I Have a APA Exercise Paper, 1 Title Page And 1 Page Of Content. Book is provided, Due Nov.10th
Accounting Principles: A Business Perspective
First Global Text Edition, Volume 1 Financial Accounting
Roger H. Hermanson,PhD, CPA Regents Professor Emeritus of Accounting
Ernst & Young-J. W. Holloway Memorial Professor Emeritus
Georgia State University
James Don Edwards PhD, D.H.C, CPA J.M. Tull Professor Emeritus of Accounting
Terry College of Business
University of Georgia
Michael W. Maher PhD, CPA Graduate School of Management
University of California at Davis
Special cont ributors to managerial chapters:
Kathleen M. Donelan-Knox
Department of Accountancy
University of Notre Dame
Funding for the First Global Text Edition was provided by the Endeavor Corporation, Houston, Texas, USA
The Global Text Project is funded by the Jacobs Foundation, Zurich, Switzerland
This book is licensed under a Creative Commons Attribution 3.0 License
Acknowledgments for the Global Text First Edition:
Revision Editor: Donald J. McCubbrey, PhD
Clinical Professor, Daniels College of Business
University of Denver
Life member, American Institute of Certified Public Accountants
Revision Assistants
Emily Anderson
Kyle Block
Assistant Editor
Jackie Sharman
Associate Editor
Marisa Drexel
Conversion Specialist
Varun Sharma
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Table of Contents Accounting principles:A business perspective.................................................................................................8
The accounting environment.......................................................................................................................... 18
Accounting defined......................................................................................................................................... 19
Financial accounting versus managerial accounting.....................................................................................23
Development of financial accounting standards............................................................................................25
Ethical behavior of accountants..................................................................................................................... 26
1. Accounting and its use in business decisions.......................................................................30 Forms of business organizations.................................................................................................................... 31
Types of activities performed by business organizations..............................................................................32
Financial statements of business organizations............................................................................................33
The financial accounting process...................................................................................................................37
Analyzing and using the financial results—the equity ratio..........................................................................46
2. Recording business transactions...........................................................................................65 The account and rules of debit and credit......................................................................................................66
The accounting cycle....................................................................................................................................... 72
The journal...................................................................................................................................................... 73
The ledger........................................................................................................................................................ 76
The accounting process in operation.............................................................................................................. 76
3. Adjustments for financial reporting....................................................................................116 Cash versus accrual basis accounting............................................................................................................ 117
Classes and types of adjusting entries.......................................................................................................... 120
Adjustments for deferred items.................................................................................................................... 122
Adjustments for accrued items..................................................................................................................... 129
4. Completing the accounting cycle.........................................................................................150 The accounting cycle summarized................................................................................................................ 151
The work sheet............................................................................................................................................... 151
Preparing financial statements from the work sheet....................................................................................157
Journalizing adjusting entries...................................................................................................................... 158
The closing process....................................................................................................................................... 159
Accounting systems: From manual to computerized...................................................................................164
A classified balance sheet.............................................................................................................................. 169
Analyzing and using the financial results — the current ratio.....................................................................175
5. Accounting theory................................................................................................................198 Traditional accounting theory...................................................................................................................... 199
Other basic concepts..................................................................................................................................... 201
The measurement process in accounting.....................................................................................................202
The major principles.................................................................................................................................... 203
Modifying conventions (or constraints)......................................................................................................209
The financial accounting standards board's conceptual framework project...............................................212
Objectives of financial reporting...................................................................................................................212
Qualitative characteristics............................................................................................................................ 214
Recognition and measurement in financial statements...............................................................................218
6. Merchandising transactions................................................................................................236 Introduction to inventories and the classified income statement...............................................................236
Two income statements compared— Service company and merchandising company...............................237
Sales revenues............................................................................................................................................... 238
Cost of goods sold......................................................................................................................................... 244
Classified income statement......................................................................................................................... 252
Analyzing and using the financial results—Gross margin percentage........................................................256
7. Measuring and reporting inventories..................................................................................279
Accounting Principles: A Business Perspective 4 A Global Text
Inventories and cost of goods sold...............................................................................................................280
Determining inventory cost.......................................................................................................................... 282
Departures from cost basis of inventory measurement...............................................................................303
Analyzing and using financial results—inventory turnover ratio................................................................308
8. Control of cash.....................................................................................................................332 Internal control............................................................................................................................................. 333
Controlling cash............................................................................................................................................ 340
The bank checking account.......................................................................................................................... 343
Bank reconciliation....................................................................................................................................... 347
Petty cash funds............................................................................................................................................ 352
Analyzing and using the financial results—The quick ratio.........................................................................355
9. Receivables and payables.....................................................................................................371 Accounts receivable...................................................................................................................................... 372
Current liabilities.......................................................................................................................................... 381
Notes receivable and notes payable.............................................................................................................387
Short-term financing through notes payable...............................................................................................391
Analyzing and using the financial results—Accounts receivable turnover and number of days' sales in
accounts receivable............................................................................................................................................ 394
10. Property, plant, and equipment........................................................................................410 Nature of plant assets.................................................................................................................................... 411
Initial recording of plant assets.................................................................................................................... 412
Depreciation of plant assets.......................................................................................................................... 416
Subsequent expenditures (capital and revenue) on assets..........................................................................428
Subsidiary records used to control plant assets...........................................................................................431
Analyzing and using the financial results—Rate of return on operating assets..........................................433
11. Plant asset disposals, natural resources, and intangible assets........................................449 Disposal of plant assets................................................................................................................................ 450
Intangible assets............................................................................................................................................ 461
Analyzing and using the financial results—Total assets turnover...............................................................468
12. Stockholders' equity: Classes of capital stock...................................................................486 The corporation............................................................................................................................................ 487
Documents, books, and records relating to capital stock.............................................................................491
Par value and no-par capital stock...............................................................................................................492
Other values commonly associated with capital stock................................................................................493
Capital stock authorized and outstanding...................................................................................................493
Classes of capital stock................................................................................................................................. 494
Types of preferred stock............................................................................................................................... 495
Balance sheet presentation of stock.............................................................................................................497
Stock issuances for cash............................................................................................................................... 498
Capital stock issued for property or services...............................................................................................500
Balance sheet presentation of paid-in capital in excess of par (or stated) value—Common or preferred. 500
Analyzing and using the financial results—Return on average common stockholders' equity..................503
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock............521 Paid-in (or contributed) capital.................................................................................................................... 522
Retained earnings......................................................................................................................................... 523
Paid-in capital and retained earnings on the balance sheet........................................................................523
Retained earnings appropriations................................................................................................................ 530
Statement of retained earnings.................................................................................................................... 532
Statement of stockholders' equity................................................................................................................ 532
Treasury stock............................................................................................................................................... 533
Net income inclusions and exclusions.........................................................................................................536
Analyzing and using the financial results—Earnings per share and price-earnings ratio..........................540
5
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14. Stock investments..............................................................................................................559 Cost and equity methods.............................................................................................................................. 560
Consolidated balance sheet at time of acquisition.......................................................................................568
Accounting for income, losses, and dividends of a subsidiary.....................................................................572
Consolidated financial statements at a date after acquisition.....................................................................572
Uses and limitations of consolidated statements.........................................................................................576
Analyzing and using the financial results—Dividend yield on common stock and payout ratios...............577
15. Long-term financing: Bonds..............................................................................................593 Bonds payable............................................................................................................................................... 594
Bond prices and interest rates.....................................................................................................................600
Analyzing and using the financial results—Times interest earned ratio......................................................611
16. Analysis using the statement of cash flows.......................................................................630 Purposes of the statement of cash flows.......................................................................................................631
Uses of the statement of cash flows..............................................................................................................631
Information in the statement of cash flows.................................................................................................632
Cash flows from operating activities............................................................................................................634
Steps in preparing statement of cash flows..................................................................................................636
Analysis of the statement of cash flows........................................................................................................641
Analyzing and using the financial results—Cash flow per share of common stock, cash flow margin, and cash
flow liquidity ratios............................................................................................................................................ 647
Appendix: Use of a working paper to prepare a statement of cash flows....................................................649
17. Analysis and interpretation of financial statements.........................................................675 Objectives of financial statement analysis...................................................................................................676
Sources of information................................................................................................................................. 678
Horizontal analysis and vertical analysis: An illustration...........................................................................679
Trend percentages........................................................................................................................................ 682
Ratio analysis................................................................................................................................................ 683
18. Managerial accounting concepts/job costing...................................................................728 Compare managerial accounting with financial accounting........................................................................729
Merchandiser and manufacturer accounting: Differences in cost concepts...............................................730
Financial reporting by manufacturing companies.......................................................................................733
The general cost accumulation model..........................................................................................................736
Job costing.................................................................................................................................................... 738
Predetermined overhead rates..................................................................................................................... 743
19. Process: Cost systems.........................................................................................................765 Nature of a process cost system.................................................................................................................... 765
Process costing illustration........................................................................................................................... 766
Process costing in service organizations.......................................................................................................775
Spoilage......................................................................................................................................................... 775
20. Using accounting for quality and cost management........................................................795 Importance of good accounting information...............................................................................................795
Quality and customer satisfaction measures...............................................................................................802
Just-in-time method.................................................................................................................................... 805
Activity-based costing and management.....................................................................................................808
Methods used for activity-based costing.......................................................................................................811
Impact of new production environment on cost drivers..............................................................................815
Activity-based costing in marketing.............................................................................................................816
Strategic use of activity-based management................................................................................................816
Behavioral and implementation issues.........................................................................................................817
Opportunities to improve activity-based costing in practice.......................................................................817
21. Cost-volume-profit analysis...............................................................................................831
Accounting Principles: A Business Perspective 6 A Global Text
Cost behavior patterns................................................................................................................................. 832
Methods for analyzing costs......................................................................................................................... 835
Cost-volume-profit (CVP) analysis...............................................................................................................837
Finding the break-even point.......................................................................................................................838
Cost-volume-profit analysis illustrated........................................................................................................841
Assumptions made in cost-volume-profit analysis.....................................................................................843
Using computer spreadsheets for CVP analysis..........................................................................................844
Effect of automation on cost-volume-profit analysis..................................................................................845
22. Short-term decision making: Differential analysis..........................................................859 Contribution margin income statements.....................................................................................................859
Differential analysis...................................................................................................................................... 861
Applications of differential analysis.............................................................................................................863
Applying differential analysis to quality......................................................................................................867
23. Budgeting for planning and control..................................................................................881 The budget—For planning and control........................................................................................................882
The master budget illustrated......................................................................................................................887
Budgeting in merchandising companies......................................................................................................899
Budgeting in service companies..................................................................................................................900
Additional concepts related to budgeting....................................................................................................900
24. Control through standard costs.........................................................................................916 Uses of standard costs................................................................................................................................... 916
Advantages and disadvantages of using standard costs..............................................................................918
Computing variances.................................................................................................................................... 920
Goods completed and sold........................................................................................................................... 930
Investigating variances from standard........................................................................................................930
Disposing of variances from standard..........................................................................................................931
Nonfinancial performance measures...........................................................................................................932
Activity-based costing, standards, and variances........................................................................................933
25. Responsibility accounting: Segmental analysis................................................................945 Responsibility accounting............................................................................................................................ 945
Responsibility reports................................................................................................................................... 947
Responsibility centers.................................................................................................................................. 949
Transfer prices.............................................................................................................................................. 952
Use of segmental analysis............................................................................................................................. 952
Concepts used in segmental analysis...........................................................................................................953
Investment center analysis........................................................................................................................... 956
Economic value added and residual income...............................................................................................960
Segmental reporting in external financial statements.................................................................................961
26. Capital budgeting:Long-range planning...........................................................................978 Capital budgeting defined............................................................................................................................ 978
Profitability index......................................................................................................................................... 987
Investments in working capital.................................................................................................................... 990
The postaudit................................................................................................................................................ 991
Investing in high technology projects..........................................................................................................992
Capital budgeting in not-for-profit organizations.......................................................................................992
Epilogue........................................................................................................................................................ 992
7
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Accounting principles:A business perspective
Eighth edition
Roger H. Hermanson, PhD, CPA (Georgia State University, USA)
James D. Edwards, PhD, D.H.C., CPA (The University of Georgia, USA)
Michael W. Maher, PhD, CPA (University of Notre Dame, USA)
About the authors
Professor Roger H. Hermanson, PhD, CPA
Regents Professor Emeritus of Accounting and Ernst & Young-J. W. Holloway Memorial Professor Emeritus at
Georgia State University. He received his doctorate at Michigan State University in 1963 and is a CPA in Georgia.
Professor Hermanson taught and later served as chairperson of the Division of Accounting at the University of
Maryland. He has authored or coauthored approximately one-hundred articles for professional and scholarly
journals and has coauthored numerous editions of several textbooks, including Accounting Principles, Financial
Accounting, Survey of Financial and Managerial Accounting, Auditing Theory and Practice, Principles of
Financial and Managerial Accounting, and Computerized Accounting with Peachtree Complete III. He also has
served on the editorial boards of the Journal of Accounting Education, New Accountant, Accounting Horizons, and
Management Accounting. Professor Hermanson has served as co-editor of the Trends in Accounting Education
column for Management Accounting. He has held the office of vice president of the American Accounting
Association and served on its Executive Committee. He was also a member of the Institute of Management
Accountants, the American Institute of Certified Public Accountants, and the Financial Executives Institute.
Professor Hermanson has been awarded two excellence in teaching awards, a doctoral fellow's award, and a
Distinguished Alumni Professor award; and he was selected as the Outstanding Faculty Member for 1985 by the
Federation of Schools of Accountancy. He has served as a consultant to many companies and organizations. In
1990, Professor Hermanson was named Accounting Educator of the Year by the Georgia Society of CPAs. His wife's
name is Dianne, and he has two children, Dana and Susan, both of whom are accounting professors.
Professor James D. Edwards, PhD, DHC, CPA
J. M. Tull Professor Emeritus of Accounting in the Terry College of Business at the University of Georgia. He is a
graduate of Louisiana State University and has been inducted into the Louisiana State University Alumni
Federation's Hall of Distinction. He received his MBA from the University of Denver and his PhD from the
University of Texas and is a CPA in Texas and Georgia. He has served as a professor and chairman of the
Department of Accounting and Financial Administration at Michigan State University, a professor and dean of the
Graduate School of Business Administration at the University of Minnesota, and a Visiting Scholar at Oxford
University in Oxford, England.
Professor Edwards is a past president of the American Accounting Association and a past national vice president
and executive committee member of the Institute of Management Accountants. He has served on the board of
directors of the American Institute of Certified Public Accountants and as chairman of the Georgia State Board of
Accountancy. He was an original trustee of the Financial Accounting Foundation, the parent organization of the
FASB, and a member of the Public Review Board of Arthur Andersen & Co.
He has published in The Accounting Review, The Journal of Accountancy, The Journal of Accounting
Research, Management Accounting, and The Harvard Business History Review. He is also the author of History
Accounting Principles: A Business Perspective 8 A Global Text
Accounting principles:A business perspective
of Public Accounting in the United States. He has served on various American Institute of Certified Public
Accountants committees and boards, including the Objectives of Financial Statements Committee, Standards of
Professional Conduct Committee, and the CPA Board of Examiners. He was the managing editor of the centennial
issue of The Journal of Accountancy.
In 1974, Beta Alpha Psi, the National Accounting Fraternity, selected Professor Edwards for its first annual
Outstanding Accountant of the Year award. This selection is made from industry, government, and educational
leaders. In 1975, he was selected by the American Accounting Association as its Outstanding Educator.
He has served the AICPA as president of the Benevolent Fund, chairman of the Awards Committee, member of
the Professional Ethics Committee and Program for World Congress of Accountants. He was on the Education
Standards Committee of the International Federation of Accountants and the Committee on Planning for the
Institute of Management Accountants. He was the director of the Seminar for Management Accountants-Financial
Reporting for the American Accounting Association. He is also a member of the Financial Executives Institute.
He received the 1993 AICPA Gold Medal Award, the highest award given by the Institute. A Doctor Honoris
Causa (Honorary Doctorate) from the University of Paris was awarded to him in 1994. He is the first accountant to
receive this distinction in France. The Academy of Accounting Historians awarded him the 1994 Hourglass Award
which is the highest international honor in the field of Accounting History. He was inducted into the Ohio State
University Accounting Hall of Fame in 2001. His wife's name is Clara, and he has one son, Jim.
Professor Michael W. Maher, PhD, CPA
Professor of management at the University of California at Davis. He is a graduate of Gonzaga University (BBA)
and the University of Washington (MBA, PhD). Before going to the University of California at Davis, he taught at
the University of Michigan and the University of Chicago. He also worked on the audit staff at Arthur Andersen &
Co. and was a self-employed financial consultant for small businesses while attending graduate school.
Professor Maher is the coauthor of two leading textbooks, Cost Accounting and Managerial Accounting. He has
coauthored several additional books and monographs, including Internal Controls in US Corporations (Financial
Executives Research Foundation, 1980); and Management Incentive Compensation Plans (National Association of
Accountants, 1986). His articles have appeared in Management Accounting, The Journal of Accountancy, The
Accounting Review, The Journal of Accounting Research, Financial Executive, and The Wall Street Journal,
among others.
For his research on internal controls, Professor Maher was awarded the American Accounting Association
Competitive Manuscript Award and the AICPA Notable Contribution in Literature Award. He has also been
awarded the American Tax Association Manuscript Award. From the students at the Graduate School of
Management, University of California, Davis, he has received the Annual Outstanding Teacher Award three times
and twice received a special award for outstanding service. In 1989, Gonzaga University honored Maher with its
Outstanding Alumni Merit Award.
Preface
Philosophy and purpose
Imagine that you have graduated from college without taking an accounting course. You are employed by a
company as a sales person, and you eventually become the sales manager of a territory. While attending a sales
managers' meeting, financial results are reviewed by the Vice President of Sales and terms such as gross margin
9
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percentage, cash flows from operating activities, and LIFO inventory methods are being discussed. The Vice
President eventually asks you to discuss these topics as they relate to your territory. You try to do so, but it is
obvious to everyone in the meeting that you do not know what you are talking about.
Accounting principles courses teach you the "language of business" so you understand terms and concepts used
in business decisions. If you understand how accounting information is prepared, you will be in an even stronger
position when faced with a management decision based on accounting information.
The importance of transactions analysis and proper recording of transactions has clearly been demonstrated in
some of the recent business failures that have been reported in the press. If the financial statements of an enterprise
are to properly represent the results of operations and the financial condition of the company, the transactions
must be analyzed and recorded in the accounts following generally accepted accounting principles. The debits and
credits are important not only to accounting majors but also to those entering or engaged in a business career to
become managers because the ultimate effects of these journal entries are reflected in the financial statements. If
expenses are reported as assets, liabilities and their related expenses are omitted from the financial statements, or
reported revenues are recorded prematurely or do not really exist, the financial statements are misleading. The
financial statements are only useful and meaningful if they are fair and clearly represent the business events of the
company.
We wrote this text to give you an understanding of how to use accounting information to analyze business
performance and make business decisions. The text takes a business perspective. We use the annual reports of real
companies to illustrate many of the accounting concepts. You are familiar with many of the companies we use, such
as The Limited, The Home Depot, and Coca-Cola Company.
Gaining an understanding of accounting terminology and concepts, however, is not enough to ensure your
success. You also need to be able to find information on the Internet, analyze various business situations, work
effectively as a member of a team, and communicate your ideas clearly. This text was developed to help you develop
these skills.
Curriculum concerns
Significant changes have been recommended for accounting education. Some parties have expressed concern
that recent accounting graduates do not possess the necessary set of skills to succeed in an accounting career. The
typical accounting graduate seems unable to successfully deal with complex and unstructured "real world"
accounting problems and generally lacks communication and interpersonal skills. One recommendation is the
greater use of active learning techniques in a re-energized classroom environment. The traditional lecture and
structured problem solving method approach would be supplemented or replaced with a more informal classroom
setting dealing with cases, simulations, and group projects. Both inside and outside the classroom, there would be
two-way communication between (1) professor and student and (2) student and student. Study groups would be
formed so that students could tutor other students. The purposes of these recommendations include enhancing
students' critical thinking skills, written and oral communication skills, and interpersonal skills.
One of the most important benefits you can obtain from a college education is that you "learn how to learn". The
concept that you gain all of your learning in school and then spend the rest of your life applying that knowledge is
not valid. Change is occurring at an increasingly rapid pace. You will probably hold many different jobs during your
career, and you will probably work for many different companies. Much of the information you learn in college will
Accounting Principles: A Business Perspective 10 A Global Text
Accounting principles:A business perspective
be obsolete in just a few years. Therefore, you will be expected to engage in life-long learning. Memorizing is much
less important than learning how to think critically.
With this changing environment in mind, we have developed a text that will lend itself to developing the skills
that will lead to success in your future career in business. The section at the end of each chapter titled, "Beyond the
numbers—Critical thinking", provides the opportunity for you to address unstructured case situations, the analysis
of real companies' financial situations, ethics cases, and team projects. Each chapter also includes one or two
Internet projects in the section titled "Using the Internet—A view of the real world". For many of these items,
you will use written and oral communication skills in presenting your results.
Objectives and overall approach of the eighth edition
The Accounting Education Change Commission (AECC) made specific recommendations regarding teaching
materials and methods used in the first-year accounting course. As a result, significant changes have taken place in
that course at many universities. The AECC states:
The first course in accounting can significantly benefit those who enter business, government, and
other organizations, where decision-makers use accounting information. These individuals will be
better prepared for their responsibilities if they understand the role of accounting information in
decision-making by managers, investors, government regulators, and others. All organizations have
accountability responsibilities to their constituents, and accounting, properly used, is a powerful tool
in creating information to improve the decisions that affect those constituents.1
One of the purposes of the first course should be to recruit accounting majors. To help accomplish this, the text
has a section preceding each chapter entitled, "Careers in accounting".
We retained a solid coverage of accounting that serves business students well regardless of the majors they
select. Those who choose not to major in accounting, which is a majority of those taking this course, will become
better users of accounting information because they will know something about the preparation of that
information.
Approach and organization
Business emphasis
Without actual business experience, business students sometimes lack a frame of reference in attempting to
apply accounting concepts to business transactions. We seek to involve the business student more in real world
business applications as we introduce and explain the subject matter.
• "An accounting perspective: Business insight" boxes throughout the text provide examples of how
companies featured in text examples use accounting information every day, or they provide other useful
information.
• "Accounting perspective: Uses of technology" boxes throughout the text demonstrate how
technology has affected the way accounting information is prepared, manipulated, and accessed.
• Some chapters contain "A broader perspective". These situations, taken from annual reports of real
companies and from articles in current business periodicals such as Accounting Today, and Management
1 Accounting Education Change Commission, Position Statement No. Two, “The First Course in Account”
(Torrance, CA, June 1992), pp. 1-2.
11
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Accounting, relate to subject matter discussed in that chapter or present other useful information. These real
world examples demonstrate the business relevance of accounting.
• Real world questions and real world business decision cases are included in almost every chapter.
• The annual report appendix included with this text contains significant portions of the annual report of The
Limited, Inc. Many of the real world questions and business decision cases are based on this annual report.
• Numerous illustrations adapted from Accounting Trends & Techniques show the frequency of use in
business of various accounting techniques. Placed throughout the text, these illustrations give students real
world data to consider while learning about different accounting techniques.
• Throughout the text we have included numerous references to the annual reports of many companies.
• Chapters 1-16 contain a section entitled, "Analyzing and using the financial results". This section discusses
and illustrates a ratio or other analysis technique that pertains to the content of the chapter. For instance, this
section in Chapter 4 discusses the current ratio as it relates to a classified balance sheet.
• Some of the chapters contain end-of-chapter questions, exercises, or business decision cases that require
the student to refer to the Annual report appendix and answer certain questions. As stated earlier, this
appendix is included with the text and contains the significant portions of the annual report of The Limited,
Inc.
• Each chapter contains a section entitled, "Beyond the numbers—Critical thinking". This section contains
business decision cases, annual report analysis problems, writing assignments based on the Ethical perspective
and Broader perspective boxes, group projects, and Internet projects.
Pedagogy
Students often come into accounting principles courses feeling anxious about learning the subject matter.
Recognizing this apprehension, we studied ways to make learning easier and came up with some helpful ideas on
how to make this edition work even better for students.
• Improvements in the text's content reflect feedback from adopters, suggestions by reviewers, and a serious
study of the learning process itself by the authors and editors. New subject matter is introduced only after the
stage has been set by transitional paragraphs between topic headings. These paragraphs provide students with
the reasons for proceeding to the new material and explain the progression of topics within the chapter.
• The Introduction contains a section entitled "How to study the chapters in this text", which should be very
helpful to students.
• Each chapter has an "Understanding the learning objectives" section. These "summaries" enable the
student to determine how well the learning objectives were accomplished. We were the first authors (1974) to
ever include Learning objectives in an accounting text. These objectives have been included at the beginning of
the chapter, as marginal notes within the chapter, at the end of the chapter, and in supplements such as the
Test bank, Instructors' resource guide, Computerized test bank, and Study guide. The objectives are also
indicated for each exercise and problem.
• Demonstration problems and solutions are included for each chapter, and a different one appears for each
chapter in the Study guide. These demonstration problems help students to assess their own progress by
showing them how problems that focus on the topic(s) covered in the chapter are worked before students do
assigned homework problems.
Accounting Principles: A Business Perspective 12 A Global Text
Accounting principles:A business perspective
• Key terms are printed for emphasis. End-of-chapter glossaries contain the definition.
• Each chapter includes a "Self-test" consisting of true-false and multiple-choice questions. The answers and
explanations appear at the end of the chapter. These self-tests are designed to determine whether the student
has learned the essential information in each chapter.
• In the margin beside each exercise and problem, we have included a description of the requirements and
the related Learning objective(s). These descriptions let students know what they are expected to do in the
problem.
• Throughout the text we use examples taken from everyday life to relate an accounting concept being
introduced or discussed to students' experiences.
Ethics
There is no better time to emphasize high ethical standards to students. This text includes many items
throughout the text entitled, "An ethical perspective". These items present situations in which students are likely to
find themselves throughout their careers. They range from resisting pressure by a superior or a client to do the
wrong thing to deciding between alternative corporate behaviors that have environmental and profit consequences.
End-of-chapter materials
Describing teaching methods, the AECC stated, "Teachers...should place a priority on their interaction with
students and on interaction among students. Students' involvement should be promoted by methods such as cases,
simulations, and group projects..."2 A section entitled "Beyond the numbers—Critical thinking" at the end of every
chapter is designed to implement these recommendations. Business decision cases require critical thinking in
complex situations often based on real companies. The Annual report analysis section requires analyzing annual
reports and interpreting the results in writing. The Ethics cases require students to respond in writing to situations
they are likely to encounter in their careers. These cases do not necessarily have one right answer. The Group
projects for each chapter teach students how to work effectively in teams, a skill that was stressed by the AECC and
is becoming increasingly necessary for success in business. The Internet projects teach students how to retrieve
useful information from the Internet.
A team approach can also be introduced in the classroom using the regular exercises and problems in the text.
Teams can be assigned the task of presenting their solutions to exercises or problems to the rest of the class. Using
this team approach in class can help re-energize the classroom by creating an active, informal environment in
which students learn from each other. (Two additional group projects are described in the Instructor's resource
guide. These projects are designed to be used throughout the semester or quarter.)
We have included a vast amount of other resource materials for each chapter within the text from which the
instructor may draw: (1) one of the largest selections of end-of-chapter questions, exercises, and problems
available; (2) several comprehensive review problems that allow students to review all major concepts covered to
that point; and (3) from one to three business decision cases per chapter. Other key features regarding end-of-
chapter material follow.
• A uniform chart of accounts appears in a separate file you can download. This uniform chart of accounts is
used consistently throughout the first 11 chapters. We believe students will benefit from using the same chart
of accounts for all homework problems in those chapters.
2 Ibid, p.2.
13
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• A comprehensive review problem at the end of Chapter 4 serves as a mini practice set to test all material
covered to that point. Another comprehensive problem at the end of Chapter 19 reviews the material covered
in Chapters 18 and 19. Two comprehensive budgeting problems are also included as business decision cases at
the end of Chapter 23.
• Some of the end-of-chapter problem materials (questions, exercises, problems, business decision cases,
other "Beyond the numbers" items, and comprehensive review problems) have been updated. Each exercise
and problem is identified with the learning objective(s) to which it relates.
• All end-of-chapter exercises and problems have been traced back to the chapters to ensure that nothing is
asked of a student that does not appear in the book. This feature was a strength of previous editions, ensuring
that instructors could confidently assign problems without having to check for applicability. Also, we took
notes while teaching from the text and clarified problem and exercise instructions that seemed confusing to
our students.
Acknowledgments
The development of all eight editions of Accounting: A Business Perspective was an evolving and challenging
process. Significant changes have taken place in the first course in accounting in schools across the country, and the
authors and publisher worked hard throughout the development of this text to stay on top of those changes. We are
grateful to the following individuals for their valuable contributions and suggestions which we have incorporated in
the various editions of this text. The affiliations shown for all individuals are as of the time of their contributions.
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Former co-author
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The accounting environment
Learning objectives
After studying this introduction, you should be able to:
• Define accounting.
• Describe the functions performed by accountants.
• Describe employment opportunities in accounting.
• Differentiate between financial and managerial accounting.
• Identify several organizations that have a role in the development of financial accounting standards.
You have embarked on the challenging and rewarding study of accounting—an old and time-honored discipline.
History indicates that all developed societies require certain accounting records. Record-keeping in an accounting
sense is thought to have begun about 4000 BCE
The record-keeping, control, and verification problems of the ancient world had many characteristics similar to
those we encounter today. For example, ancient governments also kept records of receipts and disbursements and
used procedures to check on the honesty and reliability of employees.
A study of the evolution of accounting suggests that accounting processes have developed primarily in response
to business needs. Also, economic progress has affected the development of accounting processes. History shows
that the higher the level of civilization, the more elaborate the accounting methods.
The emergence of double-entry bookkeeping was a crucial event in accounting history. In 1494, a Franciscan
monk, Luca Pacioli, described the double-entry Method of Venice system in his text called Summa de Arithmetica,
Geometric, Proportion et Proportionate (Everything about arithmetic, geometry, and proportion). Many consider
Pacioli's Summa to be a reworked version of a manuscript that circulated among teachers and pupils of the
Venetian school of commerce and arithmetic.
Accounting Principles: A Business Perspective 18 A Global Text
Accounting principles:A business perspective
Since Pacioli's days, the roles of accountants and professional accounting organizations have expanded in
business and society. As professionals, accountants have a responsibility for placing public service above their
commitment to personal economic gain. Complementing their obligation to society, accountants have analytical
and evaluative skills needed in the solution of ever-growing world problems. The special abilities of accountants,
their independence, and their high ethical standards permit them to make significant and unique contributions to
business and areas of public interest.
You probably will find that of all the business knowledge you have acquired or will learn, the study of accounting
will be the most useful. Your financial and economic decisions as a student and consumer involve accounting
information. When you file income tax returns, accounting information helps determine your taxes payable.
Understanding the discipline of accounting also can influence many of your future professional decisions. You
cannot escape the effects of accounting information on your personal and professional life.
Every profit-seeking business organization that has economic resources, such as money, machinery, and
buildings, uses accounting information. For this reason, accounting is called the language of business. Accounting
also serves as the language providing financial information about not-for-profit organizations such as governments,
churches, charities, fraternities, and hospitals. However, this text concentrates on accounting for business firms.
The accounting system of a profit-seeking business is an information system designed to provide relevant
financial information on the resources of a business and the effects of their use. Information is relevant if it has
some impact on a decision that must be made. Companies present this relevant information in their financial
statements. In preparing these statements, accountants consider the users of the information, such as owners and
creditors, and decisions they make that require financial information.
As a background for studying accounting, this Introduction defines accounting and lists the functions
accountants perform. In addition to surveying employment opportunities in accounting, it differentiates between
financial and managerial accounting. Because accounting information must conform to certain standards, we
discuss several prominent organizations contributing to these standards. As you continue your study of accounting
in this text, accounting—the language of business—will become your language also. You will realize that you are
constantly exposed to accounting information in your everyday life.
Accounting defined
The American Accounting Association—one of the accounting organizations discussed later in this Introduction
—defines accounting as "the process of identifying, measuring, and communicating economic information to permit
informed judgments and decisions by the users of the information".3 This information is primarily financial—stated
in money terms. Accounting, then, is a measurement and communication process used to report on the activities of
profit-seeking business organizations and not-for-profit organizations. As a measurement and communication
process for business, accounting supplies information that permits informed judgments and decisions by users of
the data.
The accounting process provides financial data for a broad range of individuals whose objectives in studying the
data vary widely. Bank officials, for example, may study a company's financial statements to evaluate the company's
ability to repay a loan. Prospective investors may compare accounting data from several companies to decide which
3 American Accounting Association, A Statement of Basic Accounting Theory (Evanston, III., 1966), p. 1.
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company represents the best investment. Accounting also supplies management with significant financial data
useful for decision making.
Reliable information is necessary before decision makers can make a sound decision involving the allocation of
scarce resources. Accounting information is valuable because decision makers can use it to evaluate the financial
consequences of various alternatives. Accountants eliminate the need for a crystal ball to estimate the future. They
can reduce uncertainty by using professional judgment to quantify the future financial impact of taking action or
delaying action.
Although accounting information plays a significant role in reducing uncertainty within the organization, it also
provides financial data for persons outside the company. This information tells how management has discharged its
responsibility for protecting and managing the company's resources. Stockholders have the right to know how a
company is managing its investments. In fulfilling this obligation, accountants prepare financial statements such as
an income statement, a statement of retained earnings, a balance sheet, and a statement of cash flows. In addition,
they prepare tax returns for federal and state governments, as well as fulfill other governmental filing requirements.
Accounting is often confused with bookkeeping. Bookkeeping is a mechanical process that records the routine
economic activities of a business. Accounting includes bookkeeping but goes well beyond it in scope. Accountants
analyze and interpret financial information, prepare financial statements, conduct audits, design accounting
systems, prepare special business and financial studies, prepare forecasts and budgets, and provide tax services.
Specifically the accounting process consists of the following groups of functions (see Exhibit 1 below):
• Accountants observe many events (or activities) and identify and measure in financial terms (dollars) those
events considered evidence of economic activity. (Often, these three functions are collectively referred to as
analyze.) The purchase and sale of goods and services are economic events.
• Next, the economic events are recorded, classified into meaningful groups, and summarized.
• Accountants report on economic events (or business activity) by preparing financial statements and special
reports. Often accountants interpret these statements and reports for various groups such as management,
investors, and creditors. Interpretation may involve determining how the business is performing compared to
prior years and other similar businesses.
Employment opportunities in accounting
During the last half-century, accounting has gained the same professional status as the medical and legal
professions. Today, the accountants in the United States number well over a million. In addition, several million
people hold accounting-related positions. Typically, accountants provide services in various branches of accounting.
These include public accounting, management (industrial) accounting, governmental or other not-for-profit
accounting, and higher education. The demand for accountants will likely increase dramatically in the future. This
increase is greater than for any other profession. You may want to consider accounting as a career.
Public accounting firms offer professional accounting and related services for a fee to companies, other
organizations, and individuals. An accountant may become a Certified Public Accountant (CPA) by passing an
examination prepared and graded by the American Institute of Certified Public Accountants (AICPA). The exam is
administered by computer. In addition to passing the exam, CPA candidates must meet other requirements, which
include obtaining a state license. These requirements vary by state. A number of states require a CPA candidate to
have completed specific accounting courses and earned a certain number of college credits (five years of study in
Accounting Principles: A Business Perspective 20 A Global Text
Accounting principles:A business perspective
many states); worked a certain number of years in public accounting, industry, or government; and lived in that
state a certain length of time before taking the CPA examination. As of the year 2000, five years of course work
were required to become a member of the AICPA.
After a candidate passes the CPA examination, some states (called one-tier states) insist that the candidate meet
all requirements before the state grants the CPA certificate and license to practice. Other states (called two-tier
states) issue the CPA certificate immediately after the candidate passes the exam. However, these states issue the
license to practice only after all other requirements have been met. CPAs who want to renew their licenses to
practice must stay current through continuing professional education programs and must prove that they have
done so. No one can claim to be a CPA and offer the services normally provided by a CPA unless that person holds
an active license to practice.
Exhibit 1: Functions performed by accountants.
The public accounting profession in the United States consists of the Big-Four international CPA firms, several
national firms, many regional firms, and numerous local firms. The Big-Four firms include Deloitte & Touche,
Ernst & Young, KPMG, and Pricewaterhouse Coopers. At all levels, these public accounting firms provide auditing,
tax, and, for nonaudit clients, management advisory (or consulting) services.
Auditing A business seeking a loan or attempting to have its securities traded on a stock exchange usually must
provide financial statements to support its request. Users of a company's financial statements are more confident
that the company is presenting its statements fairly when a CPA has audited the statements. For this reason,
companies hire CPA firms to conduct examinations (independent audits) of their accounting and related
records. Independent auditors of the CPA firm check some of the company's records by contacting external
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sources. For example, the accountant may contact a bank to verify the cash balances of the client. After completing
a company audit, independent auditors give an independent auditor's opinion or report. (For an example of
an auditor's opinion, see The Limited, Inc. annual report in the Annual report appendix at the end of the text.) This
report states whether the company's financial statements fairly (equitably) report the economic performance and
financial condition of the business. As you will learn in the next section, auditors within a business also conduct
audits, which are not independent audits. Currently auditing standards are established by the Public Company
Accounting Oversight Board.
In 2002 The Sarbanes-Oxley Act was passed. The Act was passed as one result of the large losses to the
employees and investors from accounting fraud situations involving companies such as Enron and WorldCom. The
Act created the Public Company Accounting Oversight Board. The Board consists of five members appointed and
overseen by the Securities and Exchange Commission. The Board oversees and investigates the audits and auditors
of public companies and can sanction both firms and individuals for violations of laws, regulations, and rules. The
Chief Executive Officer and Chief Financial Officer of a public company must now certify the company's financial
statements. Corporate audit committees, rather than the corporate management, are now responsible for hiring,
compensating, and overseeing the external auditors.
Tax services CPAs often provide expert advice on tax planning and preparing federal, state, and local tax
returns. The objective in preparing tax returns is to use legal means to minimize the taxes paid. Almost every major
business decision has a tax impact. Tax planning helps clients know the tax effects of each financial decision.
Management advisory (or consulting) services Before Sarbanes-Oxley management advisory services
were the fastest growing service area for most large and many smaller CPA firms. Management frequently identifies
projects for which it decides to retain the services of a CPA. However, the Sarbanes-Oxley Act specifically prohibits
providing certain types of consulting services to a publicly-held company by its external auditor. These services
include bookkeeping, information systems design and implementation, appraisals or valuation services, actuarial
services, internal audits, management and human resources services, broker/dealer and investment services, and
legal or expert services related to audit services. Accounting firms can perform many of these services for publicly
held companies they do not audit. Other services not specifically banned are allowed if pre-approved by the
company's audit committee.
In contrast to public accountants, who provide accounting services for many clients, management accountants
provide accounting services for a single business. In a company with several management accountants, the person
in charge of the accounting activity is often the controller or chief financial officer.
Management accountants may or may not be CPAs. If management accountants pass an examination prepared
and graded by the Institute of Certified Management Accountants (ICMA) and meet certain other requirements,
they become Certified Management Accountants (CMAs). The ICMA is an affiliate of the Institute of
Management Accountants, an organization primarily consisting of management accountants employed in private
industry.
A career in management accounting can be very challenging and rewarding. Many management accountants
specialize in one particular area of accounting. For example, some may specialize in measuring and controlling
costs, others in budgeting (the development of plans for future operations), and still others in financial accounting
and reporting. Many management accountants become specialists in the design and installation of computerized
accounting systems. Other management accountants are internal auditors who conduct internal audits. They
Accounting Principles: A Business Perspective 22 A Global Text
Accounting principles:A business perspective
ensure that the company's divisions and departments follow the policies and procedures of management. This last
group of management accountants may earn the designation of Certified Internal Auditor (CIA). The Institute
of Internal Auditors (IIA) grants the CIA certificate to accountants after they have successfully completed the IIA
examination and met certain other requirements.
Many accountants, including CPAs, work in governmental and other not-for-profit accounting. They
have essentially the same educational background and training as accountants in public accounting and
management accounting.
Governmental agencies at the federal, state, and local levels employ governmental accountants. Often the duties
of these accountants relate to tax revenues and expenditures. For example, Internal Revenue Service employees use
their accounting backgrounds in reviewing tax returns and investigating tax fraud. Government agencies that
regulate business activity, such as a state public service commission that regulates public utilities (e.g. telephone
company, electric company), usually employ governmental accountants. These agencies often employ governmental
accountants who can review and evaluate the utilities' financial statements and rate increase requests. Also, FBI
agents trained as accountants find their accounting backgrounds useful in investigating criminals involved in illegal
business activities, such as drugs or gambling.
Not-for-profit organizations, such as churches, charities, fraternities, and universities, need accountants to
record and account for funds received and disbursed. Even though these agencies do not have a profit motive, they
should operate efficiently and use resources effectively.
Approximately 10,000 accountants are employed in higher education. The activities of these academic
accountants include teaching accounting courses, conducting scholarly and applied research and publishing the
results, and performing service for the institution and the community. Faculty positions exist in two-year colleges,
four-year colleges, and universities with graduate programs. A significant shortage of accounting faculty has
developed due to the retirement beginning in the late 1990s of many faculty members. Starting salaries will
continue to rise significantly because of the shortage. You may want to talk with some of your professors about the
advantages and disadvantages of pursuing an accounting career in higher education.
A section preceding each chapter, entitled "Careers in accounting", describes various accounting careers. You
might find one that you would like to pursue.
Financial accounting versus managerial accounting
An accounting information system provides data to help decision makers both outside and inside the business.
Decision makers outside the business are affected in some way by the performance of the business. Decision makers
inside the business are responsible for the performance of the business. For this reason, accounting is divided into
two categories: financial accounting for those outside and managerial accounting for those inside.
Financial accounting information appears in financial statements that are intended primarily for external
use (although management also uses them for certain internal decisions). Stockholders and creditors are two of the
outside parties who need financial accounting information. These outside parties decide on matters pertaining to
the entire company, such as whether to increase or decrease their investment in a company or to extend credit to a
company. Consequently, financial accounting information relates to the company as a whole, while managerial
accounting focuses on the parts or segments of the company.
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Management accountants in a company prepare the financial statements. Thus, management accountants must
be knowledgeable concerning financial accounting and reporting. The financial statements are the representations
of management, not the CPA firm that performs the audit.
The external users of accounting information fall into six groups; each has different interests in the company
and wants answers to unique questions. The groups and some of their possible questions are:
• Owners and prospective owners. Has the company earned satisfactory income on its total investment?
Should an investment be made in this company? Should the present investment be increased, decreased, or
retained at the same level? Can the company install costly pollution control equipment and still be profitable?
• Creditors and lenders. Should a loan be granted to the company? Will the company be able to pay its
debts as they become due?
• Employees and their unions. Does the company have the ability to pay increased wages? Is the
company financially able to provide long-term employment for its workforce?
• Customers. Does the company offer useful products at fair prices? Will the company survive long enough
to honor its product warranties?
• Governmental units. Is the company, such as a local public utility, charging a fair rate for its services?
• General public. Is the company providing useful products and gainful employment for citizens without
causing serious environmental problems?
General-purpose financial statements provide much of the information needed by external users of financial
accounting. These financial statements are formal reports providing information on a company's financial
position, cash inflows and outflows, and the results of operations. Many companies publish these statements in
annual reports. (See The Limited, Inc., annual report in the Annual report appendix.) The annual report also
contains the independent auditor's opinion as to the fairness of the financial statements, as well as information
about the company's activities, products, and plans.
Financial accounting information is historical in nature, reporting on what has happened in the past. To
facilitate comparisons between companies, this information must conform to certain accounting standards or
principles called generally accepted accounting principles (GAAP). These generally accepted accounting
principles for businesses or governmental organizations have developed through accounting practice or been
established by an authoritative organization. We describe several of these authoritative organizations in the next
major section of this Introduction.
Managerial accounting information is for internal use and provides special information for the managers of a
company. The information managers use may range from broad, long-range planning data to detailed explanations
of why actual costs varied from cost estimates. Managerial accounting information should:
• Relate to the part of the company for which the manager is responsible. For example, a production manager
wants information on costs of production but not of advertising.
• Involve planning for the future. For instance, a budget would show financial plans for the coming year.
• Meet two tests: the accounting information must be useful (relevant) and must not cost more to gather and
process than it is worth.
Managerial accounting generates information that managers can use to make sound decisions. The four major
types of internal management decisions are:
Accounting Principles: A Business Perspective 24 A Global Text
Accounting principles:A business perspective
• Financial decisions—deciding what amounts of capital (funds) are needed to run the business and
whether to secure these funds from owners (stockholders) or creditors. In this sense, capital means money
used by the company to purchase resources such as machinery and buildings and to pay expenses of
conducting the business.
• Resource allocation decisions—deciding how the total capital of a company is to be invested, such as
the amount to be invested in machinery.
• Production decisions—deciding what products are to be produced, by what means, and when.
• Marketing decisions—setting selling prices and advertising budgets; determining the location of a
company's markets and how to reach them.
Development of financial accounting standards
Several organizations are influential in the establishment of generally accepted accounting principles (GAAP) for
businesses or governmental organizations. These are the American Institute of Certified Public Accountants, the
Financial Accounting Standards Board, the Governmental Accounting Standards Board, the Securities and
Exchange Commission, the American Accounting Association, the Financial Executives Institute, and the Institute
of Management Accountants. Each organization has contributed in a different way to the development of GAAP.
The American Institute of Certified Public Accountants (AICPA) is a professional organization of CPAs. Many of
these CPAs are in public accounting practice. Until recent years, the AICPA was the dominant organization in the
development of accounting standards. In a 20-year period ending in 1959, the AICPA Committee on Accounting
Procedure issued 51 Accounting Research Bulletins recommending certain principles or practices. From 1959
through 1973, the committee's successor, the Accounting Principles Board (APB), issued 31 numbered
Opinions that CPAs generally are required to follow. Through its monthly magazine, the Journal of Accountancy,
its research division, and its other divisions and committees, the AICPA continues to influence the development of
accounting standards and practices. Two of its committees—the Accounting Standards Committee and the Auditing
Standards Committee—are particularly influential in providing input to the Financial Accounting Standards Board
(the current rule-making body) and to the Securities and Exchange Commission and other regulatory agencies.
In 1973, an independent, seven-member, full-time Financial Accounting Standards Board (FASB)
replaced the Accounting Principles Board. The FASB has issued numerous Statements of Financial Accounting
Standards. The old Accounting Research Bulletins and Accounting Principles Board Opinions are still effective
unless specifically superseded by a Financial Accounting Standards Board Statement. The FASB is the private
sector organization now responsible for the development of new financial accounting standards.
The Emerging Issues Task Force of the FASB interprets official pronouncements for general application by
accounting practitioners. The conclusions of this task force must also be followed in filings with the Securities and
Exchange Commission.
In 1984, the Governmental Accounting Standards Board (GASB) was established with a full-time
chairperson and four part-time members. The GASB issues statements on accounting and financial reporting in the
governmental area. This organization is the private sector organization now responsible for the development of
new governmental accounting concepts and standards. The GASB also has the authority to issue interpretations of
these standards.
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Created under the Securities and Exchange Act of 1934, the Securities and Exchange Commission (SEC)
is a government agency that administers important acts dealing with the interstate sale of securities (stocks and
bonds). The SEC has the authority to prescribe accounting and reporting practices for companies under its
jurisdiction. This includes virtually every major US business corporation. Instead of exercising this power, the SEC
has adopted a policy of working closely with the accounting profession, especially the FASB, in the development of
accounting standards. The SEC indicates to the FASB the accounting topics it believes the FASB should address.
Consisting largely of accounting educators, the American Accounting Association (AAA) has sought to
encourage research and study at a theoretical level into the concepts, standards, and principles of accounting. One
of its quarterly magazines, The Accounting Review, carries many articles reporting on scholarly accounting
research. Another quarterly journal, Accounting Horizons, reports on more practical matters directly related to
accounting practice. A third journal, Issues in Accounting Education, contains articles relating to accounting
education matters. Students may join the AAA as associate members by contacting the American Accounting
Association, 5717 Bessie Drive, Sarasota, Florida 34233.
The Financial Executives Institute is an organization established in 1931 whose members are primarily
financial policy-making executives. Many of its members are chief financial officers (CFOs) of very large
corporations. The role of the CFO has evolved in recent years from number cruncher to strategic planner. These
CFOs played a major role in restructuring American businesses in the early 1990s. Slightly more than 14,000
financial officers, representing approximately 7,000 companies in the United States and Canada, are members of
the FEI. Through its Committee on Corporate Reporting (CCR) and other means, the FEI is very effective in
representing the views of the private financial sector to the FASB and to the Securities and Exchange Commission
and other regulatory agencies.
The Institute of Management Accountants (formerly the National Association of Accountants) is an
organization with approximately 70,000 members, consisting of management accountants in private industry,
CPAs, and academics. The primary focus of the organization is on the use of management accounting information
for internal decision making. However, management accountants prepare the financial statements for external
users. Thus, through its Management Accounting Practices (MAP) Committee and other means, the IMA provides
input on financial accounting standards to the Financial Accounting Standards Board and to the Securities and
Exchange Commission and other regulatory agencies.
Many other organizations such as the Financial Analysts Federation (composed of investment advisers and
investors), the Securities Industry Associates (composed of investment bankers), and CPA firms have committees
or task forces that respond to Exposure Drafts of proposed FASB Statements. Their reactions are in the form of
written statements sent to the FASB and testimony given at FASB hearings. Many individuals also make their
reactions known to the FASB.
Ethical behavior of accountants
Several accounting organizations have codes of ethics governing the behavior of their members. For instance,
both the American Institute of Certified Public Accountants and the Institute of Management Accountants have
formulated such codes. Many business firms have also developed codes of ethics for their employees to follow.
Ethical behavior involves more than merely making sure you are not violating a code of ethics. Most of us sense
what is right and wrong. Yet get-rich-quick opportunities can tempt many of us. Almost any day, newspaper
Accounting Principles: A Business Perspective 26 A Global Text
Accounting principles:A business perspective
headlines reveal public officials and business leaders who did not do the right thing. Greed won out over their sense
of right and wrong. These individuals followed slogans such as: "Get yours while the getting is good"; "Do unto
others before they do unto you"; and "You have done wrong only if you get caught". More appropriate slogans might
be: "If it seems too good to be true, it usually is"; "There are no free lunches"; and the golden rule, "Do unto others
as you would have them do unto you".
An accountant's most valuable asset is an honest reputation. Those who take the high road of ethical behavior
receive praise and honor; they are sought out for their advice and services. They also like themselves and what they
represent. Occasionally, accountants do take the low road and suffer the consequences. They sometimes find their
names mentioned in The Wall Street Journal and news programs in an unfavorable light, and former friends and
colleagues look down on them. Some of these individuals are removed from the profession. Fortunately, the
accounting profession has many leaders who have taken the high road, gained the respect of friends and colleagues,
and become role models for all of us to follow.
Many chapters in the text include an ethics case entitled, "An ethical perspective". We know you will benefit
from thinking about the situational ethics in these cases. Often you will not have much difficulty in determining
"right and wrong". Instead of making the cases "close calls", we have attempted to include situations business
students might actually encounter in their careers.
Critical thinking and communication skills
Accountants in practice and business executives have generally been dissatisfied with accounting graduates'
ability to think critically and to communicate their ideas effectively. The Accounting Education Change Commission
has recommended that changes be made in the education of accountants to remove these complaints.
To address these concerns, we have included a section at the end of each chapter entitled, "Beyond the numbers
—Critical thinking". In that section, you are required to work relatively unstructured business decision cases,
analyze real-world annual report data, write about situations involving ethics, and participate in group projects.
Most of the other end-of-chapter materials also involve analysis and written communication of ideas.
In some of the cases, analyses, ethics situations, and group projects, you are asked to write a memorandum
regarding the situation. In writing such a memorandum, identify your role (auditor, consultant), the audience
(management, stockholders, and creditors), and the task (the specific assignment). Present your ideas clearly and
concisely.
The purpose of the group projects is to assist you in learning to listen to and work with others. These skills are
important in succeeding in the business world. Team players listen to the views of others and work cohesively with
them to achieve group goals.
Internet skills
The Internet is a fact of life. It is important for accountants and students to be able to use the Internet to find
relevant information. Thus, each chapter contains approximately two Internet projects related to accounting. Your
instructor might assign some of these, or you could pursue them on your own.
How to study the chapters in this text
In studying each chapter:
• Begin by reading the learning objectives at the beginning of each chapter.
• Read "Understanding the learning objectives" at the end of the chapter for a preview of the chapter content.
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• Read the chapter content. Each exercise at the end of the chapters identifies the learning objective(s) to
which it pertains. If you learn best by reading about a concept and then working a short exercise that illustrates
that concept, work the exercises as you read the chapter.
• Reread "Understanding the learning objectives" to determine if you have achieved each objective.
• Study the Key terms to see if you understand each term. If you do not understand a certain term, refer to
the page indicated to read about the term in its original context.
• Take the Self-test and then check your answers with those at the end of the chapter.
• Work the Demonstration problem to further reinforce your understanding of the chapter content. Then,
compare your solution to the correct solution that follows immediately.
• Look over the questions at the end of the chapter and think out an answer to each one. If you cannot answer
a particular question, refer back into the chapter for the needed information.
• Work at least some of the exercises at the end of the chapter.
• Work the Problems assigned by your instructor, using the forms available. They can be downloaded from
the publisher's website (www.freeloadpress.com).
• Study the items in the "Beyond the numbers—Critical thinking" section and the "Using the Internet—A view
of the real world" section at the end of each chapter to relate what you have learned to real-world situations.
• Work the Study guide for the chapter. The Study guide is a supplement that contains (for each chapter)
Learning objectives; Demonstration problem and solution (different from the one in the text); Matching,
Completion, True-false, and Multiple-choice questions; and Solutions to all questions and exercises in the
study guide. The Study guide can be downloaded from the publisher's website (www.freeloadpress.com).
If you perform each of these steps for each chapter, you should do well in the course. Remember that a
knowledge of accounting will serve you well regardless of the career you pursue.
International accounting standards
In recent years, there has been a movement to develop a single set of global accounting standards
for use around the world. Proponents of this movement say that it will boost cross-border
investment, deepen international capital markets and save multinational companies, who must
currently report under multiple systems, a lot of time and money. The International Accounting
Standards Committee (IASC) Foundation was established as an independent, not-for profit, private
sector organisation to work towards this goal. It seeks to develop a globally accepted set of financial
reporting standards (IFRSs) under the direction of its standards-setting body, the International
Accounting Standards Board (IASB). The AICPA (as well as the other entities mentioned above)
supports this effort and, as of early 2010, states on its website that:
“The growing acceptance of International Financial Reporting Standards (IFRS) as a basis for U.S.
financial reporting represents a fundamental change for the U.S. accounting profession. Today
approximately 113 countries require or allow the use of IFRS for the preparation of financial
statements by publicly held companies. In the United States, the Securities and Exchange
Commission (SEC) has been taking steps to set a date to allow U.S. public companies to use IFRS,
and perhaps make its adoption mandatory. In fact, on November 14, 2008, the SEC released for
Accounting Principles: A Business Perspective 28 A Global Text
Accounting principles:A business perspective
public comment a proposed roadmap with a timeline and key milestones for adopting IFRS
beginning in 2014”. Clearly, many new issues can emerge between now and 2014, but the direction
seems to be clear. The AICPA has a link on its website to a page with current information on the
planned migration to IFRS. You might like to check it out from time to time at
http://www.ifrs.com/Backgrounder_Get_Ready.html. There is also a wealth of information on the
IFRS website at http://ifrs.org.
Students from countries other than the US should check the website of the professional accounting
organization in your country for an update on the current status. For example, if you go to the
website of the Institute of Chartered Accountants of India at http://icai.org and search on IFRS you
will find a number of links to documents covering the planned migration to IFRS in India.
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1. Accounting and its use in business decisions
Learning objectives
• Identify and describe the three basic forms of business organizations.
• Distinguish among the three types of activities performed by business organizations.
• Describe the content and purposes of the income statement, statement of retained earnings, balance sheet,
and statement of cash flows.
• State the basic accounting equation and describe its relationship to the balance sheet.
• Using the underlying assumptions or concepts, analyze business transactions and determine their effects on
items in the financial statements.
• Prepare an income statement, a statement of retained earnings, and a balance sheet.
• Analyze and use the financial results—the equity ratio.
A career as an entrepreneur
When today’s college students are polled about their long-term career choice, a surprisingly large number
respond that they wish to someday own and manage their own business. In fact, the aspiration to start a business,
to be an entrepreneur, is nearly universal. It is widely acknowledged that a degree in accounting offers many
advantages to a would-be entrepreneur. In fact, if you ask owners of small businesses which skill they wish they had
more expertise in, they will very frequently reply “accounting”. No matter what the business may be, the owner
and/or manager must be able to understand the accounting and financial consequences of business decisions.
Most successful entrepreneurs have learned that it takes a lot more than a great marketing idea or product
innovation to make a successful business. There are many steps involved before an idea becomes a successful and
rewarding business. Entrepreneurs must be able to raise capital, either from banks or investors. Once a business
has been launched, the entrepreneur must be a manager—a manager of people, inventory, facilities, customer
relationships, and relationships with the very banks and investors that provided the capital. Business owners
quickly learn that in order to survive they need to be well-rounded, savvy individuals who can successfully manage
these diverse relationships. An accounting education is ideal for providing this versatile background.
In addition to providing a good foundation for entrepreneurship in any business, an accounting degree offers
other ways of building your own business. For example, a large percentage of public accountants work as sole
proprietors—building and managing their own professional practice. This can be a very rewarding career, working
closely with individuals and small businesses. One advantage of this career is that you can establish your practice in
virtually any location ranging from large cities to rural settings. Finally, many accountants who have gained
specialized expertise and experience in a particular field start their own practice as consultants. Expertise such as
this, which may be in a field outside of traditional accounting practice, can generate billing rates well in the excess
of USD 100 an hour.
Accounting Principles: A Business Perspective 30 A Global Text
1. Accounting and its use in business decisions
The introduction to this text provided a background for your study of accounting. Now you are ready to learn
about the forms of business organizations and the types of business activities they perform. This chapter presents
the financial statements used by businesses. These financial statements show the results of decisions made by
management. Investors, creditors, and managers use these statements in evaluating management’s past decisions
and as a basis for making future decisions.
In this chapter, you also study the accounting process (or accounting cycle) that accountants use to prepare
those financial statements. This accounting process uses financial data such as the records of sales made to
customers and purchases made from suppliers. In a systematic manner, accountants analyze, record, classify,
summarize, and finally report these data in the financial statements of businesses. As you study this chapter, you
will begin to understand the unique, systematic nature of accounting—the language of business.
Forms of business organizations
Accountants frequently refer to a business organization as an accounting entity or a business entity. A
business entity is any business organization, such as a hardware store or grocery store, that exists as an economic
unit. For accounting purposes, each business organization or entity has an existence separate from its owner(s),
creditors, employees, customers, and other businesses.4 This separate existence of the business organization is
known as the business entity concept. Thus, in the accounting records of the business entity, the activities of
each business should be kept separate from the activities of other businesses and from the personal financial
activities of the owner(s).
Assume, for example, that you own two businesses, a physical fitness center and a horse stable. According to the
business entity concept, you would consider each business as an independent business unit. Thus, you would
normally keep separate accounting records for each business. Now assume your physical fitness center is
unprofitable because you are not charging enough for the use of your exercise equipment. You can determine this
fact because you are treating your physical fitness center and horse stable as two separate business entities. You
must also keep your personal financial activities separate from your two businesses. Therefore, you cannot include
the car you drive only for personal use as a business activity of your physical fitness center or your horse stable.
However, the use of your truck to pick up feed for your horse stable is a business activity of your horse stable.
As you will see shortly, the business entity concept applies to the three forms of businesses—single
proprietorships, partnerships, and corporations. Thus, for accounting purposes, all three business forms are
separate from other business entities and from their owner(s). Since most large businesses are corporations, we use
the corporate approach in this text and include only a brief discussion of single proprietorships and partnerships.
A single proprietorship is an unincorporated business owned by an individual and often managed by that
same person. Single proprietors include physicians, lawyers, electricians, and other people in business for
themselves. Many small service businesses and retail establishments are also single proprietorships. No legal
formalities are necessary to organize such businesses, and usually business operations can begin with only a limited
investment.
In a single proprietorship, the owner is solely responsible for all debts of the business. For accounting purposes,
however, the business is a separate entity from the owner. Thus, single proprietors must keep the financial activities
4 When first studying any discipline, students encounter new terms. Usually these terms are set in bold. The
boldface color terms are also listed and defined at the end of each chapter (see Key terms).
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of the business, such as the receipt of fees from selling services to the public, separate from their personal financial
activities. For example, owners of single proprietorships should not enter the cost of personal houses or car
payments in the financial records of their businesses.
A partnership is an unincorporated business owned by two or more persons associated as partners. Often the
same persons who own the business also manage the business. Many small retail establishments and professional
practices, such as dentists, physicians, attorneys, and many CPA firms, are partnerships.
A partnership begins with a verbal or written agreement. A written agreement is preferable because it provides a
permanent record of the terms of the partnership. These terms include the initial investment of each partner, the
duties of each partner, the means of dividing profits or losses between the partners each year, and the settlement
after the death or withdrawal of a partner. Each partner may be held liable for all the debts of the partnership and
for the actions of each partner within the scope of the business. However, as with the single proprietorship, for
accounting purposes, the partnership is a separate business entity.
A corporation is a business incorporated under the laws of a state and owned by a few stockholders or
thousands of stockholders. Almost all large businesses and many small businesses are incorporated.
The corporation is unique in that it is a separate legal business entity. The owners of the corporation are
stockholders, or shareholders. They buy shares of stock, which are units of ownership, in the corporation.
Should the corporation fail, the owners would only lose the amount they paid for their stock. The corporate form of
business protects the personal assets of the owners from the creditors of the corporation.5
Stockholders do not directly manage the corporation. They elect a board of directors to represent their interests.
The board of directors selects the officers of the corporation, such as the president and vice presidents, who manage
the corporation for the stockholders.
Accounting is necessary for all three forms of business organizations, and each company must follow generally
accepted accounting principles (GAAP). Since corporations have such an important impact on our economy, we use
them in this text to illustrate basic accounting principles and concepts.
An accounting perspective:
Business insight
Although corporations constitute about 17 per cent of all business organizations, they account for
almost 90 per cent of all sales volume. Single proprietorships constitute about 75 per cent of all
business organizations but account for less than 10 per cent of sales volume.
Types of activities performed by business organizations
The forms of business entities discussed in the previous section are classified according to the type of ownership
of the business entity. Business entities can also be grouped by the type of business activities they perform—service
5 When individuals seek a bank loan to finance the formation of a small corporation, the bank often requires those
individuals to sign documents making them personally responsible for repaying the loan if the corporation
cannot pay. In this instance, the individuals can lose their original investments plus the amount of the loan they
are obligated to repay.
Accounting Principles: A Business Perspective 32 A Global Text
1. Accounting and its use in business decisions
companies, merchandising companies, and manufacturing companies. Any of these activities can be performed by
companies using any of the three forms of business organizations.
• Service companies perform services for a fee. This group includes accounting firms, law firms, and dry
cleaning establishments. The early chapters of this text describe accounting for service companies.
• Merchandising companies purchase goods that are ready for sale and then sell them to customers.
Merchandising companies include auto dealerships, clothing stores, and supermarkets. We begin the
description of accounting for merchandising companies in Chapter 6.
• Manufacturing companies buy materials, convert them into products, and then sell the products to
other companies or to the final consumers. Manufacturing companies include steel mills, auto
manufacturers, and clothing manufacturers.
All of these companies produce financial statements as the final end product of their accounting process. These
financial statements provide relevant financial information both to those inside the company—management—and
to those outside the company—creditors, stockholders, and other interested parties. The next section introduces
four common financial statements—the income statement, the statement of retained earnings, the balance sheet,
and the statement of cash flows.
Financial statements of business organizations
Business entities may have many objectives and goals. For example, one of your objectives in owning a physical
fitness center may be to improve your physical fitness. However, the two primary objectives of every business are
profitability and solvency. Profitability is the ability to generate income. Solvency is the ability to pay debts as
they become due. Unless a business can produce satisfactory income and pay its debts as they become due, the
business cannot survive to realize its other objectives.
There are four basic financial statements. Together they present the profitability and strength of a company. The
financial statement that reflects a company’s profitability is the income statement. The statement of retained
earnings shows the change in retained earnings between the beginning and end of a period (e.g. a month or a
year). The balance sheet reflects a company’s solvency and financial position. The statement of cash flows
shows the cash inflows and outflows for a company over a period of time. The headings and elements of each
statement are similar from company to company. You can see this similarity in the financial statements of actual
companies in the appendix of this textbook.
The income statement, sometimes called an earnings statement, reports the profitability of a business
organization for a stated period of time. In accounting, we measure profitability for a period, such as a month or
year, by comparing the revenues earned with the expenses incurred to produce these revenues. Revenues are the
inflows of assets (such as cash) resulting from the sale of products or the rendering of services to customers. We
measure revenues by the prices agreed on in the exchanges in which a business delivers goods or renders services.
Expenses are the costs incurred to produce revenues. Expenses are measured by the assets surrendered or
consumed in serving customers. If the revenues of a period exceed the expenses of the same period, net income
results. Thus,
Net income = Revenues – Expenses
Net income is often called the earnings of the company. When expenses exceed revenues, the business has a net
loss, and it has operated unprofitably.
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In Exhibit 3, Part A shows the income statement of Metro Courier, Inc., for July 2010. This corporation
performs courier delivery services of documents and packages in San Diego in the state of California, USA.
Metro’s income statement for the month ended 2010 July 31, shows that the revenues (or delivery fees)
generated by serving customers for July totaled USD 5,700. Expenses for the month amounted to USD 3,600. As a
result of these business activities, Metro’s net income for July was USD 2,100. To determine its net income, the
company subtracts its expenses of USD 3,600 from its revenues of USD 5,700. Even though corporations are
taxable entities, we ignore corporate income taxes at this point.
One purpose of the statement of retained earnings is to connect the income statement and the balance sheet.
The statement of retained earnings explains the changes in retained earnings between two balance sheet dates.
These changes usually consist of the addition of net income (or deduction of net loss) and the deduction of
dividends.
Dividends are the means by which a corporation rewards its stockholders (owners) for providing it with
investment funds. A dividend is a payment (usually of cash) to the owners of the business; it is a distribution of
income to owners rather than an expense of doing business. Corporations are not required to pay dividends and,
because dividends are not an expense, they do not appear on the income statement.
The effect of a dividend is to reduce cash and retained earnings by the amount paid out. Then, the company no
longer retains a portion of the income earned but passes it on to the stockholders. Receiving dividends is, of course,
one of the primary reasons people invest in corporations.
The statement of retained earnings for Metro Courier, Inc., for July 2010 is relatively simple (see Part B of
Exhibit 3). Organized on June 1, Metro did not earn any revenues or incur any expenses during June. So Metro’s
beginning retained earnings balance on July 1 is zero. Metro then adds its USD 2,100 net income for July. Since
Metro paid no dividends in July, the USD 2,100 would be the ending balance of retained earnings. See below.
A. Income Statement METRO COURIIER INC
Income Statement For the Month Ended 2010 July 31
Revenues:
Service revenue
$ 5,700
Expenses:
Salaries expense
$ 2,600
Rent expense 400
Gas and oil expense
600
Total expenses
3,600
Net income $ 2,100 (A)
B. Statement of Retained Earnings
METRO COURIER , INC. Statement of Retained Earnings For the Month Ended 2010 July 31
Accounting Principles: A Business Perspective 34 A Global Text
1. Accounting and its use in business decisions
Retained earnings, July 1
-0-
Add: Net income for July
(A)2,100
Retained earnings, July 31
$ 2,100 (B)
C. Balance Sheet
METRO COURIER, INC. Balance Sheet 2010 July 31
Assets Liabilities and Stockholder's Equity
Cash $ 15,500 Liabilities:
Account receivables 700 Accounts payable $ 600 Trucks 20,000 Notes payable 6,000 Office equipment 2,500 Total liabilities $ 6,600
Stockholders equity:
Capital stock $ 30,000
Retained earnings (B)2,100
Total stockholders' equity $ 32,100
Total assets $ 38,700 Total liabilities and stockholders' equity $ 38,700
Exhibit 2:
Next, Metro carries this USD 2,100 ending balance in retained earnings to the balance sheet (Part C). If there
had been a net loss, it would have deducted the loss from the beginning balance on the statement of retained
earnings. For instance, if during the next month (August) there is a net loss of USD 500, the loss would be deducted
from the beginning balance in retained earnings of USD 2,100. The retained earnings balance at the end of August
would be USD 1,600.
Dividends could also have affected the Retained Earnings balance. To give a more realistic illustration, assume
that (1) Metro Courier, Inc.’s net income for August was actually USD 1,500 (revenues of USD 5,600 less expenses
of USD 4,100) and (2) the company declared and paid dividends of USD 1,000. Then, Metro’s statement of retained
earnings for August would be:
METRO COURIER, INC. Statement of Retained Earnings
For the Month Ended 2010 August 31 Retained earnings, August 1.......................... $2,100 Add: Net income for August..................... 1,500 Total.......................................... $3,600 Less: Dividends................................... 1,000 Retained earnings, August 31........................ $2,600
The balance sheet, sometimes called the statement of financial position, lists the company’s assets, liabilities,
and stockholders’ equity (including dollar amounts) as of a specific moment in time. That specific moment is the
close of business on the date of the balance sheet. Notice how the heading of the balance sheet differs from the
headings on the income statement and statement of retained earnings. A balance sheet is like a photograph; it
captures the financial position of a company at a particular point in time. The other two statements are for a period
of time. As you study about the assets, liabilities, and stockholders’ equity contained in a balance sheet, you will
understand why this financial statement provides information about the solvency of the business.
Assets are things of value owned by the business. They are also called the resources of the business. Examples
include cash, machines, and buildings. Assets have value because a business can use or exchange them to produce
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the services or products of the business. In Part C of Exhibit 3 the assets of Metro Courier, Inc., amount to USD
38,700. Metro’s assets consist of cash, accounts receivable (amounts due from customers for services previously
rendered), trucks, and office equipment.
Liabilities are the debts owed by a business. Typically, a business must pay its debts by certain dates. A
business incurs many of its liabilities by purchasing items on credit. Metro’s liabilities consist of accounts
payable (amounts owed to suppliers for previous purchases) and notes payable (written promises to pay a
specific sum of money) totaling USD 6,600.6
Metro Courier, Inc., is a corporation. The owners’ interest in a corporation is referred to as stockholders’
equity. Metro’s stockholders’ equity consists of (1) USD 30,000 paid for shares of capital stock and (2) retained
earnings of USD 2,100. Capital stock shows the amount of the owners’ investment in the corporation. Retained
earnings generally consists of the accumulated net income of the corporation minus dividends distributed to
stockholders. We discuss these items later in the text. At this point, simply note that the balance sheet heading
includes the name of the organization and the title and date of the statement. Notice also that the dollar amount of
the total assets is equal to the claims on (or interest in) those assets. The balance sheet shows these claims under
the heading “Liabilities and Stockholders’ Equity”.
Management is interested in the cash inflows to the company and the cash outflows from the company because
these determine the company’s cash it has available to pay its bills when due. The statement of cash flows shows
the cash inflows and cash outflows from operating, investing, and financing activities. Operating activities
generally include the cash effects of transactions and other events that enter into the determination of net income.
Investing activities generally include business transactions involving the acquisition or disposal of long-term assets
such as land, buildings, and equipment. Financing activities generally include the cash effects of transactions
and other events involving creditors and owners (stockholders).
Chapter 16 describes the statement of cash flows in detail. Our purpose here is to merely introduce this
important financial statement. Normally, a firm prepares a statement of cash flows for the same time period as the
income statement. The following statement, however, shows the cash inflows and outflows for Metro Courier, Inc.,
since it was formed on 2010 June 1. Thus, this cash flow statement is for two months.
METRO COURIER, INC. Statement of Cash Flows
For the Two-Month Period Ended 2010 July 31
Cash flows from operating activities:
Net income.......................................................................... $2.100
Adjustments to reconcile net income to net cash provided by operating activities:
Increase in accounts receivable...................................... (700)
Increase in accounts payable......................................... 600
Net cash provided by operating activities................. $2,000
Cash flows from investing activities:
Purchase of trucks................................................................ $(20,000)
Purchase of office equipment................................................ (2,500)
Net cash used by investing activities............................... (22,500)
Cash flows from financing activities:
Proceeds from notes payable................................................. $6,000
Proceeds from sale of capital stock........................................ 30,000
6 Most notes bear interest, but in this chapter we assume that all notes bear no interest. Interest is an amount
paid by the borrower to the lender (in addition to the amount of the loan) for use of the money over time.
Accounting Principles: A Business Perspective 36 A Global Text
1. Accounting and its use in business decisions
Net cash provided by financing activities......................... 36,000
Net increase in cash..................................................................... $15,500
At this point in the course, you need to understand what a statement of cash flows is rather than how to prepare
it. We do not ask you to prepare such a statement until you have studied Chapter 16.
The income statement, the statement of retained earnings, the balance sheet, and the statement of cash flows of
Metro Courier, Inc., show the results of management’s past decisions. They are the end products of the accounting
process, which we explain in the next section. These financial statements give a picture of the solvency and
profitability of the company. The accounting process details how this picture was made. Management and other
interested parties use these statements to make future decisions. Management is the first to know the financial
results; then, it publishes the financial statements to inform other users. The most recent financial statements for
most companies can be found on their websites under “Investor Relations” or some similar heading.
The financial accounting process
In this section, we explain the accounting equation—the framework for the entire accounting process. Then, we
show you how to recognize a business transaction and describe underlying assumptions that accountants use to
record business transactions. Next you learn how to analyze and record business transactions.
In the balance sheet presented in Exhibit 3 (Part C), the total assets of Metro Courier, Inc., were equal to its total
liabilities and stockholders’ equity. This equality shows that the assets of a business are equal to its equities; that is,
Assets = Equities
Assets were defined earlier as the things of value owned by the business, or the economic resources of the
business. Equities are all claims to, or interests in, assets. For example, assume that you purchased a new
company automobile for USD 15,000 by investing USD 10,000 in your own corporation and borrowing USD 5,000
in the name of the corporation from a bank. Your equity in the automobile is USD 10,000, and the bank’s equity is
USD 5,000. You can further describe the USD 5,000 as a liability because you owe the bank USD 5,000. If you are a
corporation, you can describe your USD 10,000 equity as stockholders’ equity or interest in the asset. Since the
owners in a corporation are stockholders, the basic accounting equation becomes:
Assets A=Liabilities LStockholders ’ equitySE
From Metro’s balance sheet in Exhibit 3 (Part C), we can enter in the amount of its assets, liabilities, and
stockholders’ equity:
A = L + SE
USD 38,700 = USD 6,600 + USD 32,100
Remember that someone must provide assets or resources—either a creditor or a stockholder. Therefore, this
equation must always be in balance.
You can also look at the right side of this equation in another manner. The liabilities and stockholders’ equity
show the sources of an existing group of assets. Thus, liabilities are not only claims against assets but also sources
of assets.
Together, creditors and owners provide all the assets in a corporation. The higher the proportion of assets
provided by owners, the more solvent the company. However, companies can sometimes improve their profitability
by borrowing from creditors and using the funds effectively. As a business engages in economic activity, the dollar
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amounts and composition of its assets, liabilities, and stockholders’ equity change. However, the equality of the
basic accounting equation always holds.
An accounting transaction is a business activity or event that causes a measurable change in the accounting
equation, Assets = Liabilities + Stockholders’ equity. An exchange of cash for merchandise is a transaction. The
exchange takes place at an agreed price that provides an objective measure of economic activity. For example, the
objective measure of the exchange may be USD 5,000. These two factors—evidence and measurement—make
possible the recording of a transaction. Merely placing an order for goods is not a recordable transaction because no
exchange has taken place.
A source document usually supports the evidence of the transaction. A source document is any written or
printed evidence of a business transaction that describes the essential facts of that transaction. Examples of source
documents are receipts for cash paid or received, checks written or received, bills sent to customers for services
performed or bills received from suppliers for items purchased, cash register tapes, sales tickets, and notes given or
received. We handle source documents constantly in our everyday life. Each source document initiates the process
of recording a transaction.
Underlying assumptions or concepts
In recording business transactions, accountants rely on certain underlying assumptions or concepts. Both
preparers and users of financial statements must understand these assumptions:
• Business entity concept (or accounting entity concept). Data gathered in an accounting system
relates to a specific business unit or entity. The business entity concept assumes that each business has an
existence separate from its owners, creditors, employees, customers, other interested parties, and other
businesses.
• Money measurement concept. Economic activity is initially recorded and reported in a common
monetary unit of measure—the dollar in the United States. This form of measurement is known as money
measurement.
• Exchange-price (or cost) concept (principle). Most of the amounts in an accounting system are the
objective money prices determined in the exchange process. As a result, we record most assets at their
acquisition cost. Cost is the sacrifice made or the resources given up, measured in money terms, to acquire
some desired thing, such as a new truck (asset).
• Going-concern (continuity) concept. Unless strong evidence exists to the contrary, accountants
assume that the business entity will continue operations into the indefinite future. Accountants call this
assumption the going-concern or continuity concept. Assuming that the entity will continue indefinitely
allows accountants to value long-term assets, such as land, at cost on the balance sheet since they are to be
used rather than sold. Market values of these assets would be relevant only if they were for sale. For
instance, accountants would still record land purchased in 1988 at its cost of USD 100,000 on the 2010
December 31, balance sheet even though its market value has risen to USD 300,000.
• Periodicity (time periods) concept. According to the periodicity (time periods) concept or
assumption, an entity’s life can be meaningfully subdivided into time periods (such as months or years) to
report the results of its economic activities.
Accounting Principles: A Business Perspective 38 A Global Text
1. Accounting and its use in business decisions
Now that you understand business transactions and the five basic accounting assumptions, you are ready to
follow some business transactions step by step. To begin, we divide Metro’s transactions into two groups: (1)
transactions affecting only the balance sheet in June, and (2) transactions affecting the income statement and/or
the balance sheet in July. Note that we could also classify these transactions as operating, investing, or financing
activities, as shown in the statement of cash flows.
Transactions affecting only the balance sheet
Since each transaction affecting a business entity must be recorded in the accounting records, analyzing a
transaction before actually recording it is an important part of financial accounting. An error in transaction analysis
results in incorrect financial statements.
To illustrate the analysis of transactions and their effects on the basic accounting equation, the activities of
Metro Courier, Inc., that led to the statements in Exhibit 3 follow. The first set of transactions (for June), 1a, 2a, and
so on, are repeated in the summary of transactions, Exhibit 2 (Part A). The second set of transactions (for July)
(1b–6b) are repeated in Exhibit 4 (Part A).
1a. Owners invested cash
When Metro Courier, Inc., was organized as a corporation on 2010 June 1, the company issued shares of capital
stock for USD 30,000 cash to Ron Chaney, his wife, and their son. This transaction increased assets (cash) of Metro
by USD 30,000 and increased equities (the capital stock element of stockholders’ equity) by USD 30,000.
Consequently, the transaction yields the following basic accounting equation:
Assets =Liabilities + Stockholders' Equity
Trans- action
Explan- ation
Cash Accounts Receiv- able
Trucks Office Equip- ment
Accounts Payable
Notes Payable +
Capital Stock
1a
Beginning balances Stockholder s invested cash
$ -0- 30,000
$ -0- $ -0- $ -0- = $ -0- $ -0- $ -0-
30,000
Balance after transaction
$ 30,000 $ 30,000
Increased by
$30,000
Increased by $30,000
2a. Borrowed money
The company borrowed USD 6,000 from Chaney’s father. Chaney signed the note for the company. The note
bore no interest and the company promised to repay (recorded as a note payable) the amount borrowed within one
year. After including the effects of this transaction, the basic accounting equation is:
Assets = Liabilities + Stockholder's Equity
Trans- action
Explan- ation
Cash Accounts
Receivable Trucks
Office Equipment
Accounts Payable
Notes Payable
Capital + Stock
Balances before transaction
$ 30,000 $ -0- $ -0- $ -0- = $ -0- $ -0- $ 30,000
2a Borrowed money
6,000 6,000
Balance after transaction
$ 36,000 = $ 6,000 + $ 30,000
Increased by $6,000
Increased by $6,000
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3a. Purchased trucks and office equipment for cash
Metro paid USD 20,000 cash for two used delivery trucks and USD 1,500 for office equipment. Trucks and office
equipment are assets because the company uses them to earn revenues in the future. Note that this transaction does
not change the total amount of assets in the basic equation but only changes the composition of the assets. This
transaction decreased cash and increased trucks and office equipment (assets) by the total amount of the cash
decrease. Metro received two assets and gave up one asset of equal value. Total assets are still USD 36,000. The
accounting equation now is:
Assets = Liabilities + Stockholders'
Equity
Cash Accounts
Receivable Trucks
Office Equipment
Accounts Payable
Notes Payable
Capital + Stock
$ 36,000 $ -0- $ -0- $ -0- = $ -0- $ 6,000 + $ 30,000
(21,500) 20,000 1,500
$ 14,500 $ 20,000 $ 1,500 = $ 6,000 + $ 30,000
Decreased by
$21,500
Increased by
$20,000
Increased by $1,500
4a. Purchased office equipment on account (for credit)
Metro purchased an additional USD 1,000 of office equipment on account, agreeing to pay within 10 days after
receiving the bill. (To purchase an item on account means to buy it on credit.) This transaction increased assets
(office equipment) and liabilities (accounts payable) by USD 1,000. As stated earlier, accounts payable are amounts
owed to suppliers for items purchased on credit. Now you can see the USD 1,000 increase in the assets and
liabilities as follows:
Assets = Liabilities + Stockholders' Equity
Cash Accounts
Receivable Trucks Office Equipment Accounts Payable
Notes Payable +
Capital Stock
$ 14,500 $ 20,000 $ 1,500 = $ 6,000 $ 30,000
1,000 1,000
$ 14,500 $ 20,000 $ 2,500 = $ 1,000 $ 6,000 + $ 30,000 Increased by
$1,000 Increased by
$1,000
5a. Paid an account payable
Eight days after receiving the bill, Metro paid USD 1,000 for the office equipment purchased on account
(transaction 4a). This transaction reduced cash by USD 1,000 and reduced accounts payable by USD 1,000. Thus,
the assets and liabilities both are reduced by USD 1,000, and the equation again balances as follows:
Assets = Liabilities + Stockholders equity
Trans- action
Explanatio n
Cash Accounts
Receivable Trucks
Office Equipment
Accounts Payable
Notes Payable
+ Capital Stock
Balances before transaction
$ 14,500 $ -0- $ 20,000 $ 2,500 = $ 1,000 $ 6,000 + $30,000
5a Paid an account payable
(1,000) (1,000)
Balance after transaction
$ 13,500 $ -0- $ 20,000 $ 2,500 $ -0- $ 6,000 +$30,000
Decreased by
$1,000
Decreased by
$1,000
A. Summary of Transactions
Accounting Principles: A Business Perspective 40 A Global Text
1. Accounting and its use in business decisions
METRO COURIER, INC. Summary of Transactions
Month of June 2010
Assets =Liabilities + Stockholders'
Equity
Transaction Explanation Cash Accounts Receivable
Trucks Office
Equipment Accounts Payable
Notes Payable
Capital + Stock
Beginning balances $ -0 $ -0- $ -0- $ -0- = $ -0- $ -0- $ -0- 1a Stockholders invested cash 30,000 30,000
$ 30,000 $ 30,000 2a Borrowed money 6,000 = 6,000
$ 36,000 = $6000 +$30,000 3a Purchased trucks and office equipment for cash (21,500) 20,000 1,500
$ 14,500 $20,000 $ 1,500 = $ 6,000 + $ 30,000 4a Purchased office equipment on account 1,000 1,000 $ 6,000 + $ 30,000
$ 14,500 $20,000 $ 2,500 = $ 1,000 $ 6,000 + $ 30,000
5a Paid an account payable (1,000) (1,000) End-of-month balances $ 13,500(A) $ -0- $20,000(B) $ 2,500(C) = $ -0- $6,000(D) + $ 30,000(E)
B. Balance Sheet METRO COURIER, INC.
Balance Sheet 2010 June 30
Assets Liabilities and Stockholders' Equity
Cash (A) $ 13,500 Liabilities:
Trucks (B) 20,000 Notes Payable (D) $6,000
Office equipment (C)2,500 Total Liabilities $ 6,000
Stockholders' equity:
Capital stock (E) 30,000
Total assets $ 36,000 Total liabilities and stockholders' equity
$ 36,000
Exhibit 3:
Exhibit 2, Part A, is a summary of transactions prepared in accounting equation form for June. A summary of
transactions is a teaching tool used to show the effects of transactions on the accounting equation. Note that the
stockholders’ equity has remained at USD 30,000. This amount changes as the business begins to earn revenues or
incur expenses. You can see how the totals at the bottom of Part A of Exhibit 2 tie into the balance sheet shown in
Part B. The date on the balance sheet is 2010 June 30. These totals become the beginning balances for July 2010.
Thus far, all transactions have consisted of exchanges or acquisitions of assets either by borrowing or by owner
investment. We used this procedure to help you focus on the accounting equation as it relates to the balance sheet.
However, people do not form a business only to hold existing assets. They form businesses so their assets can
generate greater amounts of assets. Thus, a business increases its assets by providing goods or services to
customers. The results of these activities appear in the income statement. The section that follows shows more of
Metro’s transactions as it began earning revenues and incurring expenses.
Transactions affecting the income statement and/or balance sheet
To survive, a business must be profitable. This means that the revenues earned by providing goods and services
to customers must exceed the expenses incurred.
In July 2010, Metro Courier, Inc., began selling services and incurring expenses. The explanations of
transactions that follow allow you to participate in this process and learn the necessary accounting procedures.
1b. Earned service revenue and received cash
As its first transaction in July, Metro performed delivery services for customers and received USD 4,800 cash.
This transaction increased an asset (cash) by USD 4,800. Stockholders’ equity (retained earnings) also increased by
USD 4,800, and the accounting equation was in balance.
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The USD 4,800 is a revenue earned by the business and, as such, increases stockholders’ equity (in the form of
retained earnings) because stockholders prosper when the business earns profits. Likewise, if the corporation
sustains a loss, the loss would reduce retained earnings.
Revenues increase the amount of retained earnings while expenses and dividends decrease them. (In this first
chapter, we show all of these items as immediately affecting retained earnings. In later chapters, the revenues,
expenses, and dividends are accounted for separately from retained earnings during the accounting period and are
transferred to retained earnings only at the end of the accounting period as part of the closing process described in
Chapter 4.) The effects of this USD 4,800 transaction on the financial position of Metro are:
Metro would record the increase in stockholders’ equity brought about by the revenue transaction as a separate
account, retained earnings. This does not increase capital stock because the Capital Stock account increases only
when the company issues shares of stock. The expectation is that revenue transactions will exceed expenses and
yield net income. If net income is not distributed to stockholders, it is in fact retained. Later chapters show that
because of complexities in handling large numbers of transactions, revenues and expenses affect retained earnings
only at the end of an accounting period. The preceding procedure is a shortcut used to explain why the accounting
equation remains in balance.
Assets =Liabilities + Stockholders' Equity
Transac tion
Explanation Cash Accounts
Receivable Trucks
Office Equipment
Accounts Payable
Notes Payable
Capital + Stock
Retained Earnings
Beginning balances (Exhibit 2)
$ 13,500 $ -0- $ 20,000 $ 2,500 = $ -0- $ 6,000 $ 30,000 $ -0-
1b Earned service revenue and received cash
4,800 4,800
Balances after transaction $ 18,300 $ 20,000 $ 2,500 = $ 6,000 + $ 30,000 $ 4,800
Increased by $4,800
Increased by
$4,800
2b. Service revenue earned on account (for credit)
Metro performed courier delivery services for a customer who agreed to pay USD 900 at a later date. The
company granted credit rather than requiring the customer to pay cash immediately. This is called earning revenue
on account. The transaction consists of exchanging services for the customer’s promise to pay later. This
transaction is similar to the preceding transaction in that stockholders’ equity (retained earnings) increases because
the company has earned revenues. However, the transaction differs because the company has not received cash.
Instead, the company has received another asset, an account receivable. As noted earlier, an account receivable is
the amount due from a customer for goods or services already provided. The company has a legal right to collect
from the customer in the future. Accounting recognizes such claims as assets. The accounting equation, including
this USD 900 item, is as follows:
Assets Liabilities Stockholders' + Equity
Transac tion
Explanation Cash Accounts Receivable
Trucks Office Equipment
Accounts Payable
Notes Payable
Capital + Stock
Retained Earnings
Balances before transaction
$ 18,300
$ 20,000 $ 2,500 = $ 6,000 $ 30,000 $ 4,800
2b Earned service revenue on account
$900 900
Balances after transaction $
18,300 $900 $ 20,000 $ 2,500 = $ 6,000
+ $ 30,000
$5,700
Increased by $900
Increased by
$900
Accounting Principles: A Business Perspective 42 A Global Text
1. Accounting and its use in business decisions
3b. Collected cash on accounts receivable
Metro collected USD 200 on account from the customer in transaction 2b. The customer will pay the remaining
USD 700 later. This transaction affects only the balance sheet and consists of giving up a claim on a customer in
exchange for cash. The transaction increases cash by USD 200 and decreases accounts receivable by USD 200. Note
that this transaction consists solely of a change in the composition of the assets. When the company performed the
services, it recorded the revenue. Therefore, the company does not record the revenue again when collecting the
cash.
