective Budgeting

(L.O. 1) In order to be effective management tools, budgets must be based upon a. A sound organizational structure in which authority and responsibility are clearly defined. b. Research and analysis to determine the feasibility of new products, services, and operating techniques. c. Management acceptance which is enhanced when all levels of management participate in the preparation of the budget, and the budget has the support of top management.

The most common budget period is one year. A continuous twelve-month budget results from dropping the month just ended and adding a future month. The annual budget is often supplemented by monthly and quarterly budgets.

The responsibility for coordinating the preparation of the budget is assigned to a budget committee. The budget committee usually includes the president, treasurer, chief accountant (controller), and management personnel from each major area of the company.

A budget can have a significant impact on human behavior. A budget may have a strong positive influence on a manager when a. Each level of management is invited and encouraged to participate in developing the budget. b. Criticism of a manager’s performance is tempered with advice and assistance.

Long-range planning involves the selection of strategies to achieve long-term goals and the development of policies and plans to implement the strategies. Long-range plans contain considerably less detail than budgets.

23-2

The Master Budget 9.

The master budget is a set of interrelated budgets that constitutes a plan of action for a specified time period. It is developed within the framework of a sales forecast which shows potential sales for the industry and the company’s expected share of such sales.

10.

There are two classes of budgets in the master budget. a. Operating budgets are the individual budgets that result in the preparation of the budgeted income statement. b. Financial budgets focus primarily on the cash resources needed to fund expected operations and planned capital expenditures.

11.

(L. O. 2) The sales budget is the first budget prepared. It is derived from the sales forecast, and it represents management’s best estimate of sales revenue for the budget period. It is prepared by multiplying the expected unit sales volume for each product by its anticipated unit selling price.

12.

The production budget shows the units to produce to meet anticipated sales. It is derived from the budgeted sales units plus the desired ending finished goods units less the beginning finished goods units.

13.

The direct materials budget shows both the quantity and cost of direct materials to be purchased. It is derived from the direct materials units required for production plus the desired ending direct materials units less the beginning direct materials units.

14.

(L. O. 3) The direct labor budget shows the quantity (hours) and cost of direct labor necessary to meet production requirements. The direct labor budget is critical in maintaining a labor force that can meet expected levels of production.

15.

The manufacturing overhead budget shows the expected manufacturing overhead costs. The selling and administrative expense budget is a projection of anticipated operating expenses. Both budgets distinguish between fixed and variable costs.

Budgeted Income Statement 16.

The budgeted income statement is the important end-product in preparing operating budgets. This budget indicates the expected profitability of operations and it provides a basis for evaluating company performance. a. The budget is prepared from the budgets described in review points 11-15. b. For example, to find cost of goods sold, it is necessary to determine the total unit cost of a finished product using the direct materials, direct labor, and manufacturing overhead budgets.

Cash Budget 17.

(L.O. 4) The cash budget shows anticipated cash flows. It contains three sections (cash receipts, cash disbursements, and financing) and the beginning and ending cash balances. Data for preparing this budget are obtained from the other budgets.

18.

The budgeted balance sheet is a projection of financial position at the end of the budget period. It is developed from the budgeted balance sheet for the preceding year and the budgets for the current year.

23-3

Budgeting in Nonmanufacturing Companies 19.

(L.O. 5) The major differences in the master budget of a merchandiser and a manufacturer are that a merchandiser (a) uses a merchandise purchases budget instead of a production budget and (b) does not use the manufacturing budgets (direct materials, direct labor, and manufacturing overhead).

20.

In service enterprises, the critical factor in budgeting is coordinating professional staff needs with anticipated services. Budget data for service revenue may be obtained from expected output or expected input.

21.

In the budget process for not-for-profit organizations, the emphasis is on cash flows rather than on a revenue and expense basis. For governmental units, the budget must be strictly followed and overspending is often illegal.

23-4

LECTURE OUTLINE A.

Budgeting Basics. 1. Planning is the process of establishing enterprise-wide objectives. 2. A budget is a formal written statement of management’s plans for a specified future time period, expressed in financial terms. 3. Accounting information makes major contributions to the budgeting process.

The Benefits of Budgeting. 1. It requires all levels of management to plan ahead and to formalize goals on a recurring basis. 2. It provides definite objectives for evaluating performance at each level of responsibility. 3. It creates an early warning system of potential problems so that management can make changes before things get out of hand. 4. It facilitates the coordination of activities within the business by correlating the goals of each segment with overall company objectives. 5. It results in greater management awareness of the entity’s overall operations and the impact on operations of external factors, such as economic trends. 6. It motivates personnel throughout the organization to meet planned objectives.

Essentials of Effective Budgeting. 1. The essentials of effective budgeting are (a) sound organizational structure, (b) research and analysis, and (c) acceptance by all levels of management.

23-5

Effective budgeting depends on a sound organizational structure. In such a structure, authority and responsibility for all phases of operations are clearly defined.

Budgets based on research and analysis should result in realistic goals that will contribute to the growth and profitability of a company.

2. The effectiveness of a budget program is directly related to its acceptance by all levels of management. D.

Length of the Budget Period. 1. A budget may be prepared for any period of time. Various factors influence the length of the budget period. a.

The type of budget.

The nature of the organization.

The need for periodic appraisal.

Prevailing business conditions.

2. The budget period should be long enough to provide an attainable goal under normal business conditions and should minimize the impact of seasonal or cyclical fluctuations. 3. The most common budget period is one year. E.

The Budgeting Process/Budgeting and Human Behavior. 1. The budget is developed within the framework of a sales forecast that shows potential sales for the industry and the company’s expected share of such sales. Sales forecasting involves a consideration of various factors: a.

23-6

General economic conditions.

Industry trends.

Market research studies.

Anticipated advertising and promotion.

Previous market share.

Changes in prices.

Technological developments.

2. The input of sales personnel and top management is essential to the sales forecast. 3. In larger companies, a budget committee has responsibility for coordinating the preparation of the budget. ACCOUNTING ACROSS THE ORGANIZATON A recent study found that fewer than 14% of businesses with fewer than 500 employees prepare an annual budget or have a written business plan. For many small businesses, the basic assumption is that, “As long as I sell as much as I can, and keep my employees paid, I’m doing OK”. Describe a situation in which a business “sells as much as it can” but cannot “keep its employees paid.” Answer: If sales are made to customers on credit and collection is slow, the company may find that it does not have enough cash to pay employees or suppliers. Without these resources the company will fail to survive. 4. A budget can have a significant impact on human behavior.

23-7

A budget may inspire a manager to higher levels of performance.

A budget may discourage additional effort and pull down the morale of a manager.

In developing the budget, each level of management should be invited to participate. The overall goal is to reach agreement on a budget that the managers consider fair and achievable, but which also meets the corporate goals set by top management.

MANAGEMENT INSIGHT In an effort to revive its plummeting stock, Time Warner’s top management determined and publicly announced bold new financial goals for the next year. These goals were unfortunately not reached. The company got a new CEO and new budgets were developed with each operating unit setting what it considered optimistic but attainable goals. What approach did Time Warner use to prepare the old budget? What approach did it use to prepare the new budget? Answer: Time Warner used a “top-down” approach to prepare the old budget since its goals were determined by top management. It used a participative approach to prepare the new budget since each operating unit set goals. F.

Budgeting and Long-Range Planning. 1. Budgeting and long-range planning are not the same.

23-8

One important difference is the time period involved; long-range planning usually encompasses a period of at least five years.

A second significant difference is in emphasis; long-range planning identifies long-term goals, selects strategies to achieve those goals, and develops policies and plans to implement the strategies. Management also considers anticipated trends in the economic and political environment and how the company should cope with them.

The final difference pertains to the amount of detail presented. Long-range plans contain considerably less detail than budgets because the data are intended more for a review of progress toward long-term goals than as a basis of control for achieving specific results.

2. The primary objective of long-range planning is to develop the best strategy to maximize the company’s performance over an extended future period. G.

The Master Budget. 1. The master budget is a set of interrelated budgets that constitutes a plan of action for a specified time period. 2. Sales Budget: The sales budget is the starting point in preparing the master budget. a.

Each of the other budgets depends on the sales budget.

The sales budget is derived from the sales forecast and it represents management’s best estimate of sales revenue for the budget period.

3. Production Budget: The production budget shows the units to produce to meet anticipated sales. a.

Production requirements are determined from the following formula: Budgeted Sales Units + Desired Ending Finished Goods Units – Beginning Finished Goods Units = Required Production Units.

The production budget provides the basis for the budgeted costs for each manufacturing cost element.

4. Direct Materials: The direct materials budget shows both the quantity and cost of direct materials to be purchased.

23-9

The quantities of direct materials are derived from the following formula: Direct Materials Units Required for Production + Desired Ending Direct Materials Units – Beginning Direct Materials Units = Required Direct Materials Units to be Purchased.

The desired ending inventory is a key component in the budgeting process; inadequate inventories could result in temporary shutdowns of production.

5. Direct Labor: The direct labor budget contains the quantity (hours) and cost of direct labor necessary to meet production requirements. a.

The direct labor budget is critical in maintaining a labor force that can meet the expected levels of production.

The direct labor budget is also used in preparing the budgeted cost of goods sold and the cash budget.

6. Manufacturing Overhead: The manufacturing overhead budget shows the expected variable and fixed manufacturing overhead costs for the budget period. 7. Selling and Administrative Expense: The selling and administrative expense budget projects anticipated selling and administrative expenses for the budget period. This budget classifies expenses as either variable or fixed. This budget is also used in preparing the budgeted income statement and the cash budget. 8. Budgeted Income Statement: The budgeted income statement is the important end-product of the operating budgets. a.

This budget indicates the expected profitability of operations for the budget period.

The budgeted income statement provides the basis for evaluating company performance.

9. Cash Budget: The cash budget shows anticipated cash flows. a.

Because cash is so vital, this budget is often considered to be the most important financial budget.

The cash budget contains three sections: (1) Cash receipts. (2) Cash disbursements. (3) Financing.

. 23-10

Companies obtain data for preparing the cash budget from other budgets and from information provided by management.

A cash budget contributes to more effective cash management. It can show managers when additional financing is necessary well before the actual need arises and it indicates when excess cash is available for investments or other purposes.

MANAGEMENT INSIGHT Behind the grandeur of the Olympic Games lies a huge financial challenge—how to keep budgeted costs in line with revenues. The 2006 Winter Olympics in Italy narrowly avoided going into bankruptcy before the Games even started; organizers shifted promotional responsibilities to an Italian state-run agency. Why does it matter whether the Olympic Games exceed their budget? Answer: If the Olympic Games exceed their budget, taxpayers of the sponsoring community and country will end up footing the bill. Depending on the size of the losses, and the resources of the community, this could produce a substantial burden. As a result, other communities might be reluctant to host the Olympics in the future. 10. Budgeted Balance Sheet: The budgeted balance sheet is developed from the budgeted balance sheet for the preceding year and the budgets for the current year. H.

Budgeting in Nonmanufacturing Companies. 1. Budgets are also used by: a.

Merchandisers.

Service enterprises.

Not-for-profit organizations.

2. The major differences between the master budgets of a merchandiser and a manufacturer are that a merchandiser: . 23-11

Uses a merchandise purchases budget instead of a production budget.

Does not use the manufacturing budgets (direct materials, direct labor, and manufacturing overhead).