Assets =Liabilities + Stockholders' +Equity
Transact ion
Explanation Cash Accounts Receivable
Trucks Office Equip- ment
Accounts Notes Payable Payable
+ Capital Stock
Balances before transaction
$ 18,300 $ 900 $ 20,000 $ 2,500 =
$ 6,000 $ 30,000
3b Collected cash on account
$ 200 (200)
Balances after transaction
$ 18,500 $700 20,000 $ 2,500 =
$ 6,000 + $ 30,000
Increased by $200
Decreased by $200
4b. Paid salaries
Metro paid employees USD 2,600 in salaries. This transaction is an exchange of cash for employee services.
Typically, companies pay employees for their services after they perform their work. Salaries (or wages) are costs
companies incur to produce revenues, and companies consider them an expense. Thus, the accountant treats the
transaction as a decrease in an asset (cash) and a decrease in stockholders’ equity (retained earnings) because the
company has incurred an expense. Expense transactions reduce net income. Since net income becomes a part of the
retained earnings balance, expense transactions also reduce the retained earnings.
Assets = Liabilities + Stockholders' Equity
Cash Accounts
Receivable Trucks
Office Equipment
Accounts Payable
Notes Payable +
Capital Stock Retained Earnings
$ 18,500 (2,600)
$ 700 $ 20,000 $ 2,500 = $6,000 $ 30,000 $ 5,700
(2,600)
$ 15,900 $ 700 $ 20,000 $ 2,500 = $6,000 + $ 30,000 $ 3,100
Decreased by $2,600
Decreased by $2,600
5b. Paid rent
In July, Metro paid USD 400 cash for office space rental. This transaction causes a decrease in cash of USD 400
and a decrease in retained earnings of USD 400 because of the incurrence of rent expense.
Transaction 5b has the following effects on the amounts in the accounting equation:
Assets = Liabilities + Stockholders' Equity
Cash Accounts Receivable Trucks Office
Equipment Accounts Payable
Notes Payable
+ Capital Stock Retained Earnings
$ 15,900 (400)
$ 700 $ 20,000 $ 2,500 = $ 6,000 $ 30,000 $ 3,100
(400) $ 15,500 $ 700 $ 20,000 $ 2,500 = $ 6,000 + $ 30,000 $ 2,700
Decreased by $400
Decreased by $400
6b. Received bill for gas and oil used
At the end of the month, Metro received a USD 600 bill for gas and oil consumed during the month. This
transaction involves an increase in accounts payable (a liability) because Metro has not yet paid the bill and a
decrease in retained earnings because Metro has incurred an expense. Metro’s accounting equation now reads:
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Assets =Liabilities + Stockholders' +Equity
Cash Accounts Receivable Trucks Office
Equipment Accounts Payable Notes Payable Capital + Stock Retained Earnings
$ 15,500 $ 700 $ 20,000 $ 2,500 = $ 6,000 $ 30,000 $ 2,700
600 (600)
$ 15,500 $ 700 $ 20,000 $ 2,500 = $ 600 $ 6,000 + $ 30,000 $ 2,100
Increased by $600
Decreased by $600
Summary of balance sheet and income statement transactions
Part A of Exhibit 4 summarizes the effects of all the preceding transactions on the assets, liabilities, and
stockholders’ equity of Metro Courier, Inc., in July. The beginning balances are the ending balances in Part A of
Exhibit 2. The summary shows subtotals after each transaction; these subtotals are optional and may be omitted.
Note how the accounting equation remains in balance after each transaction and at the end of the month.
The ending balances in each of the columns in Part A of Exhibit 4 are the dollar amounts in Part B and those
reported earlier in the balance sheet in Part C of Exhibit 3. The itemized data in the Retained Earnings column are
the revenue and expense items in Part C of Exhibit 4 and those reported earlier in the income statement in Part A of
Exhibit 3. The beginning balance in the Retained Earnings column (USD 0) plus net income for the month (USD
2,100) is equal to the ending balance in retained earnings (USD 2,100) shown earlier in Part B of Exhibit 3.
Remember that the financial statements are not an end in themselves, but are prepared to assist users of those
statements to make informed decisions. Throughout the text we show how people use accounting information in
decision making.
Dividends paid to owners (stockholders)
Stockholders’ equity is (1) increased by capital contributed by stockholders and by revenues earned through
operations and (2) decreased by expenses incurred in producing revenues. The payment of cash or other assets to
stockholders in the form of dividends also reduces stockholders’ equity. Thus, if the owners receive a cash dividend,
the effect would be to reduce the retained earnings part of stockholders’ equity; the amount of dividends is not an
expense but a distribution of income.
An ethical perspective:
State university
James Stevens was taking an accounting course at State University. Also, he was helping companies
find accounting systems that would fit their information needs. He advised one of his clients to
acquire a software computer package that could record the business transactions and prepare the
financial statements. The licensing agreement with the software company specified that the basic
charge for one site was USD 4,000 and that USD 1,000 must be paid for each additional site where
the software was used.
James was pleased that his recommendation to acquire the software was followed. However, he was
upset that management wanted him to install the software at eight other sites in the company and
did not intend to pay the extra USD 8,000 due the software company. A member of management
stated, “The software company will never know the difference and, besides, everyone else seems to
be pirating software. If they do find out, we will pay the extra fee at that time. Our expenses are high
Accounting Principles: A Business Perspective 44 A Global Text
1. Accounting and its use in business decisions
enough without paying these unnecessary costs.” James believed he might lose this client if he did
not do as management instructed.
An accounting perspective:
Uses of technology
Accountants and others can access the home pages of companies to find their annual reports and
other information, home pages of CPA firms to find employment opportunities and services
offered, and home pages of government agencies, universities, and any other agency that has
established a home page. By making on-screen choices you can discover all kinds of interesting
information about almost anything. You can access libraries, even in foreign countries,
newspapers, such as The Wall Street Journal, and find addresses and phone numbers of anyone in
the nation. We have included some Internet Projects at the end of the chapters to give you some
experience at “surfing the net” for accounting applications.
A. Summary of Transactions METRO COURIER, INC.
Summary of Transactions Month of July 2010
Assets -Liabilities + Stockholders' Equity
Trans- action
Explanation Cash Accounts Receiv- able
Trucks Office Equipment
Accounts Payable
Notes Payable +
Capital Stock
Retained Earnings
Beginning balances (Illustration 1.2)
$ 13,500
$ -0- $ 20,000 $ 2,500 = $ -0- $ 6,000 + $ 30,000 $ -0-
1b Earned service revenue and received cash
4,800 4,800(A)
$ 18,300
$ 20,000 $ 2,500 = $ 6,000 + $ 30,000 $ 4,800
2b Earned service revenue on account 900 900(B)
$ 18,300
$ 900 $ 20,000 $ 2,500 = $ 6,000 + $ 30,000 $ 5,700
3b Collected cash on account 200 (200)
$ 18,500
$ 700 $ 20,000 $ 2,500 = $ 6,000 + $ 30,000 $ 5,700
4b Paid salaries (2,600) (2,600)(C)
$ 15,900
$ 700 $ 20,000 $ 2,500 = $ 6,000 + $ 30,000 $ 3,100
5b Paid rent (400) (400)(D)
$ 15,500
$ 700 $ 20,000 $ 2,500 = $ 6,000 + $ 30,000 $ 2,700
6b Received bill for gas and oil used 600 (600)(E)
End-of-month balances $15,500(
F) $ 700(G)
$ 20,000(H)
$ 2,500 =(I)
$ 600(J) $ 6,000 +(K) $ 30,000(L) $ 2,100(M)
$38,700 $6,600 $32,100
B. Balance Sheet METRO COURIER, INC.
Balance Sheet 2010 July 31
Assets Liabilities and Stockholders'
Cash (F)$15,500 Liabilities:
Accounts receivable (G)700 Accounts payable (J)$600 Trucks (H)20,000 Notes payable (K)6,000 Office equipment (I)2,500 Total liabilities Stockholders' equity $6,600
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Capital stock (L)$30,000
Retained earnings (M)2,100
Total stockholders' equity
$32,100
Total assets $38,700 Total liabilities and stockholders' equity
$38,700
C. Income Statement METRO COURIER, INC.
Income Statement For the Month Ended 2010 July 31
Revenues: Service revenue (A+B)$ 5,700 Expenses: Salaries expense (C)$ 2,600 Rent expense (D)400 Gas & oil expense (F)600 Total expenses 3,600 Net income $ 2,100
Exhibit 4:
Analyzing and using the financial results—the equity ratio
The two basic sources of equity in a company are stockholders and creditors; their combined interests are called
total equities. To find the equity ratio, divide stockholders’ equity by total equities or total assets, since total
equities equals total assets. In formula format:
Equity ratio= Stockholders 'equity
Totalequities
The higher the proportion of equities (or assets) supplied by the owners, the more solvent the company.
However, a high portion of debt may indicate higher profitability because quite often the interest rate on debt is
lower than the rate of earnings realized from using the proceeds of the debt.
An example illustrates this concept: Suppose that a company with USD 100,000 in assets could have raised the
funds to acquire those assets in these two ways:
Case 1
Assets................$100,000 Liabilities.........................$20,000
Stockholders' equity............$80,000
Case 2
Assets................$100,000 Liabilities.........................$80,000
Stockholders' equity............$20,000
When a company suffers operating losses, its assets decrease. In Case 1, the assets would have to shrink by 80
per cent before the liabilities would equal the assets. In Case 2, the assets would have to shrink only 20 per cent
before the liabilities would equal the assets. When the liabilities exceed the assets, the company is said to be
insolvent. Therefore, creditors are safer in Case 1 and will more readily lend money to the company.
However, if funds borrowed at 10 per cent are used to produce earnings at a 20 per cent rate, Case 2 is
preferable in terms of profitability. Therefore, owners are better off in Case 2 if the borrowed funds can earn more
than they cost.
Next, we examine the recent equity ratios of some actual companies:
Name of Company Stockholders' Equity ($ millions)
Total Equities ($ millions) Equity Ratio
Johnson & Johnson $ 23,734 $ 37,053 64.1% 3M Corporation 6,166 15,205 40.6 General Electric Company 53,597 460,097 11.6
Accounting Principles: A Business Perspective 46 A Global Text
1. Accounting and its use in business decisions
As you can see from the preceding data, the equity ratios of actual companies vary widely. Companies such as
Johnson & Johnson and 3M Corporation employ a higher proportion of stockholders’ equity (a lower proportion of
debt) than GE in an effort to have stronger balance sheets (more solvency). GE employs a greater proportion of
debt, possibly in an attempt to increase profitability. Every company must strike a balance between solvency and
profitability to ensure long-run survival. The correct balance between proportions of stockholder and creditor
equities depends on the industry, general business conditions, and management philosophy.
Chapter 1 has introduced two important components of the accounting process—the accounting equation and
the business transaction. In Chapter 2, you learn about debits and credits and how accountants use them in
recording transactions. Understanding how data are accumulated, classified, and reported in financial statements
helps you understand how to use financial statement data in making decisions.
An accounting perspective:
Uses of technology
When you apply for your first job after graduation, prospective employers will expect you to know
how to use a PC to perform many tasks. Therefore, before you graduate you should be able to use
word processing, spreadsheet, and database software. You should be able to use the Internet to find
useful information. In many universities, you can learn these skills in courses taken for credit. If
your school does not offer credit courses, take noncredit courses or attend a training center.
Understanding the learning objectives
• A single proprietorship is an unincorporated business owned by an individual and often managed by
that individual.
• A partnership is an unincorporated business owned by two or more persons associated as partners and
is often managed by them.
• A corporation is a business incorporated under the laws of a state and owned by a few stockholders or
by thousands of stockholders.
• Service companies perform services for a fee.
• Merchandising companies purchase goods that are ready for sale and then sell them to customers.
• Manufacturing companies buy materials, convert them into products, and then sell the products to
other companies or to final customers.
• The income statement reports the revenues and expenses of a company and shows the profitability of
that business organization for a stated period of time.
• The statement of retained earnings shows the change in retained earnings between the beginning of
the period (e.g. a month) and its end.
• The balance sheet lists the assets, liabilities, and stockholders’ equity (including dollar amounts) of a
business organization at a specific moment in time.
• The statement of cash flows shows the cash inflows and cash outflows for a company for a stated
period of time.
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• The accounting equation is Assets = Liabilities + Stockholders’ equity.
• The left side of the equation represents the left side of the balance sheet and shows things of value
owned by the business.
• The right side of the equation represents the right side of the balance sheet and shows who provided
the funds to acquire the things of value (assets).
• Some transactions affect only balance sheet items: assets (such as cash, accounts receivable, and
equipment), liabilities (such as accounts payable and notes payable), and stockholders’ equity (capital
stock). Other transactions affect both balance sheet items and income statement items (revenues,
expenses, and eventually retained earnings).
• Exhibit 2 (Part A) and Exhibit 4 (Part A) show the effects of business transactions on the accounting
equation.
• The income statement appears in Exhibit 3 (Part A) and Exhibit 4 (Part C).
• The statement of retained earnings appears in Exhibit 3 (Part B).
• The balance sheet appears in Exhibit 3 (Part C) and Exhibit 4 (Part B).
• The equity ratio is the stockholders’ equity divided by total equities (or total assets).
• The equity ratio shows the percentage that assets would have to shrink before a company would become
insolvent (liabilities exceed assets).
Appendix: A comparison of corporate accounting with accounting for a sole proprietorship and a partnership
Some textbook authors use a sole proprietorship and a partnership form of business ownership to illustrate
accounting concepts and practices. In a survey of users and nonusers of our text, we learned that the majority
preferred the corporate approach because most students will probably work for or invest in corporations. Also,
many small businesses operate as corporations because of the investors’ desire for limited liability.
This appendix briefly describes the differences in accounting for these three forms of business ownership. The
major difference is in the stockholders’ equity or owner’s equity section of the balance sheet.
As you learned in this chapter, the stockholders’ equity section of the balance sheet for a corporation consists of
capital stock and retained earnings. The owner’s equity section of the balance sheet for a sole proprietorship
consists only of the owner’s capital account. The owner’s equity section of a partnership is similar to that of a single
proprietorship except that it shows a capital account and its balance for each partner.
Corporation Sole Proprietorship Partnership Stockholders' Owner's equity: Partners' capital: equity: John Smith, John Smith, Capital stock...$100,000 Capital....$150,000 Capital............ $75,000
Retained Sam Jones,
earnings..... 50,000 Capital............ 75,000
Total..................$150,000 $150,000 $150,000
The stockholders’ equity section of a corporate balance sheet can become more complex as you will see later in
the text. However, the items in the owner’s equity section of the balance sheets of a sole proprietorship and a
partnership always remain as just shown. In a sole proprietorship, the owner’s capital balance consists of the
owner’s investments in the business, plus cumulative net income since the beginning of the business, less any
amounts withdrawn by the owner. Thus, all of the amounts in the various stockholders’ equity accounts for a
corporation are in the owner’s capital account in a single proprietorship. In a partnership, each partner’s capital
Accounting Principles: A Business Perspective 48 A Global Text
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account balance consists of that partner’s investments in the business, plus that partner’s cumulative share of net
income since that partner became a partner, less any amounts withdrawn by that partner.
The Dividends account in a corporation is similar to an owner’s drawing account in a single proprietorship.
These accounts both show amounts taken out of the business by the owners. In a partnership, each partner has a
drawing account. Accountants treat asset, liability, revenue, and expense accounts similarly in all three forms of
organization.
Demonstration problem
On 2010 June 1, Green Hills Riding Stable, Incorporated, was organized. The following transactions occurred
during June:
June 1 Shares of capital stock were issued for USD 10,000 cash.
4 A horse stable and riding equipment were rented (and paid for) for the month at a cost of USD 1,200.
8 Horse feed for the month was purchased on credit, USD 800.
15 Boarding fees of USD 3,000 for June were charged to those owning horses boarded at the stable. (Fee is due
on July 10.)
20 Miscellaneous expenses of USD 600 were paid.
29 Land was purchased from a savings and loan association by borrowing USD 40,000 on a note from that
association. The loan is due to be repaid in five years. Interest payments are due at the end of each month beginning
July 31.
30 Salaries of USD 700 for the month were paid.
30 Riding and lesson fees were billed to customers in the amount of USD 2,800. (Fees are due on July 10.)
Prepare a summary of the preceding transactions. Use columns headed Cash, Accounts Receivable, Land,
Accounts Payable, Notes Payable, Capital Stock, and Retained Earnings. Determine balances after each transaction
to show that the basic accounting equation is in balance.
Prepare an income statement for June 2010.
Prepare a statement of retained earnings for June 2010.
Prepare a balance sheet as of 2010 June 30.
Solution to demonstration problem
a. GREEN HILLS RIDING STABLE, INCORPORATED
Summary of Transactions Month of June 2010
Assets = Liabilities + Stockholders Equity
Date Explanation Cash Accounts Receivable
Land Accounts Payable Notes Payable
Capital + Stock
Retained Earnings
June 1 Capital stock issued $ 10,000 = $ 10,000
4 Rent expense (1,200) $ (1,200)
$ 8,800 = + $ 10,000 $ (1,200)
8 Feed expense $ 800 (800)
$ 8,800 = $ 800 + $ 10,000 $ (2,000)
15 Boarding fees $ 3,000 3,000
$ 8,800 $ 3,000 = $ 800 + $ 10,000 $ 1,000
20 Miscellaneous expenses
(600) (600)
$ 8,200 $ 3,000 = 800 + $ 10,000 $ 400
29 Purchased land by borrowing
$ 40,000 $ 40,000
$ 8,200 $ 3,000 $ 40,000 = $ 800 $ 40,000 + $ 10,000 $ 400
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30 Salaries paid (700) (700)
$ 7,500 $ 3,000 $ 40,000 = $ 800 $ 40,000 + $ 10,000 $ (300)
30 Riding and lesson fees billed
2,800 2,800
$ 7,500 $ 5,800 $ 40,000 $ 800 $ 40,000 + $ 10,000 $ 2,500
b)
GREEN HILLS RIDING STABLE, INCORPORATE Income Statement For the Month Ended 2010 June 30
Revenues:
Horse boarding fees revenue $ 3,000
Riding and lesson fee revenue 2,800
Total revenues $ 5,800
Expenses:
Rent expense $ 1,200
Feed expense 800
Salaries expense 700
Miscellaneous expense 600
Total expenses 3,300
Net income $ 2,500
c)
GREEN HILLS RIDING STABLE, INCORPORATED Statement of Retained Earnings
For the Month Ended 2010 June 30 Retained earnings, June 1 $ -0- Add: Net income for June 2,500 Total $ 2,500 Less: Dividends -0- Retained earnings, June 30 $ 2,500
d)
GREEN HILLS RIDING STABLE, INCORPORATE Balance Sheet 2010 June 30
Assets
Cash $ 7,500
Accounts receivable 5,800
Land 40,000
Total assets $ 53,300
Liabilities and Stockholders' Equity
Liabilities:
Accounts payable $ 800
Noted payable 40,000
Total liabilities $ 40,800
Stockholders' equity:
Capital stock $ 10,000
Retained earnings 2,500
Total stockholders' equity $ 12,500
Total liabilities and stockholders' equity $53,300.00
Key terms Accounting equation Assets = Equities; or Assets = Liabilities + Stockholders’ equity.
Accounts payable Amounts owed to suppliers for goods or services purchased on credit.
Accounts receivable Amounts due from customers for services already provided.
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Assets Things of value owned by the business. Examples include cash, machines, and buildings. To their owners, assets possess service potential or utility that can be measured and expressed in money terms.
Balance sheet Financial statement that lists a company’s assets, liabilities, and stockholders’ equity (including dollar amounts) as of a specific moment in time. Also called a statement of financial position.
Business entity concept (or accounting entity concept) The separate existence of the business organization.
Capital stock The title given to an equity account showing the investment in a business corporation by its stockholders.
Continuity See going-concern concept.
Corporation Business incorporated under the laws of one of the states and owned by a few stockholders or by thousands of stockholders.
Cost Sacrifice made or the resources given up, measured in money terms, to acquire some desired thing, such as a new truck (asset).
Dividend Payment (usually of cash) to the owners of a corporation; it is a distribution of income to owners rather than an expense of doing business.
Entity A business unit that is deemed to have an existence separate and apart from its owners, creditors, employees, customers, other interested parties, and other businesses, and for which accounting records are maintained.
Equities Broadly speaking, all claims to, or interests in, assets; includes liabilities and stockholders’ equity.
Equity ratio A ratio found by dividing stockholders’ equity by total equities (or total assets).
Exchange-price (or cost) concept (principle) The objective money prices determined in the exchange process are used to record most assets.
Expenses Costs incurred to produce revenues, measured by the assets surrendered or consumed in serving customers.
Going-concern (continuity) concept The assumption by the accountant that unless strong evidence exists to the contrary, a business entity will continue operations into the indefinite future.
Income statement Financial statement that shows the revenues and expenses and reports the profitability of a business organization for a stated period of time. Sometimes called an earnings statement.
Liabilities Debts owed by a business—or creditors’ equity. Examples: notes payable, accounts payable.
Manufacturing companies Companies that buy materials, convert them into products, and then sell the products to other companies or to final customers.
Merchandising companies Companies that purchase goods ready for sale and sell them to customers.
Money measurement concept Recording and reporting economic activity in a common monetary unit of measure such as the dollar.
Net income Amount by which the revenues of a period exceed the expenses of the same period.
Net loss Amount by which the expenses of a period exceed the revenues of the same period.
Notes payable Amounts owed to parties who loan the company money after the owner signs a written agreement (a note) for the company to repay each loan.
Partnership An unincorporated business owned by two or more persons associated as partners.
Periodicity (time periods) concept An assumption that an entity’s life can be meaningfully subdivided into time periods (such as months or years) for purposes of reporting its economic activities.
Profitability Ability to generate income. The income statement reflects a company’s profitability.
Retained earnings Accumulated net income less dividend distributions to stockholders.
Revenues Inflows of assets (such as cash) resulting from the sale of products or the rendering of services to customers.
Service companies Companies (such as accounting firms, law firms, or dry cleaning establishments) that perform services for a fee.
Single proprietorship An unincorporated business owned by an individual and often managed by that individual.
Solvency Ability to pay debts as they become due. The balance sheet reflects a company’s solvency.
Source document Any written or printed evidence of a business transaction that describes the essential facts of that transaction, such as receipts for cash paid or received.
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Statement of cash flows Financial statement showing cash inflows and outflows for a company over a period of time.
Statement of retained earnings Financial statement used to explain the changes in retained earnings that occurred between two balance sheet dates.
Stockholders’ equity The owners’ interest in a corporation.
Stockholders or shareholders Owners of a corporation; they buy shares of stock, which are units of ownership, in the corporation.
Summary of transactions Teaching tool used in Chapter 1 to show the effects of transactions on the accounting equation.
Transaction A business activity or event that causes a measurable change in the items in the accounting equation, Assets = Liabilities + Stockholders’ equity.
Self-test
True-False
Indicate whether each of the following statements is true or false.
The three forms of business organizations are single proprietorship, partnership, and trust.
The three types of business activity are service, merchandising, and manufacturing.
The income statement shows the profitability of the company and is dated as of a particular date, such as 2010
December 31.
The statement of retained earnings shows both the net income for the period and the beginning and ending
balances of retained earnings.
The balance sheet contains the same major headings as appear in the accounting equation.
Multiple-choice
Select the best answer for each of the following questions.
The ending balance in retained earnings is shown in the:
a. Income statement.
b. Statement of retained earnings.
c. Balance sheet.
d. Both (b) and (c).
Which of the following is not a correct form of the accounting equation?
a. Assets = Equities.
b. Assets = Liabilities + Stockholders’ equity.
c. Assets – Liabilities = Stockholders’ equity.
d. Assets + Stockholders’ equity = Liabilities.
Which of the following is not one of the five underlying assumptions or concepts mentioned in the chapter?
a. Exchange-price concept.
b. Inflation accounting concept.
c. Business entity concept.
d. Going-concern concept.
When the stockholders invest cash in the business, what is the effect?
a. Liabilities increase and stockholders’ equity increases.
b. Both assets and liabilities increase.
c. Both assets and stockholders’ equity increase.
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1. Accounting and its use in business decisions
d. None of the above.
When services are performed on account, what is the effect?
a. Both cash and retained earnings decrease.
b. Both cash and retained earnings increase.
c. Both accounts receivable and retained earnings increase.
d. Accounts payable increases and retained earnings decreases.
Now turn to “Answers to self-test” at the end of your chapter to check your answers.
Questions
➢ Accounting has often been called the language of business. In what respects would you agree with
this description? How might you argue that this description is deficient?
➢ Define asset, liability, and stockholders’ equity.
➢ How do liabilities and stockholders’ equity differ? How are they similar?
➢ How do accounts payable and notes payable differ? How are they similar?
➢ Define revenues. How are revenues measured?
➢ Define expenses. How are expenses measured?
➢ What is a balance sheet? On what aspect of a business does the balance sheet provide information?
➢ What is an income statement? On what aspect of a business does this statement provide
information?
➢ What information does the statement of retained earnings provide?
➢ Identify the three types of activities shown in a statement of cash flows.
➢ What is a transaction? What use does the accountant make of transactions? Why?
➢ What is the accounting equation? Why must it always balance?
➢ Give an example from your personal life that illustrates your use of accounting information in
reaching a decision.
➢ You have been elected to the governing board of your church. At the first meeting you attend,
mention is made of building a new church. What accounting information would the board need in
deciding whether or not to go ahead?
➢ A company purchased equipment for USD 2,000 cash. The vendor stated that the equipment was
worth USD 2,400. At what amount should the equipment be recorded?
➢ What is meant by money measurement?
➢ Of what significance is the exchange-price (or cost) concept? How is the cost to acquire an asset
determined?
➢ What effect does the going-concern (continuity) concept have on the amounts at which long-term
assets are carried on the balance sheet?
➢ Of what importance is the periodicity (time periods) concept to the preparation of financial
statements?
➢ Describe a transaction that would:
➢ Increase both an asset and capital stock.
➢ Increase both an asset and a liability.
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➢ Increase one asset and decrease another asset.
➢ Decrease both a liability and an asset.
➢ Increase both an asset and retained earnings.
➢ Decrease both an asset and retained earnings.
➢ Increase a liability and decrease retained earnings.
➢ Decrease both an asset and retained earnings.
➢ Identify the causes of increases and decreases in stockholders’ equity
➢ Real world question: Refer to the 2000 financial statements of The Limited in the Annual Report
Appendix at the back of the text. What were the net income or loss amounts in the latest three years?
Discuss the meaning of the changes after reading management’s discussion and analysis of financial
condition and results of operations.
➢ Real world question: Refer to the financial statements of The Limited in the Annual Report
Appendix. Has the solvency of the company improved from one year to the next? Discuss.
Exercises
Exercise A Match the descriptions in Column B with the appropriate terms in Column A.
Column A Column B
1. Corporation. a. An unincorporated business owned by an individual. 2. Merchandising company. b. The form of organization used by most large businesses. 3. Partnership. c. Buys raw materials and converts them into finished products. 4. Manufacturing company. d. Buys goods in their finished form and sells them to
5. Service company. customers in that same form.
6. Single proprietorship. e. An unincorporated business with more than one owner.
f. Performs services for a fee.
Exercise B Assume that retained earnings increased by USD 3,600 from 2010 June 30, to 2011 June 30. A cash
dividend of USD 300 was declared and paid during the year.
a. Compute the net income for the year.
b. Assume expenses for the year were USD 9,000. Compute the revenue for the year.
Exercise C On 2010 December 31, Perez Company had assets of USD 150,000, liabilities of USD 97,500, and
capital stock of USD 30,000. During 2011, Perez earned revenues of USD 45,000 and incurred expenses of USD
33,750. Dividends declared and paid amounted to USD 3,000.
a. Compute the company’s retained earnings on 2010 December 31.
b. Compute the company’s retained earnings on 2011 December 31.
Exercise D At the start of the year, a company had liabilities of USD 50,000 and capital stock of USD 150,000.
At the end of the year, retained earnings amounted to USD 135,000. Net income for the year was USD 45,000, and
USD 15,000 of dividends were declared and paid. Compute retained earnings and total assets at the beginning of
the year.
Exercise E For each of the following events, determine if it has an effect on the specific items (such as cash) in
the accounting equation. For the events that do have an effect, present an analysis of the transaction showing its
two sides or dual nature.
a. Purchased equipment for cash, USD 12,000.
b. Purchased a truck for USD 40,000, signed a note (with no interest) promising payment in 10 days.
c. Paid USD 1,600 for the current month’s utilities.
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1. Accounting and its use in business decisions
d. Paid for the truck purchased in (b).
e. Employed Mary Childers as a salesperson at USD 1,200 per month. She is to start work next week.
f. Signed an agreement with a bank in which the bank agreed to lend the company up to USD 200,000 any time
within the next two years.
Exercise F Bradley Company, engaged in a courier service business, completed the following selected
transactions during July 2010:
a. Purchased office equipment on account.
b. Paid an account payable.
c. Earned service revenue on account.
d. Borrowed money by signing a note at the bank.
e. Paid salaries for month to employees.
f. Received cash on account from a charge customer.
g. Received gas and oil bill for month.
h. Purchased delivery truck for cash.
i. Declared and paid a cash dividend.
Using a tabular form similar to Exhibit 4 (Part A), indicate the effect of each transaction on the accounting
equation using (+) for increase and (–) for decrease. No dollar amounts are needed, and you need not fill in the
Explanation column.
Exercise G Indicate the amount of change (if any) in the stockholders’ equity balance based on each of the
following transactions:
a. The stockholders invested USD 100,000 cash in the business by purchasing capital stock.
b. Land costing USD 40,000 was purchased by paying cash.
c. The company performed services for a customer who agreed to pay USD 18,000 in one month.
d. Paid salaries for the month, USD 12,000.
e. Paid USD 14,000 on an account payable.
Exercise H Give examples of transactions that would have the following effects on the items in a firm’s
financial statements:
a. Increase cash; decrease some other asset.
b. Decrease cash; increase some other asset.
c. Increase an asset; increase a liability.
d. Decrease retained earnings; decrease an asset.
e. Increase an asset other than cash; increase retained earnings.
f. Decrease an asset; decrease a liability.
Exercise I Which of the following transactions results in a decrease in retained earnings? Why?
a. Employees were paid USD 20,000 for services received during the month.
b. USD 175,000 was paid to acquire land.
c. Paid an USD 18,000 note payable. No interest was involved.
d. Paid a USD 200 account payable.
Exercise J Assume that the following items were included in the Retained Earnings column in the summary of
transactions for Cinck Company for July 2010:
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Salaries expense $120,000 Service revenue 300,000 Gas and oil expense 27,000 Rent expense 48,000 Dividends paid 40,000
Prepare an income statement for July 2010.
Exercise K Given the following facts, prepare a statement of retained earnings for Brindle Company, a tanning
salon, for August 2010:
Balance in retained earnings at end of July, USD 188,000.
Dividends paid in August, USD 63,600.
Net income for August, USD 72,000.
The column totals of a summary of transactions for Speedy Printer Repair, Inc., as of 2010 December 31, were as
follows:
Accounts payable $60,000 Accounts receivable 90,000 Capital stock 100,000 Cash 40,000 Land 80,000 Building 50,000 Equipment 30,000 Notes payable 20,000 Retained earnings ?
Prepare a balance sheet. We have purposely listed the accounts out of order.
Exercise M Merck & Co., Inc. is a world leader in the discovery, development, manufacture and marketing of a
broad range of human and animal health products. The company, which has 70,000 employees, spends over USD 2
billion every year on the research and development of new drugs. As of the end of 2, its 2.2 billion shares are valued
in the stock market for a total of USD 132 billion. Given the following data for Merck, calculate the equity ratios for
2003 and 2002. Then comment on the results.
2003 2002
Stockholders' equity USD 14,832,400,000 USD 13,241,600,000
Total equities USD 39,910,400,000 USD 35,634,900,000
Problems
Problem A Lakewood Personal Finance Company, which provides financial advisory services, engaged in the
following transactions during May 2010:
May 1Received USD 300,000 cash for shares of capital stock issued when company was organized.
2 The company borrowed USD 40,000 from the bank on a note.
7 The company bought USD 182,400 of computer equipment for cash.
11 Cash received for services performed to date was USD 15,200.
14 Services performed for a customer who agreed to pay within a month were USD 10,000.
15 Employee wages were paid, USD 13,200.
19 The company paid USD 14,000 on the note to the bank.
31 Interest paid to the bank for May was USD 140. (Interest is an expense, which reduces retained earnings.)
31 The customer of May 14 paid USD 3,200 of the amount owed to the company.
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31 An order was received from a customer for services to be rendered next week, which will be billed at USD
12,000.
Prepare a summary of transactions (see Part A of Exhibit 4). Use money columns headed Cash, Accounts
Receivable, Equipment, Notes Payable, Capital Stock, and Retained Earnings. Determine balances after each
transaction to show that the accounting equation balances.
Problem B Reliable Lawn Care Service, Inc., a company that takes care of lawns and shrubbery of personal
residences, engaged in the following transactions in April 2010:
Apr.1 The company was organized and received USD 400,000 cash from the owners in exchange for capital
stock issued.
4 The company bought equipment for cash, USD 101,760.
9 The company bought additional mowing equipment that cost USD 9,120 and agreed to pay for it in 30 days.
15 Cash received for services performed to date was USD 3,840.
16 Amount due from a customer for services performed totaled USD 5,280.
30 Of the receivable (see April 16), USD 3,072 was collected in cash.
30 Miscellaneous operating expenses of USD 6,240 were paid during the month.
30 An order was placed for miscellaneous equipment costing USD 28,800.
a. Prepare a summary of transactions (see Part A of Exhibit 4). Use money columns headed Cash, Accounts
Receivable, Equipment, Accounts Payable, Capital Stock, and Retained Earnings. Determine balances after each
transaction to show that the basic accounting equation balances.
b. Prepare a balance sheet as of April 30.
Problem C Analysis of the transactions of the Moonlight Drive-In Theater for June 2010 disclosed the
following:
Ticket revenue USD 180000
Equipment rent expense 50000
Film rent expense 53400
Concession revenue 29600
Advertising expense 18600
Salaries expense 60000
Utilities expense 14100
Cash dividends declared and paid 12000
Balance sheet amounts at June 30 include the following:
Cash USD 140,000
Land 148000
Accounts payable 87600
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Capital stock 114000
Retained earnings as of 2010 June 1 84900
a. Prepare an income statement for June 2010.
b. Prepare a statement of retained earnings for June 2010.
c. Prepare a balance sheet as of 2010 June 30.
d. How solvent does this company appear to be?
Problem D Little Folks Baseball, Inc., was formed by a group of parents to meet a need for a place for kids to
play baseball. At the beginning of its second year of operations, its balance sheet appeared as follows:
LITTLE FOLKS BASEBALL Balance Sheet 2010 April 30
Assets
Cash $ 56,000
Accounts Receivable 80,000
Land 600,000
Total assets $ 736,000
Liabilities and Stockholders' Equity
Liabilities:
Accounts payable $ 64,000
Stockholders' Equity:
Capital stock $ 400,000
Retained earnings 272,000 672,000
Total liabilities and stockholders' equity $ 736,000
The summarized transactions for May 2010 are as follows:
a. Issued additional capital stock for cash, USD 200,000.
b. Collected USD 80,000 on accounts receivable.
c. Paid USD 64,000 on accounts payable.
d. Received membership fees from parents (nonrefundable): in cash, USD 260,000; and on account, USD
120,000.
e. Incurred operating expenses: for cash, USD 60,000; and on account, USD 160,000.
f. Paid dividends of USD 16,000.
g. Purchased more land for cash, USD 96,000.
h. Placed an order for new equipment expected to cost USD 120,000.
a. Prepare a summary of transactions (see Part A of Exhibit 4) using column headings as given in the balance
sheet. Determine balances after each transaction.
b. Prepare an income statement for May 2010.
c. Prepare a statement of retained earnings for May 2010.
d. Prepare a balance sheet as of 2010 May 31.
The balance sheets for 2010 May 31, and 2010 April 30, and the income statement for May of the Target-Line
Golf Driving Range follow. (Common practice is to show the most recent period first.)
TARGET-LINE GOLF DRIVING RANGE Comparative Balance Sheet
May 31, April 30,
Accounting Principles: A Business Perspective 58 A Global Text
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2010 2010
Assets
Cash $56,400 $46,800 Land 163,200 144,000 Total assets $219,600 $190,800
Liabilities and Stockholders' Equity
Accounts payable $18,000 $27,600 Capital stock 144,000 144,000 Retained earnings 57,600 19,200 Total liabilities and stockholders' equity $219,600 $190,800
TARGET-LINE GOLF DRIVING RANGE Income Statement
For the Month Ended 2010 May 31
Revenues:
Service revenue $64,000
Expenses:
Salaries expense $16,000
Equipment rental expense 9,600 25,600
Net income $38,400
All revenues earned are on account.
State the probable cause(s) of the change in each of the balance sheet accounts from April 30 to 2010 May 31.
Alternate problems
Alternate problem A Preston Auto Paint Company had the temporary free use of an old building and
completed the following transactions in September 2010:
Sept. 1 The company was organized and received USD 100,000 cash from the issuance of capital stock.
5 The company bought painting and sanding equipment for cash at a cost of USD 25,000.
7 The company painted the auto fleet of a customer who agreed to pay USD 8,000 in one week. The customer
furnished the special paint.
14 The company received the USD 8,000 from the transaction of September 7.
20 Additional sanding equipment that cost USD 2,800 was acquired today; payment was postponed until
September 28.
28 USD 2,400 was paid on the liability incurred on September 20.
30 Employee salaries for the month, USD 2,200, were paid.
30 Placed an order for additional painting equipment advertised at USD 20,000.
Prepare a summary of transactions (see Part A of Exhibit 4) for the company for these transactions. Use money
columns headed Cash, Accounts Receivable, Equipment, Accounts Payable, Capital Stock, and Retained Earnings.
Determine balances after each transaction to show that the basic accounting equation balances.
Alternate problem B Quick-Start Home Repair Company completed the following transactions in June 2010:
June 1 The company was organized and received USD 200,000 cash from the issuance of capital stock.
4 The company paid USD 48,000 cash for a truck.
7 The company borrowed USD 10,000 from its bank on a note.
9 Cash received for repair services performed was USD 4,500.
12 Expenses of operating the business so far this month were paid in cash, USD 3,400.
18 Repair services performed for a customer who agreed to pay within a month amounted to USD 5,400.
25 The company paid USD 4,065 on its loan from the bank, including USD 4,050 of principal and USD 15 of
interest. (The principal is the amount of the loan. Interest is an expense, which reduces retained earnings.)
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30 Miscellaneous expenses incurred in operating the business from June 13 to date were USD 3,825 and were
paid in cash.
30 An order (contract) was received from a customer for repair services to be performed tomorrow, which will
be billed at USD 3,000.
a. Prepare a summary of transactions (see Part A of Exhibit 4). Include money columns for Cash, Accounts
Receivable, Trucks, Notes Payable, Capital Stock, and Retained Earnings. Determine balances after each
transaction to show that the basic accounting equation balances.
b. Prepare a balance sheet as of 2010 June 30.
Alternate problem C Following are summarized transaction data for Luxury Apartments, Inc., for the year
ending 2010 June 30. The company owns and operates an apartment building.
Rent revenue from building owned USD 150,000
Building repairs 2870
Building cleaning, labor cost 3185
Property taxes on the building 4000
Insurance on the building 1225
Commissions paid to rental agent 5000
Legal and accounting fees (for preparation of tenant
leases)
1260
Utilities expense 8225
Cost of new awnings (installed on June 30, will last
10 years)
5000
Of the USD 150,000 rent revenue, USD 5,000 was not collected in cash until 2010 July 5.
Prepare an income statement for the year ended 2010 June 30.
Alternate problem D The following data are for Central District Parking Corporation:
CENTRAL DISTRICT PARKING CORPORATION Balance Sheet 2010 October 1
Assets
Cash $
344,000 Accounts Receivable 18,000
Total assets $
362,000
Liabilities and Stockholders' Equity
Accounts payable $
94,000 Capital stock 232,000 Retained earnings 36,000
Total liabilities and stockholders' equity $
362,000
The summarized transactions for October 2010 are as follows:
Oct.1 The accounts payable owed as of September 30 (USD 94,000) were paid.
Accounting Principles: A Business Perspective 60 A Global Text
1. Accounting and its use in business decisions
1 The company paid rent for the premises for October, USD 19,200.
7 The company received cash of USD 4,200 for parking by daily customers during the week.
10 The company collected USD 14,400 of the accounts receivable in the balance sheet at September 30.
14 Cash receipts for the week from daily customers were USD 6,600.
15 Parking revenue earned but not yet collected from fleet customers was USD 6,000.
16 The company paid salaries of USD 2,400 for the period October 1–15.
19 The company paid advertising expenses of USD 1,200 for October.
21 Cash receipts for the week from daily customers were USD 7,200.
24 The company incurred miscellaneous expenses of USD 840. Payment will be due November 10.
31 Cash receipts for the last 10 days of the month from daily customers were USD 8,400.
31 The company paid salaries of USD 3,000 for the period October 16–31.
31 Billings to monthly customers totaled USD 21,600 for October.
31 Paid cash dividends of USD 24,000.
a. Prepare a summary of transactions (see Part A of Exhibit 4) using column headings as given in the preceding
balance sheet. Determine balances after each transaction.
b. Prepare an income statement for October 2010.
c. Prepare a statement of retained earnings for October 2010.
d. Prepare a balance sheet as of 2010 October 31.
Alternate problem E The following balance sheets for 2010 June 30, and 2010 May 31, and the income
statement for June are for Beach Camping Trailer Storage, Inc. (Common practice is to show the most recent period
first.)
BEACH CAMPING TRAILER STOR AGE, INC Comparative Balance Sheet
June 30, May 31,
2010 2010
Assets
Cash $ 52,000 $ 60,000 Accounts receivable 24,000 -0- Land 36,000 36,000 Total assets $ 112,000 $ 96,000
Liabilities and Stockholders' Equity
Accounts payable $ 18,000 $ 24,000 Capital stock 60,000 60,000 Retained earnings 34,000 12,000 Total liabilities and stockholders' equity $ 112,000 $ 96,000
BEACH CAMPING TRAILER STORAGE, INC. , Income Statement For the Month Ended 2010 June 3
Revenues:
Service revenue $ 100,000
Expenses:
Salaries expense $ 48,000
Supplies bought and used 24,000 72,000
Net income $ 28,000
A cash dividend of USD 6,000 was declared and paid in June.
State the probable causes of the changes in each of the balance sheet accounts from May 31 to 2010 June 30.
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Beyond the numbers—critical thinking
Business decision case A Upon graduation from high school, Jim Crane went to work for a builder of houses
and small apartment buildings. During the next six years, Crane earned a reputation as an excellent employee—
hardworking, dedicated, and dependable—in the light construction industry. He could handle almost any job
requiring carpentry, electrical, or plumbing skills.
Crane then decided to go into business for himself under the name Jim’s Fix-It Shop, Inc. He invested cash,
some power tools, and a used truck in his business. He completed many repair and remodeling jobs for
homeowners and apartment owners. The demand for his services was so large that he had more work than he could
handle. He operated out of his garage, which he had converted into a shop, adding several new pieces of power
woodworking equipment.
Now, two years after going into business for himself, Crane must decide whether to continue in his own business
or to accept a position as construction supervisor for a home builder. He has been offered an annual salary of USD
50,000 and a package of fringe benefits (medical and hospitalization insurance, pension contribution, vacation and
sick pay, and life insurance) worth approximately USD 8,000 per year. The offer is attractive to Crane. But he
dislikes giving up his business since he has thoroughly enjoyed being his own boss, even though it has led to an
average workweek well in excess of the standard 40 hours
Suppose Crane comes to you for assistance in gathering the information needed to help him make a decision. He
brings along the accounting records that have been maintained for his business by an experienced accountant.
Using logic and your own life experiences, indicate the nature of the information Jim needs if he is to make an
informed decision. Pay particular attention to the information likely to be found in his business accounting records.
Does the accounting information available enter directly into the decision? Write a memorandum to Jim describing
the information he will need to make an informed decision. The memo’s headings should include Date, To, From,
and Subject. (See the format in Group Project E below.)
Annual report analysis B Recall that in this chapter we showed that the equity ratio is calculated by dividing
stockholders’ equity by total equities (or total assets). Another format for analyzing solvency is to divide total debt
by total equities. This latter calculation tells the proportion of assets financed by debt rather than the proportion of
assets financed by stockholders’ equity. These two ratios are complements and must add to 100 per cent. Thus, if 25
per cent of assets were financed by debt, 75 per cent were financed by stockholders’ equity.
Using the following historical data from Gateway, calculate the “total-debt-to total-capital” ratio for each year.
2003 2002 2001 2000 1999 1998 1997
Total
liabilities
(000's)
USD
1,772,205
USD
1,937,570
USD
1,546,005
USD
1,109,337
USD
857,870
USD
568,492
USD
394,545
Total
stockholders
equity
2380339 2017118 1344375 930044 815541 555519 376035
Accounting Principles: A Business Perspective 62 A Global Text
1. Accounting and its use in business decisions
Study these amounts and comment on the solvency of the company. Is there a trend in the company’s solvency
over time? Gateway has experienced tremendous growth in stockholders’ equity during the past six years, but has
also increased liabilities significantly. Could Gateway have grown this much without increasing liabilities?
Annual report analysis C Look at The Limited, Inc., annual report in the Annual report appendix. In that
report you will find a letter outlining Management’s responsibilities concerning the financial statements, as well as
the report of the independent auditors.
Write answers to the following questions:
Who is responsible for preparing the financial statements?
Of what importance is the internal audit?
What is the role of the audit committee?
Why are no officers or employees on the audit committee?
What is the responsibility of the external independent auditor?
Does the independent auditor have absolute assurance that the financial statements are free of material
misstatement?
To what extent does the independent auditor examine evidence?
Ethics case- writing experience D Refer to “An ethical perspective: State university”. Write a short essay
discussing the alternatives James Stevens could pursue and the likely outcomes of those alternatives. Which of the
alternatives you have discussed would you recommend?
Group project E In teams of two or three students, interview a businessperson in your community. Ask how
that person uses accounting information in making business decisions and obtain specific examples. Each team
should write a memorandum to the instructor summarizing the results of the interview. Information contained in
the memo should include:
Date:
To:
From:
Subject:
Content of the memo must include the name and title of the person interviewed, name of the company, date of
the interview, examples of the use of accounting information for decision making, and any other pertinent
information.
Group project F With a team composed of one or two other students, conceive of a business that you would
like to form after graduation. Then describe approximately 15–20 transactions that the business might undertake in
its first month of operations. Prepare a summary of transactions showing how each transaction affects the
accounting equation. Identify each asset, liability, and stockholders’ equity item in your summary of transactions.
For instance, instead of grouping all assets in one number, show cash, accounts receivable, and so on in your
accounting equation.
Group project G With a team of one or two other students and using library sources, write a paper on the
American Institute of Certified Public Accountants, their services to members, and their activities. Be careful to cite
sources for your information. Direct quotes should be labeled as such and should be single-spaced and indented if
relatively long or in quote marks and not indented if relatively short. To quote without giving the source is
plagiarism and should be avoided at all costs.
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Using the Internet—A view of the real world
Visit the following website for Nokia:
http://www.nokia.com
Write a short paper describing company information, products and services, and support available for their
products.
Visit the following website for Ford Motor Company:
http://www.ford.com
When the web page appears, search for Investor Information and then locate the Ford Motor Company Annual
Report. Based on your investigation, write a short paper describing the general content of the annual report.
Answers to self-test
True-False
False. Corporation, not trust, is the third form.
True. The accounting for all three of these is covered in this text.
False. The income statement is dated using a period of time, such as “For the Year Ended 2010 December
31”.
True. In addition, the statement of retained earnings shows dividends declared.
True. Both show assets, liabilities, and stockholders’ equity.
Multiple-choice
d. The ending balance in retained earnings is shown in both the statement of retained earnings and in the
balance sheet.
d. This form of the equation would not balance.
b. The inflation accounting concept was not one of the ones discussed. The other two were the money
measurement concept and the periodicity concept.
c. When the stockholders invest cash, assets and stockholders’ equity increase.
c. The performance of services on account increases both accounts receivable and retained earnings.
Accounting Principles: A Business Perspective 64 A Global Text
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2. Recording business transactions
Learning objectives
After studying this chapter, you should be able to:
• Use the account as the basic classifying and storage unit for accounting information.
• Express the effects of business transactions in terms of debits and credits to different types of accounts.
• List the steps in the accounting cycle.
• Record the effects of business transactions in a journal.
• Post journal entries to the accounts in the ledger.
• Prepare a trial balance to test the equality of debits and credits in the journalizing and posting process.
• Analyze and use the financial results—horizontal and vertical analyses.
Salary potential of accountants
Selecting a major represents much more than the choice of courses a student takes in college. To a significant
degree, the student's major, along with academic performance, will determine the career paths available upon
graduation. Few professionals would recommend a specific career choice based solely on salaries. However, as
students select their major and map out their career path, it is important that they make informed decisions with
respect to the potential financial rewards of the various options. Outlined below is information on selected salaries
for many accounting-related careers. These salaries, current as of 2009, should be viewed only as guidelines.
Salaries at all levels can vary significantly between locations. Also, one should add 10 to 15 per cent to the listed
salary for professional certifications (such as the CPA) or for a graduate degree (Masters of Accounting or MBA).
Salaries for Public Accounting, Non-Partners Position
Large CPA Firms: Salary Range Starting Salaries $35,750 - $42,500 Salary between 1-3 years $41,000 - $51,250 Manager/Director $77,750 - $119,000 Small CPA Firms:
Starting Salaries $29,500 - $36,250 Salary between 1-3 years $33,750 - $42,500 Manager/Director $62,750 - $84,500
Salaries for Corporate Accounting - Large Corporations Position Salary Range Chief Financial Officer/Treasurer $244,500 - $347,000 Vice President, Finance $189,000 - $293,500 Director of Finance $121,500 - $178,250 Director of Accounting $115,250 - $157,500 Controller $105,750 - $147,250 Assistant Controller $89,750 - $114,750 Tax Director $117,000 - $209,750 Tax Manager $78,000 - $113,750 Audit Director $127,750 - $200,750 General Accounting - Manager $61,250 - $83,250 General Accounting - 1-3 years experience $37,500 - $48,750 General Accounting - starting salary $31,750 - $39,750
Accounting Principles: A Business Perspective 65 A Global Text
2. Recording business transactions
Students interested in a career in accounting and finance can find detailed information for these and many other
accounting related careers at Robert Half (www.roberthalf.com). Also, accounting professors are generally familiar
with starting salaries and job opportunities for accounting graduates, so you may want to address more specific
questions about potential careers and salaries with them.
In Chapter 1, we illustrated the income statement, statement of retained earnings, balance sheet, and statement
of cash flows. These statements are the end products of the financial accounting process, which is based on the
accounting equation. The financial accounting process quantifies past management decisions. The results of these
decisions are communicated to users—management, creditors, and investors—and serve as a basis for making
future decisions.
The raw data of accounting are the business transactions. We recorded the transactions in Chapter 1 as increases
or decreases in the assets, liabilities, and stockholders' equity items of the accounting equation. This procedure
showed you how various transactions affected the accounting equation. When working through these sample
transactions, you probably suspected that listing all transactions as increases or decreases in the transactions
summary columns would be too cumbersome in practice. Most businesses, even small ones, enter into many
transactions every day. Chapter 2 teaches you how to actually record business transactions in the accounting
process.
To explain the dual procedure of recording business transactions with debits and credits, we introduce you to
some new tools: the T-account, the journal, and the ledger. Using these tools, you can follow a company through its
various business transactions. Like accountants, you can use a trial balance to check the equality of your recorded
debits and credits. This is the double-entry accounting system that the Franciscan monk, Luca Pacioli, described
centuries ago. Understanding this system enables you to better understand the content of financial statements so
you can use the information provided to make informed business decisions.
The account and rules of debit and credit
A business may engage in thousands of transactions during a year. An accountant classifies and summarizes the
data in these transactions to create useful information.
Steps in recording business transactions
Look at Exhibit 9 to see the steps in recording and posting the effects of a business transaction. Note that source
documents provide the evidence that a business transaction occurred. These source documents include such items
as bills received from suppliers for goods or services received, bills sent to customers for goods sold or services
performed, and cash register tapes. The information in the source document serves as the basis for preparing a
journal entry. Then a firm posts (transfers) that information to accounts in the ledger.
You can see from Exhibit 9 that after you prepare the journal entry, you post it to the accounts in the ledger.
However, before you can record the journal entry, you must understand the rules of debit and credit. To teach you
these rules, we begin by studying the nature of an account.
Fortunately, most business transactions are repetitive. This makes the task of accountants somewhat easier
because they can classify the transactions into groups having common characteristics. For example, a company may
have thousands of receipts or payments of cash during a year. As a result, a part of every cash transaction can be
recorded and summarized in a single place called an account.
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An account is a part of the accounting system used to classify and summarize the increases, decreases, and
balances of each asset, liability, stockholders' equity item, dividend, revenue, and expense. Firms set up accounts
for each different business element, such as cash, accounts receivable, and accounts payable. Every business has a
Cash account in its accounting system because knowledge of the amount of cash on hand is useful information.
Accountants may differ on the account title (or name) they give the same item. For example, one accountant
might name an account Notes Payable and another might call it Loans Payable. Both account titles refer to the
amounts borrowed by the company. The account title should be logical to help the accountant group similar
transactions into the same account. Once you give an account a title, you must use that same title throughout the
accounting records.
The number of accounts in a company's accounting system depends on the information needs of those interested
in the business. The main requirement is that each account provides information useful in making decisions. Thus,
one account may be set up for all cash rather than having a separate account for each form of cash (coins on hand,
currency on hand, and deposits in banks). The amount of cash is useful information; the form of cash often is not.
To illustrate recording the increases and decreases in an account, texts use the T-account, which looks like a
capital letter T. The name of the account, such as Cash, appears across the top of the T. We record increases on one
side of the vertical line of the T and decreases on the other side. A T-account appears as follows:
An accounting perspective:
Business insight
Have you ever considered starting your own business? If so, you will need to understand
accounting to successfully run your business. To know how well your business is doing, you must
understand and analyze financial statements. Accounting information also tells you why you are
performing as reported. If you are in business to sell or develop a certain product or perform a
specific service, you cannot operate profitably or consider expanding unless you base your business
decisions on accounting information.
Accounting Principles: A Business Perspective 67 A Global Text
2. Recording business transactions
Exhibit 5: The steps in recording and posting the effects of a business transaction
In Chapter 1, you saw that each business transaction affects at least two items. For example, if you—an owner—
invest cash in your business, the company's assets increase and its stockholders' equity increases. This result was
illustrated in the summary of transactions in Exhibit 1.3. In the following sections, we use debits and credits and the
double-entry procedure to record the increases and decreases caused by business transactions.
Accountants use the term debit instead of saying, "Place an entry on the left side of the T-account". They use the
term credit for "Place an entry on the right side of the T-account". Debit (abbreviated Dr.) simply means left side;
credit (abbreviated Cr.) means right side.7 Thus, for all accounts a debit entry is an entry on the left side, while a
credit entry is an entry on the right side.
Any Account Left, or Right, or debit, side credit, side
After recognizing a business event as a business transaction, we analyze it to determine its increase or decrease
effects on the assets, liabilities, stockholders' equity items, dividends, revenues, or expenses of the business. Then
we translate these increase or decrease effects into debits and credits.
In each business transaction we record, the total dollar amount of debits must equal the total dollar amount of
credits. When we debit one account (or accounts) for USD 100, we must credit another account (or accounts) for a
total of USD 100. The accounting requirement that each transaction be recorded by an entry that has equal debits
and credits is called double-entry procedure, or duality. This double-entry procedure keeps the accounting
equation in balance.
The dual recording process produces two sets of accounts—those with debit balances and those with credit
balances. The totals of these two groups of accounts must be equal. Then, some assurance exists that the arithmetic
part of the transaction recording process has been properly carried out. Now, let us actually record business
transactions in T-accounts using debits and credits.
Recording changes in assets, liabilities, and stockholders' equity
While recording business transactions, remember that the foundation of the accounting process is the following
basic accounting equation:
Assets=LiabilitiesStockholders 'Equity
7 The abbreviations “Dr.” and “Cr.” are based on the Latin words “debere” and “credere”. A synonym for debit an
account is charge an account.
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Recording transactions into the T-accounts is easier when you focus on the equal sign in the accounting
equation. Assets, which are on the left of the equal sign, increase on the left side of the T-accounts. Liabilities and
stockholders' equity, to the right of the equal sign, increase on the right side of the T-accounts. You already know
that the left side of the T-account is the debit side and the right side is the credit side. So you should be able to fill in
the rest of the rules of increases and decreases by deduction, such as:
Assets = Liabilities + Stockholders' Equity Debit for Credit for Debit for Credit for Debit for Credit for increases decreases decreases increases decreases increases
To summarize:
• Assets increase by debits (left side) to the T-account and decrease by credits (right side) to the T-account.
• Liabilities and stockholders' equity decrease by debits (left side) to the T-account and increase by credits
(right side) to the T-account.
Applying these two rules keeps the accounting equation in balance. Now we apply the debit and credit rules for
assets, liabilities, and stockholders' equity to business transactions.
Assume a corporation issues shares of its capital stock for USD 10,000 in transaction 1. (Note the figure in
parentheses is the number of the transaction and ties the two sides of the transaction together.) The company
records the receipt of USD 10,000 as follows:
(Dr.) Cash (Cr) (Dr.) Capital Stock (Cr (1) 10,000 (1) 10,000
This transaction increases the asset, cash, which is recorded on the left side of the Cash account. Then, the
transaction increases stockholders' equity, which is recorded on the right side of the Capital Stock account.
Assume the company borrowed USD 5,000 from a bank on a note (transaction 2). A note is an unconditional
written promise to pay to another party (the bank) the amount owed either when demanded or at a specified date,
usually with interest at a specified rate. The firm records this transaction as follows:
(Dr.) Cash (Cr) (Dr.) Notes Payable (Cr) (1) (2)
5,000 (2)
10,000
5,000
Observe that liabilities, Notes Payable, increase with an entry on the right (credit) side of the account.
Recording changes in revenues and expenses In Chapter 1, we recorded the revenues and expenses
directly in the Retained Earnings account. However, this is not done in practice because of the volume of revenue
and expense transactions. Instead, businesses treat the expense accounts as if they were subclassifications of the
debit side of the Retained Earnings account, and the revenue accounts as if they were subclassifications of the credit
side. Since firms need the amounts of revenues and expenses to prepare the income statement, they keep a separate
account for each type of revenue and expense. The recording rules for revenues and expenses are:
• Record increases in revenues on the right (credit) side of the T-account and decreases on the left (debit)
side. The reasoning behind this rule is that revenues increase retained earnings, and increases in retained
earnings are recorded on the right side.
• Record increases in expenses on the left (debit) side of the T-account and decreases on the right (credit)
side. The reasoning behind this rule is that expenses decrease retained earnings, and decreases in retained
earnings are recorded on the left side.
Accounting Principles: A Business Perspective 69 A Global Text
2. Recording business transactions
To illustrate these rules, assume the same company received USD 1,000 cash from a customer for services
rendered (transaction 3). The Cash account, an asset, increases on the left (debit) side of the T-account; and the
Service Revenue account, an increase in retained earnings, increases on the right (credit) side.
(Dr.) Cash (Cr) (Dr.) Service Revenue (Cr) (1) 10,000 (3) 1,000
(2) 5,000
(3) 1,000
Now assume this company paid USD 600 in salaries to employees (transaction 4). The Cash account, an asset,
decreases on the right (credit) side of the T-account; and the Salaries Expense account, a decrease in retained
earnings, increases on the left (debit) side.8
(Dr) Cash (Cr) (Dr.) Salaries Expense (Cr) (1) 10,000 (4) 600 (4) 600
(2) 5,000
(3) 1,000
Recording changes in dividends Since dividends decrease retained earnings, increases appear on the left
side of the Dividends account and decreases on the right side. Thus, the firm records payment of a USD 2,000 cash
dividend (transaction 5) as follows:
(Dr) Cash (Cr) (Dr.) Dividends3 (Cr) (1) 10,000 (4) 600 (5) 2,000
(2) 5,000 (5) 2,000
(3) 1,000
9
At the end of the accounting period, the accountant transfers any balances in the expense, revenue, and
Dividends accounts to the Retained Earnings account. This transfer occurs only after the information in the
expense and revenue accounts has been used to prepare the income statement. We discuss and illustrate this step in
Chapter 4.
To determine the balance of any T-account, total the debits to the account, total the credits to the account, and
subtract the smaller sum from the larger. If the sum of the debits exceeds the sum of the credits, the account has a
debit balance. For example, the following Cash account uses information from the preceding transactions. The
account has a debit balance of USD 13,400, computed as total debits of USD 16,000 less total credits of USD 2,600.
(Dr.) Cash (Cr) (1) 10,000 (4) 600 (2) 5,000 (5) 2,000 (3) 1,000
16,000 2,600
Dr. bal 13,400
8 Certain deductions are normally taken out of employees' pay for social security taxes, federal and state
withholding, and so on. Those deductions are ignored here.
9 As we illustrate later in the text, some companies debt dividends directly to the Retained Earnings account
rather than to a Dividends account.
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If, on the other hand, the sum of the credits exceeds the sum of the debits, the account has a credit balance.
For instance, assume that a company has an Accounts Payable account with a total of USD 10,000 in debits and
USD 13,000 in credits. The account has a credit balance of USD 3,000, as shown in the following T-account:
(Dr.) Accounts Payable (Cr) 10,000 7,000
6,000
10,000 13,000
Cr. bal 3,000
Normal balances Since debits increase asset, expense, and Dividend accounts, they normally have debit (or
left-side) balances. Conversely, because credits increase liability, capital stock, retained earnings, and revenue
accounts, they normally have credit (or right-side) balances.
The following chart shows the normal balances of the seven accounts we have used:
Normal Balances
Types of Accounts Debit Credit Assets X
Liabilities X
Stockholders' Equity
Capital Stock X
Retained earnings X
Dividends X
Expenses X
Revenues X
At this point, you should memorize the six rules of debit and credit. Later, as you proceed in your study of
accounting, the rules will become automatic. Then, you will no longer ask yourself, "Is this increase a debit or
credit?"
Asset accounts increase on the debit side, while liability and stockholders' equity accounts increase on the credit
side. When the account balances are totaled, they conform to the following independent equations:
Assets = Liabilities + Stockholders' Equity
Debits = Credits
The arrangement of these two formulas gives the first three rules of debit and credit:
• Increases in asset accounts are debits; decreases are credits.
• Decreases in liability accounts are debits; increases are credits.
• Decreases in stockholders' equity accounts are debits; increases are credits.
Accounting Principles: A Business Perspective 71 A Global Text
2. Recording business transactions
Assets Liabilities + Stockholder's Equity
Stockholders' Equity Account(s)
Asset Accounts = Liability Accounts + (Capital Stock and Retained Earnings) Debit* Credit Debit Credit* Debit Credit*
+ - - + +
Debit Credit Debit Credit Debit Credit
for for for for for for
increase decrease decrease increase decrease increase
Expense Accounts
Debits Credits and Dividends Account Revenue Accounts
1. Increase assets. 1. Decreases assets. Debit* Credit Debit Credit*
2. Decrease liabilities. 2 Increase liabilities.
3. Decrease 3. Increase + - - +
stockholders' equity. stockholders' equity. Debit Credit Debit Credit
4. Decrease revenues. 4. Increase revenues. for for for for
5. Increase expenses. 5. Decrease expenses. increase decrease decrease increase
6. Increase dividends. 6. Decrease dividends.
Exhibit 6: Rules of debit and credit
The debit and credit rules for expense and Dividends accounts and for revenue accounts follow logically if you
remember that expenses and dividends are decreases in stockholders' equity and revenues are increases in
stockholders' equity. Since stockholders' equity accounts decrease on the debit side, expense and Dividend accounts
increase on the debit side. Since stockholders' equity accounts increase on the credit side, revenue accounts
increase on the credit side. The last three debit and credit rules are:
• Decreases in revenue accounts are debits; increases are credits.
• Increases in expense accounts are debits; decreases are credits.
• Increases in Dividends accounts are debits; decreases are credits.
In Exhibit 6, we depict these six rules of debit and credit. Note first the treatment of expense and Dividends
accounts as if they were subclassifications of the debit side of the Retained Earnings account. Second, note the
treatment of the revenue accounts as if they were subclassifications of the credit side of the Retained Earnings
account. Next, we discuss the accounting cycle and indicate where steps in the accounting cycle are discussed in
Chapters 2 through 4.
The accounting cycle
The accounting cycle is a series of steps performed during the accounting period (some throughout the period
and some at the end) to analyze, record, classify, summarize, and report useful financial information for the
purpose of preparing financial statements. Before you can visualize the eight steps in the accounting cycle, you must
be able to recognize a business transaction. Business transactions are measurable events that affect the financial
condition of a business. For example, assume that the owner of a business spilled a pot of coffee in her office or
broke her leg while skiing. These two events may briefly interrupt the operation of the business. However, they are
not measurable in terms that affect the solvency and profitability of the business.
Business transactions can be the exchange of goods for cash between the business and an external party, such as
the sale of a book, or they can involve paying salaries to employees. These events have one fundamental criterion:
They must have caused a measurable change in the amounts in the accounting equation, Assets = Liabilities +
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Stockholders' Equity. The evidence that a business event has occurred is a source document such as a sales ticket,
check, and so on. Source documents are important because they are the ultimate proof of business transactions.10
After you have determined that an event is a measurable business transaction and have adequate proof of this
transaction, mentally analyze the transaction's effects on the accounting equation. You learned how to do this in
Chapter 1. This chapter and Chapters 3 and 4 describe the other steps in the accounting cycle. The eight steps in the
accounting cycle and the chapters that discuss them are:
• Analyze transactions by examining source documents (Chapters 1 and 2).
• Journalize transactions in the journal (Chapter 2).
• Post journal entries to the accounts in the ledger (Chapter 2).
• Prepare a trial balance of the accounts (Chapter 2) and complete the work sheet (Chapter 4). (This step
includes adjusting entries from Chapter 3.)
• Prepare financial statements (Chapter 4).
• Journalize and post adjusting entries (Chapters 3 and 4).
• Journalize and post closing entries (Chapter 4).
• Prepare a post-closing trial balance (Chapter 4).
This listing serves as a preview of what you will study in Chapters 2-4. Notice that firms perform the last five
steps at the end of the accounting period. Step 5 precedes steps 6 and 7 because management needs the financial
statements at the earliest possible date. After the statements have been delivered to management, the adjusting and
closing entries can be journalized and posted. In Exhibit 7, we diagram the eight steps in the accounting cycle.
You can perform many of these steps on a computer with an accounting software package. However, you must
understand a manual accounting system and all of the steps in the accounting cycle to understand what the
computer is doing. This understanding removes the mystery of what the computer is doing when it takes in raw
data and produces financial statements.
The journal
In explaining the rules of debit and credit, we recorded transactions directly in the accounts. Each ledger
(general ledger) account shows only the increases and decreases in that account. Thus, all the effects of a single
business transaction would not appear in any one account. For example, the Cash account contains only data on
changes in cash and does not show how the cash was generated or how it was spent. To have a permanent record of
an entire transaction, the accountant uses a book or record known as a journal.
A journal is a chronological (arranged in order of time) record of business transactions. A journal entry is the
recording of a business transaction in the journal. A journal entry shows all the effects of a business transaction as
expressed in debit(s) and credit(s) and may include an explanation of the transaction. A transaction is entered in a
journal before it is entered in ledger accounts. Because each transaction is initially recorded in a journal rather than
directly in the ledger, a journal is called a book of original entry.
10 Many companies send and receive source documents electronically, rather than on paper. In such an electronic
computer environment, source documents might exist only in the computer databases of the two parties
involved in the transaction.
Accounting Principles: A Business Perspective 73 A Global Text
2. Recording business transactions
A business usually has more than one journal. Chapter 4 briefly describes several special journals. In this
chapter, we use the basic form of journal, the general journal. As shown in Exhibit 8, a general journal contains the
following columns:
Exhibit 7: Steps in the accounting cycle
MICROTRAIN COMPANY General Journal
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Nov. 28 Cash (+A) 100 5 0 0 0 0
Capital Stock (+SE) 300 5 0 0 0 0
Stockholders invested $50,000 cash in business.
Exhibit 8: Journal entry
• Date column. The first column on each journal page is for the date. For the first journal entry on a page,
this column contains the year, month, and day (number). For all other journal entries on a page, this
column contains only the day of the month, until the month changes.
• Account titles and explanation column. The first line of an entry shows the account debited. The
second line shows the account credited. Notice that we indent the credit account title to the right. For
instance, in Exhibit 8 we show the debit to the Cash account and then the credit to the Capital Stock
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account. Any necessary explanation of a transaction appears on the line(s) below the credit entry and is
indented halfway between the accounts debited and credited. A journal entry explanation should be concise
and yet complete enough to describe fully the transaction and prove the entry's accuracy. When a journal
entry is self-explanatory, we omit the explanation.
• Posting reference column. This column shows the account number of the debited or credited account.
For instance, in Exhibit 8, the number 100 in the first entry means that the Cash account number is 100. No
number appears in this column until the information has been posted to the appropriate ledger account.
We discuss posting later in the chapter.
• Debit column. In the debit column, the amount of the debit is on the same line as the title of the account
debited.
• Credit column. In the credit column, the amount of the credit is on the same line as the title of the
account credited.
An account perspective:
Uses of technology
Preparing journal entries in a computerized system is different than in a manual system. The
computer normally asks for the number of the account to be debited. After you type the account
number, the computer shows the account title in its proper position. The cursor then moves to the
debit column and waits for you to enter the amount of the debit. Then it asks if there are more
debits. If not, the computer prompts you for the account number of the credit. After you type the
account number, the computer supplies the account name of the credit and enters the same
amount debited as the credit. When there is more than one credit, you can override the amount
and enter the correct amount. Then you would enter the other credit in the same way. If your
debits and credits are not equal, the computer warns you and makes you correct the error. You can
supply an explanation for the entry from a standard list or type it in. As you enter the journal
entries, the computer automatically posts them to the ledger accounts. At any time, you can have
the computer print a trial balance.
A summary of the functions and advantages of using a journal follows:
The journal—
• Records transactions in chronological order.
• Shows the analysis of each transaction in debits and credits.
• Supplies an explanation of each transaction when necessary.
• Serves as a source for future reference to accounting transactions.
• Eliminates the need for lengthy explanations from the accounts.
• Makes possible posting to the ledger at convenient times.
• Assists in maintaining the ledger in balance because the debit(s) must always equal the credit(s) in each
journal entry.
Accounting Principles: A Business Perspective 75 A Global Text
2. Recording business transactions
• Aids in tracing errors when the ledger is not in balance.
The ledger
A ledger (general ledger) is the complete collection of all the accounts of a company. The ledger may be in
loose-leaf form, in a bound volume, or in computer memory.
Accounts fall into two general groups: (1) balance sheet accounts (assets, liabilities, and stockholders' equity)
and (2) income statement accounts (revenues and expenses). The terms real accounts and permanent accounts also
refer to balance sheet accounts. Balance sheet accounts are real accounts because they are not subclassifications
or subdivisions of any other account. They are permanent accounts because their balances are not transferred
(or closed) to any other account at the end of the accounting period. Income statement accounts and the Dividends
account are nominal accounts because they are merely subclassifications of the stockholders' equity accounts.
Nominal literally means "in name only". Nominal accounts are also called temporary accounts because they
temporarily contain revenue, expense, and dividend information that is transferred (or closed) to the Retained
Earnings account at the end of the accounting period.
The chart of accounts is a complete listing of the titles and numbers of all the accounts in the ledger. The
chart of accounts can be compared to a table of contents. The groups of accounts usually appear in this order:
assets, liabilities, stockholders' equity, dividends, revenues, and expenses.
Individual accounts are in sequence in the ledger. Each account typically has an identification number and a title
to help locate accounts when recording data. For example, a company might number asset accounts, 100-199;
liability accounts, 200-299; stockholders' equity accounts and Dividends account, 300-399; revenue accounts, 400-
499; and expense accounts, 500-599. We use this numbering system in this text. The uniform chart of accounts
used in the first 11 chapters appears in a separate file at the end of the text. You should print that file and keep it
handy for working certain problems and exercises. Companies may use other numbering systems. For instance,
sometimes a company numbers its accounts in sequence starting with 1, 2, and so on. The important idea is that
companies use some numbering system.
Now that you understand how to record debits and credits in an account and how all accounts together form a
ledger, you are ready to study the accounting process in operation.
The accounting process in operation
MicroTrain Company is a small corporation that provides on-site personal computer software training using the
clients' equipment. The company offers beginning through advanced training with convenient scheduling. A small
fleet of trucks transports personnel and teaching supplies to the clients' sites. The company rents a building and is
responsible for paying the utilities.
We illustrate the capital stock transaction that occurred to form the company (in November) and the first month
of operations (December). The accounting process used by this company is similar to that of any small company.
The ledger accounts used by MicroTrain Company are:
Acct. Account Title No. Description
100 Cash Bank deposits and cash on hand.
103 Accounts Receivable Amounts owed to the company by customers.
107 Supplies on Hand Items such as paper, envelopes, writing materials, and other materials used in performing training services for customers or in doing administrative
Assets and clerical office work.
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108 Prepaid Insurance Insurance policy premiums paid in advance of the periods for which the insurance coverage applies.
112 Prepaid Rent Rent paid in advance of the periods for which the rent payment applies.
150 Trucks Trucks used to transport personnel and training supplies to clients' locations.
200 Accounts Payable Amounts owed to creditors for items purchased
Liabilities 216 Unearned Service Fees from them. Amounts received from customers before the training services have been performed for them.
Stockholders' equity
300 310
Capital Stock Retained Earnings
The stockholders' investment in the business. The earnings retained in the business.
Dividends 320 Dividends The amount of dividends declared to stockholders. Revenues 400 Service Revenue Amounts earned by performing training services for customers.
505 Advertising Expense The cost of advertising incurred in the current period.
506 Gas and Oil Expense The cost of gas and oil used in trucks in the
Expenses current period.
] 507 Salaries Expense The amount of salaries incurred in the current period.
511 Utilities Expense The cost of utilities incurred in the current period.
Notice the gaps left between account numbers (100, 103, 107, etc.). These gaps allow the firm to later add new
accounts between the existing accounts.
To begin, a transaction must be journalized. Journalizing is the process of entering the effects of a transaction
in a journal. Then, the information is transferred, or posted, to the proper accounts in the ledger. Posting is the
process of recording in the ledger accounts the information contained in the journal. We explain posting in more
detail later in the chapter.
In the following example, notice that each business transaction affects two or more accounts in the ledger. Also
note that the transaction date in both the general journal and the general ledger accounts is the same. In the ledger
accounts, the date used is the date that the transaction was recorded in the general journal, even if the entry is not
posted until several days later. Our example shows the journal entries posted to T-accounts. In practice, firms post
journal entries to ledger accounts, as we show later in the chapter.
Accountants use the accrual basis of accounting. Under the accrual basis of accounting, they recognize
revenues when the company makes a sale or performs a service, regardless of when the company receives the cash.
They recognize expenses as incurred, whether or not the company has paid out cash. Chapter 3 discusses the
accrual basis of accounting in more detail.
In the following MicroTrain Company example, transaction 1 increases (debits) Cash and increases (credits)
Capital Stock by USD 50,000. First, MicroTrain records the transaction in the general journal; second, it posts the
entry to the accounts in the general ledger.
Transaction 1:2010 Nov. 28 Stockholders invested $50,000 and formed MicroTrain Company. General Journal Date Account Titles and Explanation Post.
Ref. Debit Credit
2010 Nov. 28 Cash (+A) 100 5 0 0 0 0
Capital Stock (+SE) 300 5 0 0 0 0
Stockholders invested $50,000 cash in business.
General Ledger
Cash Capital Stock
(Dr.) Acct. No. 100 (Cr.) (Dr.) Acct. No. 300 (Cr.) 2010 2010
Nov. 28 50,000 Nov. 28 50,000
Accounting Principles: A Business Perspective 77 A Global Text
2. Recording business transactions
No other transactions occurred in November. The company prepares financial statements at the end of each
month. Exhibit 5 shows the company's balance sheet at 2010 November 30.
The balance sheet reflects ledger account balances as of the close of business on 2010 November 30. These
closing balances are the beginning balances on 2010 December 1. The ledger accounts show these closing balances
as beginning balances (Beg. bal.).
Now assume that in December 2010, MicroTrain Company engaged in the following transactions. We show the
proper recording of each transaction in the journal and then in the ledger accounts (in T-account form), and
describe the effects of each transaction.
MICROTRAIN COMPANY Balance Sheet 2010 November 30
Assets Liabilities and Stockholders' Equity
Cash $50,000 Stockholders' equity:
Capital stock $50,000
Total Assets $50,000 Total liabilities and stockholders' equity $50,000
Exhibit 9: Balance sheet
Transaction 2: Dec. 1 Paid cash for four small trucks, $40,000. General Journal
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Dec. 1 Trucks (+A) 150 4 0 0 0 0 (A)
Cash (-A) 100 4 0 0 0 0 (B)
To record the purchase of four trucks.
General Ledger
Trucks
(Dr.) Acct. No. 150 (Cr.) 2010 Dec. 1 (A)40,000
Cash
(Dr.) Acct. No. 100 (Cr.) 2010 Dec. 1 Beg. bal.
50,000 2010 Dec. 1
(B)40,0
00 Transaction 3: Dec. 1 Paid cash for insurance on the trucks to cover a one-year period from this date. General Journal
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Dec. 1 Prepaid Insurance (+A) 108 2 4 0 0
Cash (-A) 100 2 4 0 0
Purchased truck insurance to cover a one-year period.
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General Ledger
Prepaid Insurance
(Dr) Acct. No. 108 (Cr) 2010 Dec. 1
2,400
Cash
(Dr) Acct. No. 100 (Cr.) 2010 Dec. 1 Beg. Bal
50,000 2010 Dec. 1 Dec. 1
40,000 2,40
Effects of transaction
An asset, prepaid insurance, increases (debited); and an asset, cash, decreases (credited) by USD 2,400. The debit
is to Prepaid Insurance rather than Insurance Expense because the policy covers more than the current accounting
period of December (insurance policies are usually paid one year in advance). As you will see in Chapter 3, prepaid
items are expensed as they are used. If this insurance policy was only written for December, the entire USD 2,400
debit would have been to Insurance Expense.
Transaction 4: Dec. 1 Rented a building and paid $1,200 to cover a three-month period from this date. General Journal
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Dec. 1 Prepaid Rent (+A) 112 1 2 0 0
Cash (-A) 100 1 2 0 0
Paid three months' rent on a building.
General Ledger
Prepaid Rent
(Dr.) Acct. No. 112 (Cr) 2010
Dec. 1 1,200
Cash (Dr.) Acct. No. 100 (Cr.) 2010 2010
Dec. 1 Beg. Bal. 50,000 Dec. 1 40,000 Dec. 1 2,400
Dec. 1 1,200
Effects of transaction
An asset, prepaid rent, increases (debited); and another asset, cash, decreases (credited) by USD 1,200. The
debit is to Prepaid Rent rather than Rent Expense because the payment covers more than the current month. If the
payment had just been for December, the debit would have been to Rent Expense.
Transaction 5: Dec. 4 Purchased $1,400 of training supplies on account to be used over the next several months. General Journal Date Account Titles and Explanation Post.
Ref. Debit Credit
2010 Dec. 4 Supplies on Hand (+A) 107 1 4 0 0
Accounts Payable (+L) 200 1 4 0 0
To record the purchases of training supplies for future use.
General Ledger
Accounting Principles: A Business Perspective 79 A Global Text
2. Recording business transactions
Supplies on Hand
(Dr.) Acct. No. 107 (Cr) 2010
Dec. 4 1,400
Accounts Payable (Dr.) Acct. No. 200 (Cr.)
2010
Dec. 4 1,400
Effects of transaction
An asset, supplies on hand, increases (debited); and a liability, accounts payable, increases (credited) by USD
1,400. The debit is to Supplies on Hand rather than Supplies Expense because the supplies are to be used over
several accounting periods.
In each of the three preceding entries, we debited an asset rather than an expense. The reason is that the
expenditure applies to (or benefits) more than just the current accounting period. Whenever a company will not
fully use up an item such as insurance, rent, or supplies in the period when purchased, it usually debits an asset. In
practice, however, sometimes the expense is initially debited in these situations.
Companies sometimes buy items that they fully use up within the current accounting period. For example,
during the first part of the month a company may buy supplies that it intends to consume fully during that month.
If the company fully consumes the supplies during the period of purchase, the best practice is to debit Supplies
Expense at the time of purchase rather than Supplies on Hand. This same advice applies to insurance and rent. If a
company purchases insurance that it fully consumes during the current period, the company should debit
Insurance Expense at the time of purchase rather than Prepaid Insurance. Also, if a company pays rent that applies
only to the current period, Rent Expense should be debited at the time of purchase rather than Prepaid Rent. As
illustrated in Chapter 3, following this advice simplifies the procedures at the end of the accounting period.
Transaction 6: Dec. 7 Received $4,500 from a customer in payment for future training services. General Journal Date Account Titles and Explanation Post.
Ref. Debit Credit
2010 Dec. 7 Cash (+A) 100 4 5 0 0
Unearned Service Fees (+L) 216 4 5 0 0
To record the receipt of cash from a customer in payment
for future training services.
General Ledger Cash
(Dr.) Acct. No. 100 (Cr) 2010 2010
Dec. 1 Beg Bal 50,000 Dec. 1 40,000 Dec. 7 4,500 Dec. 1 2,400
Dec. 1 1,200
Unearned Service Fees
(Dr.) Acct. No. 216 (Cr.) 2010
Dec. 7 4,500
Effects of transaction
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An asset, cash, increases (debited); and a liability, unearned service revenue, increases (credited) by USD 4,500.
The credit is to Unearned Service Fees rather than Service Revenue because the USD 4,500 applies to more than
just the current accounting period. Unearned Service Fees is a liability because, if the services are never performed,
the USD 4,500 will have to be refunded. If the payment had been for services to be provided in December, the
credit would have been to Service Revenue.
Transaction 7: Dec. 15 Performed training services for a customer for cash, $5,000. General Journal
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Dec. 15 Cash (+A) 100 5 0 0 0
Service Revenue (+SE) 400 5 0 0 0
To record the receipt of cash for performing training
services for a customer.
General Ledger
Cash
(Dr.) Acct. No. 100 (Cr) 2010 2010
Dec. 1 Beg Bal. 50,000 Dec. 1 40,000 Dec. 7 4,500 Dec. 1 2,400 Dec. 15 5,000 Dec. 1 1,200 Service Revenue
(Dr.) Acct. No. 400 (Cr.) 2010
Dec. 15 5,000
Effects of transaction
An asset, cash, increases (debited); and a revenue, service revenue, increases (credited) by USD 5,000.
Transaction 8: Dec. 17 Paid the $1,400 account payable resulting from the transaction of December 4. General Journal Date Account Titles and Explanation Post.
Ref. Debit Credit
2010 Dec. 17 Accounts Payable (-L) 200 1 4 0 0
Cash (-A) 100 1 4 0 0
Paid the account payable arising from the purchase of
Supplies on December 4.
General Ledger
Accounts Payable
(Dr.) Acct. No. 200 (Cr) 2010 2010 Dec. 17 1,400 Dec. 4 1,400
Cash
(Dr.) Acct. No. 100 (Cr.) 2010 2010 Dec. 1 Beg Bal. 50,000 Dec. 1 40,000 Dec. 7 4,500 Dec. 1 2,400 Dec. 15 5,000 Dec. 1 1,200
Dec 17 1,400
Effects of transaction
Accounting Principles: A Business Perspective 81 A Global Text
2. Recording business transactions
A liability, accounts payable, decreases (debited); and an asset, cash, decreases (credited) by USD 1,400.
Transaction 9: Dec. 20 Billed a customer for training services performed, $5,700. General Journal
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Dec. 20 Accounts Receivable (+A) 103 5 7 0 0
Service Revenue (+SE) 400 5 7 0 0
To record the performance of training services on account
for which a customer was billed.
General Ledger
Accounts Receivable
(Dr.) Acct. No. 103 (Cr) 2010
Dec. 20 5,700 Service Revenue
(Dr.) Acct. No. 400 (Cr.) 2010
Dec. 15 5,000
Dec. 20 5,700
Effects of transaction
An asset, accounts receivable, increases (debited); and a revenue, service revenue, increases (credited) by USD
5,700.
Transaction 10: Dec. 24 Received a bill for advertising in a local newspaper in December, $50.
General Journal
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Dec. 24 Advertising Expense (-SE) 505 5 0
Accounts Payable (+L) 200 5 0
Received a bill for advertising for the month of December.
General Ledger
Advertising Expense
(Dr.) Acct. No. 505 (Cr)
2010
Dec. 24 50 (Dr.) Accounts Payable
Acct. No. 200 (Cr.)
2010 2010 Dec. 17 1,400 Dec. 4 1,400
Dec. 24 50
Effects of transaction
An expense, advertising expense, increases (debited); and a liability, accounts payable, increases (credited) by
USD 50. The reason for debiting an expense rather than an asset is because all the cost pertains to the current
accounting period, the month of December. Otherwise, Prepaid Advertising (an asset) would have been debited.
Transaction 11: Dec. 26 Received $500 on accounts receivable from a customer. General Journal
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Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Dec. 26 Cash (+A) 100 5 0 0
Accounts Receivable (-A) 103 5 0 0
Received $500 from a customer on accounts receivable
General Ledger Cash (Dr.) Acct. No. 100 (Cr) 2010 2010 Dec. 1 Beg Bal. 50,000 Dec. 1 40,000 Dec. 7 4,500 Dec. 1 2,400 Dec. 15 5,000 Dec. 1 1,200 Dec. 26 500 Accounts
Dec. 17 1,400 Receivable
(Dr.) Acct. N o. 103 (Cr.) 2010 2010 Dec. 20 5,700 Dec. 26 500
Effects of transaction
One asset, cash, increases (debited); and another asset, accounts receivable, decreases (credited) by USD 500.
Transaction 12: Dec. 28 Paid salaries of $3,600 to training personnel for the first four weeks of December. (Payroll and other deductions are to be ignored since they have not yet been discussed.)
General Journal
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Dec. 28 Salaries Expense (-SE) 507 3 6 0 0
Cash (-A) 100 3 6 0 0
Paid training personnel salaries for the first four weeks of
December.
General Ledger
Salaries Expense
(Dr.) Acct. No. 507 (Cr) 2010
Dec. 28
3,600
Cash
(Dr.) Acct. No. 100 (Cr.) 2010 2010
Dec. 1
50,000 Dec. 1 40,000
Dec. 7
4,500 Dec. 1 2,400
Dec. 15
5,000 Dec. 1 1,200
Dec. 26
500 Dec. 17 1,400
Dec. 28 3,600
Effects of transaction
An expense, salaries expense, increases (debited); and an asset, cash, decreases (credited) by USD 3,600.
Transaction 13: Dec. 29 Received and paid the utilities bill for December, $150. General Journal
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Dec. 29 Utilities Expense (-SE) 511 1 5 0
Cash (+A) 100 1 5 0
Accounting Principles: A Business Perspective 83 A Global Text
2. Recording business transactions
Paid the utilities bill for December.
General Ledger
Utilities Expense
(Dr.) Acct. No. 511 (Cr) 2010
Dec. 29
150
Cash
(Dr.) Acct. No. 100 (Cr.) 2010 2010
Dec. 1
50,000 Dec. 1
40,000
Dec. 7
4,500 Dec. 1
2,400
Dec. 15
5,000 Dec. 1
1,200
Dec. 26
500 Dec. 17
1,400
Dec. 28
3,600
Dec. 29 150
Effects of transaction
An expense, utilities expense, increases (debited); and an asset, cash, decreases (credited) by USD 150.
Transaction 14: Dec. 30 Received a bill for gas and oil used in the trucks for December, $680. General Journal
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Dec. 30 Gas and Oil Expense (-SE) 506 6 8 0
Accounts Payable (+L) 200 6 8 0
Received a bill for gas and oil used in the trucks for
December.
General Ledger
Gas and Oil Expense
(Dr.) Acct. No. 506 (Cr) 2010
Dec. 30
680
Accounts Payable (Dr.) Acct. No. 200 (Cr.) 2010 2010
Dec. 17
1,400 Dec. 4 1,400
Dec.24 50
Dec. 30 680
Effects of transaction
An expense, gas and oil expense, increases (debited); and a liability, accounts payable, increases (credited) by
USD 680.
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Transaction 15: Dec. 31 A dividend of $3,000 was paid to stockholders. General Journal
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Dec. 31 Dividends (-SE) 320 3 0 0 0
Cash (-A) 100 3 0 0 0
Dividends were paid to stockholders.
General Ledger
Dividends
(Dr.) Acct. No. 320 (Cr) 2010
Dec. 31 3,000
Cash
(Dr.) Acct. No. 100 (Cr.) 2010 2010
Dec. 1 Beg Bal. 50,000 Dec. 1 40,000 Dec. 7 4,500 Dec. 1 2,400 Dec. 15 5,000 Dec. 1 1,200 Dec. 26 500 Dec. 17 1,400
Dec. 28 3,600
Dec. 29 150
Dec. 31 3,000
Effects of transaction
The Dividends account increases (debited); and an asset, cash, decreases (credited) by USD 3,000.