3. In service enterprises, such as a public accounting firm, a law office, or a medical practice, the critical factor in budgeting is coordinating professional staff needs with anticipated services. a.

If a firm is overstaffed, several problems may result: (1) Labor costs are disproportionately high. (2) Profits are lower because of the additional salaries. (3) Staff turnover may increase because of lack of challenging work.

If a service enterprise is understaffed, it may lose revenue because existing and prospective client needs for service cannot be met. Also, professional staff may seek other jobs because of excessive work loads.

4. Budgeting is just as important for not-for-profit organizations as for profitoriented enterprises. a.

In most cases, not-for-profit entities budget on the basis of cash flows (expenditures and receipts), rather than on a revenue and expense basis.

The starting point in budgeting is usually expenditures, not receipts.

SERVICE COMPANY INSIGHT All organizations need to stick to budgets. The most recent recession has created budgeting challenges for nearly all governmental agencies. Even Princeton University experienced a 25% drop in the value of its endowment when the financial markets plunged. When the endowment fell, the university had to make cuts because the endowment supports 45% of the university’s budget. . 23-12

Why would a university’s budgeted scholarships fall when the stock market suffers a serious drop? Answer:

. 23-13

Scholarships typically cannot be paid out of the “principal” portion of donations made to scholarship endowment funds. Instead, scholarships are usually funded through earnings generated by endowment investments. Any excess earnings above current year scholarship needs can be used for scholarships in subsequent years. But a serious drop in the value of endowment investments can wipe out previous earnings, in some cases completely eliminating funds available for scholarships.

20 MINUTE QUIZ Circle the correct answer. True/False 1.

Budgeting is the process of establishing enterprise-wide objectives that serve as a deterrent to waste and inefficiency. True

The effectiveness of the budget program is directly related to its acceptance by all levels of management. True

False

Long-range planning differs from budgeting in the time period involved, emphasis, and the amount of detail presented. True

10.

False

The budgeted income statement indicates the expected profitability of operations for the next year and provides the basis for evaluating company performance. True

False

The manufacturing overhead budget shows only the expected indirect labor costs for the year. True

False

The quantities of direct materials in the direct materials budget are derived from the formula: Desired Ending Direct Materials Units + Direct Materials Units Required for Production – Beginning Direct Materials Units = Required Direct Materials Units to be Purchased. True

False

The sales budget is the first budget prepared and each of the other budgets depends on it. True

False

One disadvantage of budgeting is that it does not facilitate the coordination of activities within a business. True

False

Budgeting always has the effect on human behavior of inspiring managers to higher levels of performance. True

False

Budgeting is not used in not-for-profit organizations because it is not necessary for these organizations to engage in profit planning. True

. 23-14

False

Multiple Choice 1.

A formal written statement of management’s plans for a specified future time period, expressed in financial terms is a(n) a. accounting plan. b. budget. c. research analysis. d. sales budget.

Which of the following is not a benefit of budgeting? a. It reveals the prevailing business conditions. b. It results in greater management awareness of the entity’s overall operations. c. It creates an early warning system of potential problems. d. It provides definite objectives for evaluating performance at each level of responsibility.

All of the following are financial budgets except the a. budgeted balance sheet. b. budgeted income statement. c. capital expenditure budget. d. cash budget.

The master budget includes all of the following except the a. Budgeted Income Statement. b. Capital Expenditure Budget. c. Cash Budget. d. Indirect Labor Budget.

If required production units are 75,000, budgeted sales units are 65,000, required direct materials purchases units are 3,000, and beginning finished goods units are 5,000, then desired ending finished goods units would be a. 2,000. b. 5,000. c. 12,000. d. 15,000.

. 23-15

ANSWERS TO QUIZ True/ False 1. 2. 3. 4. 5.

False True False False True

Multiple Choice 1. 2. 3. 4. 5.

. 23-16

b. a. b. d. d.

6. 7. 8. 9. 10.

True False True True False

CHAPTER 24 BUDGETARY CONTROL AND RESPONSIBILITY ACCOUNTING Learning Objectives 1. DESCRIBE BUDGETARY BUDGET REPORTS.

CONTROL

AND

STATIC

2. PREPARE FLEXIBLE BUDGET REPORTS. 3. APPLY RESPONSIBILITY ACCOUNTING TO COST AND PROFIT CENTERS. 4. EVALUATE CENTERS.

24-1

PERFORMANCE

INVESTMENT

CHAPTER REVIEW Budgetary Control 1.

(L.O. 1) The use of budgets in controlling operations is known as budgetary control. Such control takes place by means of budget reports that compare actual results with planned objectives. The budget reports provide management with feedback on operations.

Budgetary control involves: a. Developing budgets. b. Analyzing the differences between actual and budgeted results. c. Taking corrective action. d. Modifying future plans, if necessary.

Budgetary control works best when a company has a formalized reporting system. The system should a. Identify the name of the budget report such as the sales budget or the manufacturing overhead budget. b. State the frequency of the report such as weekly, or monthly. c. Specify the purpose of the report. d. Indicate the primary recipient(s) of the report.

Static Budget Reports 4.

A static budget does not modify or adjust data regardless of changes in activity during the year. As a result, actual results are always compared with the budget data at the activity level used in developing the master budget.

A static budget is appropriate in evaluating a manager’s effectiveness in controlling costs when (a) the actual level of activity closely approximates the master budget activity level, and/or (b) the behavior of the costs in response to changes in activity is fixed.

Flexible Budgets 6.

(L.O. 2) A flexible budget projects budget data for various levels of activity. The flexible budget recognizes that the budgetary process is more useful if it is adaptable to changed operating conditions. This type of budget permits a comparison of actual and planned results at the level of activity actually achieved.

To develop the flexible budget, the following steps are taken: a. Identify the activity index and the relevant range of activity. b. Identify the variable costs, and determine the budgeted variable cost per unit of activity for each cost. c. Identify the fixed costs, and determine the budgeted amount for each cost. d. Prepare the budget for selected increments of activity within the relevant range.

For manufacturing overhead costs, the activity index is usually the same as the index used in developing the predetermined overhead rate; that is, direct labor hours or machine hours. For selling and administrative expenses, the activity index usually is sales or net sales.

The following formula may be used to determine total budgeted costs at any level of activity: Total budgeted costs = Fixed costs + (Total variable cost per unit X Activity level)

24-2

10.

Total budgeted costs at each level of activity can be shown graphically. a. In a graph, the activity index is shown on the horizontal axis and costs are shown on the vertical axis. b. The total budgeted costs for each level of activity are then identified from the total budgeted cost line.

11.

Flexible budget reports are another type of internal report produced by managerial accounting. The flexible budget report consists of two sections: (a) production data such as direct labor hours and (b) cost data for variable and fixed costs. It also shows differences between budget and actual results.

Responsibility Accounting 12.

Responsibility accounting involves accumulating and reporting costs (and revenues, where relevant) on the basis of the manager who has the authority to make the day-to-day decisions about the items. A manager’s performance is evaluated on matters directly under that manager’s control.

13.

Responsibility accounting can be used at every level of management in which the following conditions exist: a. Costs and revenues can be directly associated with the specific level of management responsibility. b. The costs and revenues are controllable at the level of responsibility with which they are associated. c. Budget data can be developed for evaluating the manager’s effectiveness in controlling the costs and revenues.

14.

Responsibility accounting is especially valuable in a decentralized company. Decentralization means that the control of operations is delegated to many managers throughout the organization. A segment is an identified area of responsibility in decentralized operations.

15.

Responsibility accounting is an essential part of any effective system of budgetary control. It differs from budgeting in two respects: a. A distinction is made between controllable and noncontrollable items. b. Performance reports either emphasize or include only items controllable by the individual manager.

16.

A cost is considered controllable at a given level of managerial responsibility if that manager has the power to incur it within a given period of time. Costs incurred indirectly and allocated to a responsibility level are considered to be noncontrollable at that level.

17.

Performance evaluation is a management function that compares actual results with budget goals. Performance evaluation includes both behavioral and reporting principles.

18.

Management by exception means that top management’s review of a budget report is focused either entirely or primarily to differences between actual results and planned objectives. The guidelines for identifying an exception are based on materiality and controllability.

19.

A responsibility reporting system involves the preparation of a report for each level of responsibility shown in the company’s organization chart. A responsibility reporting system permits management by exception at each level of responsibility within the organization.

24-3

20.

Responsibility centers may be classified into one of three types. A cost center incurs costs (and expenses) but does not directly generate revenues. A profit center incurs costs (and expenses) but also generates revenues. An investment center incurs costs (and expenses), generates revenues, and has control over investment funds available for use.

Cost Centers 21.

(L.O. 3) A responsibility report for cost centers compares actual controllable costs with flexible budget data. Only controllable costs are included in the report, and no distinction is made between variable and fixed costs.

22.

Direct fixed costs or traceable costs are costs that relate specifically to a responsibility center and are incurred for the sole benefit of the center. Indirect fixed costs or common costs pertain to a company’s overall operating activities and are incurred for the benefit of more than one profit center.

Profit Centers 23.

A responsibility report for a profit center shows budgeted and actual controllable revenues and costs. The report is prepared using the cost-volume-profit income statement format.

24.

In the responsibility report for a profit center: a. Controllable fixed costs are deducted from contribution margin. b. The excess of contribution margin over controllable fixed costs is identified as controllable margin. c. Noncontrollable fixed costs are not reported.

25.

Controllable margin is considered to be the best measure of the manager’s performance in controlling revenues and costs.

Investment Centers 26.

(L.O. 4) The primary basis for evaluating the performance of a manger of an investment center is return on investment (ROI). The formula for computing return on investment is: Investment Center Controllable Margin (in dollars) ÷ Average Investment Center Operating Assets = Return on Investment. a. Operating assets consist of current assets and plant assets used in operations by the center. Nonoperating assets such as idle plant assets and land held for future use are excluded. b. Average operating assets are usually based on the beginning and ending cost or book values of the assets.

27.

A manager can improve ROI by (a) increasing controllable margin or (b) reducing average operating assets.

28.

The return on investment approach includes two judgmental factors: a. Valuation of operating assets—cost, book value, appraised value, or market value. b. Margin (income) measure—controllable margin, income from operations, or net income.

24-4

LECTURE OUTLINE A.

The Concept of Budgetary Control. 1. The use of budgets in controlling operations is known as budgetary control. Such control takes place by means of budget reports that compare actual results with planned objectives. 2. Budgetary control consists of: a.

Developing periodic budget reports that compare actual results with planned objectives.

Analyzing the differences to determine their causes.

Taking appropriate corrective action.

Modifying future plans, if necessary.

3. Budgetary control works best when a company has a formalized reporting system. This system should do the following: a.

Identify the name of the budget report (i.e., sales budget).

State the frequency of the report, such as weekly or monthly.

Specify the purpose of the report.

Indicates the primary recipient(s) of the report.

4. A static budget is a projection of budget data at one level of activity. These budgets do not consider data for different levels of activity. As a result, companies always compare actual results with budget data at the activity level that was used in developing the master budget.

24-5

5. The static budget is appropriate in evaluating a manager’s effectiveness in controlling costs when: a.

The actual level of activity closely approximates the master budget activity level, and/or

The behavior of the costs in response to changes in activity is fixed.

6. A static budget report is appropriate for fixed manufacturing costs and for fixed selling and administrative expenses.

The Flexible Budget. 1. A flexible budget projects budget data for various levels of activity. In essence, the flexible budget is a series of static budgets at different levels of activity. 2. To develop the flexible budget, management should: a.