Transaction 15 concludes the analysis of the MicroTrain Company transactions. The next section discusses and
illustrates posting to ledger accounts and cross-indexing.
An accounting perspective:
Uses of technology
The concept of the Internet dates to the 1960s when the military tied together several computers
forming a "network" that allowed users to communicate with each other instantaneously on their
computers over many miles.
Then universities and scientific institutions connected to the network to meet their research and
communication needs. More and more organizations hooked up to the network over time. Today
many companies seek customers and employees over the Internet. Students and faculty use the
Internet to perform research, communicate with their colleagues (using e-mail), and search distant
libraries. Accountants in practice are heavy users of the Internet to locate company data, tax
regulations, and almost any other information they need. You will find that learning to use the
Internet effectively is essential to your future success.
Accounting Principles: A Business Perspective 85 A Global Text
2. Recording business transactions
The use of ledger accounts
A journal entry is like a set of instructions. The carrying out of these instructions is known as posting. As stated
earlier, posting is recording in the ledger accounts the information contained in the journal. A journal entry directs
the entry of a certain dollar amount as a debit in a specific ledger account and directs the entry of a certain dollar
amount as a credit in a specific ledger account. Earlier, we posted the journal entries for MicroTrain Company to T-
accounts. In practice, however, companies post these journal entries to ledger accounts.
Using a new example, Jenks Company, we illustrate posting to ledger accounts. Later, we show you how to post
the MicroTrain Company journal entries to ledger accounts.
In Exhibit 10, the first journal entry for the Jenks Company directs that USD 10,000 be posted in the ledger as a
debit to the Cash account and as a credit to the Capital Stock account. We post the debit in the general ledger Cash
account by using the following procedure: Enter in the Cash account the date, a short explanation, the journal
designation ("G" for general journal) and the journal page number from which the debit is posted, and the USD
10,000 in the Debit column. Then, enter the number of the account to which the debit is posted in the Posting
Reference column of the general journal. Post the credit in a similar manner but as a credit to Account No. 300. The
arrows in Exhibit 10 show how these amounts were posted to the correct accounts.
Exhibit 10 shows the ledger account. In contrast to the two-sided T-account format shown so far, the three-
column format has columns for debit, credit, and balance. The three-column form has the advantage of showing the
balance of the account after each item has been posted. In addition, in this chapter, we indicate whether each
balance is a debit or a credit. In later chapters and in practice, the nature of the balance is usually not indicated
since it is understood. Also, notice that we give an explanation for each item in the ledger accounts. Often
accountants omit these explanations because each item can be traced back to the general journal for the
explanation.
Posting is always from the journal to the ledger accounts. Postings can be made (1) at the time the transaction is
journalized; (2) at the end of the day, week, or month; or (3) as each journal page is filled. The choice is a matter of
personal taste. When posting the general journal, the date used in the ledger accounts is the date the transaction
was recorded in the journal, not the date the journal entry was posted to the ledger accounts.
Frequently, accountants must check and trace the origin of their transactions, so they provide cross-indexing.
Cross-indexing is the placing of (1) the account number of the ledger account in the general journal and (2) the
general journal page number in the ledger account. As shown in Exhibit 10, the account number of the ledger
account to which the posting was made is in the Posting Reference column of the general journal. Note the arrow
from Account No. 100 in the ledger to the 100 in the Posting Reference column beside the first debit in the general
journal. Accountants place the number of the general journal page from which the entry was posted in the Posting
Reference column of the ledger account. Note the arrow from page 1 in Exhibit 10 the general journal to G1 in the
Posting Reference column of the Cash account in the general ledger. The notation "G1" means general journal, page
1. The date of the transaction also appears in the general ledger. Note the arrows from the date in the general
journal to the dates in the general ledger.
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Page 1 JENKS COMPANY General Journal
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Jan. 1(B) Cash (+A) (C)100 1 0 0 0 0 (A)
Capital Stock (+SE) 300 1 0 0 0 0 (D)
Stockholders invested $10,000 cash in the business.
5 Cash (+A) 100 5 0 0 0
Notes Payable (+L) 201 5 0 0 0
Borrowed $5,000 from the bank on a note.
:- General Ledger Cash Account No 100(C)
Explanation Post Ref.
Debt Credit Balance
2010 -Jan. (B)1 Stockholders investment G1 (A) 1 0 0 0 0 1 0 0 0 0 Dr
5 Bank loan G1 5 0 0 0 1 5 0 0 0 Dr
Notes Payable Account No. 201
Date Explanation Post Ref.
Debt Credit Balance
2010 Jan. 5 Borrowed cash G1 5 0 0 0 5 0 0 0 Cr
Capital Stock Account No. 300 Explanation Post
Ref. Debt Credit Balance
2010 " Jan.
(B)1 Cash from stockholders G1 ( D )
1 0 0 0 0 1 0 0 0 0 Cr
Exhibit 10: General journal and general ledger; posting and cross-indexing
Cross-indexing aids the tracing of any recorded transaction, either from general journal to general ledger or
from general ledger to general journal. Normally, they place cross-reference numbers in the Posting Reference
column of the general journal when the entry is posted. If this practice is followed, the cross-reference numbers
indicate that the entry has been posted.
MICROTRAIN COMPANY General Journal
Page1
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Nov. 28 Cash (+A) 100* 5 0 0 0 0
Capital Stock (+SE) 300 5 0 0 0 0
Stockholders invested $50,000 cash in the business.
Accounting Principles: A Business Perspective 87 A Global Text
2. Recording business transactions
Dec 1 Truck (+A) 150 4 0 0 0 0
Cash (-A) 100 4 0 0 0 0
To record the purchase of four trucks.
1 Prepaid Insurance (+A) 108 2 4 0 0
Cash (-A) 100 2 4 0 0
Purchased truck insurance to cover a one-year period.
1 Prepaid Rent (+A) 112 1 2 0 0
Cash (-A) 100 1 2 0 0
Paid three months' rent on a building.
4 Supplies on Hand (+A) 107 1 4 0 0
Accounts Payable (+L) 200 1 4 0 0
To record the purchase of training supplies for future use.
7 Cash (+A) 100 4 5 0 0
Unearned Service Fees (+L) 216 4 5 0 0
To record the receipt of cash from a customer in payment
for future training services.
15 Cash (+A) 100 5 0 0 0
Service Revenue (+SE) 400 5 0 0 0
To record the receipt of cash for performing training
services for a customer.
17 Accounts Payable (-L) 200 1 4 0 0
Cash (-A) 100 1 4 0 0
Paid the account payable arising from the purchase of
supplies on December 4.
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General Journal
Page 2
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Dec. 20 Accounts Receivable (+A) 103 5 7 0 0
Service Revenue (+SE) 400 5 7 0 0
To record the performance of training services on account
for which a customer was billed.
24 Advertising Expense (-SE) 505 5 0
Accounts Payable (+L) 200 5 0
Received a bill for advertising for the month of December.
26 Cash (+A) 100 5 0 0
Accounts Receivable (-A) 103 5 0 0
Received $500 from a customer on accounts receivable.
28 Salaries Expense (-SE) 507 3 6 0 0
Cash (-A) 100 3 6 0 0
Paid training personnel salaries for the first four weeks
of December.
29 Utilities Expense (-SE) 511 1 5 0
Cash (-A) 100 1 5 0
Paid the utilities bill for December.
30 Gas and Oil Expense (-SE) 506 6 8 0
Accounts Payable (-A) 200 6 8 0
Received a bill for gas and oil used in the trucks for
December.
31 Dividends (-SE) 320 3 0 0 0
Cash (-A) 100 3 0 0 0
Dividends were paid to stockholders.
Exhibit 11: General journal (after posting)
To understand the posting and cross-indexing process, trace the entries from the general journal to the general
ledger. The ledger accounts need not contain explanations of all the entries, since any needed explanations can be
obtained from the general journal.
Look at Exhibit 11 to see how all the November and December transactions of MicroTrain Company would be
journalized. As shown in Exhibit 11, you skip a line between journal entries to show where one journal entry ends
and another begins. This procedure is standard practice among accountants. Note that no dollar signs appear in
journals or ledgers. When amounts are in even dollar amounts, accountants leave the cents column blank or use
zeros or a dash. When they use lined accounting work papers, commas or decimal points are not needed to record
an amount. When they use unlined paper, they add both commas and decimal points.
Accounting Principles: A Business Perspective 89 A Global Text
2. Recording business transactions
Next, observe Exhibit 12, the three-column general ledger accounts of MicroTrain Company after the journal
entries have been posted. Each ledger account would appear on a separate page in the ledger. Trace the postings
from the general journal to the general ledger to make sure you know how to post journal entries.
All the journal entries illustrated so far have involved one debit and one credit; these journal entries are called
simple journal entries. Many business transactions, however, affect more than two accounts. The journal entry
for these transactions involves more than one debit and/or credit. Such journal entries are called compound
journal entries.
As an illustration of a compound journal entry, assume that on 2011 January 2, MicroTrain Company purchased
USD 8,000 of training equipment from Wilson Company. See below.
MICROTRAIN COMPANY
General Ledger
Cash Account No. 100
Date Explanation Post Ref.
Debit Credit Balance
2010 Dec. 1 Beginning balance* 5 0 0 0 0 Dr
1 Trucks G1 4 0 0 0 0 1 0 0 0 0 Dr
1 Prepaid insurance G1 2 4 0 0 7 6 0 0 Dr
1 Prepaid rent G1 1 2 0 0 6 4 0 0 Dr
7 Unearned service fees G1 4 5 0 0 1 0 9 0 0 Dr
15 Service revenue G1 5 0 0 0 1 5 9 0 0 Dr
17 Paid account payable G1 1 4 0 0 1 4 5 0 0 Dr
26 Collected account receivable G2 5 0 0 1 5 0 0 0 Dr
28 Salaries G2 3 6 0 0 1 1 4 0 0 Dr
29 Utilities G2 1 5 0 1 1 2 5 0 Dr
31 Dividends G2 3 0 0 0 8 2 5 0 Dr
Accounts Receivable Account No. 103
Date Explanation Post Ref.
Debit Credit Balance
2010 Dec. 20 Service revenue G2 5 7 0 0 5 7 0 0 Dr
26 Collections G2 5 0 0 5 2 0 0 Dr
Supplies on Hand Account No. 107
Date Explanation Post Ref.
Debit Credit Balance
2010 Dec. 4 Purchased on account G1 1 4 0 0 1 4 0 0 Dr
Prepaid Insurance Account No. 108
Date Explanation Post Ref.
Debit Credit Balance
2010 Dec. 1 One-year policy on trucks G1 2 4 0 0 2 4 0 0 Dr
General Ledger Page 1 Prepaid Rent Account No. 112
Date Explanation Post Ref.
Debit Credit Balance
2010 Dec. 1 Three-month payment G1 1 2 0 0 1 2 0 0 Dr
Trucks Account No. 150
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Date Explanation Post Ref.
Debit Credit Balance
2010 Dec. 1 Paid cash G1 4 0 0 0 0 4 0 0 0 0 Dr
Accounts Payable Account No. 200
Date Explanation Post Ref.
Debit Credit Balance
2010 Dec. 4 Supplies G1 1 4 0 0 1 4 0 0 Cr
17 Paid for supplies G1 1 4 0 0 - 0 -
24 Advertising G2 5 0 5 0 Cr
30 Gas and oil G2 6 8 ) 7 3 0 Cr
Unearned Service Fees Account No. 216
Date Explanation Post Ref.
Debit Credit Balance
2010 Dec. 7 Received cash G1 4 5 0 0 4 5 0 0 Cr
Capital Stock Account No. 300
Date Explanation Post Ref.
Debit Credit Balance
2010 Dec. 1 Beginning balance 5 0 0 0 0 Cr
Accounting Principles: A Business Perspective 91 A Global Text
2. Recording business transactions
General Ledger Page 3 Dividends Account No. 320
Date Explanation Post Ref.
Debt Credit Balance
2010 Dec. 31 Cash G2 3 0 0 0 3 0 0 0 Dr
Service Revenue Account No. 400
Date Explanation Post Ref.
Debt Credit Balance
2010 Dec. 15 Cash G1 5 0 0 0 5 0 0 0 Cr
20 On account G2 5 7 0 0 1 0 7 0 0 Cr
Advertising Expense Account No. 505
Date Explanation Post Ref.
Debt Credit Balance
2010 Dec. 24 On account G2 5 0 5 0 Dr
Gas and Oil Expense Account No. 506
Date Explanation Post Ref.
Debt Credit Balance
2010 Dec. 30 On account G2 6 8 0 6 8 0 Dr
Salaries Expense Account No. 507
Date Explanation Post Ref.
Debt Credit Balance
2010 Dec. 28 Cash paid G2 3 6 0 0 3 6 0 0 Dr
Utilities Expense Account No. 511
Date Explanation Post Ref.
Debt Credit Balance
2010 Dec. 29 Cash paid G2 1 5 0 1 5 0 Dr
Exhibit 12: General ledger - Extended illustration
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MICROTRAIN COMPANY Trial Balance
December 31, 2010 Acct.
No. Account Title Debits Credits 100 Cash $ 8,250
103 Accounts Receivable 5,200
107 Supplies on Hand 1,400
108 Prepaid Insurance 2,400
112 Prepaid Rent 1,200
150 Trucks 40,000
200 Accounts Payable $ 730
216 Unearned Service Fees 4,500
300 Capital Stock 50,000
320 Dividends 3,000
400 Service Revenue 10,700
505 Advertising Expense 50
506 Gas and Oil Expense 680
507 Salaries Expense 3,600
511 Utilities Expense 150
Exhibit 13: Trail balance
MicroTrain paid USD 2,000 cash with the balance due on 2011 March 3. The general journal entry for
MicroTrain Company is:
Debit Credit
2011
Jan. 2 Equipment (+A) 8,000
Cash (-A) 2,000
Accounts Payable (+L) 6,000
Training equipment purchased from Wilson Company.
Note that the firm credits two accounts, Cash and Accounts Payable, in this one entry. However, the dollar totals
of the debits and credits are equal.
Periodically, accountants use a trial balance to test the equality of their debits and credits. A trial balance is a
listing of the ledger accounts and their debit or credit balances to determine that debits equal credits in the
recording process. The accounts appear in this order: assets, liabilities, stockholders' equity, dividends, revenues,
and expenses. Within the assets category, the most liquid (closest to becoming cash) asset appears first and the
least liquid appears last. Within the liabilities, those liabilities with the shortest maturities appear first. Study
Exhibit 13, the trial balance for MicroTrain Company. Note the listing of the account numbers and account titles on
the left, the column for debit balances, the column for credit balances, and the equality of the two totals.
When the trial balance does not balance, try re-totaling the two columns. If this step does not locate the error,
divide the difference in the totals by 2 and then by 9. If the difference is divisible by 2, you may have transferred a
debit-balanced account to the trial balance as a credit, or a credit-balanced account as a debit. When the difference
is divisible by 2, look for an amount in the trial balance that is equal to one-half of the difference. Thus, if the
difference is USD 800, look for an account with a balance of USD 400 and see if it is in the wrong column.
If the difference is divisible by 9, you may have made a transposition error in transferring a balance to the trial
balance or a slide error. A transposition error occurs when two digits are reversed in an amount (e.g. writing 753 as
Accounting Principles: A Business Perspective 93 A Global Text
2. Recording business transactions
573 or 110 as 101). A slide error occurs when you place a decimal point incorrectly (e.g. USD 1,500 recorded as USD
15.00). Thus, when a difference is divisible by 9, compare the trial balance amounts with the general ledger account
balances to see if you made a transposition or slide error in transferring the amounts.
An ethical perspective:
Financial Deals, Inc.
Larry Fisher was captain of the football team at Prestige University. Later, he earned a master's
degree in business administration with a concentration in accounting.
Upon graduation, Larry accepted a position with Financial Deals, Inc., in the accounting and
finance division. At first, things were going smoothly. He was tall, good looking, and had an
outgoing personality. The president of the company took a liking to him. However, Larry was
somewhat bothered when the president started asking him to do some things that were slightly
unethical. When he protested mildly, the president said: "Come on, son, this is the way the business
world works. You have great potential if you don't let things like this get in your way."
As time went on, Larry was asked to do things that were more unethical, and finally he was
performing illegal acts. When he resisted, the president appealed to his loyalty and asked him to be
a team player. The president also promised Larry great wealth sometime in the future. Finally,
when he was told to falsify some financial statements by making improper entries and to sign some
documents containing material errors, the president supported his request by stating: "You are in
too deep now to refuse to cooperate. If I go down, you are going with me." Through various
company schemes, Larry had convinced some friends and relatives to invest about USD 10 million.
Most of this would be lost if the various company schemes were revealed.
Larry could not sleep at night and began each day with a pain in his stomach and by becoming
physically ill. He was under great strain and believed that he could lose his mind. He also heard that
the president had a shady past and could become violent in retaliating against his enemies. If Larry
blows the whistle, he believes he will go to prison for his part in the schemes. (Note: This scenario is
based on an actual situation with some facts changed to protect the guilty.)
If you still cannot find the error, it may be due to one of the following causes:
• Failing to post part of a journal entry.
• Posting a debit as a credit, or vice versa.
• Incorrectly determining the balance of an account.
• Recording the balance of an account incorrectly in the trial balance.
• Omitting an account from the trial balance.
• Making a transposition or slide error in the accounts or the journal.
Usually, you should work backward through the steps taken to prepare the trial balance. Assuming you have
already re-totaled the columns and traced the amounts appearing in the trial balance back to the general ledger
account balances, use the following steps: Verify the balance of each general ledger account, verify postings to the
general ledger, verify general journal entries, and then review the transactions and possibly the source documents.
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The equality of the two totals in the trial balance does not necessarily mean that the accounting process has been
error-free. Serious errors may have been made, such as failure to record a transaction, or posting a debit or credit to
the wrong account. For instance, if a transaction involving payment of a USD 100 account payable is never
recorded, the trial balance totals still balance, but at an amount that is USD 100 too high. Both cash and accounts
payable would be overstated by USD 100.
You can prepare a trial balance at any time—at the end of a day, a week, a month, a quarter, or a year. Typically,
you would prepare a trial balance before preparing the financial statements.
An accounting perspective:
Uses of technology
The computers of persons in a given department or building are frequently connected in a Local
Area Network (LAN). These persons can then access simultaneously the programs and databases
stored in the LAN and can communicate with all other persons in the LAN through email. A more
advanced type of computer network is called Client/Server Computing. Under this structure, any
computer in the network can be used to update the information stored elsewhere in the network.
For example, accounting information stored in one computer could be updated by authorized
persons from a number of other computers in the system. The use of networks is designed to
improve efficiency and to reduce software and hardware costs.
Analyzing and using the financial results— Horizontal and vertical analyses
The calculation of dollar and/or percentage changes from one year to the next in an item on financial statements
is horizontal analysis. For instance, in the following data taken from the 2000 annual report of Hewlett-Packard
Company, the amount of inventory increased by USD 836 million from 1999 October 31, to 2000 October 31. This
amount represented a 17 per cent increase. To find the amount of the increase or decrease, subtract the 1999
amount from the 2000 amount. To find the percentage change, divide the increase or decrease by the 1999 amount.
Knowing the dollar amount and percentage of change in an amount is much more meaningful than merely
knowing the amount at one point in time. By analyzing the data, we can see that cash and cash equivalents declined
in 2000. Their decline at least partially explains the increases in some of the other current assets. We can also see
that the company invested in property, plant and equipment. Any terms in Hewlett-Packard's list of assets that you
do not understand are explained in later chapters. At this point, all we want you to understand is the nature of
horizontal and vertical analyses.
Vertical analysis shows the percentage that each item in a financial statement is of some significant total such
as total assets or sales. For instance, in the Hewlett-Packard data we can see that cash and cash equivalents were
15.3 per cent of total assets as of 1999 October 31, and had declined to 10.0 per cent of total assets by 2000 October
31. Total current assets (cash plus other amounts that will become cash or be used up within one year) increased
from 61.3 per cent of total assets to 68.3 per cent during 2000. Long-term investments and other non-current
assets accounted for 18.4 per cent of total assets as of 2000 October 31.
Increase or Percent of
Accounting Principles: A Business Perspective 95 A Global Text
2. Recording business transactions
(Decrease) Total Assets
2000 over 1999 October 31
2000 1999 Dollars Percent 2000 1999
Assets (in millions)
Current assets:
Cash and cash equivalents $ 3,415 $ 5,411 $ (1,996) -37% 10.0% 15.3% Short-term investments 592 179 413 231% 1.7% 0.5% Accounts receivable 6,394 5,958 436 7% 18.8% 16.9% Financing receivables 2,174 1,889 285 15% 6.4% 5.4% Inventory 5,699 4,863 836 17% 16.8% 13.8% Other current assets 4,970 3,342 1,628 49% 14.6% 9.5% Total current assets $ 23,244 $ 21,642 $ 1,602 7% 68.3% 61.3% Property, plant and equipment:
Property, plant and equipment, net 4,500 4,333 167 4% 13.2% 12.3% Long-term investments and
other non-current assets 6,265 9,322 (3,057) -33% 18.4% 26.4% Total assets $ 34,009 $ 35,297 $ (1,288) -4% 100.0% 100.0%
Management performs horizontal and vertical analyses along with other forms of analysis to help evaluate the
wisdom of its past decisions and to plan for the future. Other data would have to be examined before decisions
could be made regarding the assets shown. For instance, if you discovered the liabilities that would have to be paid
within a short time by Hewlett-Packard were more than USD 30 billion, you might conclude that the company is
short of cash even though current assets increased substantially during 2000. We illustrate horizontal and vertical
analyses to a much greater extent later in the text.
An accounting perspective:
Business insight
Many companies have been restructuring their organizations and reducing the number of
employees to cut expenses. General Motors, AT&T, IBM, and numerous other companies have
taken this action. One could question whether companies place as much value on their employees
as in the past. In previous years it was common to see the following statement in the annual reports
of companies: "Our employees are our most valuable asset". Companies are not permitted to show
employees as assets on their balance sheets. Do you think they should be allowed to do so?
What you have learned in this chapter is basic to your study of accounting. The entire process of accounting is
based on the double-entry concept. Chapter 3 explains that adjustments bring the accounts to their proper balances
before accurate financial statements are prepared.
Understanding the learning objectives
• An account is a storage unit used to classify and summarize money measurements of business activities of a
similar nature.
• A firm sets up an account whenever it needs to provide useful information about a particular business item
to some party having a valid interest in the business.
• A T-account resembles the letter T.
• Debits are entries on the left side of a T-account.
• Credits are entries on the right side of a T-account.
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• Debits increase asset, expense, and Dividends accounts.
• Credits increase liability, stockholders' equity, and revenue accounts.
• Analyze transactions by examining source documents.
• Journalize transactions in the journal.
• Post journal entries to the accounts in the ledger.
• Prepare a trial balance of the accounts and complete the work sheet.
• Prepare financial statements.
• Journalize and post adjusting entries.
• Journalize and post closing entries. Prepare a post-closing trial balance.
• A journal contains a chronological record of the transactions of a business. An example of a general journal
is shown in Exhibit 11. Journalizing is the process of entering a transaction in a journal.
• Posting is the process of transferring information recorded in the journal to the proper places in the ledger.
• Cross-indexing is the placing of (1) the account number of the ledger account in the general journal and (2)
the general journal page number in the ledger account.
• An example of cross-indexing appears in Exhibit 10.
• A trial balance is a listing of the ledger accounts and their debit or credit balances.
• If the trial balance does not balance, an accountant works backward to discover the error.
• A trial balance is shown in Exhibit 13.
• Horizontal analysis involves calculating the dollar and/or percentage changes in an item from one year to
the next.
• Vertical analysis shows the percentage that each item in a financial statement is of some significant total.
Demonstration problem
Green Hills Riding Stable, Incorporated, had the following balance sheet on 2010 June 30:
GREEN HILLS RIDING STABLE, INCORPORATED Balance Sheet 2010 June 30
Assets
Cash $ 7,500
Accounts receivable 5,400
Land 40,000
Total assets $ 52,900
Liabilities and Stockholders' Equity Liabilities:
Accounts payable $ 800
Notes payable 40,000
Total liabilities $ 40,800
Stockholders' equity:
Capital stock $ 10,000
Retained earnings 2,100
Total stockholders' equity 12,100
Total liabilities and stockholders' equity $52,900
a. Prepare the journal entries to record the transactions for July 2010.
b. Post the journal entries to the ledger accounts after entering the beginning balances in those accounts. Insert
cross-indexing references in the journal and ledger. Use the following chart of accounts:
Accounting Principles: A Business Perspective 97 A Global Text
2. Recording business transactions
100 Cash 320 Dividends 103 Accounts Receivable 402 Horse Boarding Fees Revenue 130 Land 404 Riding and Lesson Fees Revenue 140 Buildings 507 Salaries Expense 200 Accounts Payable 513 Feed Expense 201 Notes Payable 540 Interest Expense 300 Capital Stock 568 Miscellaneous Expense 310 Retained Earnings
c. Prepare a trial balance.
Solution to demonstration problem
a.
GREEN HILLS RIDING STABLE, INCORPORATED General Journal
Page1 Date Account Titles and Explanation Post.
Ref. Debit Credit
2010 July 1 Cash (+A) 100 2 5 0 0 0
Capital Stock (+SE) 300 2 5 0 0 0
Additional capital stock issued.
1 Buildings (+A) 140 2 4 0 0 0
Cash (-A) 100 2 4 0 0 0
Paid for building.
8 Account Payable (-L) 200 8 0 0
Cash (-A) 100 8 0 0
Paid accounts payable.
10 Cash (+A) 100 5 4 0 0
Accounts Receivable (-A) 103 5 4 0 0
Collected accounts receivable.
12 Feed Expense (-SE) 513 1 1 0 0
Accounts Payable (+L) 200 1 1 0 0
Purchased feed on account
15 Accounts Receivable (+A) 103 4 5 0 0
Horse Boarding Fee Revenue (+SE) 402 4 5 0 0
Billed boarding fees for July.
24 Miscellaneous Expense (-SE) 568 8 0 0
Cash (-A) 100 8 0 0
Paid miscellaneous expenses for July.
31 Interest Expense (-SE) 540 2 0 0
Cash (-A) 100 2 0 0
Paid interest
31 Salaries Expense (-SE) 507 1 4 0 0
Cash (-A) 100 1 4 0 0
Paid salaries for July.
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31 Accounts Receivable (+A) 103 3 6 0 0
Riding and Lesson Fee Revenue (+SE) 404 3 6 0 0
Billed riding and lesson fees for July.
31 Dividends (-SE) 320 1 0 0 0
Cash (-A) 100 1 0 0 0
Paid a dividend to stockholders.
b. GREEN HILLS RIDING STABLE, INCORPORATED
General Ledger Land Account No. 100
Date Explanation Post Ref.
Debt Credit Balance
2010 June 30 Balance 7 5 0 0 0 Dr
July 1 Stockholders' investment G1 2 5 0 0 0 3 2 5 0 0 Dr
1 Buildings G1 2 4 0 0 0 8 5 0 0 Dr
8 Accounts payable G1 8 0 0 7 7 0 0 Dr
10 Accounts receivable G1 5 4 0 0 1 3 1 0 0 Dr
24 Miscellaneous expense G1 8 0 0 1 2 3 0 0 Dr
31 Interest expense G1 2 0 0 1 2 1 0 0 Dr
31 Salaries expense G1 1 4 0 0 1 0 7 0 0 Dr
31 Dividends G1 1 0 0 0 9 7 0 0 Dr
Accounts Receivable Account No. 103
Date Explanation Post Ref.
Debt Credit Balance
2010 June 30 Balance 5 4 0 0 Dr
July 10 Cash G1 5 4 0 0 - 0 -
15 Horse boarding fees G1 4 5 0 0 4 5 0 0 Dr
31 Riding and lessons fees G1 3 6 0 0 8 1 0 0 Dr
Land Account No. 130
Date Explanation Post Ref.
Debt Credit Balance
2010 June 30 Balance 4 0 0 0 0 Dr
Buildings Account No. 140
Date Explanation Post Ref.
Debt Credit Balance
2010 July 1 Cash G1 2 4 0 0 0 2 4 0 0 0 Dr
Accounts Payable Account No. 200
Date Explanation Post Ref.
Debt Credit Balance
2010 June 30 Balance 8 0 0 Cr
July 8 Cash G1 8 0 0 - 0 -
12 Feed expense G1 1 1 0 0 1 1 0 0 Cr
General Ledger (continued) Notes Payable Account No. 201
Accounting Principles: A Business Perspective 99 A Global Text
2. Recording business transactions
Date Explanation Post Ref.
Debt Credit Balance
2010 June 30 Balance 4 0 0 0 0 Cr
Capital Stock Account No. 300
Date Explanation Post Ref.
Debt Credit Balance
2010 June 30 Balance 1 0 0 0 0 Cr
July 1 Cash G1 2 5 0 0 0 3 5 0 0 0 Cr
Retained Earnings Account No. 310
Date Explanation Post Ref.
Debt Credit Balance
2010 June 30 Balance 2 1 0 0 Cr
Dividends Account No. 320
Date Explanation Post Ref.
Debt Credit Balance
2010 July 31 Cash G1 1 0 0 0 1 0 0 0 Dr
Horse Boarding Fee Revenue Account No. 402
Date Explanation Post Ref.
Debt Credit Balance
2010 July 15 Accounts receivable G1 4 5 0 0 4 5 0 0 Cr
Riding and Lesson Fee Revenue Account No. 404
Date Explanation Post Ref.
Debt Credit Balance
2010 July 31 Accounts receivable G1 3 6 0 0 3 6 0 0 Cr
General Ledger (concluded) Salaries Expense Account No. 507
Date Explanation Post Ref.
Debt Credit Balance
2010 July 31 Cash G1 1 4 0 0 1 4 0 0 Dr
Feed Expense Account No. 513
Date Explanation Post Ref.
Debt Credit Balance
2010 July 12 Accounts payable G1 1 1 0 0 1 1 0 0 Dr
Interest Expense Account No. 540
Date Explanation Post Ref.
Debt Credit Balance
2010 July 31 Cash G1 2 0 0 2 0 0 Dr
Miscellaneous Expense Account No. 568
Date Explanation Post Ref.
Debt Credit Balance
2010 July 24 Cash G1 8 0 0 8 0 0 Dr
c. GREEN HILLS RIDING STABLE, INCORPORATED
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Trial Balance
2010 July 31
Acct.
No. Account Title Debits Credits 100 Cash $ 9,700
103 Accounts Receivable 8,100
130 Land 40,000
140 Buildings 24,000
200 Accounts Payable $ 1,100
201 Notes Payable 40,000
300 Capital Stock 35,000
310 Retained Earnings 2,100
320 Dividends 1,000
402 Horse Boarding Fee Revenue 4,500
404 Riding and Lesson Fee Revenue 3,600
507 Salaries Expense 1,400
513 Feed Expense 1,100
540 Interest Expense 200
568 Miscellaneous Expense 800
$86,300 $86,300
Key terms Account A part of the accounting system used to classify and summarize the increases, decreases, and balances of each asset, liability, stockholders' equity item, dividend, revenue, and expense. The three-column account is normally used. It contains columns for debit, credit, and balance.
Accounting cycle A series of steps performed during the accounting period (some throughout the period and some at the end) to analyze, record, classify, summarize, and report useful financial information for the purpose of preparing financial statements.
Accrual basis of accounting Recognizes revenues when sales are made or services are performed, regardless of when cash is received. Recognizes expenses as incurred, whether or not cash has been paid out.
Business transactions Measurable events that affect the financial condition of a business.
Chart of accounts The complete listing of the account titles and account numbers of all of the accounts in the ledger; somewhat comparable to a table of contents.
Compound journal entry A journal entry with more than one debit and/or credit.
Credit The right side of any account; when used as a verb, to enter a dollar amount on the right side of an account; credits increase liability, stockholders' equity, and revenue accounts and decrease asset, expense, and Dividends accounts.
Credit balance The balance in an account when the sum of the credits to the account exceeds the sum of the debits to that account.
Cross-indexing The placing of (1) the account number of the ledger account in the general journal and (2) the general journal page number in the ledger account.
Debit The left side of any account; when used as a verb, to enter a dollar amount on the left side of an account; debits increase asset, expense, and Dividends accounts and decrease liability, stockholders' equity, and revenue accounts.
Debit balance The balance in an account when the sum of the debits to the account exceeds the sum of the credits to that account.
Double-entry procedure The accounting requirement that each transaction must be recorded by an entry that has equal debits and credits.
Horizontal analysis The calculation of dollar and/or percentage changes in an item on the financial statements from one year to the next.
Journal A chronological (arranged in order of time) record of business transactions; the simplest form of journal is the two-column general journal.
Accounting Principles: A Business Perspective 101 A Global Text
2. Recording business transactions
Journal entry Shows all of the effects of a business transaction as expressed in debit(s) and credit(s) and may include an explanation of the transaction.
Journalizing A step in the accounting recording process that consists of entering the effects of a transaction in a journal.
Ledger The complete collection of all of the accounts of a company; often referred to as the general ledger.
Nominal accounts See temporary accounts.
Note An unconditional written promise to pay to another party the amount owed either when demanded or at a certain specified date.
Permanent accounts (real accounts) Balance sheet accounts; their balances are not transferred (or closed) to any other account at the end of the accounting period.
Posting Recording in the ledger accounts the information contained in the journal.
Real accounts See permanent accounts.
Simple journal entry An entry with one debit and one credit.
T-account An account resembling the letter T, which is used for illustrative purposes only. Debits are entered on the left side of the account, and credits are entered on the right side of the account.
Temporary accounts (nominal accounts) They temporarily contain the revenue, expense, and dividend information that is transferred (or closed) to a stockholders' equity account (Retained Earnings) at the end of the accounting period.
Trial balance A listing of the ledger accounts and their debit or credit balances to determine that debits equal credits in the recording process.
Vertical analysis Shows the percentage that each item in a financial statement is of some significant total such as total assets or sales.
Self-test
True-false
Indicate whether each of the following statements is true or false.
All of the steps in the accounting cycle are performed only at the end of the accounting period.
A transaction must be journalized in the journal before it can be posted to the ledger accounts.
The left side of any account is the credit side.
Revenues, liabilities, and capital stock accounts are increased by debits.
The dividends account is increased by debits.
If the trial balance has equal debit and credit totals, it cannot contain any errors.
Multiple-choice
Select the best answer for each of the following questions.
When the stockholders invest cash in the business:
a. Capital Stock is debited and Cash is credited.
b. Cash is debited and Dividends is credited.
c. Cash is debited and Capital Stock is credited.
d. None of the above.
Assume that cash is paid for insurance to cover a three-year period. The recommended debit and credit are:
a. Debit Insurance Expense, credit Cash.
b. Debit Prepaid Insurance, credit Cash.
c. Debit Cash, credit Insurance Expense.
d. Debit Cash, credit Prepaid Insurance.
A company received cash from a customer in payment for future delivery services. The correct debit and credit
are:
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a. Debit Cash, credit Unearned Delivery Fees.
b. Debit Cash, credit Delivery Fee Revenue.
c. Debit Accounts Receivable, credit Delivery Fee Revenue.
d. None of the above.
A company performed delivery services for a customer for cash. The correct debit and credit are:
a. Debit Cash, credit Unearned Delivery Fees.
b. Debit Cash, credit Delivery Fee Revenue.
c. Debit Accounts Receivable, credit Delivery Fee Revenue.
d. None of the above.
A cash dividend of USD 500 was declared and paid to stockholders. The correct journal entry is:
a. Capital stock 500 Cash 500 b. Cash 500 Dividends 500 c. Dividends 500 Cash 500 d. Cash 500 Capital stock 500
Now turn to “Answers to self-test” at the end of the chapter to check your answers.
Questions
➢ Describe the steps in recording and posting the effects of a business transaction.
➢ Give some examples of source documents.
➢ Define an account. What are the two basic forms (styles) of accounts illustrated in the chapter?
➢ What is meant by the term double-entry procedure, or duality?
➢ Describe how you would determine the balance of a T-account.
➢ Define debit and credit. Name the types of accounts that are:
➢ Increased by a debit.
➢ Decreased by a debit.
➢ Increased by a credit.
➢ Decreased by a credit.
➢ Do you think this system makes sense? Can you conceive of other possible methods for recording
changes in accounts?
➢ Which of the steps in the accounting cycle are performed throughout the accounting period?
➢ Which of the steps in the accounting cycle are performed only at the end of the accounting period?
➢ Why are expense and revenue accounts used when all revenues and expenses could be shown directly
in the Retained Earnings account?
➢ What is the purpose of the Dividends account and how is it increased?
➢ Are the following possibilities conceivable in an entry involving only one debit and one credit? Why?
➢ Increase a liability and increase an expense.
➢ Increase an asset and decrease a liability.
➢ Increase a revenue and decrease an expense.
➢ Decrease an asset and increase another asset.
Accounting Principles: A Business Perspective 103 A Global Text
2. Recording business transactions
➢ Decrease an asset and increase a liability.
➢ Decrease a revenue and decrease an asset.
➢ Decrease a liability and increase a revenue.
➢ Describe the nature and purposes of the general journal. What does journalizing mean? Give an
example of a compound entry in the general journal.
➢ Describe a ledger and a chart of accounts. How do these two compare with a book and its table of
contents?
➢ Describe the act of posting. What difficulties could arise if no cross-indexing existed between the
general journal and the ledger accounts?
➢ Which of the following cash payments would involve the immediate recording of an expense? Why?
➢ Paid vendors for office supplies previously purchased on account.
➢ Paid an automobile dealer for a new company auto.
➢ Paid the current month's rent.
➢ Paid salaries for the last half of the current month.
➢ What types of accounts appear in the unadjusted trial balance? What are the purposes of this trial
balance?
➢ You have found that the total of the Debits column of the trial balance of Burns Company is USD
200,000, while the total of the Credits column is USD 180,000. What are some possible causes of
this difference? If the difference between the columns is divisible by 9, what types of errors are
possible?
➢ Store equipment was purchased for USD 2,000. Instead of debiting the Store Equipment account,
the debit was made to Delivery Equipment. Of what help will the trial balance be in locating this
error? Why?
➢ A student remembered that the side toward the window in the classroom was the debit side of an
account. The student took an examination in a room where the windows were on the other side of the
room and became confused and consistently reversed debits and credits. Would the student's trial
balance have equal debit and credit totals? If there were no existing balances in any of the accounts
to begin with, would the error prevent the student from preparing correct financial statements?
Why?
Exercises
Exercise A A diagram of the various types of accounts follows. Show where pluses (+) or minuses (-) should be
inserted to indicate the effect debits and credits have on each account.
Asset Accounts = Liability Accounts + Stockholders' Equity Accounts Debit Credit Debit Credit Debit Credit
Expense and Dividends Accounts Account
Revenue Accounts
Debit* Credit Debit Credit*
Exercise B Prepare the journal entry required for each of the following transactions:
a. Cash was received for services performed for customers, USD 1,200.
b. Services were performed for customers on account, USD 4,200.
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Exercise C Prepare the journal entry required for each of the following transactions:
a. Capital stock was issued for USD 100,000.
b. Purchased machinery for cash, USD 30,000.
Exercise D Prepare the journal entry required for each of the following transactions:
a. Capital stock was issued for USD 200,000 cash.
b. A USD 30,000 loan was arranged with a bank. The bank increased the company's checking account by USD
30,000 after management of the company signed a written promise to return the USD 30,000 in 30 days.
c. Cash was received for services performed for customers, USD 700.
d. Services were performed for customers on account, USD 1,200.
Exercise E For each of the following unrelated transactions, give the journal entry to record the transaction.
Then show how the journal entry would be posted to T-accounts. You need not include explanations or account
numbers.
a. Capital stock was issued for USD 100,000 cash.
b. Salaries for a period were paid to employees, USD 24,000.
c. Services were performed for customers on account, USD 40,000.
Exercise F Explain each of the sets of debits and credits in these accounts for Tuxedos, Inc., a company that
rents wedding clothing and accessories. There are 10 transactions to be explained. Each set is designated by the
small letters to the left of the amount. For example, the first transaction is the issuance of capital stock for cash and
is denoted by the letter (a).
Cash Dividends
(a) 200,000 (b) 150,000 (e) 1,000
(d) 1,800 (e) 1,000
(f) 600
(g) 2,000 (i) 30,000
Bal. ' 18,200
Accounts Receivable Service Revenue
(c) 1,800 (d) 1,800 (c) 1,800
(J) 12,000 (J) 12,000
Bal. 12,000 Bal. 13,80C
Supplies on Hand Rent Expense
(b) 150,000 (f) 600
(i) 30,000
Bal. 180,000
Accounts Payable Delivery Expense
(h) 800 (h) 800
Capital Stock Salaries Expense
(a) 200,000 (g) 2,000
Exercise G Assume the ledger accounts given in the previous problem are those of Tuxedos, Inc., as they
appear at 2010 December 31. Prepare the trial balance as of that date.
Exercise H Prepare journal entries to record each of the following transactions for Sanchez Company. Use the
letter of the transaction in place of the date. Include an explanation for each entry.
Accounting Principles: A Business Perspective 105 A Global Text
2. Recording business transactions
a. Capital stock was issued for cash, USD 300,000.
b. Purchased trucks by signing a note bearing no interest, USD 210,000.
c. Earned service revenue on account, USD 4,800.
d. Collected the account receivable resulting from transaction (c), USD 4,800.
e. Paid the note payable for the trucks purchased, USD 210,000.
f. Paid utilities for the month in the amount of USD 1,800.
g. Paid salaries for the month in the amount of USD 7,500.
h. Incurred supplies expenses on account in the amount of USD 1,920.
i. Purchased another truck for cash, USD 48,000.
j. Performed delivery services on account, USD 24,000.
Exercise I Using the data in the previous problem, post the entries to T-accounts. Write the letter of the
transaction in the account before the dollar amount. Determine a balance for each account.
Exercise J Using your answer for the previous exercise, prepare a trial balance. Assume the date of the trial
balance is 2010 March 31.
Exercise K John Adams owns and manages a bowling center called Strike Lanes. He also maintains his own
accounting records and was about to prepare financial statements for the year 2010. When he prepared the trial
balance from the ledger accounts, the total of the debits column was USD 435,000, and the total of the credits
column was USD 425,000. What are the possible reasons why the totals of the debits and credits are out of balance?
How would you normally proceed to find an error if the two trial balance columns do not agree?
Exercise L Refer to the Consolidated Balance Sheets of The Limited in the Annual Report Appendix located in
the back of this text. Perform both horizontal and vertical analysis on each of The Limited's asset accounts, treating
total assets as a significant total for vertical analysis. comment on the results.
Note: While you can certainly do this exercise with a calculator, computer spreadsheets such as Excel are ideal
for this type of analysis.
Problems
Problem A The transactions of Lightning Package Delivery Company for March 2010 follow:
Mar. 1 The company was organized and issued capital stock for USD 300,000 cash.
2 Paid USD 6,000 as the rent for March on a completely furnished building.
5 Paid cash for delivery trucks, USD 180,000.
6 Paid USD 4,000 as the rent for March on two forklift trucks.
9 Paid USD 2,200 for supplies received and used in March.
12 Performed delivery services for customers who promised to pay USD 27,000 at a later date.
20 Collected cash of USD 4,500 from customers on account (see March 12 entry).
21 Received a bill for USD 1,200 for advertising in the local newspaper in March.
27 Paid cash for gas and oil consumed in March, USD 450.
31 Paid USD 2,400 salaries to employees for March.
31 Received an order for services at USD 12,000. The services will be performed in April.
31 Paid cash dividend, USD 1,000.
Prepare the journal entries required to record these transactions in the general journal of the company.
Problem B Economy Laundry Company had the following transactions in August 2010:
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Aug. 1 Issued capital stock for cash, USD 150,000.
3 Borrowed USD 40,000 from the bank on a note.
4 Purchased cleaning equipment for USD 25,000 cash.
6 Performed services for customers who promised to pay later, USD 16,000.
7 Paid this month's rent on a building, USD 2,800.
10 Collections were made for the services performed on August 6, USD 3,200.
14 Supplies were purchased on account for use this month, USD 3,000.
17 A bill for USD 400 was received for utilities for this month.
25 Laundry services were performed for customers who paid immediately, USD 22,000.
31 Paid employee salaries, USD 6,000.
31 Paid cash dividend, USD 2,000.
a. Prepare journal entries for these transactions.
b. Post the journal entries to T-accounts. Enter the account number in the Posting Reference column of the
journal as you post each amount. Use the following account numbers:
Acct. No. Account Title 100 Cash 103 Accounts receivable 170 Equipment 200 Accounts payable 201 Notes payable 300 Capital stock 320 Dividends 400 Service revenue 507 Salaries expense 511 Utilities expense 515 Rent expense 518 Supplies expense
c. Prepare a trial balance as of 2010 August 31.
Problem C Clean-Sweep Janitorial, Inc., a company providing janitorial services, was organized 2010 July 1.
The following account numbers and titles constitute the chart of accounts for the company:
Acct. No. Account Title 100 Cash 103 Accounts receivable 150 Trucks 160 Office equipment 170 Equipment 200 Accounts payable 201 Notes payable 300 Capital stock 310 Retained earnings 320 Dividends 400 Service revenue 506 Gas and oil expense 507 Salaries expense 511 Utilities expense 512 Insurance expense 515 Rent expense 518 Supplies expense
July 1 The company issued USD 600,000 of capital stock for cash.
5 Office space was rented for July, and USD 5,000 was paid for the rental.
8 Desks and chairs were purchased for the office on account, USD 28,800.
Accounting Principles: A Business Perspective 107 A Global Text
2. Recording business transactions
10 Equipment was purchased for USD 50,000; a note was given, to be paid in 30 days.
15 Purchased trucks for USD 150,000, paying USD 120,000 cash and giving a 60-day note to the dealer for USD
30,000.
July 18 Paid for supplies received and already used, USD 2,880.
23 Received USD 17,280 cash as service revenue.
27 Insurance expense for July was paid, USD 4,500.
30 Paid for gasoline and oil used by the truck in July, USD 576.
31 Billed customers for janitorial services rendered, USD 40,320.
31 Paid salaries for July, USD 51,840.
31 Paid utilities bills for July, USD 5,280.
31 Paid cash dividends, USD 9,600.
a. Prepare general ledger accounts for all of these accounts except Retained Earnings. The Retained Earnings
account has a beginning balance of zero and maintains this balance throughout the period.
b. Journalize the transactions given for July 2010 in the general journal.
c. Post the journal entries to ledger accounts.
d. Prepare a trial balance as of 2010 July 31.
Problem D Trim Lawn, Inc., is a lawn care company. Thus, the company earns its revenue from sending its
trucks to customers' residences and certain commercial establishments to care for lawns and shrubbery. Trim
Lawn's trial balance at the end of the first 11 months of the year follows:
TRIM LAWN, INC.
Trial Balance
2010 November 30
Acct.
No. Account Title Debits Credits 100 Cash $ 63,740
103 Accounts Receivable 88,600
150 Trucks 102,900
160 Office Furniture 8,400
200 Accounts Payable $ 33,600
300 Capital Stock 30,000
310 Retained Earnings, 2010 January 1 30,540
400 Service Revenue 371,010
505 Advertising Expense 18,300
506 Gas an d Oil Expense 21,900
507 Salaries Expense 65,850
511 Utilities Expense 2,310
515 Rent Expense 15,000
518 Supplies Expense 75,600
531 Entertainment Expense 2,550
$465,150 $465,150
Dec. 2 Paid rent for December, USD 3,000.
5 Paid the accounts payable of USD 33,600.
8 Paid advertising for December, USD 1,500.
10 Purchased a new office desk on account, USD 1,050.
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13 Purchased USD 240 of supplies on account for use in December.
15 Collected cash from customers on account, USD 75,000.
20 Paid for customer entertainment, USD 450.
24 Collected an additional USD 6,000 from customers on account.
26 Paid for gasoline used in the trucks in December, USD 270.
28 Billed customers for services rendered, USD 79,500.
30 Paid for more December supplies, USD 12,000.
31 Paid December salaries, USD 15,300.
31 Paid a USD 4,000 cash dividend. (The Dividends account is No. 320.)
a. Open three-column general ledger accounts for each of the accounts in the trial balance under the date of
2010 December 1. Place the word Balance in the explanation space of each account. Also open an account for
Dividends, No. 320.
b. Prepare entries in the general journal for the preceding transactions for December 2010.
c. Post the journal entries to three-column general ledger accounts.
d. Prepare a trial balance as of 2010 December 31.
Problem E Marc Miller prepared the following trial balance from the ledger of the Quick-Fix TV Repair
Company. The trial balance did not balance.
QUICK-FIX REPAIR COMPANY
Trial Balance
2010 December 31
Acct.
No. Account Title Debits Credits 100 Cash $ 69,200
103 Accounts Receivable 60,800
160 Office Furniture 120,000
172 Office Equipment 48,000
200 Accounts Payable $ 32,400
300 Capital Stock 180,000
310 Retained Earnings 80,000
320 Dividends 28,800
400 Service Revenue 360,000
507 Salaries Expense 280,000
515 Rent Expense 40,000
568 Miscellaneous Expense 7,200
$654,000 $652,400
The difference in totals in the trial balance caused Miller to carefully examine the company's accounting records.
In searching back through the accounting records, Miller found that the following errors had been made:
• One entire entry that included a USD 10,000 debit to Cash and a USD 10,000 credit to Accounts Receivable
was never posted.
• In computing the balance of the Accounts Payable account, a credit of USD 3,200 was omitted from the
computation.
• In preparing the trial balance, the Retained Earnings account balance was shown as USD 80,000. The
ledger account has the balance at its correct amount of USD 83,200.
Accounting Principles: A Business Perspective 109 A Global Text
2. Recording business transactions
• One debit of USD 2,400 to the Dividends account was posted as a credit to that account.
• Office equipment of USD 12,000 was debited to Office Furniture when purchased.
Prepare a corrected trial balance for the Quick-Fix TV Repair Company as of 2010 December 31. Also, write a
description of the effect(s) of each error.
Alternate problems
Alternate problem A Speedy Laundry Company, Inc., entered into the following transactions in August 2010:
Aug. 1 Received cash for capital stock issued to owners, USD 400,000.
3 Paid rent for August on a building and laundry equipment rented, USD 3,000.
6 Performed laundry services for USD 2,000 cash.
8 Secured an order from a customer for laundry services of USD 7,000. The services are to be performed next
month.
13 Performed laundry services for USD 6,300 on account for various customers.
15 Received and paid a bill for USD 430 for supplies used in operations.
23 Cash collected from customers on account, USD 2,600.
31 Paid USD 2,400 salaries to employees for August.
31 Received the electric and gas bill for August, USD 385, but did not pay it at this time.
31 Paid cash dividend, USD 1,000.
Prepare journal entries for these transactions in the general journal.
Alternate problem B The transactions listed below are those of Reliable Computer Repair, Inc., for April
2010:
Apr. 1 Cash of USD 500,000 was received for capital stock issued to the owners.
3 Rent was paid for April, USD 3,500.
6 Trucks were purchased for USD 56,000 cash.
7 Office equipment was purchased on account from Wagner Company for USD 76,800.
14 Salaries for first two weeks were paid, USD 12,000.
15 USD 28,000 was received for services performed.
18 An invoice was received from Roger's Gas Station for USD 400 for gas and oil used during April.
23 A note was arranged with the bank for USD 80,000. The cash was received, and a note promising to return
the USD 80,000 on 2010 May 30, was signed.
29 Purchased trucks for USD 73,600 by signing a note.
30 Salaries for the remainder of April were paid, USD 14,400.
a. Prepare journal entries for these transactions.
b. Post the journal entries to T-accounts. Enter the account number in the Posting Reference column of the
journal as you post each amount. Use the following account numbers:
Acct. No. Account Title 100 Cash 150 Trucks 172 Office equipment 200 Accounts payable 201 Notes payable 300 Capital stock 400 Service revenue
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506 Gas and oil expense 507 Salaries expense 515 Rent expense
c. Prepare a trial balance as of 2010 April 30.
Alternate problem C Rapid Pick Up & Delivery, Inc., was organized 2010 January 1. Its chart of accounts is as
follows:
Acct. No. Account title 100 Cash 103 Accounts receivable 150 Trucks 160 Office furniture 172 Office equipment 200 Accounts payable 201 Notes payable 300 Capital stock 310 Retained earnings 400 Service revenue 506 Gas and oil expense 507 Salaries expense 511 Utilities expense 512 Insurance expense 515 Rent expense 530 Repairs expense
Jan. 1 The company received USD 560,000 cash and USD 240,000 of office furniture in exchange for USD
800,000 of capital stock.
2 Paid garage rent for January, USD 6,000.
4 Purchased computers on account, USD 13,200.
6 Purchased delivery trucks for USD 280,000; payment was made by giving cash of USD 150,000 and a 30-day
note for the remainder.
Jan 12 Purchased insurance for January on the delivery trucks. The cost of the policy, USD 800, was paid in
cash.
15 Received and paid January utilities bills, USD 960.
15 Paid salaries for first half of January, USD 3,600.
17 Cash received for delivery services to date amounted to USD 1,800.
20 Received bill for gasoline purchased and used in January, USD 180.
23 Purchased delivery trucks for cash, USD 108,000.
25 Cash sales of delivery services were USD 2,880.
27 Purchased a copy machine on account, USD 3,600.
31 Paid salaries for last half of January, USD 4,800.
31 Sales of delivery services on account amounted to USD 11,400.
31 Paid for repairs to a delivery truck, USD 1,120.
a. Prepare general ledger accounts for all these accounts except Retained Earnings. The Retained Earnings
account has a beginning balance of zero and maintains this balance throughout the period.
b. Journalize the transactions given for 2010 January in the general journal.
c. Post the journal entries to ledger accounts.
d. Prepare a trial balance as of 2010 January 31.
Accounting Principles: A Business Perspective 111 A Global Text
2. Recording business transactions
Alternate problem 4 The trial balance of California Tennis Center, Inc., at the end of the first 11 months of its
fiscal year follows:
CALIFORNIA TENNIS CENTER, INC.
Trial Balance
2010 November 30
Acct.
No. Account Title Debits Credits 100 Cash $71,180
103 Accounts Receivable 81,750
130 Land 60,000
200 Accounts Payable $18,750
201 Notes Payable 15,000
300 Capital Stock 50,000
310 Retained Earnings, 2010 January 1 53,700
413 Membership and Lesson Revenue 202,500
505 Advertising Expense 21,000
507 Salaries Expense 66,000
511 Utilities Expense 2,100
515 Rent Expense 33,000
518 Supplies Expense 2,250
530 Repairs Expense 1,500
531 Entertainment Expense 870
540 Interest Expense 300
$339,950 $339,950
Dec. 1 Paid building rent for December, USD 4,000.
2 Paid vendors on account, USD 18,000.
5 Purchased land for cash, USD 10,000.
7 Sold memberships on account for December, USD 27,000.
10 Paid the note payable of USD 15,000, plus interest of USD 150.
13 Cash collections from customers on account, USD 36,000.
19 Received a bill for repairs, USD 225.
24 Paid the December utilities bill, USD 180.
28 Received a bill for December advertising, USD 1,650.
29 Paid the equipment repair bill received on the 19th, USD 225.
30 Gave tennis lessons for cash, USD 4,500.
30 Paid salaries, USD 6,000.
30 Sales of memberships on account since December 7, USD 18,000 (for the month of December).
30 Costs paid in entertaining customers in December, USD 350.
30 Paid dividends of USD 1,500. (The Dividends account is No. 320.)
a. Open three-column general ledger accounts for each of the accounts in the trial balance. Place the word
Balance in the explanation space and enter the date 2010 December 1, on this same line. Also open an account for
Dividends, No. 320.
b. Prepare entries in the general journal for the transactions during December 2010.
c. Post the journal entries to ledger accounts.
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d. Prepare a trial balance as of 2010 December 31.
Alternate problem E Bill Baxter prepared a trial balance for Special Party Rentals, Inc., a company that rents
tables, chairs, and other party supplies. The trial balance did not balance. The trial balance he prepared was as
follows:
SPECIAL PARTY RENTALS, INC.
Trial Balance
2010 December 31
Acct.
No. Account Title Debits Credits
100 Cash $ 74,000
103 Accounts Receivable 50,800
170 Equipment 160,000
200 Accounts Payable $ 34,000
300 Capital Stock 130,000
310 Retained Earnings 44,000
320 Dividends 16,000
400 Service Revenue 432,000
505 Advertising Expense 1,200
507 Salaries Expense 176,000
511 Utilities Expense 44,800
515 Rent Expense 64,000
$ 586,800 $ 640,000
In trying to f ind out why the trial balance did not balance, Baxter discovered the following errors:
Equipment was understated (too low) by USD 12,000 because of an error in addition in determining the balance
of that account in the ledger.
A credit of USD 4,800 to Accounts Receivable in the journal was not posted to the ledger account at all.
A debit of USD 16,000 for a semiannual dividend was posted as a credit to the Capital Stock account.
The balance of USD 12,000 in the Advertising Expense account was entered as USD 1,200 in the trial balance.
Miscellaneous Expense (Account No. 568), with a balance of USD 3,200, was omitted from the trial balance.
Prepare a corrected trial balance as of 2010 December 31. Also, write a description of the effect(s) of each error.
Beyond the numbers—Critical thinking
Business decision case A John Jacobs lost his job as a carpenter with a contractor when a recession hit the
construction industry. Jacobs had been making USD 50,000 per year. He decided to form his own company, Jacobs
Corporation, and do home repairs.
The following is a summary of the transactions of the business during the first three months of operations in
2010:
Jan. 15 Stockholders invested USD 40,000 in the business.
Feb. 25 Received payment of USD 4,400 for remodeling a basement into a recreation room. The homeowner
purchased all of the building materials.
Mar. 5 Paid cash for an advertisement that appeared in the local newspaper, USD 150.
Apr. 10 Received USD 7,000 for converting a room over a garage into an office for a college professor. The
professor purchased all of the materials for the job.
11 Paid gas and oil expenses for automobile, USD 900.
Accounting Principles: A Business Perspective 113 A Global Text
2. Recording business transactions
12 Miscellaneous business expenses were paid, USD 450.
15 Paid dividends of USD 2,000.
a. Prepare journal entries for these transactions.
b. Post the journal entries to T-accounts.
c. How profitable is this new venture? Should Jacobs stay in this business?
Annual report analysis B Refer to the Annual Report of The Limited, Inc. in the Annual Report Appendix.
Perform horizontal and vertical analyses of the liabilities and stockholder's equity sections of the balance sheets for
the two most recent years shown. Horizontal analysis involves showing the dollar amount and percentage increase
or decrease of the latest year over the preceding year amounts. Vertical analysis involves showing the percentage of
total liabilities and stockholder's equity that each account represents as of the balance sheet dates. Write comments
on any important changes between the two years that are evidence of decisions made by management.
Annual report analysis C In The Home Depot's recent Annual Report, the following passages appear:
The primary key to our success is our 39,000 employees who wear those orange aprons you see in our stores.
Few great achievements—in business or in any aspect of life—are reached and sustained without the support
and involvement of large numbers of people committed to shared values and goals they deem worthy. Indeed, one
need look no further than the business section of the morning newspaper to read of how yet another "blue chip"
American business, entrenched in and isolated by its own bureaucracy, has lost the support of its employees and
customers...
Frankly, the biggest difference between The Home Depot and our competitors is not the products on our
shelves, it is our people and their ability to forge strong bonds of loyalty and trust with our customers...
...Contrary to conventional management wisdom, those at the top of organization charts are not the source of
all wisdom. Many of our best ideas come from the people who work on the sales floor. We encourage our
employees to challenge senior management directives if they feel strongly enough about their dissenting
opinions...
...We want our people to be themselves and to be bold enough to apply their talents as individuals. Certainly,
people can often perceive great risk acting this way. Thus, we go to great lengths to empower our employees to be
mavericks, to express differences of opinion without fear of being fired or demoted...We do everything we can to
make people feel challenged and inspired at work instead of being threatened and made to feel insecure. An
organization can, after all, accomplish more when people work together instead of against each other.
Write answers to the following questions:
a. Do you think The Home Depot management regards its employees more as expenses or assets? Explain.
b. What does The Home Depot regard as its most valuable asset? Explain your answer.
c. Is The Home Depot permitted to list its human resources as assets on its balance sheet? Why or why not?
d. Could its philosophy regarding its employees be the major factor in its outstanding financial performance?
Explain.
Ethics case – Writing experience D Refer to "An ethical perspective: Financial deals, Inc.". Write out the
answers to the following questions:
a. What motivated Larry to go along with unethical and illegal actions? Explain.
b. What are Larry's options now? List each possibility.
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c. What would you do if you were Larry? Describe in detail.
d. What do you think the real Larry did? Describe in detail.
Group project E In teams of two or three students, interview in person or by speakerphone a new staff
member who has worked for a CPA firm for only one or two years. Seek information on the advantages and
disadvantages of working for a CPA firm. Also, inquire about the nature of the work and the training programs
offered by the firm for new employees. As a team, write a memorandum to the instructor summarizing the results of
the interview. The heading of the memorandum should contain the date, to whom it is written, from whom, and the
subject matter.
Group project F With one or two other students and using library resources, write a report on the life of Luca
Pacioli, sometimes referred to as the father of accounting. Pacioli was a Franciscan monk who wrote a book on
double-entry accounting in 1494. Be careful to cite sources and treat direct quotes properly. (If you do not know
how to do this, ask your instructor.)
Using the Internet—A view of the real world
Visit the following website:
http://www.roberthalf.com
Click on Job Seekers. Read the information and write a memo to your instructor about your search and what you
learned about certain jobs in accounting.
Visit the following website:
http://www.sec.gov
Investigate this site for anything of interest. Write a memo to your instructor about your search.
Answers to self-test
True-false
False. Only the last five steps are performed at the end of the period. The first three steps are performed
throughout the accounting period.
True. The journal is the book of original entry. Any amounts appearing in a ledger account must have been
posted from the journal.
False. The left side of any account is the debit side.
False. These accounts are all increased by credits.
True. Since dividends reduce stockholders' equity, the Dividends account is increased by debits.
False. An entire journal entry may not have been posted, or a debit or credit might have been posted to the
wrong account.
Multiple-choice
c. An asset, Cash, is increased by a debit, and the Capital Stock account is increased by a credit.
b. Since the insurance covers more than the current accounting period, an asset is debited instead of an expense.
The credit is to Cash.
a. The receipt of cash before services are performed creates a liability, Unearned Delivery Fees. To increase a
liability, it is credited. Cash is debited to increase its balance.
b. Cash is increased by the debit, and Delivery Service Revenue is increased by the credit.
c. Dividends is increased by the debit, and Cash is decreased by the credit.
Accounting Principles: A Business Perspective 115 A Global Text
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3. Adjustments for financial reporting
Learning objectives
• Describe the basic characteristics of the cash basis and the accrual basis of accounting.
• Identify the reasons why adjusting entries must be made.
• Identify the classes and types of adjusting entries.
• Prepare adjusting entries.
• Determine the effects of failing to prepare adjusting entries.
• Analyze and use the financial results and trend percentages.
A career as a tax specialist
While most students are aware that accountants frequently assist their clients with tax returns and other tax
issues, few are aware of the large number of diverse and challenging careers available in the field of taxation. Nearly
all public accounting firms, ranging from the “Big 4” international firms to the sole practitioner, generate a
significant portion of their fees through tax compliance, planning and consulting. With over 155 million individual
tax returns filed in the US every year, it is not surprising that many individuals and most businesses need assistance
in dealing with the incredibly complex US and international tax laws. This complexity also provides tremendous tax
planning opportunities. As a tax specialist, you will show individual clients how to reduce their taxes while
simultaneously helping them make decisions about investing, buying a house, funding their children’s education,
and planning their retirement. For your business clients, careful planning and structuring of business investments
and transactions can save millions of dollars in taxes. In fact, it is safe to say that very few significant business
transactions take place without the careful guidance of a tax specialist.
A career in taxation is by no means limited to public accounting. Because there are so many types of taxes
impacting so many aspects of our lives, tax specialists act as consultants in a large number of fields. For example,
many companies offer deferred compensation or stock bonus plans to their executives. Nearly all companies
provide some sort of pension or other retirement plan for their employees, as well as health care benefits.
Significant tax savings can be generated for both the company and their employees if these benefits are structured
correctly. In response to the amazing complexity of our tax laws, many schools offer masters degrees specializing in
tax. Such a degree is not required to specialize in tax, but does offer students a significant advantage if they want to
pursue a career in taxation. In a recent survey of 1,400 chief financial officers, the top two responses to the question
“which one of the following areas of specialization would you recommend to someone just beginning his or her
career in accounting?” were personal financial planning and tax accounting. These responses reflect the
indisputable fact that as the US demographic includes more wealthy, and older, Americans than ever before,
professional tax guidance will be in ever-increasing demand.
Accounting Principles: A Business Perspective 116 A Global Text
3. Adjustments for financial reporting
The career paths outlined above do not nearly cover all of the many professional options available to tax
specialists. For example, are you concerned that a traditional tax accounting job may be too tame for you? Special
agents of the IRS routinely participate in criminal investigations and arrests, working closely with other federal law
enforcement agencies. Are you interested in law? Accounting offers an ideal undergraduate degree for aspiring
business and tax attorneys. If you think you may be interested in a career as a tax specialist, be sure to consult with
one of your school’s tax professors about the many job opportunities this field provides.
Chapters 1 and 2 introduced the accounting process of analyzing, classifying, and summarizing business
transactions into accounts. You learned how these transactions are entered into the journal and posted to the ledger
accounts. You also know how to use the trial balance to test the equality of debits and credits in the journalizing and
posting process. The purpose of the accounting process is to produce accurate financial statements so they may be
used for making sound business decisions. At this point in your study of accounting, you are concentrating on three
financial statements—the income statement, the statement of retained earnings, and the balance sheet. Detailed
coverage of the statement of cash flows appears in Chapter 16.
When you began to analyze business transactions in Chapter 1, you saw that the evidence of the transaction is
usually a source document. It is any written or printed evidence that describes the essential facts of a business
transaction. Examples are receipts for cash paid or received, checks written or received, bills sent to customers, or
bills received from suppliers. The giving, receiving, or creating of source documents triggered the journal entries
made in Chapter 2.
The journal entries we discuss in this chapter are adjusting entries. The arrival of the end of the accounting
period triggers adjusting entries. Accountants use adjusting entries to bring accounts to their proper balances
before preparing financial statements. In this chapter, you learn the difference between the cash basis and accrual
basis of accounting. Then you learn about the classes and types of adjusting entries and how to prepare them.
Cash versus accrual basis accounting
Professionals such as physicians and lawyers and some relatively small businesses may account for their
revenues and expenses on a cash basis. The cash basis of accounting recognizes revenues when cash is received
and recognizes expenses when cash is paid out. For example, under the cash basis, a company would treat services
rendered to clients in 2010 for which the company collected cash in 2011 as 2011 revenues. Similarly, under the
cash basis, a company would treat expenses incurred in 2010 for which the company disbursed cash in 2011 as 2011
expenses. Under the “pure” cash basis, even the purchase of a building would be debited to an expense. However,
under the “modified” cash basis, the purchase of long-lived assets (such as a building) would be debited to an asset
and depreciated (gradually charged to expense) over its useful life. Normally the “modified” cash basis is used by
those few individuals and small businesses that use the cash basis.
Cash Basis Accrual Basis
Revenues are recognized As cash is received As earned (goods are delivered or services are
performed)
Expenses are recognized As cash is paid As incurred to produce revenues
Exhibit 14: Cash basis and accrual basis of accounting compared
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Because the cash basis of accounting does not match expenses incurred and revenues earned, it is generally
considered theoretically unacceptable. The cash basis is acceptable in practice only under those circumstances
when it approximates the results that a company could obtain under the accrual basis of accounting. Companies
using the cash basis do not have to prepare any adjusting entries unless they discover they have made a mistake in
preparing an entry during the accounting period. Under certain circumstances, companies may use the cash basis
for income tax purposes.
Throughout the text we use the accrual basis of accounting, which matches expenses incurred and revenues
earned, because most companies use the accrual basis. The accrual basis of accounting recognizes revenues
when sales are made or services are performed, regardless of when cash is received. Expenses are recognized as
incurred, whether or not cash has been paid out. For instance, assume a company performs services for a customer
on account. Although the company has received no cash, the revenue is recorded at the time the company performs
the service. Later, when the company receives the cash, no revenue is recorded because the company has already
recorded the revenue. Under the accrual basis, adjusting entries are needed to bring the accounts up to date for
unrecorded economic activity that has taken place. In Exhibit 14, shown below, we show when revenues and
expenses are recognized under the cash basis and under the accrual basis.
The need for adjusting entries
The income statement of a business reports all revenues earned and all expenses incurred to generate those
revenues during a given period. An income statement that does not report all revenues and expenses is incomplete,
inaccurate, and possibly misleading. Similarly, a balance sheet that does not report all of an entity’s assets,
liabilities, and stockholders’ equity at a specific time may be misleading. Each adjusting entry has a dual purpose:
(1) to make the income statement report the proper revenue or expense and (2) to make the balance sheet report
the proper asset or liability. Thus, every adjusting entry affects at least one income statement account and one
balance sheet account.
January 30 February 9 March 16 April 8 May 18 June 49 July 8 August 14 September 42 October 17 November 13 Subtotal 224 December 376 Total Companies 600 Source' American Institute of Certified Public Accountants Accounting Trends & Techniques (New York' AICPA, 2004) p39
Exhibit 15: Summary-fiscal year ending by month
Since those interested in the activities of a business need timely information, companies must prepare financial
statements periodically. To prepare such statements, the accountant divides an entity’s life into time periods. These
time periods are usually equal in length and are called accounting periods. An accounting period may be one
month, one quarter, or one year. An accounting year, or fiscal year, is an accounting period of one year. A fiscal
year is any 12 consecutive months. The fiscal year may or may not coincide with the calendar year, which ends
on December 31. As we show in Exhibit 15, 63 per cent of the companies surveyed in 2004 had fiscal years that
coincide with the calendar year. In 2008, the comparable figure for publicly-traded companies in the US was 65 per
cent. Companies in certain industries often have a fiscal year that differs from the calendar year. For instance many
Accounting Principles: A Business Perspective 118 A Global Text
3. Adjustments for financial reporting
retail stores end their fiscal year on January 31 to avoid closing their books during their peak sales period. Other
companies select a fiscal year ending at a time when inventories and business activity are lowest.
Periodic reporting and the matching principle necessitate the preparation of adjusting entries. Adjusting
entries are journal entries made at the end of an accounting period or at any time financial statements are to be
prepared to bring about a proper matching of revenues and expenses. The matching principle requires that
expenses incurred in producing revenues be deducted from the revenues they generated during the accounting
period. The matching principle is one of the underlying principles of accounting. This matching of expenses and
revenues is necessary for the income statement to present an accurate picture of the profitability of a business.
Adjusting entries reflect unrecorded economic activity that has taken place but has not yet been recorded. Why has
the company not recorded this activity by the end of the period? One reason is that it is more convenient and
economical to wait until the end of the period to record the activity. A second reason is that no source document
concerning that activity has yet come to the accountant’s attention.
Adjusting entries bring the amounts in the general ledger accounts to their proper balances before the company
prepares its financial statements. That is, adjusting entries convert the amounts that are actually in the general
ledger accounts to the amounts that should be in the general ledger accounts for proper financial reporting. To
make this conversion, the accountants analyze the accounts to determine which need adjustment. For example,
assume a company purchased a three-year insurance policy costing USD 600 at the beginning of the year and
debited USD 600 to Prepaid Insurance. At year-end, the company should remove USD 200 of the cost from the
asset and record it as an expense. Failure to do so misstates assets and net income on the financial statements.
Exhibit 16: Two classes and four types of adjusting entries
Companies continuously receive benefits from many assets such as prepaid expenses (e.g. prepaid insurance and
prepaid rent). Thus, an entry could be made daily to record the expense incurred. Typically, firms do not make the
entry until financial statements are to be prepared. Therefore, if monthly financial statements are prepared,
monthly adjusting entries are required. By custom, and in some instances by law, businesses report to their owners
at least annually. Accordingly, adjusting entries are required at least once a year. Remember, however, that the
entry transferring an amount from an asset account to an expense account should transfer only the asset cost that
has expired.
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An accounting perspective:
Uses of technology
Eventually, computers will probably enter adjusting entries continuously on a real-time basis so
that up-to-date financial statements can be printed at any time without prior notice. Computers
will be fed the facts concerning activities that would normally result in adjusting entries and
instructed to seek any necessary information from their own databases or those of other computers
to continually adjust the accounts.
Classes and types of adjusting entries
Adjusting entries fall into two broad classes: deferred (meaning to postpone or delay) items and accrued
(meaning to grow or accumulate) items. Deferred items consist of adjusting entries involving data previously
recorded in accounts. These entries involve the transfer of data already recorded in asset and liability accounts to
expense and revenue accounts, respectively. Accrued items consist of adjusting entries relating to activity on
which no data have been previously recorded in the accounts. These entries involve the initial, or first, recording of
assets and liabilities and the related revenues and expenses (see Exhibit 16).
Deferred items consist of two types of adjusting entries: asset/expense adjustments and liability/revenue
adjustments. For example, prepaid insurance and prepaid rent are assets until they are used up; then they become
expenses. Also, unearned revenue is a liability until the company renders the service; then the unearned revenue
becomes earned revenue.
Accrued items consist of two types of adjusting entries: asset/revenue adjustments and liability/expense
adjustments. For example, assume a company performs a service for a customer but has not yet billed the customer.
The accountant records this transaction as an asset in the form of a receivable and as revenue because the company
has earned a revenue. Also, assume a company owes its employees salaries not yet paid. The accountant records
this transaction as a liability and an expense because the company has incurred an expense.
Accounting Principles: A Business Perspective 120 A Global Text
3. Adjustments for financial reporting
MICROTRAIN COMPANY
Trial Balance
2010 December 31
Acct.
No. Account Title Debits Credits 100 Cash $ 8,250
103 Accounts Receivable 5,200
107 Supplies on Hand 1,400
108 Prepaid Insurance 2,400
112 Prepaid Rent 1,200
150 Trucks 40,000
200 Accounts Payable $ 730
216 Unearned Service Fees 4,500
300 Capital Stock 50,000
320 Dividends 3,000
400 Service Revenue 10,700
505 Advertising Expense 50
506 Gas and Oil Expense 680
507 Salaries Expense 3,600
511 Utilities Expense 150 $65,930
$65,930
Exhibit 17: Trial balance
In this chapter, we illustrate each of the four types of adjusting entries: asset/expense, liability/revenue,
asset/revenue, and liability/expense. Look at Exhibit 17, the trial balance of the MicroTrain Company at 2010
December 31. As you can see, MicroTrain must adjust several accounts before it can prepare accurate financial
statements. The adjustments for these accounts involve data already recorded in the company’s accounts.
In making adjustments for MicroTrain Company, we must add several accounts to the company’s chart of
accounts shown in Chapter 2. These new accounts are:
Type of Account Asset Contra asset* Liability Revenue Expenses
Acct. No. 121 151 206 418 512 515 518 521
Account Title Interest Receivable Accumulated Deprecation—Trucks Salaries Payable Interest Revenue Insurance Expense Rent Expense Supplies Expense Depreciation Expense— Trucks
Description The amount of interest earned but not yet received. The total depreciation expense taken on trucks since the acquisition date. The balance of this account is deducted from that of Trucks on the balance sheet. The amount of salaries earned by employees but not yet paid by the company. The amount of interest earned in the current period. The cost of insurance incurred in the current period. The cost of rent incurred in the current period. The cost of supplies used in the current period. The portion of the cost of the trucks assigned to expense during the current period.
*Accountants deduct the balance of a contra asset from the balance of the related reasons for using a contra asset account later in the chapter.
asset account on the balance sheet. We explain the
Now you are ready to follow as MicroTrain Company makes its adjustments for deferred items. If you find the
process confusing, review the beginning of this chapter so you clearly understand the purpose of adjusting entries.
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An accounting perspective:
Uses of technology
It is difficult to name a publicly owned company that does not provide an extensive website. In fact,
websites have become an important link between companies and their investors. Most websites
will have a link titled investor relations or merely company information which provides a wealth of
financial information ranging from audited financial statements to charts of the company's stock
prices. As an example, check out the Gap, Incs website at:
http://www.gapinc.com
Browse the Gap site and see for yourself the comprehensiveness of the financial information
available there.
Adjustments for deferred items
This section discusses the two types of adjustments for deferred items: asset/expense adjustments and
liability/revenue adjustments. In the asset/expense group, you learn how to prepare adjusting entries for prepaid
expenses and depreciation. In the liability/revenue group, you learn how to prepare adjusting entries for unearned
revenues.
MicroTrain Company must make several asset/expense adjustments for prepaid expenses. A prepaid expense
is an asset awaiting assignment to expense, such as prepaid insurance, prepaid rent, and supplies on hand. Note
that the nature of these three adjustments is the same.
Prepaid insurance When a company pays an insurance policy premium in advance, the purchase creates the
asset, prepaid insurance. This advance payment is an asset because the company will receive insurance coverage in
the future. With the passage of time, however, the asset gradually expires. The portion that has expired becomes an
expense. To illustrate this point, recall that in Chapter 2, MicroTrain Company purchased for cash an insurance
policy on its trucks for the period 2010 December 1, to 2011 November 30. The journal entry made on 2010
December 1, to record the purchase of the policy was:
2010
Dec. 1 Prepaid Insurance 2,400
Cash 2400
Purchased truck insurance to cover a one-year period.
The two accounts relating to insurance are Prepaid Insurance (an asset) and Insurance Expense (an expense).
After posting this entry, the Prepaid Insurance account has a USD 2,400 debit balance on 2010 December 1. The
Insurance Expense account has a zero balance on 2010 December 1, because no time has elapsed to use any of the
policy’s benefits.
(Dr.) Prepaid Insurance (Cr) (Dr.) Insurance Expense (Cr) 2010 2010
Dec. 1 Dec. 1
Bal. 2,400 Bal. -0-
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3. Adjustments for financial reporting
By 2010 December 31, one month of the year covered by the policy has expired. Therefore, part of the service
potential (or benefit obtained from the asset) has expired. The asset now provides less future services or benefits
than when the company acquired it. We recognize this reduction by treating the cost of the services received from
the asset as an expense. For the MicroTrain Company example, the service received was one month of insurance
coverage. Since the policy provides the same services for every month of its one-year life, we assign an equal
amount (USD 200) of cost to each month. Thus, MicroTrain charges 1/ 12
of the annual premium to Insurance
Expense on 2010 December 31. The adjusting journal entry is:
2010
Dec. 31 Insurance Expense 200 Adjustment
Prepaid Insurance 200 1—Insurance
To record insurance expense for December.
After posting these two journal entries, the accounts in T-account format appear as follows:
(Dr.) Prepaid Insurance (Cr)
2010 Dec. 1 Purchased on account 2,400
2010 Dec. 31 Adjustment 1 200
Decreased by $200 Bal. After adjustment 2,200
(Dr.) Insurance Expense (Cr.)
Increased by $200
2010 31 Adjustment 1 200
In practice, accountants do not use T-accounts. Instead, they use three-column ledger accounts that have the
advantage of showing a balance after each transaction. After posting the preceding two entries, the three-column
ledger accounts appear as follows:
Prepaid Insurance
Date Explanation Post Ref. Debit Credit Balance
Dec. 2010 1 Purchased on Account G1 2400 2400 Dr.
31 Adjustment G3* 200 2200 Dr.
Insurance Expense
Date Explanation Post Ref. Debit Credit Balance
Dec. 2010 31 Adjustment G3* 200 200 Dr.
*Assumed page number
Before this adjusting entry was made, the entire USD 2,400 insurance payment made on 2010 December 1, was
a prepaid expense for 12 months of protection. So on 2010 December 31, one month of protection had passed, and
an adjusting entry transferred USD 200 of the USD 2,400 (USD 2,400/12 = USD 200) to Insurance Expense. On
the income statement for the year ended 2010 December 31, MicroTrain reports one month of insurance expense,
USD 200, as one of the expenses it incurred in generating that year’s revenues. It reports the remaining amount of
the prepaid expense, USD 2,200, as an asset on the balance sheet. The USD 2,200 prepaid expense represents 11
months of insurance protection that remains as a future benefit.
Prepaid rent Prepaid rent is another example of the gradual consumption of a previously recorded asset.
Assume a company pays rent in advance to cover more than one accounting period. On the date it pays the rent, the
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company debits the prepayment to the Prepaid Rent account (an asset account). The company has not yet received
benefits resulting from this expenditure. Thus, the expenditure creates an asset.
We measure rent expense similarly to insurance expense. Generally, the rental contract specifies the amount of
rent per unit of time. If the prepayment covers a three-month rental, we charge one-third of this rental to each
month. Notice that the amount charged is the same each month even though some months have more days than
other months.
For example, MicroTrain Company paid USD 1,200 rent in advance on 2010 December 28, to cover a three-
month period beginning on that date. The journal entry would be:
2010
Dec. 1 Prepaid Rent 1,200
Cash 1,200
Paid three months' rent on a building.
The two accounts relating to rent are Prepaid Rent (an asset) and Rent Expense. After this entry is posted, the
Prepaid Rent account has a USD 1,200 balance and the Rent Expense account has a zero balance because no part of
the rent period has yet elapsed.
(Dr.) Prepaid Rent (Cr) (Dr.) Rent Expense (Cr) 2010 2010
Dec. 1 Dec. 1
Bal. Cash Paid 1,200 Bal. -0-
On 2010 December 31, MicroTrain must prepare an adjusting entry. Since one third of the period covered by the
prepaid rent has elapsed, it charges one-third of the USD 1,200 of prepaid rent to expense. The required adjusting
entry is:
2010 Dec.
Adjustment 31 Rent Expense 400
2—Rent Prepaid Rent To record rent expense for December 400
After posting this adjusting entry, the T-accounts appear as follows:
(Dr.) Prepaid Rent (Cr)
2010 Dec. 1 Cash Paid
1,200 2010 Dec. 31 Adjustment 2 400
Decreased
Bal. after adjustment 800 by $400
(Dr.) Rent Expense (Cr)
Increased by $400
2010 Dec. 31 Adjustment 2
400
The USD 400 rent expense appears in the income statement for the year ended 2010 December 31. MicroTrain
reports the remaining USD 800 of prepaid rent as an asset in the balance sheet on 2010 December 31. Thus, the
adjusting entries have accomplished their purpose of maintaining the accuracy of the financial statements.
Supplies on hand Almost every business uses supplies in its operations. It may classify supplies simply as
supplies (to include all types of supplies), or more specifically as office supplies (paper, stationery, floppy diskettes,
pencils), selling supplies (gummed tape, string, paper bags, cartons, wrapping paper), or training supplies
(transparencies, training manuals). Frequently, companies buy supplies in bulk. These supplies are an asset until
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3. Adjustments for financial reporting
the company uses them. This asset may be called supplies on hand or supplies inventory. Even though these terms
indicate a prepaid expense, the firm does not use prepaid in the asset’s title.
On 2010 December 4, MicroTrain Company purchased supplies for USD 1,400 and recorded the transaction as
follows:
2010 Dec. 4 Supplies on Hand 1,400
Cash 1,400 To record the purchase of supplies for future use.
MicroTrain’s two accounts relating to supplies are Supplies on Hand (an asset) and Supplies Expense. After this
entry is posted, the Supplies on Hand account shows a debit balance of USD 1,400 and the Supplies Expense
account has a zero balance as shown in the following T-accounts:
(Dr.) Supplies On Hand (Cr.) (Dr.) Supplies Expense (Cr.) 2010 2010 Dec. 4 Dec. 4
Bal. Cash Paid 1,400 Bal. -0-
An actual physical inventory (a count of the supplies on hand) at the end of the month showed only USD 900 of
supplies on hand. Thus, the company must have used USD 500 of supplies in December. An adjusting journal entry
brings the two accounts pertaining to supplies to their proper balances. The adjusting entry recognizes the
reduction in the asset (Supplies on Hand) and the recording of an expense (Supplies Expense) by transferring USD
500 from the asset to the expense. According to the physical inventory, the asset balance should be USD 900 and
the expense balance, USD 500. So MicroTrain makes the following adjusting entry:
2010
Dec. 31 Supplies Expense 500 Adjustment
Supplies on Hand To record supplies used during December.
500 3—Supplies
After posting this adjusting entry, the T-accounts appear as follows:
(Dr.) Supplies on Hand (Cr)
2010 Dec. 4 Cash Paid 1,400
2010 Dec. 31 Adjustment 3 500
Decreased by $500
Bal. after 900 adjustment
(Dr.) Supplies Expense (Cr.)
Increased by $500
2010 Dec 31 Adjustment 3
500
The entry to record the use of supplies could be made when the supplies are issued from the storeroom.
However, such careful accounting for small items each time they are issued is usually too costly a procedure.
Accountants make adjusting entries for supplies on hand, like for any other prepaid expense, before preparing
financial statements. Supplies expense appears in the income statement. Supplies on hand is an asset in the balance
sheet.
Sometimes companies buy assets relating to insurance, rent, and supplies knowing that they will use them up
before the end of the current accounting period (usually one month or one year). If so, an expense account is
usually debited at the time of purchase rather than debiting an asset account. This procedure avoids having to make
an adjusting entry at the end of the accounting period. Sometimes, too, a company debits an expense even though
the asset will benefit more than the current period. Then, at the end of the accounting period, the firm’s adjusting
entry transfers some of the cost from the expense to the asset. For instance, assume that on January 1, a company
paid USD 1,200 rent to cover a three-year period and debited the USD 1,200 to Rent Expense. At the end of the
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year, it transfers USD 800 from Rent Expense to Prepaid Rent. To simplify our approach, we will consistently debit
the asset when the asset will benefit more than the current accounting period.
Depreciation Just as prepaid insurance and prepaid rent indicate a gradual using up of a previously recorded
asset, so does depreciation. However, the overall time involved in using up a depreciable asset (such as a building)
is much longer and less definite than for prepaid expenses. Also, a prepaid expense generally involves a fairly small
amount of money. Depreciable assets, however, usually involve larger sums of money.
A depreciable asset is a manufactured asset such as a building, machine, vehicle, or piece of equipment that
provides service to a business. In time, these assets lose their utility because of (1) wear and tear from use or (2)
obsolescence due to technological change. Since companies gradually use up these assets over time, they record
depreciation expense on them. Depreciation expense is the amount of asset cost assigned as an expense to a
particular period. The process of recording depreciation expense is called depreciation accounting. The three
factors involved in computing depreciation expense are:
• Asset cost. The asset cost is the amount that a company paid to purchase the depreciable asset.
• Estimated residual value. The estimated residual value (scrap value) is the amount that the
company can probably sell the asset for at the end of its estimated useful life.
• Estimated useful life. The estimated useful life of an asset is the estimated time that a company can
use the asset. Useful life is an estimate, not an exact measurement, that a company must make in advance.
However, sometimes the useful life is determined by company policy (e.g. keep a fleet of automobiles for three
years).
Accountants use different methods for recording depreciation. The method illustrated here is the straight-line
method. We discuss other depreciation methods in Chapter 10. Straight-line depreciation assigns the same amount
of depreciation expense to each accounting period over the life of the asset. The depreciation formula
(straight-line) to compute straight-line depreciation for a one-year period is:
Annual deprecation= Asset cost – Estimated residual value
Estimated years of useful life
To illustrate the use of this formula, recall that on December 1, MicroTrain Company purchased four small
trucks at a cost of USD 40,000. The journal entry was:
2010
Dec. 1 Trucks 40,000
Cash 40,000
To record the purchase of four trucks.
The estimated residual value for each truck was USD 1,000, so MicroTrain estimated the total residual value for
all four trucks at USD 4,000. The company estimated the useful life of each truck to be four years. Using the
straight-line depreciation formula, MicroTrain calculated the annual depreciation on the trucks as follows:
Annual deprecation = USD40,000 – USD 4,000
4years =USD9,000
The amount of depreciation expense for one month would be 1/ 12
of the annual amount. Thus, depreciation
expense for December is USD 9,000 ÷ 12 = USD 750.
The difference between an asset’s cost and its estimated residual value is an asset’s depreciable amount. To
satisfy the matching principle, the firm must allocate the depreciable amount as an expense to the various periods
in the asset’s useful life. It does this by debiting the amount of depreciation for a period to a depreciation expense
Accounting Principles: A Business Perspective 126 A Global Text
3. Adjustments for financial reporting
account and crediting the amount to an accumulated depreciation account. MicroTrain’s depreciation on its
delivery trucks for December is USD 750. The company records the depreciation as follows:
2010
Dec. 31 Depreciation Expense – Trucks 750
Accumulated Depreciation - Trucks 750 Adjusted 4- Depreciation
To record depreciation expense for December.
After posting the adjusting entry, the T-accounts appear as follows:
(Dr.) Depreciation Expense—Trucks (Cr)
Increased by $750
2010 Dec 31 Adjustment 4 750
(Dr.) Accumulated Depreciation—Trucks (Cr.) Increased by $750 (book value of asset decreased)
2010 Dec. 31 Adjustment 4 750
MicroTrain reports depreciation expense in its income statement. And it reports accumulated depreciation in
the balance sheet as a deduction from the related asset.