Identify the activity index and the relevant range of activity.

Identify the variable costs, and determine the budgeted variable cost per unit of activity for each cost.

Identify the fixed costs, and determine the budgeted amount for each cost.

Prepare the budget for selected increments of activity within the relevant range.

3. Flexible budget reports are another type of internal report. The flexible budget report consists of two sections:

24-6

Production data for a selected activity index, such as direct labor hours.

Cost data for variable and fixed costs.

4. The flexible budget report provides a basis for evaluating a manager’s performance in two areas: a.

Production control.

Cost control.

5. Flexible budget reports are appropriate for evaluating performance since both actual and budgeted costs are based on the actual activity level achieved. SERVICE COMPANY INSIGHT When the Exotic Newcastle Disease (an infectious bird disease) broke out in Southern California in 2003, it could have spelled disaster for the San Diego Zoo. The zoo spent almost half a million dollars on quarantine measures in 2003. It worked: no birds got sick and the damage to the zoo’s budget was minimized by a monthly budget reforecast. The new planning process, introduced a year earlier, allowed the zoo to redirect resources to ward off the disease. The San Diego Zoo’s annual static budget was behind the times before Paula Brock took over as CFO in 2001. Brock’s first efforts were to link strategy to the process. Consultants believe it’s a key way to improve people’s improvement in budgeting. What is the major benefit of tying a budget to the overall goals of the company? Answer: People working on a budgeting process that is clearly guided and focused by strategic goals spend less time arguing about irrelevant details and more time focusing on the items that matter.

The Concept of Responsibility Accounting. 1. Responsibility accounting involves accumulating and reporting costs (and revenues) on the basis of the manager who has the authority to make the day-to-day decisions about the items.

24-7

2. Under responsibility accounting, a manager’s performance is evaluated on matters directly under that manager’s control. 3. Responsibility accounting can be used at every level of management in which the following conditions exist: a.

Costs and revenues can be directly associated with the specific level of management responsibility.

The costs and revenues can be controlled by employees at the level of responsibility with which they are associated.

Budget data can be developed for evaluating the manager’s effectiveness in controlling the costs and revenues.

4. The reporting of costs and revenues under responsibility accounting differs from budgeting in two respects: a.

A distinction is made between controllable and noncontrollable items.

Performance reports either emphasize or include only items controllable by the individual manager.

MANAGEMENT INSIGHT While many compensation and promotion programs encourage competition and hard work, they do not foster collaboration, and can lead to distrust and disloyalty. As a consequence, many companies now explicitly include measures of collaboration in their performance measures. How might managers of separate divisions be able to reduce division costs through collaboration? Answer: Division managers might reduce costs by sharing design and marketing resources or by jointly negotiating with suppliers. In addition, they can reduce the need to hire and lay off employees by sharing staff across divisions as human resource needs change. 24-8

5. A cost over which a manager has control is called a controllable cost. It follows that: a.

All costs are controllable by top management because of the broad range of its activity.

Fewer costs are controllable as one moves down to each lower level of managerial responsibility because of the manager’s decreasing authority.

6. Noncontrollable costs are costs incurred indirectly and allocated to a responsibility level. D.

Management by Exception. 1. Management by exception means that top management’s review of a budget report is focused either entirely or primarily on differences between actual results and planned objectives. 2. For management by exception to be effective, there must be guidelines for identifying an exception. The usual criteria are: a.

Materiality—usually expressed as a percentage difference from budget.

Controllability of the item—exception guidelines are more restrictive for controllable items than for items the manager cannot control.

3. A responsibility reporting system involves the preparation of a report for each level of responsibility in the company’s organization chart. 4. Responsibility reports for cost centers compare actual costs with flexible budget data. The reports show only controllable costs and no distinction is made between variable and fixed costs.

24-9

Principles of Performance Evaluation. 1. The human factor is critical in evaluating performance. Behavioral principles include: a.

Managers of responsibility centers should have direct input into the process of establishing budget goals of their area of responsibility.

The evaluation of performance should be based entirely on matters that are controllable by the manager being evaluated.

Top management should support the evaluation process.

The evaluation process must allow managers to respond to their evaluations.

The evaluation should identify both good and poor performance.

2. Performance evaluation under responsibility accounting should be based on certain reporting principles. Performance reports should:

24-10 .

Contain only data that are controllable by the manager of the responsibility center.

Provide accurate and reliable budget data to measure performance.

Highlight significant differences between actual results and budget goals.

Be tailor-made for the intended evaluation.

Be prepared at reasonable intervals.

MANAGEMENT INSIGHT Among automobile manufacturing facilities in the U.S., nobody has more flexible plants than Honda. At the Honda plant, the switch from the production of one type of vehicle to a different type of vehicle takes only minutes instead of months like for most plants. This ability to adjust quickly to changing demand gave Honda a huge advantage when demand for more fuel-efficient cars increased quickly. What implications do these improvement in production capabilities have for management accounting within the organization? Answer:

In order to maximize the potential of flexible manufacturing facilities managers need to be supplied with information on a more frequent basis. In turn, the tools used to evaluate performance need to take into account what information management had at its disposal, and what decisions were made in response to this information.

3. There are three basic types of responsibility centers: cost centers, profit centers, and investment centers.

A cost center incurs costs (and expenses) but does not directly generate revenues.

A profit center incurs costs (and expenses) and also generates revenues.

Like a profit center, an investment center incurs costs (and expenses) and generates revenues. In addition, an investment center has control over decisions regarding the assets available for use.

Responsibility Reports. a.

. 24-11

The evaluation of a manager’s performance for cost centers is based on his or her ability to meet budgeted goals for controllable costs.

To evaluate the performance of a profit center manager, upper management needs detailed information about both controllable revenues and controllable costs. The report is prepared using the cost-volume-profit income statement. In the report: (1) Controllable fixed costs are deducted from contribution margin. (2) The excess of contribution margin over controllable fixed costs is identified as controllable margin. (3) Noncontrollable fixed costs are not reported.

The primary basis for evaluating the performance of a manager of an investment center is return on investment (ROI).

Return on investment is computed by dividing controllable margin by average operating assets.

Judgmental factors in ROI are (1) valuation of operating assets and (2) margin (income) measure.

ACCOUNTING ACROSS THE ORGANIZATION No matter how you slice the movie business, by far the best return on investment comes from the not-so-glamorous world of G-rated films. However, these movies represent only 3% of the total films made in a typical year. What might be the reason that movie studios do not produce G-rated movies as often as R-rated ones? Answer: Perhaps Hollywood believes that big-name stars or large budgets, both of which are typical of R-rated movies, sell movies. However, one study recently concluded, “We can’t find evidence that stars help movies, and we can’t find evidence that bigger budgets increase return on investment.” Some film companies are going out of their way to achieve at least a PG rating.

24-12 .

20 MINUTE QUIZ Circle the correct answer. True/False 1.

In a static budget, the data may be modified or adjusted if activity changes more than a specified amount during the year. True

Flexible budgets can be prepared for each of the types of budgets included in the master budget. True

False

There are three types of responsibility centers: cost, segment, and investment. True

10.

False

A responsibility reporting system begins with the lowest level of responsibility in an organization and moves upward to each higher level. True

False

Only controllable costs are included in a responsibility performance report, and there is no distinction made between variable and fixed costs. True

False

The terms “controllable costs” and “noncontrollable costs” are synonymous with variable costs and fixed costs, respectively. True

False

Under responsibility accounting, the evaluation of a manager’s performance is based on the matters directly under that manager’s control. True

False

Flexible budget reports consist of two sections: production data and cost data. True

False

With a flexible budget, if production increases, budget allowances for variable costs should increase both directly and proportionately. True

False

The primary basis for evaluating the performance of a manager of an investment center is return on investment. True

. 24-13

False

Multiple Choice 1.

A static budget report is appropriate for a. evaluating a manager’s performance in controlling variable costs. b. fixed manufacturing costs and fixed selling and administrative expenses. c. variable costs and fixed costs. d. none of the above.

The manufacturing overhead budget (1) provides the basis for computing the predetermined overhead rate for the year, and (2) is used in costing work in process and finished goods inventories. Is the above statement true for a. (1) only. b. (2) only. c. both (1) and (2). d. neither (1) nor (2).

At 40,000 direct labor hours, the flexible budget for indirect labor is $160,000. If $172,000 of indirect labor costs are incurred at 44,000 direct labor hours, the flexible budget report should show the following difference for indirect labor. a. $12,000 favorable. b. $4,000 unfavorable. c. $4,000 favorable. d. $12,000 unfavorable.

Controllable fixed costs are deducted from the contribution margin to arrive at a(n) a. income from operations. b. net income. c. controllable margin. d. realized income.

The numerator in computing return on investment is a. controllable margin. b. average operating assets. c. contribution margin. d. net assets.

24-14 .

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True True True False True

Multiple Choice 1. 2. 3. 4. 5.

. 24-15

b. d. c. c. a.

6. 7. 8. 9. 10.

False True True False True

CHAPTER 25 STANDARD COSTS AND BALANCED SCORECARD

Learning Objectives 1. DESCRIBE STANDARDS COST. 2. DETERMINE DIRECT MATERIALS VARIANCES. 3. DETERMINE DIRECT LABOR AND TOTAL MANUFACTURING OVERHEAD VARIANCES. 4. PREPARE VARIANCE SCORECARD.

REPORTS

BALANCED

*5. APPROACH TO PERFORMANCE EVALUATION. *6. IDENTIFY THE FEATURES OF A STANDARD COST ACCOUNTING SYSTEM. *7. COMPUTE OVERHEAD VOLUME VARIANCES.

25-1

CONTROLLABLE

AND

CHAPTER REVIEW Standards and Budgets 1.

(L.O. 1) In concept, standards and budgets are essentially the same. Both are predetermined costs and both contribute significantly to management planning and control. a. A standard is a unit amount, whereas a budget is a total amount. b. Standard costs may be incorporated into a cost accounting system.

Why Standard Costs? 2.

Standard costs offer the following advantages to an organization: a. They facilitate management planning. b. They promote greater economy by making employees more “cost conscious.” c. They are useful in setting selling prices. d. They contribute to management control by providing a basis for the evaluation of cost control. e. They are useful in highlighting variances in management by exception. f. They simplify the costing of inventories and reduce clerical costs.

Setting Standard Costs 3.

Setting standards requires input from all persons who have responsibility for costs and quantities. Standards may be set at one of two levels. Ideal standards represent optimum levels of performance under perfect operating conditions. Normal standards represent efficient levels of performance that are attainable under expected operating conditions.

To establish the standard cost of producing a product, it is necessary to establish standards for each manufacturing cost element—direct materials, direct labor, and manufacturing overhead. The standard for each element is derived from the standard price to be paid and the standard quantity to be used.

Direct Materials 5.

The direct materials price standard is the cost per unit of direct materials that should be incurred. a. This standard is based on the purchasing department’s best estimate of the cost of raw materials. b. This standard should include an amount for related costs such as receiving, storing, and handling.

The direct materials quantity standard is the quantity of direct materials that should be used per unit of finished goods. a. This standard is expressed as a physical measure, such as pounds, barrels, or board feet. b. This standard should include allowances of unavoidable waste and normal storage.

The standard direct materials cost per unit is the standard direct materials price times the standard direct materials quantity.

Direct Labor 8.

The direct labor price standard is the rate per hour that should be incurred for direct labor. a. This standard is based on current wage rates adjusted for anticipated changes, such as cost of living adjustments included in many union contracts. b. This standard generally includes employer payroll taxes and fringe benefits.

The direct labor quantity standard is the time that should be required to make one unit of the product. a. This standard is especially critical in labor-intensive companies.

25-2

b. 10.

In setting this standard, allowances should be made for rest periods, cleanup, machine setup and machine downtime. The standard direct labor cost per unit is the standard direct labor rate times the standard direct labor hours.

Manufacturing Overhead 11.

The manufacturing overhead standard is based on a standard predetermined overhead rate. a. This overhead rate is determined by dividing budgeted overhead costs by an expected standard activity index. b. Normal capacity is the average activity output that a company should experience over the long run. c. The standard manufacturing overhead rate per unit is the predetermined overhead rate times the activity index quantity standard.

Variances 12.

A variance is the difference between total actual costs and total standard costs. An unfavorable variance suggests that too much was paid for materials, labor, and manufacturing overhead or that there were inefficiencies in using materials, labor, and manufacturing overhead. Favorable variances indicate efficiencies in incurring costs and in using materials, labor, and manufacturing overhead.

13.

Analyzing variances begins with a determination of the cost elements that comprise the variance. For each manufacturing cost element, a total dollar variance is computed. Then this variance is analyzed into a price variance and a quantity variance.

Direct Materials Variances 14.

(L.O. 2) The formulas for the direct materials variances are: Actual Quantity X Actual Price (AQ) X (AP)

–

Standard Quantity X Standard Price (SQ) X (SP)

Total Materials Variance (TMV)

Actual Quantity X Actual Price (AQ) X (AP)

–

Actual Quantity X Standard Price (AQ) X (SP)

Materials Price Variance (MPV)

Actual Quantity X Standard Price (AQ) X (SP)

–

Standard Quantity X Standard Price (SQ) X (SP)

Materials Quantity Variance (MQV)

15.

A variance matrix can be used in analyzing variances. In such cases, the formulas for each cost element are computed first and then the variances.

16.

Materials price variances are usually the responsibility of the purchasing department, whereas materials quantity variances are usually attributable to the production department.

Direct Labor Variances 17.

(L. O. 3)The formulas for the direct labor variances are: Actual Hours X Actual Rate (AH) X (AR)

25-3

–

Standard Hours X Standard Rate (SH) X (SR)

Total Labor Variance (TLV)

Actual Hours X Actual Rate (AH) X (AR) Actual Hours X Standard Rate (AH) X (SR) 18.

–

Actual Hours X Standard Rate (AH) X (SR)

–

Standard Hours X Standard Rate (SH) X (SR)

Labor Price Variance (LPV)

Labor Quantity Variance (LQV)

Labor price variances usually result from paying workers higher wages than expected and/or misallocation of workers. Labor quantity variances relate to the efficiency of the workers and are the responsibility of the production department.

Manufacturing Overhead Variances 19.

The total overhead variance is the difference between the actual overhead costs and overhead costs applied based on standard hours allowed.

20.

To find the total overhead variance in a standard costing system, we determine the overhead costs applied based on standard hours allowed. Standard hours allowed are the hours that should have been worked for the units produced. The total overhead variance formula is as follows: Actual Overhead

21.

Overhead –

Applied

Total Overhead =

Variance

One reason for an overhead variance relates to over- or underapplied spending on overhead items. Generally the responsibility for these variances rests with the production department. The overhead variance can also result from inefficient use of overhead. The responsibility for these variances rests on either the production or sales departments.

Reporting of Variances 22.

(L.O. 4) All variances should be reported to appropriate levels of management as soon as possible. Variance reports facilitate the principle of “management by exception.” Rather than analyze every variance, top management will normally look for significant variances.

Statement Presentation of Variances 23.

In income statements prepared for management under a standard cost accounting system, cost of goods sold is stated at standard cost and the variances are separately disclosed. In financial statements prepared for stockholders and other external users, standard costs may be used.

24.

Standard costs may be used in costing inventories in financial statements prepared for stockholders when there are no significant differences between actual and standard costs. However, if the difference is material, the inventories and cost of goods sold must be reported at actual costs.

25-4

Balanced Scorecard 25.

Many companies use both financial and nonfinancial measures to evaluate performance. This approach is known as the balanced scorecard. The four most commonly employed perspectives are as follows: a. The financial perspective employs financial measures of performance used by most firms. b. The customer perspective evaluates how well the company is performing from the viewpoint of those people who buy and use its products or services. c. The internal process perspective evaluates the internal operating processes critical to success. d. The learning and growth perspective evaluates how well the company develops and retains its employees. The different perspectives are linked together so a company can better understand how to achieve its goals and what measures to use to evaluate performance.

APPENDIX 25A Standard Cost Accounting System NOTE – NEED SOMETHING FOR LO5 – FEATURES OF STANDARD COST ACCOUNTING SYSTEMS? *26. A standard cost accounting system is a double-entry system of accounting in which standard costs are used in making entries and variances are formally recognized in the accounts. A standard cost system may be used with either job order or process costing. *27. As an example, the purchase of raw materials inventory for $5,000 when the standard cost is $6,000 would be recorded as follows: Raw Materials Inventory ................................................................. Materials Price Variance.......................................................... Accounts Payable.................................................................... a. b.

6,000 1,000 5,000

A debit balance in a variance account indicates an unfavorable variance. A credit balance in a variance account indicates a favorable variance.

APPENDIX 25B Overhead Variances *28. (L.O. 6) The computation of the manufacturing overhead variances is conceptually the same as the computation of the materials and labor variances. For manufacturing overhead, however, both variable and fixed overhead must be considered. The formulas are: Actual Overhead

–

Overhead Applied*

Actual Overhead

–

Overhead Budgeted*

Normal Standard Capacity – Hours Hours Allowed

)

Fixed Overhead .

25-5

(

Total Overhead Variance Overhead Controllable Variance

Overhead Volume

Rate

Variance

*29. The overhead controllable variance shows whether overhead costs were effectively controlled. a. Budgeted costs are determined from the flexible manufacturing overhead budget for standard hours allowed. b. Most controllable variances are associated with variable costs which are controllable costs. *30. The overhead volume variance indicates whether plant facilities were efficiently used during the period. a. This variance relates solely to fixed costs. b. It measures the amount that fixed overhead costs are under - or overapplied. *31. In computing the overhead variances, a. Standard hours allowed are used in each of the variances. b. Budgeted costs are derived from the flexible budget. c. The controllable variance generally pertains to variable costs. d. The volume variance pertains solely to fixed costs.

25-6

LECTURE OUTLINE A.

The Need for Standards. 1. Standards are common in business; those imposed by government agencies are often called regulations. 2. Both standards and budgets are predetermined costs, and both contribute to management planning and control. a.

A standard is a unit amount.

A budget is a total amount.

3. A standard is the budgeted cost per unit of product. 4. Standard costs offer a number of advantages to an organization:

They facilitate management planning.

They promote greater economy by making employees more “cost-conscious.”

They are useful in setting selling prices.

They contribute to management control by providing a basis for evaluation of cost control.

They are useful in highlighting variances in management by exception.

They simplify costing of inventories and reduce clerical costs.

Setting Standard Costs. 1. Companies set standards at one of two levels:

25-7

Ideal, or

Normal.

2. Ideal standards represent optimum levels of performance under perfect operating conditions. 3. Normal standards represent efficient levels of performance that are attainable under expected operating conditions. 4. Most companies that use standards set them at a normal level. Properly set, normal standards should be rigorous but attainable. ACCOUNTING ACROSS THE ORGANIZATION Recently a number of organizations, including corporations, consultants, and governmental agencies, agreed to share information regarding performance standards in an effort to create a standard set of measures for thousands of business processes. Companies that are interested in participating can go to the group’s Website and enter their information. How will the creation of such standards help a business or organization? Answer: A business or organization may use the data to compare its performance relative to others with regard to common practices such as processing a purchase order or filling a sales order. Armed with this information, an organization can determine which areas to focus on with improvement campaigns. 5. The direct materials price standard should be based on the delivered cost of raw materials plus an allowance for receiving and handling. 6. The direct materials quantity standard should establish the required quantity plus an allowance for unavoidable waste and normal spoilage. 7. The direct labor price standard should be based on current wage rates and anticipated adjustments such as cost of living adjustments (COLAs). 8. The direct labor quantity standard should be based on required production time plus an allowance for rest periods, cleanup, machine setup, and machine downtime.

25-8

The direct labor quantity standard is also called the direct labor efficiency standard. It is especially critical in labor-intensive companies.

10. For manufacturing overhead, a standard predetermined overhead rate is used. It is based on an expected standard activity index such as standard direct labor hours or standard machine hours. 11. The total standard cost per unit is the sum of the standard costs of direct materials, direct labor, and manufacturing overhead. MANAGEMENT INSIGHT The cost of manufacturing Susan’s Chili Factory chili consists of the costs of raw materials, labor to convert the basic ingredients to chili, and overhead. Susan’s managers need to determine the mix of ingredients for one gallon of chili and to develop the standard cost for the individual ingredients that go into the chili. How might management use this raw material cost information? Answer: Management might decide to increase the price of its chili. Or it might revise its recipes to use cheaper ingredients. Or it might eliminate some products until ingredients are available at costs closer to standard. C.

Analyzing and Reporting Variances from Standards. 1. One of the major management uses of standard costs is to identify variances from the standards. Variances are the differences between total actual costs and total standard costs.

25-9

Variances are expressed in total dollars and not on a per unit basis.

When actual costs exceed standard costs, the variance is unfavorable.

If actual costs are less than standard costs, the variance is favorable.

2. Direct materials variances. a.

(Actual Quantity X Actual Price) – (Standard Quantity X Standard Price) = Total Materials Variance (TMV).

(Actual Quantity X Actual Price) – (Actual Quantity X Standard Price) = Materials Price Variance (MPV).

(Actual Quantity X Standard Price) – (Standard Quantity X Standard Price) = Materials Quantity Variance (MQV).

3. Causes of materials variances. The investigation of a materials price variance usually begins in the purchasing department. The starting point for determining the cause(s) of an unfavorable materials quantity variance is in the production department. 4. Direct labor variances. a.

(Actual Hours X Actual Rate) – (Standard Hours X Standard Rate) = Total Labor Variance (TLV).

(Actual Hours X Actual Rate) – (Actual Hours X Standard Rate) = Labor Price Variance (LPV).

(Actual Hours X Standard Rate) – (Standard Hours X Standard Rate) = Labor Quantity Variance (LQV).

5. Causes of labor variances. a.

Labor price variances usually result from two factors: (1) Paying workers higher wages than expected, (2) Misallocation of workers.

25-10 .

Labor quantity variances relate to the efficiency of workers and generally can be traced to the production department.

6. Manufacturing overhead variance. a.

Actual Overhead – Overhead Applied = Total Overhead Variance. (Overhead applied is based on standard hours allowed.

This variance is considered favorable when overhead is overapplied and considered unfavorable when overhead is underapplied.

7. Causes of manufacturing overhead variance. Responsibility for the overhead variance rests with the production department. The cause of the variance may be: a.

Higher than expected use of indirect materials, indirect labor, and electricity, or

Inefficient use of overhead (i.e., reduced production due to machine breakdowns because of poor maintenance).