The accumulated depreciation account is a contra asset account that shows the total of all depreciation
recorded on the asset from the date of acquisition up through the balance sheet date. A contra asset account is a
deduction from the asset to which it relates in the balance sheet. The purpose of a contra asset account is to reduce
the original cost of the asset down to its remaining undepreciated cost or book value. The accumulated
depreciation account does not represent cash that is being set aside to replace the worn out asset. The
undepreciated cost of the asset is the debit balance in the asset account (original cost) minus the credit balance in
the accumulated depreciation contra account. Accountants also refer to an asset’s cost less accumulated
depreciation as the book value (or net book value) of the asset. Thus, book value is the cost not yet allocated to an
expense. In the previous example, the book value of the equipment after the first month is:
Cost USD 40,000 Less: Accumulated depreciation 750 Book value (or cost not yet allocated to as an expense) 39,250
MicroTrain credits the depreciation amount to an accumulated depreciation account, which is a contra asset,
rather than directly to the asset account. Companies use contra accounts when they want to show statement readers
the original amount of the account to which the contra account relates. For instance, for the asset Trucks, it is useful
to know both the original cost of the asset and the total accumulated depreciation amount recorded on the asset.
Therefore, the asset account shows the original cost. The contra account, Accumulated Depreciation—Trucks,
shows the total amount of recorded depreciation from the date of acquisition. By having both original cost and the
accumulated depreciation amounts, a user can estimate the approximate percentage of the benefits embodied in the
asset that the company has consumed. For instance, assume the accumulated depreciation amount is about three-
fourths the cost of the asset. Then, the benefits would be approximately three-fourths consumed, and the company
may have to replace the asset soon.
Thus, to provide more complete balance sheet information to users of financial statements, companies show
both the original acquisition cost and accumulated depreciation. In the preceding example for adjustment 4, the
balance sheet at 2010 December 31, would show the asset and contra asset as follows:
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Assets Trucks USD 40,000 Less: Accumulated deprecation 750
USD 39,250
As you may expect, the accumulated depreciation account balance increases each period by the amount of
depreciation expense recorded until the remaining book value of the asset equals the estimated residual value.
A liability/revenue adjustment involving unearned revenues covers situations in which a customer has
transferred assets, usually cash, to the selling company before the receipt of merchandise or services. Receiving
assets before they are earned creates a liability called unearned revenue. The firm debits such receipts to the
asset account Cash and credits a liability account. The liability account credited may be Unearned Fees, Revenue
Received in Advance, Advances by Customers, or some similar title. The seller must either provide the services or
return the customer’s money. By performing the services, the company earns revenue and cancels the liability.
Companies receive advance payments for many items, such as training services, delivery services, tickets, and
magazine or newspaper subscriptions. Although we illustrate and discuss only advanced receipt of training fees,
firms treat the other items similarly.
Unearned service fees On December 7, MicroTrain Company received USD 4,500 from a customer in
payment for future training services. The firm recorded the following journal entry:
2010
Dec. 7 Cash Unearned Service Fees To record the receipt of cash from a customer in payment for future training services.
4,500 4,500
The two T-accounts relating to training fees are Unearned Service Fees (a liability) and Service Revenue. These
accounts appear as follows on 2010 December 31 (before adjustment):
(Dr.) Unearned Service Fees (Cr.)
(Dr.)
2010 Dec. 7 Cash received in advance 4,500
Service Revenue (Cr.)
*The $10,700 balance came 2010 Bal. before adjustment 10,700* from transactions discussed in Chapter 2.
The balance in the Unearned Service Fees liability account established when MicroTrain received the cash will
be converted into revenue as the company performs the training services. Before MicroTrain prepares its financial
statements, it must make an adjusting entry to transfer the amount of the services performed by the company from
a liability account to a revenue account. If we assume that MicroTrain earned one-third of the USD 4,500 in the
Unearned Service Fees account by December 31, then the company transfers USD 1,500 to the Service Revenue
account as follows:
2010 Dec.
Adjustment 5— Revenue earned
31 Unearned Service Fees Service Revenue To transfer a portion of training fees from the liability account to the revenue account.
1,500 1,500
After posting the adjusting entry, the T-accounts would appear as follows:
Decreased by $1,500
(Dr.) Unearned Service Fees (Cr.)
2010 2010
Accounting Principles: A Business Perspective 128 A Global Text
3. Adjustments for financial reporting
2010 Dec. 31 Adjustment 5 1,500 Dec. 7 Cash received
in advance 4,500
Bal. after adjustment 3,000
(Dr.) Service Revenue (Cr.)
2010 Bal. before adjustment Dec. 31 Adjustment 5
10,700 1,500
Increased — by $1,500
Bal. after adjustment 12,200
MicroTrain reports the service revenue in its income statement for 2010. The company reports the USD 3,000
balance in the Unearned Service Fees account as a liability in the balance sheet. In 2011, the company will likely
earn the USD 3,000 and transfer it to a revenue account.
If MicroTrain does not perform the training services, the company would have to refund the money to the
training service customers. For instance, assume that MicroTrain could not perform the remaining USD 3,000 of
training services and would have to refund the money. Then, the company would make the following entry:
Unearned Service Fees 3,000
Cash 3,000
To record the refund of unearned training fees.
Thus, the company must either perform the training services or refund the fees. This fact should strengthen your
understanding that unearned service fees and similar items are liabilities.
Accountants make the adjusting entries for deferred items for data already recorded in a company’s asset and
liability accounts. They also make adjusting entries for accrued items, which we discuss in the next section, for
business data not yet recorded in the accounting records.
An accounting perspective:
Business insight
According to the National Association of Colleges and Employers, the average offer to an
accounting major in 2009 was USD 48,334 and tends to increase each year. According to recent
surveys, the market for accounting graduates remains brisk. Often, one of the chief problems for
graduates is how to handle multiple job offers. As a result of the low unemployment rate,
employers—especially small accounting firms with limited recruiting budgets—are doing whatever
they can to grab qualified candidates.
Adjustments for accrued items
Accrued items require two types of adjusting entries: asset/revenue adjustments and liability/expense
adjustments. The first group—asset/revenue adjustments—involves accrued assets; the second group—
liability/expense adjustments—involves accrued liabilities.
Accrued assets are assets, such as interest receivable or accounts receivable, that have not been recorded by
the end of an accounting period. These assets represent rights to receive future payments that are not due at the
balance sheet date. To present an accurate picture of the affairs of the business on the balance sheet, firms
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recognize these rights at the end of an accounting period by preparing an adjusting entry to correct the account
balances. To indicate the dual nature of these adjustments, they record a related revenue in addition to the asset.
We also call these adjustments accrued revenues because the revenues must be recorded.
Interest revenue Savings accounts literally earn interest moment by moment. Rarely is payment of the
interest made on the last day of the accounting period. Thus, the accounting records normally do not show the
interest revenue earned (but not yet received), which affects the total assets owned by the investor, unless the
company makes an adjusting entry. The adjusting entry at the end of the accounting period debits a receivable
account (an asset) and credits a revenue account to record the interest earned and the asset owned.
For example, assume MicroTrain Company has some money in a savings account. On 2010 December 31, the
money on deposit has earned one month’s interest of USD 600, although the company has not received the interest.
An entry must show the amount of interest earned by 2010 December 31, as well as the amount of the asset, interest
receivable (the right to receive this interest). The entry to record the accrual of revenue is:
2010
Adjustment Dec. 31 Interest Receivable 600
6—Interest Interest Revenue 600
revenue accrued To record one month's interest revenue.
The T-accounts relating to interest would appear as follows:
(Dr.) Interest Receivable (Cr.)
Increased by $600
2010 Dec 31 Adjustment 6 600
(Dr.) Interest Revenue (Cr.) 2010 Dec. 31 Adjustment 6 600.
Increased by $600
MicroTrain reports the USD 600 debit balance in Interest Receivable as an asset in the 2010 December 31,
balance sheet. This asset accumulates gradually with the passage of time. The USD 600 credit balance in Interest
Revenue is the interest earned during the month. Recall that in recording revenue under accrual basis accounting, it
does not matter whether the company collects the actual cash during the year or not. It reports the interest revenue
earned during the accounting period in the income statement.
Unbilled training fees A company may perform services for customers in one accounting period while it bills
for the services in a different accounting period.
MicroTrain Company performed USD 1,000 of training services on account for a client at the end of December.
Since it takes time to do the paper work, MicroTrain will bill the client for the services in January. The necessary
adjusting journal entry at 2010 December 31, is:
Adjustment 7—Unbilled 2010
Dec. 31 Accounts Receivable (or Service Fees Receivable) Service Revenue
1,000 1,000
To record unbilled training services performed in
December.
After posting the adjusting entry, the T-accounts appear as follows:
(Dr.) Accounts Receivable (Cr.) 2010
Accounting Principles: A Business Perspective 130 A Global Text
3. Adjustments for financial reporting
Previous bal. 5,200*
Dec. 31 Adjustment 7 1,000*_
Bal. after adjustment 6,200
*This previous balance came from transactions discussed in Chapter 2. (Dr.) Service Revenue (Cr.)
2010
Bal. before adjustment 10,700
Dec. 31 Adjustment
5—previously
unearned
revenue. 1,500
Dec. 31 Adjustment 7 1,000
Bal. after both adjustments 13200
The service revenue appears in the income statement; the asset, accounts receivable, appears in the balance
sheet.
Accrued liabilities are liabilities not yet recorded at the end of an accounting period. They represent
obligations to make payments not legally due at the balance sheet date, such as employee salaries. At the end of the
accounting period, the company recognizes these obligations by preparing an adjusting entry including both a
liability and an expense. For this reason, we also call these obligations accrued expenses.
Salaries The recording of the payment of employee salaries usually involves a debit to an expense account and
a credit to Cash. Unless a company pays salaries on the last day of the accounting period for a pay period ending on
that date, it must make an adjusting entry to record any salaries incurred but not yet paid.
MicroTrain Company paid USD 3,600 of salaries on Friday, 2010 December 28, to cover the first four weeks of
December. The entry made at that time was:
2010
Dec. 28 Salaries Expense 3,600
Cash 3,600
Paid training employee salaries for the first four weeks of December.
Assuming that the last day of December 2010 falls on a Monday, this expense account does not show salaries
earned by employees for the last day of the month. Nor does any account show the employer’s obligation to pay
these salaries. The T-accounts pertaining to salaries appear as follows before adjustment:
(Dr.) Salaries Expense (Cr) (Dr.) Salaries Payable (Cr) 2010 Dec. 28
3,600 2010 Dec. 28 Bal.
-0-
If salaries are USD 3,600 for four weeks, they are USD 900 per week. For a five-day workweek, daily salaries are
USD 180. MicroTrain makes the following adjusting entry on December 31 to accrue salaries for one day:
2010
Dec. 31 Salaries Expense 180
Salaries Payable 180
To accrue one day's salaries that were earned but not paid.
After adjustment, the two T-accounts involved appear as follows:
(Dr.) Salaries Expense (Cr)
2010 Dec. 28 Bal. 3,600 Dec. 31 Adjustment 8 180
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Bal. after adjustment 3,780
(Dr.) Salaries Payable (Cr.)
2010 Dec. 31 Adjustment 8
180 Increased by $180
Failure to Recognize Effect on Net Income Effect on Balance Sheet Items
1. Consumption of the benefits of an asset (prepaid expense)
Overstates net income Overstates assets Overstates retained earnings
2. Earning of previously unearned revenues Understates net income Overstates liabilities Understates retained earnings
3. Accrual of assets Understates net income Understates assets Understates retained earnings
4. Accrual of liabilities Overstates net income Understates liabilities Overstates retained earnings
Exhibit 18: Effects of failure to recognize adjustments
The debit in the adjusting journal entry brings the month’s salaries expense up to its correct USD 3,780 amount
for income statement purposes. The credit to Salaries Payable records the USD 180 salary liability to employees.
The balance sheet shows salaries payable as a liability.
Another example of a liability/expense adjustment is when a company incurs interest on a note payable. The
debit would be to Interest Expense, and the credit would be to Interest Payable. We discuss this adjustment in
Chapter 9.
Effects of failing to prepare adjusting entries
Failure to prepare proper adjusting entries causes net income and the balance sheet to be in error. You can see
the effect of failing to record each of the major types of adjusting entries on net income and balance sheet items in
Exhibit 18.
Using MicroTrain Company as an example, this chapter has discussed and illustrated many of the typical entries
that companies must make at the end of an accounting period. Later chapters explain other examples of adjusting
entries.
Analyzing and using the financial results—trend percentages
It is sometimes more informative to express all the dollar amounts as a percentage of one of the amounts in the
base year rather than to look only at the dollar amount of the item in the financial statements. You can calculate
trend percentages by dividing the amount for each year for an item, such as net income or net sales, by the
amount of that item for the base year:
Trend percentage= Current year amount
Base year amount
To illustrate, assume that ShopaLot, a large retailer, and its subsidiaries reported the following net income for
the years ended 2001 January 31, through 2010. The last column expresses these dollar amounts as a percentage of
the 2001 amount. For instance, we would calculate the 125 per cent for 2002 as:
[(USD 1,609,000/USD 1,291,000)5 100]
Dollar Amount
of Net Income Percentage of
(millions) 1991 Net Income
1991 $1,291 100 % 1992 1.609 125 1993 1,995 155 1994 2,333 181 1995 2,681 208 1996 2,740 212 1997 3,056 237
Accounting Principles: A Business Perspective 132 A Global Text
3. Adjustments for financial reporting
1998 3,526 273 1999 4,430 343 2000 5,377 416 2001 6,295 488
Examining the trend percentages, we can see that ShopaLot's s net income has increased steadily over the 10-
year period. The 2010 net income is over 4 times as much as the 2001 amount. This is the kind of performance that
management and stockholders seek, but do not always get.
In the first three chapters of this text, you have learned most of the steps of the accounting process. Chapter 4
shows the final steps in the accounting cycle.
An accounting perspective:
Uses of technology
The Internet sites of the Big-4 accounting firms are as follows:
Ernst & Young http://www.ey.com
Deloitte Touche Tohmatsu http://www.deloitte.com
KPMG http://www.kpmg.com
PricewaterhouseCoopers http://www.pwcglobal.com
You might want to visit these sites to learn more about a possible career in accounting.
Understanding the learning objectives
• The cash basis of accounting recognizes revenues when cash is received and recognizes expenses when cash
is paid out.
• The accrual basis of accounting recognizes revenues when sales are made or services are performed,
regardless of when cash is received; expenses are recognized as incurred, whether or not cash has been paid
out.
• The accrual basis is more generally accepted than the cash basis because it provides a better matching of
revenues and expenses.
• Adjusting entries convert the amounts that are actually in the accounts to the amounts that should be in the
accounts for proper periodic financial reporting.
• Adjusting entries reflect unrecorded economic activity that has taken place but has not yet been recorded.
• Deferred items consist of adjusting entries involving data previously recorded in accounts. Adjusting entries
in this class normally involve moving data from asset and liability accounts to expense and revenue accounts.
The two types of adjustments within this deferred items class are asset/expense adjustments and
liability/revenue adjustments.
• Accrued items consist of adjusting entries relating to activity on which no data have been previously recorded
in the accounts. These entries involve the initial recording of assets and liabilities and the related revenues
and expenses. The two types of adjustments within this accrued items class are asset/revenue adjustments
and liability/expense adjustments.
• This chapter illustrates entries for deferred items and accrued items.
• Failure to prepare adjusting entries causes net income and the balance sheet to be in error.
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• For a particular item such as sales or net income, select a base year and express all dollar amounts in other
years as a percentage of the base year dollar amount.
Demonstration problem
Among other items, the trial balance of Korman Company for 2010 December 31, includes the following account
balances:
Debits Credits
Supplies on Hand $ 6,000
Prepaid Rent 25,200
Buildings 200,000
Accumulated Depreciation—Buildings $33,250
Salaries Expense 124,000
Unearned Delivery Fees 4,000
Some of the supplies represented by the USD 6,000 balance of the Supplies on Hand account have been
consumed. An inventory count of the supplies actually on hand at December 31 totaled USD 2,400.
On May 1 of the current year, a rental payment of USD 25,200 was made for 12 months’ rent; it was debited to
Prepaid Rent.
The annual depreciation for the buildings is based on the cost shown in the Buildings account less an estimated
residual value of USD 10,000. The estimated useful lives of the buildings are 40 years each.
The salaries expense of USD 124,000 does not include USD 6,000 of unpaid salaries earned since the last
payday.
The company has earned one-fourth of the unearned delivery fees by December 31.
Delivery services of USD 600 were performed for a customer, but a bill has not yet been sent.
a. Prepare the adjusting journal entries for December 31, assuming adjusting entries are prepared only at year-
end.
b. Based on the adjusted balance shown in the Accumulated Depreciation—Buildings account, how many years
has Korman Company owned the building?
Solution to demonstration problems KORMAN COMPANY General Journal Date Account Titles and Explanation Post.
Ref. Debit Credit
2010 Dec. 31 Supplies Expense 3 6 0 0
Supplies on Hand 3 6 0 0
To record supplies expense ($6,000 - $2,400).
31 Rent Expense 1 6 8 0 0
Prepaid Rent 1 6 8 0 0
To record rent expense ($25,200 X 8/12).
31 Depreciation Expense—Buildings 4 7 5 0
Accumulated Deprecation—Buildings 4 7 5 0
To record depreciation ($200,000 - $10,000 / 40 years).
31 Salaries Expense 6 0 0 0
Salaries Payable 6 0 0 0
Accounting Principles: A Business Perspective 134 A Global Text
3. Adjustments for financial reporting
To record accrued salaries.
31 Unearned Delivery Fees 1 0 0 0
Service Revenue 1 0 0 0
To record delivery fees earned.
31 Accounts Receivable 6 0 0
Service Revenue 6 0 0
To record delivery fees earned.
Eight years; computed as:
Total accumulated deprecation
Annual deprecation expense =
USD33,250USD 4,750 USD4,750
Key terms Accounting period A time period normally of one month, one quarter, or one year into which an entity’s life is arbitrarily divided for financial reporting purposes.
Accounting year An accounting period of one year. The accounting year may or may not coincide with the calendar year.
Accrual basis of accounting Recognizes revenues when sales are made or services are performed, regardless of when cash is received. Recognizes expenses as incurred, whether or not cash has been paid out.
Accrued assets and liabilities Assets and liabilities that exist at the end of an accounting period but have not yet been recorded; they represent rights to receive, or obligations to make, payments that are not legally due at the balance sheet date. Examples are accrued fees receivable and salaries payable.
Accrued items Adjusting entries relating to activity on which no data have been previously recorded in the accounts. Also, see accrued assets and liabilities.
Accrued revenues and expenses Other names for accrued assets and liabilities.
Accumulated depreciation account A contra asset account that shows the total of all depreciation recorded on the asset up through the balance sheet date.
Adjusting entries Journal entries made at the end of an accounting period to bring about a proper matching of revenues and expenses; they reflect economic activity that has taken place but has not yet been recorded. Adjusting entries are made to bring the accounts to their proper balances before financial statements are prepared.
Book value For depreciable assets, book value equals cost less accumulated depreciation.
Calendar year The normal year, which ends on December 31.
Cash basis of accounting Recognizes revenues when cash is received and recognizes expenses when cash is paid out.
Contra asset account An account shown as a deduction from the asset to which it relates in the balance sheet; used to reduce the original cost of the asset down to its remaining undepreciated cost or book value.
Deferred items Adjusting entries involving data previously recorded in the accounts. Data are transferred from asset and liability accounts to expense and revenue accounts. Examples are prepaid expenses, depreciation, and unearned revenues.
Depreciable amount The difference between an asset’s cost and its estimated residual value.
Depreciable asset A manufactured asset such as a building, machine, vehicle, or equipment on which depreciation expense is recorded.
Depreciation accounting The process of recording depreciation expense.
Depreciation expense The amount of asset cost assigned as an expense to a particular time period.
Depreciation formula (straight-line):
Estimated residual value (scrap value) The amount that the company can probably sell the asset for at the end of its estimated useful life.
Estimated useful life The estimated time periods that a company can make use of the asset.
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Fiscal year An accounting year of any 12 consecutive months that may or may not coincide with the calendar year. For example, a company may have an accounting, or fiscal, year that runs from April 1 of one year to March 31 of the next.
Matching principle An accounting principle requiring that expenses incurred in producing revenues be deducted from the revenues they generated during the accounting period.
Prepaid expense An asset awaiting assignment to expense. An example is prepaid insurance. Assets such as cash and accounts receivable are not prepaid expenses.
Service potential The benefits that can be obtained from assets. The future services that assets can render make assets “things of value” to a business.
Trend percentages Calculated by dividing the amount of an item for each year by the amount of that item for the base year.
Unearned revenue Assets received from customers before services are performed for them. Since the revenue has not been earned, it is a liability, often called revenue received in advance or advances by customers.
Self-test
True-false
Indicate whether each of the following statements is true or false:
Every adjusting entry affects at least one income statement account and one balance sheet account.
All calendar years are also fiscal years, but not all fiscal years are calendar years.
The accumulated depreciation account is an asset account that shows the amount of depreciation for the current
year only.
The Unearned Delivery Fees account is a revenue account.
If all of the adjusting entries are not made, the financial statements are incorrect.
Multiple-choice
Select the best answer for each of the following questions.
An insurance policy premium of USD 1,200 was paid on 2010 September 1, to cover a one-year period from that
date. An asset was debited on that date. Adjusting entries are prepared once a year, at year-end. The necessary
adjusting entry at the company’s year-end, 2010 December 31, is:
a. Prepaid insurance 400 Insurance expense 400 b. Insurance expense 800 Prepaid insurance 800 c. Prepaid insurance 800 Insurance expense 800 d. Insurance expense 400 Prepaid insurance 400
The Supplies on Hand account has a balance of USD 1,500 at year-end. The actual amount of supplies on hand
at the end of the period was USD 400. The necessary adjusting entry is:
a. Supplies expense 1,100 Supplies on hand 1,100 b. Supplies expense 400 Supplies on hand 400 c. Supplies on hand 1,100 Supplies expense 1,100 d. Supplies on hand 400 Supplies expense 400
A company purchased a truck for USD 20,000 on 2010 January 1. The truck has an estimated residual value of
USD 5,000 and is expected to last five years. Adjusting entries are prepared only at year-end. The necessary
adjusting entry at 2010 December 31, the company’s year-end, is:
Accounting Principles: A Business Perspective 136 A Global Text
3. Adjustments for financial reporting
a. Deprecation expense – Trucks 4,000
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Accumulated 4,000 b. Deprecation expense – Trucks 3,000 Trucks 3,000 c. Deprecation expense – Trucks 3,000 Accumulated deprecation – Trucks 3,000 d. Accumulated deprecation trucks 3,000 Deprecation expense – Trucks 3,000
A company received cash of USD 24,000 on 2010 October 1, as subscriptions for a one-year period from that
date. A liability account was credited when the cash was received. The magazine is to be published by the company
and delivered to subscribers each month. The company prepares adjusting entries at the end of each month because
it prepares financial statements each month. The adjusting entry the company would make at the end of each of the
next 12 months would be:
a. Unearned subscription fees 6,000
Subscription fee revenue 6,000
b. Unearned subscription fees 2,000
Subscription fee revenue 2,000
c. Unearned subscription feeds
Subscription fee revenue
d. Subscription fee revenue
18,000
2,000
18,000
Unearned subscription fees 2,000
When a company earns interest on a note receivable or on a bank account, the debit and credit are as follows:
Debit Credit a. Accounts receivable Interest revenue b. Interest receivable Interest revenue c. Interest revenue Accounts receivable d. Interest revenue Interest receivable
If USD 3,000 has been earned by a company’s workers since the last payday in an accounting period, the
necessary adjusting entry would be:
a. Debit an expense and credit a liability.
b. Debit an expense and credit an asset.
c. Debit a liability and credit an asset.
d. Debit a liability and credit an expense.
Now turn to “Answers to self test” at the back of the book to check your answers.
Questions
➢ Which events during an accounting period trigger the recording of normal journal entries? Which
event triggers the making of adjusting entries?
➢ Describe the difference between the cash basis and accrual basis of accounting.
➢ Why are adjusting entries necessary? Why not treat every cash disbursement as an expense and
every cash receipt as a revenue when the cash changes hands?
➢ “Adjusting entries would not be necessary if the ‘pure’ cash basis of accounting were followed
(assuming no mistakes were made in recording cash transactions as they occurred). Under the cash
basis, receipts that are of a revenue nature are considered revenue when received, and expenditures
that are of an expense nature are considered expenses when paid. It is the use of the accrual basis of
Accounting Principles: A Business Perspective 138 A Global Text
3. Adjustments for financial reporting
accounting, where an effort is made to match expenses incurred against the revenues they create,
that makes adjusting entries necessary.” Do you agree with this statement? Why?
➢ Why do accountants not keep all the accounts at their proper balances continuously throughout the
period so that adjusting entries would not have to be made before financial statements are prepared?
➢ What is the fundamental difference between deferred items and accrued items?
➢ Identify the types of adjusting entries included in each of the two major classes of adjusting entries.
➢ Give an example of a journal entry for each of the following:
➢ Equal growth of an expense and a liability.
➢ Earning of revenue that was previously recorded as unearned revenue.
➢ Equal growth of an asset and a revenue.
➢ Increase in an expense and decrease in an asset.
➢ A fellow student makes the following statement: “You can easily tell whether a company is using the
cash or accrual basis of accounting. When an amount is paid for future rent or insurance services, a
firm that is using the cash basis debits an expense account while a firm that is using the accrual basis
debits an asset account.” Is the student correct?
➢ You notice that the Supplies on Hand account has a debit balance of USD 2,700 at the end of the
accounting period. How would you determine the extent to which this account needs adjustment?
➢ Some assets are converted into expenses as they expire and some liabilities become revenues as they
are earned. Give examples of asset and liability accounts for which this statement is true. Give
examples of asset and liability accounts to which the statement does not apply.
➢ Give the depreciation formula to compute straight-line depreciation for a one-year period.
➢ What does the term accrued liability mean?
➢ What is meant by the term service potential?
➢ When assets are received before they are earned, what type of an account is credited? As the amounts
are earned, what type of account is credited?
➢ What does the word accrued mean? Is there a conceptual difference between interest payable and
accrued interest payable?
➢ Matching expenses incurred with revenues earned is more difficult than matching expenses paid
with revenues received. Do you think the effort is worthwhile?
➢ Real world question Refer to the financial statements of The Limited, Inc., in the Annual report
appendix. Approximately what percentage of the depreciable assets under property, plant, and
equipment has been depreciated as of the end of the most recent year shown?
Exercises
Exercise A Select the correct response for each of the following multiple-choice questions:
The cash basis of accounting:
(a) Recognizes revenues when sales are made or services are rendered.
(b)Recognizes expenses as incurred.
(c) Is typically used by some relatively small businesses and professional persons.
(d)Recognizes revenues when cash is received and recognizes expenses when incurred.
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The accrual basis of accounting:
(a) Recognizes revenues only when cash is received.
(b)Is used by almost all companies.
(c) Recognizes expenses only when cash is paid out.
(d)Recognizes revenues when sales are made or services are performed and recognizes expenses only
when cash is paid out.
Exercise B Select the correct response for each of the following multiple-choice questions:
The least common accounting period among the following is:
(a) One month.
(b)Two months.
(c) Three months.
(d)Twelve months.
The need for adjusting entries is based on:
(a) The matching principle.
(b)Source documents.
(c) The cash basis of accounting.
(d)Activity that has already been recorded in the proper accounts.
Exercise C Select the correct response for each of the following multiple-choice questions:
Which of the following types of adjustments belongs to the deferred items class?
(a) Asset/revenue adjustments.
(b)Liability/expense adjustments.
(c) Asset/expense adjustments.
(d)Asset/liability adjustments.
Which of the following types of adjustments belongs to the accrued items class?
(a) Asset/expense adjustments.
(b)Liability/revenue adjustments.
(c) Asset/liability adjustments.
(d)Liability/expense adjustments.
Exercise D A one-year insurance policy was purchased on August 1 for USD 2,400, and the following entry was
made at that time:
Prepaid Insurance 2,400
Cash 2,400
What adjusting entry is necessary at December 31, the end of the accounting year?
Show how the T-accounts for Prepaid Insurance and Insurance Expense would appear after the entries are
posted.
Exercise E Assume that rent of USD 12,000 was paid on 2010 September 1, to cover a one-year period from
that date. Prepaid Rent was debited. If financial statements are prepared only on December 31 of each year, what
adjusting entry is necessary on 2010 December 31, to bring the accounts involved to their proper balances?
Exercise F At 2010 December 31, an adjusting entry was made as follows:
Rent Expense 1,500
Accounting Principles: A Business Perspective 140 A Global Text
3. Adjustments for financial reporting
Prepaid Rent 1,500
You know that the gross amount of rent paid was USD 4,500, which was to cover a one-year period. Determine:
a. The opening date of the year to which the USD 4,500 of rent applies.
b. The entry that was made on the date the rent was paid.
Exercise G Supplies were purchased for cash on 2010 May 2, for USD 8,000. Show how this purchase would be
recorded. Then show the adjusting entry that would be necessary, assuming that USD 2,500 of the supplies
remained at the end of the year.
Exercise H Assume that a company acquired a building on 2010 January 1, at a cost of USD 1,000,000. The
building has an estimated useful life of 40 years and an estimated residual value of USD 200,000. What adjusting
entry is needed on 2010 December 31, to record the depreciation for the entire year 2010?
Exercise I On 2010 September 1, Professional Golfer Journal, Inc., received a total of USD 120,000 as payment
in advance for one-year subscriptions to a monthly magazine. A liability account was credited to record this cash
receipt. By the end of the year, one-third of the magazines paid for in advance had been delivered. Give the entries
to record the receipt of the subscription fees and to adjust the accounts at December 31, assuming annual financial
statements are prepared at year-end.
Exercise J On 2010 April 15, Rialto Theater sold USD 90,000 in tickets for the summer musicals to be
performed (one per month) during June, July, and August. On 2010 July 15, Rialto Theater discovered that the
group that was to perform the July and August musicals could not do so. It was too late to find another group
qualified to perform the musicals. A decision was made to refund the remaining unearned ticket revenue to its
ticket holders, and this was done on July 20. Show the appropriate journal entries to be made on April 15, June 30,
and July 20. Rialto has a June 30th year-end.
Exercise K Guilty & Innocent, a law firm, performed legal services in late December 2010 for clients. The USD
30,000 of services would be billed to the clients in January 2011. Give the adjusting entry that is necessary on 2010
December 31, if financial statements are prepared at the end of each month.
Exercise L A firm borrowed USD 30,000 on November 1. By December 31, USD 300 of interest had been
incurred. Prepare the adjusting entry required on December 31.
Exercise M Convenient Mailing Services, Inc., incurs salaries at the rate of USD 3,000 per day. The last payday
in January is Friday, January 27. Salaries for Monday and Tuesday of the next week have not been recorded or paid
as of January 31. Financial statements are prepared monthly. Give the necessary adjusting entry on January 31.
Exercise N State the effect that each of the following independent situations would have on the amount of
annual net income reported for 2010 and 2011.
a, No adjustment was made for accrued salaries of USD 8,000 as of 2010 December 31.
b. The collection of USD 5,000 for services yet unperformed as of 2010 December 31, was credited to a revenue
account and not adjusted. The services are performed in 2011.
Exercise O In the following table, indicate the effects of failing to recognize each of the indicated adjustments
by writing “O” for overstated and “U” for understated.
Effect on Balance Sheet Items
Effect on Stockholders'
Failure to Recognize Net Income Assets Liabilities Equity
1. Depreciation on a building
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2. Consumption of supplies on hand
3. The earning of ticket revenue
received in advance
4. The earning of interest on a bank
account
5. Salaries incurred by unpaid
Exercise P The following data regarding net income (loss) are for Perkins Parts, a medium-sized automotive
supplier, for the period 2004–2009.
Net Income Net Income
(Earnings) (Earnings)
($ millions) ($ millions)
1989 ...... ........... $ 860 1995 ........ .............. $ 4,139 1990 ...... ........... 3,835 1996 ........ .............. 4,446 1991 ...... ........... (2,258) 1997 ........ .............. 6,920 1992 ...... ........... (7,385) 1998 ........ .............. 22,071 1993 ...... ........... 2,529 1999 ........ .............. 7,237 1994 ...... ........... 5,308 2000 ........ .............. 3,467
Using 1989 as the base year, calculate the trend percentages, and comment on the results.
Problems
Problem A Among other items, the trial balance of Filmblaster, Inc., a movie rental company, at December 31
of the current year includes the following account balances:
Debits
Prepaid Insurance USD 10,000
Prepaid Rent USD 14,400
Supplies on Hand USD 2,800
Examination of the records shows that adjustments should be made for the following items:
a. Of the prepaid insurance in the trial balance, USD 4,000 is for coverage during the months after December 31
of the current year.
b. The balance in the Prepaid Rent account is for a 12-month period that started October 1 of the current year.
c. USD 300 of interest has been earned but not received.
d. Supplies used during the year amount to USD 1,800.
Prepare the annual year-end adjusting journal entries at December 31.
Problem B Marathon Magazine, Inc., has the following account balances, among others, in its trial balance at
December 31 of the current year:
Debits Credits
Supplies on Hand.................. $3,720
Prepaid Rent ......................... 7,200
Unearned Subscription Fees ... $15,000
Subscriptions Revenue........... 261,000
Salaries Expense ................... 123,000
• The inventory of supplies on hand at December 31 amounts to USD 720.
• The balance in the Prepaid Rent account is for a one-year period starting October 1 of the current year.
• One-third of the USD 15,000 balance in Unearned Subscription Fees has been earned.
Accounting Principles: A Business Perspective 142 A Global Text
3. Adjustments for financial reporting
• Since the last payday, the employees of the company have earned additional salaries in the amount of USD
5,430.
a. Prepare the year-end adjusting journal entries at December 31.
b. Open ledger accounts for each of the accounts involved, enter the balances as shown in the trial balance, post
the adjusting journal entries, and calculate year-end balances.
Problem C Hillside Apartments, Inc., adjusts and closes its books each December 31. Assume the accounts for
all prior years have been properly adjusted and closed. Following are some of the company’s account balances prior
to adjustment on 2010 December 31:
HILLSIDE APARTMENTS, INC.
Partial Trial Balance
2010 December 31
Debits Credits Prepaid insurance $ 7,500 Supplies on hand 7,000 Buildings 255,000 Accumulated deprecation – Buildings $ 96,000 Unearned rent 2,700 Salaries expense 69,000 Rent revenue 277,500
The Prepaid Insurance account balance represents the remaining cost of a four-year insurance policy dated 2011
June 30, having a total premium of USD 12,000.
The physical inventory of the office supply stockroom indicates that the supplies on hand cost USD 3,000.
The building was originally acquired on 1994 January 1, at which time management estimated that the building
would last 40 years and have a residual value of USD 15,000.
Salaries earned since the last payday but unpaid at December 31 amount to USD 5,000.
Interest earned but not collected on a savings account during the year amounts to USD 400.
The Unearned Rent account arose through the prepayment of rent by a tenant in the building for 12 months
beginning 2010 October 1.
Prepare the annual year-end adjusting entries indicated by the additional data.
Problem D The reported net income amounts for Gulf Coast Magazine, Inc., for calendar years 2010 and 2011
were USD 200,000 and USD 222,000, respectively. No annual adjusting entries were made at either year-end for
any of the following transactions:
A fire insurance policy to cover a three-year period from the date of payment was purchased on 2010 March 1 for
USD 3,600. The Prepaid Insurance account was debited at the date of purchase.
Subscriptions for magazines in the amount of USD 72,000 to cover an 18-month period from 2010 May 1, were
received on 2010 April 15. The Unearned Subscription Fees account was credited when the payments were received.
A building costing USD 180,000 and having an estimated useful life of 50 years and a residual value of USD
30,000 was purchased and put into service on 2010 January 1.
On 2011 January 12, salaries of USD 9,600 were paid to employees. The account debited was Salaries Expense.
One-third of the amount paid was earned by employees in December of 2010.
Calculate the correct net income for 2010 and 2011. In your answer, start with the reported net income. Then
show the effects of each correction (adjustment), using a plus or a minus to indicate whether reported income
should be increased or decreased as a result of the correction. When the corrections are added to or deducted from
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the reported net income amounts, the result should be the correct net income amounts. The answer format should
appear as follows:
Explanation of corrections 2010 2011 Reported net income $200,000 $222,000 To correct error in accounting for: Fire insurance policy premium: Correct expense in 2010 -1,000 Correct expense in 2011 -1,200
Problem E Jupiter Publishing Company began operations on 2010 December 1. The company’s bookkeeper
intended to use the cash basis of accounting. Consequently, the bookkeeper recorded all cash receipts and
disbursements for items relating to operations in revenue and expense accounts. No adjusting entries were made
prior to preparing the financial statements for December.
Dec. 1 Issued capital stock for USD 300,000 cash.
3 Received USD 144,000 for magazine subscriptions to run for two years from this date. The magazine is
published monthly on the 23rd.
4 Paid for advertising to be run in a national periodical for six months (starting this month). The cost was
USD 36,000.
7 Purchased for cash an insurance policy to cover a two-year period beginning December 15, USD 24,000.
12 Paid the annual rent on the building, USD 36,000, effective through 2011 November 30.
15 Received USD 216,000 cash for two-year subscriptions starting with the December issue.
15 Salaries for the period December 1–15 amounted to USD 48,000. Beginning as of this date, salaries will be
paid on the 5th and 20th of each month for the preceding two-week period.
20 Salaries for the period December 1–15 were paid.
23 Supplies purchased for cash, USD 21,600. (Only USD 1,800 of these were subsequently used in 2010.)
27 Printing costs applicable equally to the next six issues beginning with the December issue were paid in
cash, USD 144,000.
31 Cash sales of the December issue, USD 84,000.
31 Unpaid salaries for the period December 16–31 amounted to USD 22,000.
31 Sales on account of December issue, USD 14,000.
a. Prepare journal entries for the transactions as the bookkeeper prepared them.
b. Prepare journal entries as they would have been prepared under the accrual basis. Where the entry is the
same as under the cash basis, merely indicate “same”. Where possible, record the original transaction so that no
adjusting entry would be necessary at the end of the month. Ignore explanations.
Alternate problems
Alternate problem A The trial balance of Caribbean Vacation Tours, Inc., at December 31 of the current year
includes, among other items, the following account balances:
Debits Credits
Prepaid Insurance ........................................ $24,000
Prepaid Rent ................................................ 24,000
Buildings...................................................... 188,000
Accumulated Depreciation—Buildings............. $31,600
Salaries Expense .......................................... 200,000
Accounting Principles: A Business Perspective 144 A Global Text
3. Adjustments for financial reporting
The balance in the Prepaid Insurance account is the advance premium for one year from September 1 of the
current year.
The buildings are expected to last 25 years, with an expected residual value of USD 30,000.
Salaries incurred but not paid as of December 31 amount to USD 8,400.
The balance in Prepaid Rent is for a one-year period that started March 1 of the current year.
Prepare the annual year-end adjusting journal entries at December 31.
Alternate problem B Among the account balances shown in the trial balance of Dunwoody Mail Station, Inc.,
at December 31 of the current year are the following:
Debits Credits Supplies on hand $10,000 Prepaid insurance 6,000 Buildings 168,000 Accumulated deprecation and buildings $ 39,000
The inventory of supplies on hand at December 31 amounts to USD 3,000.
The balance in the Prepaid Insurance account is for a two-year policy taken out June 1 of the current year.
Depreciation for the buildings is based on the cost shown in the Buildings account, less residual value estimated
at USD18,000. When acquired, the lives of the buildings were estimated at 50 years each.
a. Prepare the year-end adjusting journal entries at December 31.
b. Open ledger accounts for each of the accounts involved, enter the balances as shown in the trial balance, post
the adjusting journal entries, and calculate year-end balances.
Alternate problem C Nevada Camping Equipment Rental Company occupies rented quarters on the main
street of Las Vegas. To get this location, the company rented a store larger than needed and subleased (rented) a
portion of the area to Max’s Restaurant. The partial trial balance of Nevada Camping Equipment Rental Company
as of 2010 December 31, is as follows:
NEVEDA CAMPING EQUIPMENT RENTAL COMPANY
Trial Balance
2010 December 31
Debits Credits
Cash $100,000
Prepaid Insurance 11,400
Supplies on Hand 20,000
Camping Equipment 176,000
Accumulated Depreciation—Camping Equipment $ 19,200
Notes Payable 40,000
Equipment Rental Revenue 1,500,000
Sublease Rental Revenue 8,800
Building Rent Expense 14,400
Salaries Expense 196,000
a. Salaries of employees amount to USD 300 per day and were last paid through Wednesday, December 27.
December 31 is a Sunday. The store is closed Sundays.
b. An analysis of the Camping Equipment account disclosed:
Balance, 2010 January 1 $128,000 Addition, 2010 July 1 48,000 Balance, 2010 December 31, per trial balance $176,000
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The company estimates that all equipment will last 20 years from the date they were acquired and that the
residual value will be zero.
c. The store carries one combined insurance policy, which is taken out once a year effective August 1. The
premium on the policy now in force amounts to USD 7,200 per year.
d. Unused supplies on hand at 2010 December 31, have a cost of USD 9,200.
e. December’s rent from Max’s Restaurant has not yet been received, USD 800.
f. Interest accrued on the note payable is USD 700.
Prepare the annual year-end entries required by the preceding statement of facts.
Alternate problem D The reported net income amounts for Safety Waste Control Company were 2010, USD
200,000; and 2011, USD 230,000. No annual adjusting entries were made at either year-end for any of these
transactions:
a. A building was rented on 2010 April 1. Cash of USD 14,400 was paid on that date to cover a two-year period.
Prepaid Rent was debited.
b. The balance in the Office Supplies on Hand account on 2010 December 31, was USD 6,000. An inventory of
the supplies on 2010 December 31, revealed that only USD 3,500 were actually on hand at that date. No new
supplies were purchased during 2011. At 2011 December 31, an inventory of the supplies revealed that USD 800
were on hand.
c. A building costing USD 1,200,000 and having an estimated useful life of 40 years and a residual value of USD
240,000 was put into service on 2010 January 1.
d. Services were performed for customers in December 2010. The USD 24,000 bill for these services was not
sent until January 2011. The only transaction that was recorded was a debit to Cash and a credit to Service Revenue
when payment was received in January.
Calculate the correct net income for 2010 and 2011. In your answer, start with the reported net income amounts.
Then show the effects of each correction (adjustment) using a plus or a minus to indicate whether reported income
should be increased or decreased as a result of the correction. When the corrections are added to or deducted from
the reported net income amounts, the result should be the correct net income amounts. The answer format should
be as follows:
Explanation of Corrections 2010 2011
Reported net income $200,000 $230,000 To correct error in accounting for:
Prepaid rent:
Correct expense in 2010 -5,400
Correct expense in 2011 -7,200
Alternate problem E On 2010 June 1, Richard Cross opened a swimming pool cleaning and maintenance
service, Cross Pool Company. He vaguely recalled the process of making journal entries and establishing ledger
accounts from a high school bookkeeping course he had taken some years ago. At the end of June, he prepared an
income statement for the month of June, but he had the feeling that he had not proceeded correctly. He contacted
his brother, John, a recent college graduate with a major in accounting, for assistance. John immediately noted that
his brother had kept his records on a cash basis.
June 1 Received cash of USD 28,000 from various customers in exchange for service agreements to clean and
maintain their pools for June, July, August, and September.
Accounting Principles: A Business Perspective 146 A Global Text
3. Adjustments for financial reporting
5 Paid rent for automotive and cleaning equipment to be used during the period June through September, USD
8,000. The payment covered the entire period.
8 Purchased a two-year liability insurance policy effective June 1 for USD 12,000 cash.
10 Received an advance of USD 9,000 from a Florida building contractor in exchange for an agreement to help
service pools in his housing development during October through May.
16 Paid salaries for the first half of June, USD 8,400.
17 Paid USD 900 for advertising to be run in a local newspaper for two weeks in June and four weeks in July.
19 Paid the rent of USD 24,000 under a four-month lease on a building rented and occupied on June 1.
26 Purchased USD 5,400 of supplies for cash. (Only USD 900 of these supplies were used in June.)
29 Billed various customers for services rendered, USD 16,000.
30 Unpaid employee services received in the last half of June amounted to USD 12,600.
30 Received a bill for USD 600 for gas and oil used in June.
a. Prepare the entries for the transactions as Richard must have recorded them under the cash basis of
accounting.
b. Prepare journal entries as they would have been prepared under the accrual basis. Where the entry is the
same as under the cash basis, merely indicate “same”. Where possible, record the original transaction so that no
adjusting entry would be necessary at the end of the month. Ignore explanations.
Beyond the numbers—Critical thinking
Business decision case A You have just been hired by Top Executive Employment Agency, Inc., to help
prepare adjusting entries at the end of an accounting period. It becomes obvious to you that management does not
seem to have much of an understanding about the necessity or adjusting entries or which accounts might possibly
need adjustment. The first step you take is to prepare the following unadjusted trial balance from the general
ledger. Only those ledger accounts that had end-of-year balances are included in the trial balance.
Debits Credits
Cash $ 80,000
Accounts Receivable 28,000
Supplies on Hand 3,000
Prepaid Insurance 2,700
Office Equipment 120,000
Accumulated Depreciation—Office Equipment $ 45,000
Buildings 360,000
Accumulated Depreciation—Buildings 105,000
Accounts Payable 9,000
Loan Payable (Bank) 15,000
Unearned Commission Fees 30,000
Capital Stock 160,000
Retained Earnings 89,300
Commissions Revenue 270,000
Advertising Expense 6,000
Salaries Expense 112,500
Utilities Expense 7,500
Miscellaneous Expense 3,600
$723,300 $723,300
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a. Explain to management why adjusting entries in general are made.
b. Explain to management why some of the specific accounts appearing in the trial balance may need adjustment
and what the nature of each adjustment might be (do not worry about specific dollar amounts).
Business decision case B A friend of yours, Jack Andrews, is quite excited over the opportunity he has to
purchase the land and several miscellaneous assets of Drake Bowling Lanes Company for USD 400,000. Andrews
tells you that Mr and Mrs Drake (the sole stockholders in the company) are moving due to Mr Drake’s ill health.
The annual rent on the building and equipment is USD 54,000.
Drake reports that the business earned a profit of USD 100,000 in 2010 (last year). Andrews believes an annual
profit of USD 100,000 on an investment of USD 400,000 is a really good deal. But, before completing the deal, he
asks you to look it over. You agree and discover the following:
Drake has computed his annual profit for 2010 as the sum of his cash dividends plus the increase in the Cash
account: Dividends of USD 60,000 + Increase in Cash account of USD 40,000 = USD 100,000 profit.
As buyer of the business, Andrews will take over responsibility for repayment of a USD 300,000 loan (plus
interest) on the land. The land was acquired at a cost of USD 624,000 seven years ago.
An analysis of the Cash account shows the following for 2010:
Rental revenues received $465,000
Cash paid out in 2010 for—
Salaries paid to employees $260,000
Utilities paid 18,000
Advertising expenses paid 15,000
Supplies purchased and used 24,000
Interest paid on loan 18,000
Loan principal paid 30,000
Cash dividends 60,000 425,000 In crease in cash balance for the year $ 40,000
You also find that the annual rent of USD 54,000, a December utility bill of USD 4,000, and an advertising bill
of USD 6,000 have not been paid.
a. Prepare a written report for Andrews giving your appraisal of Drake Bowling Lanes Company as an
investment. Comment on Drake’s method of computing the annual profit of the business.
b. Include in your report an approximate income statement for 2010.
Group project C In teams of two or three students, go to the library to locate one company’s annual report for
the most recent year. Identify the name of the company and the major products or services offered, as well as gross
revenues, major expenses, and the trend of profits over the last three years. Calculate trend percentages for
revenues, expenses, and profits using the oldest year as the base year. Each team should write a memorandum to
management summarizing the data and commenting on the trend percentages. The heading of the memorandum
should contain the date, to whom it is written, from whom, and the subject matter.
Group project D With one or two other students and using library and internet sources, write a paper on
Statement of Accounting Standards No. 106, “Accounting for Postretirement Benefits Other Than Pensions”. This
standard resulted in some of the largest adjusting entries ever made. Companies had to record an expense and a
liability to account for these costs on an accrual basis. In the past they typically had recorded this expense on a cash
basis, recognizing the expense only when cash was paid to retirees. Be sure to cite your sources and treat direct
quotes properly.
Accounting Principles: A Business Perspective 148 A Global Text
3. Adjustments for financial reporting
Group project E With one or two other students and using library sources, write a paper on human resource
accounting. Generally accepted accounting principles do not allow “human assets” to be included among assets on
the balance sheet. Why is this? Be sure to cite your sources and to treat direct quotes properly.
Using the Internet—A view of the real world
Visit the website:
http://www.pwcglobal.com
Click on the Sarbanes-Oxley Act. Write a brief report to your instructor summarizing your findings.
Answers to self-test
True-false
True. Every adjusting entry involves either moving previously recorded data from an asset account to an
expense account or from a liability account to a revenue account (or in the opposite direction) or simultaneously
entering new data in an asset account and a revenue account or in a liability account and an expense account.
True. A fiscal year is any 12 consecutive months, so all calendar years are also fiscal years. A calendar year,
however, must end on December 31, so it does not include fiscal years that end on any date other than December 31
(such as June 30).
False. The accumulated depreciation account is a contra asset that shows the total of all depreciation recorded
on an asset from its acquisition date up through the balance sheet date.
False. The Unearned Delivery Fees account is a liability. As the fees are earned, the amount in that account is
transferred to a revenue account.
True. If an adjusting entry is overlooked and not made, at least one income statement account and one balance
sheet account will be incorrect.
Multiple-choice
d. One-third of the benefits have expired. Therefore, USD 400 must be moved from the asset (credit) to an
expense (debit).
a. USD 1,100 of the supplies have been used, so that amount must be moved from the asset (credit) to an
expense (debit).
c. The amount of annual depreciation is determined as (USD 20,000 – USD 5,000) divided by 5 = USD 3,000.
The debit is to Depreciation Expense—Trucks, and the credit is to Accumulated Depreciation—Trucks, a contra
asset account.
b. Each month USD 2,000 would be transferred from the liability account (debit), Unearned Subscription Fees,
to a revenue account (credit).
b. An asset, Interest Receivable, is debited, and Interest Revenue is credited.
a. The debit would be to Salaries Expense, and the credit would be to Salaries Payable.
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4. Completing the accounting cycle
Learning objectives
After studying this chapter, you should be able to:
• Summarize the steps in the accounting cycle.
• Prepare a work sheet for a service company.
• Prepare an income statement, statement of retained earnings, and balance sheet using information contained
in the work sheet.
• Prepare adjusting and closing entries using information contained in the work sheet.
• Prepare a post-closing trial balance.
• Describe the evolution of accounting systems.
• Prepare a classified balance sheet.
• Analyze and use the financial results—the current ratio.
A career in information systems
Have you ever heard the sayings "knowledge is power" or "information is money"? When people talk about
accounting, what they are really talking about is information. The information used by businesses, as well as the
technology that supports that information, represents some of the most valuable assets for organizations around
the world. Very often, the success of a business depends on effective creation, management, and use of information.
As companies become ever more reliant on technology, the need for well-educated Management Information
Systems (MIS) auditors and control professionals increases. Improved technology has the potential to dramatically
improve business organizations and practices, reduce costs and exploit new business and investment opportunities.
At the same time, companies face constant challenges in selecting and implementing these new technologies.
Because of their high value and inherent complexity, the development, support, and auditing of information
systems has become one of the fastest growing specialties in accounting.
Graduates with special interests and skills in computing and technology have expansive opportunities. In
addition to traditional accounting and auditing functions, MIS professionals perform evaluations of technologies
and communications protocols involving electronic data interchange, client servers, local and wide area networks,
data communications, telecommunications, and integrated voice/data/video systems. In public accounting,
technology has impacted the auditing profession by extending the knowledge required to draw conclusions and the
skills required to audit advanced accounting and information systems.
With management consulting practices growing and information systems becoming a larger percentage of public
accounting revenue, MIS professionals are in high demand. If you are considering a degree in computer or
information systems, you should consider the advantages that an accounting major or minor can give you in
Accounting Principles: A Business Perspective 150 A Global Text
4. Completing the accounting cycle
working closely with businesses and consulting firms. A dual major in accounting and MIS is one of the most
desirable undergraduate degree combinations in the workforce.
This chapter explains two new steps in the accounting cycle—the preparation of the work sheet and closing
entries. In addition, we briefly discuss the evolution of accounting systems and present a classified balance sheet.
This balance sheet format more closely resembles actual company balance sheets. After completing this chapter,
you will understand how accounting begins with source documents that are evidence of a business entity's
transactions and ends with financial statements that show the solvency and profitability of the entity.
The accounting cycle summarized
In Chapter 1, you learned that when an event is a measurable business transaction, you need adequate proof of
this transaction. Then, you analyze the transaction's effects on the accounting equation, Assets = Liabilities +
Stockholders' equity. In Chapters 2 and 3, you performed other steps in the accounting cycle. Chapter 2 presented
the eight steps in the accounting cycle as a preview of the content of Chapters 2 through 4. As a review, study the
diagram of the eight steps in the accounting cycle in Exhibit 19. Remember that the first three steps occur during
the accounting period and the last five occur at the end. The next section explains how to use the work sheet to
facilitate the completion of the accounting cycle.
The work sheet
The work sheet is a columnar sheet of paper or a computer spreadsheet on which accountants summarize
information needed to make the adjusting and closing entries and to prepare the financial statements. Usually, they
save these work sheets to document the end-of-period entries. A work sheet is only an accounting tool and not part
of the formal accounting records. Therefore, work sheets may vary in format; some are prepared in pencil so that
errors can be corrected easily. Other work sheets are prepared on personal computers with spreadsheet software.
Accountants prepare work sheets each time financial statements are needed—monthly, quarterly, or at the end of
the accounting year.
This chapter illustrates a 12-column work sheet that includes sets of columns for an unadjusted trial balance,
adjustments, adjusted trial balance, income statement, statement of retained earnings, and balance sheet. Each set
has a debit and a credit column. (See Exhibit 20.)
Accountants use these initial steps in preparing the work sheet. The following sections describe the detailed
steps for completing the work sheet.
• Enter the titles and balances of ledger accounts in the Trial Balance columns.
• Enter adjustments in the Adjustments columns.
• Enter adjusted account balances in the Adjusted Trial Balance columns.
• Extend adjusted balances of revenue and expense accounts from the Adjusted Trial Balance columns to the
Income Statement columns.
• Extend any balances in the Retained Earnings and Dividends accounts to the Statement of Retained
Earnings columns.
• Extend adjusted balances of asset, liability, and capital stock accounts from the Adjusted Trial Balance
columns to the Balance Sheet columns.
Instead of preparing a separate trial balance as we did in Chapter 2, accountants use the Trial Balance columns
on a work sheet. Look at Exhibit 20 and note that the numbers and titles of the ledger accounts of MicroTrain
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Company are on the left portion of the work sheet. Usually, only those accounts with balances as of the end of the
accounting period are listed. (Some accountants do list the entire chart of accounts, even those with zero balances.)
Assume you are MicroTrain's accountant. You list the Retained Earnings account in the trial balance even though it
has a zero balance to (1) show its relative position among the accounts and (2) indicate that December 2010 is the
first month of operations for this company. Next, you enter the balances of the ledger accounts in the Trial Balance
columns. The accounts are in the order in which they appear in the general ledger: assets, liabilities, stockholders'
equity, dividends, revenues, and expenses. Then, total the columns. If the debit and credit column totals are not
equal, an error exists that must be corrected before you proceed with the work sheet.
As you learned in Chapter 3, adjustments bring the accounts to their proper balances before accountants
prepare the income statement, statement of retained earnings, and balance sheet. You enter these adjustments in
the Adjustments columns of the work sheet. Also, you cross-reference the debits and credits of the entries by
placing a key number or letter to the left of the amounts. This key number facilitates the actual journalizing of the
adjusting entries later because you do not have to rethink the adjustments to record them. For example, the number
(1) identifies the adjustment debiting Insurance Expense and crediting Prepaid Insurance. Note in the Account
Titles column that the Insurance Expense account title is below the trial balance totals because the Insurance
Expense account did not have a balance before the adjustment and, therefore, did not appear in the trial balance.
Work sheet preparers often provide brief explanations at the bottom for the keyed entries as in Exhibit 20.
Although these explanations are optional, they provide valuable information for those who review the work sheet
later.
The adjustments (which were discussed and illustrated in Chapter 3) for MicroTrain Company are:
Accounting Principles: A Business Perspective 152 A Global Text
4. Completing the accounting cycle
Exhibit 19: Steps in the accounting cycle
• Entry (1) records the expiration of USD 200 of prepaid insurance in December.
• Entry (2) records the expiration of USD 400 of prepaid rent in December.
• Entry (3) records the using up of USD 500 of supplies during the month.
• Entry (4) records USD 750 depreciation expense on the trucks for the month. MicroTrain acquired the
trucks at the beginning of December.
MicroTrain acquired the trucks at the beginning of December
• Entry (5) records the earning of USD 1,500 of the USD 4,500 in the Unearned Service Fees account.
• Entry (6) records USD 600 of interest earned in December.
• Entry (7) records USD 1,000 of unbilled training services performed in December.
• Entry (8) records the USD 180 accrual of salaries expense at the end of the month.
Often it is difficult to discover all the adjusting entries that should be made. The following steps are helpful:
• Examine adjusting entries made at the end of the preceding accounting period. The same types of entries
often are necessary period after period.
• Examine the account titles in the trial balance. For example, if the company has an account titled Trucks, an
entry must be made for depreciation.
• Examine various business documents (such as bills for services received or rendered) to discover other
assets, liabilities, revenues, and expenses that have not yet been recorded.
• Ask the manager or other personnel specific questions regarding adjustments that may be necessary. For
example: "Were any services performed during the month that have not yet been billed?"
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MICROTRAIN COMPANY Work Sheet For the Month Ended 2010 December 31
Acc t.
Account Titles
Trial Balance Adjustments Adjusted Trail Balance
Income Statement
Statement of Retained Earnings
Balance Sheet
No. Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit Debit
100 Cash 8,250 8,250 8,250 103 Accounts
Receivable 5,200 (7)
1,000 6,200 6,200
107 Supplies on Hand 1,400 (3) 500 900 900 108 Prepaid Insurance 2,400 n) 200 2,200 2,200 112 Prepaid Rent 1,200 (2) 400 BOO 800 150 Trucks 40,0 0 0 40,00
0 40,000
200 Accounts Payable 730 730 216 Unearned Service
Fees 4,500 (5)
1,500 3,000
300 Capital Stock 50,000 50,000 310 Retained Earnings
2010 December 31
—0- —0— -0-
320 Dividends 3,000 3,000 3,000 400 Service (5)
1,500 Revenue 10,700 (7)
1,000 13,200 13,20
0 505 Advertising
Expense 50 SO 50
506 Gas and Oil Expense
690 660 680
507 Salaries Expense 3,600 (3) 130 3,7S0 3,780 511 Utilities Expense 150 ISO 150
65,930 65,930 512 Insurance Expense (1) 200 200 200
SIS Rent Expense (Z) 400 400 400
518 Supplies Expense (3) 500 500 500 521 Depreciation
Expense- Trucks (t) 750 750 750
151 Accumulated Depreciation- Trucks (t) 750 750
121 Interest Receivable m 6O0
600 600
418 Interest Revenue (6) 500 600 GOO 206 Salaries Payable (S) 180 ISO
5,130 5,130 53,40 0
6S,4G0 6,510 13,80 0
Net Income 7,290 7,290
13,80 0
13,80 0
3,000 7,29C
Retained Earnings, 2010 December 31
4,290
7,290 7,29C 53,950
Exhibit 20: Completed worksheet
(1) To record insurance expenses for December.
(2) To record rent expenses for December.
(3) To record supplies expenses for December.
(4) To record depreciation expenses for December.
(5) To transfer fees for service provided in December from the liability account to the revenue account.
(6) To record one month's interest revenue.
Accounting Principles: A Business Perspective 154 A Global Text
4. Completing the accounting cycle
(7) To record unbilled training services performed in December.
(8) To accrue one day's salaries that were earned but are unpaid.
After all the adjusting entries are entered in the Adjustments columns, total the two columns. The totals of these
two columns should be equal when all debits and credits are entered properly.
After MicroTrain's adjustments, compute the adjusted balance of each account and enter these in the Adjusted
Trial Balance columns. For example, Supplies on Hand (Account No. 107) had an unadjusted balance of USD 1,400.
Adjusting entry (3) credited the account for USD 500, leaving a debit balance of USD 900. This amount is a debit in
the Adjusted Trial Balance columns.
Next, extend all accounts having balances to the Adjusted Trial Balance columns. Note carefully how the rules of
debit and credit apply in determining whether an adjustment increases or decreases the account balance. For
example, Salaries Expense (Account No. 507) has a USD 3,600 debit balance in the Trial Balance columns. A USD
180 debit adjustment increases this account, which has a USD 3,780 debit balance in the Adjusted Trial Balance
columns.
Some account balances remain the same because no adjustments have affected them. For example, the balance
in Accounts Payable (Account No. 200) does not change and is simply extended to the Adjusted Trial Balance
columns.
Now, total the Adjusted Trial Balance debit and credit columns. The totals must be equal before taking the next
step in completing the work sheet. When the Trial Balance and Adjustments columns both balance but the Adjusted
Trial Balance columns do not, the most probable cause is a math error or an error in extension. The Adjusted Trial
Balance columns make the next step of sorting the amounts to the Income Statement, the Statement of Retained
Earnings, and the Balance Sheet columns much easier.
Begin by extending all of MicroTrain's revenue and expense account balances in the Adjusted Trial Balance
columns to the Income Statement columns. Since revenues carry credit balances, extend them to the credit column.
After extending expenses to the debit column, subtotal each column. MicroTrain's total expenses are USD 6,510 and
total revenues are USD 13,800. Thus, net income for the period is USD 7,290 (USD 13,800—USD 6,510). Enter this
USD 7,290 income in the debit column to make the two column totals balance. You would record a net loss in the
opposite manner; expenses (debits) would have been larger than revenues (credits) so a net loss would be entered
in the credit column to make the columns balance.
Next, complete the Statement of Retained Earnings columns. Enter the USD 7,290 net income amount for
December in the credit Statement of Retained Earnings column. Thus, this net income amount is the balancing
figure for the Income Statement columns and is also in the credit Statement of Retained Earnings column. Net
income appears in the Statement of Retained Earnings credit column because it causes an increase in retained
earnings. Add the USD 7,290 net income to the beginning retained earnings balance of USD 0, and deduct the
dividends of USD 3,000. As a result, the ending balance of the Retained Earnings account is USD 4,290.
Now extend the assets, liabilities, and capital stock accounts in the Adjusted Trial Balance columns to the
Balance Sheet columns. Extend asset amounts as debits and liability and capital stock amounts as credits.
Note that the ending retained earnings amount determined in the Statement of Retained Earnings columns
appears again as a credit in the Balance Sheet columns. The ending retained earnings amount is a debit in the
Statement of Retained Earnings columns to balance the Statement of Retained Earnings columns. The ending
retained earnings is a credit in the Balance Sheet columns because it increases stockholders' equity, and increases
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in stockholders' equity are credits. (Retained earnings would have a debit ending balance only if cumulative losses
and dividends exceed cumulative earnings.) With the inclusion of the ending retained earnings amount, the Balance
Sheet columns balance.
When the Balance Sheet column totals do not agree on the first attempt, work backward through the process
used in preparing the work sheet. Specifically, take the following steps until you discover the error:
MICROTRAIN COMPANY
Income Statement
For the Month Ended 2010 December 31
Revenues:
Service Revenue $13,200
Interest Revenue 600
Total Revenue $13,800
Expenses:
Advertising Expense $ 50
Gas and Oil Expense 680
Salaries Expense 3,780
Utilities Expense 150
Insurance Expense 200
Rent Expense 400
Supplies Expense 500
Depreciation Expense—Trucks 750
Total Expense 6,510
Net Income $ 7,290
Exhibit 21: Income statement
• Re-total the two Balance Sheet columns to see if you made an error in addition. If the column totals do not
agree, check to see if you did not extend a balance sheet item or if you made an incorrect extension from the
Adjusted Trial Balance columns.
• Re-total the Statement of Retained Earnings columns and determine whether you entered the correct
amount of retained earnings in the appropriate Statement of Retained Earnings and Balance Sheet
columns.
• Re-total the Income Statement columns and determine whether you entered the correct amount of net
income or net loss for the period in the appropriate Income Statement and Statement of Retained Earnings
columns.
An accounting perspective:
Uses of technology
Electronic spreadsheets have numerous applications in accounting. An electronic spreadsheet is
simply a large blank page that contains rows and columns on the computer screen. The blocks
created by the intersection of the rows and columns are cells; each cell can hold one or more words,
a number, or the product of a mathematical formula. Spreadsheets are ideal for creating large work
sheets, trial balances, and other schedules, and for performing large volumes of calculations such
Accounting Principles: A Business Perspective 156 A Global Text
4. Completing the accounting cycle
as depreciation calculations. The most popular spreadsheet program is Microsoft Excel®. Free
spreadsheet programs are also available from companies such as Google and Zoho.
Preparing financial statements from the work sheet
When the work sheet is completed, all the necessary information to prepare the income statement, statement of
retained earnings, and balance sheet is readily available. Now, you need only recast the information into the
appropriate financial statement format.
The information you need to prepare the income statement in Exhibit 21 is in the work sheet's Income
Statement columns in Exhibit 20.
The information you need to prepare the statement of retained earnings is taken from the Statement of Retained
Earnings columns in the work sheet. Look at Exhibit 22, MicroTrain Company's statement of retained earnings for
the month ended 2010 December 31. To prepare this statement, use the beginning Retained Earnings account
balance (Account No. 310), add the net income (or deduct the net loss), and then subtract the Dividends (Account
No. 320). Carry the ending Retained Earnings balance forward to the balance sheet. Remember that the statement
of retained earnings helps to relate income statement information to balance sheet information. It does this by
indicating how net income on the income statement relates to retained earnings on the balance sheet.
MICROTRAIN COMPANY
Statement of Retained Earnings
For the Month Ended 2010 December 31,
Retained earnings, 2010 December 1 $ —0— Net income for the December 7,290
Total $ 7,290 Less: Dividends 3,000
Retained earnings, 2010 December 31 $ 4,290
Exhibit 22: Statement of retained earnings
MICROTRAIN COMPANY
Balance Sheet
2010 December 31
Assets
Cash $ 8,250 Accounts receivable 6,200 Supplies on hand 900 Prepaid insurance 2,200 Prepaid rent 800 Interest receivable 600 Trucks $ 40,000
Less: Accumulated depredation 750 39,250 Total assets $ 58,200 Liabilities and Stockholders' Equity
Liabilities:
Accounts payable $ 730 Unearned service fees 3,000 Salaries payable 180 Total liabilities $ 3,910 Stockholders' equity:
Capital stock $ 50,000
Retained earnings 4,290
Total stockholders' equity 54,290 Total liabilities and stockholders' equity $ 58,200
Exhibit 23: Balance sheet
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The information needed to prepare a balance sheet comes from the Balance Sheet columns of MicroTrain's work
sheet (Exhibit 20). As stated earlier, the correct amount for the ending retained earnings appears on the statement
of retained earnings. See the completed balance sheet for MicroTrain in Exhibit 23.
Journalizing adjusting entries
After completing MicroTrain's financial statements from the work sheet, you should enter the adjusting entries
in the general journal and post them to the appropriate ledger accounts. You would prepare these adjusting entries
as you learned in Chapter 3, except that the work sheet is now your source for making the entries. The preparation
of a work sheet does not eliminate the need to prepare and post adjusting entries because the work sheet is only an
informal accounting tool and is not part of the formal accounting records.
The numerical notations in the Adjustments columns and the adjustments explanations at the bottom of the
work sheet identify each adjusting entry. The Adjustments columns show each entry with its appropriate debit and
credit. MicroTrain's adjusting entries as they would appear in the general journal after posting are:
MICROTRAIN COMPANY General Journal page3
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Adjusting Entries
Dec. 31 Insurance Expense (-SE) 512 2 0 0
Prepaid Insurance (-A) 108 2 0 0
To record insurance expense for December.
31 Rent Expense (-SE) 515 4 0 0
Prepaid Rent (-A) 112 4 0 0
To record rent expense for December.
31 Supplies Expense (-SE) 518 5 0 0
Supplies on Hand (-A) 107 5 0 0
To record supplies used during December.
31 Depreciation Expense—Trucks (-SE) 521 7 5 0
Accumulated Depredation—Trucks (-A) 151 7 5 0
To record depreciation expense for December.
31 Unearned Service Fees (-L) 216 1 5 0 0
Service Revenue (+SE) 400 1 5 0 0
To transfer a potion of training fees from the liability account
to the revenue account.
31 Interest Receivable (+A) 121 6 0 0
Interest Revenue (+SE) 418 6 0 0
To record one month's interest revenue.
31 Accounts Receivable (+A) 103 1 0 0 0
Service Revenue (+SE) 400 1 0 0 0
To record unbilled training services performed in December.
Accounting Principles: A Business Perspective 158 A Global Text
4. Completing the accounting cycle
31 Salaries Expense (-SE) 507 1 8 0
Salaries Payable (+L) 206 1 8 0
To accrue one day's salaries that were earned by are unpaid.
The closing process
In Chapter 2, you learned that revenue, expense, and dividends accounts are nominal (temporary) accounts that
are merely subclassifications of a real (permanent) account, Retained Earnings. You also learned that we prepare
financial statements for certain accounting periods. The closing process transfers (1) the balances in the revenue
and expense accounts to a clearing account called Income Summary and then to Retained Earnings and (2) the
balance in the Dividends account to the Retained Earnings account. The closing process reduces revenue, expense,
and Dividends account balances to zero so they are ready to receive data for the next accounting period.
Accountants may perform the closing process monthly or annually.
The Income Summary account is a clearing account used only at the end of an accounting period to
summarize revenues and expenses for the period. After transferring all revenue and expense account balances to
Income Summary, the balance in the Income Summary account represents the net income or net loss for the
period. Closing or transferring the balance in the Income Summary account to the Retained Earnings account
results in a zero balance in Income Summary.
Also closed at the end of the accounting period is the Dividends account containing the dividends declared by
the board of directors to the stockholders. We close the Dividends account directly to the Retained Earnings
account and not to Income Summary because dividends have no effect on income or loss for the period.
In accounting, we often refer to the process of closing as closing the books. Remember that only revenue,
expense, and Dividend accounts are closed—not asset, liability, Capital Stock, or Retained Earnings accounts. The
four basic steps in the closing process are:
• Closing the revenue accounts—transferring the balances in the revenue accounts to a clearing account
called Income Summary.
• Closing the expense accounts—transferring the balances in the expense accounts to a clearing account
called Income Summary.
• Closing the Income Summary account—transferring the balance of the Income Summary account to
the Retained Earnings account.
• Closing the Dividends account—transferring the balance of the Dividends account to the Retained
Earnings account.
Revenues appear in the Income Statement credit column of the work sheet. The two revenue accounts in the
Income Statement credit column for MicroTrain Company are service revenue of USD 13,200 and interest revenue
of USD 600 (Exhibit 20). Because revenue accounts have credit balances, you must debit them for an amount equal
to their balance to bring them to a zero balance. When you debit Service Revenue and Interest Revenue, credit
Income Summary (Account No. 600). Enter the account numbers in the Posting Reference column when the
journal entry has been posted to the ledger. Do this for all other closing journal entries.
MICROTRAIN COMPANY General Journal Page 4
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Closing Entries
Dec. 31 Service Revenue 400 1 3 2 0 0
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Interest Revenue 418 6 0 0
Income Summary 600 1 3 8 0 0
To close the revenue accounts in the Income Statement credit
column to Income Summary.
After the closing entries have been posted, the Service Revenue and Interest Revenue accounts (in T-account
format) of MicroTrain appear as follows. Note that the accounts now have zero balances.
Service Revenue (Dr) Account No. 400 (Cr.) 2010 Bal. before
closing 13,200
Dec. 31 To close to Decreased Income by $13,200 Summary13,20
0 Bal. after closing —0—
Interest Revenue Account No. 418 (Cr.)
2010 Bal. before closing
600
Dec. 31 To close to Decreased Income by $600 Summary 600
Bal. after closing —0—
As a result of the previous entry, you would credit the Income Summary account for USD 13,800. We show the
Income Summary account in Step 3.
Expenses appear in the Income Statement debit column of the work sheet. MicroTrain Company has eight
expenses in the Income Statement debit column. As shown by the column subtotal, these expenses add up to USD
6,510. Since expense accounts have debit balances, credit each account to bring it to a zero balance. Then, make the
debit in the closing entry to the Income Summary account for USD 6,510. Thus, to close the expense accounts,
MicroTrain makes the following entry:
MICROTRAIN COMPANY General Journal Page 4
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 Dec. 31 Income Summary 600 6 5 1 0
Advertising Expense 505 5 0
Gas and Oil Expense 506 6 8 0
Salaries Expense 507 3 7 8 0
Utilities Expense 511 1 5 0
Insurance Expense 512 2 0 0
Rent Expense 515 4 0 0
Supplies Expense 518 5 0 0
Depreciation Expense—Trucks 521 7 5 0
To close the expense accounts appearing in the Income
The debit of USD 6,510 to the Income Summary account agrees with the Income Statement debit column
subtotal in the work sheet. This comparison with the work sheet serves as a check that all revenue and expense
items have been listed and closed. If the debit in the preceding entry was made for a different amount than the
column subtotal, the company would have an error in the closing entry for expenses.
Accounting Principles: A Business Perspective 160 A Global Text
4. Completing the accounting cycle
After they have been closed, MicroTrain's expense accounts appear as follows. Note that each account has a zero
balance after closing.
Advertising Expense (Dr) Account No. 505 (Cr.)
Bal. before
closing
■ 50 2010 ■ ■
Dec. 31 To close to
Income
Decreased
Summary 50 by $50
Bal. after
closing
—0—
Gas and Oil Expense (Dr.) Account No. 506 (Cr.)
Bal. before
closing
680 2010
Dec. 31 To close to
Income Decreased
Summary 680 by $680
Bal. after
closing
—0—
(Dr.) Salaries Expense Account No. 507 (Cr.)
Bal. before
closing
3,780 2010
Dec. 31 To close to
Income
Decreased
Summary 3,780 by $3,780
Bal. after
closing
—0—
(Dr.) Utilities Expense Account No. 511 (Cr.)
Bal. before
closing
150 2010
Dec. 31 To close to
Income Decreased
Summary 150 by $150
Bal. after
closing
—0—
(Dr.) Insurance Expense Account No. 512 (Cr.)
Bal. before
closing
200 2010
Dec. 31 To close to
Income Decreased
Summary 200 by $200
Bal. after
closing
—0—
(Dr.) Rent Expense Account No. 515 (Cr.)
Bal. before
closing
400 2010
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Dec. 31 To close to
Income Decreased
Summary 400 by $400
Bal. after
closing
—0—
(Dr.) Supplies Expense Account No. 518 (Cr.)
Bal. before
closing
500 2010
Dec. 31 To close to
Income Decreased
Summary 500 by $500
Bal. after
closing
—0—
Depreciation Expense-Trucks (Dr.) Account No. 521 (Cr.)
Bal. before
closing
■ 750' 2010 "
Dec. 31 To close to
Income Decreased
Summary 750 by $750
Bal. after
closing
—0—
The expense accounts could be closed before the revenue accounts; the end result is the same.
As the result of closing the revenues and expenses of MicroTrain, the total revenues and expenses have been
transferred to the Income Summary account.
Income Summary If total expenses exceed total revenues, the account has a debit balance, which is the net loss for the period
Total expenses w
Total revenues If total revenues exceed total expenses, the account has a credit balance, which is the net income for the period.
MicroTrain's Income Summary account now has a credit balance of USD 7,290, the company's net income for
December.
(Dr) Income Summary (Cr.)
2010 Dec. 31
From closing the expense accounts
6,510 2010 Dec. 31 From closing the revenue accounts
13,800
Bal. before closing this account (net income) 7,290
Next, close MicroTrain's Income Summary account to its Retained Earnings account. The journal entry to do
this is:
MICROTRAIN COMPANY General Journal Page 4
Date Account Titles and Explanation Post. Ref. Debt Credit
2010 Dec. 31 Income Summary 600 7 2 9 0
Retained Earnings 310 7 2 9 0
To close the Income Summary account to the Retained
Earnings account.
After its Income Summary account is closed, the company's Income Summary and Retained Earnings accounts
appear as follows:
Accounting Principles: A Business Perspective 162 A Global Text
4. Completing the accounting cycle
Income Summary (Dr.) Account No. 600 (Cr.)
2010 Dec. 31 From closing the expense accounts 6,510
"2010 Dec. 31 From closing The revenue accounts 13,800 Bal. before closing this account (net income) 7,290
Dec. 31 To close this account to Retain ed Earnings 7,290
Bal. after closing —0—
Retained Earnings (Dr) Account No. 310 (Cr.)
Bal. before closing -0-
Process
2010
Dec. 31 From Income Summary
7,290 Decreased by $7,290
The last closing entry closes MicroTrain's Dividends account. This account has a debit balance before closing. To
close the account, credit the Dividends account and debit the Retained Earnings account. The Dividends account is
not closed to the Income Summary because it is not an expense and does not enter into income determination. The
journal entry to close MicroTrain's Dividends account is:
MICROTRAIN COMPANY General Journal Page 4
Date Account Titles and Explanation Post. Ref. Debit Credit
2010 Dec. 31 Retained Earnings (-SE) 310 3 0 0 0
Dividends (+SE) 320 3 0 0 0
To close the Dividends account to the Retained Earnings
account.
After this closing entry is posted, the company's Dividends and Retained Earnings accounts appear as follows:
Dividends (Dr.) Account No. 320 (Cr.)
Bal. before closing 3,000 2010 Dec. 31 To close to Retained Earning
3000
Decreased by $3,000
Bal. after closing —0—
Retained Earnings (Dr.) Account No. 310 (Cr.)
2010 Bal. before closing process -0-
Dec. 31 From dividends 3,000 2010 Dec. 31 From Income Summary 7,290 Bal. after closing process is complete 4,290
After you have completed the closing process, the only accounts in the general ledger that have not been closed
are the permanent balance sheet accounts. Because these accounts contain the opening balances for the coming
accounting period, debit balance totals must equal credit balance totals. The preparation of a post-closing trial
balance serves as a check on the accuracy of the closing process and ensures that the books are in balance at the
start of the new accounting period. The post-closing trial balance differs from the adjusted trial balance in only two
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important respects: (1) it excludes all temporary accounts since they have been closed; and (2) it updates the
Retained Earnings account to its proper ending balance.
A post-closing trial balance is a trial balance taken after the closing entries have been posted. The only
accounts that should be open are assets, liabilities, capital stock, and Retained Earnings accounts. List all the
account balances in the debit and credit columns and total them to make sure debits and credits are equal.
Look at Exhibit 24, a post-closing trial balance for MicroTrain Company as of 2010 December 31. The amounts
in the post-closing trial balance are from the ledger after the closing entries have been posted.
The next section briefly describes the evolution of accounting systems from the one-journal, one-ledger manual
system you have been studying to computerized systems. Then, we discuss the role of an accounting system.
An accounting perspective:
Uses of technology
If you are studying in the US, you may want to visit the American Institute of Certified Public
Accountants website at:
http://www.aicpa.org
You will find information about the CPA exam, about becoming a CPA, hot accounting topics, and
various other topics, such as the US states that have passed a 150-hour requirement to sit for the
CPA exam. You can also learn such things as the states that have approved limited liability
companies (LLCs) and limited liability partnerships (LLPs). These forms of organization serve to
place limits on accountants' liability. You can also find the phone numbers and mailing addresses
of State Boards of accountancy and State Societies of CPAs. Browse around this site to investigate
anything else that is of interest. Similar sites are available in other countries as well.
Accounting systems: From manual to computerized
The manual accounting system with only one general journal and one general ledger has been in use for
hundreds of years and is still used by some very small companies. Gradually, some manual systems evolved to
include multiple journals and ledgers for increased efficiency. For instance, a manual system with multiple journals
and ledgers often includes: a sales journal to record all credit sales, a purchases journal to record all credit
purchases, a cash receipts journal to record all cash receipts, and a cash disbursements journal to record all cash
payments. Still recorded in the general journal are adjusting and closing entries and any other entries that do not fit
in one of the special journals. Besides the general ledger, such a system normally has subsidiary ledgers for
accounts receivable and accounts payable showing how much each customer owes and how much is owed to each
supplier. The general ledger shows the total amount of accounts receivable and accounts payable, but the details in
the subsidiary ledgers allow companies to send bills to customers and pay bills to suppliers.
Another innovation in manual systems was the "one write" or pegboard system. By creating one document and
aligning other records under it on a pegboard, companies could record transactions more efficiently. These systems
permit the writing of a check and the simultaneous recording of the check in the cash disbursements journal. Even
though some of these systems are still in use today, computers make them obsolete.
Accounting Principles: A Business Perspective 164 A Global Text
4. Completing the accounting cycle
During the 1950s, companies also used bookkeeping machines to supplement manual systems. These machines
recorded recurring transactions such as sales on account. They posted transactions to the general ledger and
subsidiary ledger accounts and computed new balances. With the development of computers, bookkeeping
machines became obsolete. They were quite expensive, and computers easily outperformed them. In the mid-1950s,
large companies began using mainframe computers. Early accounting applications were in payroll, accounts
receivable, accounts payable, and inventory. Within a few years, programs existed for all phases of accounting,
including manufacturing operations and the total integration of other accounting programs with the general ledger.
Until the 1980s, small and medium-sized companies either continued with a manual system, rented time on
another company's computer, or hired a service bureau to perform at least some accounting functions.
MICROTRAIN COMPANY
Trial Balance
2010 December 31
Acct.
No. Account Title Debits Credits 100 Cash $ 8,250
103 Accounts Receivable 6,200
107 Supplies on Hand 900
108 Prepaid Insurance 2,200
112 Prepaid Rent 800
121 Interest Receivable 600
150 Trucks 40,000
151 Accumulated Depreciation—Trucks $ 750
200 Accounts Payable 730
206 Salaries Payable 180
216 Unearned Service Fees 3,000
300 Capital Stock 50,000
310 Retained Earnings 4,290
$ 58,950 $ 58,950
Exhibit 24: Post closing trial balance
An accounting perspective:
Business insight
Imagine a company with an Accounts Receivable account and an Accounts Payable account in its
general ledger and no Accounts Receivable Subsidiary Ledger or Accounts Payable Subsidiary
Ledger. How would this company know to whom to send bills and in what amounts? Also, how
would employees know for which suppliers to write checks and in what amounts? Such subsidiary
records are necessary either on paper or in a computer file.
Here is how the general ledger and subsidiary ledgers might look:
Subsidiary Accounts Receivable Ledger
General Ledger Subsidiary Accounts Payable Ledger
JOHN JONES ACCOUNTS RECEIVABLE BELL CORPORATION
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200 1 900 100
SYLVIA SMITH GRANGER CORPORATION
300 1 ACCOUNTS PAYABLE 600
1,000
JAMES WELLS WONG CORPORATION
400 1 300
When a sale on account is made to John Jones, the debit is posted to both the control account,
Accounts Receivable, in the General Ledger and the subsidiary account, John Jones, in the
Subsidiary Accounts Receivable Ledger. Likewise, when a purchase on account is made from Bell
Corporation, the credit is posted to both the control account, Accounts Payable, in the General
Ledger and to the subsidiary account, Bell Corporation, in the Subsidiary Accounts Payable Ledger.
At the end of the accounting period, the balances in each of the control accounts in the General
Ledger must agree with the totals of the accounts in their respective subsidiary ledgers as shown
above. A given company could have hundreds or even thousands of accounts in their subsidiary
ledgers that show the detail not supplied by the totals in the control accounts.
A broader perspective:
Skills for the long haul
The decision has been made: You [Tracy] have opted to start your career by joining an
international accounting firm. But you can not help wondering if you have the right skills both for
short and long-term success in public accounting.
Most students understand that accounting knowledge, organizational ability and interpersonal
skills are critical to success in public accounting. But it is important for the beginner to realize that
different skills are emphasized at different points in a public accountant's career.
Let us examine the duties and skills needed at each level—Staff Accountant (years 1-2), Senior
Accountant (years 3-4), Manager/ Senior Manager (years 5-11) and Partner (years 11+).
Staff accountant—Enthusiastic learner
Let us travel with Tracy as she begins her career at the staff level. At the outset, she works directly
under a senior accountant on each of her audits and is responsible for completing audits and
administrative tasks assigned to her. Her duties include documenting work papers, interacting
with client accounting staff, clerical tasks and discussing questions that arise with her senior. Tracy
will work on different audit engagements during her first year and learn the firm's audit approach.
She will be introduced to various industries and accounting systems.
The two most important traits to be demonstrated at the staff level are (1) a positive attitude and
(2) the ability to learn quickly while adapting to unfamiliar situations.
Senior accountant—Organizer and teacher
Accounting Principles: A Business Perspective 166 A Global Text
4. Completing the accounting cycle
As a senior accountant, Tracy will be responsible for the day-to-day management of several audit
engagements during the year. She will plan the audits, oversee the performance of interim audit
testing and direct year-end field work. She will also perform much of the final wrap-up work, such
as preparing checklists, writing the management letter and reviewing or drafting the financial
statements. Throughout this process, Tracy will spend a substantial amount of time instructing and
supervising staff accountants.
The two most critical skills needed at the senior level are (1) the ability to organize and control an
audit and (2) the ability to teach staff accountants how to audit.
Manager/senior manager—General manager and salesperson
Upon promotion to manager, Tracy will begin the transformation from auditor to executive. She
will manage several audits at one time and become active in billing clients as well as negotiating
audit fees. She will handle many important client meetings and closing conferences. Tracy will also
become more involved in the firm's administrative tasks. Finally, outside of her client service and
administrative duties, Tracy will be evaluated to a large extent on her community involvement and
ability to assist the partners in generating new business for the firm.
The two skills most emphasized at the manager level are (1) general management ability and (2)
sales and communication skills.
Partner—Leader and expert
As a partner in the firm, Tracy will have many broad responsibilities. She will engage in high-level
client service activities, business development, recruiting, strategic planning, office administration
and counseling. Besides serving as the engagement partner on several audits, she will have
ultimate responsibility for the quality of service provided to each of her clients. Although a certain
industry or administrative function will become her specialty, she will often be called upon to
perform a wide variety of audit and administrative duties when other partners have scheduling
conflicts. She will be expected to serve as a positive example to those who work for her and will
train others in her areas of expertise.
At the partnership level, what is looked for is leadership ability plus the ability to become an expert
in a specific industry or administrative function.
In the meantime
Those planning on a public accounting career should do more than just learn accounting. To
develop the needed skills, a broad education background in business and nonbusiness courses is
required plus participation in extracurricular activities that promote leadership and
communication skills. It is never too early to start building the skills for long-term success.
Source: Dana R. Hermanson and Heather M. Hermanson, New Accountant, January 1990, pp. 24-
26, © 1990, New DuBois Corporation.
The development of the personal computer (PC) in 1976 and its widespread use a decade later drastically
changed the accounting systems of small and medium-sized businesses. The number and quality of accounting
software packages for PCs and the power of PCs quickly increased. Soon small and medium-sized businesses could
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maintain all accounting functions on a PC. By the 1990s, the cost of PCs and accounting software packages had
decreased significantly, accounting software packages had become more user-friendly, and computer literacy had
increased so much that many very small businesses converted from manual to computerized systems. However,
some small business owners still use manual systems because they are familiar and meet their needs, and the
persons keeping the records may not be computer literate.
Your knowledge of the basic manual accounting system described in these first four chapters enables you to
better understand a computerized accounting system. The computer automatically performs some of the steps in
the accounting cycle, such as posting journal entries to the ledger accounts, closing the books, and preparing the
financial statements. However, if you understand all of the steps in the accounting cycle, you will better understand
how to use the resulting data in decision making.
An accounting perspective:
The impact of technology
Results from a recent survey of 1,400 chief financial officers (CFOs) indicate that tomorrow's
accounting professionals will be called upon to bridge the gap between technology and business.
With the rise of integrated accounting and information systems, technical expertise will go hand in
hand with general business knowledge.
As we show in Exhibit 25, an accounting system is a set of records and the procedures and equipment used to
perform the accounting functions. Manual systems consist of journals and ledgers on paper. Computerized
accounting systems consist of accounting software, computer files, computers, and related peripheral equipment
such as printers.
Regardless of the system, the functions of accountants include: (1) observing, identifying, and measuring
economic events; (2) recording, classifying, and summarizing measurements; and (3) reporting economic events
and interpreting financial statements. Both internal and external users tell accountants their information needs.
The accounting system enables a company's accounting staff to supply relevant accounting information to meet
those needs. As internal and external users make decisions that become economic events, the cycle of information,
decisions, and economic events begins again.
The primary focus of the first four chapters has been on how you can use an accounting system to prepare
financial statements. However, we also discussed how to use that information in making decisions. Later chapters
also show how to prepare information and how that information helps users to make informed decisions. We have
not eliminated the preparation aspects because we believe that the most informed users are ones who also
understand how the information was prepared. These users understand not only the limitations of the information
but also its relevance for decision making.
The next section discusses and illustrates the classified balance sheet, which aids in the analysis of the financial
position of companies. One example of this analysis is the current ratio and its use in analyzing the short-term debt-
paying ability of a company.
Accounting Principles: A Business Perspective 168 A Global Text
4. Completing the accounting cycle
Exhibit 25: The role of an accounting system
An accounting perspective
Uses of technology
Accounting software packages are typically menu driven and organized into modules such as
general ledger, accounts payable, accounts receivable, invoicing, inventory, payroll, fixed assets,
job cost, and purchase order. For instance, general journal entries are made in the general ledger
module, and this module contains all of the company's accounts. The accounts payable module
records all transactions involving credit purchases from suppliers and payments made to those
suppliers. The accounts receivable module records all sales on credit to various customers and
amounts received from customers.
A classified balance sheet
The balance sheets we presented so far have been unclassified balance sheets. As shown in Exhibit 23, an
unclassified balance sheet has three major categories: assets, liabilities, and stockholders' equity. A classified
balance sheet contains the same three major categories and subdivides them to provide useful information for
interpretation and analysis by users of financial statements.
Exhibit 26, shows a slightly revised classified balance sheet for The Home Depot, Inc., and subsidiaries. 11 Note
that The Home Depot classified balance sheet is in a vertical format (assets appearing above liabilities and
stockholders' equity) rather than the horizontal format (assets on the left and liabilities and stockholders' equity on
the right). The two formats are equally acceptable.
11 Founded in 1978, The Home Depot is America's largest home improvement retailer and ranks among the
nation's 30 largest retailers. The company has more than 1,000 full-service warehouse stores. Their primary
customers are do-it-yourselfers.
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The Home Depot classified balance sheet subdivides two of its three major categories. The Home Depot
subdivides its assets into current assets, property and equipment, long-term investments, long-term notes
receivable, intangible assets (cost in excess of the fair value of net assets acquired), and other assets. The company
subdivides its liabilities into current liabilities and long-term liabilities (including deferred income taxes). A later
chapter describes minority interest. Stockholders' equity is the same in a classified balance sheet as in an
unclassified balance sheet. Later chapters describe further subdivisions of the stockholders' equity section.
We discuss the individual items in the classified balance sheet later in the text. Our only purpose here is to
briefly describe the items that can be listed under each category. Some of these items are not in The Home Depot's
balance sheet.
Accounting Principles: A Business Perspective 170 A Global Text
4. Completing the accounting cycle
THE HOME DEPOT, INC. AND SUBSIDIARIES
Consolidated Balance Sheet
2001 January 28
(amounts in millions, except share data)
January 28,
2001
Assets
Current Assets:
Cash and Cash Equivalents $ 167
Short-Term Investments, including current maturities of long-term investments 10
Receivables, net 835
Merchandise Inventories 6,556
Other Current Assets 209
Total Current Assets $ 7,777
Property and Equipment, at cost:
Land $ 4,230
Buildings 6,167
Furniture, Fixtures and Equipment 2,877
Leasehold Improvements 665
Construction in Progress 1,032
Capital Leases 261
$ 15,232
Less: Accumulated Depreciation and Amortization 2,164
Net Property and Equipment $ 13,068
Long-Term Investments 15
Notes Receivable 77
Cost in Excess of Fair Value of Net Assets Acquired, net of accumulated amortization
of $41 at January 25, 2001 and $33 at January 30, 2000 314
Other 134 13,608
Total assets $ 21,385
Liabilities and Stockholders' Equity
Current Liabilities:
Accounts Payable $ 1,976
Accrued Salaries and Related Expenses 627
Sales Taxes Payable 298
Other Accrued Expenses 1,402
Income Taxes Payable 78
Current Installments of Long-Term Debt 4
Total Current Liabilities $4,385
Long-Term Debt, excluding current installments $ 1,545
Other Long-Term Liabilities 245
Deferred Income Taxes 195 1,985
Minority Interest 11
Stockholders' equity:
Common Stock, par value $0.05. Authorized: 10,000,000,000 shares; issued and
outstanding-
2,323,747,000 shares at 2001 January 28 and 2,304,317,000 shares at 2000 January 30 116
Paid-In Capital 4,810
Retained Earnings 10,151
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Accumulated Other Comprehensive Income (67)
15,010
Less: Shares Purchased for Compensation Plans 6
Total Stockholders' Equity 15,004
Total Liabilities and Stockholders' Equity $ 21,385
Exhibit 26: A classified balance sheet
Current assets are cash and other assets that a business can convert to cash or uses up in a relatively short
period—one year or one operating cycle, whichever is longer. An operating cycle is the time it takes to start with
cash, buy necessary items to produce revenues (such as materials, supplies, labor, and/or finished goods), sell
services or goods, and receive cash by collecting the resulting receivables. Companies in service industries and
merchandising industries generally have operating cycles shorter than one year. Companies in some manufacturing
industries, such as distilling and lumber, have operating cycles longer than one year. However, since most operating
cycles are shorter than one year, the one-year period is usually used in identifying current assets and current
liabilities. Common current assets in a service business include cash, marketable securities, accounts receivable,
notes receivable, interest receivable, and prepaid expenses. Note that on a balance sheet, current assets are in order
of how easily they are convertible to cash, from most liquid to least liquid.
Cash includes deposits in banks available for current operations at the balance sheet date plus cash on hand
consisting of currency, undeposited checks, drafts, and money orders. Cash is the first current asset to appear on a
balance sheet. The term cash normally includes cash equivalents.
Cash equivalents are highly liquid, short-term investments acquired with temporarily idle cash and easily
convertible into a known cash amount. Examples are Treasury bills, short-term notes maturing within 90 days,
certificates of deposit, and money market funds.
Marketable securities are temporary investments such as short-term ownership of stocks and bonds of other
companies. Such investments do not qualify as cash equivalents. These investments earn additional money on cash
that the business does not need at present but will probably need within one year.
Accounts receivable (also called trade accounts receivable) are amounts owed to a business by customers. An
account receivable arises when a company performs a service or sells merchandise on credit. Customers normally
provide no written evidence of indebtedness on sales invoices or delivery tickets except their signatures. Notice the
term net in the balance sheet of The Home Depot (Exhibit 26). This term indicates the possibility that the company
may not collect some of its accounts receivable. In the balance sheet, the accounts receivable amount is the sum of
the individual accounts receivable from customers shown in a subsidiary ledger or file.
Merchandise inventories are goods held for sale. Chapter 6 begins our discussion of merchandise
inventories.
A note is an unconditional written promise to pay another party the amount owed either when demanded or at
a certain specified date, usually with interest (a charge made for use of the money) at a specified rate. A note
receivable appears on the balance sheet of the company to which the note is given. A note receivable arises (1) when
a company makes a sale and receives a note from the customer, (2) when a customer gives a note for an amount due
on an account receivable, or (3) when a company loans money and receives a note in return. Chapter 9 discusses
notes at length.
Accounting Principles: A Business Perspective 172 A Global Text
4. Completing the accounting cycle
Other current assets might include interest receivable and prepaid expenses. Interest receivable arises when
a company has earned but not collected interest by the balance sheet date. Usually, the amount is not due until
later. Prepaid expenses include rent, insurance, and supplies that have been paid for but all the benefits have not
yet been realized (or consumed) from these expenses. If prepaid expenses had not been paid for in advance, they
would require the future disbursement of cash. Furthermore, prepaid expenses are considered assets because they
have service potential.
Long-term assets are assets that a business has on hand or uses for a relatively long time. Examples include
property, plant, and equipment; long-term investments; and intangible assets.
Property, plant, and equipment are assets with useful lives of more than one year; a company acquires
them for use in the business rather than for resale. (These assets are called property and equipment in The Home
Depot's balance sheet.) The terms plant assets or fixed assets are also used for property, plant, and equipment. To
agree with the order in the heading, balance sheets generally list property first, plant next, and equipment last.
These items are fixed assets because the company uses them for long-term purposes. We describe several types of
property, plant, and equipment next.
Land is ground the company uses for business operations; this includes ground on which the company locates
its business buildings and that is used for outside storage space or parking. Land owned for investment is not a
plant asset because it is a long-term investment.
Buildings are structures the company uses to carry on its business. Again, the buildings that a company owns
as investments are not plant assets.
Office furniture includes file cabinets, desks, chairs, and shelves.
Office equipment includes computers, copiers, FAX machines, and phone answering machines.
Leasehold improvements are any physical alterations made by the lessee to the leased property when these
benefits are expected to last beyond the current accounting period. An example is when the lessee builds room
partitions in a leased building. (The lessee is the one obtaining the rights to possess and use the property.)
Construction in progress represents the partially completed stores or other buildings that a company such
as The Home Depot plans to occupy when completed.
Accumulated depreciation is a contra asset account to depreciable assets such as buildings, machinery, and
equipment. This account shows the total depreciation taken for the depreciable assets. On the balance sheet,
companies deduct the accumulated depreciation (as a contra asset) from its related asset.
Long-term investments A long-term investment usually consists of securities of another company held
with the intention of (1) obtaining control of another company, (2) securing a permanent source of income for the
investor, or (3) establishing friendly business relations. The long-term investment classification in the balance sheet
does not include those securities purchased for short-term purposes. For most businesses, long-term investments
may be stocks or bonds of other corporations. Occasionally, long-term investments include funds accumulated for
specific purposes, rental properties, and plant sites for future use.
Intangible assets Intangible assets consist of the noncurrent, nonmonetary, nonphysical assets of a
business. Companies must charge the costs of intangible assets to expense over the period benefited. Among the
intangible assets are rights granted by governmental bodies, such as patents and copyrights. Other intangible assets
include leaseholds and goodwill.
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A patent is a right granted by the federal government; it gives the owner of an invention the authority to
manufacture a product or to use a process for a specified time.
A copyright granted by the federal government gives the owner the exclusive privilege of publishing written
material for a specified time.
Leaseholds are rights to use rented properties, usually for several years.
Goodwill is an intangible value attached to a business, evidenced by the ability to earn larger net income per
dollar of investment than that earned by competitors in the same industry. The ability to produce superior profits is
a valuable resource of a business. Normally, companies record goodwill only at the time of purchase and then only
at the price paid for it. The Home Depot has labeled its goodwill "cost in excess of the fair value of net assets
acquired".
Accumulated amortization is a contra asset account to intangible assets. This account shows the total
amortization taken on the intangible assets.
Current liabilities are debts due within one year or one operating cycle, whichever is longer. The payment of
current liabilities normally requires the use of current assets. Balance sheets list current liabilities in the order they
must be paid; the sooner a liability must be paid, the earlier it is listed. Examples of current liabilities follow.
Accounts payable are amounts owed to suppliers for goods or services purchased on credit. Accounts payable
are generally due in 30 or 60 days and do not bear interest. In the balance sheet, the accounts payable amount is
the sum of the individual accounts payable to suppliers shown in a subsidiary ledger or file.
Notes payable are unconditional written promises by the company to pay a specific sum of money at a certain
future date. The notes may arise from borrowing money from a bank, from the purchase of assets, or from the
giving of a note in settlement of an account payable. Generally, only notes payable due in one year or less are
included as current liabilities.
Salaries payable are amounts owed to employees for services rendered. The company has not paid these
salaries by the balance sheet date because they are not due until later.
Sales taxes payable are the taxes a company has collected from customers but not yet remitted to the taxing
authority, usually the state.
Other accrued expenses might include taxes withheld from employees, income taxes payable, and interest
payable. Taxes withheld from employees include federal income taxes, state income taxes, and social security
taxes withheld from employees' paychecks. The company plans to pay these amounts to the proper governmental
agencies within a short period. Income taxes payable are the taxes paid to the state and federal governments by
a corporation on its income. Interest payable is interest that the company has accumulated on notes or bonds but
has not paid by the balance sheet date because it is not due until later.
Dividends payable, or amounts the company has declared payable to stockholders, represent a distribution of
income. Since the corporation has not paid these declared dividends by the balance sheet date, they are a liability.
Unearned revenues (revenues received in advance) result when a company receives payment for goods or
services before earning the revenue, such as payments for subscriptions to a magazine. These unearned revenues
represent a liability to perform the agreed services or other contractual requirements or to return the assets
received.
Companies report any current installment on long-term debt due within one year under current liabilities. The
remaining portion continues to be reported as a long-term liability.
Accounting Principles: A Business Perspective 174 A Global Text
4. Completing the accounting cycle
Long-term liabilities are debts such as a mortgage payable and bonds payable that are not due for more than
one year. Companies should show maturity dates in the balance sheet for all long-term liabilities. Normally, the
liabilities with the earliest due dates are listed first.
Notes payable with maturity dates at least one year beyond the balance sheet date are long-term liabilities.
Bonds payable are long-term liabilities and are evidenced by formal printed certificates sometimes secured by
liens (claims) on property, such as mortgages. Maturity dates should appear on the balance sheet for all major long-
term liabilities.
The deferred income taxes on The Home Depot's balance sheet result from a difference between income tax
expense in the accounting records and the income tax payable on the company's tax return.
Stockholders' equity shows the owners' interest in the business. This interest is equal to the amount
contributed plus the income left in the business.
The items under stockholders' equity in The Home Depot's balance sheet are paid-in capital (including common
stock) and retained earnings. Paid-in capital shows the capital paid into the company as the owners' investment.
Retained earnings shows the cumulative income of the company less the amounts distributed to the owners in
the form of dividends. Cumulative translation adjustments result from translating foreign currencies into US
dollars (a topic discussed in advanced accounting courses). The unrealized loss on investments is discussed in
Chapter 14.
The next section shows how two categories on the classified balance sheet relate to each other. Together they
help reveal a company's short-term debt-paying ability.
Analyzing and using the financial results — the current ratio
The current ratio indicates the short-term debt-paying ability of a company. To find the current ratio, we
divide current assets by current liabilities. For instance, Exhibit 26 shows that The Home Depot's current assets as
of 2001 January 28, were USD 7,777,000,000 and its current liabilities were USD 4,385,000,000. Thus, its current
ratio was: Current ratio= Current assets
Current liabilities
USD7,777,000,000
USD4,385,000,000 =1.77 :1
The current ratio of 1.77:1 for The Home Depot means that it has almost twice as many current assets as current
liabilities. Because current liabilities are normally paid with current assets, the company appears to be able to pay
its short-term obligations easily.
In evaluating a company's short-term debt-paying ability, you should also examine the quality of the current
assets. If they include large amounts of uncollectable accounts receivable and/or obsolete and unsalable inventory,
even a 2:1 current ratio may be inadequate to allow the company to pay its current liabilities. The Home Depot
undoubtedly does not have such a problem.
The current assets, current liabilities, and current ratios of some other companies as of the third quarter of 2001
were:
Current Company
Current Assets
Current Liabilities
Ratio
Wal-Mart Stores, Inc. $ 32,620,000,000 $ 32,869,000,000 .99:1 Hewlett-Packard Company 15,782,000,000 13,950,000,000 1.13:1 3M Corporation 6,556,000,000 5,006,000,000 1.31:1 General Electric Company 313,050,000,000 168,788,000,000 1.85:1 Johnson & Johnson 19,079,000,000 7,504,000,000 2.54:1
We described each of these companies earlier in the text.
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As you can see from these comparisons, the current ratios vary a great deal. An old rule of thumb is that the
current ratio should be at least 2:1. However, what constitutes an adequate current ratio depends on available lines
of credit, the cash-generating ability of the company, and the nature of the industry in which the company operates.
For instance, companies in the airline industry are able to generate huge amounts of cash on a daily basis and may
be able to pay their current liabilities even if their current ratio is less than 1:1. Comparing a company's current
ratio with other companies in the same industry makes sense because all of these companies face about the same
economic conditions. A company with the lowest current ratio in its industry may be unable to pay its short-term
obligations on a timely basis, unless it can borrow funds from a bank on a line of credit. A company with the highest
current ratio in its industry may have on hand too many current assets, such as cash and marketable securities,
which could be invested in more productive assets.
The next chapter describes the assumptions, concepts, and principles that constitute the accounting theory
underlying financial accounting. Thus, accounting theory dictates the standards and procedures applied to the
reporting of financial information in the financial statements.
Understanding the learning objectives
• Analyze transactions by examining source documents.
• Journalize transactions in the journal.
• Post journal entries to the accounts in the ledger.
• Prepare a trial balance of the accounts and complete the work sheet.
• Prepare financial statements.
• Journalize and post adjusting entries.
• Journalize and post closing entries.
• Prepare a post-closing trial balance.
• The work sheet is a columnar sheet of paper on which accountants summarize information needed to make
the adjusting and closing entries and to prepare the financial statements.
• Work sheets may vary in format. The work sheet illustrated in the chapter has 12 columns—two each for
trial balance, adjustments, adjusted trial balance, income statement, statement of retained earnings, and
balance sheet.
• The information needed to prepare the income statement is in the Income Statement columns of the work
sheet. Net income for the period is the amount needed to balance the two Income Statement columns in the
work sheet.
• The information needed to prepare the statement of retained earnings is in the Statement of Retained
Earnings columns of the work sheet. The ending Retained Earnings balance is carried forward to the
balance sheet.
• The information needed to prepare the balance sheet is in the Balance Sheet columns of the work sheet.
• As explained in Chapter 3, adjusting entries are necessary to bring the accounts to their proper balances
before preparing the financial statements. Closing entries are necessary to reduce the balances of revenue,
expense, and Dividends accounts to zero so they are ready to receive data for the next accounting period.
• Revenue accounts are closed by debiting them and crediting the Income Summary account.
• Expense accounts are closed by crediting them and debiting the Income Summary account.
Accounting Principles: A Business Perspective 176 A Global Text
4. Completing the accounting cycle
• The balance in the Income Summary account represents the net income or net loss for the period.
• To close the Income Summary account, the balance is transferred to the Retained Earnings account.
• To close the Dividends account, the balance is transferred to the Retained Earnings account.
• Only the balance sheet accounts have balances and appear on the post-closing trial balance.
• All revenue, expense, and Dividends accounts have zero balances and are not included in the post-closing
trial balance.
• Manual systems and computerized systems perform the same accounting functions.
• The ease of accounting with a PC has encouraged even small companies to convert to computerized
systems.
• A classified balance sheet subdivides the major categories on the balance sheet. For instance, a classified
balance sheet subdivides assets into current assets; long-term investments; property, plant, and equipment;
and intangible assets. It subdivides liabilities into current liabilities and long-term liabilities. Later chapters
show more accounts in the stockholders' equity section, but the subdivisions remain basically the same.
• The current ratio gives some indication of the short-term debt-paying ability of a company.
• To find the current ratio, divide current assets by current liabilities.
Demonstration problem
This problem involves using a work sheet for Green Hills Riding Stable, Incorporated, for the month ended 2010
July 31, and performing the closing process. The trial balance for Green Hills Riding Stable, Incorporated, as of
2010 July 31, was as follows:
GREEN HILLS RIDING STABLE, INCORPORATED Trial Balance 2010 July 31
Acct.
No. Account Title Debits Credits 100 Cash $ 10,700
103 Accounts Receivable 8,100
130 Land 40,000
140 Buildings 24,000
200 Accounts Payable $ 1,100
201 Notes Payable 40,000
300 Capital Stock 35,000
310 Retained Earnings, 2010 July 1 3,100
320 Dividends 1,000
402 Horse Boarding Fees Revenue 4,500
404 Riding Lesson Fees Revenue 3,600
507 Salaries Expense 1,400
513 Feed Expense 1,100
540 Interest Expense 200
568 Miscellaneous Expense 800 $ 87,300 $87,300
Depreciation expense for the month is USD 200. Accrued salaries on July 31 are USD 300.
a. Prepare a 12-column work sheet for the month ended 2010 July 31.
b. Journalize the adjusting entries.
c. Journalize the closing entries.
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Solution to demonstration problem
a. See the work sheet below.
GREEN HILLS RIDING STABLE, INCORPORATE Work Sheet
For the Month Ended 2010 July 31
Acct .
Account Titles Trial Balance Adjustments
Adjusted
Balance Income Statement
Statement of Retained Earnings
Balance Sheet
No. Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
100 Cash 10,700 10,700 10,700 103 Accounts Receivable S,100 3,100 8,100 130 Land 40,000 40,000 40,000 140 Buildings 24,000 24,000 24,000 200 Accounts Payable 1,100 1,100 1,100 201 Notes Payable 40,000 40,0 0 0 40,000 300 Capital Stock 35,000 35,000 35,000 310 Retained Earnings
2010 July 1 3,100 3,100 3,100
320 Dividends 1,000 1,000 1,000 402 Horse Boarding Fees
Revenue 4,500 4,500 4,500
404 Riding and Lesson Fees Revenue
3,500 3,600 3,600
507 Salaries Expense 1,400 (2) 300
1,700 1,700
513 Feed Expense 1,100 1,100 1,100 540 Interest Expense 200 200 200 563 Miscellaneous
Expense 300 SOO SOO
87,300 37,300 520 Depreciation
Expense—Buildings (1)
200 200 200
141 Accumulated Depreciation- Buildings (1)
200 200 200
206 Salaries Payable (2) 300
300 300
EOO 5oo 87,500 37,300 4,000 8,100
Net Income 4,100 4,100 8,100 8,100 1,000 7,200 82,300 76,600
Retained Earnings, 2010 July 31
6,200 6,200
7,200 7,200 S2,S00 32,800
Adjustments:
(i) To record depreciation of building for July.
(2) To record accrued salaries of $300.
b.
GREEN HILLS RIDING STABLE, INCORPORATED
General Journal Page 4 Date Account Titles and
Explanation Post. Ref.
Debt Credit
201 0
Adjusting Entries
July 3 1
Depredation Expense— Buildings (-SE)
520 2 0 0
Accumulated Depreciation— Buildings (-A)
141 2 0 0
To record depreciation expense.
3 1
Salaries Expense (-SE) 507 3 0 0
Salaries Payable (+L) 206 3 0 0
To record accrued salaries.
c.
GREEN HILLS RIDING STABLE, INCORPORATED General Journal Page 4
Accounting Principles: A Business Perspective 178 A Global Text
4. Completing the accounting cycle
Date Account Titles and Explanation Post.
Ref. Debt Credit
2010 Closing Entries
July 31 Horse Boarding Fees Revenue 402 4 5 0 0
Riding Lesson Fees Revenue 404 3 6 0 0
Income Summary 600 8 1 0 0
To close revenue accounts.
31 Income Summary 600 4 0 0 0
Salaries Expense 507 1 7 0 0
Feed Expense 513 1 1 0 0
Interest Expense 540 2 0 0
Miscellaneous Expense 568 8 0 0
Depreciation Expense—Buildings 520 2 0 0
To close expense accounts.
31 Income Summary 600 4 1 0 0
Retained Earnings 310 4 1 0 0
To close Income Summary account.
31 Retained Earnings 310 1 0 0 0
Dividends 320 1 0 0 0
To close dividends account.
Key terms* Accounting cycle Series of steps performed during the accounting period to analyze, record, classify, summarize, and report useful financial information for the purpose of preparing financial statements. The steps include analyzing transactions, journalizing transactions, posting journal entries, taking a trial balance and completing the work sheet, preparing financial statements, journalizing and posting adjusting entries, journalizing and posting closing entries, and taking a post-closing trial balance.
Accounting system A set of records and the procedures and equipment used to perform accounting functions.
Accounts payable Amounts owed to suppliers for goods or services purchased on credit.
Accounts receivable Amounts due from customers for services performed or merchandise sold on credit.
Accumulated amortization A contra account to intangible assets.
Accumulated depreciation A contra account to depreciable assets such as buildings, machinery, and equipment.
Bonds payable Written promises to pay a definite sum at a certain date as evidenced by formal printed certificates that are sometimes secured by liens on property, such as mortgages.
Buildings Structures used to carry on the business.
Cash Includes deposits in banks available for current operations at the balance sheet date plus cash on hand consisting of currency, undeposited checks, drafts, and money orders.
Cash equivalents Highly liquid, short-term investments acquired with temporarily idle cash.
Classified balance sheet Subdivides the three major balance sheet categories (assets, liabilities, and stockholders' equity) to provide more information for users of financial statements. Assets may be divided into current assets; long-term investments; property, plant, and equipment; and intangible assets. Liabilities may be divided into current liabilities and long-term liabilities.
Closing process The act of transferring the balances in the revenue and expense accounts to a clearing account called Income Summary and then to the Retained Earnings account. The balance in the Dividends account is also transferred to the Retained Earnings account.
Construction in progress Represents the partially completed stores or other buildings that a company plans to occupy when completed.
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Copyright Grants the owner the exclusive privilege of publication of written material for a specific time.
Current assets Cash and other assets that a business can convert into cash or use up in one year or one operating cycle, whichever is longer.
Current liabilities Debts due within one year or one operating cycle, whichever is longer. The payment of current liabilities normally requires the use of current assets.
Current ratio Calculated by dividing current assets by current liabilities.
Dividends payable Amounts declared payable to stockholders and that represent a distribution of income.
Goodwill An intangible value attached to a business, evidenced by the ability to earn larger net income per dollar of investment than that earned by competitors in the same industry.
Income Summary account A clearing account used only at the end of an accounting period to summarize revenues and expenses for the period.
Income taxes payable Are the taxes payable to the state and federal governments by a corporation based on its income.
Intangible assets Noncurrent, nonmonetary, nonphysical assets of a business.
Interest payable Interest that has accumulated on debts, such as notes or bonds. This accrued interest has not been paid at the balance sheet date because it is not due until later.
Interest receivable Arises when interest has been earned but not collected at the balance sheet date.
Land Ground the company uses for business operations. Land could include ground on which the company locates its business buildings and that used for outside storage space or a parking lot.
Leasehold improvements Are any physical alterations made by the lessee to the leased property when these benefits are expected to last beyond the current accounting period.
Leaseholds Rights to use rented properties.
Long-term assets Assets that are on hand or used by a business for a relatively long time. Examples include long-term investments; property, plant, and equipment; and intangible assets.
Long-term investment Usually securities of another company held with the intention of (1) obtaining control of another company, (2) securing a permanent source of income for the investor, or (3) establishing friendly business relations.
Long-term liabilities Debts such as a mortgage payable and bonds payable that are not due for more than one year.
Marketable securities Temporary investments that a company makes to earn a return on idle cash.
Merchandise inventory Goods held for sale.
Note An unconditional written promise to pay to another party the amount owed either when demanded or at a certain date.
Notes payable Unconditional written promises by a company to pay a specific sum of money at a certain future date.
Office equipment Includes computers, copiers, FAX machines, and phone answering machines.
Office furniture Includes file cabinets, desks, chairs, and shelves.
Operating cycle The time it takes to start with cash, buy necessary items to produce revenues (such as materials, supplies, labor, and/or inventories), sell services or goods, and receive cash by collecting the resulting receivables.
Paid-in capital Shows the capital paid into the company as the owners' investment.
Patent A right granted by the federal government authorizing the owner of an invention to manufacture a product or to use a process for a specific time.
Post-closing trial balance A trial balance taken after the closing entries have been posted.
Prepaid expenses Assets awaiting assignment to expense. Items such as rent, insurance, and supplies that have been paid for but from which all of the benefits have not yet been realized (or consumed). Prepaid expenses are classified as current assets.
Property, plant, and equipment Assets with useful lives of more than one year that a company acquired for use in a business rather than for resale; also called plant assets or fixed assets.
Retained earnings Shows the cumulative income of the company less the amounts distributed to the owners in the form of dividends.
Salaries payable Amounts owed to employees for services rendered.
Accounting Principles: A Business Perspective 180 A Global Text
4. Completing the accounting cycle
Sales taxes payable Are taxes a company has collected from customers but has not remitted to the taxing authority, usually the state.
Stockholders' equity Shows the owners' interest (equity) in the business.
Taxes withheld from employees Items such as federal income taxes, state income taxes, and social security taxes withheld from employees' paychecks.
Unclassified balance sheet A balance sheet showing only three major categories: assets, liabilities, and stockholders' equity.
Unearned revenues (revenues received in advance) Result when payment is received for goods or services before revenue has been earned.
Work sheet A columnar sheet of paper on which accountants have summarized information needed to make the adjusting and closing entries and to prepare the financial statements.
*Some of these terms have been defined in earlier chapters but are included here for your convenience.
Self-test
True-false
Indicate whether each of the following statements is true or false.
At the end of the accounting period, three trial balances are prepared.
The amounts in the Adjustments columns are always added to the amounts in the Trial Balance columns to
determine the amounts in the Adjusted Trial Balance columns.
If a net loss occurs, it appears in the Income Statement credit column and Statement of Retained Earnings debit
column.
After the closing process is complete, no balance can exist in any revenue, expense, Dividends, or Income
Summary account.
The post-closing trial balance may contain revenue and expense accounts.
All accounting systems currently in use are computerized.
Multiple-choice
Select the best answer for each of the following questions.
Which of the following accounts is least likely to be adjusted on the work sheet?
a. Supplies on Hand.
b. Land.
c. Prepaid Rent.
d. Unearned Delivery Fees.
If the Balance Sheet columns do not balance, the error is most likely to exist in the:
a. General journal.
b. General ledger.
c. Last six columns of the work sheet.
d. First six columns of the work sheet.
Net income for a period appears in all but which one of the following?
a. Income Statement debit column of the work sheet.
b. Statement of Retained Earnings credit column of the work sheet.
c. Statement of retained earnings.
d. Balance sheet.
Which of the following statements is false regarding the closing process?
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a. The Dividends account is closed to Income Summary.
b. The closing of expense accounts results in a debit to Income Summary.
c. The closing of revenues results in a credit to Income Summary.
d. The Income Summary account is closed to the Retained Earnings account.
Which of the following statements is true regarding the classified balance sheet?
a. Current assets include cash, accounts receivable, and equipment.
b. Plant, property, and equipment is one category of long-term assets.
c. Current liabilities include accounts payable, salaries payable, and notes receivable.
d. Stockholders' equity is subdivided into current and long-term categories.
Now turn to “Answers to self-test” at the end of the chapter to check your answers.
Questions
➢ At which stage of the accounting cycle is a work sheet usually prepared?
➢ Why are the financial statements prepared before the adjusting and closing entries are journalized
and posted?
➢ Describe the purposes for which the work sheet is prepared.
➢ You have taken over a set of accounting books for a small business as a part-time job. At the end of
the first accounting period, you have partially completed the work sheet by entering the proper
ledger accounts and balances in the Trial Balance columns. You turn to the manager and ask, "Where
is the list of additional information I can use in entering the adjusting entries?" The manager
indicates there is no such list. (In all the text problems you have done, you have always been given
this information.) How would you obtain the information for this real-life situation? What are the
consequences of not making all of the required adjustments at the end of the accounting period?
➢ How are the amounts in the Adjusted Trial Balance columns of a work sheet determined?
➢ The work sheet for Bridges Company shows net income of USD 40,000. The following four
adjustments were ignored:
➢ Subscriptions Fees earned, USD 1,200.
➢ Depreciation of equipment, USD 4,000.
➢ Depreciation of building, USD 10,000.
➢ Salaries accrued, USD 3,000. What is the correct net income?
➢ After the Adjusted Trial Balance columns of a work sheet have been totaled, which account balances
are extended to the Income Statement columns, which account balances are extended to the
Statement of Retained Earnings columns, and which account balances are extended to the Balance
Sheet columns?
➢ How is the statement of retained earnings prepared?
➢ What is the purpose of closing entries? What accounts are not affected by closing entries?
➢ A company has net income of USD 50,000 for the year. In which columns of the work sheet would
net income appear?
➢ Is it possible to prepare monthly financial statements without journalizing and posting adjusting and
closing entries? How?
Accounting Principles: A Business Perspective 182 A Global Text
4. Completing the accounting cycle
➢ What is the purpose of a post-closing trial balance?
➢ Describe some of the ways in which the manual accounting system has evolved.
➢ When did computerized accounting systems come into use?
➢ Define an accounting system.
➢ How is a classified balance sheet different than an unclassified balance sheet?
➢ Real world question Refer to "A broader perspective: Skills for the long haul" to answer the
following true-false questions:
➢ The same skills are needed at each level in a CPA firm.
➢ The two most important traits at the staff accountant level are a positive attitude and the ability
to learn quickly while adapting to unfamiliar situations.
➢ The senior accountant needs management skills in addition to technical skills.
➢ Partners become increasingly involved in technical matters and have less and less interaction
with people.
➢ Real world question Referring to the Annual report appendix in your text, identify the
classifications (or categories) of assets used by The Limited in its balance sheet.
➢ Real world question Referring to the Annual report appendix in your text, identify the
classifications (or categories) of liabilities used by The Limited in its balance sheet.
Exercises
Exercise A List the steps in the accounting cycle. Would the system still work if any of the steps were
performed out of order?
Exercise B Three of the major column headings on a work sheet are Trial Balance, Income Statement, and
Balance Sheet. Determine under which major column headings each of the following items would appear and
whether it would be a debit or credit. (For example, Cash would appear on the debit side of the Trial Balance and
Balance Sheet columns.)
Statement of Trial Income Retained Balance Balance Statement Earnings Sheet
Account Titles Debit Credit Debit Credit Debit Credit Debit Credit a. Accounts Receivable
b. Accounts Payable
c. Interest Revenue
d. Advertising Expense
e. Capital Stock
f. Retained Earnings (Beg.)
g. Net income for the month
h. Retained Earnings (End)
Exercise C Assume a beginning balance in Retained Earnings of USD 84,000 and net income for the year of
USD 36,000. Illustrate how these would appear in the Statement of Retained Earnings columns and Balance Sheet
columns in the work sheet.
Exercise D In the previous exercise, if there was a debit balance of USD 216,000 in the Retained Earnings
account as of the beginning of the year and a net loss of USD 192,000 for the year, show how these would be treated
in the work sheet.
Exercise E Damon Davis was preparing the work sheet for Drano Plumbing Company. He calculated the net
income to be USD 50,000. When he totaled the Balance Sheet columns, the column totals were debit, USD
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400,000; and credit, USD 300,000. What was the probable cause of this difference? If this was not the cause, what
should he do to find the error?
Exercise F The Trial Balance of the Printer Repair Company at 2010 December 31, contains the following
account balances listed in alphabetical order to increase your skill in sorting amounts to the proper work sheet
columns.
Printer Repair Company Trial Balance Account Balances
2010 December 31
Accounts Payable $ 41,000 Accounts Receivable 92,000 Accumulated Depreciation—Buildings 25,000 Accumulated Depreciation—Equipment 9,000 Buildings 140,000 Capital Stock 65,000 Cash 60,000 Equipment 36,000 Prepaid Insurance 3,600 Retained Earnings, 2010 January 1 4,800 Salaries Expense 96,000 Service Revenue 290,000 Supplies on Hand 4,000 Utilities Expense 3,200
Using these account balances and the following additional information, prepare a work sheet for Printer Repair
Company. Arrange the accounts in their approximate usual order.
• Supplies on hand at 2010 December 31, have a cost of USD 2,400.
• The balance in the Prepaid Insurance account represents the cost of a two-year insurance policy covering
the period from 2010 January 1, through 2011 December 31.
• The estimated lives of depreciable assets are buildings, 40 years, and equipment, 20 years. No salvage
values are anticipated.
Exercise G Texban Corporation had a 2010 January 1, balance in its Retained Earnings account of USD
90,000. For the year 2010, net income was USD 50,000 and dividends declared and paid were USD 24,000.
Prepare a statement of retained earnings for the year ended 2010 December 31.
Exercise H Rubino Company reported net income of USD 100,000 for the current year. Examination of the
work sheet and supporting data indicates that the following items were ignored:
• Accrued salaries were USD 6,000 at December 31.
• Depreciation on equipment acquired on July 1 amounted to USD 4,000.
Based on this information, (a) what adjusting journal entries should have been made at December 31, and (b)
what is the correct net income?
Exercise I Refer to the work sheet prepared in the Printer Repair Company exercise. Prepare the adjusting and
closing journal entries.
Exercise J The Income Statement column totals on a work sheet prepared at 2010 December 31, are debit,
USD 500,000; and credit, USD 900,000. In T-account format, show how the postings to the Income Summary
account would appear as a result of the closing process. Identify what each posting represents.
Exercise K After adjustment, these selected account balances of Cold Stream Campground are:
Debits Credits
Retained earnings $540,000.00
Rental revenue 960000
Salaries expense $336,000.00
Accounting Principles: A Business Perspective 184 A Global Text
4. Completing the accounting cycle
Depreciated expense – Buildings 64000
Utilities expense 208000
Dividends 32000
In T-account format, show how journal entries to close the books for the period would be posted. (You do not
need to show the closing journal entries.) Enter these balances in the accounts before doing so. Key the postings
from the first closing entry with the number (1), the second with the number (2), and so on.
Exercise L The following account balances appeared in the Income Statement columns of the work sheet
entries prepared for Liu Company for the year ended 2010 December 31:
Account Titles Income Statement Debit Credit
Service Revenue 330,000
Advertising Expense 1,350
Salaries Expense 130,000
Utilities Expense 2,250
Insurance Expense 900
Rent Expense 6,750
Supplies Expense 2,250
Depreciation Expense—Equipment 4,500
Interest Expense 562
Interest Revenue 1,125
148,552 331,125
Net Income 182,553
331,125 331,125
Prepare the closing journal entries.
Exercise M Which of the following accounts are likely to appear in the post-closing trial balance for the Blake
Company?
• Accounts Receivable
• Cash
• Service Revenue
• Buildings
• Salaries Expense
• Capital Stock
• Dividends
• Accounts Payable
• Income Summary
• Unearned Subscription Fees
Exercise N Using the legend at the right, determine the category (number) into which you would place each of
these items.
Item Legend
a. Land. 1. Current assets. b. Marketable securities. 2. Long-term investments. c. Notes payable, due in three years. 3. Property, plant, and equipment. d. Taxes withheld from employees. 4. Intangible assets. e. Patents. 5. Current liabilities. f. Retained earnings. 6. Long-term liabilities. g. Unearned subscription fees. 7. Stockholders' equity.
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h. Bonds of another corporation (a 20-year investment).
i. Notes payable, due in six months.
j. Accumulated depreciation.
Exercise O The following data are from the 2001 annual report of The Procter & Gamble Company and its
subsidiaries. This company markets a broad range of laundry, cleaning, paper, beauty care, health care, food, and
beverage products in more than 140 countries around the world. Leading brands include Ariel, Crest, Pampers,
Pantene, Crisco, Vicks, and Max Factor. The dollar amounts are in millions.
June 30
2001 2000
Current assets $10,889 $10,146 Current liabilities 9,846 10,141
Calculate the current rations for the two years. Comment on whether the trend is favorable or unfavorable.
Problems
Problem A The following adjusted trial balance is for Jasper Appliance Repair Company:
JASPER APPLIANCE REPAIR COMPANY
Adjusted Trial Balance
2010 June 30
Debits Credits
Cash $ 63,000
Accounts Receivable 42,000
Trucks 110,000
Accumulated Depreciation—Trucks $ 30,000
Accounts Payable 10,800
Notes Payable 20,000
Capital Stock 50,000
Retained Earnings, 2009 July 1 5,500
Dividends 10,000
Service Revenue 230,000
Rent Expense 12,000
Advertising Expense 5,000
Salaries Expense 90,000
Supplies Expense 1,500
Insurance Expense 1,200
Depreciation Expense—Trucks 10,000
Interest Expense 1,000
Miscellaneous Expense 600
$346,300 $346,300
Prepare the closing journal entries at the end of the fiscal year, 2010 June 30.
Problem B The adjusted trial balance for Denver Architects , Inc., follows:
DENVER ARCHITECTS, INC.
Adjusted Trial Balance
2010 December 31
Debits Credits
Cash $ 90,000
Accounts Receivable 20,000
Interest Receivable 200
Accounting Principles: A Business Perspective 186 A Global Text
4. Completing the accounting cycle
Notes Receivable 4,000
Prepaid Insurance 960
Prepaid Rent 2,400
Supplies on Hand 600
Equipment 60,000
Accumulated Depreciation—Equipment $ 12,500
Buildings 140,000
Accumulated Depreciation—Buildings 15,000
Land 56,240
Accounts Payable 60,000
Notes Payable 10,000
Interest Payable 750
Salaries Payable 7,000
Capital Stock 100,000
Retained Earnings, 2010 January 1 20,200
Dividends 40,000
Service Revenue 360,000
Insurance Expense 1,920
Rent Expense 9,600
Advertising Expense 1,200
Depreciation Expense—Equipment 2,500
Depreciation Expense—Buildings 3,000
Supplies Expense 2,280
Salaries Expense 150,000
Interest Expense 750
Interest Revenue 200
$ 585,650 $ 585,650
a. Prepare an income statement.
b. Prepare a statement of retained earnings.
c. Prepare a classified balance sheet.
d. Prepare the closing journal entries.
e. Show the post-closing trial balance assuming you had posted the closing entries to the general ledger.
Problem C The following trial balance and additional data are for Sure Sale Reality Company
SURE SALE REALTY COMPANY
Trial Balance
2010 December 31
Debits Credits
Cash $ 62,800
Accounts Receivable 117,120
Prepaid Rent 46,080
Equipment 173,760
Accumulated Depreciation—Equipment $ 21,120
Accounts Payable 62,400
Capital Stock 96,000
Retained Earnings, 2010 January 1 49,920
Dividends 46,080
Commissions Revenue 653,200
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Salaries Expense 321,600
Travel Expense 96,480
Miscellaneous Expense 18,720
$ 882,640 $ 882,640
The prepaid rent is for the period 2010 July 1, to 2011 June 30.
The equipment has an expected life of 10 years with no salvage value.
Accrued salaries are USD 11,520.
Travel expenses accrued but unreimbursed to sales staff at December 31 were USD 17,280
a. Prepare a 12-column work sheet for the year ended 2010 December 31. You need not include account numbers
or explanations of adjustments.
b. Prepare adjusting journal entries.
c. Prepare closing journal entries.
Problem D The following trial balance and additional data are for South Sea Tours, Inc.:
SOUTH SEA TOURS, INC.
Trial Balance
2010 December 31
Debits Credits
Cash $ 109,050
Accounts Receivable 133,750
Prepaid Insurance 4,350
Prepaid Advertising 18,000
Notes Receivable 11,250
Land 90,000
Buildings 165,000
Accumulated Depreciation—Buildings $ 49,500
Office Equipment 83,400
Accumulated Depreciation—Office Equipment 16,680
Accounts Payable 56,850
Notes Payable 75,000
Capital Stock 240,000
Retained Earnings, 2010 January 1 47,820
Dividends 30,000
Service Revenue 368,350
Salaries Expense 96,000
Travel Expense 111,000
Interest Revenue 600
Interest Expense 3,000
$ 854,800 $ 854,800
The company consistently followed the policy of initially debiting all prepaid items to asset accounts.
The buildings have an expected life of 50 years with no salvage value.
The office equipment has an expected life of 10 years with no salvage value.
Accrued interest on notes receivable is USD 450.
Accrued interest on the notes payable is USD 1,000.
Accrued salaries are USD 2,100.
Expired prepaid insurance is USD 3,750.
Accounting Principles: A Business Perspective 188 A Global Text
4. Completing the accounting cycle
Expired prepaid advertising is USD 16,500.
a. Prepare a 12-column work sheet for the year ended 2010 December 31. You need not include account
numbers. Briefly explain the entries in the Adjustments columns at the bottom of the work sheet, as was done in
Exhibit 20.
b. Prepare the required closing entries.
Problem E The following trial balance and additional data are for Florida Time-Share Property Management
Company:
FLORIDA TIME-SHARE PROPERTY MANAGEMENT COMPANY Trial Balance
2010 December 31
Debits Credits
Cash $ 424,000
Prepaid Rent 28,800
Prepaid Insurance 7,680
Supplies on Hand 2,400
Office Equipment 24,000
Accumulated Depreciation—Office Equipment $ 5,760
Automobiles 64,000
Accumulated Depreciation—Automobiles 16,000
Accounts Payable 2,880
Unearned Management Fees 12,480
Capital Stock 360,000
Retained Earnings, 2010 January 1 120,640
Dividends 28,000
Commissions Revenue 260,000
Management Fee Revenue 19,200
Salaries Expense 199,840
Advertising Expense 2,400
Gas and Oil Expense 14,240
Miscellaneous Expense 1,600
$ 796,960 $ 796,960
Insurance expense for the year, USD 3,840.
Rent expense for the year, USD 19,200.
Depreciation expense: office equipment, USD 2,880; and automobiles, USD 12,800.
Salaries earned but unpaid at December 31, USD 26,640.
Supplies on hand at December 31, USD 1,000.
The unearned management fees were received and recorded on 2010 November 1. The advance payment
covered six months' management of an apartment building.
a. Prepare a 12-column work sheet for the year ended 2010 December 31. You need not include account numbers
or explanations of adjustments.
b. Prepare an income statement.
c. Prepare a statement of retained earnings.
d. Prepare a classified balance sheet.
e. Prepare adjusting and closing entries.
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Alternate problems
Alternate problem A The following adjusted trial balance is for Dream Home Realty Company:
DREAM HOME REALTY COMPANY
Adjusted Trial Balance
2010 June 30
Debits Credits
Cash $ 98,000
Accounts Receivable 40,000
Office Equipment 35,000
Accumulated Depreciation—Office Equipment $ 14,000
Automobiles 40,000
Accumulated Depreciation—Automobiles 20,000
Accounts Payable 63,000
Capital Stock 75,000
Retained Earnings, 2009 July 1 54,700
Dividends 5,000
Commissions Revenue 170,000
Salaries Expense 25,000
Commissions Expense 120,000
Gas and Oil Expense 4,000
Rent Expense 14,800
Supplies Expense 1,400
Utilities Expense 2,000
Depreciation Expense—Office Equipment 3,500
Depreciation Expense—Automobiles 8,000
$ 396,700 $ 396,700
Prepare the closing journal entries at the end of the fiscal year, 2010 June 30.
Alternate problem B The adjusted trial balance for Penrod Insurance Consultants, Inc., follows:
Penrod Insurance Consultants, Inc. Adjusted Trial Balance
2010 December 31
Debits Credits
Cash $ 107,200
Accounts Receivable 68,000
Interest Receivable 400
Notes Receivable 20,000
Prepaid Insurance 2,400
Supplies on Hand 1,800
Land 32,000
Buildings 190,000
Accumulated Depreciation—Buildings $ 40,000
Office Equipment 28,000
Accumulated Depreciation—Office Equipment 8,000
Accounts Payable 48,000
Salaries Payable 8,500
Interest Payable 900
Accounting Principles: A Business Perspective 190 A Global Text
4. Completing the accounting cycle
Notes Payable (due 2011) 64,000
Capital Stock 120,000
Retained Earnings, 2010 January 1 42,800
Dividends 40,000
Commissions Revenue 392,520
Advertising Expense 24,000
Commissions Expense 75,440
Travel Expense 12,880
Depreciation Expense—Buildings 8,500
Salaries Expense 98,400
Depreciation Expense—Office Equipment 2,800
Supplies Expense 3,800
Insurance Expense 3,600
Repairs Expense 1,900
Utilities Expense 3,400
Interest Expense 1,800
Interest Revenue 1,600
$ 726,320 $ 726,320
a. Prepare an income statement for the year ended 2010 December 31.
b. Prepare a statement of retained earnings.
c. Prepare a classified balance sheet.
d. Prepare the closing journal entries.
e. Show the post-closing trial balance assuming you had posted the closing entries to the general ledger.
Alternate problem C The following trial balance and additional data are for Ramon Data Processing
Company:
RAMON DATA PROCESSING COMPANY
Trial Balance
2010 December 31
Debits Credits
Cash $ 76,000
Accounts Receivable 98,000
Prepaid Rent 7,200
Prepaid Insurance 2,400
Equipment 80,000
Accumulated Depreciation—Equipment $ 40,000
Accounts Payable 30,000
Capital Stock 100,000
Retained Earnings, 2010 January 1 65,600
Dividends 24,000
Service Revenue 370,000
Commissions Expense 270,000
Travel Expense 36,000
Miscellaneous Expense 12,000
$ 605,600 $ 605,600
The prepaid rent is for the period 2010 January 1, to 2011 December 31.
The equipment is expected to last 10 years with no salvage value.
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The prepaid insurance was for the period 2010 April 1, to 2011 March 31.
Accrued commissions payable total USD 3,000 at December 31.
a. Prepare a 12-column work sheet for the year ended 2010 December 31. You need not include account numbers
or explanations of adjustments.
b. Prepare the adjusting journal entries.
c. Prepare the closing journal entries.
Alternate problem D The following trial balance and additional data are for Best-Friend Pet Hospital, Inc.
BEST-FRIEND PET HOSPITAL, INC.
Trial Balance
2010 December 31 Debits Credits
Cash $ 16,490
Accounts Receivable 54,390
Supplies on Hand 900
Prepaid Fire Insurance 1,800
Prepaid Rent 21,600
Equipment 125,000
Accumulated Depreciation —Equipment $ 25,000
Accounts Payable 29,550
Notes Payable 9,000
Capital Stock 150,000
Retained Earnings, 2010 January 1 20,685
Service Revenue 179,010
Interest Expense 225
Salaries Expense 142,200
Advertising Expense 29,250
Supplies Expense 2,135
Miscellaneous Expense 3,705
Legal and Accounting Expense 13,750
Utilities Expense 1,800
$ 413,245 $ 413,245
The company consistently followed the policy of initially debiting all prepaid items to asset accounts.
Prepaid fire insurance is USD 600 as of the end of the year.
Supplies on hand are USD 638 as of the end of the year.
Prepaid rent is USD 2,625 as of the end of the year.
The equipment is expected to last 10 years with no salvage value.
Accrued salaries are USD 2,625.
a. Prepare a 12-column work sheet for the year ended 2010 December 31. You need not include account
numbers. Briefly explain the entries in the Adjustments columns at the bottom of the work sheet, as was done in
Exhibit 20.
b. Prepare the 2010 December 31, closing entries.
Alternate problem E The following trial balance and additional data are for Roswell Interior Decorators, Inc.:
ROSWELL INTERIOR DECORATORS, INC
Trial Balance
2010 December 31
Accounting Principles: A Business Perspective 192 A Global Text
4. Completing the accounting cycle
Debits Credits
Cash $ 85,400
Accounts Receivable 81,600
Supplies on Hand 4,000
Prepaid Rent 12,240
Prepaid Advertising 2,880
Prepaid Insurance 4,400
Office Equipment 7,600
Accumulated Depreciation—Office Equipment $ 2,760
Office Furniture 29,200
Accumulated Depreciation—Office Furniture 8,280
Accounts Payable 25,200
Notes Payable (due 2011) 4,000
Capital Stock 100,000
Retained Earnings, 2010 January 1 22,400
Dividends 45,520
Service Revenue 250,000
Salaries Expense 98,800
Utilities Expense 20,000
Miscellaneous Expense 24,000
$ 412,640 $ 412,640
Supplies on hand at 2010 December 31, are USD 1,000.
Rent expense for 2010 is USD 10,000.
Advertising expense for 2010 is USD 2,304.
Insurance expense for 2010 is USD 2,400.
Depreciation expense is office equipment, USD 912, and office furniture, USD 3,000.
Accrued interest on notes payable is USD 150.
Accrued salaries are USD 4,200.
a. Prepare a 12-column work sheet for the year ended 2010 December 31. You need not include account numbers
or explanations of adjustments.
b. Prepare an income statement.
c. Prepare a statement of retained earnings.
d. Prepare a classified balance sheet.
e. Prepare adjusting and closing entries.
Beyond the numbers—Critical thinking
Business decision case A Heather and Dan Holt met while both were employed in the interior trim and
upholstery department of an auto manufacturer. After their marriage, they decided to earn some extra income by
doing small jobs involving canvas, vinyl, and upholstered products. Their work was considered excellent, and at the
urging of their customers, they decided to go into business for themselves, operating out of the basement of the
house they owned. To do this, they invested USD 120,000 cash in their business. They spent USD 10,500 for a
sewing machine (expected life, 10 years) and USD 12,000 for other miscellaneous tools and equipment (expected
life, 5 years). They undertook only custom work, with the customers purchasing the required materials, to avoid
stocking any inventory other than supplies. Generally, they required an advance deposit on all jobs.
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The business seemed successful from the start, as the Holts received orders from many customers. But they felt
something was wrong. They worked hard and charged competitive prices. Yet there seemed to be barely enough
cash available from the business to cover immediate personal needs. Summarized, the checkbook of the business
for 2010, their second year of operations, showed:
Balance, 2010 January 1 $ 99,200
Cash received from customers:
For work done in 2009 $ 36,000
For work done in 2010 200,000
For work to be done in 2011 48,000 284,000
$ 383,200
Cash paid out:
Two-year insurance policy dated 2010 January 1 $ 19,200
Utilities 48,000
Supplies 104,000
Other Expenses 72,000
Taxes, including sales taxes 26,400
Dividends 40,000 309,600
Balance, 2010 December 31 $ 73,600
Considering how much they worked, the Holts were concerned that the cash balance decreased by USD 25,600
even though they only received dividends of USD 40,000. Their combined income from the auto manufacturer had
been USD 45,000. They were seriously considering giving up their business and going back to work for the auto
manufacturer. They turned to you for advice. You discovered the following:
Of the supplies purchased in 2010, USD 24,000 were used on jobs billed to customers in 2010; no supplies were
used for any other work.
Work completed in 2010 and billed to customers for which cash had not yet been received by year-end
amounted to USD 40,000.
Prepare a written report for the Holts, responding to their belief that their business is not sufficiently profitable.
(Hint: Prepare an income statement for 2010 and include it in your report.)
Annual report analysis B Using the Annual report appendix, calculate the current ratios for the two years
shown for The Limited, Inc. Write a summary of the results of your calculations. Also, look at some of the other data
provided by the company in preparing your comments. For instance, look at the net income for the last three years.
Broader perspective – Writing experience C Read the "A broader perspective: Skills for the long haul".
Write a description of a career in public accounting broader perspective at each level within the firm. Discuss the
skills needed and how you could develop these skills.
Group project D In teams of two or three students, interview a management accountant. Management
accountants may have the title of chief financial officer (CFO), controller, or some other accounting title within a
company. Seek information on the advantages and disadvantages of working as a management accountant. Also
inquire about the nature of the work and any training programs offered by the company. As a team, write a
memorandum to the instructor summarizing the results of the interview. The heading of the memorandum should
contain the date, to whom it is written, from whom, and the subject matter.
Group project E With a small group of students, obtain an annual report of a company in which you have
some interest. You may obtain the annual report from your instructor, the library, the Internet, or the company.
Accounting Principles: A Business Perspective 194 A Global Text
4. Completing the accounting cycle
Describe the nature of each item on the classified balance sheet. You may have to do library research on some of the
items. Also, calculate the current ratio for the most recent two years and comment. Write a report to your instructor
summarizing the results of the project.
Group project F With a small group of students and using library sources, write a paper comparing the
features of three different accounting software packages (such as Peachtree Complete, Quikbooks Pro, DacEasy,
MYOB Business Essentials, NetSuite Small Businee and Cougar Mountain ). Give the strengths and weaknesses of
each. Cite sources for the information and treat direct quotes properly.
Using the Internet—A view of the real world
Visit the following Internet site:
http://www.merck.com
Pursue choices you are offered on the screen under Investor Relations until you locate the most recent
consolidated balance sheet. In a short report to your instructor, describe how you got to the balance sheet and
identify the major headings used in the balance sheet. For instance, the first such heading is Assets. Also, calculate
the current ratio.
Visit the following Internet site:
http://www.kodak.com
Type in "Annual report" in the search box to locate the most recent annual report and then find the consolidated
statement of financial position. Identify the major headings within the balance sheet and calculate the current ratio
for the most recent year. Write a memo to your instructor summarizing your findings.
Answers to self-test
True-false
True. The three trial balances are the unadjusted trial balance, the adjusted trial balance, and the post-closing
trial balance. The first two trial balances appear on the work sheet.
False. If a debit-balance account (such as Prepaid Rent) is credited in the adjustment, the amount in the
Adjustments columns is deducted from the amount in the Trial Balance columns to determine the amount for that
item in the Adjusted Trial Balance columns.
True. The net loss appears in the Income Statement credit column to balance the Income Statement columns.
Then the loss appears in the Statement of Retained Earnings debit column because it reduces Retained Earnings.
True. All of these accounts are closed, or reduced to zero balances, as a result of the closing process.
False. All revenue and expense accounts have zero balances after closing.
False. Some manual accounting systems are still in use.
Multiple-choice
b. The other accounts are very likely to be adjusted. The Land account would be adjusted only if an error has
been made involving that account.
c. The Adjusted Trial Balance columns should balance before items are spread to the Income Statement,
Statement of Retained Earnings, and Balance Sheet columns. Therefore, if the Balance Sheet columns do not
balance, the error is likely to exist in the last six columns of the work sheet.
d. The net income for the period does not appear in the balance sheet. It does appear in all of the other places
listed.
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a. The Dividends account is closed to the Retained Earnings account rather than to the Income Summary
account.
b. Plant, property, and equipment is one of the long-term asset categories. Response (a) should not include
equipment. Response (c) should not include notes receivable. Stockholders' equity is not subdivided into current
and long-term categories.
Comprehensive review problem
Lopez Delivery Service Company has the following chart of accounts:
Acct. Acct.
No. Account Title No. Account Title 100 Cash 310 Retained Earnings 103 Accounts Receivable 320 Dividends 107 Supplies on Hand 400 Service Revenue 108 Prepaid Insurance 507 Salaries Expense 112 Prepaid Rent 511 Utilities Expense 140 Buildings 512 Insurance Expense 141 Accumulated Depreciation—Buildings 515 Rent Expense 150 Trucks 518 Supplies Expense 151 Accumulated Depreciation—Trucks 520 Depreciation Expense—Buildings 200 Accounts Payable 521 Depreciation Expense—Trucks 206 Salaries Payable 568 Miscellaneous Expense 300 Capital Stock 600 Income Summary
The post-closing trial balance as of 2010 May 31, was as follows:
LOPEZ DELIVERY SERVICE COMPANY
Post-Closing Trial Balance
2010 May 31
Acct.
No. Account Title Debits Credits 100 Cash $ 80,000
103 Accounts Receivable 30,000
107 Supplies on Hand 14,000
108 Prepaid Insurance 4,800
112 Prepaid Rent 12,000
140 Buildings 320,000
141 Accumulated Depreciation —Buildings $ 36,000
150 Trucks 80,000
151 Accumulated Depreciation—Trucks 30,000
200 Accounts Payable 24,000
300 Capital Stock 300,000
310 Retained Earnings 150,800
$ 540,800 $ 540,800
The transactions for June 2010 were as follows:
June 1 Performed delivery services for customers on account, USD 60,000.
3 Paid dividends, USD 10,000.
4 Purchased a USD 20,000 truck on account.
7 Collected USD 22,000 of the accounts receivable.
8 Paid USD 16,000 of the accounts payable.
11 Purchased USD 4,000 of supplies on account. The asset account for supplies was debited.
17 Performed delivery services for cash, USD 32,000.
20 Paid the utilities bills for June, USD 1,200.
Accounting Principles: A Business Perspective 196 A Global Text
4. Completing the accounting cycle
23 Paid miscellaneous expenses for June, USD 600.
28 Paid salaries of USD 28,000 for June.
• Depreciation expense on the buildings for June is USD 800.
• Depreciation expense on the trucks for June is USD 400.
• Accrued salaries at June 30 are USD 4,000.
• A physical count showed USD 12,000 of supplies on hand on June 30.
• The prepaid insurance balance of USD 4,800 applies to a two-year period beginning 2010 June 1.
• The prepaid rent of USD 12,000 applies to a one-year period beginning 2010 June 1.
• Performed USD 12,000 of delivery services for customers as of June 30 that will not be billed to those
customers until July.
a. Open three-column ledger accounts for the accounts listed in the chart of accounts.
b. Enter the 2010 May 31, account balances in the accounts.
c. Journalize the transactions for June 2010.
d. Post the June journal entries and include cross-references (assume all journal entries appear on page 10 of the
journal).
e. Prepare a 12-column work sheet as of 2010 June 30.
f. Prepare an income statement, a statement of retained earnings, and a classified balance sheet.
g. Prepare and post the adjusting entries (assume they appear on page 11 of the general journal).
h. Prepare and post the closing entries (assume they appear on page 12 of the general journal).
i. Prepare a post-closing trial balance.
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5. Accounting theory Learning objectives
After studying this chapter, you should be able to:
• Identify and discuss the underlying assumptions or concepts of accounting.
• Identify and discuss the major principles of accounting.
• Identify and discuss the modifying conventions (or constraints) of accounting.
• Describe the conceptual framework project of the Financial Accounting Standards Board.
• Discuss the nature and content of a company's summary of significant accounting policies in its annual
report.
A career as an accounting professor
Do you enjoy college life? Do you enjoy teaching others? If so, you might want to consider a career as a college
professor. Although a position as a college professor may pay less than some other career alternatives, the
intangible benefits are beyond measure. A college professor can make a real difference in the lives of hundreds,
even thousands, of students over a career. Students come to college with great potential, but are in need of some
additional training and guidance. The work of a college professor is a valuable investment in our nation's most
valuable resource—people.
College faculty generally teach fewer hours each week than elementary and secondary school teachers. This is
because most college faculty have at least two additional important responsibilities: research and service. The
research component represents far more than just summarizing what others have already learned. It represents
arriving at new knowledge by discovering things that previously were unknown. For instance, accounting research
has demonstrated the ways in which accounting numbers such as earnings and stockholder's equity are related to
stock prices. This illustrates the importance of accounting numbers and has resulted in a large stream of discovery
called Capital Markets research. Besides teaching and research, most faculty have significant service responsibilities
as well. Accounting faculty are involved in service to the university, the accounting profession, and to the general
public. Many college faculty dedicate 10-20 hours or more each week to the service component of their jobs.
The demand for college professors varies greatly by discipline. In fields such as English, Fine Arts, Philosophy,
and Psychology there is a large supply of candidates with advanced degrees and, thus, the competition for positions
as college professors in these areas is intense. However, in applied fields such as accounting and engineering, there
is a shortage of candidates with advanced degrees. The opportunities for professors in these applied fields are
excellent, and the chance to make a real difference in the lives of others is exciting.
Chapter 1 briefly introduced the body of theory underlying accounting procedures. In this chapter, we discuss
accounting theory in greater depth. Now that you have learned some accounting procedures, you are better able to
relate these theoretical concepts to accounting practice. Accounting theory is "a set of basic concepts and
Accounting Principles: A Business Perspective 198 A Global Text
5. Accounting theory
assumptions and related principles that explain and guide the accountant's actions in identifying, measuring, and
communicating economic information".12
To some people, the word theory implies something abstract and out of reach. Understanding the theory behind
the accounting process, however, helps one make decisions in diverse accounting situations. Accounting theory
provides a logical framework for accounting practice.
The first part of the chapter describes underlying accounting assumptions or concepts, the measurement
process, the major principles, and modifying conventions or constraints. Accounting theory has developed over the
years and is contained in authoritative accounting literature and textbooks. The next part of the chapter describes
the development of the Financial Accounting Standards Board's (FASB) conceptual framework for accounting. This
framework builds on accounting theory developed over time and serves as a basis for formulating accounting
standards in the future. Presenting the traditional body of theory first and the conceptual framework second gives
you a sense of the historical development of accounting theory. Despite some overlap between the two parts of the
chapter, remember that FASB's conceptual framework builds on traditional theory rather than replaces it. The final
part of the chapter discusses significant accounting policies contained in annual reports issued by companies and
illustrates them with an actual example from an annual report of the Walt Disney Company.
Traditional accounting theory
Traditional accounting theory consists of underlying assumptions, rules of measurement, major principles, and
modifying conventions (or constraints). The following sections describe these aspects of accounting theory that
greatly influence accounting practice.
Underlying assumptions or concepts
The major underlying assumptions or concepts of accounting are (1) business entity, (2) going concern
(continuity), (3) money measurement, (4) stable dollar, and (5) periodicity. This section discusses the effects of
these assumptions on the accounting process.
Data gathered in an accounting system must relate to a specific business unit or entity. The business entity
concept assumes that each business has an existence separate from its owners, creditors, employees, customers,
interested parties, and other businesses. For each business (such as a horse stable or a fitness center), the business,
not the business owner, is the accounting entity. Therefore, financial statements are identified as belonging to a
particular business entity. The content of these financial statements reports only on the activities, resources, and
obligations of that entity.
A business entity may be made up of several different legal entities. For instance, a large business (such as
General Motors Corporation) may consist of several separate corporations, each of which is a separate legal entity.
For reporting purposes, however, the corporations may be considered as one business entity because they have a
common ownership. Chapter 14 illustrates this concept.
When accountants record business transactions for an entity, they assume it is a going concern. The going-
concern (continuity) assumption states that an entity will continue to operate indefinitely unless strong
evidence exists that the entity will terminate. The termination of an entity occurs when a company ceases business
operations and sells its assets. The process of termination is called liquidation. If liquidation appears likely, the
going-concern assumption is no longer valid.
12 American Accounting Association, A Statement of Basic Accounting Theory (Sarasota, Fla., 1966), pp. 1-2.
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Accountants often cite the going-concern assumption to justify using historical costs rather than market values
in measuring assets. Market values are of less significance to an entity using its assets rather than selling them. On
the other hand, if an entity is liquidating, it should use liquidation values to report assets.
The economic activity of a business is normally recorded and reported in money terms. Money measurement
is the use of a monetary unit such as the dollar instead of physical or other units of measurement. Using a particular
monetary unit provides accountants with a common unit of measurement to report economic activity. Without a
monetary unit, it would be impossible to add such items as buildings, equipment, and inventory on a balance sheet.
Financial statements identify their unit of measure (such as the dollar in the United States) so the statement
user can make valid comparisons of amounts. For example, it would be difficult to compare relative asset amounts
or profitability of a company reporting in US dollars with a company reporting in Japanese yen.
In the United States, accountants make another assumption regarding money measurement—the stable dollar
assumption. Under the stable dollar assumption, the dollar is accepted as a reasonably stable unit of
measurement. Thus, accountants make no adjustments for the changing value of the dollar in the primary financial
statements.
Using the stable dollar assumption creates a difficulty in depreciation accounting. Assume, for example, that a
company acquired a building in 1975 and computed the 30-year straight-line depreciation on the building without
adjusting for any changes in the value of the dollar. Thus, the depreciation deducted in 2008 is the same as the
depreciation deducted in 1975. The company makes no adjustments for the difference between the values of the
1975 dollar and the 2008 dollar. Both dollars are treated as equal monetary units of measurement despite
substantial price inflation over the 30-year period. Accountants and business executives have expressed concern
over this inflation problem, especially during periods of high inflation.
According to the periodicity (time periods) assumption, accountants divide an entity's life into months or
years to report its economic activities. Then, accountants attempt to prepare accurate reports on the entity's
activities for these periods. Although these time-period reports provide useful and timely financial information for
investors and creditors, they may be inaccurate for some of these time periods because accountants must estimate
depreciation expense and certain other adjusting entries.
Accounting reports cover relatively short periods. These time periods are usually of equal length so that
statement users can make valid comparisons of a company's performance from period to period. The length of the
accounting period must be stated in the financial statements. For instance, so far, the income statements in this text
were for either one month or one year. Companies that publish their financial statements, such as publicly held
corporations, generally prepare monthly statements for internal management and publish financial statements
quarterly and annually for external statement users.
Accrual basis and periodicity Chapter 3 demonstrated that financial statements more accurately reflect the
financial status and operations of a company when prepared under the accrual basis rather than the cash basis of
accounting. Under the cash basis, we record revenues when cash is received and expenses when cash is paid. Under
the accrual basis, however, we record revenues when services are rendered or products are sold and expenses when
incurred.
The periodicity assumption requires preparing adjusting entries under the accrual basis. Without the periodicity
assumption, a business would have only one time period running from its inception to its termination. Then, the
concepts of cash basis and accrual basis accounting would be irrelevant because all revenues and all expenses would
Accounting Principles: A Business Perspective 200 A Global Text
5. Accounting theory
be recorded in that one time period and would not have to be assigned to artificially short periods of one year or
less.
Approximation and judgment because of periodicity To provide periodic financial information,
accountants must often estimate expected uncollectible accounts (see Chapter 9) and the useful lives of depreciable
assets. Uncertainty about future events prevents precise measurement and makes estimates necessary in
accounting. Fortunately, these estimates are often reasonably accurate.
Other basic concepts
Other basic accounting concepts that affect accounting for entities are (1) general-purpose financial statements,
(2) substance over form, (3) consistency, (4) double entry, and (5) articulation. We discuss these basic accounting
concepts next.
Accountants prepare general-purpose financial statements at regular intervals to meet many of the
information needs of external parties and top-level internal managers. In contrast, accountants can gather special-
purpose financial information for a specific decision, usually on a one-time basis. For example, management may
need specific information to decide whether to purchase a new computer system. Since special-purpose financial
information must be specific, this information is best obtained from the detailed accounting records rather than
from the financial statements.
In some business transactions, the economic substance of the transaction conflicts with its legal form. For
example, a contract that is legally a lease may, in fact, be equivalent to a purchase. A company may have a three-
year contract to lease (rent) an automobile at a stated monthly rental fee. At the end of the lease period, the
company receives title to the auto after paying a nominal sum (say, USD 1). The economic substance of this
transaction is a purchase rather than a lease of the auto. Thus, under the substance-over-form concept, the auto is
an asset on the balance sheet and is depreciated instead of showing rent expense on the income statement.
Accountants record a transaction's economic substance rather than its legal form.
Consistency generally requires that a company use the same accounting principles and reporting practices
through time. This concept prohibits indiscriminate switching of accounting principles or methods, such as
changing inventory methods every year. However, consistency does not prohibit a change in accounting principles
if the information needs of financial statement users are better served by the change. When a company makes a
change in accounting principles, it must make the following disclosures in the financial statements: (1) nature of the
change; (2) reasons for the change; (3) effect of the change on current net income, if significant; and (4) cumulative
effect of the change on past income.
Chapter 2 introduced the basic accounting concept of the double-entry method of recording transactions. Under
the double-entry approach, every transaction has a two-sided effect on each party engaging in the transaction.
Thus, to record a transaction, each party debits at least one account and credits at least one account. The total
debits equal the total credits in each journal entry.
When learning how to prepare work sheets in Chapter 4, you learned that financial statements are
fundamentally related and articulate (interact) with each other. For example, we carry the amount of net income
from the income statement to the statement of retained earnings. Then we carry the ending balance on the
statement of retained earnings to the balance sheet to bring total assets and total equities into balance.
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In Exhibit 27 we summarize the underlying assumptions or concepts. The next section discusses the
measurement process used in accounting.
The measurement process in accounting
Earlier, we defined accounting as "the process of identifying, measuring, and communicating economic
information to permit informed judgments and decisions by the users of the information".13 In this section, we
focus on the measurement process of accounting.
Accountants measure a business entity's assets, liabilities, and stockholders' equity and any changes that occur
in them. By assigning the effects of these changes to particular time periods (periodicity), they can find the net
income or net loss of the accounting entity for those periods.
Accountants measure the various assets of a business in different ways. They measure cash at its specified
amount. Chapter 9 explains how they measure claims to cash, such as accounts receivable, at their expected cash
inflows, taking into consideration possible uncollectibles. They measure inventories, prepaid expenses, plant assets,
and intangibles at their historical costs (actual amounts paid). After the acquisition date, they carry some items,
such as inventory, at the lower-of-cost-or-market value. After the acquisition date, they carry plant assets and
intangibles at original cost less accumulated depreciation or amortization. They measure liabilities at the amount of
cash that will be paid or the value of services that will be performed to satisfy the liabilities.
Accountants can easily measure some changes in assets and liabilities, such as the acquisition of an asset on
credit and the payment of a liability. Other changes in assets and liabilities, such as those recorded in adjusting
entries, are more difficult to measure because they often involve estimates and/or calculations. The accountant
must determine when a change has taken place and the amount of the change. These decisions involve matching
revenues and expenses and are guided by the principles discussed next.
13 Ibid., p. 1.
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5. Accounting theory
Assumption or Concept Description Importance
Business entity Each business has an existence separate Defines the scope of the business such as a horse from its owners, creditors, employees, stable or physical fitness center. Identifies which customers, other interested parties, and transactions should be recorded on the company's other businesses. books.
Going concern (continuity) An entity will continue to operate indefinitely Allows a company to continue carrying plant assets unless strong evidence exists that the entity at their historical costs in spite of a change in their will terminate. market values.
Money measurement Each business uses a monetary unit of Provides accountants with a common unit of measurement, such as the dollar, instead of measure to report economic activity. This concept physical or other units of measurement. permits us to add an d subtract items on the
financial statements.
Stable dollar The dollar is accepted as a reasonably Permits us to make no adjustments in the financial stable unit of measure. statements for the changing value of the dollar.
This assumption works fairly well in the United States because of our relatively low rate of inflation.
Periodicity (time periods) An entity's life can be subdivided into Permits us to prepare financial statements that months or years to report its economic cover periods shorter than the entire life of a activities. business. Thus, we know how well a business is
performing before it terminates its operations. The need for adjusting entries arises because of this concept and the use of accrual accounting.
General-purpose financial One set of financial statements serves the Allows companies to prepare only one set of statements needs of all users. financial statements instead of a separate set for
each potential type of user of those statements. The financial statements should be free of bias so they do not favor the interests of any one type of user.
Substance over form Accountants should record the economic Encourages the accountant to record the true substance of a transaction rather than its nature of a transaction rather than its apparent legal form. nature. This approach is the accounting equivalent
of "tell it like it is." An apparent lease transaction that has all the characteristics of a purchase should be recorded as a purchase.
Consistency Generally requires that a company use the Prevents a company from changing accounting same accounting principles and reporting methods whenever it likes to present a better practices every accounting period. picture or to manipulate income. The inventory and
depreciation chapters (Chapters 7 and 10) both mention the importance of this concept.
Double entry Every transaction has a two-sided effect on Uses a system of checks and balances to help each company or party engaging in the identify whether or not errors have been made in transaction. recording transactions. When the debits do not
equal the credits, this inequality immediately signals us to stop and find the error.
Articulation Financial statements are fundamentally Changes in account balances during an accounting related and articulate (interact) with each period are reflected in financial statements that are other. related to one another. For instance, earning
revenue increases net income on the income statement, retained earnings on the statement of
retained earnings, and assets and retained earnings on the balance sheet. The statement of retained earnings ties the income statement and balance sheet together.
Exhibit 27: The underlying assumptions or concepts
The major principles
Generally accepted accounting principles (GAAP) set forth standards or methods for presenting financial
accounting information. A standardized presentation format enables users to compare the financial information of
different companies more easily. Generally accepted accounting principles have been either developed through
accounting practice or established by authoritative organizations. Organizations that have contributed to the
development of the principles are the American Institute of Certified Public Accountants (AICPA), the Financial
Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC), the American Accounting
Association (AAA), the Financial Executives Institute (FEI), and the Institute of Management Accounting (IMA).
This section explains the following major principles:
• Exchange-price (or cost) principle.
• Revenue recognition principle.
• Matching principle.
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• Gain and loss recognition principle.
• Full disclosure principle.
Whenever resources are transferred between two parties, such as buying merchandise on account, the
accountant must follow the exchange-price (or cost) principle in presenting that information. The exchange-price
(or cost) principle requires an accountant to record transfers of resources at prices agreed on by the parties to
the exchange at the time of exchange. This principle sets forth (1) what goes into the accounting system—
transaction data; (2) when it is recorded—at the time of exchange; and (3) the amounts—exchange prices—at which
assets, liabilities, stockholders' equity, revenues, and expenses are recorded.
As applied to most assets, this principle is often called the cost principle. It dictates that purchased or self-
constructed assets are initially recorded at historical cost. Historical cost is the amount paid, or the fair market
value of the liability incurred or other resources surrendered, to acquire an asset and place it in a condition and
position for its intended use. For instance, when the cost of a plant asset (such as a machine) is recorded, its cost
includes the net purchase price plus any costs of reconditioning, testing, transporting, and placing the asset in the
location for its intended use. Accountants prefer the term exchange-price principle to cost principle because it
seems inappropriate to refer to liabilities, stockholders' equity, and such assets as cash and accounts receivable as
being measured in terms of cost.
More recently, the FASB in SFAS 157 has moved definitively towards fair market value accounting, or “mark-to-
market”, which records the value of an asset or liability at its current market value (also known as a “fair value”)
rather than its book value.
SFAS 157 defines “fair value” as “the price that would be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants at the measurement date”.
It is also defined as “an exit price from the perspective of a market participant that holds the asset or owes the
liability”, whether or not the business plans to hold the asset/liability for investment, or sell it.
“The fair value accounting standard SFAS 157 applies to financial assets of all publicly-traded companies in the
US as of 2007 Nov. 15. It also applies to non-financial assets and liabilities that are recognized, or disclosed, at fair
value on a recurring basis. Beginning in 2009, the standard will apply to other non-financial assets. SFAS 157
applies to items for which other accounting pronouncements require or permit fair value measurements except
share-based payment transactions, such as stock option compensation.
“SFAS 157 provides a hierarchy of three levels of input data for determining the fair value of an asset or liability.
This hierarchy ranks the quality and reliability of information used to determine fair values, with level 1 inputs
being the most reliable and level 3 inputs being the least reliable.
• Level 1 is quoted prices for identical items in active, liquid and visible markets such as stock exchanges.
• Level 2 is observable information for similar items in active or inactive markets, such as two similarly
situated buildings in a downtown real estate market.
• Level 3 are unobservable inputs to be used in situations where markets do not exist or are illiquid such as
the present credit crisis. At this point fair market valuation becomes highly subjective.”
Fair value accounting has been a contentious topic since it was introduced, For example, “banks and investment
banks have had to reduce the value of the mortgages and mortgage-backed securities to reflect current prices”.
Those prices declined severely with the collapse of credit markets as mortgage defaults escalated in the financial
crisis of 2008-2009. Despite debate over the proper implementation of fair market value accounting, International
Accounting Principles: A Business Perspective 204 A Global Text
5. Accounting theory
Financial Reporting Standards utilize this approach much more than the Generally Accepted Accounting Principles
of the United States.
To learn more about fair market value accounting, visit the AICPA site,
(http://www.aicpa.org/MediaCenter/fva_faq.htm), the source used for the explanation of this topic.
An accounting perspective:
Business insight
In some European countries, the financial statements contain secret reserves. These secret reserves arise
from a company not reporting all of its profits when it has a very good year. The justification is that the
stockholders vote on the amount of dividends they receive each year; if all profits were reported, the
stockholders might vote to pay the entire amount out as dividends. By holding back some profits, not only
are the creditors more protected but the company is also more solvent and has more resources to invest
in productive assets.
Revenue is not difficult to define or measure; it is the inflow of assets from the sale of goods and services to
customers, measured by the cash expected to be received from customers. However, the crucial question for the
accountant is when to record a revenue. Under the revenue recognition principle, revenues should be earned
and realized before they are recognized (recorded).
Earning of revenue All economic activities undertaken by a company to create revenues are part of the
earning process. Many activities may have preceded the actual receipt of cash from a customer, including (1)
placing advertisements, (2) calling on the customer several times, (3) submitting samples, (4) acquiring or
manufacturing goods, and (5) selling and delivering goods. For these activities, the company incurs costs. Although
revenue was actually being earned by these activities, accountants do not recognize revenue until the time of sale
because of the requirement that revenue be substantially earned before it is recognized (recorded). This
requirement is the earning principle.
Realization of revenue Under the realization principle, the accountant does not recognize (record)
revenue until the seller acquires the right to receive payment from the buyer. The seller acquires this right from the
buyer at the time of sale for merchandise transactions or when services have been performed in service
transactions. Legally, a sale of merchandise occurs when title to the goods passes to the buyer. The time at which
title passes normally depends on the shipping terms—FOB shipping point or FOB destination (as we discuss in
Chapter 6). As a practical matter, accountants generally record revenue when goods are delivered.
The advantages of recognizing revenue at the time of sale are (1) the actual transaction—delivery of goods—is an
observable event; (2) revenue is easily measured; (3) risk of loss due to price decline or destruction of the goods has
passed to the buyer; (4) revenue has been earned, or substantially so; and (5) because the revenue has been earned,
expenses and net income can be determined. As discussed later, the disadvantage of recognizing revenue at the time
of sale is that the revenue might not be recorded in the period during which most of the activity creating it occurred.
Exceptions to the realization principle The following examples are instances when practical
considerations may cause accountants to vary the point of revenue recognition from the time of sale. These
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examples illustrate the effect that the business environment has on the development of accounting principles and
standards.
Cash collection as point of revenue recognition Some small companies record revenues and expenses at
the time of cash collection and payment, which may not occur at the time of sale. This procedure is the cash basis of
accounting. The cash basis is acceptable primarily in service enterprises that do not have substantial credit
transactions or inventories, such as business entities of doctors or dentists.
Installment basis of revenue recognition When collecting the selling price of goods sold in monthly or
annual installments and considerable doubt exists as to collectibility, the company may use the installment basis of
accounting. Companies make these sales in spite of the doubtful collectibility of the account because their margin of
profit is high and the goods can be repossessed if the payments are not received. Under the installment basis, the
percentage of total gross margin (selling price of a good minus its cost) recognized in a period is equal to the
percentage of total cash from a sale that is received in that period. Thus, the gross margin recognized in a period is
equal to the cash received times the gross margin percentage (gross margin divided by selling price). The formula to
recognize gross profit on cash collections made on installment sales of a certain year is:
Cash collections x Gross margin percentage=Gross margin recognized
To be more precise, we expand the descriptions in the formula as follows:
Cash collections this year resulting from installment sales made in a certain year
X Gross margin percentage for the year of sale
= Gross margin recognized this year on cash collections this year from installment sales made in a certain year
To illustrate, assume a company sold a stereo set. The facts of the sale are:
Date of sale Selling price Cost Gross margin (Selling price – Cost)
Gross margin percentage (Gross margin/Selling price)
2010 Oct. 1 USD 500 USD 300 (500-300) – 200 (200/500) = 40 per cent
The buyer makes 10 equal monthly installment payments of USD 50 to pay for the set (10 X USD 50 = USD
500). If the company receives three monthly payments in 2010, the total amount of cash received in 2010 is USD
150 (3 X USD 50). The gross margin to recognize in 2010 is:
2010 cash collections from 2010 installment sales
X Gross margin percentage on 2010 installment sales
= 2010 gross margin recognized on 2010 cash collections from 2010 installment sales
USD 150 X 40 per cent = USD 60
The company collects the other installments when due so it receives a total of USD 350 in 2011 from 2010
installment sales. The gross margin to recognize in 2011 on these cash collections is as follows:
2011 cash collections from 2010 installment sales
X Gross margin percentage on 2010 installment sales
= 2011 gross margin recognized on 2011 cash collections from 2010 installment sales
USD 350 X 40 per cent = USD 140
In summary, the total receipts and gross margin recognized in the two years are as follows:
Total Amount of Gross Margin
Year Cash Recognized Recognized
2010 $150 30% $ 60 30% 2011 ..... 350 70% 140 70%
$500 100% $200 100%
Because the installment basis delays some revenue recognition beyond the time of sale, it is acceptable for
accounting purposes only when considerable doubt exists as to collectibility of the installments.
Accounting Principles: A Business Perspective 206 A Global Text
5. Accounting theory
Revenue recognition on long-term construction projects Companies recognize revenue from a long-
term construction project under two different methods: (1) the completed-contract method or (2) the percentage-
of-completion method. The completed-contract method does not recognize any revenue until the project is
completed. In that period, they recognize all revenue even though the contract may have required three years to
complete. Thus, the completed-contract method recognizes revenues at the time of sale, as is true for most sales
transactions. Companies carry costs incurred on the project forward in an inventory account (Construction in
Process) and charge them to expense in the period in which the revenue is recognized.
Some accountants argue that waiting so long to recognize any revenue is unreasonable. They believe that
because revenue-producing activities have been performed during each year of construction, revenue should be
recognized in each year of construction even if estimates are needed. The percentage-of-completion method
recognizes revenue based on the estimated stage of completion of a long-term project. To measure the stage of
completion, firms compare actual costs incurred in a period with the total estimated costs to be incurred on the
project.
To illustrate, assume that a company has a contract to build a dam for USD 44 million. The estimated
construction cost is USD 40 million. You calculate the estimated gross margin as follows:
Sales price of dam Estimated costs of construct dam
Estimated gross margin (sales price – estimated costs)
USD 44 million USD 40 million (44 million – 40 million) – 4 million
The firm recognizes the USD 4 million gross margin in the financial statements by recording the assigned
revenue for the year and then deducting actual costs incurred that year. The formula to recognize revenue is:
Actual construction costs incurred during the period
Total estimated construction costs for the entire project xTotal sales price=Revenue recognized for period
Suppose that by the end of the first year (2010), the company had incurred actual construction costs of USD 30
million. These costs are 75 per cent of the total estimated construction costs (USD 30 million/USD 40 million = 75
per cent). Under the percentage-of-completion method, the firm would use the 75 per cent figure to assign revenue
to the first year. In 2011, it incurs another USD 6 million of construction costs. In 2012, it incurs the final USD 4
million of construction costs. The amount of revenue to assign to each year is as follows:
Year Ratio of Actual Construction Costs to Total Estimated
Construction Costs
X Agreed Price =
of Dam =
Amount of Revenue to
Recognize (Assign)
2010 ($30 million + $40 million = 75%)
75% X $44 million = $33 million
2011 ($6 million + $40 million = 15%)
15% X $44 million = $6.6 million
2012 ($4 million + $40 million = 10%)
10% X $44 million = $4.4 million $44 million
The amount of gross margin to recognize in each year is as follows:
Year Assigned Revenues
Actual - Construction Costs
Recognized = Gross Margin
2010 $33.0 million - $30.0 million = $3.0 million 2011 6.6 - 6.0 = 0.6 2012 4.4 - 4.0 = 0.4
$44.0 million $40.0 million $4.0 million
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Number of Companies
2003 2002 2001 2000
Percentage of completion 78 82 80 71 Units of delivery 32 26 21 19 Completed contract 9 5 3 5 Source: American Institute of Certified Public Accountants,
Accounting Trends & Techniques (New York: AICPA, 2004), p. 432
Exhibit 28: Methods of accounting for long-term contracts
This company would deduct other costs incurred in the accounting period, such as general and administrative
expenses, from gross margin to determine net income. For instance, assuming general and administrative expenses
were USD 100,000 in 2010, net income would be (USD 3,000,000 - USD 100,000) = USD 2,900,000.
Expense recognition is closely related to, and sometimes discussed as part of, the revenue recognition principle.
The matching principle states that expenses should be recognized (recorded) as they are incurred to produce
revenues. An expense is the outflow or using up of assets in the generation of revenue. Firms voluntarily incur
expense to produce revenue. For instance, a television set delivered by a dealer to a customer in exchange for cash is
an asset consumed to produce revenue; its cost becomes an expense. Similarly, the cost of services such as labor are
voluntarily incurred to produce revenue.
The measurement of expense Accountants measure most assets used in operating a business by their
historical costs. Therefore, they measure a depreciation expense resulting from the consumption of those assets by
the historical costs of those assets. They measure other expenses, such as wages that are paid for currently, at their
current costs.
The timing of expense recognition The matching principle implies that a relationship exists between
expenses and revenues. For certain expenses, such as costs of acquiring or producing the products sold, you can
easily see this relationship. However, when a direct relationship cannot be seen, we charge the costs of assets with
limited lives to expense in the periods benefited on a systematic and rational allocation basis. Depreciation of plant
assets is an example.
Product costs are costs incurred in the acquisition or manufacture of goods. As you will see in the next
chapter, included as product costs for purchased goods are invoice, freight, and insurance-in-transit costs. For
manufacturing companies, product costs include all costs of materials, labor, and factory operations necessary to
produce the goods. Product costs attach to the goods purchased or produced and remain in inventory accounts as
long as the goods are on hand. We charge product costs to expense when the goods are sold. The result is a precise
matching of cost of goods sold expense to its related revenue.
Period costs are costs not traceable to specific products and expensed in the period incurred. Selling and
administrative costs are period costs.
The gain and loss recognition principle states that we record gains only when realized, but losses when
they first become evident. Thus, we recognize losses at an earlier point than gains. This principle is related to the
conservatism concept.
Gains typically result from the sale of long-term assets for more than their book value. Firms should not
recognize gains until they are realized through sale or exchange. Recognizing potential gains before they are
actually realized is not allowed.
Accounting Principles: A Business Perspective 208 A Global Text
5. Accounting theory
Losses consume assets, as do expenses. However, unlike expenses, they do not produce revenues. Losses are
usually involuntary, such as the loss suffered from destruction by fire on an uninsured building. A loss on the sale of
a building may be voluntary when management decides to sell the building even though incurring a loss.
The full disclosure principle states that information important enough to influence the decisions of an
informed user of the financial statements should be disclosed. Depending on its nature, companies should disclose
this information either in the financial statements, in notes to the financial statements, or in supplemental
statements. In judging whether or not to disclose information, it is better to err on the side of too much disclosure
rather than too little. Many lawsuits against CPAs and their clients have resulted from inadequate or misleading
disclosure of the underlying facts.
We summarize the major principles and describe the importance of each in Exhibit 29.
An accounting perspective:
Business insight
The accounting model involves reporting revenues earned and expenses incurred by the company.
Some have argued that social benefits and social costs created by the company should also be
reported. Suppose, for instance, that a company is dumping toxic waste into a river and this action
causes cancer among the citizens downstream. Should this cost be reported when preparing
financial statements showing the performance of the company? What do you think?
Modifying conventions (or constraints)
In certain instances, companies do not strictly apply accounting principles because of modifying conventions (or
constraints). Modifying conventions are customs emerging from accounting practice that alter the results
obtained from a strict application of accounting principles. Three modifying conventions are cost-benefit,
materiality, and conservatism.
Cost-benefit The cost-benefit consideration involves deciding whether the benefits of including optional
information in financial statements exceed the costs of providing the information. Users tend to think information
is cost free since they incur none of the costs of providing the information. Preparers realize that providing
information is costly. The benefits of using information should exceed the costs of providing it. The measurement of
benefits is inexact, which makes application of this modifying convention difficult in practice.
Materiality Materiality is a modifying convention that allows accountants to deal with immaterial
(unimportant) items in an expedient but theoretically incorrect manner. The fundamental question accountants
must ask in judging the materiality of an item is whether a knowledgeable user's decisions would be different if the
information were presented in the theoretically correct manner. If not, the item is immaterial and may be reported
in a theoretically incorrect but expedient manner. For instance, because inexpensive items such as calculators often
do not make a difference in a statement user's decision to invest in the company, they are immaterial (unimportant)
and may be expensed when purchased. However, because expensive items such as mainframe computers usually do
make a difference in such a decision, they are material (important) and should be recorded as assets and
depreciated. Accountants should record all material items in a theoretically correct manner. They may record
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immaterial items in a theoretically incorrect manner simply because it is more convenient and less expensive to do
so. For example, they may debit the cost of a wastebasket to an expense account rather than an asset account even
though the wastebasket has an expected useful life of 30 years. It simply is not worth the cost of recording
depreciation expense on such a small item over its life.