8. The overhead variance is the responsibility of the production department if the cause is lack of skilled labor or machine breakdowns. When the cause is a lack of sales orders, the responsibility rests outside the production department.

Reporting Variances. 1. All variances should be reported to appropriate levels of management as soon as possible. 2. Variance reports facilitate the principle of “management by exception” by highlighting significant differences. 3. Top management normally looks for significant variances. These may be judged on the basis of some quantitative measure, such as more than 10% of the standard or more than $1,000.

. 25-11

Statement Presentation of Variances. 1. In income statements prepared for management under a standard cost accounting system, cost of goods sold is stated at standard cost and the variances are disclosed separately. 2. When there are no significant differences between actual costs and standard costs, companies report their inventories at standard costs. 3. If there are significant differences between actual and standard costs, the financial statements must report inventories and cost of goods sold at actual costs.

Balanced Scorecard. 1. The balanced scorecard incorporates financial and nonfinancial measures in an integrated system that links performance measurement and a company’s strategic goals. 2. The balanced scorecard evaluates company performance from four perspectives: a.

Financial perspective—employs financial measures of performance used by most firms.

Customer perspective—evaluates how well the company is performing from the viewpoint of those people who buy and use its products or services.

Internal process perspective—evaluates the internal operating processes critical to success.

Learning and growth perspective—evaluates how well the company develops and retains its employees.

3. Within each perspective, the balanced scorecard identifies objectives that will contribute to attainment of strategic goals. The objectives are linked across perspectives in order to tie performance measurement to company goals.

25-12 .

4. The balanced scorecard provides measurable objectives for nonfinancial measures such as product quality. 5. It integrates all of the company’s goals into a single performance measurement system. ACCOUNTING ACROSS THE ORGANIZATION Many of the benefits of a balanced scorecard approach are evident in the improved operations at United Airlines. When Glenn Tilton took over as United’s Chief Executive Officer he implemented an incentive program that allowed all employees to earn a bonus if the company “exceeded its goals for on-time flight departures and for customer intent to fly United again.” Which of the perspectives of a balanced scorecard were the focus of United’s CEO? Answer: Improving on-time flight departures is an objective within the internal process perspective. Customer intent to fly United again is an objective within the customer perspective. APPENDIX 25A *G. Standard Cost Accounting System. 1. A standard cost accounting system is a double-entry system of accounting. In this system, companies use standard costs in making entries, and they formally recognize variances in the accounts. 2. The system is based on two important assumptions:

. 25-13

Variances from standards are recognized at the earliest opportunity, and

The Work in Process account is maintained exclusively on the basis of standard costs.

APPENDIX 25B *H

Overhead Controllable and Volume Variances. 1. The total overhead variance is generally analyzed through a price variance (controllable variance) and a quantity variance (volume variance). 2. The overhead controllable variance shows whether overhead costs are effectively controlled. 3. The overhead volume variance relates to whether fixed costs were under-or overapplied during the year.

25-14 .

Actual Overhead – Overhead Budgeted = Overhead Controllable Variance. (Overhead budgeted is based on standard hours allowed).

Fixed Overhead Rate X [Normal Capacity Hours – Standard Hours Allowed] = Overhead Volume Variance.

20 MINUTE QUIZ Circle the correct answer. True/False 1. The primary difference between standards and budgets is that a standard is a unit amount, whereas a budget is a total amount. True

False

2. An advantage of standard costs is that standard costs facilitate management planning by establishing expected future costs. True

False

3. Ideal standards represent an efficient level of performance that is attainable under expected operating conditions. True

False

4. The direct labor price standard generally includes employer payroll taxes and fringe benefits, such as paid holidays and vacations. True

False

5. (Actual Quantity X Standard Price) – (Standard Quantity X Actual Price) = Materials Price Variance. True

False

6. (Actual Hours X Actual Rate) – (Actual Hours X Standard Rate) = Labor Price Variance. True

False

7. Standard hours allowed are the hours that should have been worked for the units produced. True

False

8. Variance reports facilitate the principle of “management by exception.” True

False

9. In income statements prepared under a standard cost accounting system, cost of goods sold is stated at standard cost. True

False

*10. The overhead controllable variance is the difference between the actual overhead costs incurred and the overhead applied. True

. 25-15

False

Multiple Choice 1.

Which of the following is an advantage of standard costs? a. Contribution to management control. b. Promotion of greater economy and efficiency. c. Simplification of the costing of inventories and reduction of clerical costs. d. All of the above.

If the predetermined overhead rate per hour is $6 for variable and $2 for fixed overhead, standard direct labor hours per unit is 2 hours and actual direct labor hours per unit was 1.5 hours, then the overhead standard per unit is a. $4 per unit. b. $8 per unit. c. $16 per unit. d. $12 per unit.

The formula for the labor quantity (or efficiency) variance is a. (Actual Hours X Actual Rate) – (Actual Hours X Standard Rate). b. (Actual Hours X Standard Rate) – (Standard Hours X Standard Rate). c. (Standard Hours X Actual Rate) – (Standard Hours X Standard Rate). d. none of the above.

*4.

If actual overhead is $70,000, overhead applied is $67,000 and overhead budgeted for the standard hours allowed is $78,000, then the overhead controllable variance is a. $3,000 F. b. $11,000 U. c. $8,000 F. d. $8,000 U.

*5.

In a standard cost accounting system, a company purchased raw materials on account for $46,500 when the standard cost was $44,000. The journal entry would not include a a. debit to Raw Materials Inventory for $44,000. b. debit to Materials Price Variance for $2,500. c. credit to Materials Price Variance for $2,500. d. credit to Accounts Payable for $46,500.

25-16 .

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True True False True False

Multiple Choice 1. 2. 3. *4. *5.

. 25-17

d. c. b. c. c.

6. 7. 8. 9. 10.

True True True True False

CHAPTER 26 INCREMENTAL ANALYSIS AND CAPITAL BUDGETING

Learning Objectives 1. DESCRIBE MANAGEMENT’S DECISION-MAKING PROCESS AND INCREMENTAL ANALYSIS. 2. ANALYZE THE RELEVANT COSTS IN VARIOUS DECISIONS INVOLVING INCREMENTAL ANALYSIS. 3. CONTRAST ANNUAL RATE OF RETURN AND CASH PAYBACK IN CAPITAL BUDGETING. 4. DISTINGUISH BETWEEN THE NET PRESENT VALUE AND INTERNAL RATE OF RETURN METHODS.

26-1

CHAPTER REVIEW Incremental Analysis Approach 1.

(L.O. 1) Management’s decision-making process frequently involves the following steps: a. Identify the problem and assign responsibility. b. Determine and evaluate possible courses of action. c. Make a decision. d. Review results of the decision.

(L.O. 2) Business decisions involve a choice among alternative courses of action. In making such decisions, management ordinarily considers both financial and nonfinancial information. The process used to identify the financial data that change under alternative courses of action is called incremental analysis. a. Incremental analysis identifies the probable effects of the decision on future earnings. b. Data for incremental analysis involves estimates and uncertainty. c. Gathering data may involve market analysts, engineers, and accountants.

In incremental analysis, both costs and revenues may change. However, in some cases (1) variable costs may not change under the alternative courses of action, and (2) fixed costs may change.

Accept an Order at a Special Price 4.

An order at a special price should be accepted when the incremental revenue from the order exceeds the incremental costs. a. It is assumed that sales in other markets will not be affected by the special order. b. If the units can be produced within existing plant capacity, generally only variable costs will be affected.

Make or Buy 5.

In a make or buy decision, management must determine the costs which are different under the two alternatives. If there is an opportunity to use the productive capacity for another purpose, opportunity cost should be considered. Opportunity cost is the potential benefit that may be obtained by following an alternative course of action. This cost is an additional cost of making the component.

Sell or Process Further 6.

The basic decision rule in a sell or process further decision is: Process further as long as the incremental revenue from such processing exceeds the incremental processing costs. Incremental revenue is the increase in sales which results from processing the product further.

Repair, Retain, or Replace Equipment 7.

In a decision to retain or replace equipment, management compares the costs which are affected by the two alternatives. Generally, these are variable manufacturing costs and the cost of the new equipment. a. The book value of the old machine is a sunk cost which does not affect the decision. A sunk cost is a cost that cannot be changed by any present or future decision. b. However, any trade-in allowance or cash disposal value of the existing asset must be considered.

25-2

Eliminate an Unprofitable Segment or Product 8.

In deciding whether to eliminate an unprofitable segment, management should choose the alternative which results in the highest net income. Often fixed costs allocated to the unprofitable segment must be absorbed by the other segments. It is possible, therefore, for net income to decrease when an unprofitable segment is eliminated.

Allocate Limited Resources 9.

When a company has limited resources (floor space, raw materials, or machine hours), management must decide which products to make and sell. In an allocation of limited resources decision, it is necessary to find the contribution margin per unit of limited resource. a. This is obtained by dividing the contribution margin per unit of each product by the number of units of the limited resource required for each product. For example, if the unit contribution margin for a product is $6 and three machine hours are required, the contribution margin per unit of limited resource is $2 ($6 ÷ 3). b. Production should be geared to the product with the highest contribution margin per unit of limited resource.

Capital Budgeting 10.

The process of making capital expenditure decisions is known as capital budgeting. The three most commonly used capital budgeting techniques are (a) annual rate of return, (b) cash payback, and (c) discounted cash flow.

Annual Rate of Return 11.

(L. O. 3) The annual rate of return technique is based directly on accrual-accounting data. It indicates the profitability of a capital expenditure. The formula is: Expected Annual Net Income ÷ Average Investment = Annual Rate of Return Average investment is based on the following: Original Investment + Value at End of Useful Life = Average Investment 2

12.

A project is acceptable if its rate of return is greater than management’s required rate of return. a. The required rate of return rate is based on the company’s cost of capital, which is the rate of return management expects to pay on all borrowed and equity funds. b. When choosing among several acceptable projects, the higher the annual rate of return, the more attractive the investment. c. This technique is simple and familiar, but it does not consider the time value of money.

Cash Payback 13.

The cash payback technique identifies the time period required to recover the cost of the capital investment from the annual cash inflow produced by the investment. The formula for computing the cash payback period is: Cost of Capital Investment ÷ Net Annual Cash Flow = Cash Payback Period Net annual cash flow is approximated by adding depreciation expense back to net income.

26-3

14.

The evaluation of the payback period is often related to the expected useful life of the asset. a. With this technique, the shorter the payback period, the more attractive the investment. b. This technique is useful as an initial screening tool. c. This technique ignores both the expected profitability of the investment and the time value of money.

Discounted Cash Flow 15.

(L.O. 4) The discounted cash flow technique is generally recognized as the best conceptual approach to making capital budgeting decisions. This technique considers both the estimated total Net cash flows and the time value of money. Two methods are used with the discounted cash flow technique: net present value and internal rate of return.

Net Present Value Method 16.

Under the net present value method, cash flows are discounted to their present value and then compared with the capital outlay required by the investment. The difference between these two amounts is the net present value (NPV). a. The interest rate used in discounting the future net cash flows is the required minimum rate of return. b. A proposal is acceptable when NPV is zero or positive. c. The higher the positive NPV, the more attractive the investment.

17.

When there are equal annual cash flows, the table showing the present value of an annuity of 1 can be used in determining present value. When there are unequal annual cash flows, the table showing the present value of a single future amount for each net annual cash flow must be used in determining present value.

Internal Rate of Return Method 18.