The FASB defines materiality as "the magnitude of an omission or misstatement of accounting information that,
in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on
the information would have been changed or influenced by the omission or misstatement".14 The term magnitude in
this definition suggests that the materiality of an item may be assessed by looking at its relative size. A USD 10,000
error in an expense in a company with earnings of USD 30,000 is material. The same error in a company earning
USD 30,000,000 may not be material.
Materiality involves more than the relative dollar amounts. Often the nature of the item makes it material. For
example, it may be quite significant to know that a company is paying bribes or making illegal political
contributions, even if the dollar amounts of such items are relatively small.
Conservatism Conservatism means being cautious or prudent and making sure that assets and net income
are not overstated. Such overstatements can mislead potential investors in the company and creditors making loans
to the company. We apply conservatism when the lower-of-cost-or-market rule is used for inventory (see Chapter
7). Accountants must realize a fine line exists between conservative and incorrect accounting.
See Exhibit 30 for a summary of the modifying conventions and their importance.
The next section of this chapter discusses the conceptual framework project of the Financial Accounting
Standards Board. The FASB designed the conceptual framework project to resolve some disagreements about the
proper theoretical foundation for accounting. We present only the portions of the project relevant to this text.
14 FASB, Statement of Financial Accounting Concepts No. 2, "Qualitative Characteristics of Accounting
Information" (Stamford, Conn., 1980), p. xv. Copyright © by the Financial Accounting Standards Board, High
Ridge Park, Stamford, Connecticut 06905, U.S.A. Quoted (or excerpted) with permission. Copies of the
complete documents are available from the FASB.
Accounting Principles: A Business Perspective 210 A Global Text
5. Accounting theory
Principle Description Importance
Exchange-price (or cost)
Requires transfers of resources to be Tells the accountant to record a transfer of
recorded at prices agreed on by the parties resources at an objectively determinable amount at
to the exchange at the time of the the time of the exchange. Also, self-constructed exchange. assets are recorded at their actual cost rather than
at some estimate of what they would have cost if they had been purchased.
Revenue recognition Revenues should be earned and realized Informs accountant that revenues generally should before they are recognized (recorded). be recognized when services are performed or
goods are sold. Exceptions are made for items such as installment sales and long-term construction projects.
Matching Expenses should be recognized (recorded) Indicates that expenses are to be recorded as soon as they are incurred to produce revenues. as they are incurred rather than waiting until some
future time.
Gain and loss recognition
Gains may be recorded only when realized, Tells the accountant to be conservative when
but losses should be recorded when they recognizing gains and losses. Gains can only be first become evident. recognized when they have been realized through
sale or exchange. Losses should be recognized as soon as they become evident. Thus, potential losses can be recorded, but only gains that have actually been realized can be recorded.
Full disclosure Information important enough to influence Requires the accountant to disclose everything that the decisions of an informed user of the is important. A good rule to follow is—if in doubt, financial statements should be disclosed. disclose. Another good rule is—if you are not
consistent, disclose all the facts and the effect on income.
Exhibit 29: The major principles
211
5. Accounting theory
Modifying Convention
Description Importance
Cost-benefit Optional information should be included financial statements only if the benefits providing it exceed its costs. In of
Lets the accountant know that information that is not required should be made available only if its benefits exceed its costs. An example may be companies going to the expense of providing information on the effects of inflation when the inflation rate is low and/or users do not seem to benefit significantly from the information.
Materiality Only items that would affect a knowledgeable user's decision are material (important) and must be reported in a theoretically correct way.
Allow accountants to treat immaterial (relatively small dollar amount) information in a theoretically incorrect but expedient manner. For instance, a wastebasket can be expensed rather than capitalized and depreciated even though it may last for 30 years.
Conservatism Transactions should be recorded so that assets and net income are not overstated.
Warns accountants that assets and net income are not to be overstated. "Anticipate (and record) all possible losses and do not anticipate (or record) any possible gains" is common advice under this constraint. Also, conservative application of the matching principle involves making sure that adjustments for expenses for such items as uncollectible accounts, warranties, and depreciation are adequate.
Exhibit 30: Modifying conventions
The financial accounting standards board's conceptual framework project
Experts have debated the exact nature of the basic concepts and related principles composing accounting theory
for years. The debate continues today despite numerous references to generally accepted accounting principles
(GAAP). To date, all attempts to present a concise statement of GAAP have received only limited acceptance.
Due to this limited success, many accountants suggest that the starting point in reaching a concise statement of
GAAP is to seek agreement on the objectives of financial accounting and reporting. The belief is that if a person (1)
carefully studies the environment, (2) knows what objectives are sought, (3) can identify certain qualitative traits of
accounting information, and (4) can define the basic elements of financial statements, that person can discover the
principles and standards leading to the stated objectives. The FASB completed the first three goals by publishing
"Objectives of Financial Reporting by Business Enterprises" and "Qualitative Characteristics of Accounting
Information".15 Addressing the fourth goal are concepts statements entitled "Elements of Financial Statements of
Business Enterprises" and "Elements of Financial Statements".16
Objectives of financial reporting
Financial reporting objectives are the broad overriding goals sought by accountants engaging in financial
reporting. According to the FASB, the first objective of financial reporting is to:
15 FASB, Statement of Financial Accounting Concepts No. 1, "Objectives of Financial Reporting by Business
Enterprises" (Stamford, Conn., 1978); and Statement of Financial Accounting Concepts No. 2, "Qualitative
Characteristics of Accounting Information" (Stamford, Conn., 1980). Copyright © by the Financial Accounting
Standards Board, High Ridge Park, Stamford, Connecticut 06905, U.S.A. Quoted (or excerpted) with
permission. Copies of the complete documents are available from the FASB.
16 FASB, Statement of Financial Accounting Concepts No. 3, "Elements of Financial Statements of Business
Enterprises" (Stamford, Conn., 1980); and Statement of Financial Accounting Concepts No. 6, "Elements of
Financial Statements" (Stamford, Conn., 1985). Copyright © by the Financial Accounting Standards Board,
High Ridge Park, Stamford, Connecticut 06905, U.S.A. Quoted (or excerpted) with permission. Copies of the
complete documents are available from the FASB.
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provide information that is useful to present and potential investors and creditors and other users in
making rational investment, credit, and similar decisions. The information should be comprehensible
to those who have a reasonable understanding of business and economic activities and are willing to
study the information with reasonable diligence.17
Interpreted broadly, the term other users includes employees, security analysts, brokers, and lawyers. Financial
reporting should provide information to all who are willing to learn to use it properly.
The second objective of financial reporting is to:
provide information to help present and potential investors and creditors and other users in
assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends [owner
withdrawals] or interest and the proceeds from the sale, redemption, or maturity of securities or
loans. Since investors' and creditors' cash flows are related to enterprise cash flows, financial
reporting should provide information to help investors, creditors, and others assess the amounts,
timing, and uncertainty of prospective net cash inflows to the related enterprise.18
This objective ties the cash flows of investors (owners) and creditors to the cash flows of the enterprise, a tie-in
that appears entirely logical. Enterprise cash inflows are the source of cash for dividends, interest, and the
redemption of maturing debt.
Third, financial reporting should:
provide information about the economic resources of an enterprise, the claims to those resources
(obligations of the enterprise to transfer resources to other entities and owners' equity), and the
effects of transactions, events, and circumstances that change its resources and claims to those
resources.19
We can draw some conclusions from these three objectives and from a study of the environment in which
financial reporting is carried out. For example, financial reporting should:
• Provide information about an enterprise's past performance because such information is a basis for
predicting future enterprise performance.
• Focus on earnings and its components, despite the emphasis in the objectives on cash flows. (Earnings
computed under the accrual basis generally provide a better indicator of ability to generate favorable cash
flows than do statements prepared under the cash basis.)
On the other hand, financial reporting does not seek to:
• Measure the value of an enterprise but to provide information useful in determining its value.
• Evaluate management's performance, predict earnings, assess risk, or estimate earning power but to
provide information to persons who wish to make these evaluations.
These conclusions are some of those reached in Statement of Financial Accounting Concepts No. 1. As the Board
stated, these statements "are intended to establish the objectives and concepts that the Financial Accounting
Standards Board will use in developing standards of financial accounting and reporting".20 How successful the
Board will be in the approach adopted remains to be seen.
17 FASB, Statement of Financial Accounting Concepts No. 1, p. viii.
18 Ibid.
19 Ibid.
20 Ibid., p. i.
Accounting Principles: A Business Perspective 213 A Global Text
5. Accounting theory
Qualitative characteristics
Accounting information should possess qualitative characteristics to be useful in decision making. This
criterion is difficult to apply. The usefulness of accounting information in a given instance depends not only on
information characteristics but also on the capabilities of the decision makers and their professional advisers.
Accountants cannot specify who the decision makers are, their characteristics, the decisions to be made, or the
methods chosen to make the decisions. Therefore, they direct their attention to the characteristics of accounting
information. Note the FASB's graphic summarization of the qualities accountants consider in Exhibit 2821
To have relevance, information must be pertinent to or affect a decision. The information must make a
difference to someone who does not already have it. Relevant information makes a difference in a decision either by
affecting users' predictions of outcomes of past, present, or future events or by confirming or correcting
expectations. Note that information need not be a prediction to be useful in developing, confirming, or altering
expectations. Expectations are commonly based on the present or past. For example, any attempt to predict future
earnings of a company would quite likely start with a review of present and past earnings. Although information
that merely confirms prior expectations may be less useful, it is still relevant because it reduces uncertainty.
Critics have alleged that certain types of accounting information lack relevance. For example, some argue that a
cost of USD 1 million paid for a tract of land 40 years ago and reported in the current balance sheet at that amount
is irrelevant (except for possible tax implications) to users for decision making today. Such criticism has
encouraged research into the types of information relevant to users. Some suggest using a different valuation basis,
such as current cost, in reporting such assets.
Predictive value and feedback value Since actions taken now can affect only future events, information is
obviously relevant when it possesses predictive value, or improves users' abilities to predict outcomes of events.
Information that reveals the relative success of users in predicting outcomes possesses feedback value. Feedback
reports on past activities and can make a difference in decision making by (1) reducing uncertainty in a situation,
(2) refuting or confirming prior expectations, and (3) providing a basis for further predictions. For example, a
report on the first quarter's earnings of a company reduces the uncertainty surrounding the amount of such
earnings, confirms or refutes the predicted amount of such earnings, and provides a possible basis on which to
predict earnings for the full year. Remember that although accounting information may possess predictive value, it
does not consist of predictions. Making predictions is a function performed by the decision maker.
Timeliness Timeliness requires accountants to provide accounting information at a time when it may be
considered in reaching a decision. Utility of information decreases with age. To know what the net income for 2010
was in early 2011 is much more useful than receiving this information a year later. If information is to be of any
value in decision making, it must be available before the decision is made. If not, the information is of little value.
In determining what constitutes timely information, accountants consider the other qualitative characteristics and
the cost of gathering information. For example, a timely estimate for uncollectible accounts may be more valuable
than a later, verified actual amount. Timeliness alone cannot make information relevant, but potentially relevant
information can be rendered irrelevant by a lack of timeliness.
21 FASB, Statement of Financial Accounting Concepts No. 2, p. 15.
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Exhibit 31: A hierarchy of accounting qualities
In addition to being relevant, information must be reliable to be useful. Information has reliability when it
faithfully depicts for users what it purports to represent. Thus, accounting information is reliable if users can
depend on it to reflect the underlying economic activities of the organization. The reliability of information depends
on its representational faithfulness, verifiability, and neutrality. The information must also be complete and free of
bias.
Representational faithfulness To gain insight into this quality, consider a map. When it shows roads and
bridges where roads and bridges actually exist, a map possesses representational faithfulness. A
correspondence exists between what is on the map and what is present physically. Similarly, representational
faithfulness exists when accounting statements on economic activity correspond to the actual underlying activity.
Where there is no correspondence, the cause may be (1) bias or (2) lack of completeness.
• Effects of bias. Accounting measurements contain bias if they are consistently too high or too low.
Accountants create bias in accounting measurements by choosing the wrong measurement method or
introducing bias either deliberately or through lack of skill.
• Completeness. To be free from bias, information must be sufficiently complete to ensure that it validly
represents underlying events and conditions. Completeness means disclosing all significant information in a
way that aids understanding and does not mislead. Firms can reduce the relevance of information by omitting
information that would make a difference to users. Currently, full disclosure requires presentation of a balance
sheet, an income statement, a statement of cash flows, and necessary notes to the financial statements and
supporting schedules. Also required in annual reports of corporations are statements of changes in
stockholders' equity which contain information included in a statement of retained earnings. Such statements
must be complete, with items properly classified and segregated (such as reporting sales revenue separately
from other revenues). Required disclosures may be made in (1) the body of the financial statements, (2) the
Accounting Principles: A Business Perspective 215 A Global Text
5. Accounting theory
notes to such statements, (3) special communications, and/or (4) the president's letter or other management
reports in the annual report.
Another aspect of completeness is fully disclosing all changes in accounting principles and their effects.22
Disclosure should include unusual activities (loans to officers), changes in expectations (losses on inventory),
depreciation expense for the period, long-term obligations entered into that are not recorded by the accountant (a
20-year lease on a building), new arrangements with certain groups (pension and profit-sharing plans for
employees), and significant events that occur after the date of the statements (loss of a major customer). Firms
must also disclose accounting policies (major principles and their manner of application) followed in preparing the
financial statements.23 Because of its emphasis on disclosure, we often call this aspect of reliability the full
disclosure principle.
Verifiability Financial information has verifiability when independent measurers can substantially duplicate
it by using the same measurement methods. Verifiability eliminates measurer bias. The requirement that financial
information be based on objective evidence arises from the demonstrated needs of users for reliable, unbiased
financial information. Unbiased information is especially necessary when parties with opposing interests (credit
seekers and credit grantors) rely on the same information. If the information is verifiable, this enhances the
reliability of information.
Financial information is never completely free of subjective opinion and judgment; it always possesses varying
degrees of verifiability. Canceled checks and invoices support some measurements. Accountants can never verify
other measurements, such as periodic depreciation charges, because of their very nature. Thus, financial
information in many instances is verifiable only in that it represents a consensus of what other accountants would
report if they followed the same procedures.
Neutrality Neutrality means that the accounting information should be free of measurement method bias.
The primary concern should be relevance and reliability of the information that results from application of the
principle, not the effect that the principle may have on a particular interest. Non-neutral accounting information
favors one set of interested parties over others. For example, a particular form of measurement might favor
stockholders over creditors, or vice versa. "To be neutral, accounting information must report economic activity as
faithfully as possible, without coloring the image it communicates for the purpose of influencing behavior in some
particular direction."24 Accounting standards are not like tax regulations that deliberately foster or restrain certain
types of activity. Verifiability seeks to eliminate measurer bias; neutrality seeks to eliminate measurement method
bias.
When comparability exists, reported differences and similarities in financial information are real and not the
result of differing accounting treatments. Comparable information reveals relative strengths and weaknesses in a
single company through time and between two or more companies at the same time.
Consistency requires that a company use the same accounting principles and reporting practices through time.
Consistency leads to comparability of financial information for a single company through time. Comparability
between companies is more difficult because they may account for the same activities in different ways. For
example, Company B may use one method of depreciation, while Company C accounts for an identical asset in
22 APB, APB Opinion No. 20, "Accounting Changes" (New York: AICPA, July 1971).
23 APB, APB Opinion No. 22, "Disclosure of Accounting Policies" (New York: AICPA, April 1972).
24 FASB, Statement of Financial Accounting Concepts No. 2, par. 100.
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similar circumstances using another method. A high degree of inter-company comparability in accounting
information does not exist unless accountants are required to account for the same activities in the same manner
across companies and through time.
As we show in Exhibit 28, accountants must consider one pervasive constraint and one threshold for recognition
in providing useful information. First, the benefits secured from the information must be greater than the costs of
providing that information. Second, only material items need be disclosed and accounted for strictly in accordance
with generally accepted accounting principles (GAAP). We discussed cost-benefit and materiality earlier in the
chapter.
An accounting perspective:
Use of technology
You may want to visit the home page of the Financial Accounting Standards Board at:
http://www.fasb.org
You can check out the latest developments at the FASB to see how the rules of accounting might be
changing. You can investigate facts about the FASB, press releases, exposure drafts, publications,
emerging issues, board actions, forthcoming meetings, and many other topics.
The basic elements of financial statements
Thus far we have discussed objectives of financial reporting and qualitative characteristics of accounting
information. A third important task in developing a conceptual framework for any discipline is identifying and
defining its basic elements. The FASB identified and defined the basic elements of financial statements in Concepts
Statement No. 3. Later, Concepts Statement No. 6 revised some of the definitions. We defined most of the terms
earlier in this text in a less technical way; the more technical definitions follow. (These items are not repeated in
this chapter's Key terms.)
Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past
transactions or events.
Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular
entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
Equity or net assets is the residual interest in the assets of an entity that remains after deducting its
liabilities. In a business enterprise, the equity is the ownership interest. In a not-for-profit organization, which has
no ownership interest in the same sense as a business enterprise, net assets is divided into three classes based on
the presence or absence of donor-imposed restrictions—permanently restricted, temporarily restricted, and
unrestricted net assets.
Comprehensive income is the change in equity of a business enterprise during a period from transactions
and other events and circumstances from non-owner sources. It includes all changes in equity during a period
except those resulting from investments by owners and distributions to owners.
Accounting Principles: A Business Perspective 217 A Global Text
5. Accounting theory
Revenues are inflows or other enhancements of assets of any entity or settlements of its liabilities (or a
combination of both) from delivering or producing goods, rendering services, or other activities that constitute the
entity's ongoing major or central operations.
Expenses are outflows or other using up of assets or incurrences of liabilities (or a combination of both) from
delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's
ongoing major or central operations.
Gains are increases in equity (net assets) from peripheral or incidental transactions of an entity and from all
other transactions and other events and circumstances affecting the entity except those that result from revenues or
investments by owners.
Losses are decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all
other transactions and other events and circumstances affecting the entity except those that result from expenses or
distributions to owners.
Investments by owners are increases in equity of a particular business enterprise resulting from transfers to
it from other entities of something valuable to obtain or increase ownership interests (or equity) in it. Assets are
most commonly received as investments by owners, but that which is received may also include services or
satisfaction or conversion of liabilities of the enterprise.
Distributions to owners are decreases in equity of a particular business enterprise resulting from
transferring assets, rendering services, or incurring liabilities by the enterprise to owners. Distributions to owners
decrease ownership interest (or equity) in an enterprise.25
An accounting perspective:
Business insight
Accountants record expenditures on physical resources such as land, buildings, and equipment
that benefit future periods as assets. However, they expense expenditures on human resources for
hiring and training that benefit future periods. Also, when a computer is dropped and destroyed,
accountants record a loss. However, when the president of the company dies, they record no loss.
Should the accounting model be changed regarding the accounting for human resources?
Recognition and measurement in financial statements
In December 1984, the FASB issued Statement of Financial Accounting Concepts No. 5, "Recognition and
Measurement in Financial Statements of Business Enterprises", describing recognition criteria and providing
guidance for the timing and nature of information included in financial statements.26 The recognition criteria
25 FASB, Statement of Financial Accounting Concepts No. 6.
26 FASB, Statement of Financial Accounting Concepts No. 5, "Recognition and Measurement in Financial
Statements of Business Enterprises" (Stamford, Conn., 1984). Copyright © by the Financial Accounting
Standards Board, High Ridge Park, Stamford, Connecticut 06905, U.S.A. Copies of the complete document are
available from the FASB. (In case you are wondering why we do not mention Statement of Financial Accounting
Concepts No. 4, it pertains to accounting for not-for-profit organizations and is, therefore, not relevant to this
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established in the Statement are fairly consistent with those used in current practice. The Statement indicates,
however, that when information more useful than currently reported information is available at a reasonable cost, it
should be included in financial statements.
Summary of significant accounting policies
As part of their annual reports, companies include summaries of significant accounting policies. These policies
assist users in interpreting the financial statements. To a large extent, accounting theory determines the nature of
these policies. Companies must follow generally accepted accounting principles in preparing their financial
statements.
The accounting policies of The Walt Disney Company, one of the world's leading entertainment companies, as
contained in a recent annual report follow. After each, the chapter of this text where we discuss that particular
policy is in parentheses. While a few of the items have already been covered, the remainder offer a preview of the
concepts explained in later chapters.
An ethical perspective:
Maplehurst company
Maplehurst Company manufactures large spinning machines for the textile industry. The company
had purchased USD 100,000 of small hand tools to use in its business. The company's accountant
recorded the tools in an asset account and was going to write them off over 20 years. Management
wanted to write these tools off as an expense of this year because revenues this year had been
abnormally high and were expected to be lower in the future. Management's goal was to smooth out
income rather than showing sharp increases and decreases. When told by the accountant that USD
100,000 was a material item that must be accounted for in a theoretically correct manner,
management decided to consider the tools as consisting of 10 groups, each having a cost of USD
10,000. Since amounts under USD 20,000 are considered immaterial for this company, all of the
tools could then be charged to expense this year.
The accountant is concerned about this treatment. She doubts that she could successfully defend
management's position if the auditors challenge the expensing of these items.
Significant accounting policies
Principles of consolidation
The consolidated financial statements of the Company include the accounts of The Walt Disney Company and its
subsidiaries after elimination of inter-company accounts and transactions.
Investments in affiliated companies are accounted for using the equity method. (Chapter 14)
Accounting changes
The Company changed its method of accounting for pre-opening costs (see Note 12). These changes had no cash
impact.
The pro forma amounts presented in the consolidated statement of income reflect the effect of retroactive
application of expensing pre-opening costs. (Chapters 13 and 14)
text.)
Accounting Principles: A Business Perspective 219 A Global Text
5. Accounting theory
Revenue recognition
Revenues from the theatrical distribution of motion pictures are recognized when motion pictures are exhibited.
Television licensing revenues are recorded when the program material is available for telecasting by the licensee
and when certain other conditions are met. Revenues from video sales are recognized on the date that video units
are made widely available for sale by retailers.
Revenues from participants and sponsors at the theme parks are generally recorded over the period of the
applicable agreements commencing with the opening of the related attraction. (Chapter 5)
Cash, cash equivalents and investments
Cash and cash equivalents consist of cash on hand and marketable securities with original maturities of three
months or less. (Chapter 8)
SFAS 115 requires that certain investments in debt and equity securities be classified into one of three categories.
Debt securities that the Company has the positive intent and ability to hold to maturity are classified as "held-to-
maturity" and reported at amortized cost. Debt securities not classified as held-to-maturity and marketable equity
securities are classified as either "trading" or "available-for-sale", and are recorded at fair value with unrealized
gains and losses included in earnings or stockholders' equity, respectively. (Chapter 14)
Merchandise inventories
Carrying amounts of merchandise, materials and supplies inventories are generally determined on a moving
average cost basis and are stated at the lower of cost or market. (Chapter 7)
Film and television costs
Film and television production and participation costs are expensed based on the ratio of the current period's
gross revenues to estimated total gross revenues from all sources on an individual production basis. Estimates of
total gross revenues are reviewed periodically and amortization is adjusted accordingly.
Television broadcast rights are amortized principally on an accelerated basis over the estimated useful lives of
the programs. (Chapter 11)
Theme parks, resorts and other property
Theme parks, resorts and other property are carried at cost. Depreciation is computed on the straight-line
method based upon estimated useful lives ranging from three to fifty years. (Chapter 3)
Other assets
Rights to the name, likeness and portrait of Walt Disney, goodwill and other intangible assets are amortized over
periods ranging from two to forty years. (Chapter 11)
Risk management contracts
In the normal course of business, the Company employs a variety of off-balance-sheet financial instruments to
manage its exposure to fluctuations in interest and foreign currency exchange rates, including interest rate and
cross-currency swap agreements, forward and option contracts, and interest rate exchange-traded futures. The
company designates interest rate and cross-currency swaps as hedges of investments and debt, and accrues the
differential to be paid or received under the agreements as interest rates change over the lives of the contracts.
Differences paid or received on swap agreements are recognized as adjustments to interest income or expense over
the life of the swaps, thereby adjusting the effective interest rate on the underlying investment or obligation. Gains
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and losses on the termination of swap agreements, prior to the original maturity, are deferred and amortized to
interest income or expense over the original term of the swaps. Gains and losses arising from interest rate futures,
forwards and option contracts, and foreign currency forward and option contracts are recognized in income or
expense as offsets of gains and losses resulting from the underlying hedged transactions. (Chapter 14)
Cash flows from interest rate and foreign exchange risk management activities are classified in the same
category as the cash flows from the related investment, borrowing or foreign exchange activity. (Chapter 16)
The Company classifies its derivative financial instruments as held or issued for purposes other than trading.
(Chapter 14)
Earnings per share
Earnings per share amounts are based upon the weighted average number of common and common equivalent
shares outstanding during the year. Common equivalent shares are excluded from the computation in periods in
which they have an antidilutive effect. (Chapter 13)
As you proceed through the remaining chapters, you can see the accounting theories introduced in this chapter
being applied. In Chapter 6, for instance, we discuss why sales revenue is recognized and recorded only after goods
have been delivered to the customer. So far, we have used service companies to illustrate accounting techniques.
Chapter 6 introduces merchandising operations. Merchandising companies, such as clothing stores, buy goods in
their finished form and sell them to customers.
Understanding the learning objectives
• The major underlying assumptions or concepts of accounting are (1) business entity, (2) going concern
(continuity), (3) money measurement, (4) stable dollar, (5) periodicity, and (6) accrual basis and periodicity.
• Other basic accounting concepts that affect the accounting for entities are (1) general-purpose financial
statements, (2) substance over form, (3) consistency, (4) double entry, and (5) articulation.
• The major principles include exchange-price (or cost), revenue recognition, matching, gain and loss
recognition, and full disclosure. Major exceptions to the realization principle include cash collection as point of
revenue recognition, installment basis of revenue recognition, and the percentage-of-completion method of
recognizing revenue on long-term construction projects.
• Modifying conventions include cost-benefit, materiality, and conservatism.
• The FASB has defined the objectives of financial reporting, qualitative characteristics of accounting
information, and elements of financial statements.
• Financial reporting objectives are the broad overriding goals sought by accountants engaging in financial
reporting.
• Qualitative characteristics are those that accounting information should possess to be useful in decision
making. The two primary qualitative characteristics are relevance and reliability. Another qualitative
characteristic is comparability.
• Pervasive constraints include cost-benefit analysis and materiality.
• The FASB has identified and defined the basic elements of financial statements.
• The FASB has also described revenue recognition criteria and provided guidance as to the timing and
nature of information to be included in financial statements.
• The summary of significant accounting policies aid users in interpreting the financial statements.
Accounting Principles: A Business Perspective 221 A Global Text
5. Accounting theory
• To a large extent, accounting theory determines the nature of those policies.
Demonstration problem
For each of the following transactions or circumstances and the entries made, state which, if any, of the
assumptions, concepts, principles, or modifying conventions of accounting have been violated. For each violation,
give the entry to correct the improper accounting assuming the books have not been closed.
During the year, Dorsey Company did the following:
• Had its buildings appraised. They were found to have a market value of USD 410,000, although their book
value was only USD 380,000. The accountant debited the Buildings and Accumulated Depreciation—Buildings
accounts for USD 15,000 each and credited Paid-in Capital—From Appreciation. No separate mention was
made of this action in the financial statements.
• Purchased new electric pencil sharpeners for its offices at a total cost of USD 60. These pencil sharpeners
were recorded as assets and are being depreciated over five years.
Solution to demonstration problem
• The cost principle and the modifying convention of conservatism may have been violated. Such write-ups
simply are not looked on with favor in accounting. To correct the situation, the entry made needs to be
reversed:
Paid-in Capital 30,000
Building 15,000
Accumulated Depreciation—Building 15,000
• Theoretically, no violations occurred, but the cost of compiling insignificant information could be
considered a violation of acceptable accounting practice. As a practical matter, the USD 60 could have been
expensed on materiality grounds.
Key terms Accounting theory "A set of basic concepts and assumptions and related principles that explain and guide the accountant's actions in identifying, measuring, and communicating economic information".
Bias Exists when accounting measurements are consistently too high or too low.
Business entity concept The specific unit for which accounting information is gathered. Business entities have a separate existence from owners, creditors, employees, customers, other interested parties, and other businesses.
Comparability A qualitative characteristic of accounting information; when information is comparable, it reveals differences and similarities that are real and are not the result of differing accounting treatments.
Completed-contract method A method of recognizing revenue on long-term projects under which no revenue is recognized until the period in which the project is completed; similar to recognizing revenue upon the completion of a sale.
Completeness A qualitative characteristic of accounting information; requires disclosure of all significant information in a way that aids understanding and does not mislead; sometimes called the full disclosure principle.
Conservatism Being cautious or prudent and making sure that net assets and net income are not overstated.
Consistency Requires a company to use the same accounting principles and reporting practices through time.
Cost-benefit consideration Determining whether benefits of including information in financial statements exceed costs.
Cost principle See Exchange-price principle.
Earning principle The requirement that revenue be substantially earned before it is recognized (recorded).
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Exchange-price (or cost) principle Transfers of resources are recorded at prices agreed on by the parties at the time of the exchange.
Feedback value A qualitative characteristic that information has when it reveals the relative success of users in predicting outcomes.
Financial reporting objectives The broad overriding goals sought by accountants engaging in financial reporting.
Full disclosure principle Information important enough to influence the decisions of an informed user of the financial statements should be disclosed.
Gain and loss recognition principle Gains may be recorded only when realized, but losses should be recorded when they first become evident.
Gains Typically result from the sale of long-term assets for more than their book value.
Going-concern (continuity) assumption The assumption that an entity will continue to operate indefinitely unless strong evidence exists that the entity will terminate.
Historical cost The amount paid, or the fair market value of a liability incurred or other resources surrendered, to acquire an asset and place it in a condition and position for its intended use.
Installment basis A revenue recognition procedure in which the percentage of total gross margin recognized in a period on an installment sale is equal to the percentage of total cash from the sale that is received in that period.
Liquidation Terminating a business by ceasing business operations and selling off its assets.
Losses Asset expirations that are usually involuntary and do not create revenues.
Matching principle Expenses should be recognized as they are incurred to produce revenues.
Materiality A modifying convention that allows the accountant to deal with immaterial (unimportant) items in an expedient but theoretically incorrect manner; also a qualitative characteristic specifying that financial accounting report only information significant enough to influence decisions or evaluations.
Modifying conventions Customs emerging from accounting practice that alter the results obtained from a strict application of accounting principles; conservatism is an example.
Money measurement Use of a monetary unit of measurement, such as the dollar, instead of physical or other units of measurement—feet, inches, grams, and so on.
Neutrality A qualitative characteristic that requires accounting information to be free of measurement method bias.
Percentage-of-completion method A method of recognizing revenue based on the estimated stage of completion of a long-term project. The stage of completion is measured by comparing actual costs incurred in a period with total estimated costs to be incurred in all periods.
Period costs Costs that cannot be traced to specific products and are expensed in the period incurred.
Periodicity (time periods) assumption An assumption of the accountant that an entity's life can be divided into time periods for reporting its economic activities.
Predictive value A qualitative characteristic that information has when it improves users' abilities to predict outcomes of events.
Product costs Costs incurred in the acquisition or manufacture of goods. Product costs are accounted for as if they were attached to the goods, with the result that they are charged to expense when the goods are sold.
Qualitative characteristics Characteristics that accounting information should possess to be useful in decision making.
Realization principle A principle that directs that revenue is recognized only after the seller acquires the right to receive payment from the buyer.
Relevance A qualitative characteristic requiring that information be pertinent to or affect a decision.
Reliability A qualitative characteristic requiring that information faithfully depict for users what it purports to represent.
Representational faithfulness A qualitative characteristic requiring that accounting statements on economic activity correspond to the actual underlying activity.
Revenue recognition principle The principle that revenues should be earned and realized before they are recognized (recorded).
Stable dollar assumption An assumption that the dollar is a reasonably stable unit of measurement.
Accounting Principles: A Business Perspective 223 A Global Text
5. Accounting theory
Timeliness A qualitative characteristic requiring that accounting information be provided at a time when it may be considered before making a decision.
Verifiability A qualitative characteristic of accounting information; information is verifiable when it can be substantially duplicated by independent measurers using the same measurement methods.
Self-test
True-false
Indicate whether each of the following statements is true or false.
The business entity concept assumes that each business has an existence separate from all parties except its
owners.
When the substance of a transaction differs from its legal form, the accountant should record the economic
substance.
The matching principle is fundamental to the accrual basis of accounting.
Exceptions to the realization principle include the installment basis of revenue recognition for sales revenue and
the completed-contract method for long-term construction projects.
Immaterial items do not have to be recorded at all.
The conceptual framework project resulted in identifying two primary qualitative characteristics that accounting
information should possess—relevance and reliability.
Multiple-choice
Select the best answer for each of the following questions.
The underlying assumptions of accounting includes all the following except:
a. Business entity.
b. Going concern.
c. Matching.
d. Money measurement and periodicity.
The concept that requires companies to use the same accounting practices and reporting practices through time
is:
a. Substance over form.
b. Consistency.
c. Articulation.
d. None of the above.
Which of the following statements is false regarding the revenue recognition principle?
a. Revenue must be substantially earned before it is recognized.
b. The accountant usually recognizes revenue before the seller acquires the right to receive payment from the
buyer.
c. Some small companies use the cash basis of accounting.
d. Under the installment basis, the gross margin recognized in a period is equal to the amount of cash received
from installment sales times the gross margin percentage for the year of sale.
Assume the following facts regarding the construction of a bridge:
Construction costs this period...... USD 3,000,000
Total estimated construction costs...10,000,000
Total sales price............... 15,000,000
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The revenue that should be recognized this period is:
a. USD 3,000,000.
b. USD 4,500,000.
c. USD 5,000,000.
d. USD 6,500,000.
Modifying conventions include all of the following except:
a. Periodicity.
b. Cost-benefit.
c. Materiality.
d. Conservatism.
Which of the following is not part of the conceptual framework project?
a. Objectives of financial reporting.
b. Quantitative characteristics.
c. Qualitative characteristics.
d. Basic elements of financial statements.
Now turn to “Answers to self-test” at the end of the chapter to check your answers.
Questions
➢ Name the assumptions underlying generally accepted accounting principles. Comment on the
validity of the stable unit of measurement assumption during periods of high inflation.
➢ Why does the accountant use the business entity concept?
➢ When is the going-concern assumption not to be used?
➢ What is meant by the term accrual basis of accounting? What is its alternative?
➢ What does it mean to say that accountants record substance rather than form?
➢ If a company changes an accounting principle because the change better meets the information
needs of users, what disclosures must be made?
➢ What is the exchange-price (or cost) principle? What is the significance of adhering to this principle?
➢ What two requirements generally must be met before recognizing revenue in a period?
➢ Under what circumstances, if any, is the receipt of cash an acceptable time to recognize revenue?
➢ What two methods may be used in recognizing revenues on long-term construction contracts?
➢ Define expense. What principles guide the recognition of expense?
➢ How does an expense differ from a loss?
➢ What is the full disclosure principle?
➢ What role does cost-benefit play in financial reporting?
➢ What is meant by the accounting term conservatism? How does it affect the amounts reported in the
financial statements?
➢ Does materiality relate only to the relative size of dollar amounts?
➢ Identify the three major parts of the conceptual framework project.
➢ What are the two primary qualitative characteristics?
➢ Real world question A recent annual report of the American Ship Building Company stated:
Accounting Principles: A Business Perspective 225 A Global Text
5. Accounting theory
Revenues, costs, and profits applicable to construction and conversion contracts are included in the
consolidated statements of operations using the... percentage-of- completion accounting method.... The
completed contract method was used for income tax reporting in the years this method was allowed.
Why might the management of a company want to use two different methods for accounting and tax purposes?
➢ Real world question A recent annual report of Chevron Corporation stated:
Environmental expenditures that relate to current or future revenues are expensed or capitalized as
appropriate. Expenditures that relate to an existing condition caused by past operations, and do not
contribute to current or future revenue generation, are expensed.
Which principle of accounting is being followed by this policy?
➢ What is the purpose of including a "Summary of significant accounting policies" in the company's
annual report?
Exercises
Exercise A Match the items in Column A with the proper descriptions in Column B.
Column A Column B
Going concern (continuity). a. An assumption relied on in the preparation of the
primary financial statements that would be
unreasonable when the inflation rate is high.
Consistency. b. Concerned with relative dollar amounts.
Disclosure. c. The usual basis for the recording of assets.
Periodicity. d. Required if the accounting treatment differs from
that previously used for a particular item.
Conservatism. e. An assumption that would be unreasonable to use
in reporting on a firm that had become insolvent.
Stable dollar. f. None of these.
Matching. g. Requires a company to use the same accounting
procedures and practices through time.
Materiality. h. An assumption that the life of an entity can be
subdivided into time periods for reporting purposes.
Exchange-price (cost). i. Discourages undue optimism in measuring and
reporting net assets and net income.
Business entity. j. Requires separation of personal from business
activities in the recording and reporting processes.
Exercise B Parker Clothing Company sells its products on an installment sales basis. Data for 2010 and 2011
follow:
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2010 2011
Installment sales......................... $800,000 $960,000
Cost of goods sold on installment sales ..... 560,000 720,000 Other expenses.......................... 120,000 160,000
Cash collected from 2010 sales.............. 480,000 240,000 Cash collected from 2011 sales.............. 640,000
a. Compute the net income for 2011, assuming use of the accrual (sales) basis of revenue recognition.
b. Compute the net income for 2011, assuming use of the installment basis of recognizing gross margin.
Exercise C A company has a contract to build a ship at a price of USD 500 million and an estimated cost of
USD 400 million. Costs of USD 100 million were incurred. Under the percentage-of-completion method, how much
revenue would be recognized?
Exercise D A company follows a practice of expensing the premium on its fire insurance policy when the policy
is paid. In 2010, the company charged to expense the USD 6,000 premium paid on a three-year policy covering the
period 2010 July 1, to 2010 June 30. In 2010, a premium of USD 5,400 was charged to expense on the same policy
for the period 2010 July 1, to 2010 July 30.
a. State the principle of accounting that was violated by this practice.
b. Compute the effects of this violation on the financial statements for the calendar year 2010.
c. State the basis on which the company's practice might be justified.
Exercise E Match the descriptions in Column B with the accounting qualities in Column A. Use some
descriptions more than once.
Column A: Accounting qualities Column B: Descriptions
Relevance. a. Users of accounting information.
Feedback value. b. Pervasive constraint.
Decision makers. c . User-specific qualities.
Representational faithfulness. d. Primary decision-specific qualities.
Reliability. e. Ingredients of primary qualities.
Comparability. f. Secondary and interactive qualities.
Benefits exceed costs. g. Threshold for recognition.
Predictive value.
Timeliness.
Decision usefulness.
Verifiability.
Understandability.
Neutrality.
Materiality.
Accounting Principles: A Business Perspective 227 A Global Text
5. Accounting theory
Problems
Problem A Select the best answer to each of the following questions:
The assumption that each business has an existence separate from its owners, creditors, employees, customers,
other interested parties, and other businesses is the:
a. Going-concern assumption.
b. Business entity concept.
c. Separate entity concept.
d. Corporation concept.
Companies should use liquidation values to report assets if which of the following conditions exists?
a. There are changes in the value of the dollar.
b. The periodicity assumption is applied.
c. The company is not a going concern and will be dissolved.
d. The accrual basis of accounting is not used.
Assume that a company has paid for advertising and that the ad has already appeared. The company chose to
report the item as prepaid advertising and includes it among the assets on the balance sheet. Previously, the
company had always expensed expenditures such as this. This practice is a violation of:
a. Generally accepted accounting principles.
b. The matching concept.
c. The consistency concept.
d. All of the above.
Recording revenue only after the seller has obtained the right to receive payment from the buyer for
merchandise sold or services performed is called the:
a. Earning principle.
b. Installment basis.
c. Realization principle.
d. Completed-contract method.
Problem B Ramirez Video, Inc., sells video recorders under terms calling for a small down payment and
monthly payments spread over three years. Following are data for the first three years of the company's operations:
2008 2009 2010 Gross margin rate 30% 40% 50% Cash collected in 2010: From sales in............................$216,000 From sales in.............................................. $288,000 From sales in............................................ $480,000
Total sales for 2010 were USD 1,600,000, while general and selling expenses amounted to USD 400,000.
a. Compute net income for 2010, assuming revenues are recognized at the time of sale.
b. Compute net income for 2010, using the installment method of accounting for sales and gross margin.
Problem C The following data relate to Merit Construction Company's long-term construction projects for the
year 2010:
Completed Incomplete Projects Projects
Contract price.................................... $20,000,000 $100,000,000 Costs incurred prior to 2010 ............... ..... 3,700,000 16,000,000 Costs incurred in 2010........................ ..... 11,100,000 32,000,000 Estimated costs to be incurred in future years................................ - 0- 32,000,000
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General and administrative expenses incurred in 2010 amounted to USD 2 million, none of which is to be
considered a construction cost.
a. Compute net income for 2010 under the completed-contract method.
b. Compute net income for 2010 under the percentage-of-completion method.
Problem D For each of the following numbered items, state the letter or letters of the principle(s),
assumption(s), or concept(s) used to justify the accounting procedure followed. The accounting procedures are all
correct.
a. Business entity.
b. Conservatism.
c. Earning principle of revenue recognition.
d. Going concern (continuity).
e. Exchange-price (cost) principle.
f. Matching principle.
g. Period cost (or principle of immediate recognition of expense).
h. Realization principle.
i. Stable dollar assumption.
Inventory is recorded at the lower of cost or market value.
A truck purchased in January was reported at 80 per cent of its cost even though its market value at year-end
was only 70 per cent of its cost.
The collection of USD 40,000 of cash for services to be performed next year was reported as a current liability.
The president's salary was treated as an expense of the year even though he spent most of his time planning the
next two years' activities.
No entry was made to record the company's receipt of an offer of USD 800,000 for land carried in its accounts
at USD 435,000.
A supply of printed stationery, checks, and invoices with a cost of USD 8,500 was treated as a current asset at
year-end even though it had no value to others.
A tract of land acquired for USD 180,000 was recorded at that price even though it was appraised at USD
230,000, and the company would have been willing to pay that amount.
The company paid and charged to expense the USD 4,200 paid to Craig Nelson for rent of a truck owned by him.
Craig Nelson is the sole stockholder of the company.
Problem E Match the descriptions in Column B with the proper terms in Column A.
Column A Column B 1. Financial a. Information is free of measurement method bias.
reporting b. The benefits exceed the costs. objectives. c. Relatively large items must be accounted for in a theoretically correct way.
2. Qualitative d. The information can be substantially duplicated by independent measurers characteristics. using the same measurement methods.
3. Relevance. e. When information improves users' ability to predict outcomes of events. 4. Predictive value. f. Broad overriding goals sought by accountants engaging in financial reporting. 5. Feedback value. g. When information is pertinent or bears on a decision. 6. Timeliness. h. The characteristics that accounting information should possess to be useful 7. Reliability. in decision making. 8. Representational i. Information that reveals the relative success of users in predicting outcomes.
faithfulness. j. When accounting statements on economic activity correspond to the actual 9. Verifiability. underlying activity. 10. Neutrality. k. When information is provided soon enough that it may be considered in 11. Comparability. decision making. 12. Consistency. l. When information faithfully depicts for users what it purports to represent. 13. Cost-benefit. m. Requires a company to use the same accounting principles and reporting
Accounting Principles: A Business Perspective 229 A Global Text
5. Accounting theory
14. Materiality. practices through time. n. When reported differences and similarities in information are real and not
the result of differing accounting treatments.
Alternate problems
Alternate problem A Select the best answer to each of the following questions:
A set of basic concepts and assumptions and related principles that explain and guide the accountant's actions in
identifying, measuring, and communicating economic information is called:
a. Accounting theory.
b. Accounting rules.
c. Accrual basis.
d. Matching concept.
Which of the following statements is false?
a. Several separate legal entities properly may be considered to be one accounting entity.
b. The stable dollar assumption is used only when the dollar is absolutely stable.
c. Publicly held corporations generally prepare monthly financial statements for internal management and
publish quarterly and annual financial statements for users outside the company.
d. Without the periodicity assumption, a business would have only one time period running from the inception
of the business to its termination.
Which of the following statements is true?
a. When the substance of a transaction conflicts with the legal form of the transaction, the accountant should be
guided by the legal form in recording the transaction.
b. The consistency concept prohibits a change in accounting principle even when such a change would better
meet the information needs of financial statement users.
c. Under the double-entry approach, each transaction must be recorded with one debit and one credit of equal
dollar amounts.
d. Special-purpose financial information for a specific decision, such as whether or not to purchase a new
machine, is best obtained from the detailed accounting records rather than from the financial statements.
Which of the following statements is true?
a. All assets are carried indefinitely at their original costs in the financial statements.
b. Liabilities are measured in the cash to be paid or the value of services to be performed to satisfy the liabilities.
c. Accounting principles are derived by merely summarizing accounting practices used to date.
d. Accountants can easily measure all changes in assets and liabilities since they never involve estimates or
calculations.
Which of the following statements is false?
a. The exchange-price principle is also called the cost principle.
b. The matching principle is closely related to the revenue recognition principle.
c. The installment sales method recognizes revenue sooner than it would normally be recognized.
d. The percentage-of-completion method recognizes revenue sooner than the completed- contract method.
Alternate problem B Nevada Real Estate Sales Company sells lots in its development in Dry Creek Canyon
under terms calling for small cash down payments with monthly installment payments spread over a few years.
Following are data on the company's operations for its first three years:
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2008 2009 2010 Gross margin rate ...................... ..... 45% 48% 50% Cash collected in 2010 from sales of lots made in................ ..... $640,000 $800,000 $900,000
The total selling price of the lots sold in 2010 was USD 3,000,000, while general and administrative expenses
(which are not included in the costs used to determine gross margin) were USD 800,000.
a. Compute net income for 2010 assuming revenue is recognized on the sale of a lot.
b. Compute net income for 2010 assuming use of the installment basis of accounting for sales and gross margin.
Alternate problem C The following contract prices and costs relate to all of Orlando Construction Company's
long-term construction projects (in millions of dollars):
Costs Incurred Cost to Be
Contract Prior to In Incurred in Price 2010 2010 Future Years
On projects completed in 2010 $46 $4 $36 $0 On incomplete projects 144 24 48 48
General and administrative expenses for 2010 amounted to USD 1,200,000. Assume that the general and
administrative expenses are not to be treated as a part of the construction cost.
a. Compute net income for 2010 using the completed-contract method.
b. Compute net income for 2010 using the percentage-of-completion method.
Alternate problem D In each of these circumstances, the accounting practices may be questioned. Indicate
whether you agree or disagree with the accounting practice employed and state the assumptions, concepts, or
principles that justify your position.
The salaries paid to the top officers of the company were charged to expense in the period in which they were
incurred even though the officers spent over half of their time planning next year's activities.
No entry was made to record the belief that the market value of the land owned (carried in the accounts at USD
800,000) had increased.
The acquisition of a tract of land was recorded at the price paid for it of USD 400,000, even though the company
would have been willing to pay USD 600,000.
A truck acquired at the beginning of the year was reported at year-end at 80 per cent of its acquisition price even
though its market value then was only 65 per cent of its original acquisition price.
Alternate problem E Select the best answer to each of the following questions:
In the conceptual framework project, how many financial reporting objectives were identified by the FASB?
a. One.
b. Two.
c. Three.
d. Four.
The two primary qualitative characteristics are:
a. Predictive value and feedback value.
b. Timeliness and verifiability.
c. Comparability and neutrality.
d. Relevance and reliability.
A pervasive constraint of accounting information is that:
a. Benefits must exceed costs.
Accounting Principles: A Business Perspective 231 A Global Text
5. Accounting theory
b. The information must be timely.
c. The information must be neutral.
d. The information must be verifiable.
To be reliable, information must (identify the incorrect quality):
a. Be verifiable.
b. Be timely.
c. Have representational faithfulness.
d. Be neutral.
The basic elements of financial statements consist of:
a. Terms and their definitions.
b. The objectives of financial reporting.
c. The qualitative characteristics.
d. The new income statement format.
Beyond the numbers—Critical thinking
Business decision case A Jim Casey recently received his accounting degree from State University and went
to work for a Big-Four CPA firm. After he had been with the firm for about six months, he was sent to the Ling
Clothing Company to work on the audit. He was not very confident of his knowledge at this early point in his career.
He noticed, however, that some of the company's transactions and events were recorded in a way that might be in
violation of accounting theory and generally accepted accounting principles.
Study each of the following facts to see if the auditors should challenge the financial accounting practices used or
the intentions of management. Write your decisions and the reasoning behind your conclusions.
This problem can serve as an opportunity to apply accounting theory to situations with which you are not yet
familiar and as a preview of future chapters. Some of the following situations relate to material you have already
covered, and some situations relate to material to be covered in future chapters. After each item, we have given an
indication of the chapter in which that item is discussed. You may research future chapters to find the correct
answer. Alternatively, you could use your present knowledge of accounting theory to determine whether or not
Casey should challenge each of the financial accounting practices used. Realize, however, that some generally
accepted accounting practices were based on compromise and seem to differ with accounting theory as described in
this chapter.
One of the senior members of management stated the company planned to replace all of the furniture next year.
He said that the cash in the Accumulated Depreciation account would be used to pay for the furniture. (Ch. 3)
The company held the books open at the end of 2010 so they could record some early 2011 sales as 2010
revenue. The justification for this practice was that 2010 was not a good year for profits. (Ch. 3, 5, 6)
The company's buildings were appraised for insurance purposes. The appraised values were USD 10,000,000
higher than the book value. The accountant debited Buildings and credited Paid-in Capital from Appreciation for
the difference. (Ch. 5)
The company recorded purchases of merchandise at the list price rather than the gross selling (invoice) price.
(Ch. 6)
Goods shipped to the company from a supplier, FOB destination, were debited to Purchases. The goods were not
included in ending inventory because the goods had not yet arrived. (Ch. 5, 6)
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The company counted some items twice in taking the physical inventory at the end of the year. The person
taking the inventory said he had forgotten to include some items in last year's physical inventory, and counting
some items twice would make up for the items missed last year so that net income this year would be about correct.
(Ch. 7)
The company switched from FIFO to LIFO in accounting for inventories. The preceding year it had switched
from the weighted-average method to FIFO. The reason given for the most recent change was that federal income
taxes would be lower. No indication of this switch was to appear in the financial statements. (Ch. 5, 7)
Since things were pretty hectic at year-end, the accountant made no effort to reconcile the bank account. His
reason was that the bank probably had not made any errors. The bank balance was lower than the book balance, so
the accountant debited Miscellaneous Expense and credited Cash for the difference. (Ch. 8)
When a customer failed to pay the amount due, the accountant debited Allowance for Uncollectible Accounts
and credited Accounts Receivable. The amount of accounts written off in this manner was huge. (Ch. 9)
A completely depreciated machine was still being used. The accountant left the asset and its related accumulated
depreciation on the books, stopped recording depreciation on the machine, and did not go back and correct earlier
years' net income and reduce accumulated depreciation. (Ch. 10)
The accountant stated that even though research and development costs incurred to develop a new product
would benefit future periods, these costs must be expensed as incurred. This year USD 200,000 of these costs were
charged to expense. (Ch. 11)
An old truck was traded for a new truck. Since the trade-in value of the old truck was higher than its book value,
a gain was recorded on the transaction. (Ch. 11)
The company paid for a franchise giving it the exclusive right to operate in a given geographical area for 60
years. The accountant is amortizing the asset over 60 years. (Ch. 11)
The company leases a building and has a nonrenewable lease that expires in 15 years. The company made some
improvements to the building. Since the improvements will last 30 years, they are being written off over 30 years.
(Ch. 11)
Annual report analysis B Refer to the "Summary of significant accounting policies" in the annual report of
The Limited, Inc. List the policies discussed. For each of the policies, explain in writing what the company is trying
to communicate.
Ethics – A writing experience C Refer to the item "An ethical perspective: Maplehurst company". Write out
the answers to the following questions:
Is management being ethical in this situation? Explain.
Is the accountant correct in believing that management's position could not be successfully defended? Explain.
What would you do if you were the accountant? Describe in detail.
Group project D In teams of two or three students, go to the library to locate one company's annual report for
the most recent year. (As an alternative, annual reports can be downloaded from the SEC's EDGAR site at
www.sec.gov/edgar.shtml) Examine the "Summary of accounting policies", which is part of the “Notes to financial
statements" section immediately following the financial statements. As a team, write a memorandum to the
instructor detailing the significant accounting policies of the company. The heading of the memorandum should
contain the date, to whom it is written, from whom, and the subject matter.
Accounting Principles: A Business Perspective 233 A Global Text
5. Accounting theory
Group project E With one or two other students and using library sources, write a paper on the history and
achievements of the Financial Accounting Standards Board. This board is responsible for establishing the
accounting standards and principles for financial accounting in the private sector. It was formed in 1973 and took
over the rule setting function from the Accounting Principles Board of the American Institute of Certified Public
Accountants at that time. Be sure to cite sources used and to treat direct quotes properly.
Group project F Your team of students should obtain a copy of the report, "Improving Business Reporting—A
Customer Focus" by the AICPA Special Committee on Financial Reporting (1994). Your library might have a copy.
If not, it can be obtained from the AICPA [Product No. 019303, Order Department, AICPA, Harborside Financial
Center, 201 Plaza Three, Jersey City, NJ 07311- 3881] [Toll free number 1-800-862-4272; FAX 1-800-362-5066].
Write a report giving a description of the recommendations of the committee. Be sure to cite sources used and treat
direct quotes properly.
Using the Internet—A view of the real world
Visit the following Internet site for General Electric:
http://www.ge.com
Find the annual report listed under Financial Reporting, and then Notes to Financial Statements. Print a copy of
the summary of Significant Accounting Policies. Write a short report to your instructor summarizing your findings.
Visit the following Internet site for Oracle.:
http://www. oracle.com
Click on “about”, then under "Investor Relations" click on “Detailed Financials”. Examine the notes on the
financial statements for the latest quarter. Write a short report for your instructor on your findings.
Answers to self-test
True-false
False. The business entity concept assumes that each business has an existence separate from its owners,
creditors, employees, customers, other interested parties, and other businesses.
True. Accountants should be guided by the economic substance of a transaction rather than its legal form.
True. The accrual basis of accounting seeks to match effort and accomplishment by matching expenses against
the revenues they created.
False. Exceptions include the installment basis of revenue recognition for sales and the percentage-of-
completion method for long-term construction projects.
False. Immaterial items do have to be recorded, but they can be recorded in a theoretically incorrect way (e.g.
expensing a wastebasket that will last many years).
True. Relevance and reliability are the two primary characteristics.
Multiple-choice
c. The matching concept is one of the major principles of accounting rather than an assumption.
b. The consistency concept requires that a company use the same accounting principles and reporting practices
through time.
b. Usually, the accountant does not recognize revenue until the seller acquires the right to receive payment from
the buyer.
b. USD3,000,000
USD10,000,000 X USD15,000,000=USD 4,500,000 .
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a. Periodicity is an underlying assumption rather than a modifying convention.
b. The category, quantitative characteristics, is not part of the conceptual framework project.
Accounting Principles: A Business Perspective 235 A Global Text
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6. Merchandising transactions
Introduction to inventories and the classified income statement
Learning objective
After studying this chapter, you should be able to:
• Record journal entries for sales transactions involving merchandise.
• Describe briefly cost of goods sold and the distinction between perpetual and periodic inventory procedures.
• Record journal entries for purchase transactions involving merchandise.
• Describe the freight terms and record transportation costs.
• Determine cost of goods sold.
• Prepare a classified income statement.
• Analyze and use the financial results—gross margin percentage.
• Prepare a work sheet and closing entries for a merchandising company (Appendix).
A career as a CEO
Are you a leader? Would you enjoy someday becoming the president or chief executive officer (CEO) of the
company you work for? Then you should consider a degree in accounting. The accounting field greatly values
individuals with leadership potential. Accounting students with the most job offers and the highest starting salaries
are also likely to be the ones who best demonstrate an ability to lead others. Recruiters in public accounting (i.e.
auditing, tax, consulting) and private accounting (i.e. financial reporting, cost accounting, financial analysis,
internal auditing) alike demonstrate a strong preference for students with leadership potential.
Fortunately, you do not have to run a company to demonstrate leadership abilities to college recruiters. Some
examples of leadership potential that would look good on a resume include organizing a successful fund-raiser,
participating effectively as an officer in a student club, or taking the lead in a group project. If you do not have a
resume yet, stop by the career placement center at your college and ask them to assist you in preparing one. Many
students at your level already have a resume, and it takes time to refine and develop an effective one. A well-
prepared resume will be important for securing internship opportunities and part-time work in the business field,
as well as for landing that first job upon graduation.
Did you know that the chief executive officers (CEO) of many of the largest manufacturing, merchandising, and
service organizations in the United States have degrees in accounting? James Dimon of JPMorgan Chase, Gary C.
Kelly of Southwest Airlines, Phil Knight of Nike, James J. Mulva of ConocoPhillips, and Indra K. Nooyi of PepsiCo
all have degrees in accounting. It is really not that surprising that accounting majors are so successful, as
accounting provides an excellent foundation in business. With a strong accounting foundation and the continued
development of leadership abilities over your career, you might become a CEO yourself someday.
Accounting Principles: A Business Perspective 236 A Global Text
6. Merchandising transactions
Your study of accounting began with service companies as examples because they are the least complicated type
of business. You are now ready to apply the accounting process to a more complex business—a merchandising
company. Although the fundamental accounting concepts for service businesses apply to merchandising businesses,
merchandise accounting requires some additional accounts and techniques to record sales and purchases.
The normal flow of goods from manufacturer to final customer is as follows:
Manufacturers produce goods from raw materials and normally sell them to wholesalers. After performing
certain functions, such as packaging or labeling, wholesalers sell the goods to retailers. Retailers sell the goods
to final customers. The two middle boxes in the diagram represent merchandising companies. These companies buy
goods in finished form for resale.
This chapter begins by comparing the income statement of a service company with that of a merchandising
company. Then, we describe (1) how to record merchandise-related transactions (2) a classified income statement
and (3) the gross margin percentage. Finally, in the appendix we explain the work sheet and the closing process for
a merchandising company.
SERVICE COMPANY MERCHANDISING COMPANY
Income Statement Income Statement
For the Year Ended 2010 December 31 For the Year Ended 2010 December 31
Service revenues $13,200 Sales revenues $262,000
Cost of goods sold 159,000
Gross Margin $103,000
Expenses 6,510 Expenses 74,900
Net income $ 6,690 Net income $ 28,100
Exhibit 32: Condensed income statements of a service company and a merchandising company compared
Two income statements compared— Service company and merchandising company
In Exhibit 32 we compare the main divisions of an income statement for a service company with those for a
merchandising company. To determine profitability or net income, a service company deducts total expenses
incurred from revenues earned. A merchandising company is a more complex business and, therefore, has a more
complex income statement.
As shown in Exhibit 32, merchandising companies must deduct from revenues the cost of the goods they sell to
customers to arrive at gross margin. Then, they deduct other expenses. The income statement of a merchandising
company has three main divisions: (1) sales revenues, which result from the sale of goods by the company; (2) cost
of goods sold, which is an expense that indicates how much the company paid for the goods sold; and (3) expenses,
which are the company's other expenses in running the business.
In the next two sections we discuss the first two main divisions of the income statement of a merchandising
company. The third division (expenses) is similar to expenses for a service company, which we illustrated in
preceding chapters. As you study these sections, keep in mind how the divisions of the merchandising income
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statement are related to each other and produce the final figure—net income or net loss—which indicates the
profitability of the company.
Sales revenues
The sale of goods occurs between two parties. The seller of the goods transfers them to the buyer in exchange for
cash or a promise to pay at a later date. This exchange is a relatively simple business transaction. Sellers make sales
to create revenues; this inflow of assets in the form of cash or accounts receivable results from selling goods to
customers.
In Exhibit 32, we show a condensed income statement to emphasize its major divisions. Next, we describe the
more complete income statement actually prepared by accountants. The merchandising company that we use to
illustrate the income statement is Hanlon Retail Food Store. This section explains how to record sales revenues,
including the effect of trade discounts. Then, we explain how to record two deductions from sales revenues—sales
discounts and sales returns and allowances (Exhibit 33). The amount that remains is net sales. The formula for
determining net sales is:
Net sales = Gross sales - (Sales discounts + Sales returns and allowances)
HANLON RETAIL FOOD STORE
Partial income Statement
For the Year Ended 2010 December 31
Operating revenues:
Gross sales $282,000 Less: Sales discounts $ 5,000
Sales returns and allowances 15,000 20,000 Net sales $262,000
Exhibit 33: Partial income statement of merchandising company
BRYAN WHOLESALE CO. 476 Mason Street Detroit, Michigan 48823
Invoice No.: 1258 Date: 2010 Dec. 19,
Customer's Order No.: 218
Sold to: Baier Company
Address: 2255 Hannon Street
Big Rapids, Michigan 48106 Date Shipped: 2010 Dec. 19,
Terms: Net 30, FOB Destination Shipped by: Nagel Trucking Co.
Description Item Number Quantity Price per Unit Total Amount
True-tone stereo radio Model No. 5868-24393 200 $100 $20,000
Total $20,000
Exhibit 34: Invoice
In a sales transaction, the seller transfers the legal ownership (title) of the goods to the buyer. Usually, the
physical delivery of the goods occurs at the same time as the sale of the goods. A business document called an
invoice (a sales invoice for the seller and a purchase invoice for the buyer) becomes the basis for recording the sale.
An invoice is a document prepared by the seller of merchandise and sent to the buyer. The invoice contains the
details of a sale, such as the number of units sold, unit price, total price billed, terms of sale, and manner of
shipment. A retail company prepares the invoice at the point of sale. A wholesale company, which supplies goods to
retailers, prepares the invoice after the shipping department notifies the accounting department that it has shipped
Accounting Principles: A Business Perspective 238 A Global Text
6. Merchandising transactions
the goods to the retailer. Exhibit 34 is an example of an invoice prepared by a wholesale company for goods sold to
a retail company.
Using the invoice as the source document, a wholesale company records the revenue from the sale at the time of
the sale for the following reasons:
• The seller has passed legal title of the goods to the buyer, and the goods are now the responsibility and
property of the buyer.
• The seller has established the selling price of the goods.
• The seller has completed its obligation.
• The seller has exchanged the goods for another asset, such as cash or accounts receivable.
• The seller can determine the costs incurred in selling the goods.
Each time a company makes a sale, the company earns revenue. This revenue increases a revenue account called
Sales. Recall from Chapter 2 that credits increase revenues. Therefore, the firm credits the Sales account for the
amount of the sale.
Usually sales are for cash or on account. When a sale is for cash, the company credits the Sales account and
debits Cash. For example, it records a USD 20,000 sale for cash as follows:
Cash (+A) 20,000
Sales (+SE) 20,000
To record the sales of merchandise for cash.
When a sale is on account, it credits the Sales account and debits Accounts Receivable. The following entry
records a USD 20,000 sale on account:
Accounts Receivable (+A) 20,000
Sales (+SE) 20,000
To record the sales of merchandise on account.
Usually, a seller quotes the gross selling price, also called the invoice price, of goods to the buyer. However,
sometimes a seller quotes a list price of goods along with available trade discounts. In this latter situation, the buyer
must calculate the gross selling price. The list price less all trade discounts is the gross selling price.
Merchandising companies that sell goods use the gross selling price as the credit to sales.
An accounting perspective:
Uses of technology
A database management system stores related data—such as monthly sales data (salespersons,
customers, products, and sales amounts)—independent of the application. Once you have defined
this information to the database management system, you can use commands to answer such
questions as: Which products have been sold to which customers? What are the amounts of sales
by individual salespersons? You could also print a customer list sorted by ZIP code, the alphabet,
or salesperson.
A trade discount is a percentage deduction, or discount, from the specified list price or catalog price of
merchandise. Companies use trade discounts to:
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• Reduce the cost of catalog publication. A seller can use a catalog for a longer time by printing list prices in
the catalog and giving separate discount sheets to salespersons whenever prices change.
• Grant quantity discounts.
• Allow quotation of different prices to various customers, such as retailers and wholesalers.
The seller's invoice may show trade discounts. However, sellers do not record trade discounts in their
accounting records because the discounts are used only to calculate the gross selling price. Nor do trade discounts
appear on the books of the purchaser. To illustrate, assume an invoice contains the following data:
List price, 200 swimsuits at $24 $4,800 Less: Trade discount, 30% 1,440 Gross selling price (invoice price) $3,360
The seller records a sale of USD 3,360. The purchaser records a purchase of USD 3,360. Thus, neither the seller
nor the purchaser enters list prices and trade discounts on their books.
Sometimes the list price of a product is subject to several trade discounts; this series of discounts is a chain
discount. Chain discounts exist, for example, when a wholesaler receives two trade discounts for services
performed, such as packaging and distributing. When more than one discount is given, the buyer applies each
discount to the declining balance successively. If a product has a list price of USD 100 and is subject to trade
discounts of 20 per cent and 10 per cent, the gross selling price (invoice price) would be USD 100 - 0.2(USD 100) =
USD 80; USD 80 - 0.1(USD 80) = USD 72, computed as follows:
List price $100 Less 20% - 20
$ 80
Less 10% ■ 8
Gross selling price (invoice price) $ 72
You could obtain the same results by multiplying the list price by the complements of the trade discounts
allowed. The complement of 20 per cent is 80 per cent because 20 per cent + 80 per cent = 100 per cent. The
complement of 10 per cent is 90 per cent because 10 per cent + 90 per cent = 100 per cent. Thus, the gross selling
price is USD 100 X 0.8 X 0.9 = USD 72.
Two common deductions from gross sales are (1) sales discounts and (2) sales returns and allowances. Sellers
record these deductions in contra revenue accounts to the Sales account. Contra accounts have normal balances
that are opposite to the balance of the account they reduce. For example, since the Sales account normally has a
credit balance, the Sales Discounts account and Sales Returns and Allowances account have debit balances. We
explain the methods of recording these contra revenue accounts next.
Sales discounts Whenever a company sells goods on account, it clearly specifies terms of payment on the
invoice. For example, the invoice in Exhibit 34 states the terms of payment as "net 30".
Net 30 is sometimes written as "n/30". Either way, this term means that the buyer may not take a discount and
must pay the entire amount of the invoice (USD 20,000) on or before 30 days after 2010 December 19 (invoice
date)—or 2011 January 18. In Exhibit 34, if the terms had read "n/10/EOM" (EOM means end of month), the buyer
could not take a discount, and the invoice would be due on the 10th day of the month following the month of sale—
or 2011 January 10. Credit terms vary from industry to industry.
In some industries, credit terms include a cash discount of 1 per cent to 3 per cent to induce early payment of an
amount due. A cash discount is a deduction from the invoice price that can be taken only if the invoice is paid
within a specified time. A cash discount differs from a trade discount in that a cash discount is a deduction from the
Accounting Principles: A Business Perspective 240 A Global Text
6. Merchandising transactions
gross selling price for the prompt payment of an invoice. In contrast, a trade discount is a deduction from the list
price to determine the gross selling price (or invoice price). Sellers call a cash discount a sales discount and
buyers call it a purchase discount. Companies often state cash discount terms as follows:
• 2/10, n/30—means a buyer who pays within 10 days following the invoice date may deduct a discount of 2
per cent of the invoice price. If payment is not made within the discount period, the entire invoice price is due
30 days from the invoice date.
• 2/EOM, n/60—means a buyer who pays by the end of the month of purchase may deduct a 2 per cent
discount from the invoice price. If payment is not made within the discount period, the entire invoice price is
due 60 days from the invoice date.
• 2/10/EOM, n/60—means a buyer who pays by the 10th of the month following the month of purchase
may deduct a 2 per cent discount from the invoice price. If payment is not made within the discount period,
the entire invoice price is due 60 days from the invoice date.
Sellers cannot record the sales discount before they receive the payment since they do not know when the buyer
will pay the invoice. A cash discount taken by the buyer reduces the cash that the seller actually collects from the
sale of the goods, so the seller must indicate this fact in its accounting records. The following entries show how to
record a sale and a subsequent sales discount.
Assume that on July 12, a business sold merchandise for USD 2,000 on account; terms are 2/10, n/30. On July
21 (nine days after invoice date), the business received a USD 1,960 check in payment of the account. The required
journal entries for the seller are:
July 12 Accounts Receivable (+A) 2,000
Sales (+SE) 2,000
To record sale on account; terms 2/10, n/30
21 Cash (+A) 1,960
Sales Discounts (-SE; Contra-Revenue Account) 40
Accounts Receivable (-A) 2,000
To record collection on account, less a discount.
The Sales Discounts account is a contra revenue account to the Sales account. In the income statement, the
seller deducts this contra revenue account from gross sales. Sellers use the Sales Discounts account (rather than
directly reducing the Sales account) so management can examine the sales discounts figure to evaluate the
company's sales discount policy. Note that the Sales Discounts account is not an expense incurred in generating
revenue. Rather, the purpose of the account is to reduce recorded revenue to the amount actually realized from the
sale.
Sales returns and allowances Merchandising companies usually allow customers to return goods that are
defective or unsatisfactory for a variety of reasons, such as wrong color, wrong size, wrong style, wrong amounts, or
inferior quality. In fact, when their policy is satisfaction guaranteed, some companies allow customers to return
goods simply because they do not like the merchandise. A sales return is merchandise returned by a buyer. Sellers
and buyers regard a sales return as a cancellation of a sale. Alternatively, some customers keep unsatisfactory
goods, and the seller gives them an allowance off the original price. A sales allowance is a deduction from the
original invoiced sales price granted when the customer keeps the merchandise but is dissatisfied for any of a
number of reasons, including inferior quality, damage, or deterioration in transit. When a seller agrees to the sales
return or sales allowance, the seller sends the buyer a credit memorandum indicating a reduction (crediting) of the
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buyer's account receivable. A credit memorandum is a document that provides space for the name and address of
the concerned parties, followed by a space for the reason for the credit and the amount to be credited. A credit
memorandum becomes the basis for recording a sales return or a sales allowance.
In theory, sellers could record both sales returns and sales allowances as debits to the Sales account because
they cancel part of the recorded selling price.
However, because the amount of sales returns and sales allowances is useful information to management, it
should be shown separately. The amount of returns and allowances in relation to goods sold can indicate the quality
of the goods (high-return percentage, equals low quality) or of pressure applied by salespersons (high-return
percentage, equals high-pressure sales). Thus, sellers record sales returns and sales allowances in a separate Sales
Returns and Allowances account. The Sales Returns and Allowances account is a contra revenue account (to
Sales) that records the selling price of merchandise returned by buyers or reductions in selling prices granted.
(Some companies use separate accounts for sales returns and for sales allowances, but this text does not.)
Following are two examples illustrating the recording of sales returns in the Sales Returns and Allowances
account:
• Assume that a customer returns USD 300 of goods sold on account. If payment has not yet been received,
the required entry is:
Sales Returns and Allowances (-SE) 300
Accounts Receivable (-A) 300
To record a sales return from a customer.
• Assume that the customer has already paid the account and the seller gives the customer a cash refund.
Now, the credit is to Cash rather than to Accounts Receivable. If the customer has taken a 2 per cent discount
when paying the account, the company would return to the customer the sales price less the sales discount
amount. For example, if a customer returns goods that sold for USD 300, on which a 2 per cent discount was
taken, the following entry would be made:
Sales Returns and Allowances (-SE) 300
Cash (-A) 294
Sales Discount (+SE) 6
To record a sales return from a customer who had taken a
discount and was sent a cash refund.
The debit to the Sales Returns and Allowances account is for the full selling price of the purchase. The credit of
USD 6 reduces the balance of the Sales Discounts account.
Next, we illustrate the recording of a sales allowance in the Sales Returns and Allowances account. Assume that
a company grants a USD 400 allowance to a customer for damage resulting from improperly packed merchandise.
If the customer has not yet paid the account, the required entry would be:
Sales Returns and Allowances (-SE) 400
Accounts Receivable (-A) 400
To record a sales allowance granted for damaged
merchandise.
If the customer has already paid the account, the credit is to Cash instead of Accounts Receivable. If the
customer took a 2 per cent discount when paying the account, the company would refund only the net amount
(USD 392). Sales Discounts would be credited for USD 8. The entry would be:
Accounting Principles: A Business Perspective 242 A Global Text
6. Merchandising transactions
Sales Returns and Allowances (-SE) 400
Cash (-A) 392
Sales Discount (+SE) 8
To record a sales allowance when a customer has paid and
taken a 2% discount.
HANLON RETAIL FOOD STORE
Partial income Statement
For the Year Ended 2010 December 31,
Operating revenues:
Gross sales $282,000 Less: Sales discounts $ 5,000
Sales returns and allowances 15,000 20,000 Net sales $262,000
*This illustration is the same as Exhibit 33, repeated here for your convenience.
Exhibit 35: Partial income statement*
Exhibit 35 shows how a company could report sales, sales discounts, and sales returns and allowances in the
income statement. More often, the income statement in a company's annual report begins with "Net sales" because
sales details are not important to external financial statement users.
An accounting perspective:
Business insight
When examining a company's sales cycle, management and users of financial data should be aware
of any seasonal changes that may affect its reported sales. A national retailer of personal computers
and related products and services, for example, should include wording similar to that in the
following paragraph in its Annual Report describing seasonality.
Seasonality
Based upon its operating history, the company believes that its business is seasonal. Excluding
the effects of new store openings, net sales and earnings are generally lower during the first and
fourth fiscal quarters than in the second and third fiscal quarters.
An accounting perspective:
Business insight
For many retailers a large percentage of their annual sales occurs during the period from
Thanksgiving to Christmas. They attempt to stock just the right amount of goods to meet demand.
Since this is a difficult estimate to make accurately, many retailers end up with a large amount of
unsold goods at the end of this season. The only way they can unload these goods is to offer huge
discounts during the following period.
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Cost of goods sold
The second main division of an income statement for a merchandising business is cost of goods sold. Cost of
goods sold is the cost to the seller of the goods sold to customers. For a merchandising company, the cost of goods
sold can be relatively large. All merchandising companies have a quantity of goods on hand called merchandise
inventory to sell to customers. Merchandise inventory (or inventory) is the quantity of goods available for sale
at any given time. Cost of goods sold is determined by computing the cost of (1) the beginning inventory, (2) the net
cost of goods purchased, and (3) the ending inventory.
Look at the cost of goods sold section of Hanlon Retail Food Store's income statement in Exhibit 36. The
merchandise inventory on 2010 January 1, was USD 24,000. The net cost of purchases for the year was USD
166,000. Thus, Hanlon had USD 190,000 of merchandise available for sale during 2010. On 2010 December 31, the
merchandise inventory was USD 31,000, meaning that this amount was left unsold. Subtracting the unsold
inventory (the ending inventory), USD 31,000, from the amount Hanlon had available for sale during the year, USD
190,000, gives the cost of goods sold for the year of USD 159,000. Understanding this relationship shown on
Hanlon Retail Food Store's partial income statement gives you the necessary background to determine the cost of
goods sold as presented in this section.
Cost of goods sold:
Merchandise inventory, 2010 January 1 $ 24,000
Purchases $167,00 0
Less: Purchase discounts $3,00 0
Purchase returns and allowances 8,000 11,000
Net Purchases $156,00 0
Add: Transportation-in 10,000
Net cost of purchases 166,000
Cost of goods available for sale $190,00 0
Less: Merchandise inventory, 2010 December 31
31,000
Cost of goods sold $159,00 0
Exhibit 36: Determination of cost of goods sold for Hanlon Retail Food Store
To determine the cost of goods sold, accountants must have accurate merchandise inventory figures.
Accountants use two basic methods for determining the amount of merchandise inventory—perpetual inventory
procedure and periodic inventory procedure. We mention perpetual inventory procedure only briefly here. In the
next chapter, we emphasize perpetual inventory procedure and further compare it with periodic inventory
procedure.
When discussing inventory, we need to clarify whether we are referring to the physical goods on hand or the
Merchandise Inventory account, which is the financial representation of the physical goods on hand. The difference
between perpetual and periodic inventory procedures is the frequency with which the Merchandise Inventory
account is updated to reflect what is physically on hand. Under perpetual inventory procedure, the
Merchandise Inventory account is continuously updated to reflect items on hand. For example, your supermarket
uses a scanner to ring up your purchases. When your box of Rice Krispies crosses the scanner, the Merchandise
Inventory account shows that one less box of Rice Krispies is on hand.
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6. Merchandising transactions
Under periodic inventory procedure, the Merchandise Inventory account is updated periodically after a
physical count has been made. Usually, the physical count takes place immediately before the preparation of
financial statements.
Perpetual inventory procedure Companies use perpetual inventory procedure in a variety of business
settings. Historically, companies that sold merchandise with a high individual unit value, such as automobiles,
furniture, and appliances, used perpetual inventory procedure. Today, computerized cash registers, scanners, and
accounting software programs automatically keep track of inflows and outflows of each inventory item.
Computerization makes it economical for many retail stores to use perpetual inventory procedure even for goods of
low unit value, such as groceries.
Under perpetual inventory procedure, the Merchandise Inventory account provides close control by showing the
cost of the goods that are supposed to be on hand at any particular time. Companies debit the Merchandise
Inventory account for each purchase and credit it for each sale so that the current balance is shown in the account
at all times. Usually, firms also maintain detailed unit records showing the quantities of each type of goods that
should be on hand. Company personnel also take a physical inventory by actually counting the units of inventory on
hand. Then they compare this physical count with the records showing the units that should be on hand. Chapter 7
describes perpetual inventory procedure in more detail.
Periodic inventory procedure Merchandising companies selling low unit value merchandise (such as nuts
and bolts, nails, Christmas cards, or pencils) that have not computerized their inventory systems often find that the
extra costs of record-keeping under perpetual inventory procedure more than outweigh the benefits. These
merchandising companies often use periodic inventory procedure.
Under periodic inventory procedure, companies do not use the Merchandise Inventory account to record each
purchase and sale of merchandise. Instead, a company corrects the balance in the Merchandise Inventory account
as the result of a physical inventory count at the end of the accounting period. Also, the company usually does not
maintain other records showing the exact number of units that should be on hand. Although periodic inventory
procedure reduces record-keeping, it also reduces control over inventory items.
Companies using periodic inventory procedure make no entries to the Merchandise Inventory account nor do
they maintain unit records during the accounting period. Thus, these companies have no up-to-date balance against
which to compare the physical inventory count at the end of the period. Also, these companies make no attempt to
determine the cost of goods sold at the time of each sale. Instead, they calculate the cost of all the goods sold during
the accounting period at the end of the period. To determine the cost of goods sold, a company must know:
• Beginning inventory (cost of goods on hand at the beginning of the period).
• Net cost of purchases during the period.
• Ending inventory (cost of unsold goods at the end of the period).
The company would show this information as follows:
Beginning inventory $ 34,000 Add: Net cost of purchases during the period 140,000 Cost of goods available for sale during the period $174,000 Deduct: Ending inventory 20,000 Cost of goods sold during the period $154,000
In this schedule, notice that the company began the accounting period with USD 34,000 of merchandise and
purchased an additional USD 140,000, making a total of USD 174,000 of goods that could have been sold during
the period. Then, a physical inventory showed that USD 20,000 remained unsold, which implies that USD 154,000
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was the cost of goods sold during the period. Of course, the USD 154,000 is not necessarily the precise amount of
goods sold because no actual record was made of the dollar cost of the goods sold. Periodic inventory procedure
basically assumes that everything not on hand at the end of the period has been sold. This method disregards
problems such as theft or breakage because the Merchandise Inventory account contains no up-to-date balance at
the end of the accounting period against which to compare the physical count.
Under periodic inventory procedure, a merchandising company uses the Purchases account to record the cost
of merchandise bought for resale during the current accounting period. The Purchases account, which is increased
by debits, appears with the income statement accounts in the chart of accounts.
To illustrate entries affecting the Purchases account, assume that Hanlon Retail Food Store made two purchases
of merchandise from Smith Wholesale Company. Hanlon purchased USD 30,000 of merchandise on credit (on
account) on May 4, and on May 21 purchased USD 20,000 of merchandise for cash. The required journal entries for
Hanlon are:
May 4 Purchases (+A) Accounts Payable (+L) To record purchases of merchandise on account.
30,000 30,000
21 Purchases (+A) Cash (-A) To record purchase of merchandise for cash.
20,000 20,000
The buyer deducts purchase discounts and purchase returns and allowances from purchases to arrive at net
purchases. The accountant records these items in contra accounts to the Purchases account.
Purchase discounts Often companies purchase merchandise under credit terms that permit them to deduct a
stated cash discount if they pay invoices within a specified time. Assume that credit terms for Hanlon's May 4
purchase are 2/10, n/30. If Hanlon pays for the merchandise by May 14, the store may take a 2 per cent discount.
Thus, Hanlon must pay only USD 29,400 to settle the USD 30,000 account payable. The entry to record the
payment of the invoice on May 14 is:
May 14 Accounts Payable (-L) 30,000
Cash (-A) 29,400
Purchase Discount (+SE) 600
To record payment on account within the
discount period.
The buyer records the purchase discount only when the invoice is paid within the discount period and the
discount is taken. The Purchase Discounts account is a contra account to Purchases that reduces the recorded
invoice price of the goods purchased to the price actually paid. Hanlon reports purchase discounts in the income
statement as a deduction from purchases.
Companies base purchase discounts on the invoice price of goods. If an invoice shows purchase returns or
allowances, they must be deducted from the invoice price before calculating purchase discounts. For example, in
the previous transaction, the invoice price of goods purchased was USD 30,000. If Hanlon returned USD 2,000 of
the goods, the seller calculates the 2 per cent purchase discount on USD 28,000.
Interest rate implied in cash discounts To decide whether you should take advantage of discounts by using
your cash or borrowing, make this simple analysis. Assume that you must pay USD 10,000 within 30 days or USD
9,800 within 10 days to settle a USD 10,000 invoice with terms of 2/10, n/30. By advancing payment 20 days from
the final due date, you can secure a discount of USD 200. The interest expense incurred to borrow USD 9,800 at 12
Accounting Principles: A Business Perspective 246 A Global Text
6. Merchandising transactions
per cent per year for 20 days is USD 65.33, calculated as (USD 9,800 x .12 x 20/360). You would save USD 134.67
(USD 200 - USD 65.33) by borrowing the money and paying the invoice within the discount period.
In terms of an annual rate of interest, the 2 per cent rate of discount for 20 days is equivalent to a 36 per cent
annual rate: (360/20) X 2 per cent. The formula is:
You can convert all cash discount terms to their approximate annual interest rate equivalents by use of this
formula. Thus, a company could afford to pay up to 36 per cent [(360/20) X 2 per cent] on borrowed funds to take
advantage of discount terms of 2/10, n/ 30. The company could pay 18 per cent on terms of 1/10, n/30.
Purchase returns and allowances A purchase return occurs when a buyer returns merchandise to a seller.
When a buyer receives a reduction in the price of goods shipped, a purchase allowance results. Then, the buyer
commonly uses a debit memorandum to notify the seller that the account payable with the seller is being reduced
(Accounts Payable is debited). The buyer may use a copy of a debit memorandum to record the returns or
allowances or may wait for confirmation, usually a credit memorandum, from the seller.
Both returns and allowances reduce the buyer's debt to the seller and decrease the cost of the goods purchased.
The buyer may want to know the amount of returns and allowances as the first step in controlling the costs incurred
in returning unsatisfactory merchandise or negotiating purchase allowances. For this reason, buyers record
purchase returns and allowances in a separate Purchase Returns and Allowances account. If Hanlon
returned USD 350 of merchandise to Smith Wholesale before paying for the goods, it would make this journal
entry:
Accounts Payable (-L) 350
Purchase Returns and Allowances (+SE) 350
To record return of damaged merchandise to supplier
The entry would have been the same to record a USD 350 allowance. Only the explanation would change.
If Hanlon had already paid the account, the debit would be to Cash instead of Accounts Payable, since Hanlon
would receive a refund of cash. If the company took a discount at the time it paid the account, only the net amount
would be refunded. For instance, if a 2 per cent discount had been taken, Hanlon's journal entry for the return
would be:
Cash (+A) 343
Purchase Discounts (-SE) 7
Purchase Returns and Allowances (+SE) 350
To record return of damaged merchandise to supplier and
record receipt of cash.
Purchase returns and allowances is a contra account to the Purchases account, and the income statement shows
it as a deduction from purchases. When both purchase discounts and purchase returns and allowances are deducted
from purchases, the result is net purchases.
Transportation costs are an important part of cost of goods sold. To understand how to account for
transportation costs, you must know the meaning of the following terms:
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• FOB shipping point means "free on board at shipping point". The buyer incurs all transportation costs
after the merchandise has been loaded on a railroad car or truck at the point of shipment. Thus, the buyer is
responsible for ultimately paying the freight charges.
• FOB destination means "free on board at destination". The seller ships the goods to their destination
without charge to the buyer. Thus, the seller is ultimately responsible for paying the freight charges.
• Passage of title is a term that indicates the transfer of the legal ownership of goods. Title to the goods
normally passes from seller to buyer at the FOB point. Thus, when goods are shipped FOB shipping point, title
usually passes to the buyer at the shipping point. When goods are shipped FOB destination, title usually passes
at the destination.
• Freight prepaid means the seller must initially pay the freight at the time of shipment.
• Freight collect indicates the buyer must initially pay the freight bill on the arrival of the goods.
To illustrate the use of these terms, assume that a company ships goods FOB shipping point, freight collect. Title
passes at the shipping point. The buyer is responsible for paying the USD 100 freight costs and does so. The seller
makes no entry for freight charges; the entry on the buyer's books is:
Transportation-In (or Freight-In) (+SE) 100
Cash (-A) 100
To record payment of freight bill on goods purchased.
The Transportation-In account records the inward freight costs of acquiring merchandise. Transportation-
In is an adjunct account in that it is added to net purchases to arrive at net cost of purchases. An adjunct
account is closely related to another account (Purchases, in this instance), and its balance is added to the balance
of the related account in the financial statements. Recall that a contra account is just the opposite of an adjunct
account. Buyers deduct a contra account, such as accumulated depreciation, from the related fixed asset account in
the financial statements.
When shipping goods FOB destination, freight prepaid, the seller is responsible for and pays the freight bill.
Because the seller cannot bill a separate freight cost to the buyer, the buyer shows no entry for freight on its books.
The seller, however, has undoubtedly considered the freight cost in setting selling prices. The following entry is
required on the seller's books:
Delivery Expense (or Transportation-Out Expense) (-SE) 100
Cash (-A) 100
To record freight cost on goods sold.
When the terms are FOB destination, the seller records the freight costs as delivery expense; this selling
expense appears on the income statement with other selling expenses.
FOB terms are especially important at the end of an accounting period. Goods in transit then belong to either
the seller or the buyer, and one of these parties must include these goods in its ending inventory. Goods shipped
FOB destination belong to the seller while in transit, and the seller includes these goods in its ending inventory.
Goods shipped FOB shipping point belong to the buyer while in transit, and the buyer records these goods as a
purchase and includes them in its ending inventory. For example, assume that a seller ships goods on 2009
December 30, and they arrive at their destination on 2010 January 5. If terms are FOB destination, the seller
includes the goods in its 2009 December 31, inventory, and neither seller nor buyer records the exchange
Accounting Principles: A Business Perspective 248 A Global Text
6. Merchandising transactions
transaction until 2010 January 5. If terms are FOB shipping point, the buyer includes the goods in its 2009
December 31, inventory, and both parties record the exchange transaction as of 2009 December 30.
Sometimes the seller prepays the freight as a convenience to the buyer, even though the buyer is ultimately
responsible for it. The buyer merely reimburses the seller for the freight paid. For example, assume that Wood
Company sold merchandise to Loud Company with terms of FOB shipping point, freight prepaid. The freight
charges were USD 100. The following entries are necessary on the books of the buyer and the seller:
Buyer—Loud Company Seller—Wood Company
Transportation-In (-SE) Accounts Payable (+L)
100 100
Accounts Receivable (+A) Cash (-A)
100 100
Such entries are necessary because Wood initially paid the freight charges when not required to do so.
Therefore, Loud Company must reimburse Wood for the charges. If the buyer pays freight for the seller (e.g. FOB
destination, freight collect), the buyer merely deducts the freight paid from the amount owed to the seller. The
following entries are necessary on the books of the buyer and the seller:
Buyer—Loud Company Seller—Wood Company
Accounts Payable (-L)
Cash (-A)
100 100
Delivery Expense (-SE) Accounts Receivable (-A)
100 100
Purchase discounts may be taken only on the purchase price of goods. Therefore, a buyer who owes the seller for
freight charges cannot take a discount on the freight charges owed, even if the buyer makes payment within the
discount period. We summarize our discussion of freight terms and the resulting journal entries to record the
freight charges in Exhibit 37.
Merchandise inventory is the cost of goods on hand and available for sale at any given time. To determine
the cost of goods sold in any accounting period, management needs inventory information. Management must
know its cost of goods on hand at the start of the period (beginning inventory), the net cost of purchases during the
period, and the cost of goods on hand at the close of the period (ending inventory). Since the ending inventory of
the preceding period is the beginning inventory for the current period, management already knows the cost of the
beginning inventory. Companies record purchases, purchase discounts, purchase returns and allowances, and
transportation-in throughout the period. Therefore, management needs to determine only the cost of the ending
inventory at the end of the period in order to calculate cost of goods sold.