The internal rate of return method results in finding the interest yield of the potential investment. This is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected net annual cash flows. Determining the true interest rate involves two steps: a. An internal rate of return factor is computed by dividing the capital investment by the net annual cash flows. b. The factor is then used with the present value of an ordinary annuity of 1 table to find the internal rate of return.

19.

The decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return, and reject the project when the internal rate of return is less than the required rate.

20.

The internal rate of return method is widely used in practice because most managers find it easy to interpret.

25-4

LECTURE OUTLINE A.

Management’s Decision-Making Process. 1. The steps are: a.

Identify the problem and assign responsibility.

Determine and evaluate possible courses of action.

Make a decision.

Review results of the decision.

2. Accounting’s contribution to the decision-making process occurs primarily in steps (b) and (d)—evaluating possible courses of action, and reviewing the results. B.

The Incremental Analysis Approach. 1. The process used to identify the financial data that change under alternative courses of action is called incremental analysis. 2. These data are relevant to the decision because they will vary in the future among the possible alternatives. 3. Incremental analysis sometimes involves changes that might seem contrary to your intuition. For example, sometimes:

26-5

Variable costs do not change under the alternative courses of action.

Fixed costs do change.

SERVICE COMPANY INSIGHT American Express decided to offer some of its customers $300 if they would give back their credit card. Customers could receive the $300 even if they hadn’t paid off their balance yet, as long as they agreed to give up their credit card. What are the relevant costs and other information that American Express would need to know in order to determine to whom to make this offer? Answer:

Clearly American Express would make this offer to those customers that are most likely to default on their bills. The most important relevant cost would be the “expected loss” that an at risk customer posed. If a customer has a high probability of defaulting, and if the expected loss exceeds the $300 cost, then American Express can probably save money by paying that customer to quit using their card so that the customer doesn’t ring up an even bigger bill.

4. Accept an order at a special price. a.

The relevant information is the difference between the variable manufacturing costs to produce the special order and expected revenues.

If other sales are affected, then the company would have to consider the lost sales in making the decision.

If the company is operating at full capacity, it is likely that the special order would be rejected.

5. Make or buy. a.

In a make or buy decision, the relevant costs are: (1) The variable manufacturing costs that will be saved. (2) The fixed manufacturing costs that can be eliminated. (3) The purchase price.

25-6

b. Opportunity costs: The potential benefit that may be obtained by following an alternative course of action. ACCOUNTING ACROSS THE ORGANIZATION Manufacturers in various industries have engaged in overseas off-shoring (outsourcing) in recent years. Incremental analysis, comparing the relative labor costs in various nations, often leads to outsourcing production to countries like China. What are the disadvantages of outsourcing to a foreign country? Answer: One issue relates to whether the quality of the product will suffer if the car-makers outsource manufacture of aluminum wheels. In addition, transportation costs will also increase. 6. Sell or process further. a.

Many manufacturers have the option of selling products at a given point in the production cycle or continuing to process with the expectation of selling them at a higher price.

The basic decision rule is: Process further as long as the incremental revenue from such processing exceeds the incremental processing costs.

7. Repair, retain, or replace equipment. a.

Management often has to decide whether to continue using an asset or replace it.

The factors to consider are: (1) The effects on variable costs. (2) The cost of the new equipment.

26-7

The book value of the old asset does not affect the decision. Book value is a sunk cost, which is a cost that cannot be changed by any present or future decision.

Any cash disposal value or trade-in allowance of the existing asset is relevant to the decision.

8. Eliminate an unprofitable segment or product. a.

In deciding whether to eliminate an unprofitable segment, determine the contribution margin, if any, produced by the segment and the disposition of the segment’s fixed expenses.

In deciding on the future status of an unprofitable segment, management should consider the effect of elimination on related product lines.

Management should also consider the effect of eliminating the product line on employees who may have to be discharged or retrained.

9. Allocate limited resources.

When a company has limited resources, find the contribution margin per unit of limited resource.

This amount is then multiplied by the units of limited resource to determine which product maximizes net income.

Capital Budgeting. 1. The process of making capital expenditure decisions in business is known as capital budgeting. 2. Quantitative techniques that may be used for capital budgeting decisions include:

25-8

Annual rate of return.

Cash payback.

Discounted cash flow.

3. The annual rate of return technique is based directly on accounting data. a.

Annual rate of return is obtained from the following formula: Expected Annual Net Income ÷ Average Investment.

The required rate of return is generally based on the company’s cost of capital.

The cost of capital is the rate of return that management expects to pay on all borrowed and equity funds.

The annual rate of return decision rule is: A project is acceptable if its rate of return is greater than management’s required rate of return. It is unacceptable when the reverse is true.

The higher the rate of return for a given risk, the more attractive the investment.

The principal advantages of the annual rate of return technique are simplicity of calculation and management’s familiarity with the accounting terms used in the computation.

A major limitation of this approach is that it does not consider the time value of money.

4. The cash payback technique identifies the time period required to recover the cost of the capital investment from the net annual cash flow produced by the investment. a.

The formula for computing the cash payback period is: Cost of Capital Investment ÷ Net Annual Cash Flow = Cash Payback Period.

The shorter the payback period, the more attractive the investment.

The cash payback technique recognizes that: (1) The earlier the investment is recovered, the sooner the cash funds can be used for other purposes.

26-9

(2) The risk of loss from obsolescence and changed economic conditions is less in a shorter payback period. d.

In the case of uneven cash flows, the company determines the cash payback period when the cumulative cash flows from the investment equal the cost of the investment.

The cash payback technique is relatively easy to compute and understand.

It should not ordinarily be the only basis for the capital budgeting decision because it ignores the expected profitability of the project.

5. The discounted cash flow technique is generally recognized as the best conceptual approach to making capital budgeting decisions. a.

This technique considers both the estimated total net cash flows from the investment and the time value of money.

Two methods are used with the discounted cash flow technique: (1) Net present value. (2) Internal rate of return.

6. The net present value method involves discounting net cash flows to their present value and then comparing the present value with the capital outlay required by the investment. The difference between these two amounts is referred to as net present value (NPV).

. 25-10

The interest rate to be used in discounting the future net cash flows is the required rate of return.

The NPV decision rule is: A proposal is acceptable when net present value is zero or positive, because this means that the rate of return on the investment equals or exceeds the required rate of return.

The higher the positive net present value, the more attractive the investment.

7. The internal rate of return method finds the interest yield of the potential investment. a.

The internal rate of return (IRR) is the rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected net annual cash flows.

The determination of the internal rate of return involves two steps: (1) Compute the internal rate of return factor. (2) Use the factor and the present value of an annuity of 1 table to find the internal rate of return.

The formula for determining the internal rate of return factor is: Capital Investment ÷ Net Annual Cash Flow = Internal Rate of Return Factor.

The IRR decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return. Reject the project when the internal rate of return is less than the required rate.

8. The two discounted cash flow methods differ as follows: a.

Objective:

(1) Net present value: compute net present value (a dollar amount). (2) Internal rate of return: compute internal rate of return (a percentage). Decision rule: (1) Net present value: If NPV is zero or positive, accept the proposal; if NPV is negative, reject the proposal. (2) Internal rate of return: If IRR is equal to or greater than the minimum required rate of return, accept the proposal; if IRR is less than the minimum rate, reject the proposal.

. 26-11

20 MINUTE QUIZ Circle the correct answer. True/False 1.

Determining and evaluating possible courses of action is a step in management’s decision-making process. True

In incremental analysis fixed costs may not change under alternative courses of action, while variable costs may change. True

False

Net present value and internal rate or return are both methods used with the discounted cash flow technique. True

10.

False

The cash payback technique recognizes the time value of money plus expected profitability of a project, and is therefore the most desirable approach to making capital budgeting decisions. True

False

A major limitation of the annual rate of return approach is that it does not consider the time value of money. True

False

Contribution margin per unit of limited resource is obtained by dividing the contribution margin per unit of each product by the number of units of the limited resource required for each product. True

False

Book value is a sunk cost and is therefore relevant in incremental analysis of retain or replace equipment. True

False

The basic decision rule to sell or process further is: process further as long as the incremental revenue from such processing exceeds the incremental processing costs. True

False

The relevant factors to consider in accepting an order at a special price are the additional manufacturing costs incurred and expected revenues. True

False

The net present value method results in finding the interest yield of the potential investment. True

. 25-12

False

Multiple Choice 1.

Which of the following is not a step in management’s decision-making process? a. Identify the problem and assign responsibility. b. Determine possible courses of action. c. Review the results of the decision. d. Prepare financial statements.

If revenues are $1,050,000 under alternative A and $1,080,000 under alternative B, and costs are $950,000 for A and $1,020,000 for B, then using the basic approach in incremental analysis, incremental revenues, costs, and net income, in comparing B to A are respectively a. $30,000, $70,000, $(40,000). b. $(30,000), $70,000, $40,000. c. $30,000, $70,000, $40,000. d. $(30,000), $(70,000), $(40,000).

The cost to manufacture an unfinished unit is $160 ($120 variable, $40 fixed). The selling price per unit is $200. The company has unused productive capacity and has determined that units could be finished and sold for $260 with an increase in variable costs of 40%. What is the additional net income per unit to be gained by finishing the unit? a. $12.00. b. $40.00. c. $60.00. d. $48.00.

Which of the following is generally recognized as the most informative and best conceptual approach to making capital budgeting decisions? a. Annual rate of return technique. b. Cash payback technique. c. Discounted cash flow technique. d. None of the above.

If capital investment is $200,000 and equal annual cash inflows are $40,000, the internal rate of return factor is a. 20.0. b. 5.0. c. 4.0. d. .25.

. 26-13

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True True True True False

Multiple Choice 1. 2. 3. 4. 5.

. 25-14

d. a. a. c. b.

6. 7. 8. 9. 10.

True True False True False

APPENDIX G TIME VALUE OF MONEY LEARNING OBJECTIVES 1. COMPUTE INTEREST AND FUTURE VALUES. 2. COMPUTE PRESENT VALUE. 3. SOLVE FOR FUTURE VALUE OF AN ANNUITY. 4. IDENTIFY THE VARIABLES FUNDAMENTAL TO SOLVING PRESENT VALUE PROBLEMS.

G-1

APPENDIX G REVIEW Value of Interest 1.

(L.O. 1) Interest is payment for the use of another person’s money. The amount of interest involved in any financing transaction is based on three elements: a. Principal: The original amount borrowed or invested. b. Interest Rate: An annual percentage of the principal. c. Time: The number of years that the principal is borrowed or invested.

Simple interest is computed on the principal amount only. Simple interest is usually expressed as: Interest = Principal X Rate X Time

Compound interest is computed on principal and on any interest earned that has not been paid or withdrawn. It is the return on (or growth of) the principal for two or more time periods.

Future Value of a Single Amount 4.

The future value of a single amount is the value at a future date of a given amount invested assuming compound interest. Future value is usually expressed as: FV = P X (1 + i)n FV = future value of a single amount P = principal i = interest rate for one period n = number of periods

The Future Value of 1 table is used for obtaining a 5-digit decimal number which is multiplied by the principal to calculate the future value.

Future Value of an Annuity 6.

The future value of an annuity is the sum of all the payments (receipts) plus the accumulated compound interest on them. In computing the future value of an annuity, it is necessary to know the (1) interest rate, (2) the number of compounding periods, and (3) the amount of the periodic payments or receipts. When the periodic payments or receipts are the same in each period, the future value can be computed by using a future value of an annuity of 1 table.

Present Value Variables 7.

(L.O. 2) The present value is based on three variables: (1) the dollar amount to be received (future amount), (2) the length of time until the amount is received (number of periods), and (3) the interest rate (the discount rate). PV = FV/(1 + i) PV = present value FV = future value i = interest rate

G-2

The present value of 1 may also be determined through tables that show the present value of 1 for n periods.

Present Value of an Annuity 9.

In computing the present value of an annuity, it is necessary to know (1) the discount rate, (2) the number of discount periods, and (3) the amount of the periodic receipts or payments. When the future receipts are the same in each period, there are two other ways to compute the present value. First, the annual cash flow can be multiplied by the sum of the three present value factors. Second, annuity tables may be used.

Time Periods and Discounting 10.

Discounting may also be done over shorter periods of time such as monthly, quarterly, or semiannually. When the time frame is less than one year, it is necessary, to convert the annual interest rate to the applicable time frame.

Computing the Present Value of a Long-Term Note or Bond 11.

The present value (or market price) of a long-term note or bond is a function of three variables: (1) the payment amounts, (2) the length of time until the amounts are paid, and (3) the discount rate. When the investor’s discount rate is equal to the bond’s contractual interest rate, the present value of the bonds will equal the face value of the bonds.

Computing the Present Values in Capital Budgeting Situations 12.

(L.O. 3) The decision to make long-term capital investments is best evaluated using discounting techniques that calculate the present value of the cash flows involved in a capital investment.

13.

If the net present value of a capital investment is positive, the proposal should be accepted (make the investment). If the net present value is negative, the proposal should be rejected.

Using a Financial Calculator 14.

(L.O. 4) Financial calculators can be used to solve the same and additional problems as those solved with time value of money tables. The amounts for all of the known elements of a time value of money problem are entered into a financial calculator and it solves for the unknown element. Financial calculators are particularly useful in situations involving interest rates and compounding periods not presented in the compound interest tables.

G-3

LECTURE OUTLINE A.

Nature of Interest 1. Interest is payment for the use of another person’s money. It is the difference between the amount borrowed or invested (called the principal) and the amount repaid or collected. 2. The amount of interest involved in any financing transaction is based on: a.

Principal (p): The original amount borrowed or invested,

Interest Rate (i): An annual percentage of the principal,

Time (n): The number of years that the principal is borrowed or invested.

3. Simple interest is computed on the principal amount only.

4. Compound interest is computed on principal and on any interest earned that has not been paid or withdrawn. It is the return on the principal for two or more time periods. B.

Future Value of a Single Amount 1. The future value of a single amount is the value at a future date of a given amount invested assuming compound interest. 2. The future value of a single amount can be computed using the following formula: FV = p X (1 + i )n p = principal; i = interest rate; n = number of periods. 3. Another way to compute the future value of a single amount is to use Table 1, which shows the future value of 1 for n periods. 4. Using Table 1, the future value of a single amount is computed by multiplying the principal by the appropriate future value of 1 factor.

G-4

Future Value of an Annuity 1. An annuity is an equal dollar amount of payments or receipts. 2. The future value of an annuity is the sum of all the payments (receipts) plus the accumulated compound interest on them. 3. In computing the future value of an annuity, it is necessary to know the: a.

interest rate,

number of compounding periods,

amount of the periodic payments or receipts.

4. The future value of an annuity can be computed by using Table 2, which shows the future value of 1 to be received periodically for a given number of periods.

Present Value Variables 1. The present value is based on the: a.

dollar amount to be received (future amount),

length of time until the amount is received (number of periods),

interest rate (the discount rate).

2. The process of determining the present value is referred to as discounting the future amount.

G-5

Present Value of a Single Amount 1. The present value of a single amount is the value today of a future amount to be received (or paid), assuming compound interest. 2. The present value of a single amount can be computed using the following formula: PV = FV ÷ (1 + i )n FV = future amount; i = interest rate; n = number of periods. 3. Another way to compute the present value of a single amount is to use Table 3, which shows the present value of 1 for n periods. 4. Using Table 3, the present value of a single amount is computed by multiplying the future amount by the appropriate present value of 1 factor.

Present Value of an Annuity 1. The present value of an annuity is the value today of a series of future receipts or payments, discounted assuming compound interest. 2. In computing the present value of an annuity, one needs to know the: a.

discount rate.

number of discount periods.

amount of the periodic receipts or payments.

3. The present value of an annuity can be computed by using Table 4, which shows the present value of 1 to be received periodically for a given number of periods.

G-6

Computing the Present Value of a Long-Term Note or Bond 1. The present value (or market price) of a long-term note or bond is a function of the: a.

payment amounts.

length of time until the amounts are paid.

discount rate.

2. The payment amounts are made up of two elements: a.

a series of interest payments (an annuity),

the principal amount (a single sum).

3. To compute the present value of the bond, one must discount both the interest payments and the principal amount. a.

Multiply the principal amount by the appropriate present value factor from Table 3.

Multiply the amount of the interest payments by the appropriate present value factor from Table 4.

Add the present value of the principal amount to the present value of the interest payments to determine the present value of the bond.

4. Since interest on bonds is paid semiannually, the discount rate used in computing the present value of the bonds is the semiannual rate.

G-7

Computing the Present Values in a Capital Budgeting Decision 1. The decision to make long-term capital investments is best evaluated using discounting techniques that recognize the time value of money. This is done by calculating the present value of the cash flows involved in a capital investment. 2. When the present value of the cash receipts (inflows) from a capital investment exceeds the present value of the cash payments (outflows), the net present value is positive, and the investment should be accepted. 3. When the present value of the cash payments (outflows) for a capital investment exceeds the present value of the cash receipts (inflows), the net present value is negative, and the investment should be rejected.

Using Financial Calculators. 1. Financial calculators can be used to solve present and future value problems using the following keys.

G-8

N = Number of periods

I = interest rate per period

PV = present value (occurs at the beginning of the first period)

PMT = payment (all payments are equal, and none are skipped)

FV = future value (occurs at the end of the last period)

10 MINUTE QUIZ Circle the correct answer. True/False 1.

Simple interest is computed on the principal and any interest earned that has not been paid or received. True

The future value of an annuity is the sum of all the payments plus the accumulated compound interest on them. True

False

To compute the present value of a bond, both the interest payments and the principal amount must be discounted. True

False

In computing the present value of an annuity, it is necessary to know the discount rate, the number of discount periods, and the amount of the periodic payments. True

False

The process of determining the present value is referred to as discounting the present amount. True

False

G-9

False

Multiple Choice 1.

Interest that is computed on the principal and any interest earned is called a. simple interest. b. present interest. c. future interest. d. compound interest.

The value at a future date of a given amount invested assuming compound interest is the a. compounded value of a single amount. b. compounded value of an annuity. c. future value of a single amount. d. future value of an annuity.

The process of determining the present value is referred to as discounting the a. compound amount. b. future amount. c. present amount. d. simple amount.

In computing the present value of an annuity, it is not necessary to know the a. discount rate. b. number of discount periods. c. amount of the periodic payments. d. year the payments will begin.

Cogswell Company issued 6%, 10-year bonds that pay interest semiannually. The discount rate of interest for such bonds is 8%. In computing the present value of these bonds, the appropriate discount rate is a. 8%. b. 6%. c. 4%. d. 3%.

G-10

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

False True False True True

Multiple Choice 1. 2. 3. 4. 5.

G-11

d. c. b. d. c.

Bloom’s Taxonomy in Accounting 1. Knowledge: Recalling information. a. To identify the users and uses of accounting information. b. To define assets, liabilities, and owner’s equity. 2. Comprehension: Translating, interpreting, and extrapolating information. a. To associate accounts with their respective financial statements. b. To infer the generally accepted accounting principle (e.g., the cost principle) involved in a given scenario. 3. Application: Using principles or abstractions to solve novel or real-life problems. a. To record transactions. b. To prepare financial statements. 4. Analysis: Breaking down complex information into simpler parts and understanding how these parts are related. a. To correct errors in transactions. b. To complete information missing from financial statements. 5. Synthesis: Creating something new. a. To write an essay discussing the accounting career one may be interested in and why. b. To produce a flow-chart to help one decide the generally accepted accounting principle applicable in a given situation. 6. Evaluation: To judge something against a given standard. a. To grade how well a classmate prepared a financial statement. b. To critique how a company calculated its net income for the period.

Bloom’s Taxonomy in general: 1. Knowledge (K): Knowledge, as defined here, involves the recall of specifics and universals, the recall of methods and processes, or the recall of a pattern, structure, or setting. For measurement purposes, the recall situation involves little more than bringing to mind the appropriate material. Although some alteration of the material may be required, this is a relatively minor part of the task. The knowledge objectives emphasize most the psychological processes of remembering. 2. Comprehension (C): This represents the lowest level of understanding. It refers to a type of understanding or apprehension such that the individual knows what is being communicated and can make use of the material or idea being communicated without necessarily relating it to other material or seeing its fullest implications. 3. Application (AP): The use of abstractions in particular and concrete situations. The abstractions may be in the form of general ideas, rules or procedures, or generalized methods. The abstractions may also be technical principles, ideas, and theories which must be remembered and applied.

4. Analysis (AN): The breakdown of a communication into its constituent elements or parts such that the relative hierarchy of ideas is made clear and the relations between the ideas expressed are made explicit. Such analyses are intended to clarify the communication, to indicate how the communication is organized, and [to show] the way in which it manages to convey its effects as well as its basis and arrangement. 5. Synthesis (S): The putting together of elements and parts so as to form a whole. This involves the process of working with pieces, parts, elements, etc., and arranging and combining them in such a way as to constitute a pattern or structure not clearly there before. 6. Evaluation (E): Judgements about the value of material and methods of given purposes. Quantitative and qualitative judgements about the extent to which material and methods satisfy criteria. Use of a standard of appraisal. The criteria may be those determined by the student or those which are given to him.

IMA: Derived from the IMA website. Tags IMA-Business Economics

IMA-Global Business

IMA-Internal Controls

IMAQuantitative Methods IMA-FSA

IMA-Budget Preparation IMA-Cost Management

IMAInformation Management

Skills The candidate should be knowledgeable of micro economics and should be able to demonstrate an understanding of the laws of supply and demand. The candidate should be able to define and apply knowledge of various costs including fixed, variable, and marginal. The candidate should be able to identify and understand pure competition, monopoly, monopolistic competition, and oligopoly. The candidate will be able to explain resource planning and the cost of resources. The candidate should be knowledgeable of macro economics and should be able to demonstrate an understanding of inflation, unemployment and economic growth. The candidate should be define and calculate Gross Domestic Product (GDP). The candidate will be knowledgeable of the business cycle and demonstrate an understanding of fiscal monetary policies. The candidate should be able to define terms associated with global trade, including net exports and net imports. The candidate should be knowledgeable of foreign currency terms and policies and be able to apply calculations relevant to foreign monetary exchanges. The candidate should be aware of the functions of the World Bank and International Monetary Fund and be able to identify legal and ethical issues in conducting business worldwide. The candidate should be able to demonstrate an understanding of risk assessment and the management of risk and be able to define inherent risk, control risk, and detection risk. The candidate should be able to define and give examples of segregation of duties. The candidate should be able to define the internal audit function and recognize that the internal audit function provides information concerning activities reviewed to assist management. The candidate should be able to identify threats to information systems and be knowledgeable of controls to limit the threats. The candidate should understand and be capable of implementing a disaster recovery plan. The candidate should be able to show an understanding of the regression equation and identifying assumptions of simple regression analysis. The candidate should be able to demonstrate an understanding of the objectives of linear programming and demonstrate the mathematical formulation of a constraint. The candidate should be able to demonstrate an understanding of the development of U.S. accounting standards and the distinct responsibilities of management and of auditors for the financial statements. The candidate should be able to identify related provisions of the Sarbanes-Oxley Act of 2002 and the related rulings of the Public Company Accounting Oversight Board (PCAOB). The candidate should be able to calculate financial ratios and use the information to measure the organization's financial performance. The candidate should understand budgeting concepts and should be familiar with budgeting systems. The candidate should be able to use the knowledge of budgeting concepts and budgeting systems to prepare operational, financial, and capital budgets and pro forma financial statements. The candidate should know and be able to apply terminology related to cost principles. The candidate should demonstrate an understanding of cost behavior cost drivers. The candidate should be able to apply this knowledge to inventorialable costs, cost of goods sold and other cost applications. The candidate should be able to implement various cost accumulation systems, including job, process, activity, lifecycle and other costing methods. The candidate should understand the nature of overhead expenses; the nature of cost drivers and other relevant principles applicable to overhead. The candidate should be able to identify the different types of business information processing systems and recognize that information systems support the business functions of accounting, finance, marketing, operations management, and human resources.