Taking a physical inventory Under periodic inventory procedure, company personnel determine ending
inventory cost by taking a physical inventory. Taking a physical inventory consists of counting physical units of
each type of merchandise on hand. To calculate inventory cost, they multiply the number of each kind of
merchandise by its unit cost. Then, they combine the total costs of the various kinds of merchandise to provide the
total ending inventory cost.
In taking a physical inventory, company personnel must be careful to count all goods owned, regardless of where
they are located, and include them in the inventory.
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Shipping point: Detroit- Destination: San Diego Goods travel from shipping point to destination If shipping terms are:
FOB shipping point—Buyer incurs the freight FOB destination—Seller incurs the freight charges charge Freight prepaid—Seller initially pays the freight Freight collect—Buyer initially pays the freight charges charges If the freight terms are combined as follows:
Party that
Party that Ultimately Bears
Terms Initially Pays Expense
(1) FOB shipping point, freight collect Buyer Buyer (2) FOB destination, freight prepaid Seller Seller (3) FOB shipping point, freight prepaid Seller Buyer (4) FOB destination, freight collect Buyer Seller
Exhibit 37: Summary of shipping terms
Explanations: FOB shipping point, freight collect – Buyer both incurs and initially pays the freight chargers. The proper party (buyer) paid the freight. The buyer debits Transportation-In and credits Cash. FOB destination, freight prepaid – Seller both incurs and initially pays the freight charges. The proper party (seller) paid the freight. The seller debits Delivery Expense and credits Cash. FOB shipping point, freight prepaid – Buyer incurs the freight chargers, and seller initially pays the freight charges. Buyer must reimburse seller for freight charges. The seller debits Accounts Receivable and credits Cash upon paying the freight. The buyer debits Transportation-In and credits Accounts Payable when informed of the freight charges. FOB destination, freight collect – Seller incurs freight charges, and buyer initially pays freight charges. Buyer deducts freight charges from amount owed to seller. The buyer debits Accounts Payable and credits Cash when paying the freight. The seller debits Delivery Expense and credits Accounts Receivable when informed of the freight charges.
Thus, companies should include goods shipped to potential customers on approval in their inventories.
Similarly, companies should not record consigned goods (goods delivered to another party who attempts to sell
them for a commission) as sold goods. These goods remain the property of the owner (consignor) until sold by the
consignee and must be included in the owner's inventory.
Merchandise in transit is merchandise in the hands of a freight company on the date of a physical inventory.
As stated above, buyers must record merchandise in transit at the end of the accounting period as a purchase if the
goods were shipped FOB shipping point and they have received title to the merchandise. In general, the goods
belong to the party who ultimately bears the transportation charges.
When accounting personnel know the beginning and ending inventories and the various items making up the
net cost of purchases, they can determine the cost of goods sold. To illustrate, assume the following account
balances for Hanlon Retail Food Store as of 2010 December 31:
Merchandise Inventory, 2010 January 1 $ 24,000 Dr. Purchases 167,000 Dr. Purchase Discounts 3,000 Cr. Purchase Returns and Allowances 8,000 Cr. Transportation-In 10,000 Dr.
By taking a physical inventory, Hanlon determined the 2010 December 31, merchandise inventory to be USD
31,000. Hanlon then calculated its cost of goods sold as shown in Exhibit 38. This computation appears in a section
of the income statement directly below the calculation of net sales.
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6. Merchandising transactions
Cost of goods sold:
Merchandise inventory, 2010 January 1 $ 24,000
Purchases $167,000
Less: Purchase discounts $3,000
Purchase returns and allowances 8,000 11,000
Net Purchases $156,000
Add: Transportation-in 10,000
Net cost of purchases 166,000
Cost of goods available for sale $190,000
Less: Merchandise inventory, 2010 December 31 31,000
Cost of goods sold $159,000
This illustration is the same as Exhibit 36, repeated here for your convenience.
Exhibit 38: Determination of cost of goods sold for Hanlon Retain Food Store*
In Exhibit 38, Hanlon's beginning inventory (USD 24,000) plus net cost of purchases (USD 166,000) is equal to
cost of goods available for sale (USD 190,000). The firm deducts the ending inventory cost (USD 31,000) from
cost of goods available for sale to arrive at cost of goods sold (USD 159,000).
Another way of looking at this relationship is the following diagram:
Beginning inventory and net cost of purchases combine to form cost of goods available for sale. Hanlon divides
the cost of goods available for sale into ending inventory (which is the cost of goods not sold) and cost of goods sold.
To continue the calculation appearing in Exhibit 38, net cost of purchases (USD 166,000) is equal to purchases
(USD 167,000), less purchase discounts (USD 3,000) and purchase returns and allowances (USD 8,000), plus
transportation-in (USD 10,000).
As shown in Exhibit 38, ending inventory cost (merchandise inventory) appears in the income statement as a
deduction from cost of goods available for sale to compute cost of goods sold. Ending inventory cost (merchandise
inventory) is also a current asset in the end-of-period balance sheet.
Companies use periodic inventory procedure because of its simplicity and relatively low cost. However, periodic
inventory procedure provides little control over inventory. Firms assume any items not included in the physical
count of inventory at the end of the period have been sold. Thus, they mistakenly assume items that have been
stolen have been sold and include their cost in cost of goods sold.
To illustrate, suppose that the cost of goods available for sale was USD 200,000 and ending inventory was USD
60,000. These figures suggest that the cost of goods sold was USD 140,000. Now suppose that USD 2,000 of goods
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were actually shoplifted during the year. If such goods had not been stolen, the ending inventory would have been
USD 62,000 and the cost of goods sold only USD 138,000. Thus, the USD 140,000 cost of goods sold calculated
under periodic inventory procedure includes both the cost of the merchandise delivered to customers and the cost
of merchandise stolen.
An accounting perspective:
Uses of technology
Many companies are building private networks to link their employees, customers, and suppliers
together. These networks within the Internet are referred to as companies' intranets. The Internet
can be likened to the entire universe, while an intranet can be likened to a solar system within the
universe. A company's intranet is built to be secure from outside users. For instance, these
networks are designed to be secure against "hackers" and other unauthorized persons. The intranet
software typically encrypts data sent over the Internet to safeguard financial transactions.
Classified income statement
In preceding chapters, we illustrated the unclassified (or single-step) income statement. An unclassified
income statement has only two categories—revenues and expenses. In contrast, a classified income
statement divides both revenues and expenses into operating and nonoperating items. The statement also
separates operating expenses into selling and administrative expenses. A classified income statement is also called a
multiple-step income statement.
In Exhibit 39, we present a classified income statement for Hanlon Retail Food Store. This statement uses the
previously presented data on sales (Exhibit 35) and cost of goods sold (Exhibit 38), together with additional
assumed data on operating expenses and other expenses and revenues. Note in Exhibit 39 that a classified income
statement has the following four major sections:
• Operating revenues.
• Cost of goods sold.
• Operating expenses.
• Nonoperating revenues and expenses (other revenues and other expenses).
The classified income statement shows important relationships that help in analyzing how well the company is
performing. For example, by deducting cost of goods sold from operating revenues, you can determine by what
amount sales revenues exceed the cost of items being sold. If this margin, called gross margin, is lower than desired,
a company may need to increase its selling prices and/or decrease its cost of goods sold. The classified income
statement subdivides operating expenses into selling and administrative expenses. Thus, statement users can see
how much expense is incurred in selling the product and how much in administering the business. Statement users
can also make comparisons with other years' data for the same business and with other businesses. Nonoperating
revenues and expenses appear at the bottom of the income statement because they are less significant in assessing
the profitability of the business.
Accounting Principles: A Business Perspective 252 A Global Text
6. Merchandising transactions
An accounting perspective:
Business insight
Management chooses whether to use a classified or unclassified income statement to present a
company's financial data. This choice may be based either on how their competitors present their
data or on the costs associated with assembling the data.
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HANLON RETAIL FOOD STORE
Income Statement
For the Year Ended 2010 December 31
Operating revenues:
Gross sales $282,000
Less: Sales discounts $ 5,000
Sales return and allowances 15,000 20,000
Net sales $262,000
Cost of goods sold:
Merchandise inventory, 2010 January 1 $24,000
Purchases $167,00 0
Less: Purchase discount $3,00 0
Purchase returns and allowances 8,000 11,000
Net purchases $156,00 0
Add: Transportation-in 10,000
Net cost of purchases 166,000
Cost of goods available for sale $190,00 0
Less: Merchandise inventory, 2010 December 31
31,000
Cost of goods sold 159,000
Gross Margin $103,000
Operating expenses:
Selling expenses:
Salaries and commissions expense $ 26,000
Salespersons' travel expense 3,000
Delivery expense 2,000
Advertising expense 4,000
Rent expense—store building 2,500
Supplies expense 1,000
Utilities expense 1,800
Depreciation expense—store equipment 700
Other selling expense 400 $41,400
Administrative expenses:
Salaries expense, executive $29,000
Rent expense—administrative building 1,600
Insurance expense 1,500
Supplies expense 800
Depreciation expense—office equipment 1,100
Other administrative expenses 300 34,300
Total operating expenses 75,700
Income from operations $ 27,300
Nonoperating revenues and expenses:
Nonoperating revenues:
Interest revenue 1,400 $ 28,700
Nonoperating expenses:
Interest expense 600
Net income $ 28,100
Exhibit 39: Classified income statement for a merchandising company
Accounting Principles: A Business Perspective 254 A Global Text
6. Merchandising transactions
Next, we explain the major headings of the classified income statement in Exhibit 39. The terms in some of these
headings are already familiar to you. Although future illustrations of classified income statements may vary
somewhat in form, we retain the basic organization.
• Operating revenues are the revenues generated by the major activities of the business—usually the sale
of products or services or both.
• Cost of goods sold is the major expense in merchandising companies. Note the cost of goods sold section
of the classified income statement in Exhibit 39. This chapter has already discussed the items used in
calculating cost of goods sold. Merchandisers usually highlight the amount by which sales revenues exceed the
cost of goods sold in the top part of the income statement. The excess of net sales over cost of goods sold is the
gross margin or gross profit. To express gross margin as a percentage rate, we divide gross margin by net
sales. In Exhibit 39, the gross margin rate is approximately 39.3 per cent (USD 103,000/USD 262,000). The
gross margin rate indicates that out of each sales dollar, approximately 39 cents is available to cover other
expenses and produce income. Business owners watch the gross margin rate closely since a small percentage
fluctuation can cause a large dollar change in net income. Also, a downward trend in the gross margin rate may
indicate a problem, such as theft of merchandise. For instance, one Southeastern sporting goods company,
SportsTown, Inc., suffered significant gross margin deterioration from increased shoplifting and employee
theft.
• Operating expenses for a merchandising company are those expenses, other than cost of goods sold,
incurred in the normal business functions of a company. Usually, operating expenses are either selling
expenses or administrative expenses. Selling expenses are expenses a company incurs in selling and
marketing efforts. Examples include salaries and commissions of salespersons, expenses for salespersons'
travel, delivery, advertising, rent (or depreciation, if owned) and utilities on a sales building, sales supplies
used, and depreciation on delivery trucks used in sales. Administrative expenses are expenses a company
incurs in the overall management of a business. Examples include administrative salaries, rent (or
depreciation, if owned) and utilities on an administrative building, insurance expense, administrative supplies
used, and depreciation on office equipment.
Certain operating expenses may be shared by the selling and administrative functions. For example, a company
might incur rent, taxes, and insurance on a building for both sales and administrative purposes. Expenses covering
both the selling and administrative functions must be analyzed and prorated between the two functions on the
income statement. For instance, if USD 1,000 of depreciation expense relates 60 per cent to selling and 40 per cent
to administrative based on the square footage or number of employees, the income statement would show USD 600
as a selling expense and USD 400 as an administrative expense.
• Nonoperating revenues (other revenues) and nonoperating expenses (other expenses) are revenues
and expenses not related to the sale of products or services regularly offered for sale by a business. An example
of a nonoperating revenue is interest that a business earns on notes receivable. An example of a nonoperating
expense is interest incurred on money borrowed by the company.
To summarize the more important relationships in the income statement of a merchandising firm in equation
form:
• Net sales = Gross sales - (Sales discounts + Sales returns and allowances).
• Net purchases = Purchases - (Purchase discounts + Purchase returns and allowances).
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• Net cost of purchases = Net purchases + Transportation-in.
• Cost of goods sold = Beginning inventory + Net cost of purchases - Ending inventory.
• Gross margin = Net sales - Cost of goods sold.
• Income from operations = Gross margin - Operating (selling and administrative) expenses.
• Net income = Income from operations + Nonoperating revenues - Nonoperating expenses.
Each of these relationships is important because of the way it relates to an overall measure of business
profitability. For example, a company may produce a high gross margin on sales. However, because of large sales
commissions and delivery expenses, the owner may realize only a very small percentage of the gross margin as
profit. The classifications in the income statement allow a user to focus on the whole picture as well as on how net
income was derived (statement relationships).
An ethical perspective:
World auto parts corporation
John Bentley is the chief financial officer for World Auto Parts Corporation. The company buys
approximately USD 500 million of auto parts each year from small suppliers all over the world and
resells them to auto repair shops in the United States.
Most of the suppliers have cash discount terms of 2/10, n/30. John has instructed his personnel to
pay invoices on the 30th day after the invoice date but to take the 2 per cent discount even though
they are not entitled to do so. Whenever a supplier complains, John instructs his purchasing agent
to find another supplier who will go along with this practice. When some of his own employees
questioned the practice, John responded as follows:
This practice really does no harm. These small suppliers are much better off to go along and have
our business than to not go along and lose it. For most of them, we are their largest customer.
Besides, if they are willing to sell to others at a 2 per cent discount, why should they not be willing
to sell to us at that same discount even though we pay a little later? The benefit to our company is
very significant. Last year our profits were USD 100 million. A total of USD 10 million of the
profits was attributable to this practice. Do you really want me to change this practice and give
up USD 10 million of our profits?
Analyzing and using the financial results—Gross margin percentage
As discussed earlier, you can calculate the gross margin percentage by using the following formula:
Gross margin percentage= Gross margin
Net sales
To demonstrate the use of this ratio, consider the following information from the 2000 Annual Report of
Abercrombie & Fitch.
($ millions) 2000 1999 1998
Revenues $ 1,238.6 $ 1,030.9 $ 805.2 Gross profit 509.4 450.4 331.4 Gross profit (margin) percentage $ 509.5/$1,238.6 = 41.13% $450.4/$1,030.9 = 43.69% $331.4/$805.2 = 41.16%
Abercrombie's gross margin held at a rather high 41-43 per cent over those three years.
Accounting Principles: A Business Perspective 256 A Global Text
6. Merchandising transactions
You should now understand the distinction between accounting for a service company and a merchandising
company. The next chapter continues the discussion of merchandise inventory carried by merchandising
companies.
Understanding the learning objectives
• In a sales transaction, the seller transfers the legal ownership (title) of the goods to the buyer.
• An invoice is a document, prepared by the seller of merchandise and sent to the buyer, that contains the
details of a sale, such as the number of units sold, unit price, total price, terms of sale, and manner of
shipment.
• Usually sales are for cash or on account. When a sale is for cash, the debit is to Cash and the credit is to
Sales. When a sale is on account, the debit is to Accounts Receivable and the credit is to Sales.
• When companies offer trade discounts, the gross selling price (gross invoice price) at which the sale is
recorded is equal to the list price minus any trade discounts.
• Two common deductions from gross sales are (1) sales discounts and (2) sales returns and allowances.
These deductions are recorded in contra revenue accounts to the Sales account. Both the Sales Discounts
account and the Sales Returns and Allowances account normally have debit balances. Net sales = Sales - (Sales
discounts + Sales returns and allowances).
• Sales discounts arise when the seller offers the buyer a cash discount of 1 per cent to 3 per cent to induce
early payment of an amount due.
• Sales returns result from merchandise being returned by a buyer because the goods are considered
unsatisfactory or have been damaged. A sales allowance is a deduction from the original invoiced sales price
granted to a customer when the customer keeps the merchandise but is dissatisfied.
• Cost of goodssold=Beginning inventoryNet cost of purchases−Ending inventory .
Net cost of purchases=Purchases−Purchase discountsPurchase returns Transportation−¿
• Two methods of accounting for inventory are perpetual inventory procedure and periodic inventory
procedure. Under perpetual inventory procedure, the inventory account is continuously updated during the
accounting period. Under periodic inventory procedure, the inventory account is updated only periodically—
after a physical count has been made.
• Purchases of merchandise are recorded by debiting Purchases and crediting Cash (for cash purchases) or
crediting Accounts Payable (for purchases on account).
• Two common deductions from purchases are (1) purchase discounts and (2) purchase returns and
allowances. In the general ledger, both of these items normally carry credit balances. From the buyer's side of
the transactions, cash discounts are purchase discounts, and merchandise returns and allowances are purchase
returns and allowances.
• FOB shipping point means free on board at shipping point—the buyer incurs the freight.
• FOB destination means free on board at destination—the seller incurs the freight.
• Passage of title is a term indicating the transfer of the legal ownership of goods.
• Freight prepaid is when the seller must initially pay the freight at the time of shipment.
• Freight collect is when the buyer must initially pay the freight on the arrival of the goods.
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• Expansion and application of the relationship introduced in Learning objective 2. Beginning inventory +
Net cost of purchases = Cost of goods available for sale. Cost of goods available for sale - Ending inventory =
Cost of goods sold.
• A classified income statement has four major sections—operating revenues, cost of goods sold, operating
expenses, and nonoperating revenues and expenses.
• Operating revenues are the revenues generated by the major activities of the business—usually the sale of
products or services or both.
• Cost of goods sold is the major expense in merchandising companies.
• Operating expenses for a merchandising company are those expenses other than cost of goods sold incurred
in the normal business functions of a company. Usually, operating expenses are classified as either selling
expenses or administrative expenses.
• Nonoperating revenues and expenses are revenues and expenses not related to the sale of products or
services regularly offered for sale by a business.
• Gross margin percentage= Gross margin
Net sales
• The gross margin rate indicates the amount of sales dollars available to cover expenses and produce
income.
• Except for the merchandise-related accounts, the work sheet for a merchandising company is the same as
for a service company.
• Any revenue accounts and contra purchases accounts in the Adjusted Trial Balance credit column of the
work sheet are carried to the Income Statement credit column.
• Beginning inventory, contra revenue accounts. Purchases, Transportation-In, and expense accounts in the
Adjusted Trial Balance debit column are carried to the Income Statement debit column.
• Ending merchandise inventory is entered in the Income Statement credit column and in the Balance Sheet
debit column.
• Closing entries may be prepared directly from the work sheet. The first journal entry debits all items
appearing in the Income Statement credit column and credits Income Summary. The second entry credits all
items appearing in the Income Statement debit column and debits Income Summary. The third entry debits
Income Summary and credits the Retained Earnings account (assuming positive net income). The fourth entry
debits the Retained Earnings account and credits the Dividends account.
Appendix: The work sheet for a merchandising company
Exhibit 40 shows a work sheet for a merchandising company. Lyons Company is a small sporting goods firm.
The illustration for Lyons Company focuses on merchandise-related accounts. Thus, we do not show the fixed
assets (land, building, and equipment). Except for the merchandise-related accounts, the work sheet for a
merchandising company is the same as for a service company. Recall that use of a work sheet assists in the
preparation of the adjusting and closing entries. The work sheet also contains all the information needed for the
preparation of the financial statements.
To further simplify this illustration, assume Lyons needs no adjusting entries at month-end. The trial balance is
from the ledger accounts at 2010 December 31. The USD 7,000 merchandise inventory in the trial balance is the
Accounting Principles: A Business Perspective 258 A Global Text
6. Merchandising transactions
beginning inventory. The sales and sales-related accounts and the purchases and purchases-related accounts
summarize the merchandising activity for December 2010.
Lyons carries any revenue accounts (Sales) and contra purchases accounts (Purchase Discounts, Purchase
Returns and Allowances) in the Adjusted Trial Balance credit columns of the work sheet to the Income Statement
credit column. It carries beginning inventory, contra revenue accounts (Sales Discounts, Sales Returns and
Allowances), Purchases, Transportation-In, and expense accounts (Selling Expenses, Administrative Expenses) in
the Adjusted Trial Balance debit column to the Income Statement debit column.
Assume that ending inventory is USD 8,000. Lyons enters this amount in the Income Statement credit column
because it is deducted from cost of goods available for sale (beginning inventory plus net cost of purchases) in
determining cost of goods sold. It also enters the ending inventory in the Balance Sheet debit column to establish
the proper balance in the Merchandise Inventory account. The beginning and ending inventories are on the Income
Statement because Lyons uses both to calculate cost of goods sold in the income statement. Net income of USD
5,843 for the period balances the Income Statement columns. The firm carries the net income to the Statement of
Retained Earnings credit column. Retained earnings of USD 18,843 balances the Statement of Retained Earnings
columns. Lyons Company carries the retained earnings to the Balance Sheet credit column.
Lyons carries all other asset account balances (Cash, Accounts Receivable, and ending Merchandise Inventory)
to the Balance Sheet debit column. It also carries the liability (Accounts Payable) and Capital Stock account
balances to the Balance Sheet credit column. The balance sheet columns total to USD 29,543.
Once the work sheet has been completed, Lyons prepares the financial statements. After entering any adjusting
and closing entries in the journal, the firm posts them to the ledger. This process clears the records for the next
accounting period. Finally, it prepares a post-closing trial balance.
Income statement Exhibit 41 shows the income statement Lyons prepared from its work sheet in Exhibit 40.
The focus in this income statement is on determining the cost of goods sold.
Statement of retained earnings The statement of retained earnings, as you recall, is a financial statement
that summarizes the transactions affecting the Retained Earnings account balance. In Exhibit 42, the statement of
retained earnings shows an increase in equity resulting from net income and a decrease in equity resulting from
dividends.
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LYONS COMPANY Worksheet
For the Month Ended 2010 December 31
Acct. no.
Account Titles Trial Balance Adjustments
Adjusted Trial Balance
Income Statement
Statement of Retained Earnings
Balance Sheet
Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit Debit
100 Cash 19,663 19,663 19,653 103 Accounts Receivable 1,380 1,880 1,880 105 Merchandise Inventory,
December 1 7,000 7,000 7,000 8,000 8,000 200 Accounts Payable 700 700 300 Capital Stock 10,00
0 10,00 0
310 Retained Earnings, Decernl5er 1
15,00 0
15,00 0
15,000
320 Dividends 2,000 2,000 2,000 410 Sales 14,60
0 14,60 0
14,600
411 Sales Discounts 44 44 44 412 Sales Returns and
Allowances 20 20 20
500 Purchases 6,000 6,000 6,000 SOI Purchases Discounts 82 82 32 502 Purchase Returns and
Allowances 100 100 100
503 Transportation-In 75 75 75 557 Miscellaneous Selling
Expenses 2,650 2,650 2,650
567 Miscellaneous Administrative Expenses 1,150 1,150 1,150
40,482 40,48 2
40,432 40,48 2
16,939 22,782
Net Income 5,843 5,343 22,732 22,782 2,000 20,343 29,543
Retained Earnings, December 31
18,S43
20,843 20,843 29,543
Exhibit 40: Work sheet for a merchandising company
Accounting Principles: A Business Perspective 260 A Global Text
6. Merchandising transactions
LYONS COMPANY
Income Statement
For the Month Ended 2010 December 31
Operating revenues:
Gross sales $14,600
Less: Sales discounts $ 44
Sales return and allowances 20 64
Net sales $14,536
Cost of goods sold:
Merchandise inventory, 2010 January 1 $ 7,000
Purchases $ 6,000
Less: Purchase discount $ 82
Purchase returns and allowances 100 182
Net purchases $5,818
Add: Transportation-in 75
Net cost of purchases 5,893
Cost of goods available for sale $12,893
Less: Merchandise inventory, 2010 December 31 8,000
Cost of goods sold 4,893
Gross Margin $ 9,643
Operating expenses:
Miscellaneous selling expense $2,650
Miscellaneous administrative expense 1,150
Total operating expenses 3,800
Net income $ 5,843
Exhibit 41: Income statement for a merchandising company
LYONS COMPANY
Statement of Retained Earnings
For the Month Ended 2010 December 31
Retained earnings, 2010 December 1 $15,000 Add: Net income for the month 5,843 Total $20,843 Deduct: Dividends 2,000 Retained earnings, 2010 December 31 $18,843
Exhibit 42: Statement of retained earnings
LYONS COMPANY Balance Sheet 2010 December 31
Assets
Cash Accounts receivable Merchandise inventory
$19,663 1,880 8,000
Total assets $29,543 Liabilities and Stockholders' Equity
Liabilities:
Accounts payable $ 700
Stockholders' equity:
Capital stock Retained earnings
$ 10,000 18,843
Total stockholders' equity Total liabilities and stockholders' equity
28,843 $29,543
Exhibit 43: Balance sheet for a merchandising company
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Balance sheet The balance sheet, Exhibit 43, contains the assets, liabilities, and stockholders' equity items
taken from the work sheet. Note the USD 8,000 ending inventory is a current asset. The Retained Earnings account
balance comes from the statement of retained earnings.
Recall from Chapter 4 that the closing process normally takes place after the accountant has prepared the
financial statements for the period. The closing process closes revenue and expense accounts by transferring their
balances to a clearing account called Income Summary and then to Retained Earnings. The closing process reduces
the revenue and expense account balances to zero so that information for each accounting period may be
accumulated separately.
Lyons's accountant would prepare closing entries directly from the work sheet in Exhibit 40 using the same
procedure presented in Chapter 4. The closing entries for Lyons Company follow.
The first journal entry debits all items appearing in the Income Statement credit column of the work sheet and
credits Income Summary for the total of the column, USD 22,782.
2010
Dec. 31 Merchandise Inventory (ending) Sales Purchase Discounts
8,000 14,600 82
• 1st entry Purchase Returns and Allowances Income Summary To close accounts with a credit balance in the Income Statement columns and to establish ending merchandise inventory.
100 22,782
The second entry credits all items appearing in the Income Statement debit column and debits Income
Summary for the total of that column, USD 16,939.
2010
Dec. 31 Income Summary Merchandise Inventory (beginning) Sales Discounts Sales Returns and Allowance
16,939 7,000 44 20
• 2nd entry Purchases Transportation-In Miscellaneous Selling Expenses Miscellaneous Administrative Expenses To close accounts with a debit balance in the Income Statement columns.
6,000 75 2,650 1,150
The third entry closes the credit balance in the Income Summary account of USD 5,843 to the Retained
Earnings account.
2010 5,843
Dec. 31 Income Summary Retained Earnings To close the Income Summary account to the Retained Earnings account.
5,843
The fourth entry closes the Dividends account balance of $2,000 to the Retained Earnings account by debiting
Retained Earnings and crediting Dividends.
2010 2,000
Dec. 31 Retained Earnings Dividends To close the Dividends account to the Retained Earnings account.
2,000
Note how the first three closing entries tie into the totals in the Income Statement columns of the work sheet in
Exhibit 40. In the first closing journal entry, the credit to the Income Summary account is equal to the total of the
Income Statement credit column. In the second entry, the debit to the Income Summary account is equal to the
Accounting Principles: A Business Perspective 262 A Global Text
6. Merchandising transactions
subtotal of the Income Statement debit column. The difference between the totals of the two Income Statement
columns (USD 5,843) represents net income and is the amount of the third closing entry.
Demonstration problem
The following transactions occurred between Companies C and D in June 2010:
June 10 Company C purchased merchandise from Company D for USD 80,000; terms 2/10/EOM, n/60, FOB
destination, freight prepaid.
11 Company D paid freight of USD 1,200.
14 Company C received an allowance of USD 4,000 from the gross selling price because of damaged goods.
23 Company C returned USD 8,000 of goods purchased because they were not the quality ordered.
30 Company D received payment in full from Company C.
a. Journalize the transactions for Company C.
b. Journalize the transactions for Company D.
Solution to demonstration problem
a.
General Journal
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 June
1 0
Company C
Purchases 8 0 0 0 0 Accounts Payable 8 0 0 0 0
Purchased merchandise from Company D; terms 2/10/EOM, n/60
1 4
Accounts Payable 4 0 0 0
Purchase Return and Allowances 4 0 0 0
Received an allowance from Company D for damaged goods.
2 3
Accounts Payable 8 0 0 0
Purchase Returns and Allowances 8 0 0 0
Returned merchandise to Company D because of improper quality
3 0
Accounts Payable ($80,000 - $4,000 - $8,000) 6 8 0 0 0
Purchase Discounts ($68,000 x 0.02) 1 3 6 0
Cash ($68,000 - $1,360) 6 6 6 4 0
Paid the amount due to Company D.
b.
General Journal
Date Account Titles and Explanation Post. Ref.
Debit Credit
2010 June
1 0
Company D
Accounts Receivable 8 0 0 0 0 Sales 8 0 0 0 0
Sold merchandise to Company C; terms 2/10/EOM, n/60
1 Delivery Expense 1 2 0 0
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1 Cash 1 2 0 0
Paid freight on sale of merchandise shipped FOB destination, freight prepaid.
1 4
Sales Returns and Allowances 4 0 0 0
Accounts Receivable 4 0 0 0
Granted an allowance to Company C for damaged goods.
2 3
Sales Returns and Allowances 8 0 0 0
Accounts Receivable 8 0 0 0
Merchandise returned from Company C due to improper quality.
3 0
Cash ($68,000 - $1,360) 6 6 6 4 0
Sales Discounts ($68,000 x 0.02) 1 3 6 0
Accounts Receivable ($80,000 - $4,000 - $8,000) 6 8 0 0 0
Received the amount due from Company C.
Key terms Adjunct account Closely related to another account; its balance is added to the balance of the related account in the financial statements.
Administrative expenses Expenses a company incurs in the overall management of a business.
Cash discount A deduction from the invoice price that can be taken only if the invoice is paid within a specified time. To the seller, it is a sales discount; to the buyer, it is a purchase discount.
Chain discount Occurs when the list price of a product is subject to a series of trade discounts.
Classified income statement Divides both revenues and expenses into operating and nonoperating items. The statement also separates operating expenses into selling and administrative expenses. Also called the multiple-step income statement.
Consigned goods Goods delivered to another party who attempts to sell the goods for the owner at a commission.
Cost of goods available for sale Equal to beginning inventory plus net cost of purchases.
Cost of goods sold Shows the cost to the seller of the goods sold to customers; under periodic inventory procedure, cost of goods sold is computed as Beginning inventory + Net cost of purchases - Ending inventory.
Delivery expense A selling expense recorded by the seller for freight costs incurred when terms are FOB destination.
FOB destination Means free on board at destination; goods are shipped to their destination without charge to the buyer; the seller is responsible for paying the freight charges.
FOB shipping point Means free on board at shipping point; buyer incurs all transportation costs after the merchandise is loaded on a railroad car or truck at the point of shipment.
Freight collect Terms that require the buyer to pay the freight bill on arrival of the goods.
Freight prepaid Terms that indicate the seller has paid the freight bill at the time of shipment.
Gross margin or gross profit Net sales - Cost of goods sold; identifies the number of dollars available to cover expenses other than cost of goods sold.
Gross margin percentage Gross margin divided by net sales.
Gross selling price (also called the invoice price) The list price less all trade discounts.
Income from operations Gross margin - Operating (selling and administrative) expenses.
Invoice A document prepared by the seller of merchandise and sent to the buyer. It contains the details of a sale, such as the number of units sold, unit price, total price billed, terms of sale, and manner of shipment. It is a purchase invoice from the buyer's point of view and a sales invoice from the seller's point of view.
Accounting Principles: A Business Perspective 264 A Global Text
6. Merchandising transactions
Manufacturers Companies that produce goods from raw materials and normally sell them to wholesalers.
Merchandise in transit Merchandise in the hands of a freight company on the date of a physical inventory.
Merchandise inventory The quantity of goods available for sale at any given time.
Net cost of purchases Net purchases + Transportation-in.
Net income Income from operations + Nonoperating revenues - Nonoperating expenses.
Net purchases Purchases - (Purchase discounts +Purchase returns and allowances).
Net sales Gross sales - (Sales discounts + Sales returns and allowances).
Nonoperating expenses (other expenses) Expenses incurred by a business that are not related to the acquisition and sale of the products or services regularly offered for sale.
Nonoperating revenues (other revenues) Revenues not related to the sale of products or services regularly offered for sale by a business.
Operating expenses Those expenses other than cost of goods sold incurred in the normal business functions of a company.
Operating revenues Those revenues generated by the major activities of a business.
Passage of title A legal term used to indicate transfer of legal ownership of goods.
Periodic inventory procedure A method of accounting for merchandise acquired for sale to customers wherein the cost of merchandise sold and the cost of merchandise on hand are determined only at the end of the accounting period by taking a physical inventory.
Perpetual inventory procedure A method of accounting for merchandise acquired for sale to customers wherein the Merchandise Inventory account is continuously updated to reflect items on hand; this account is debited for each purchase and credited for each sale so that the current balance is shown in the account at all times.
Physical inventory Consists of counting physical units of each type of merchandise on hand.
Purchase discount See Cash discount.
Purchase Discounts account A contra account to Purchases that reduces the recorded gross invoice cost of the purchase to the price actually paid.
Purchase Returns and Allowances account An account used under periodic inventory procedure to record the cost of merchandise returned to a seller and to record reductions in selling prices granted by a seller because merchandise was not satisfactory to a buyer; viewed as a reduction in the recorded cost of purchases.
Purchases account An account used under periodic inventory procedure to record the cost of goods or merchandise bought for resale during the current accounting period.
Retailers Companies that sell goods to final consumers.
Sales allowance A deduction from original invoiced sales price granted to a customer when the customer keeps the merchandise but is dissatisfied for any of a number of reasons, including inferior quality, damage, or deterioration in transit.
Sales discount See Cash discount.
Sales Discounts account A contra revenue account to Sales; it is shown as a deduction from gross sales in the income statement.
Sales return From the seller's point of view, merchandise returned by a buyer for any of a variety of reasons; to the buyer, a purchase return.
Sales Returns and Allowances account A contra revenue account to Sales used to record the selling price of merchandise returned by buyers or reductions in selling prices granted.
Selling expenses Expenses a company incurs in selling and marketing efforts.
Trade discount A percentage deduction, or discount, from the specified list price or catalog price of merchandise to arrive at the gross invoice price; granted to particular categories of customers (e.g. retailers and wholesalers). Also see Chain discount.
Transportation-In account An account used under periodic inventory procedure to record inward freight costs incurred in the acquisition of merchandise; a part of cost of goods sold.
Unclassified income statement Shows only major categories for revenues and expenses. Also called the single-step income statement.
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Wholesalers Companies that normally sell goods to other companies (retailers) for resale.
Self-test
True-false
Indicate whether each of the following statements is true or false.
To compute net sales, sales discounts are added to, and sales returns and allowances are deducted from, gross
sales.
Under perpetual inventory procedure, the Merchandise Inventory account is debited for each purchase and
credited for each sale.
Purchase discounts and purchase returns and allowances are recorded in contra accounts to the Purchases
account.
In taking a physical inventory, consigned goods delivered to another party who attempts to sell the goods are not
included in the ending inventory of the company that sent the goods.
A classified income statement consists of only two categories of items, revenues and expenses.
Multiple-choice
Select the best answer for each of the following questions.
A seller sold merchandise which has a list price of USD 4,000 on account, giving a trade discount of 20 per cent.
The entry on the books of the seller is:
a. Accounts Receivable 3,200
Trade Discounts 800
Sales 4,000
b. Accounts Receivable 4,000
Sales 4,000
c. Accounts Receivable 3,200
Trade Discounts 800
Sales 4,000
d. Accounts Receivable 3,200
Sales 3,200
X Company began the accounting period with USD 60,000 of merchandise, and net cost of purchases was USD
240,000. A physical inventory showed USD 72,000 of merchandise unsold at the end of the period. The cost of
goods sold of Y Company for the period is:
a. USD 300,000.
b. USD 228,000.
c. USD 252,000.
d. USD 168,000.
e. None of the above.
A business purchased merchandise for USD 12,000 on account; terms are 2/10, n/30. If USD 2,000 of the
merchandise was returned and the remaining amount due was paid within the discount period, the purchase
discount would be:
a. USD 240.
b. USD 200.
c. USD 1,200.
Accounting Principles: A Business Perspective 266 A Global Text
6. Merchandising transactions
d. USD 1,000.
e. USD 3,600.
A classified income statement consists of all of the following major sections except for:
a. Operating revenues.
b. Cost of goods sold.
c. Operating expenses.
d. Nonoperating revenues and expenses.
e. Current assets.
(Appendix) Closing entries for merchandise-related accounts include all of the following except for:
a. A credit to Sales Discounts.
b. A credit to Merchandise Inventory for the cost of ending inventory.
c. A debit to Purchase Discounts.
d. A credit to Transportation-In.
e. A debit to Sales.
Now turn to “Answers to self-test” at the end of the chapter to check your answers.
Questions
➢ Which account titles are likely to appear in a merchandising company's ledger that do not appear in
the ledger of a service enterprise?
➢ What entry is made to record a sale of merchandise on account under periodic inventory procedure?
➢ Describe trade discounts and chain discounts.
➢ Sales discounts and sales returns and allowances are deducted from sales on the income statement to
arrive at net sales. Why not deduct these directly from the Sales account by debiting Sales each time
a sales discount, return, or allowance occurs?
➢ What are the two basic procedures for accounting for inventory? How do these two procedures
differ?
➢ What useful purpose does the Purchases account serve?
➢ What do the letters FOB stand for? When terms are FOB destination, who incurs the cost of freight?
➢ What type of an expense is delivery expense? Where is this expense reported in the income
statement?
➢ Periodic inventory procedure is said to afford little control over inventory. Explain why.
➢ How does the accountant arrive at the total dollar amount of the inventory after taking a physical
inventory?
➢ How is cost of goods sold determined under periodic inventory procedure?
➢ If the cost of goods available for sale and the cost of the ending inventory are known, what other
amount appearing on the income statement can be calculated?
➢ What are the major sections in a classified income statement for a merchandising company, and in
what order do these sections appear?
➢ What is gross margin? Why might management be interested in the percentage of gross margin to
net sales?
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➢ (Appendix) After closing entries are posted to the ledger, which types of accounts have balances?
Why?
➢ The Limited, Inc. Based on the financial statements of The Limited in the Annual Report
Appendix, what were the 2000 operating expenses? For each of the three years shown, what
percentage of net sales were these expenses? Is the trend favorable or unfavorable?
➢ The Limited, Inc. Based on the financial statements of The Limited, Inc., in the Annual Report
Appendix, what were the 2000 cost of goods sold, occupancy, and buying costs? For each of the three
years shown, what percentage of net sales were these expenses? Is the trend favorable or
unfavorable?
Exercises
Exercise A In the following table, indicate how to increase or decrease (debit or credit) each account, and
indicate its normal balance (debit or credit).
Increased Decreased Normal
by by Balance
(debit (debit (debit
Title of Account or credit) or credit) or credit)
Merchandise Inventory
Sales
Sales Returns and Allowances
Sales Discounts
Accounts Receivable
Purchases
Purchase Returns and Allowances
Purchase Discounts
Accounts Payable
Transportation-In
Exercise B a. Silver Company purchased USD 56,000 of merchandise from Milton Company on account.
Before paying its account, Silver Company returned damaged merchandise with an invoice price of USD 11,680.
Assuming use of periodic inventory procedure, prepare entries on both companies' books to record both the
purchase/sale and the return.
b. Show how any of the required entries would change assuming that Milton Company granted an allowance of
USD 3,360 on the damaged goods instead of giving permission to return the merchandise.
Exercise C What is the last payment date on which the cash discount can be taken on goods sold on March 5
for USD 51,200; terms 3/10/EOM, n/60? Assume that the bill is paid on this date and prepare the correct entries
on both the buyer's and seller's books to record the payment.
Exercise D You have purchased merchandise with a list price of USD 36,000. Because you are a wholesaler,
you are granted a trade discount of 49.6 per cent. The cash discount terms are 2/EOM, n/60. How much will you
remit if you pay the invoice by the end of the month of purchase? How much will discounts on payment you remit if
you do not pay the invoice until the following month?
Exercise E Lasky Company sold merchandise with a list price of USD 60,000 on July 1. For each of the
following independent assumptions, calculate (1) the gross selling price used to record the sale and (2) the amount
that the buyer would have to remit when paying the invoice.
Trade Discount Credit Date
Accounting Principles: A Business Perspective 268 A Global Text
6. Merchandising transactions
Granted Terms Paid
a. 30%, 20% 2/10, n/30 July 10 b. 40%, 10% 2/EOM, n/60 August 10 c. 30%, 10%, 5% 3/10/EOM, n/60 August 10 d. 40% 1/10, n/30 July 12
Exercise F Raiser Company purchased goods at a gross selling price of USD 2,400 on August 1. Discount terms
of 2/10, n/30 were available. For each of the following independent situations, determine (1) the cash discount
available on the final payment and (2) the amount paid if payment is made within the discount period.
Purchase
Transportation Freight Allowance Terms Paid (by) Granted
a. FOB shipping point $240 (buyer) $480 b. FOB destination 120 (seller) 240 c. FOB shipping point 180 (seller) 720 d. FOB destination 192 (buyer) 120
Exercise G Stuart Company purchased goods for USD 84,000 on June 14, under the following terms: 3/10, n/
30; FOB shipping point, freight collect. The bill for the freight was paid on June 15, USD 1,200.
a. Assume that the invoice was paid on June 24, and prepare all entries required on Stuart Company's books.
b. Assume that the invoice was paid on July 11. Prepare the entry to record the payment made on that date.
Exercise H Cramer Company uses periodic inventory procedure. Determine the cost of goods sold for the
company assuming purchases during the period were USD 40,000, transportation-in was USD 300, purchase
returns and allowances were USD 1,000, beginning inventory was USD 25,000, purchase discounts were USD
2,000, and ending inventory was USD 13,000.
Exercise I In each case, use the following information to calculate the missing information:
Case 1 Case 2 Case 3
Gross sales $ 640,000 $ ? $ ? Sales discounts ? 25,600 19,200 Sales returns and allowances 19,200 44,800 32,000 Net sales 608,000 1,209,600
Merchandise inventory, January 1 256,000 384,000
Purchases 384,000 768,000
Purchase discounts 7,680 13,440 12,800 Purchase returns and allowances 24,320 31,360 32,000 Net purchases 352,000 672,000
Transportation-in 25,600 38,400 32,000 Net cost of purchases 377,600 761,600 ? Cost of goods available for sale ? 1,081,600 1,088,000 Merchandise inventory, December 31 ? 384,000 448,000 Cost of goods sold 320,000 ? 640,000 Gross margin 512,000 320,000
Exercise J In each of the following equations supply the missing term(s):
a. Net sales = Gross sales - (______________________ + Sales returns and allowances).
b. Cost of goods sold = Beginning inventory + Net cost of purchases - ________ ________.
c. Gross margin = ________ ________ - Cost of goods sold.
d. Income from operations = __________ _________ - Operating expenses.
e. Net income = Income from operations + _________ ________ - ________ ________.
Exercise K Given the balances in this partial trial balance, indicate how the balances would be treated in the
work sheet. The ending inventory is USD 96. (The amounts are unusually small for ease in rewriting the numbers.
We purposely left out the Statement of Retained Earnings columns since they are not used.)
Accounts Titles Trial Balance Adjustments
Adjusted Trial Balance
Income Statement Balance Sheet
Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
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Merchandise
Inventory 120
Sales S40
Sales Discounts 18
Sales Returns
and Allowances 45
Purchases 600
Purchase
Discounts 12
Purchase Returns
and Allowances 24
Transportation-In 36
Exercise L Using the data in the previous exercise prepare closing entries for the preceding accounts. Do not
close the Income Summary account.
Problems
Problem A a. Spencer Sporting Goods Company engaged in the following transactions in April 2010
Apr. 1 Sold merchandise on account for USD 288,000; terms 2/10, n/30, FOB shipping point, freight collect.
5 USD 43,200 of the goods sold on account on April 1 were returned for a full credit. Payment for these goods
had not yet been received.
8 A sales allowance of USD 5,760 was granted on the merchandise sold on April 1 because the merchandise was
damaged in shipment.
10 Payment was received for the net amount due from the sale of April 1.
b. High Stereo Company engaged in the following transactions in July 2010.
July 2 Purchased stereo merchandise on account at a cost of USD 43,200; terms 2/10, n/30, FOB destination,
freight prepaid.
15 Sold merchandise for USD 64,800, terms 2/10, n/30, FOB destination, freight prepaid.
16 Paid freight costs on the merchandise sold, USD 2,160.
20 High Stereo Company was granted an allowance of USD 2,880 on the purchase of July 2 because of damaged
merchandise.
31 Paid the amount due on the purchase of July 2.
Prepare journal entries to record the transactions.
Problem B Mars Musical Instrument Company and Tiger Company engaged in the following transactions with
each other during July 2010:
July 2 Mars Musical Instrument Company purchased merchandise on account with a list price of USD 48,000
from Tiger Company. The terms were 3/EOM, n/60, FOB shipping point, freight collect. Trade discounts of 15 per
cent, 10 per cent, and 5 per cent were granted by Tiger Company.
5 The buyer paid the freight bill on the purchase of July 2, USD 1,104.
6 The buyer returned damaged merchandise with an invoice price of USD 2,790 to the seller and received full
credit.
On the last day of the discount period, the buyer paid the seller for the merchandise.
Prepare all the necessary journal entries for the buyer and the seller.
Accounting Principles: A Business Perspective 270 A Global Text
6. Merchandising transactions
Problem C The following data for June 2010 are for Rusk Company's first month of operations:
June 1 Rusk Company was organized, and the stockholders invested USD 1,008,000 cash, USD 336,000 of
merchandise inventory, and a USD 288,000 plot of land in exchange for capital stock.
4 Merchandise was purchased for cash, USD 432,000; FOB shipping point, freight collect.
9 Cash of USD 10,080 was paid to a trucking company for delivery of the merchandise purchased June 4.
13 The company sold merchandise on account, USD 288,000; terms 2/10, n/ 30.
15 The company sold merchandise on account, USD 230,400; terms 2/10, n/30.
16 Of the merchandise sold June 13, USD 31,680 was returned for credit.
20 Salaries for services received were paid as follows: to office employees, USD 31,680; to salespersons, USD
83,520.
22 The company collected the amount due on the remaining USD 256,320 of accounts receivable arising from
the sale of June 13.
24 The company purchased merchandise on account at a cost of USD 345,600; terms 2/10, n/30, FOB shipping
point, freight collect.
26 The company returned USD 57,600 of the merchandise purchased June 24 to the vendor for credit.
27 A trucking company was paid USD 7,200 for delivery to Rusk Company of the goods purchased June 24.
29 The company sold merchandise on account, USD 384,000; terms 2/10, n/30.
30 Sold merchandise for cash, USD 172,800.
30 Payment was received for the sale of June 15.
30 Paid store rent for June, USD 43,200.
30 Paid the amount due on the purchase of June 24.
The inventory on hand at the close of business June 30 was USD 672,000 at cost.
a. Prepare journal entries for the transactions.
b. Post the journal entries to the proper ledger accounts. Use the account numbers in the chart of accounts
shown in a separate file at the end of the text. Assume that all postings are from page 20 of the general journal.
c. Prepare a trial balance as of 2010 June 30.
d. Prepare a classified income statement for the month ended 2010 June 30. No adjusting entries are needed.
Problem D The Western Wear Company, a wholesaler of western wear clothing, sells to retailers. The company
entered into the following transactions in May 2010:
May 1 The Western Wear Company was organized as a corporation. The stockholders purchased stock at par for
the following assets in the business: USD 462,000 cash, USD 168,000 merchandise, and USD 105,000 land.
1 Paid rent on administrative offices for May, USD 25,200.
5 The company purchased merchandise from Carl Company on account, USD 189,000; terms 2/10, n/30.
Freight terms were FOB shipping point, freight collect.
8 Cash of USD 8,400 was paid to a trucking company for delivery of the merchandise purchased May 5.
14 The company sold merchandise on account, USD 315,000; terms 2/10, n/30.
15 Paid Carl Company the amount due on the purchase of May 5.
16 Of the merchandise sold May 14, USD 13,860 was returned for credit.
19 Salaries for services received were paid for May as follows: office employees, USD 16,800; salespersons, USD
33,600.
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24 The company collected the amount due on USD 126,000 of the accounts receivable arising from the sale of
May 14.
25 The company purchased merchandise on account from Bond Company, USD 151,200; terms 2/10, n/30.
Freight terms were FOB shipping point, freight collect.
27 Of the merchandise purchased May 25, USD 25,200 was returned to the vendor.
28 A trucking company was paid USD 2,100 for delivery to The Western Wear Company of the goods purchased
May 25.
29 The company sold merchandise on open account, USD 15,120; terms 2/10, n/30.
30 Cash sales were USD 74,088.
30 Cash of USD 100,800 was received from the sale of May 14.
31 Paid Bond Company for the merchandise purchased on May 25, taking into consideration the merchandise
returned on May 27.
The inventory on hand at the close of business on May 31 is USD 299,040.
From the data given for The Western Wear Company:
a. Prepare journal entries for the transactions.
b. Post the journal entries to the proper ledger accounts. Use the account numbers in the chart of accounts
shown in a separate file at the end of the text. Assume that all postings are from page 15 of the general journal.
(There were no adjusting journal entries.)
c. Prepare a trial balance.
d. Prepare a classified income statement for the month ended 2010 May 31.
e. Prepare a classified balance sheet as of 2010 May 31.
Problem E The following data are for Leone Lumber Company:
LEONE LUMBER COMPANY Trial Balance
2010 December 31 Acct. No.
Account Title Debits Credits
100 103 105 107 108 112 170 171 200 300 310 410 412 418 500 502 503 505 508 509 510 511 536 540 567
Cash Accounts Receivable Merchandise Inventory, 2010 January 1 Supplies on Hand Prepaid Insurance Prepaid Rent Equipment Accumulated Depreciation—Equipment Accounts Payable Capital Stock Retained Earnings, 2010 January 1 Sales Sales Returns and Allowances Interest Revenue Purchases Purchases Returns and Allowances Transportation-In Advertising Expense Sales Salaries Expense Office Salaries Expense Officers' Salaries Expense Utilities Expense Legal and Accounting Expense Interest Expense Miscellaneous Administrative Expense
$ 70,640 159,520 285,200 5,360 4,800 57,600 88,000
5,160 $ 500,840 $7,840 78,000 138,400 80,800 160,000 4,800 10,000 600 9,880
$ 17,600 102,800 200,000 219,640 1,122,360 $ 1,000 $4,040
$1,667,440 $1,667,440
• A total of USD 3,400 of the prepaid insurance has expired.
• An inventory of supplies showed that USD 1,700 are still on hand.
Accounting Principles: A Business Perspective 272 A Global Text
6. Merchandising transactions
• Prepaid rent expired during the year is USD 50,600.
• Depreciation expense on store equipment is USD 8,800.
• Accrued sales salaries are USD 4,000.
• Accrued office salaries are USD 3,000.
• Merchandise inventory on hand is USD 350,000.
Prepare the following:
a. A work sheet for the year ended 2010 December 31. Refer to the chart of accounts shown in a separate file at
the end of the text for any other account numbers you need.
b. A classified income statement. The only selling expenses are sales salaries, advertising, supplies, and
depreciation expense—equipment.
c. A statement of retained earnings.
d. A classified balance sheet.
e. Required closing entries.
Alternate problems
Alternate problem A a. Candle Carpet Company engaged in the following transactions in August 2010:
Aug. 2 Sold merchandise on account for USD 300,000; terms 2/10, n/30, FOB shipping point, freight collect.
18 Received payment for the sale of August 2.
20 A total of USD 10,000 of the merchandise sold on August 2 was returned, and a full refund was made
because it was the wrong merchandise.
28 An allowance of USD 16,000 was granted on the sale of August 2 because some merchandise was found to be
damaged; USD 16,000 cash was returned to the customer.
b. Lee Furniture Company engaged in the following transactions in August 2010:
Aug. 4 Purchased merchandise on account at a cost of USD 140,000; terms 2/10, n/30, FOB shipping point,
freight collect.
6 Paid freight of USD 2,000 on the purchase of August 4.
10 Sold goods for USD 100,000; terms 2/10, n/30.
12 Returned USD 24,000 of the merchandise purchased on August 4.
14 Paid the amount due on the purchase of August 4.
Prepare journal entries for the transactions.
Alternate problem B Edwardo Auto Parts Company and Spoon Company engaged in the following
transactions with each other during August 2010:
Aug.15 Edwardo Auto Parts Company purchased merchandise on account with a list price of USD 192,000 from
Spoon Company. Trade discounts of 20 per cent and 10 per cent were allowed. Terms were 2/10, n/30, FOB
destination, freight prepaid.
16 The seller paid the freight charges, USD 2,400.
17 The buyer requested an allowance of USD 4,512 against the amount due because the goods were damaged in
transit.
20 The seller granted the allowance requested on August 17.
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The buyer paid the amount due on the last day of the discount period. Record all of the entries required on the
books of both the buyer and the seller.
Alternate problem C Gardner Company engaged in the following transactions in June 2010, the company's
first month of operations:
June 1 Stockholders invested USD 384,000 cash and USD 144,000 of merchandise inventory in the business in
exchange for capital stock.
3 Merchandise was purchased on account, USD 192,000; terms 2/10, n/30, FOB shipping point, freight collect.
4 Paid height on the June 3 purchase, USD 5,280.
7 Merchandise was purchased on account, USD 96,000; terms 2/10, n/30, FOB destination, freight prepaid.
10 Sold merchandise on account, USD 230,400; terms 2/10, n/30, FOB shipping point, freight collect.
11 Returned USD 28,800 of the merchandise purchased on June 3.
12 Paid the amount due on the purchase of June 3.
13 Sold merchandise on account, USD 240,000; terms 2/10, n/30, FOB destination, height prepaid.
14 Paid height on sale of June 13, USD 14,400.
20 Paid the amount due on the purchase of June 7.
21 USD 48,000 of the goods sold on June 13 were returned for credit.
22 Received the amount due on sale of June 13.
25 Received the amount due on sale of June 10.
29 Paid rent for the administration building for June, USD 19,200.
30 Paid sales salaries of USD 57,600 for June.
30 Purchased merchandise on account, USD 48,000; terms 2/10, n/30, FOB destination, freight prepaid.
The inventory on hand on June 30 was USD 288,000.
a. Prepare journal entries for the transactions.
b. Post the journal entries to the proper ledger accounts. Use the account numbers in the chart of accounts
shown in a separate file at the end of the text. Assume that all postings are from page 10 of the general journal.
c. Prepare a trial balance as of 2010 June 30.
d. Prepare a classified income statement for the month ended 2010 June 30. No adjusting entries are needed.
Alternate problem D Organized on 2010 May 1, Noah Cabinet Company engaged in the following
transactions:
May 1 The stockholders invested USD 900,000 in this new business by purchasing capital stock.
1 Purchased merchandise on account from String Company, USD 46,800; terms n/60, FOB shipping point,
freight collect.
3 Sold merchandise for cash, USD 28,800.
6 Paid transportation charges on May 1 purchase, USD 1,440 cash.
7 Returned USD 3,600 of merchandise to String Company due to improper size.
10 Requested and received an allowance of USD 1,800 from String Company for improper quality of certain
items.
14 Sold merchandise on account to Texas Company, USD 18,000; terms 2/20, n/30, FOB shipping point, freight
collect.
16 Issued cash refund for return of merchandise relating to sale made on May 3, USD 180.
Accounting Principles: A Business Perspective 274 A Global Text
6. Merchandising transactions
18 Purchased merchandise on account from Tan Company invoiced at USD 28,800; terms 2/15, n/30, FOB
shipping point, freight collect.
18 Received a bill for freight charges of USD 900 from Ball Trucking Company on the purchase from Tan
Company.
19 Texas Company returned USD 360 of merchandise purchased on May 14.
24 Returned USD 2,880 of defective merchandise to Tan Company. Received full credit.
28 Texas Company remitted balance due on sale of May 14.
31 Paid Tan Company for the purchase of May 18 after adjusting for transaction of May 24.
31 Paid miscellaneous selling expenses of USD 7,200.
31 Paid miscellaneous administrative expenses of USD 10,800.
The May 31st inventory is USD 57,600. From the data for Noah Cabinet Company:
a. Journalize the transactions. Round all amounts to the nearest dollar.
b. Post the entries to the proper ledger accounts. Use the account numbers appearing in the chart of account
shown in a separate file at the end of the text. Assume all postings are from page 5 of the general journal.
(There were no adjusting journal entries.)
c. Prepare a trial balance.
d. Prepare a classified income statement for the month ended 2010 May 31.
Alternate problem E The following data are for Bayer Lamp Company:
Bayer Lamp Company Trial Balance 2010 December 31
Acct. Account Title Debits Credits
No.
100 Cash $ 228,800
103 Accounts Receivable 193,200
105 Merchandise Inventory, 2010 January 1 166,400
108 Prepaid Insurance 11,600
130 Land 240,000
140 Building 440,000
141 Accumulated Depreciation – Building $ 132,000
174 Store Fixtures 222,400
175 Accumulated Depreciation – Store Fixtures 44,480
200 Accounts Payable 151,600
300 Capital Stock 400,000
310 Retained Earnings, 2010 January 1 480,720
410 Sales 2,206,000
411 Sales Discounts 14,800
412 Sales Returns and Allowances 8,000
418 Interest Revenue 1,600
500 Purchases 1,251,600
501 Purchases Discounts 10,400
502 Purchases Returns and Allowances 5,600
503 Transportation-In 29,200
505 Advertising Expense 48,000
508 Sales Salaries Expense 256,000
509 Office Salaries Expense 296,000
519 Delivery Expense 18,400
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540 Interest Expense 8,000
$ 3,432,400 $ 3,432,400
• Depreciation expense on the store building is USD 8,800.
• Depreciation expense on the store fixtures is USD 22,240.
• Accrued sales salaries are USD 5,600.
• Insurance expired in 2010 is USD 10,000.
• Cost of merchandise inventory on hand 2010 December 31, is USD 222,000.
Prepare the following:
a. A work sheet for the year ended 2010 December 31. Refer to the chart of accounts shown in a separate file at
the end of the text for any other account numbers you need.
b. A classified income statement. The only administrative expenses are office salaries and insurance. The
building depreciation is on the store building.
c. A statement of retained earnings.
d. A classified balance sheet.
e. The required closing entries.
Beyond the numbers—Critical thinking
Business decision case A Candy's Shirts, Inc., has an opportunity to purchase 40,000 shirts with the logo of
her favorite school in January 2009. Candy, who is not currently in business, is considering buying these shirts and
then renting a display cart from which to sell these shirts (called a kiosk) in a shopping mall. Based on the following
information and estimates, Candy needs to decide if the business would be profitable:
• Cost of the 40,000 shirts, all of which must be purchased in January 2009, is USD 440,000.
• Candy thinks it would take two years to sell all of the shirts. She estimates her sales at 25,000 shirts in
2009 and 15,000 shirts in 2010.
• Rent of the kiosk would be USD 1,500 per month in 2009 and USD 1,600 per month in 2010.
• Candy can buy some counters on which to display the merchandise for USD 4,000. She could sell the
counters for USD 500 at the end of the second year.
• Candy estimates the cost to decorate her kiosk would be USD 2,500.
• Candy would hire employees and pay them USD 1 per shirt sold.
• Candy plans to sell the shirts for USD 17 each.
• Candy and her husband purchased USD 100,000 of capital stock in the business. Therefore, she plans to
borrow USD 400,000 from their family banker. Interest expense on this loan will be USD 52,000 in 2009 and
USD 6,500 in 2010. Candy plans to repay USD 300,000 on 2010 January 2, and the remaining USD 100,000
on 2010 July 1
• Candy needs to rent some storage space because all 40,000 shirts cannot be stored at the kiosk. Storage
space costs USD 2,500 per year.
a. Prepare estimated income statements for 2009 and 2010 for Candy's business. Does it appear that the
business will be profitable?
b. Will Candy have the cash available to pay the bank loan as she planned?
Accounting Principles: A Business Perspective 276 A Global Text
6. Merchandising transactions
Business decision case B In the Annual report appendix, refer to the consolidated statements of earnings for
The Limited's most recent three years. Calculate the gross margin percentage and write an explanation of what the
results mean for each of the three years.
Annual report analysis C Refer to the consolidated statements of income of The Limited in the Annual
report appendix. Identify the 2000, 1999, and 1998 net sales; cost of goods sold; gross profit; selling,
administrative, and general expenses; and operating income. Do the results present a favorable trend? Comment on
the results.
Ethics case – Writing experience D Based on the ethics case related to World Auto Parts Corporation,
respond in writing to the following questions:
a. Do you agree that the total impact of this practice could be as much as USD 10 million?
b. Are the small suppliers probably better off going along with the practice?
c. Is this practice ethical?
Group project E In teams of two or three students, go to the library (or find an annual report at
www.sec.gov/edgar.shtml) to locate one merchandising company's annual report for the most recent year. Calculate
the company's gross margin percentage for each of the most recent three years. As a team, write a memorandum to
the instructor showing your calculations and commenting on the results. The heading of the memorandum should
contain the date, to whom it is written, from whom, and the subject matter.
Group project F In a team of two or three students, contact a variety of businesses in your area and inquire as
to the types of sales discount terms they offer to credit customers and the types of purchase discount terms they are
offered by their suppliers. Calculate the approximate annual rate of interest implied in several of the more common
discount terms. For instance, the book states that the implied annual rate of interest on terms of 2/10, n/30 is 36
per cent, assuming we use a 360-day year. Present your findings in a written report to your instructor.
Group project G In a team of two or three students, obtain access to several annual reports of companies in
different industries (see www.sec.gov/edgar.shtml.) Examine their income statements and identify differences in
their formats. Discuss these differences within your group and then present your findings in a report to your
instructor.
Using the Internet—A view of the real world
Visit the Fat Brains Toys website at:
http://fatbraintoys.com website
Browse around the site for interesting information. What products do they sell? What journal entries would they
make to record sales of these products? Write a report to your instructor summarizing your experience at this site.
Answers to self-test
True-false
False. Sales discounts, as well as sales returns and allowances, are deducted from gross sales.
True. Under perpetual inventory procedure, the Merchandise Inventory account is debited for each purchase
and credited for each sale.
True. Purchase Discounts and Purchase Returns and Allowances are contra accounts to the Purchases account.
The balances of those accounts are deducted from purchases to arrive at net purchases.
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False. Consigned goods delivered to another party for attempted sale are included in the ending inventory of
the company that sent the goods.
False. An unclassified income statement, not a classified income statement, has only two categories of items.
Multiple-choice
d. Trade discounts are not recorded on the books of either a buyer or a seller. In other words, the invoice price of
sales (purchases) is recorded: USD 4,000 X0.8=USD3,200
b. The cost of goods sold is computed as follows:
Beginning inventory $60,000 Net cost of purchases 240,000 Cost of goods available for sale $ 300,000 Ending inventory 72,000 Cost of goods sold $228,000
b. Purchase discounts are based on invoice prices less purchase returns and allowances, if any.
Purchase discount=USD12,000−USD2,000X0.02=USD 200
e. All of the sections mentioned in (a-d) appear in a classified income statement. Current assets appear on a
classified balance sheet.
b. Merchandise Inventory is debited for the cost of ending inventory.
You may close debit balanced accounts (in the income statement) before credit balanced accounts. This practice
does not affect the balance of the Income Summary account or the amount of net income.
Accounting Principles: A Business Perspective 278 A Global Text
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7. Measuring and reporting inventories
Learning objectives
After studying this chapter, you should be able to:
• Explain and calculate the effects of inventory errors on certain financial statement items.
• Indicate which costs are properly included in inventory.
• Calculate cost of ending inventory and cost of goods sold under the four major inventory costing methods
using periodic and perpetual inventory procedures.
• Explain the advantages and disadvantages of the four major inventory costing methods.
• Record merchandise transactions under perpetual inventory procedure.
• Apply net realizable value and the lower-of-cost-or-market method of inventory.
• Estimate cost of ending inventory using the gross margin and retail inventory methods.
• Analyze and use the financial results- inventory turnover ratio.
Choosing an accounting career
Chapter 7 discusses how companies have a choice in inventory cost methods between specific identification,
FIFO, LIFO, and weighted-average. Similarly, one of the greatest benefits of obtaining an accounting degree is the
broad range of career choices available. There are over 40 different types of accounting jobs available in public
accounting, private industry, and governmental accounting. For example, check out the list of accounting jobs at:
http://www.uncwil.edu/stuaff/career/Majors/accounting.htm#related careertitles.
One of the primary reasons many students go into accounting is successful job placement. Accounting majors
have been better able to find positions than majors in any of the other business options, with the possible exception
of management information systems (MIS). Even the relative demand for MIS majors has diminished recently,
while the demand for accounting majors remains strong. We are currently experiencing a shortage of accounting
majors across the nation. Another important factor to keep in mind regarding job placement is where you would
like to be three to five years from now. Accounting offers an excellent foundation with opportunities for
advancement, whereby many accounting graduates make double their entry-level salary in only five years.
Many students pursue an accounting degree because it does not restrict their career opportunities as much as
having a different business degree. For example, with an accounting degree, a student can apply for positions in
management, marketing, and finance, as well as accounting. In fact, many recruiters in business favor accounting
graduates because they recognize an accounting degree as a more difficult business degree to obtain. However,
management, marketing, and finance students cannot apply for accounting positions because they lack necessary
accounting coursework. In fact, with some additional courses in systems, an accounting major is well equipped to
pursue a career in any business field including information systems.
Accounting Principles: A Business Perspective 279 A Global Text
7. Measuring and reporting inventories
Have you ever taken advantage of a pre-inventory sale at your favorite retail store? Many stores offer bargain
prices to reduce the merchandise on hand and to minimize the time and expense of taking the inventory. A smaller
inventory also enhances the probability of taking an accurate inventory since the store has less merchandise to
count. From Chapter 6 you know that companies use inventory amounts to determine the cost of goods sold; this
major expense affects a merchandising company's net income. In this chapter, you learn how important inventories
are in preparing an accurate income statement, statement of retained earnings, and balance sheet.
This chapter discusses merchandise inventory carried by merchandising retailers and wholesalers.
Merchandise inventory is the quantity of goods held by a merchandising company for resale to customers.
Merchandising companies determine the quantity of inventory items by a physical count.
The merchandise inventory figure used by accountants depends on the quantity of inventory items and the cost
of the items. This chapter discusses four accepted methods of costing the items: (1) specific identification; (2) first-
in, first-out (FIFO); (3) last-in, first-out (LIFO); and (4) weighted-average. Each method has advantages and
disadvantages.
This chapter stresses the importance of having accurate inventory figures and the serious consequences of using
inaccurate inventory figures. When you finish this chapter, you should understand how taking inventory connects
with the cost of goods sold figure on the store's income statement, the retained earnings amount on the statement
of retained earnings, and both the inventory figure and the retained earnings amount on the store's balance sheet.
Inventories and cost of goods sold
Inventory is often the largest and most important asset owned by a merchandising business. The inventory of
some companies, like car dealerships or jewelry stores, may cost several times more than any other asset the
company owns. As an asset, the inventory figure has a direct impact on reporting the solvency of the company in
the balance sheet. As a factor in determining cost of goods sold, the inventory figure has a direct impact on the
profitability of the company's operations as reported in the income statement. Thus, the importance of the
inventory figure should not be underestimated.
Importance of proper inventory valuation
A merchandising company can prepare accurate income statements, statements of retained earnings, and
balance sheets only if its inventory is correctly valued. On the income statement, a company using periodic
inventory procedure takes a physical inventory to determine the cost of goods sold. Since the cost of goods sold
figure affects the company's net income, it also affects the balance of retained earnings on the statement of retained
earnings. On the balance sheet, incorrect inventory amounts affect both the reported ending inventory and retained
earnings. Inventories appear on the balance sheet under the heading "Current Assets", which reports current assets
in a descending order of liquidity. Because inventories are consumed or converted into cash within a year or one
operating cycle, whichever is longer, inventories usually follow cash and receivables on the balance sheet.
Recall that under periodic inventory procedure we determine the cost of goods sold figure by adding the
beginning inventory to the net cost of purchases and deducting the ending inventory. In each accounting period, the
appropriate expenses must be matched with the revenues of that period to determine the net income. Applied to
inventory, matching involves determining (1) how much of the cost of goods available for sale during the period
should be deducted from current revenues and (2) how much should be allocated to goods on hand and thus carried
forward as an asset (merchandise inventory) in the balance sheet to be matched against future revenues. Because
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we determine the cost of goods sold by deducting the ending inventory from the cost of goods available for sale, a
highly significant relationship exists: Net income for an accounting period depends directly on the valuation of
ending inventory. This relationship involves three items:
First, a merchandising company must be sure that it has properly valued its ending inventory. If the ending
inventory is overstated, cost of goods sold is understated, resulting in an overstatement of gross margin and net
income. Also, overstatement of ending inventory causes current assets, total assets, and retained earnings to be
overstated. Thus, any change in the calculation of ending inventory is reflected, dollar for dollar (ignoring any
income tax effects), in net income, current assets, total assets, and retained earnings.
Second, when a company misstates its ending inventory in the current year, the company carries forward that
misstatement into the next year. This misstatement occurs because the ending inventory amount of the current year
is the beginning inventory amount for the next year.
Third, an error in one period's ending inventory automatically causes an error in net income in the opposite
direction in the next period. After two years, however, the error washes out, and assets and retained earnings are
properly stated.
Exhibit 44 and Exhibit 45 prove that net income for an accounting period depends directly on the valuation of
the inventory. Allen Company's income statements and the statements of retained earnings for years 2009 and
2010 show this relationship.
ALLEN COMPANY For Year Ended 2009 December 31
Ending Inventory Ending Inventory Overstated
Income Statement Correctly Stated By $5,000 Sales $400,000 $400,000 Cost of goods available for sale $300,000 $300,000 Ending inventory 35,000 40,000 Cost of goods sold 265,000 260,000 Gross margin $135,000 $140,000 Other expenses $85,000 85,000 Net income $ 50,000 $55,000 Statement of Retained Earnings Beginning retained earnings $120,000 $120,000 Net income 50,000 55,000 Ending retained earnings $170,000 $175,000
Exhibit 44: Effects of an overstated ending inventory
ALLEN COMPANY For Year Ended 2010 December 31
Beginning Beginning Inventory Inventory Overstated
Income Statement Correctly Stated By $5,000 Sales $425,000 $425,000 Beginning inventory $ 35,000 $40,000 Purchases 290,000 290,000 Cost of goods available for sale $325,000 $330,000 Ending inventory 45,000 45,000 Cost of goods sold 280,000 285,000 Gross margin $145,000 $140,000 Other expenses 53,500 53,500 Net income $ 91,500 $ 86,500 Statement of Retained Earnings Beginning retained earnings $170,000 $175,000 Net income 91,500 86,500 Ending retained earnings $261,500 $261,500
Exhibit 45: Effects of an overstated beginning inventory
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7. Measuring and reporting inventories
In Exhibit 44 the correctly stated ending inventory for the year 2009 is USD 35,000. As a result, Allen has a
gross margin of USD 135,000 and net income of USD 50,000. The statement of retained earnings shows a
beginning retained earnings of USD 120,000 and an ending retained earnings of USD 170,000. When the ending
inventory is overstated by USD 5,000, as shown on the right in Exhibit 44, the gross margin is USD 140,000, and
net income is USD 55,000. The statement of retained earnings then has an ending retained earnings of USD
175,000. The ending inventory overstatement of USD 5,000 causes a USD 5,000 overstatement of net income and a
USD 5,000 overstatement of retained earnings. The balance sheet would show both an overstated inventory and an
overstated retained earnings. Due to the error in ending inventory, both the stockholders and creditors may
overestimate the profitability of the business.
Exhibit 45 is a continuation of Exhibit 44 and contains Allen's operating results for the year ended 2010
December 31. Note that the ending inventory in Exhibit 44 now becomes the beginning inventory of Exhibit 45.
However, Allen's inventory at 2010 December 31, is now an accurate inventory of USD 45,000. As a result, the
gross margin in the income statement with the beginning inventory correctly stated is USD 145,000, and Allen
Company has net income of USD 91,500 and an ending retained earnings of USD 261,500. In the income statement
columns at the right, in which the beginning inventory is overstated by USD 5,000, the gross margin is USD
140,000 and net income is USD 86,500, with the ending retained earnings also at USD 261,500.
Thus, in contrast to an overstated ending inventory, resulting in an overstatement of net income, an overstated
beginning inventory results in an understatement of net income. If the beginning inventory is overstated, then cost
of goods available for sale and cost of goods sold also are overstated. Consequently, gross margin and net income
are understated. Note, however, that when net income in the second year is closed to retained earnings, the
retained earnings account is stated at its proper amount. The overstatement of net income in the first year is offset
by the understatement of net income in the second year. For the two years combined the net income is correct. At
the end of the second year, the balance sheet contains the correct amounts for both inventory and retained
earnings. Exhibit 46 summarizes the effects of errors of inventory valuation:
Ending Inventory Beginning Inventory
Understated Overstated Understated Overstated
Cost of good sold Overstated Understated Understated Overstated
Net income Understated Overstated Overstated Understated
Exhibit 46: Inventory errors
Determining inventory cost
To place the proper valuation on inventory, a business must answer the question: Which costs should be
included in inventory cost? Then, when the business purchases identical goods at different costs, it must answer the
question: Which cost should be assigned to the items sold? In this section, you learn how accountants answer these
questions.
The costs included in inventory depend on two variables: quantity and price. To arrive at a current inventory
figure, companies must begin with an accurate physical count of inventory items. They multiply the quantity of
inventory by the unit cost to compute the cost of ending inventory. This section discusses the taking of a physical
inventory and the methods of costing the physical inventory under both perpetual and periodic inventory
procedures. The remainder of the chapter discusses departures from the cost basis of inventory measurement.
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As briefly described in Chapter 6, to take a physical inventory, a company must count, weigh, measure, or
estimate the physical quantities of the goods on hand. For example, a clothing store may count its suits; a hardware
store may weigh bolts, washers, and nails; a gasoline company may measure gasoline in storage tanks; and a
lumberyard may estimate quantities of lumber, coal, or other bulky materials. Throughout the taking of a physical
inventory, the goal should be accuracy.
Taking a physical inventory may disrupt the normal operations of a business. Thus, the count should be
administered as quickly and as efficiently as possible. The actual taking of the inventory is not an accounting
function; however, accountants often plan and coordinate the count. Proper forms are required to record accurate
counts and determine totals. Identification names or symbols must be chosen, and those persons who count, weigh,
or measure the inventory items must know these symbols.
Inventory Tag
JMA Corp.
Inventory Tag No. 281 Date
Description
Location
Quantity Counted
Counted by
Checked by
Duplicate Inventory Tag
Inventory Tag No. 281 Date
Description
Location
Quantity Counted
Counted by
Checked by
Exhibit 47: Inventory tag
Taking a physical inventory often involves using inventory tags, such as that in Exhibit 47. These tags are
consecutively numbered for control purposes. A tag usually consists of a stub and a detachable duplicate section.
The duplicate section facilitates checking discrepancies. The format of the tags can vary. However, the tag usually
provides space for (1) a detailed description and identification of inventory items by product, class, and model; (2)
location of items; (3) quantity of items on hand; and (4) initials of the counters and checkers.
The descriptive information and count may be entered on one copy of the tag by one team of counters. Another
team of counters may record its count on the duplicate copy of the tag. Discrepancies between counts of the same
items by different teams are reconciled by supervisors, and the correct counts are assembled on intermediate
inventory sheets. Only when the inventory counts are completed and checked does management send the final
sheets to the accounting department for pricing and extensions (quantity X price). The tabulated result is the dollar
amount of the physical inventory. Later in the chapter we explain the different methods accountants use to cost
inventory.
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7. Measuring and reporting inventories
Usually, inventory cost includes all the necessary outlays to obtain the goods, get the goods ready to sell, and
have the goods in the desired location for sale to customers. Thus, inventory cost includes:
• Seller's invoice price less any purchase discount.
• Cost of the buyer's insurance to cover the goods while in transit.
• Transportation charges when borne by the buyer.
• Handling costs, such as the cost of pressing clothes wrinkled during shipment.
In theory, the cost of each unit of inventory should include its net invoice price plus its share of other costs
incurred in shipment. The 1986 Tax Reform Act requires companies to assign these costs to inventory for tax
purposes. For accounting purposes, these cost assignments are recommended but not required.
Practical difficulties arise in allocating some of these costs to inventory items. Assume, for example, that the
freight bill on a shipment of clothes does not separate out the cost of shipping one shirt. Also, assume that the
company wants to include the freight cost as part of the inventory cost of the shirt. Then, the freight cost would
have to be allocated to each unit because it cannot be measured directly. In practice, allocations of freight,
insurance, and handling costs to the individual units of inventory purchased are often not worth the additional cost.
Consequently, in the past many companies have not assigned the costs of freight, insurance, and handling to
inventory. Instead, they have expensed these costs as incurred. When companies omit these costs from both
beginning and ending inventories, they minimize the effect of expensing these costs on net income. The required
allocation for tax purposes has probably resulted in many companies using the same inventory amounts in their
financial statements.
Even if a company derives a cost for each unit in inventory, the inventory valuation problem is not solved.
Management must consider two other aspects of the problem:
• If goods were purchased at varying unit costs, how should the cost of goods available for sale be allocated
between the units sold and those that remain in inventory? For example, assume Hi-Fi Buys, Inc.,
purchased two identical DVD players for resale. One cost USD 250 and the other, USD 200. If one was sold
during the period, should Hi-Fi Buys assign it a cost of USD 250, USD 200, or an average cost of USD 225?
• Does the fact that current replacement costs are less than the costs of some units in inventory have any
bearing on the amount at which inventory should be carried? Using the same example, if Hi-Fi Buys can
currently buy all DVD players for USD 200, is it reasonable to carry some units in inventory at USD 250
rather than USD 200?
We answer these questions in the next section.
Generally companies should account for inventories at historical cost; that is, the cost at which the items were
purchased. However, this rule does not indicate how to assign costs to ending inventory and to cost of goods sold
when the goods have been purchased at different unit costs. For example, suppose a retailer has three shirts on
hand. One costs USD 20; another, USD 22; and a third, USD 24. If the retailer sells two shirts for USD 30 each,
what is the cost of the two shirts sold?
Accountants developed these four inventory costing methods to solve costing problems: (1) specific
identification; (2) first-in, first-out (FIFO); (3) last-in, first-out (LIFO); and (4) weighted-average. Before explaining
the inventory costing methods, we briefly introduce perpetual inventory procedure and compare periodic and
perpetual inventory procedures.
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In Chapter 6, the emphasis was on periodic inventory procedure. Under periodic inventory procedure, firms
debit the Purchases account when goods are acquired; they use other accounts, such as Purchase Discounts,
Purchase Returns and Allowances, and Transportation-In, for purchase-related transactions. Companies determine
cost of goods sold only at the end of the period as the difference between cost of goods available for sale and ending
inventory. They keep no records of the cost of items as they are sold, and have no information on possible inventory
shortages. They assume any goods not in ending inventory have been sold.
Accounting Principles: A Business Perspective 285 A Global Text
Item TV-96874 Maximum 26
Location Minimum 6
Purchased Sold Balance
2008 Date Units
Unit Cost
Total Cost Units
Unit Cost
Total Cost Units
Unit Cost
Total Cost
Beg. inv. 8 $300 $2,400
July 5 10 $300 $3,000 18 300 5,400
7 12 $300 $3,600 6 300 1,800
12 10 315 3,150 6 300 1,800
22 6 300 1,800 10 315 3,150
2 315 630
24 8 320 2,560 8 315 315
2,520 2,520
8 320 2,560
Exhibit 48: Perpetual inventory record (FIFO menthod)
The availability of inventory management software packages is causing more and more businesses to change
from periodic to perpetual inventory procedure. Under perpetual inventory procedure, companies have no
Purchases and purchase-related accounts. Instead, they make all entries involving merchandise purchased for sale
to customers directly in the Merchandise Inventory account. Thus, they debit or credit Merchandise Inventory in
place of debiting or crediting Purchases, Purchase Discounts, Purchase Returns and Allowances, and
Transportation-In. At the time of each sale, firms make two entries: the first debits Accounts Receivable or Cash
and credits Sales at the retail selling price. The second debits Cost of Goods Sold and credits Merchandise Inventory
at cost. Therefore, at the end of the period the Merchandise Inventory account shows the cost of the inventory that
should be on hand. Comparison of this amount with the cost obtained by taking and pricing a physical inventory
may reveal inventory shortages. Thus, perpetual inventory procedure is an important element in providing internal
control over goods in inventory.
Perpetual inventory records Even though companies could apply perpetual inventory procedure manually,
tracking units and dollars in and out of inventory is much easier using a computer. Both manual and computer
processing maintain a record for each item in inventory. Look at Exhibit 48, an inventory record for Entertainment
World, a firm that sells many different brands of television sets. This inventory record shows the information on
one particular brand and model of television set carried in inventory. Other information on the record includes (1)
the maximum and minimum number of units the company wishes to stock at any time, (2) when and how many
units were acquired and at what cost, and (3) when and how many units were sold and what cost was assigned to
cost of goods sold. The number of units on hand and their cost are readily available also. Entertainment World
assumes that the first units acquired are the first units sold. This assumption is the first-in, first-out (FIFO) method
of inventory costing; we will discuss it later.
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An accounting perspective:
Uses of technology
Keeping track of inventories under a perpetual inventory system is much more cost-effective with
computers. Under a manual system, the cost of an up-to-date inventory for stores with high
turnover would outweigh the benefit. Most retail stores use scanning devices to read the inventory
numbers of products purchased at the cash register. These bar codes not only provide accurate
sales prices but also record the merchandise sold so that the total cost of the store's inventory is up
to date.
The following comparison reveals several differences between accounting for inventories under periodic and
perpetual procedures. We explain these differences by using data from Exhibit 48 and making additional
assumptions. Later, we discuss other journal entries under perpetual inventory procedure.
These entries record the purchase on July 5 under each of the methods:
Periodic Procedure Perpetual Procedure Purchases (+A) Accounts Payable (+L)
3,000 3,000
Merchandise Inventory (+A) Accounts Payable (+L)
3,000 3,000
Assuming the merchandise sold on July 7 was priced at USD 4,800, these entries record the sale:
Periodic Procedure Perpetual Procedure Accounts Receivable (+A) 4,800 Accounts Receivable (+A) 4,800 Sales (+SE) 4,800 Sales (+SE) 4,800
Cost of Goods Sold (-SE) 3,600 Merchandise Inventory(-A) 3,600
Several other transactions not included in Exhibit 48 could occur:
• Assume that two of the units purchased on July 5 were returned to the supplier because they were defective.
The entries would be:
Periodic Procedure Perpetual Procedure Accounts Payable 600 Accounts Payable 600 Purchase Merchandise Returns and Inventory 600 Allowances 600
• Assume that the supplier instead granted an allowance of USD 600 to the company because of the defective
merchandise. The entries would be:
Periodic Procedure Perpetual Procedure Accounts Payable (-L) 600 Accounts Payable (-L) 600 Purchase Merchandise Returns and Inventory (-A) 600 Allowances (-A) 600
• Assume that the company incurred and paid freight charges of USD 100 on the purchase of July 5. The
entries would be:
Periodic Procedure Perpetual Procedure Transportation-In (+A) Cash (-A)
100 100
Merchandise Inventory (+A) Cash (-A)
100 100
In these entries, notice that under perpetual inventory procedure the Merchandise Inventory account records
purchases, purchase returns and allowances, purchase discounts, and transportation-in. Also, when goods are sold,
the seller debits (increases) Cost of Goods Sold and credits or reduces Merchandise Inventory.
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At the end of the accounting period, under perpetual inventory procedure, the only merchandise-related expense
account to be closed is Cost of Goods Sold. The Purchases, Purchase Returns and Allowances, Purchase Discounts,
and Transportation-In accounts do not even exist.
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Beginning Inventory and Purchases Sales
Unit Total
Date Units Cost Cost Date Units Price Total
Beginning inventory
10 $8.00 $ 80 March 10 10 $12.00 $120
March 2 10 8.50 85 July 14 20 12.00 240
May 28 20 8.40 168 September 7 10 14.00 140
August 12 10 9.00 90 November 22 20 14.00 280
October 12 20 8.80 176
December 21 10 9.10 91
80 $690 60 $780
Ending inventory = 20 units, determined By taking a physical inventory.
Exhibit 49: Beginning inventory, purchases and sales
An accounting perspective:
Business insight
When you buy a box of breakfast cereal at the supermarket, the cashier scans the bar code on the
box. The name of the item and the price appear on a video display that you can see. The
information is also printed on the sales slip so that you can later compare the items paid for with
the items received. But this is not the end of the story. The information is also fed to the store's
computer to update the inventory records. The information is included with other information and
is used to order more merchandise from the warehouse so the items can be replenished in the
store. At a certain point, the company also uses the reduced inventory levels to order more
merchandise from suppliers, such as wholesalers that supply the region with breakfast cereals and
other goods. The paperwork for the purchase and payment are often handled electronically
through a process called electronic data interchange (EDI) and electronic funds transfer (EFT).
Using the data for purchases, sales, and beginning inventory in Exhibit 49, next we explain the four inventory
costing methods. Except for the specific identification method, we first present all of the methods using periodic
inventory procedure and then present all of the methods using perpetual inventory procedure. Total goods available
for sale consist of 80 units with a total cost of USD 690. A physical inventory determined that 20 units are on hand
at the end of the period. Sales revenue for the 60 units sold was USD 780. The questions to be answered are: What
is the cost of the 20 units in inventory? What is the cost of the 60 units sold?
Specific identification The specific identification method of inventory costing attaches the actual cost to
an identifiable unit of product. Firms find this method easy to apply when purchasing and selling large inventory
items such as autos. Under the specific identification method, the firm must identify each unit in inventory, unless
it is unique, with a serial number or identification tag.
To illustrate, assume that the company in Exhibit 49 can identify the 20 units on hand at year-end as 10 units
from the August 12 purchase and 10 units from the December 21 purchase. The company computes the ending
inventory as shown in Exhibit 50; it subtracts the USD 181 ending inventory cost from the USD 690 cost of goods
Accounting Principles: A Business Perspective 289 A Global Text
7. Measuring and reporting inventories
available for sale to obtain the USD 509 cost of goods sold. Note that you can also determine the cost of goods sold
for the year by recording the cost of each unit sold. The USD 509 cost of goods sold is an expense on the income
statement, and the USD 181 ending inventory is a current asset on the balance sheet.
The specific identification costing method attaches cost to an identifiable unit of inventory. The method does not
involve any assumptions about the flow of the costs as in the other inventory costing methods. Conceptually, the
method matches the cost to the physical flow of the inventory and eliminates the emphasis on the timing of the cost
determination. Therefore, periodic and perpetual inventory procedures produce the same results for the specific
identification method.
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Units Unit Cost
Total Cost
Ending inventory composed of purchases made on: August 12 10 $ 9.00 $ 90 December 21 10 9.10 91 Ending inventory 20 $181 Cost of goods sold composed of: Beginning inventory 10 8.00 $ 80 Purchases made on: March 2 10 8.50 85 May 28 20 8.40 168 October 12 20 8.80 176
$509 Cost of goods available for sale $690 Ending inventory 181 Cost of goods sold $509
Exhibit 50: Determining ending inventory under specific identification
FIFO (first-in, first-out) under periodic inventory procedure The FIFO (first-in, first-out) method
of inventory costing assumes that the costs of the first goods purchased are those charged to cost of goods sold
when the company actually sells goods. This method assumes the first goods purchased are the first goods sold. In
some companies, the first units in (bought) must be the first units out (sold) to avoid large losses from spoilage.
Such items as fresh dairy products, fruits, and vegetables should be sold on a FIFO basis. In these cases, an
assumed first-in, first-out flow corresponds with the actual physical flow of goods.
Because a company using FIFO assumes the older units are sold first and the newer units are still on hand, the
ending inventory consists of the most recent purchases. When using periodic inventory procedure, to determine the
cost of the ending inventory at the end of the period under FIFO, you would begin by listing the cost of the most
recent purchase. If the ending inventory contains more units than acquired in the most recent purchase, it also
includes units from the next-to-the-latest purchase at the unit cost incurred, and so on. You would list these units
from the latest purchases until that number agrees with the units in the ending inventory.
In Exhibit 51, you can see how to determine the cost of ending inventory under FIFO using periodic inventory
procedure. The company assumes that the 20 units in inventory consist of 10 units purchased December 21 and 10
units purchased October 12. The total cost of ending inventory is USD 179, and the cost of goods sold is USD 511.
We show the relationship between the cost of goods sold and the cost of ending inventory under FIFO using
periodic inventory procedure in Exhibit 52. The 80 units in cost of goods available for sale consists of the beginning
inventory and all of the purchases during the period. Under FIFO, the ending inventory of 20 units consists of the
most recent purchases—10 units of the December 21 purchase and 10 units of the October 12 purchase—costing
USD 179. We assume the beginning inventory and other earlier purchases have been sold during the period,
representing the cost of goods sold of USD 511.
Accounting Principles: A Business Perspective 291 A Global Text
7. Measuring and reporting inventories
Units Unit Cost
Total Cost
Ending inventory composed of purchases made on: December 21 10 $9.10 $ 91 October 12 10 8.80 88 Ending inventory 20 $179 Cost of goods sold composed of: Beginning inventory 10 8.00 $ 80 Purchases made on: March 2 10 8.50 85 May 28 20 8.40 168 August 12 10 9.00 90 October 12 10 8.80 88
$511 Cost of goods available for sale $690 Ending inventory 179 Cost of goods sold $511
Exhibit 51: Determining FIFO cost of ending inventory under periodic inventory procedure
Exhibit 52: FIFO flow of costs
LIFO (last-in, first-out) under periodic inventory procedure The LIFO (last-in, first-out) method of
inventory costing assumes that the costs of the most recent purchases are the first costs charged to cost of goods
sold when the company actually sells the goods.