IMAPerformance Measurement

IMA-Reporting

IMA-Strategic Planning

IMA-Strategic Marketing

IMA-Corporate Finance

IMA-Decision Analysis

IMA-

The candidate should be able to demonstrate an understanding of the technology of information systems including networks, applicable software, electronic commerce and enterprise-wide planning systems. The candidate should be able to design procedures for measuring operational goals through a variety of methods and be able to apply analysis of variances is using standard cost techniques. The candidate should be able to recognize responsibility centers and reporting segments. The candidate should understand and be able to apply transfer pricing to organizational segments. The candidate should be able to apply the concepts and applications related to balanced scorecard. The candidate should be able to identify the objectives of external financial reporting; identify and demonstrate an understanding of basic accounting assumptions and conventions; identify financial statement elements for each of the financial statements and be knowledgeable of special accounting topics. The candidate should be able to identify the two major Acts establishing the SEC and its powers; and demonstrate knowledge of the major provisions of each Act; identify and explain the major provisions of the Sarbanes-Oxley Act of 2002; and be identify the functions and responsibilities of the Public Company Accounting Oversight Board (PCAOB). The candidate should be able to identify the basic components of the annual report; demonstrate an awareness of the Audit Committee’s level of responsibility for the integrity of the financial information presented in the annual reports; and identify and describe the other sections in the annual report. The candidate must be knowledgeable of various manufacturing paradigms including just-intime manufacturing, MRP, theory of constraints, and capacity management. The candidate must be able to assess business process performance. The candidate will be familiar with value chain analysis; understand value added concepts; process analysis; benchmarking; activity based management; and continuous improvement concepts. The candidate should be able to identify the interrelationships between strategy and marketing and recognize the critical importance of customer value and customer satisfaction. The candidate should be able to identify marketing information needs. The candidate should be able to distinguish between products and services; classify products and services; demonstrate an understanding of product line decisions and product mix decisions; demonstrate an understanding of new product development strategy and product life-cycle strategies. The candidate should be able to identify internal and external factors affecting pricing decisions; demonstrate an understanding of general pricing approaches; demonstrate an understanding of product mix pricing strategies; and recognize that public policy can influence pricing decisions. The candidate should be able to calculate rates of return ; demonstrate an understanding of the different types of risk; and define hedging and demonstrate how hedging can be used to manage financial risk. The candidate should be able to define and identify the characteristics of various financial instruments; value bonds, common stock, and preferred stock using discounted cash flow methods; and recognize how income taxes impact financing decisions. The candidate should be able to define the cost of capital and demonstrate an understanding of its applications in capital structure decisions. The candidate should identify and demonstrate an understanding of the steps needed to reach a decision. The candidate should be able to identify and apply concepts relevant to decision analysis, including sunk costs and opportunity costs. The candidate must be able to use cost/volume/profit analysis. The candidate will be able to apply marginal analysis for making decisions related to special orders and pricing; make versus buying decisions; sale or process further decisions; and to determine if a segment should be added or dropped. Finally, the candidate will be able to apply concepts and knowledge related to setting prices and target costing. The candidate must be able to develop information to assist management in making investment

Investment Decisions IMA-Business Applications

decisions. In order to do this in candidate must be knowledgeable of capital budgeting; discounted cash flow analysis; payback and discounted payback; and ranking of investment projects. The candidate will be familiar with the provisions of "Standards of Ethical Conduct for IMA Members" in the evaluation and resolution of relevant ethical issues.

AICPA Core Competency Framework Functional Competencies Functional competencies relate to the technical competencies, which are most closely aligned with the value contributed by accounting professionals. Decision Modeling Individuals preparing to enter the accounting profession must be able to use strategic and critical approaches to decision-making. They must objectively consider issues, identify alternatives, and choose and implement solution approaches in order to deliver services and provide value. Risk Analysis Risk analysis and control is fundamental to professional service delivery. The identification and management of audit risk (that is, the risk that the auditor will fail to detect a misstatement, caused by inadvertent error or fraud, that is, material to financial statements) is the basis for the conduct of a GAAS audit. The understanding of business risk (that is, the risk that an entity— either a client or the prospective accounting professional's employer—will fail to achieve its objectives) affects how business strategy is created and implemented. Measurement Measures used should be both relevant (that is, bear on the decision to be made) and reliable (consistently measure what they purport to measure). Various measurement and disclosure criteria used by accounting professionals—such as GAAP, OCBOA (Other Comprehensive Basis of Accounting) and tax reporting—have been codified to some degree. Other performance measures (such as Economic Value Added) or stated criteria (for example, investment performance) are used for special purposes. Some measurement criteria (such as effectiveness of internal control) are measured qualitatively, rather than quantitatively. Reporting Communicating the scope of work and findings or recommendations is an integral part of a professional service. An accounting professional in public practice might issue an audit or attestation report, recommendations for improved services, or tax or financial planning advice. An accounting professional in business, industry, or government might analyze operations or provide communications to the board of directors. Communicating clearly and objectively the work done and the resulting findings is critical to the value of the professional service. Some forms of communication are governed by professional standards (such as the form and content of the standard auditor's report or the required communications to audit committees) or law. Others are based on the service applied and the needs of those to whom the accounting professional reports. Research

Although accounting professionals need a foundation in standards and other relevant rules, such guidance is constantly evolving. Many accounting profession functions depend on obtaining information from within and outside of an entity. Accordingly, the individual preparing to enter the accounting profession needs to have strong research skills to access relevant guidance or other information, understand it, and apply it. Leverage Technology to Develop and Enhance Functional Competencies Technology is pervasive in the accounting profession. Individuals entering the accounting profession must acquire the necessary skills to use technology tools effectively and efficiently. These technology tools can be used both to develop and apply other functional competencies. Personal Competencies Personal competencies relate to the attitudes and behaviors of individuals preparing to enter the accounting profession. Developing these personal competencies will enhance the way professional relationships are handled and facilitate individual learning and personal improvement. Professional Demeanor The accounting profession is committed to maintaining a public reputation for excellence in the performance of important roles in business and society. Individuals entering the accounting profession should behave in a manner that is consistent with the character and standards of the discipline of accounting, as well as the norms of the environment in which they interact. This competency involves demonstrating objectivity, integrity, and ethical behavior. It also includes a commitment to stable work performance, as well as a commitment to continuously acquire new skills and knowledge.

Problem Solving and Decision Making Accounting professionals are often asked to discern the true nature of a situation and then determine the principles and techniques needed to solve problems or make judgments. Thus, individuals entering the accounting profession should display effective problem solving and decision-making skills, good insight, and judgment, as well as innovative and creative thinking. Interaction Accounting professionals must be able to work with others to accomplish objectives. This requires them to act as valuable business partners within organizations and markets and work in teams to provide business solutions. Thus, individuals entering the accounting profession should demonstrate an ability to work productively with individuals in a diversity of roles and with varying interests in the outcome.

Leadership Individuals entering the accounting profession should be able to effectively lead in appropriate circumstances. This involves acquiring the skills needs to influence, inspire, and motivate individuals and groups to achieve results. Communication Accounting professionals are called upon to communicate financial and non-financial information so that it is understood by individuals with diverse capabilities and interests. Individuals entering the accounting profession should have the skills necessary to give and exchange information within a meaningful context and with appropriate delivery. They should have the ability to listen, deliver powerful presentations and produce examples of effective business writing. Project Management Accounting professionals must successfully manage a diversity of projects throughout their career. Individuals entering the accounting profession should demonstrate the ability to effectively control the course of a multi-dimensional, multi-step undertaking. This includes managing project assets, including human, financial, property, and technical resources. Leverage Technology to Develop and Enhance Personal Competencies Technological adaptability is a requirement for today's accounting professional. As technology advances, the accounting professional must acquire new skills and determine how new technologies should be best incorporated into their practices. This commitment to continual technological learning will enhance the development and application of other personal competencies. Broad Business Perspective Competencies Broad business perspective competencies relate to the context in which accounting professionals perform their services. Individuals preparing to enter the accounting profession should consider both the internal and external business environments and how their interactions determine success or failure. They must be conversant with the overall realities of the business environment. Strategic/Critical Thinking Critical thinking encompasses the ability to link data, knowledge, and insight together from various disciplines to provide information for decision-making. Being in tune with the "big picture" perspective is a necessary component for success. Individuals entering the accounting profession should be able to communicate to others the vision, strategy, goals, and culture of organizations.

Industry/Sector Perspective Individuals entering the accounting profession should be able to identify (through research and analysis) the economics accounting and broad business financial risks and opportunities of the industry and economic sector in which a given organization operates. Identification of these risks and opportunities should include both issues specific to the enterprise, as well as those pervasive throughout the industry/sector. International/Global Perspective Individuals entering the accounting profession should be able to identify and communicate the variety of threats and opportunities of doing business in a borderless world. The accounting professional of the future must provide services to support and facilitate commerce in the global marketplace. Resource Management The ability to appreciate the importance of all resources (human, financial, physical, environmental, etc.) is critical for success. Individuals entering the accounting profession should be able to apply management and human resources development theories to human resource issues and organizational problems. Individuals preparing to enter the accounting profession should be able to identify sources of capital, and analyze the impact of participation in the global capital markets. Legal/Regulatory Perspective Regulatory forces are being shaped by collaboration, migration, and reform as the various stakeholders globalize, share information, and force their particular needs and viewpoints onto political agendas. Individuals preparing to enter the accounting profession need to be capable of describing the legal and regulatory environment and analyzing the impact of changes in relevant requirements, constraints, and competitive practices. Marketing/Client Focus Individuals who are marketing- and client- focused are better able to anticipate and meet the changing needs of clients, employers, customers, and markets. This involves both the ability to recognize market needs and the ability to develop new markets.

Leverage Technology to Develop and Enhance a Broad Business Perspective Technology alters how organizations operate. To provide the greatest value, today's accounting professional must understand and appreciate the effects of technology on the broader business environment.

AACSB: Derived from the AACSB website “The Assurance of Learning Standards. 15. Management of Curricula”