In Exhibit 53, we show the use of LIFO under periodic inventory procedure. Since the company charges the
latest costs to cost of goods sold under periodic inventory procedure, the ending inventory always consists of the
oldest costs. Therefore, when determining the cost of inventory under periodic inventory procedure, the company
lists the oldest units and their costs. The first units listed are those in beginning inventory, then the first purchase,
and so on, until the number listed agrees with the units in ending inventory. Thus, ending inventory in Exhibit 53
consists of the 10 units from beginning inventory and the 10 units purchased on March 2. The total cost of these 20
units, USD 165, is the ending inventory cost; the cost of goods sold is USD 525. Exhibit 54 is a graphic
representation of the LIFO flow of costs under periodic inventory procedure.
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Units Unit Cost
Total Cost
Ending inventory composed of: Beginning inventory 10 $8.00 $ 80 March 2 purchase 10 8.50 85 Ending inventory 20 $165 Cost of goods sold composed of purchases made on: December 21 10 9.10 $ 91 October 12 20 8.80 176 August 12 10 9.00 90 May 28 20 8.40 168
$525 Cost of goods available for sale $690 Ending inventory 165 Cost of goods sold $525
Exhibit 53: Determining LIFO cost of ending inventory under periodic inventory procedure
Exhibit 54: LIFO flow of costs under periodic inventory procedure
Weighted-average under periodic inventory procedure The weighted-average method of inventory
costing is a means of costing ending inventory using a weighted-average unit cost. Companies most often use the
weighted-average method to determine a cost for units that are basically the same, such as identical games in a toy
store or identical electrical tools in a hardware store. Since the units are alike, firms can assign the same unit cost to
them.
Under periodic inventory procedure, a company determines the average cost at the end of the accounting period
by dividing the total units purchased plus those in beginning inventory into total cost of goods available for sale.
The ending inventory is carried at this per unit cost. To see how a company uses the weighted-average method to
determine inventory costs using periodic inventory procedure, look at Exhibit 55. Note that we compute weighted-
average cost per unit by dividing the cost of units available for sale, USD 690, by the total number of units available
for sale, 80. Thus, the weighted-average cost per unit is USD 8.625, meaning that each unit sold or remaining in
inventory is valued at USD 8.625.
Accounting Principles: A Business Perspective 293 A Global Text
7. Measuring and reporting inventories
Unit Total Units Cost Cost
Beginning inventory 10 $8.00 $ 80.00 Purchases March 2 10 8.50 85.00 May 28 20 8.40 168.00 August 12 10 9.00 90.00 October 12 20 8.80 176.00 December 21 10 9.10 91.00 Total 80 $690.00 Weighted-average unit cost is $690 / 80, or $8.625 Ending inventory then is $8.625 x 20 172.50 Cost of goods sold: $8.625 x 60 $517.50
Exhibit 55: Determining ending inventory under weighted-average method using periodic inventory procedure
Purchased Sold Balance
Unit Total Unit Total Unit Total
Date Units Cost Cost Units Cost Cost Units Cost Cost
Beg. inv. 10 $8.00 80
Mar. 2 10 $8.50 $85 10(A) 8.00 80
10 8.50 85
Mar. 10 10 $8.00 (A)$80 10 8.50 85
May 28 20 8.40 168 10(B) 8.50 85
20(C) 8.40 168
Sales are assumed to be from the oldest units on hand
July 14 10 8.50 (B)85
10 8.40 (C)85 10 8.40 84
Aug. 12 10 9.00 90 10(D) 8.40 84
10 9.00 90
Sept. 7 10 8.40 (D)84 10 9.00 90
Oct. 12 20 8.80 176 10(E) 9.00 90
20(F) 8.80 176
Nov. 22 10 9.00 (E)90
10 8.80 (F)88 10 8.80 88
Dec 21 10 9.10 91 10 8.80 88
10 9.10 91
Total of $179 would agree with balance already existing in Merchandise Inventory account.
Total cost of ending inventory = $179
Exhibit 56: Determining FIFO cost of ending inventory under perpetual inventory procedure
FIFO under perpetual inventory procedure Under perpetual inventory procedure, the ending balance in
the Merchandise Inventory account reflects the most recent purchases as a result of making the required entries
during the period. Also, the firm has already recorded the cost of goods sold in the Cost of Goods Sold account.
Exhibit 56 shows how to determine the cost of ending inventory under FIFO using perpetual inventory procedure.
This illustration uses the same format as the earlier perpetual inventory record in Exhibit 48. The company keeps a
record of the balance in the inventory account as it makes purchases and sells items from inventory.
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Purchased Sold Balance
Date Beg. inv.
Units Unit Cost
Total Cost
Units Unit Cost
Total Cost
Units Unit Cost $8.00
Total Cost 80
Mar. 2 10 $8.50 $85 10 10
8.00 8.50
80 85
Mar. 10 10 $8.50 85 10 8.00 80
May 28 20 8.40 168 10 20
8.00 8.40
80 168
Sales are assumed to be from most recent purchases
July 14 20 8.40 168 10 8.00 80
Aug.12 10 9.00 90 10 10
8.00 9.00
80 90
Sept. 7 10 9.00 90 10 8.00 80
Oct. 12 20 8.80 176 10 20
8.00 8.80
80 176
Nov. 22 20 8.80 176 10 8.00 80
Dec. 21 10 9.10 91 10 10
8.00 9.10
80 91
Total of $171 would agree with balance already existing in Merchandise Inventory account.
Total cost of ending inventory = $171
Exhibit 57: Determining LIFO cost of ending inventory under perpectual inventory procedure
Notice in Exhibit 56 that each time a sale occurs, the company assumes the items sold are the oldest on hand.
Thus, after each transaction, it can readily determine the balance in the Merchandise Inventory account from the
perpetual inventory record. The balance after the December 21 purchase represents the 20 units from the most
recent purchases. The total cost of ending inventory is USD 179, which the company reports as a current asset on
the balance sheet. During the accounting period, as sales occurred the firm would have debited a total of USD 511 to
Cost of Goods Sold. Adding this USD 511 to the ending inventory of USD 179 accounts for the USD 690 cost of
goods available for sale. Under FIFO, using either perpetual or periodic inventory procedures results in the same
total amounts for ending inventory and for cost of goods sold.
LIFO under perpetual inventory procedure Look at Exhibit 57 to see the LIFO method using perpetual
inventory procedure. Under this procedure, the inventory composition and balance are updated with each purchase
and sale. Notice in Exhibit 57 that each time a sale occurs, the items sold are assumed to be the most recent ones
acquired. Despite numerous purchases and sales during the year, the ending inventory still includes the 10 units
from beginning inventory in our example. The remainder of the ending inventory consists of the last purchase
because no sale occurred after the December 21 purchase. The total cost of the 20 units in ending inventory is USD
171; the cost of goods sold is USD 519. Exhibit 58 shows graphically the LIFO flow of costs under perpetual
inventory procedure.
Applying LIFO on a perpetual basis during the accounting period, as shown in Exhibit 57, results in different
ending inventory and cost of goods sold figures than applying LIFO only at year-end using periodic inventory
procedure. (Compare Exhibit 57 and Exhibit 53 to verify that ending inventory and cost of goods sold are different
under the two procedures.) For this reason, if LIFO is applied on a perpetual basis during the period, special
adjustments are sometimes necessary at year-end to take full advantage of using LIFO for tax purposes.
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7. Measuring and reporting inventories
Complicated applications of LIFO perpetual inventory procedures that require such adjustments are beyond the
scope of this text.
Exhibit 58: LIFO flow of costs under perpetual inventory procedure
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Purchased Sold Balance
Date Beg. inv.
Units Unit Cost
Total Cost
Units Unit Cost
Total Cost
Units 10
Unit Cost $8.00
Total Cost 80.00
Mar. 2 10 $8.50 $85 20 8.25aA 165.00
Mar. 10 10 $8.25 B $82.50 10 8.25 82.80
May 28 20 8.40 168 30 8.35b 250.50
July 14 20 8.35 167.00 10 8.35 83.50
Aug. 12 10 9.00 90 20 8.675c 173.50
Sept. 7 10 8.675 86.75 10 8.675 86.75
Oct. 12 20 8.80 176 30 8.758 c 262.75
Nov. 22 8.758 175.17 10 8.758 87.58
Dec 21 10 9.10 91 20 $8.929e $178.58C
a$165.00/2 0 e$175.58/2 0
= $8.25. b$250.50/30 = $8.35. c$173.50/20 = $8.929 * rounding difference.
= $8.675. d$262.75/30 = $8.758.
A A new unit cost is calculated after each purchase. BThe unit cost of sales is the most recently calculated cost. C Balance of $178.58 would agree with balance already existing in the Merchandise Inventory account.
Exhibit 59: Determining ending inventory under weighted-average method using perpetual inventory procedure
Look at Exhibit 58 and Exhibit 54, the flow of inventory costs under LIFO using both the perpetual and periodic
inventory procedures. Note that ending inventory and cost of goods sold are different under the two procedures.
Weighted-average under perpetual inventory procedure Under perpetual inventory procedure, firms
compute a new weighted-average unit cost after each purchase by dividing total cost of goods available for sale by
total units available for sale. The unit cost is a moving weighted-average because it changes after each purchase. In
Exhibit 59, you can see how to compute the moving weighted-average using perpetual inventory procedure. The
new weighted-average unit cost computed after each purchase is the unit cost for inventory items sold until a new
purchase is made. The unit cost of the 20 units in ending inventory is USD 8.929 for a total inventory cost of USD
178.58. Cost of goods sold under this procedure is USD 690 minus the USD 178.58, or USD 511.42.
Advantages and disadvantages of specific identification Companies that use the specific identification
method of inventory costing state their cost of goods sold and ending inventory at the actual cost of specific units
sold and on hand. Some accountants argue that this method provides the most precise matching of costs and
revenues and is, therefore, the most theoretically sound method. This statement is true for some one-of-a-kind
items, such as autos or real estate. For these items, use of any other method would seem illogical.
One disadvantage of the specific identification method is that it permits the manipulation of income. For
example, assume that a company bought three identical units of a given product at different prices. One unit cost
USD 2,000, the second cost USD 2,100, and the third cost USD 2,200. The company sold one unit for USD 2,800.
The units are alike, so the customer does not care which of the identical units the company ships. However, the
gross margin on the sale could be either USD 800, USD 700, or USD 600, depending on which unit the company
ships.
Advantages and disadvantages of FIFO The FIFO method has four major advantages: (1) it is easy to
apply, (2) the assumed flow of costs corresponds with the normal physical flow of goods, (3) no manipulation of
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7. Measuring and reporting inventories
income is possible, and (4) the balance sheet amount for inventory is likely to approximate the current market
value. All the advantages of FIFO occur because when a company sells goods, the first costs it removes from
inventory are the oldest unit costs. A company cannot manipulate income by choosing which unit to ship because
the cost of a unit sold is not determined by a serial number. Instead, the cost attached to the unit sold is always the
oldest cost. Under FIFO, purchases at the end of the period have no effect on cost of goods sold or net income.
The disadvantages of FIFO include (1) the recognition of paper profits and (2) a heavier tax burden if used for
tax purposes in periods of inflation. We discuss these disadvantages later as advantages of LIFO.
Advantages and disadvantages of LIFO The advantages of the LIFO method are based on the fact that
prices have risen almost constantly for decades. LIFO supporters claim this upward trend in prices leads to
inventory, or paper, profits if the FIFO method is used. Inventory, or paper, profits are equal to the current
replacement cost of a unit of inventory at the time of sale minus the unit's historical cost.
For example, assume a company has three units of a product on hand, each purchased at a different cost: USD
12, USD 15, and USD 20 (the most recent cost). The sales price of the unit normally rises because the unit's
replacement cost is rising. Assume that the company sells one unit for USD 30. FIFO gross margin would be USD
18 (USD 30 – USD 12), while LIFO would show a gross margin of USD 10 (USD 30 – USD 20). LIFO supporters
would say that the extra USD 8 gross margin shown under FIFO represents inventory (paper) profit; it is merely the
additional amount that the company must spend over cost of goods sold to purchase another unit of inventory
(USD 8 + USD 12 = USD 20). Thus, the profit is not real; it exists only on paper. The company cannot distribute the
USD 8 to owners, but must retain it to continue handling that particular product. LIFO shows the actual profits that
the company can distribute to the owners while still replenishing inventory.
During periods of inflation, LIFO shows the largest cost of goods sold of any of the costing methods because the
newest costs charged to cost of goods sold are also the highest costs. The larger the cost of goods sold, the smaller
the net income.
Those who favor LIFO argue that its use leads to a better matching of costs and revenues than the other
methods. When a company uses LIFO, the income statement reports both sales revenue and cost of goods sold in
current dollars. The resulting gross margin is a better indicator of management's ability to generate income than
gross margin computed using FIFO, which may include substantial inventory (paper) profits.
Supporters of FIFO argue that LIFO (1) matches the cost of goods not sold against revenues, (2) grossly
understates inventory, and (3) permits income manipulation.
The first criticism—that LIFO matches the cost of goods not sold against revenues—is an extension of the debate
over whether the assumed flow of costs should agree with the physical flow of goods. LIFO supporters contend that
it makes more sense to match current costs against current revenues than to worry about matching costs for the
physical flow of goods.
The second criticism—that LIFO grossly understates inventory—is valid. A company may report LIFO inventory
at a fraction of its current replacement cost, especially if the historical costs are from several decades ago. LIFO
supporters contend that the increased usefulness of the income statement more than offsets the negative effect of
this undervaluation of inventory on the balance sheet.
The third criticism—that LIFO permits income manipulation—is also valid. Income manipulation is possible
under LIFO. For example, assume that management wishes to reduce income. The company could purchase an
abnormal amount of goods at current high prices near the end of the current period, with the purpose of selling the
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goods in the next period. Under LIFO, these higher costs are charged to cost of goods sold in the current period,
resulting in a substantial decline in reported net income. To obtain higher income, management could delay
making the normal amount of purchases until the next period and thus include some of the older, lower costs in
cost of goods sold.
Tax benefit of LIFO The LIFO method results in the lowest taxable income, and thus the lowest income taxes,
when prices are rising. The Internal Revenue Service allows companies to use LIFO for tax purposes only if they use
LIFO for financial reporting purposes. Companies may also report an alternative inventory amount in the notes to
their financial statements for comparison purposes. Because of high inflation during the 1970s, many companies
switched from FIFO to LIFO for tax advantages.
Advantages and disadvantages of weighted-average When a company uses the weighted-average
method and prices are rising, its cost of goods sold is less than that obtained under LIFO, but more than that
obtained under FIFO. Inventory is not as badly understated as under LIFO, but it is not as up-to-date as under
FIFO. Weighted-average costing takes a middle-of-the-road approach. A company can manipulate income under
the weighted-average costing method by buying or failing to buy goods near year-end. However, the averaging
process reduces the effects of buying or not buying.
The four inventory costing methods, specific identification, FIFO, LIFO, and weighted-average, involve
assumptions about how costs flow through a business. In some instances, assumed cost flows may correspond with
the actual physical flow of goods. For example, fresh meats and dairy products must flow in a FIFO manner to avoid
spoilage losses. In contrast, firms use coal stacked in a pile in a LIFO manner because the newest units purchased
are unloaded on top of the pile and sold first. Gasoline held in a tank is a good example of an inventory that has an
average physical flow. As the tank is refilled, the new gasoline mixes with the old. Thus, any amount used is a blend
of the old gas with the new.
Although physical flows are sometimes cited as support for an inventory method, accountants now recognize
that an inventory method's assumed cost flows need not necessarily correspond with the actual physical flow of the
goods. In fact, good reasons exist for simply ignoring physical flows and choosing an inventory method based on
other criteria.
In Exhibit 60 and Exhibit 61, we use data from Exhibit 49 to show the cost of goods sold, inventory cost, and
gross margin for each of the four basic costing methods using perpetual and periodic inventory procedures. The
differences for the four methods occur because the company paid different prices for goods purchased. No
differences would occur if purchase prices were constant. Since a company's purchase prices are seldom constant,
inventory costing method affects cost of goods sold, inventory cost, gross margin, and net income. Therefore,
companies must disclose on their financial statements which inventory costing methods were used.
Which is the correct method? All four methods of inventory costing are acceptable; no single method is the
only correct method. Different methods are attractive under different conditions.
If a company wants to match sales revenue with current cost of goods sold, it would use LIFO. If a company
seeks to reduce its income taxes in a period of rising prices, it would also use LIFO. On the other hand, LIFO often
charges against revenues the cost of goods not actually sold. Also, LIFO may allow the company to manipulate net
income by changing the timing of additional purchases.
The FIFO and specific identification methods result in a more precise matching of historical cost with revenue.
However, FIFO can give rise to paper profits, while specific identification can give rise to income manipulation. The
Accounting Principles: A Business Perspective 299 A Global Text
7. Measuring and reporting inventories
weighted-average method also allows manipulation of income. Only under FIFO is the manipulation of net income
not possible.
An accounting perspective:
Business insight
Management decides which inventory costing method or methods (LIFO, FIFO, etc.) to use. Also,
management must determine which method is the most meaningful and useful in representing
economic results. Then, it must use the selected method consistently.
The principal business of Kellwood Company is the marketing, merchandising, and manufacturing
of apparel, primarily for women. Note in the following footnote from Kellwood's financial
statements that it, like other companies, uses several costing methods within the same enterprise:
Summary of significant accounting policies
3. Inventories and revenue recognition
Inventories are stated at the lower of cost or market. The first-in, first-out (FIFO) method is used
to determine the value of 46 per cent of the domestic inventories, and the last-in, first-out (LIFO)
method is used to value the remaining domestic inventories. Inventories of foreign subsidiaries
are valued using the specific identification method. Sales are recognized when goods are shipped.
Generally, companies use the inventory method that best fits their individual circumstances. However, this
freedom of choice does not include changing inventory methods every year or so, especially if the goal is to report
higher income. Continuous switching of methods violates the accounting principle of consistency, which requires
using the same accounting methods from period to period in preparing financial statements. Consistency of
methods in preparing financial statements enables financial statement users to compare statements of a company
from period to period and determine trends.
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Specific Weighted -
Identification FIFO LIFO Average Sales $780.00 $780.00 $780.00 $780.00 Cost of goods sold: Beginning inventory $ 80.00 $ 80.00 $ 80.00 $ 80.00 Purchases 610.00 610.00 610.00 610.00 Cost of goods available for sale $690.00 $690.00 $690.00 $690.00 Ending inventory 181.00 179.00 171.00 178.58 Cost of goods sold $509.00 $511.00 $519.00 $511.42 Gross Margin $271.00 $269.00 $261.00 $268.58
Exhibit 60: Effects of different inventory costing methods using perpetual inventory procedure
Specific Weighted- Identification FIFO LIFO Average
Sales $780.00 $780.00 $780.00 $780.00 Cost of goods sold: Beginning inventory $ 80.00 $ 80.00 $ 80.00 $ 80.00 Purchases 610.00 610.00 610.00 610.00 Cost of goods available for sale $690.00 $690.00 $690.00 $690.00 Ending inventory 181.00 179.00 165.00 172.50 Cost of goods sold $509.00 $511.00 $525.00 $517.50 Gross Margin $271.00 $269.00 $255.00 $262.50
Exhibit 61: Effects of different inventory costing methods using periodic inventory procedure
An accounting perspective:
Business insight
Sometimes, companies change inventory methods in spite of the principle of consistency.
Improved financial reporting is the only justification for a change in inventory method. A company
that changes its inventory method must make a full disclosure of the change. Usually, the company
makes a full disclosure in a footnote to the financial statements. The footnote consists of a
complete description of the change, the reasons why the change was made, and, if possible, the
effect of the change on net income.
J. M. Tull Industries, Inc., sells a diverse range of metals (aluminum, brass, copper, steel, stainless
steel, and nickel alloys) for severe corrosion conditions and high-temperature applications. For
example, when J. M. Tull changed from lower of average cost or market to LIFO, the following
footnote appeared in its annual report:
Note B. Change in accounting method for inventory
The company changed its method of determining inventory cost from the lower of average cost
or market method to the last-in, first-out (LIFO) method for substantially all inventory. This
change was made because management believes LIFO more clearly reflects income by providing
a closer matching of current cost against current revenue.
Now we illustrate in more detail the journal entries made when using perpetual inventory procedure. Data from
Exhibit 56 serves as the basis for some of the entries.
You would debit the Merchandise Inventory account to record the increases in the asset due to purchase costs
and transportation-in costs. You would credit Merchandise Inventory to record the decreases in the asset brought
about by purchase returns and allowances, purchase discounts, and cost of goods sold to customers. The balance in
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7. Measuring and reporting inventories
the account is the cost of the inventory that should be on hand at any date. This entry records the purchase of 10
units on March 2 in Exhibit 56:
Mar. 2 Merchandise Inventory (+A) 85 Accounts Payable (+L) 85 To record purchases of 10 units at $8.50 on account.
You would also record the 10 units sold on the perpetual inventory record in Exhibit 56. Perpetual inventory
procedure requires two journal entries for each sale. One entry is at selling price—a debit to Accounts Receivable
(or Cash) and a credit to Sales. The other entry is at cost—a debit to Cost of Goods Sold and a credit to Merchandise
Inventory. Assuming that the 10 units sold on March 10 in Exhibit 56 had a retail price of USD 13 each, you would
record the following entries:
Mar. 10 Accounts Receivable (+A) Sales (+SE) To record 10 units sold at $13 each on account.
130 130
10 Cost of Goods Sold (-SE) Merchandise Inventory (-A) To record cost of $8 on each of the 10 units sold.
80 80
When a company sells merchandise to customers, it transfers the cost of the merchandise from an asset account
(Merchandise Inventory) to an expense account (Cost of Goods Sold). The company makes this transfer because the
sale reduces the asset, and the cost of the goods sold is one of the expenses of making the sale. Thus, the Cost of
Goods Sold account accumulates the cost of all the merchandise that the company sells during a period.
A sales return also requires two entries, one at selling price and one at cost. Assume that a customer returned
merchandise that cost USD 20 and originally sold for USD 32. The entry to reduce the accounts receivable and to
record the sales return of USD 32 is:
Mar. 17 Sales Return and Allowances (-SE) 32 Accounts Receivable (-A) 32 To record the reduction in amount owed by a customer upon return of goods.
The entry that increases the Merchandise Inventory account and decreases the Cost of Goods Sold account by
USD 20 is as follows:
Mar. 17 Merchandise Inventory (+A) 20 Cost of Goods Sold (+SE) 20 To record replacement of goods returned to inventory.
Sales returns affect both revenues and cost of goods sold because the goods charged to cost of goods sold are
actually returned to the seller. In contrast, sales allowances granted to customers affect only revenues because the
customers do not have to return goods. Thus, if the company had granted a sales allowance of USD 32 on March 17,
only the first entry would be required.
The balance of the Merchandise Inventory account is the cost of the inventory that should be on hand. This fact
is a major reason some companies choose to use perpetual inventory procedure. The cost of inventory that should
be on hand is readily available. A physical inventory determines the accuracy of the account balance. Management
may investigate any major discrepancies between the balance in the account and the cost based on the physical
count. It thereby achieves greater control over inventory. When a shortage is discovered, an adjusting entry is
required. Assuming a USD 15 shortage (at cost) is discovered, the entry is:
Dec. 31 Loss from Inventory Shortage (-SE) 15 Merchandise Inventory (-A) 15 To record inventory shortage
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Assume that the Cost of Goods Sold account had a balance of USD 200,000 by year-end when it is closed to
Income Summary. There are no other purchase-related accounts to be closed. The entry to close the Cost of Goods
Sold account is:
Dec. 31 Income Summary 200,000 Cost of Goods Sold 200,000 To close Cost of Goods Sold account to Income Summary at the end of the year.
Departures from cost basis of inventory measurement
Generally, companies should use historical cost to value inventories and cost of goods sold. However, some
circumstances justify departures from historical cost. One of these circumstances is when the utility or value of
inventory items is less than their cost. A decline in the selling price of the goods or their replacement cost may
indicate such a loss of utility. This section explains how accountants handle some of these departures from the cost
basis of inventory measurement.
Companies should not carry goods in inventory at more than their net realizable value. Net realizable value is
the estimated selling price of an item less the estimated costs that the company incurs in preparing the item for sale
and selling it. Damaged, obsolete, or shopworn goods often have a net realizable value lower than their historical
cost and must be written down to their net realizable value. However, goods do not have to be damaged, obsolete,
or shopworn for this situation to occur. Technological changes and increased competition have caused significant
reductions in selling prices for such products as computers, TVs, DVD players, and digital cameras.
To illustrate a necessary write-down in the cost of inventory, assume that an automobile dealer has a
demonstrator on hand. The dealer acquired the auto at a cost of USD 18,000. The auto had an original selling price
of USD 19,600. Since the dealer used the auto as a demonstrator and the new models are coming in, the auto now
has an estimated selling price of only USD 18,100. However, the dealer can get the USD 18,100 only if the
demonstrator receives some scheduled maintenance, including a tune-up and some paint damage repairs. This
work and the sales commission cost USD 300. The net realizable value of the demonstrator, then, is USD 17,800
(selling price of USD 18,100 less costs of USD 300). For inventory purposes, the required journal entry is:
Loss Due to the Decline in Market Value of Inventory (-SE) 200 Merchandise Inventory (-A) 200 To write down inventory to net realizable value ($18,000 - $17,800)
This entry treats the USD 200 inventory decline as a loss in the period in which the decline in utility occurred.
Such an entry is necessary only when the net realizable value is less than cost. If net realizable value declines but
still exceeds cost, the dealer would continue to carry the item at cost.
The lower-of-cost-or-market (LCM) method is an inventory costing method that values inventory at the
lower of its historical cost or its current market (replacement) cost. The term cost refers to historical cost of
inventory as determined under the specific identification, FIFO, LIFO, or weighted-average inventory method.
Market generally refers to a merchandise item's replacement cost in the quantity usually purchased. The basic
assumption of the LCM method is that if the purchase price of an item has fallen, its selling price also has fallen or
will fall. The LCM method has long been accepted in accounting.
Under LCM, inventory items are written down to market value when the market value is less than the cost of the
items. For example, assume that the market value of the inventory is USD 39,600 and its cost is USD 40,000. Then,
the company would record a USD 400 loss because the inventory has lost some of its revenue-generating ability.
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7. Measuring and reporting inventories
The company must recognize the loss in the period the loss occurred. On the other hand, if ending inventory has a
market value of USD 45,000 and a cost of USD 40,000, the company would not recognize this increase in value. To
do so would recognize revenue before the time of sale.
LCM applied A company may apply LCM to each inventory item (such as Monopoly), each inventory class
(such as games), or total inventory. To see how the company would apply the method to individual items and total
inventory, look at Exhibit 62.
If LCM is applied on an item-by-item basis, ending inventory would be USD 5,000. The company would deduct
the USD 5,000 ending inventory from cost of goods available for sale on the income statement and report this
inventory in the current assets section of the balance sheet. Under the class method, a company applies LCM to the
total cost and total market for each class of items compared. One class might be games; another might be toys.
Then, the company values each class at the lower of its cost or market amount. If LCM is applied on a total
inventory basis, ending inventory would be USD 5,100, since total cost of USD 5,100 is lower than total market of
USD 5,150.
An annual report of Du Pont contains an actual example of applying LCM. The report states that "substantially
all inventories are valued at cost as determined by the last-in, first-out (LIFO) method; in the aggregate, such
valuations are not in excess of market". The term in the aggregate means that Du Pont applied LCM to total
inventory.
An accounting perspective:
Business insight
Procter & Gamble markets a broad range of laundry, cleaning, paper, beauty care, health care,
food, and beverage products around the world. Procter & Gamble's footnote in its Notes to
Consolidated Financial Statements in its annual report illustrates that companies often disclose
LCM in their notes to financial statements.
Inventories are valued at cost, which is not in excess of current market price. Cost is primarily
determined by either the average cost or the first-in, first-out method. The replacement cost of
last-in, first-out inventories exceeds carrying value by approximately USD 169 [million].
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LCM on Unit Unit Total Total Item-by-Item
Item Quantity Cost Market Cost Market Basis 1 100 un i t s $10 $9 .00 $1 ,000 $ 900 $ 900 2 200 un i t s 8 8 .75 1 ,600 1 ,750 1 ,600 3 500 un i t s 5 5 .00 2 ,500 2 ,500 2 ,500
$5 ,100 $5 ,150 $5 ,000
Exhibit 62: Application of lower-of-cost-or-market method
Merchand ise inventory, 2010 January
$ 40 ,000
Net cos t o f purchases 480 ,000 Cos t o f goods ava i lab le for sa le $520 ,000 Less es t imated cos t o f goods so ld: Net sa les $700 ,000 Gross marg in (30% o f $700 ,000) 210 ,000 Es t imated cost o f goods so ld 490 ,000 Es t imated inventory, 2010 December 31
$ 30 ,000
Exhibit 63: Inventory estimation using gross margin method
A company using periodic inventory procedure may estimate its inventory for any of the following reasons:
• To obtain an inventory cost for use in monthly or quarterly financial statements without taking a physical
inventory. The effort of taking a physical inventory can be very expensive and disrupts normal business
operations; once a year is often enough.
• To compare with physical inventories to determine whether shortages exist.
• To determine the amount recoverable from an insurance company when fire has destroyed inventory or the
inventory has been stolen.
Next, we introduce two recognized methods of estimating the cost of ending inventory when a company has not
taken a physical inventory—the gross margin method and the retail inventory method.
Gross margin method The steps in calculating ending inventory under the gross margin method are:
• Estimate gross margin (based on net sales) using the same gross margin rate experienced in prior
accounting periods.
• Determine estimated cost of goods sold by deducting estimated gross margin from net sales.
• Determine estimated ending inventory by deducting estimated cost of goods sold from cost of goods
available for sale.
Thus, the gross margin method estimates ending inventory by deducting estimated cost of goods sold from
cost of goods available for sale.
The gross margin method assumes that a fairly stable relationship exists between gross margin and net sales. In
other words, gross margin has been a fairly constant percentage of net sales, and this relationship has continued
into the current period. If this percentage relationship has changed, the gross margin method does not yield
satisfactory results.
To illustrate the gross margin method of computing inventory, assume that for several years Field Company has
maintained a 30 per cent gross margin on net sales. The following data for 2010 are available: The January 1
inventory was USD 40,000; net cost of purchases of merchandise was USD 480,000; and net sales of merchandise
were USD 700,000. As shown in Exhibit 63, Field can estimate the inventory for 2010 December 31, by deducting
the estimated cost of goods sold from the actual cost of goods available for sale.
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7. Measuring and reporting inventories
An alternative format for calculating estimated ending inventory uses the standard income statement format
and solves for the one unknown (ending inventory):
Net sales $700,000 Less cost of goods sold: Merchandise inventory, 2010 January 1 $ 40,000 Net cost of purchases 480,000 Cost of goods available for sale $520,000 Less estimated inventory, 2010 December 31
Estimated cost of goods sold 490,000 (70% of net sales
Estimated gross margin $210,000 (30% of net sales)
We know that:
Costs of goods available for sale−Ending inventory=Cost of goodssold
Therefore (let X = Ending inventory):
USD 520,000 - X = USD 490,000
X = USD 30,000
The gross margin method is not precise enough to be used for year-end financial statements. At year-end, a
physical inventory must be taken and valued by either the specific identification, FIFO, LIFO, or weighted-average
methods.
Retail inventory method Retail stores frequently use the retail inventory method to estimate ending
inventory at times other than year-end. Taking a physical inventory during an accounting period (such as monthly
or quarterly) is too time consuming and significantly interferes with business operations. The retail inventory
method estimates the cost of the ending inventory by applying a cost/retail price ratio to ending inventory stated
at retail prices. The advantage of this method is that companies can estimate ending inventory (at cost) without
taking a physical inventory. Thus, the use of this estimate permits the preparation of interim financial statements
(monthly or quarterly) without taking a physical inventory. The steps for finding the ending inventory by the retail
inventory method are:
• Total the beginning inventory and the net amount of goods purchased during the period at both cost and
retail prices.
• Divide the cost of goods available for sale by the retail price of the goods available for sale to find the
cost/retail price ratio.
• Deduct the retail sales from the retail price of the goods available for sale to determine ending inventory at
retail.
• Multiply the cost/retail price ratio or percentage by the ending inventory at retail prices to reduce it to the
ending inventory at cost.
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Cost Retail Merchandise inventory, 2010 January 1 $ 22,000 $ 40,000 Purchases 182,000 303,000 Purchase returns (2,000) (3,000) Purchase allowances (3,000) Transportation-in 5,000 Goods available for sale $204,000 $340,000 Cost/retail price ratio: $204,000/$340,000=60% Sales 280,000 Ending inventory at retail prices $ 60,000 Times cost/retail price ratio x 60% Ending inventory at cost, 2010 March 31 $ 36,000
Exhibit 64: Inventory estimation
In Exhibit 64, we show the retail inventory method. In the exhibit, the cost (USD 22,000) and retail (USD
40,000) amounts for beginning inventory are available from the preceding period's computation. The amounts for
the first quarter purchases, purchase returns, purchase allowances, and transportation-in came from the
accounting records. The amounts for purchase allowances and transportation-in appear only in the cost column.
The first quarter sales amount (USD 280,000) is from the Sales account and stated at retail (sales) prices. The
difference between what was available for sale at retail prices and what was sold at retail prices (which is sales)
equals what should be on hand (March 31 inventory of USD 60,000) expressed in retail prices. The retail price of
the March 31 inventory needs to be converted into cost for use in the financial statements. We do this by
multiplying it times the cost/retail price ratio. In the example, the cost/retail price ratio is 60 per cent, which means
that on the average, 60 cents of each sales dollar is cost of goods sold. To find the 2010 March 31, inventory at cost
(USD 36,000), we multiplied the ending inventory at retail (USD 60,000) by 60 per cent.
Once the March 31 inventory has been estimated at cost (USD 36,000), we deduct the cost of the inventory from
cost of goods available for sale (USD 204,000) to determine cost of goods sold (USD 168,000). We can also find the
cost of goods sold by multiplying the cost/retail price ratio of 60 per cent by sales of USD 280,000.
For the next quarterly period, the USD 36,000 and USD 60,000 amounts would appear on the schedule as
beginning inventory at cost and retail, respectively. We would include other quarterly data regarding purchases,
purchase returns, purchase allowances, and transportation-in to determine goods available for sale at cost and at
retail. From these amounts, we could compute a new cost/retail price ratio for the second quarter.
At the end of each year, merchandisers usually take a physical inventory at retail prices. Since the retail prices
are on the individual items (while the cost is not), taking an inventory at retail prices is more convenient than
taking an inventory at cost. Accountants can then compare the results of the physical inventory to the calculation of
inventory at retail under the retail inventory method for the fourth quarter to determine whether a shortage exists.
Both the gross margin and the retail inventory methods can help you detect inventory shortages. To illustrate
how you can determine inventory shortages using the retail method, assume that a physical inventory taken at year
end, showed only USD 62,000 of retail-priced goods in the store. Assume that use of the retail method for the
fourth quarter showed that USD 66,000 of goods should be on hand, thus indicating a USD 4,000 inventory
shortage at retail. After converting the USD 4,000 to USD 2,400 of cost (USD 4,000 X 0.60) you would report this
as a "Loss from inventory shortage" in the income statement. Knowledge of such shortages may lead management
to reduce or prevent them, by increasing security or improving the training of employees.
Accounting Principles: A Business Perspective 307 A Global Text
7. Measuring and reporting inventories
An ethical perspective:
Dorsey hardware
Terry Dorsey started Dorsey Hardware, a small hardware store, two years ago and has struggled to
make it successful. The first year of operations resulted in a substantial loss; in the second year,
there was a small net income. His initial cash investment was almost depleted because he had to
withdraw money for living expenses. The current year of operations looked much better. His
customer base was growing and seemed to be loyal. To increase sales, however, Terry had to invest
his remaining funds and the proceeds of a USD 40,000 bank loan into doubling the size of his
inventory and purchasing some new display shelves and a new truck.
At the end of the third year, Terry's accountant asked him for his ending inventory figure and later
told him that initial estimates indicated that net income (and taxable income) for the year would be
approximately USD 80,000. Terry was delighted until he learned that the federal income taxes on
that income would be about USD 17,250. He told the accountant that he did not have enough cash
to pay the taxes and could not even borrow it, since he already had an outstanding loan at the bank.
Terry asked the accountant for a copy of the income statement figures so he could see if any items
had been overlooked that might reduce his net income. He noticed that ending inventory of USD
160,000 had been deducted from cost of goods available for sale of USD 640,000 to arrive at cost of
goods sold of USD 480,000. Net sales of USD 720,000 and expenses of USD 160,000 could not be
changed. But Terry hit on a scheme to reduce his net income. The next day he told his accountant
that he had made an error in determining ending inventory and that its correct amount was USD
120,000. This lower inventory amount would increase cost of goods sold by USD 40,000 and
reduce net income by that same amount. The resulting income taxes would be about USD 6,000,
which was just about what Terry had paid in estimated taxes.
To justify his action in his own mind, Terry used the following arguments: (1) federal taxes are too
high, and the federal government seems to be taxing the little guy out of existence; (2) no harm is
really done because, when the business becomes more profitable, I will use correct inventory
amounts, and this loan from the government will be paid back; (3) since I am the only one who
knows the correct ending inventory I will not get caught; and (4) I bet a lot of other people do the
same thing.
Analyzing and using financial results—inventory turnover ratio
An important ratio for managers, investors, and creditors to consider when analyzing a company's inventory is
the inventory turnover ratio. This ratio tests whether a company is generating a sufficient volume of business based
on its inventory. To calculate the inventory turnover ratio:
Inventory turnover ratio= Cost of goodssold
Average inventory
Inventory turnover measures the efficiency of the firm in managing and selling inventory: thus, it gauges the
liquidity of the firm's inventory. A high inventory turnover is generally a sign of efficient inventory management
and profit for the firm; the faster inventory sells, the less time funds are tied up in inventory. A relatively low
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turnover could be the result of a company carrying too much inventory or stocking inventory that is obsolete, slow-
moving, or inferior.
In assessing inventory turnover, analysts also consider the type of industry. When making comparisons among
firms, they check the cost-flow assumption used to value inventory and cost of products sold.
Abercrombie & Fitch reported the following financial data for 2000 (in thousands):
Cost of goods sold....... $728,229 Beginning inventory...... 75,262 Ending inventory........ 120,997
Their inventory turnover is:
USD 728,229/[(USD 75,262 + USD 120,997)/2] = 7.4 times
You should now understand the importance of taking an accurate physical inventory and knowing how to value
this inventory. In the next chapter, you will learn the general principles of internal control and how to control cash.
Cash is one of a company's most important and mobile assets.
Understanding the learning objectives
• Net income for an accounting period depends directly on the valuation of ending inventory.
• If ending inventory is overstated, cost of goods sold is understated, resulting in an overstatement of gross
margin, net income, and retained earnings.
• When ending inventory is misstated in the current year, companies carry that misstatement forward into
the next year.
• An error in the net income of one year caused by misstated ending inventory automatically causes an error
in net income in the opposite direction in the next period because of the misstated beginning inventory.
• Inventory cost includes all necessary outlays to obtain the goods, get the goods ready to sell, and have the
goods in the desired location for sale to customers.
• Inventory cost includes:
a. Seller's gross selling price less purchase discount.
b. Cost of insurance on the goods while in transit.
c. Transportation charges when borne by the buyer.
d. Handling costs, such as the cost of pressing clothes wrinkled during shipment.
• Specific identification: Attaches actual cost of each unit of product to units in ending inventory and cost
of goods sold. Specific identification creates precise matching in determining net income.
• FIFO (first-in, first-out): Ending inventory consists of the most recent purchases. FIFO assumes that
the costs of the first goods purchased are those charged to cost of goods sold when goods are sold. During
periods of rising prices, FIFO creates higher net income since the costs charged to cost of goods sold are lower.
• LIFO (last-in, first-out): Ending inventory consists of the oldest costs. LIFO assumes that the costs of
the most recent purchases are the first costs charged to cost of goods sold. Net income is usually lower under
LIFO since the costs charged to cost of goods sold are higher due to inflation. The ending inventory may differ
between perpetual and periodic inventory procedures.
• Weighted-average: Ending inventory is priced using a weighted-average unit cost. Under perpetual
inventory procedure, a new weighted-average is determined after each purchase. Under periodic procedure,
the average is determined at the end of the accounting period by dividing the total number of units purchased
plus those in beginning inventory into total cost of goods available for sale. In determining cost of goods sold,
Accounting Principles: A Business Perspective 309 A Global Text
7. Measuring and reporting inventories
this average unit cost is applied to each item. Under the weighted-average method, in a period of rising prices
net income is usually higher than income under LIFO and lower than income under FIFO.
• Specific identification: Advantages: (1) States cost of goods sold and ending inventory at the actual cost
of specific units sold and on hand, and (2) provides the most precise matching of costs and revenues.
Disadvantage: Income manipulation is possible.
• FIFO: Advantages: (1) FIFO is easy to apply, (2) the assumed flow of costs often corresponds with the
normal physical flow of goods, (3) no manipulation of income is possible, and (4) the balance sheet amount for
inventory is likely to approximate the current market value. Disadvantages: (1) Recognizes paper profits, and
(2) tax burden is heavier if used for tax purposes when prices are rising.
• LIFO: Advantages: (1) LIFO reports both sales revenue and cost of goods sold in current dollars, and (2)
lower income taxes result if used for tax purposes when prices are rising. Disadvantages: (1) Often matches the
cost of goods not sold against revenues, (2) grossly understates inventory, and (3) permits income
manipulation.
• Weighted-average: Advantages: Due to the averaging process, the effects of year-end buying or not
buying are lessened. Disadvantage: Manipulation of income is possible.
• Perpetual inventory procedure requires an entry to Merchandise Inventory whenever goods are purchased,
returned, sold, or otherwise adjusted, so that inventory records reflect actual units on hand at all times. Thus,
an entry is required to record cost of goods sold for each sale.
• Companies should not carry goods in inventory at more than their net realizable value. Net realizable value
is the estimated selling price of an item less the estimated costs incurred in preparing the item for sale and
selling it. Inventory items are written down to market value when the market value is less than the cost of the
items. If market value is greater than cost, the increase in value is not recognized. LCM may be applied to each
inventory item, each inventory class, or total inventory.
• The steps in calculating ending inventory under the gross margin method are:
a. Estimate gross margin (based on net sales) using the same gross margin rate experienced in prior
accounting periods.
b. Determine estimated cost of goods sold by deducting estimated gross margin from net sales.
c. Determine estimated ending inventory by deducting estimated cost of goods sold from cost of goods
available for sale.
• The retail inventory method estimates the cost of the ending inventory by applying a cost/retail price ratio
to ending inventory stated at retail prices. To find the cost/retail price ratio, divide the cost of goods available
for sale by the retail price of the goods available for sale.
• Inventory turnover ration= Costof goodssold
Average inventory
• Inventory turnover measures the efficiency of the firm in managing and selling inventory. It gauges the
liquidity of the firm's inventory.
Demonstration problem
Demonstration problem A Following are data related to Adler Company's beginning inventory, purchases,
and sales:
Beginning Inventory Sales
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and Purchases Unit
Units Cost Units Beginning inventory 6,250 @ $3.00 February 3 5,250 March 15 5,000 @ 3.12 May 4 4,500 May 10 8,750 @ 3.30 September 16 8,000 August 12 6,250 @ 3.48 October 9 7,250 November 20 3,750 @ 3.72 30,000 25,000
a. Compute the ending inventory under each of the following methods:
Specific identification (assume ending inventory is taken equally from the August 12 and November 20
purchases).
FIFO: (a) Assume use of perpetual inventory procedure.
(b) Assume use of periodic inventory procedure.
LIFO: (a) Assume use of perpetual inventory procedure.
(b) Assume use of periodic inventory procedure.
Weighted-average: (a) Assume use of perpetual inventory procedure.
(b) Assume use of periodic inventory procedure.
(Carry unit cost to four decimal places and round total cost to nearest dollar.)
b. Give the journal entries to record the individual purchases and sales (Cost of Goods Sold entry only) under the
LIFO method and perpetual procedure.
Demonstration problem B a. Joel Company reported annual net income as follows:
2007.... USD 27,200
2008.... USD 28,400
2009.... USD 24,000
Analysis of the inventories shows that certain clerical errors were made with the following results:
Incorrect inventory amount Correct inventory amount
2007 December 31 $4,800 $5,680
2008 December 31 5,600 4,680
What is the corrected net income for 2007, 2008, and 2009?
b. The records of Little Corporation show the following account balances on the day a fire destroyed the
company's inventory:
Merchandise inventory, January 1 USD 40,000
Net cost of purchases (to date) USD 200,000
Sales (to date) USD 300,000
Average rate of gross margin for the past five years 30 per cent of net sales.
Compute an estimated value of the ending inventory using the gross margin method.
c. The records of Draper Company show the following account balances at year-end:
Cost Retail Merchandise inventory, January 1 .$17,600 $25,000 Purchases 68,000 100,000 Transportation-in 1,900 Sales 101,000
Compute the estimated ending inventory at cost using the retail inventory method.
Accounting Principles: A Business Perspective 311 A Global Text
7. Measuring and reporting inventories
Solution to demonstration problem
Solution to demonstration problem A a. The ending inventory is 5,000 units, calculated as follows:
Units Beginning inventory 6,250 Purchases 23,750 Goods available 30,000 Sales 25,000 Ending inventory 5,000
Ending inventory under specific identification:
Purchased Units Unit Cost
Total Cost
November 20 2,500 $3.72 $ 9,300 August 12 2,500 3.48 8,700
$ 18,000
2. Ending inventory under FIFO:
(a) Perpetual:
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Purchased Sold Balance Date
Units Unit Cost
Total Cost
Units Unit Cost
Total Cost
Units Unit
Beg. inv. 6,250 $3.00 $18,750 Feb. 3 5,250 $3.00 $15,750 1,000 3.00 3,000 Mar. 15 5,000 $3.12 $15,600 1,000
5,000 3.00 3.12
3,000 15,600
May 4 1,000 3,500
3.00 3.12
3,000 10,920
1,500 3.12 4,680
May 10 8,750 3.30 28,875 1,500 8,750
3.12 3.30
4,680 28,875
Aug. 12 6,250 3.48 21,750 1,500 8,750 6,250
3.12 3.30 3.48
4,680 28,875 21,750
Sept. 16 1,500 6,500
3.12 3.30
4,680 21,450
2,250 6,250
3.30 3.48
7,425 21,750
Oct. 9 2,250 5,000
3.30 3.48
7,425 17,400
1,250 3.48 4,350
Nov. 20 3,750 3.72 13,950 1,250 3,750
3.48 3.72
4,350 13,950
Ending inventory = (1,250 X $3.48) + (3,750 X $3.72) = $18,300
(b) Periodic:
Purchased Units Unit Cost
Total Cost
November 20 3,750 $3.72 $ 13,950 August 12 1,250 3.48 4,350
5,000 $ 18,300 * *Note that the cost of ending inventory is the same as under perpetual.
3. Ending inventory under LIFO:
(a) Perpetual:
Purchased Sold Balanc e
Date Units Unit Cost
Total Cost
Units Unit Cost
Total Cost
Units Unit
Beg. inv. 6,250 $3.00 $18,750
Feb. 3 5,250 $3.00 $15,750 1,000 3.00 3,000
Mar. 15 5,000 $3.12 $15,600 1,000 5,000
3.00 3.12
3,000 15,600
May 4 4,500 3.12 14,040 1,000 500
3.00 3.12
3,000 1,560
May 10 8,750 3.30 28,875 1,000
500 8,750
3.00 3.12 3.30
3,000 1,560 28,875
Aug. 12 6,250 3.48 21,750 1,000 500 8,750 6,250
3.00 3.12 3.30 3.48
3,000 1,560 28,875 21,750
Sept. 16 6,250 1,750
3.48 3.30
21,750 5,775
1,000 500 7,000
3.00 3.12 3.30
3,000 1,560 23,100
Oct. 9 7,000 250
3.30 3.12
23,100 780
1,000 250
3.00 3.12
3,000 780
Nov. 20 3,750 3.72 13,950 1,000 250 3,750
3.00 3.12 3.72
3,000 780 13,950
Ending inventory =
(1,00 0
X $3.00) + (250 X $3.12) + (3,750 X
$3.72) = $17,730
(b) Periodic:
Accounting Principles: A Business Perspective 313 A Global Text
7. Measuring and reporting inventories
Unit Total
Units Cost Cost Merchandise Inventory, January 1 5,000 $3.00 $ 15,000
4. Ending inventory under weighted-average:
(a) Perpetual:
Purchased Sold Balance Unit Total Unit Total Unit
Date Units Cost Cost Units Cost Cost Units Cost Total Cost Beg. inv. 6,250 $3.0000 $18,750 Feb. 3 5,250 $3.00 $15,750 1,000 3.0000 3,000 Mar. 15 5,000 $3.12 $15,600 6,000 3.1000
a
18,600
May 4 4,500 3.10 13,950 1,500 3.1000 4,650 May 10 8,750 3.30 28,875 10,250 3.2707
b
33,525
Aug. 12 6,250 3.48 21,750 16,500 3.3500 c
55,275
Sept. 16 8,000 3.35 26,800 8,500 3.3500 28,475 * Oct. 9 7,250 3.35 24,288 1,250 3.3500 4,187 * Nov. 20 3,750 3.72 13,950 5.000 3.6274
d
18,137
Ending inventory = (5,000 X $3.6274) = $18,137 a $18,600 = $3.100 b $33,525 = $3.2707 c $55,275 = $3.3500 d $18,137 = $3.6274 6,000 10,250 16,500 5,000 * Rounding difference.
(b) Periodic Unit Total Purchased Units Cost Cost Merchand ise Inventory, January 1
6 ,250 $3 .00 $ 18 ,75 0
March 15 5 ,000 3 .12 15 ,60 0
May 10 8 ,750 3 .30 28 ,87 5
Augus t 12 6 ,250 3 .48 21 ,75 0
November 20 3 ,750 3 .72 13 ,95 0
30 ,000 $ 98 ,92 5
Weighted-average unit cost = $98,925/30,000 = $3.2975 Ending inventory cost = $3.2975 x 5,000 = $16,488*
*Rounding difference
b. Journal entries under LIFO perpetual:
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Feb. 3 Cost of Goods Sold (-SE) Merchandise Inventory (-A) To record cost of $3 on 5,200 units sold
15,750 15,750
Mar. 15 Merchandise Inventory (+A) Accounts Payable (+L) To record purchase of 5,000 units at $3.12 on Account.
15,600 15,600
May 4 Cost of Goods Sold (-SE) Merchandise Inventory (-A) To record cost of $3.12 on 4,500 units sold.
14,040 14,040
10 Merchandise Inventory (+A) Accounts Payable (+L) To record purchase of 8,750 units at $3.30 on account.
28,875 28,875
Aug. 12 Merchandise Inventory (+A) Accounts Payable (+L) To record purchase of 6,250 units at $3.48 on account
21,750 21,750
Sept. 16 Cost of Goods Sold (-SE) Merchandise Inventory (-A) To record costs of $3.48 and $3.30 on 6,250 units at 1,750 units sold, respectively.
27,525 27,525
Oct. 9 Cost of Goods Sold (-SE) Merchandise Inventory (-A) To record costs of $3.30 and $3.12 on 7,000 units and 250 units sold, respectively.
23,880 23,880
Nov. 20 Merchandise Inventory (+A) Accounts Payable (+L) To record purchase of 3,750 units at $3.72 on account.
13,950 13,950
Solution to demonstration problem B a. Corrected net income:
2007 2008 2009 Total Net income as reported $ 27,200 28,400 24,000 $ 79,600 Adjustments (1) 880 (2) (880)
(920) (3) 920 Corrected net income $ 28,080 26,600 24,920 $ 79,600
(1) Ending inventory understated ($ 5,680 - $ 4,800 = $ 880) (2) Beginning inventory understated (5,680 – 4,800 = 880)
Ending inventory overstated (5,600 – 4,680 = 920) (3) Beginning inventory overstated (5,600 – 4,680 = 920)
b. Computation of inventory: Merchandise Inventory, January 1 $
40,000 Net cost of purchases 200,000 Cost of goods available for sale $
240,000 Less estimated cost of goods sold: Net Sales $ 300,000 Gross margin ($300,000 X 0.30) 90,000 Estimated cost of goods sold 210,000 Inventory at cost, estimated by gross margin method. $
30,000
c. Computation of inventory:
Cost Retail Merchandise Inventory, January 1 $ 17,600 $ 25,000
Purchases 68,000 100,000 Transportation-in 1,900 — Goods available for sale $
$ 87,500 $ 125,000
Cost/retail price ratio: $87,500/$125,000 = 70% Sales 101,000
Accounting Principles: A Business Perspective 315 A Global Text
7. Measuring and reporting inventories
Ending inventory at retail price $24,000 Times cost/retail price ratio X 70% Ending inventory at cost, December 31. $ 16,800
Key terms FIFO (first-in, first-out) A method of costing inventory that assumes the costs of the first goods purchased are those charged to cost of goods sold when the company actually sells goods.
Gross margin method A procedure for estimating inventory cost in which estimated cost of goods sold (determined using an estimated gross margin) is deducted from the cost of goods available for sale to determine estimated ending inventory. The estimated gross margin is calculated using gross margin rates (in relation to net sales) of prior periods.
Inventory, or paper, profits Equal to the current replacement cost to purchase a unit of inventory at time of sale minus the unit's historical cost.
Inventory turnover ratio Cost of goods sold/Average inventory.
LIFO (last-in, first-out) A method of costing inventory that assumes the costs of the most recent purchases are the first costs charged to cost of goods sold when the company actually sells the goods.
Lower-of-cost-or-market (LCM) method An inventory costing method that values inventory at the lower of its historical cost or its current market (replacement) cost.
Merchandise inventory The quantity of goods held by a merchandising company for resale to customers.
Net realizable value Estimated selling price of an item less the estimated costs incurred in preparing the item for sale and selling it.
Retail inventory method A procedure for estimating the cost of the ending inventory by applying a cost/ retail price ratio to ending inventory stated at retail prices.
Specific identification method An inventory costing method that attaches the actual cost to an identifiable unit of product.
Weighted-average method A method of costing ending inventory using a weighted-average unit cost. Under perpetual inventory procedure, a new weighted-average is calculated after each purchase. Under periodic procedure, the weighted-average is determined by dividing the total number of units purchased plus those in beginning inventory into total cost of goods available for sale. Units in the ending inventory are carried at this per unit cost.
Self-test
True-false
Indicate whether each of the following statements is true or false.
Overstated ending inventory results in an overstatement of cost of goods sold and an understatement of gross
margin and net income.
In a period of rising prices, FIFO results in the lowest cost of goods sold.
Under LCM, inventory is written down to market value when the market value is less than the cost, and
inventory is written up to market value when the market value is greater than the cost.
Under the gross margin method, an estimate must be made of gross margin to determine estimated cost of
goods sold and estimated ending inventory.
To use the retail inventory method, both cost and retail prices must be known for the goods available for sale.
Under perpetual procedure, cost of goods sold is determined as a result of the closing entries made at the end of
the period.
Multiple-choice
Select the best answer for each of the following questions.
Jack Company began the accounting period with inventory of 3,000 units at USD 30 each. During the period,
the company purchased an additional 5,000 units at USD 36 each and sold 4,600 units. Assume the use of periodic
inventory procedure for the following six questions.
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Cost of ending inventory using FIFO is:
a. USD 104,400.
b. USD 122,400.
c. USD 120,000.
d. USD 147,600.
e. None of the above.
Cost of goods sold using FIFO is:
a. USD 165,600.
b. USD 150,000.
c. USD 147,600.
d. USD 122,400.
e. None of the above.
Cost of ending inventory using LIFO is:
a. USD 104,400.
b. USD 114,750.
c. USD 156,000.
d. USD 122,400.
e. None of the above.
Cost of goods sold using LIFO is:
a. USD 155,250.
b. USD 114,000.
c. USD 147,600.
d. USD 165,600.
e. None of the above.
Cost of ending inventory using weighted-average is:
a. USD 114,750.
b. USD 157,600.
c. USD 122,400.
d. USD 109,650.
e. None of the above.
Cost of goods sold using weighted-average is:
a. USD 147,200.
b. USD 160,350.
c. USD 155,250.
d. USD 114,000.
e. None of the above.
During a period of rising prices, which inventory method might be expected to give the highest net income?
a. Weighted-average.
b. FIFO.
c. LIFO.
Accounting Principles: A Business Perspective 317 A Global Text
7. Measuring and reporting inventories
d. Specific identification.
e. Cannot determine.
Now turn to “Answers to self-test” at the end of the chapter to check your answers.
Questions
➢ Why is proper inventory valuation so important?
➢ Why does an understated ending inventory understate net income for the period by the same
amount?
➢ Why does an error in ending inventory affect two accounting periods?
➢ What is the meaning of taking a physical inventory?
➢ What is the accountant's responsibility regarding taking a physical inventory?
➢ Which cost elements are included in inventory? What practical problems arise by including the costs
of such elements?
➢ Which accounts that are used under periodic inventory procedure are not used under perpetual
inventory procedure?
➢ What entries are necessary under perpetual inventory procedure when goods are sold?
➢ Why is there closer control over inventory under perpetual inventory procedure than under periodic
inventory procedure?
➢ Why is perpetual inventory procedure being used increasingly in business?
➢ What is the cost flow assumption? What is meant by the physical flow of goods? Does a relationship
between cost flows and the physical flow of goods exist, or should such a relationship exist?
➢ Indicate how a company can manipulate its net income if it uses LIFO. Is the same opportunity
available under FIFO? Why or why not?
➢ What are the main advantages of using FIFO and LIFO?
➢ Which inventory method is the correct one? Can a company change inventory methods?
➢ Why are ending inventory and cost of goods sold the same under FIFO perpetual and FIFO periodic?
➢ Would you agree with the following statement? Reducing the amount of taxes payable currently is a
valid objective of business management and, since LIFO results in such a reduction, all businesses
should use LIFO.
➢ What is net realizable value, and how is it used?
➢ Why is it acceptable accounting practice to recognize a loss by writing down an item in inventory to
market, but unacceptable to recognize a gain by writing up an inventory item?
➢ Under what conditions would the gross margin method of computing an estimated inventory yield
approximately correct amounts?
➢ What are the main reasons for estimating ending inventory?
➢ Should a company rely exclusively on the gross margin method to determine the ending inventory
and cost of goods sold for the end-of-year financial statements?
➢ How can the retail method be used to estimate inventory?
➢ The Limited Based on the notes to the financial statements of The Limited contained in the Annual
Report Appendix, what inventory methods were used?
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Exercises
Exercise A Crocker Company reported annual net income as follows:
2008 $484,480 2009 487,680 2010 409,984
Analysis of its inventories revealed the following incorrect inventory amounts and these correct amounts:
Incorrect Inventory Amount
Correct inventory amount
2008 December 31 $ 76,800 $89,600
2009 December 31 86,400 77,600
Compute the annual net income for each of the three years assuming the correct inventories had been used.
Exercise B Slate Truck Company manufactures trucks and identifies each truck with a unique serial plate. On
December 31, a customer ordered 5 trucks from the company, which currently has 20 trucks in its inventory. Ten of
these trucks cost USD 20,000 each, and the other 10 cost USD 25,000 each. If Slate wished to minimize its net
income, which trucks would it ship? By how much could Slate reduce net income by selecting units from one group
versus the other group?
Exercise C Miami Discount Company inventory records show:
Unit Total Units Cost Cost
Beginning inventory 3,000 $38.00 $114,000 Purchases: February 14 900 39.00 35,100 March 18 2,400 40.00 96,000 July 21 1,800 40.30 72,540 September 27 1,800 40.60 73,080 November 27 600 41.00 24,600 Sales: April 15 2,800 August 20 2,000 October 3 1,500
The December 31 inventory was 4,200 units. Miami Discount Company uses perpetual inventory procedure.
Present a schedule showing the measurement of the ending inventory using FIFO perpetual inventory procedure.
Exercise D Using the data in the previous exercise for Miami Discount Company, present a schedule showing
the measurement of the ending inventory using LIFO perpetual inventory procedure.
Exercise E London Company had a beginning inventory of 160 units at USD 24 (total = USD 3,840) and the
following inventory transactions during the year:
January 8, sold 40 units.
January 11, purchased 80 units at USD 30.00.
January 15, purchased 80 units at USD 32.00.
January 22, sold 80 units.
Using the preceding information, price the ending inventory at its weighted-average cost, assuming perpetual
inventory procedure.
Exercise F Kettle Company made the following purchases of Product A in its first year of operations:
Units Unit Cost
January 2 1,400 @ $7.40 March 31 1,200 @ 7.00 July 5 2,400 @ 7.60 November 1 1,800 @ 8.00
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7. Measuring and reporting inventories
The ending inventory that year consisted of 2,400 units. Kettle uses periodic inventory procedure.
a. Compute the cost of the ending inventory using each of the following methods: (1) FIFO, (2) LIFO, and (3)
weighted-average.
b. Which method would yield the highest amount of gross margin? Explain why it does.
Exercise G The following are selected transactions and other data of the Custer Company:
Purchased 20 units at USD 360 per unit on account on 2010 September 18.
Sold 6 units on account for USD 576 per unit on 2010 September 20.
Discovered a shortage of USD 2,640 at year-end after a physical inventory.
Prepare journal entries for these transactions using FIFO perpetual inventory procedure. Assume the beginning
inventory consists of 20 units at USD 336 per unit.
Exercise H Following are selected transactions of Gamble Company:
Purchased 100 units of merchandise at USD 240 each; terms 2/10, n/30.
Paid the invoice in transaction 1 within the discount period.
Sold 80 units at USD 384 each for cash.
Purchased 100 units at USD 360; terms 2/10, n/30.
Paid the invoice in transaction 4 within the discount period.
Sold 60 units at USD 552 each for cash.
Prepare journal entries for the six preceding items. Assume Gamble uses FIFO perpetual inventory procedure.
Exercise I Wells Company had the following transactions during February:
Purchased 135 units at USD 65 on account.
Sold 108 units at USD 90 on account.
Purchased 170 units at USD 75 on account.
Sold 122 units at USD 95 on account.
Sold 67 units at USD 100 on account.
The beginning inventory consisted of 67 units purchased at a cost of USD 55.
Prepare the journal entries relating to inventory for these five transactions, assuming Wells accounts for
inventory using perpetual inventory procedure and the LIFO inventory method. Do not record the entries for sales.
Exercise J Following are inventory data for Kintech Company:
January 1 inventory on hand, 400 units at USD 28.80.
January sales were 80 units.
February sales totaled 120 units.
March 1, purchased 200 units at USD 30.24.
Sales for March through August were 160 units.
September 1, purchased 40 units at USD 33.12.
September through December sales were 180 units.
Exercise K A company purchased 1,000 units of a product at USD 12.00 and 2,000 units at USD 13.20. It sold
all of these units at USD 18.00 each at a time when the current cost to replace the units sold was USD 13.80.
Compute the amount of gross margin under FIFO that LIFO supporters would call inventory, or paper, profits.
Exercise L Clayton Company's inventory was 12,000 units with a cost of USD 160 each on 2010 January 1.
During 2010, numerous units were purchased and sold. Also during 2010, the purchase price of this product fell
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steadily until at year-end it was USD 120. The inventory at year-end was 18,000 units. State which method of
inventory measurement, LIFO or FIFO, would have resulted in higher reported net income, and explain briefly.
Exercise M Levi Motor Company owns a luxury automobile that it has used as a demonstrator for eight
months. The auto has a list or sticker price of USD 85,000 and cost Levi USD 75,000. At the end of the fiscal year,
the auto is on hand and has an expected selling price of USD 80,000. Costs expected to be incurred to sell the auto
include tune-up and maintenance costs of USD 3,000, advertising of USD 1,000, and a commission of 5 per cent of
the selling price to the employee selling the auto. Compute the amount at which the auto should be carried in
inventory.
Exercise N Pure Sound Systems used one sound system as a floor model. It cost USD 3,600 and had an
original selling price of USD 4,800. After six months, the sound system was damaged and replaced by a newer
model. The sound system had an estimated selling price of USD 2,880, but when the company performed USD 480
in repairs, it could be sold for USD 3,840. Prepare the journal entry, if any, that must be made on Pure Sound's
books to record the decline in market value.
Exercise O Your assistant has compiled the following data:
Quantity Unit Unit Total Total Item (units) Cost Market Cost Market A 300 $ 57.60 $ 55.20 $17,280 $16,560 B 300 28.80 33.60 8,640 10,080 C 900 21.60 21.60 19,440 19,440 D 500 12.00 13.20 6,000 6,600
Calculate the dollar amount of the ending inventory using the LCM method, applied on an item-by-item basis,
and the amount of the decline from cost to lower-of-cost-or-market.
Exercise P Use the data in the previous exercise to compute the cost of the ending inventory using the LCM
method applied to the total inventory.
Exercise Q Tilley-Mill Company takes a physical inventory at the end of each calendar-year accounting period
to establish the ending inventory amount for financial statement purposes. Its financial statements for the past few
years indicate an average gross margin on net sales of 25 per cent. On July 18, a fire destroyed the entire store
building and its contents. The records in a fireproof vault were intact. Through July 17, these records show:
Merchandise inventory, January 1 USD 672,000
Merchandise purchases USD 9,408,000
Purchase returns USD 134,400
Transportation-in USD 504,000
Sales USD 14,336,000
Sales returns USD 672,000
The company was fully covered by insurance and asks you to determine the amount of its claim for loss of
merchandise.
Exercise R Ryan Company takes a physical inventory at the end of each calendar-year accounting period. Its
financial statements for the past few years indicate an average gross margin on net sales of 30 per cent.
On June 12, a fire destroyed the entire store building and the inventory. The records in a fireproof vault were
intact. Through June 11, these records show:
Merchandise inventory, January 1 $120,000 Merchandise purchases $3,000,000 Purchase returns $36,000
Accounting Principles: A Business Perspective 321 A Global Text
7. Measuring and reporting inventories
Transportation -in $204,000 Sales $3,720,000
The company was fully covered by insurance and asks you to determine the amount of its claim for loss of
merchandise.
Exercise S Victoria Falls Company, Inc., records show the following account balances for the year ending 2010
December 31:
Cost Retail
Beginning inventory USD 42,000 USD 57,500
Purchases 25000 37500
Transportation-in 500
Sales 52500
Using these data, compute the estimated cost of ending inventory using the retail method of inventory valuation.
Problems
Problem A Kelley Company reported net income of USD 358,050 for 2009, USD 371,400 for 2010, and USD
325,800 for 2011, using the incorrect inventory amounts shown for 2009 December 31, and 2010. Recently, Kelley
corrected the inventory amounts for those dates. Kelley used the correct 2011 December 31, inventory amount in
calculating 2011 net income.
Incorrect Correct
2009 December 31 USD 72,600 USD 86,200
2010 December 31 84000 70200
Prepare a schedule that shows: (a) the reported net income for each year, (b) the amount of correction needed
for each year, and (c) the correct net income for each year.
Problem B An examination of the financial records of Lanal Company on 2009 December 31, disclosed the
following with regard to merchandise inventory for 2009 and prior years:
2005 December 31, inventory was correct.
2006 December 31, inventory was overstated USD 200,000.
2007 December 31, inventory was overstated USD 100,000.
2081 December 31, inventory was understated USD 220,000.
2009 December 31, inventory was correct.
The reported net income for each year was:
2006 $384,000 2007 544,000 2008 670,000 2009 846,000
a. Prepare a schedule of corrected net income for each of the four years, 2006-2009.
b. What error(s) would have been included in each December 31 balance sheet? Assume each year's error is
independent of the other years' errors.
c. Comment on the implications of your corrected net income as contrasted with reported net income.
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Problem C Brett Company sells personal computers and uses the specific identification method to account for
its inventory. On 2010 November 30, the company had 46 Orange III personal computers on hand that were
acquired on the following dates and at these stated costs:
Units Unit cost July 3 10 @ $10,080 September 10 20 @ $ 9,600 November 29 16 @ $10,700
Brett sold 36 Orange III computers at USD 12,720 each in December. There were no purchases of this model in
December.
a. Compute the gross margin on December sales of Orange III computers assuming the company shipped those
units that would maximize reported gross margin.
b. Repeat part (a) assuming the company shipped those units that would minimize reported gross margin for
December.
c. In view of your answers to parts (a) and (b), what would be your reaction to an assertion that the specific
identification method should not be considered an acceptable method for costing inventory?
Problem D The inventory records of Thimble Company show the following:
March 1 Beginning inventory consists of 10 units costing USD 40 per unit.
3 Sold 5 units at USD 94 per unit.
10 Purchased 16 units at USD 48 per unit.
12 Sold 8 units at USD 96 per unit.
20 Sold 7 units at USD 96 per unit.
25 Purchased 16 units at USD 50 per unit.
31 Sold 8 units at USD 96 per unit.
Assume all purchases and sales are made on credit.
Using FIFO perpetual inventory procedure, prepare the appropriate journal entries for March.
Problem E The following purchases and sales for Ripple Company are for April 2010. There was no inventory
on April 1.
Purchases Sales Unit
Units Cost Units April 3 3,200 @ $33.00 April 6 1,500 April 10 1,600 @ 34.00 April 12 1,400 April 22 2,000 @ 35.00 April 25 2,300 April 28 1,800 @ 36.00
a. Compute the ending inventory as of 2010 April 30, using perpetual inventory procedure, under each of the
following methods: (1) FIFO, (2) LIFO, and (3) weighted-average (carry unit cost to four decimal places and round
total cost to nearest dollar).
b. Repeat a using periodic inventory procedure.
Problem F Refer to the data in problem E
a. Using LIFO perpetual inventory procedure, prepare the journal entries for the purchases and sales (Cost of
Goods Sold entry only).
b. Repeat (a) using LIFO periodic inventory procedure, including closing entries. (Note: You may want to refer
to the Appendix in Chapter 6 for this part.)
Accounting Principles: A Business Perspective 323 A Global Text
7. Measuring and reporting inventories
Problem G The following data relate to the beginning inventory, purchases, and sales of Braxton Company for
the year 2010:
Unit Units Cost
Merchandise Inventory, January 1 1,400 @ $5.04 Purchases: February 2 1,000 @ 4.80 April 5 2,000 @ 3.60 June 15 1,200 @ 3.00 September 30 1,400 @ 2.88 November 28 1,800 @ 4.20 Sales: March 10 900 May 15 1,800 July 6 800 August 23 600 December 22 2,500
a. Assuming use of perpetual inventory procedure, compute the ending inventory and cost of goods sold under
each of the following methods: (1) FIFO, (2) LIFO, and (3) weighted-average (carry unit cost to four decimal places
and round total cost to nearest dollar).
b. Repeat (a) assuming use of periodic inventory procedure.
Problem H Welch Company accounts for a product it sells using LIFO periodic inventory procedure. Product
data for the year ended 2009 December 31, are shown below. Merchandise inventory on January 1 was 3,000 units
at USD 14.40 each.
Purchases Sales Unit Unit
Units Cost Units Co st January 5 6,000 @ $18.00 January 10 4,000 @ $28.80 March 31 18,000 @ 21.60 April 2 15,000 @ 32.40 August 12 12,000 @ 27.00 August 22 16,000 @ 36.00 December 26 6,000 @ 28.80 December 24 3,000 @ 39.60
a. Compute the gross margin earned on sales of this product for 2009.
b. Repeat part (a) assuming that the December 26 purchase was made in January 2010.
c. Recompute the gross margin assuming that 10,000 rather than 6,000 units were purchased on December 26
at the same cost per unit.
d. Solve parts (a), (b), and (c) using the FIFO method.
Problem I The accountant for Gentry Company prepared the following schedule of the company's inventory at
2009 December 31, and used the LCM method applied to total inventory in determining cost of goods sold:
Unit Unit Item Quantity Cost Market Q 4,200 $7.20 $7.20 R 2,400 6.00 5.76 S 5,400 4.80 4.56 T 4,800 4.20 4.32
a. State whether this approach is an acceptable method of inventory measurement and show the calculations
used to determine the amounts.
b. Compute the amount of the ending inventory using the LCM method on an item-by-item basis.
c. State the effect on net income in 2009 if the method in (b) was used rather than the method referred to in (a).
Problem J As part of a loan agreement with a local bank, Brazos Company must present quarterly and
cumulative income statements for the year 2009. The company uses periodic inventory procedure and marks its
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merchandise to sell at a price yielding a gross margin of 30 per cent. Selected data for the first six months of 2009
are as follows:
First Second Quarter Quarter
Sales $248,000 $256,000 Purchases 160,000 184,000 Purchase returns and allowances 9,600 11,200 Purchase discounts 3,200 3,520 Sales returns and allowances 8,000 4,800 Transportation-in 8,000 8,320 Miscellaneous selling expenses 25,600 24,000 Miscellaneous administrative expenses 9,600 8,000
The cost of the physical inventory taken 2008 December 31, was USD 30,400.
a. Indicate how income statements can be prepared without taking a physical inventory at the end of each of the
first two quarters of 2009.
b. Prepare income statements for the first quarter, the second quarter, and the first six months of 2009.
Cobb Company records show the following information for 2010:
Cost Retail Sales $350,400 Purchases $2/0,000 420,000 Transportation-in 26,280 — Merchandise inventory, January 1 12,000 1/,400 Purchase returns 15,120 18,600
Compute the estimated year-end inventory balance at cost using the retail method of estimating inventory.
Alternate problems
Alternate problem A Harris Company reported net income of USD 312,000 for 2009, USD 324,000 for 2010,
and USD 348,000
Recently Harris corrected these inventory amounts. Harris used the correct 2011 December 31, inventory
amount in calculating 2011 net income.
Accounting Principles: A Business Perspective 325 A Global Text
7. Measuring and reporting inventories
2009 December 31 $96,000 $108,000 2010 December 31 91,200 84,000
Prepare a schedule that shows: (a) the reported net income for each year, (b) the amount of correction needed
for each year, and (c) the correct net income for each year.
Alternate problem B An examination of the financial records of Jersey Company on 2009 December 31,
disclosed the following with regard to merchandise inventory for 2009 and prior years:
2008 December 31, inventory was correct.
2009 December 31, inventory was understated USD 50,000.
2010 December 31, inventory was overstated USD 35,000.
2011 December 31, inventory was understated USD 30,000.
2012 December 31, inventory was correct.
The reported net income for each year was:
2009 $292,500 2010 $355,000 2011 $382,500 2012 $350,000
a. Prepare a schedule of corrected net income for each of the four years, 2009-2012.
b. What errors would have been included in each December 31 balance sheet? Assume each year's error is
independent of the other years' errors.
c. Comment on the implications of the corrected net income as contrasted with reported net income.
Alternate problem C High Surf Company sells the Ultra-Light model wind surfer and uses the specific
identification method to account for its inventory. The Ultra-Lights are identical except for identifying serial
numbers. On 2009 August 1, the company had three Ultra-Lights that cost USD 14,000 each in its inventory.
During the month, the company purchased the following:
Units Unit cost August 3 5 @ $13,000 August 17 6 @ $14,500 August 28 6 @ 15,000
High Surf Company sold 13 Ultra-Lights in August at USD 20,000 each.
a. Compute the gross margin earned by the company in August if it shipped the units that would maximize gross
margin.
b. Repeat part (a) assuming the company shipped the units that would minimize gross margin.
c. Do you think High Surf Company should be permitted to use the specific identification method of accounting
for Ultra-Lights in view of the manipulation possible as shown by your calculations in (a) and (b)?
Alternate problem D The inventory records of Coral Company show the following:
Jan. 1 Beginning inventory consists of 12 units costing USD 48 per unit.
5 Purchased 15 units @ USD 49.92 per unit.
10 Sold 9 units @ USD 108 per unit.
12 Sold 7 units @ USD108 per unit.
20 Purchased 20 units @ USD 50.16 per unit.
22 Purchased 5 units @ USD 48 per unit.
30 Sold 20 units @ USD 110.40 per unit.
Assume all purchases and sales are made on account.
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a. Using FIFO perpetual inventory procedure, compute cost of goods sold for January.
b. Using FIFO perpetual inventory procedure, prepare the journal entries for January.
c. Compute the cost of goods sold under FIFO periodic inventory procedure. Is there a difference between the
amount computed using the two different procedures?
Alternate problem E Following are data for Dandy Company for the year 2010:
Units Unit Cost
Merchand ise Inventory, January 1
700 @ $20.4 0
Purchases : February 2 500 @
@ 21.00
Apr i l 5 1 ,000 24.00 June 1 5 600 @ 2/ .00 September 30 700 @ 30.00 November 28 900
4,400 @ 31.20
Sa les : March 5 400 Ju ly 18 1 ,200 Augus t 12 800 October 15 900
3 ,300
a. Compute the ending inventory as of 2010 December 31, assuming use of perpetual inventory procedure, under
each of the following methods: (1) FIFO, (2) LIFO, and (3) weighted-average (carry unit cost to four decimal places
and round total cost to nearest dollar).
b. Compute the ending inventory as of 2010 December 31, assuming use of periodic inventory procedure, under
each of the following methods: (1) FIFO, (2) LIFO, and (3) weighted-average.
Alternate problem F Refer to the data in alternate problem E
a. Give the journal entries to record the purchases and sales (Cost of Goods Sold entry only) for the year under
FIFO perpetual.
b. Give the journal entries to record the purchases for the year and necessary year-end entries to charge Income
Summary with the cost of goods sold for the year under FIFO periodic. (Note: You may want to refer to the
Appendix in Chapter 6 for this part.)
Alternate problem G Following are data related to a product of Coen Company for the year 2010:
Unit Units Cost
Merchandise Inventory, January 1 2,100 @ $12.60 Purchases: March 10 1,500 @ 12.00 May 24 3,000 @ 11.20 July 15 1,800 @ 10.50 September 20 2,100 @ 9.00 December 1 2,700 @ 10.00 Sales: April 5 1,400 June 13 2,900 October 9 2,300 November 21 1,700
a. Assuming use of perpetual inventory procedure, compute the ending inventory and cost of goods sold under
each of the following methods: (1) FIFO, (2) LIFO, and (3) weighted-average (carry unit cost to four decimal places
and round total cost to nearest dollar).
Accounting Principles: A Business Perspective 327 A Global Text
7. Measuring and reporting inventories
b. Assuming use of periodic inventory procedure, compute the ending inventory and cost of goods sold under
each of the following methods: (1) FIFO, (2), LIFO, and (3) weighted-average (carry unit cost to four decimal places
and round total cost to nearest dollar).
Alternate problem H Star Company accounts for its inventory using the LIFO method under periodic
inventory procedure. Data on purchases, sales, and inventory for the year ended 2009 December 31, are:
Units Unit Cost
Merchandise inventory, January 1 2,000 @ $20 Purchases: January / 5,000 @ 24 July 7 10,000 @ 28 December 21 6,000 @ 32
During 2009, 16,000 units were sold for USD 1,280,000, leaving an inventory on 2009 December 31, of 7,000
units.
a. Compute the gross margin earned on sales during 2009.
b. Compute the change in gross margin that would have resulted if the purchase of December 21 had been
delayed until 2010 January 6.
c. Recompute the gross margin assuming that 9,000 units rather than 6,000 units were purchased on December
21 at the same cost per unit.
d. Solve parts (a), (b), and (c) using the FIFO method.
Alternate problem I Data on the ending inventory of Jannis Company on 2009 December 31, are:
Unit Unit Item Quantity Cost Market 1 8,400 $3.20 $3.12 2 16,800 2.88 3.04 3 5,600 2.80 2.88 4 14,000 3.84 3.60 5 11,200 3.60 3.68 6 2,800 3.04 2.88
a. Compute the ending inventory applying the LCM method to the total inventory.
b. Determine the ending inventory by applying the LCM method on an item-by-item basis.
Alternate problem J The sales and cost of goods sold for Lively Company for the past five years were as
follows:
Sales Cost of Year (net) Goods Sold 2004 $ 9,984,960 $ 6,240,600 2005 10,794,240 6,746,400 2006 12,346,560 7,716,600 2007 11,926,080 7,272,000 2008 12,747,840 7,920,000
The following information is for the seven months ended 2009 July 31:
Sales $7,748,000 Purchases 4,588,800 Purchase returns 28,800 Sales returns 173,760 Merchandise inventory, 2009 January 1 948,000
To secure a loan, Lively Company has been asked to present current financial statements. However, the
company does not wish to take a complete physical inventory as of 2009 July 31.
a. Indicate how financial statements can be prepared without taking a complete physical inventory.
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b. From the data given, compute the estimated inventory as of 2009 July 31.
Alternate problem K Apple Company's records contained the following inventory information:
Cost Retail Sales $420,000 Purchases $396,000 582,000 Purchase returns 8,400 12,000 Transportation-in 10,800 — Merchandise inventory January 1 21,600 30,000
Beyond the numbers—Critical thinking
Business decision case A Susan Green and Carol Lewis, were interested in starting part-time business
activities to supplement their family incomes. Both heard a presentation by the manufacturer of an exercise device
and decided to become a distributor of this exerciser. Green's sales territory is Cobb County, and Lewis's sales
territory is Gwinnett County. Each owns her own business.
To induce Green and Lewis to become distributors, the manufacturer made price concessions on the first 1,000
units purchased. The manufacturer sold the first 200 units at USD 15 each, the next 300 at USD 18 per unit, and
the next 500 at USD 19 per unit. After that, Green and Lewis had to pay USD 20 per unit.
During the first year, each bought 1,200 units; coincidentally, both sold exactly 950 units for USD 27 each.
Green had USD 2,600 of selling expenses; Lewis incurred USD 1,700 of selling expenses. (Green's expenses were
considerably higher because on December 28 she distributed 4,000 sales brochures to households in her territory
at a cost of USD 800. The brochures stressed that people would want to take off the extra pounds gained during the
holiday season; also, these exercisers were inexpensive and could be used at home.)
At the end of the year, both had to determine their net incomes. Green received a B in the accounting course she
took at State University. She remembered the FIFO inventory method and plans to use it. Lewis knows nothing
about inventory costing methods. However, her husband is acquainted with the LIFO inventory method used at the
company where he works. He will help her compute the cost of the ending inventory and the cost of goods using
LIFO.
a. Prepare income statements for Green and Lewis.
b. Which business has performed better? Explain why.
c. Determine the inventory turnovers for Green and Lewis.
Business decision case B Connie Dalton owns and operates a sporting goods store. On February 2 the store
suffered extensive fire damage, and all of the inventory was destroyed. Dalton uses periodic inventory procedure
and has the following information in her accounting records, which were undamaged:
Accounting Principles: A Business Perspective 329 A Global Text
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Merchandise Inventory, January 1 $ 80,000 Purchases: January 8 32,000 January 20 48,000 January 30 64,000 Net Sales: During January 240,000 February 1 and 2 16,000
Dalton's gross margin rate on net sales has been 40 per cent for the past three years. Her insurance company
offered to pay USD 56,000 to settle this inventory loss unless Dalton can show that she suffered a greater loss. She
has asked you, her CPA, to help her in determining her loss.
Answer these questions: Based on your analysis, should Dalton settle for USD 56,000? If not, how can she show
that she suffered a greater loss? What is your estimate of her loss?
Annual report analysis C Refer to the financial statements of The Limited in the Annual Report Appendix.
Describe how inventory values are determined (see Footnote 1). Also, determine the inventory turnover ratio for
2000.
Ethics case – Writing experience D Respond in writing to the following questions based on the ethics case
concerning Terry Dorsey:
a. Do you believe that Terry's scheme will work?
b. What would you do if you were Terry's accountant?
c. Comment on each of Terry's points of justification.
Group project E In teams of two or three students, interview the manager of a merchandising company.
Inquire about inventory control methods, inventory costing methods, and any other information about the
company's inventory procedures. As a team, write a memorandum to your instructor summarizing the results of the
interview. The heading of the memorandum should include the date, to whom it is written, from whom, and the
subject matter.
Group project F In a team of two or three students, locate and visit a nearby retail store that uses perpetual
inventory procedure and a computerized inventory management system. Investigate how the system works by
interviewing a knowledgeable person in the company. Write a report to your instructor and make a short
presentation to the class on your findings.
Group project G With a small group of students, identify and visit a retail store that uses periodic inventory
procedure and uses the retail inventory method for preparing interim (monthly or quarterly) financial reports.
Discover how the retail inventory method is applied and how the end-of-year inventory amount is calculated. Write
a report to your instructor summarizing your findings.
Using the Internet—A view of the real world
Visit the National Association of State Boards of Accountancy website at:
http://www.nasba.org
Find the address of the state board of accountancy in your state. Also check out some of the information
provided at websites of other state boards by clicking on any sites that appear at the end of a listing for a particular
state. In a report to your instructor, summarize what you learned about state boards at some of these sites.
Visit the Lexis-Nexis website at:
http://www.lexis-nexis.com
Accounting Principles: A Business Perspective 330 A Global Text
7. Measuring and reporting inventories
Determine the kinds of information that can be obtained at this site. Specifically, what kinds of products and
services are available? What is the background of Lexis-Nexis? What pricing information is available for using its
services? Write a report to your instructor summarizing your findings.
Answers to self-test
True-false
False. Overstated ending inventory results in an understatement of cost of goods sold and an overstatement of
gross margin and net income.
True. The cost of goods sold consists of the earliest purchases at the lowest costs in a period of rising prices.
False. Under LCM, inventory is adjusted to market value only when the market (replacement) value is less than
the cost.
True. The first step in the gross margin method is to estimate gross margin using the gross margin rate
experienced in the past.
True. The cost/retail ratio is computed by dividing the cost of goods available for sale by the retail price of the
goods available for sale.
False. Under perpetual procedure, the Cost of Goods Sold account is updated as sales occur.
Multiple-choice
b. The cost of ending inventory using FIFO consists of the most recent purchase:
Cost of ending inventory=3,400×USD 36=USD122,400
c. The cost of goods sold using FIFO is:
Cost of goods availablefor sale=3,000×USD305,000×USD36=USD270,000
Cost of goodssold=USD 270,000 – USD122,400=USD147,600
a. The cost of ending inventory using LIFO is:
3,000×USD 30400×USD36=USD104,400
d. The cost of goods sold using LIFO is:
USD 270,000 – USD 104,400=USD165,600
a. The cost of ending inventory using weighted-average cost is computed:
Unit cost=USD270,000−8,000=USD33.75
Cost of ending inventory=3,400 X USD33.75=USD114,750
c. The cost of goods sold using weighted-average cost is:
USD 270,000 – USD 114,750=USD155,250
b. During a period of rising prices, FIFO results in the lowest cost of goods sold, thus the highest net income.
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8. Control of cash Learning objective
After studying this chapter, you should be able to:
• Describe the necessity for and features of internal control.
• Define cash and list the objectives sought by management in handling a company's cash.
• Identify procedures for controlling cash receipts and disbursements.
• Prepare a bank reconciliation and make necessary journal entries based on that schedule.
• Explain why a company uses a petty cash fund, describe its operations, and make the necessary journal
entries.
• Analyze and use the financial results-quick ratio.
A career in forensic accounting
This chapter emphasizes the importance of having effective internal controls in every business. Unfortunately,
many smaller companies do not heed this advice. Failure to implement adequate internal controls can result in
financial statement fraud (purposely misstated financial statements) or embezzlement (theft). This is when the
services of a forensic accountant may be necessary. Forensic accounting is the application of accounting
methodology to legal issues. It is frequently associated with the investigation of civil or criminal white-collar crime
such as fraud, embezzlement, and general abuse of funds issues. Typical tools used in forensic accounting are bank
records, personal financial statements, interviews, and credit reports. The forensic accountant's responsibility is to
gather and analyze the evidence and deliver clear, accurate, and unbiased reports reflecting the results of the
investigation. Forensic accounting is commonly performed by Certified Fraud Examiners (CFEs). CFEs have
extensive training and possess special expertise in investigation and interview techniques specifically designed to
detect or prevent fraud.
A well-known agency performing forensic accounting in the United States is in the Federal Bureau of
Investigation (FBI). You can learn more about the FBI from their homepage at www.fbi.gov. Click on employment
in the 'About Us' section and then click on special agent employment to learn more about what it takes to be an FBI
special agent. Did you know that the fastest track to becoming an FBI agent is with an accounting undergraduate
degree? There are four entry programs for becoming an FBI special agent: accounting, law, language, and
diversified. Law requires an undergraduate degree and a law degree, language requires an undergraduate degree
and proficiency in a second language, and diversified requires three years of work experience beyond an
undergraduate degree. The only entry program requiring only an undergraduate degree is one with an
undergraduate accounting option. Why accounting? Because an ever-increasing portion of crimes investigated by
the FBI are white-collar crimes where accounting knowledge is essential.
In a small corporation the president might make all the important decisions and will usually maintain a close
watch over the affairs of the business. However, as the business grows and the need arises for additional employees,
officers, and managers, the president begins to lose absolute control. Realizing that precautions are necessary to
protect the company's interests, the company establishes an internal control structure at this point.
Accounting Principles: A Business Perspective 332 A Global Text
8. Control of cash
The internal control structure of a company consists of "the policies and procedures established to provide
reasonable assurance that specific entity objectives will be achieved".27 The three elements of an internal control
structure are the control environment, the accounting system, and the control procedures.
The control environment reflects the overall attitude, awareness, and actions of the board of directors,
management, and stockholders. The accounting system consists of the methods and records that identify,
assemble, analyze, classify, record, and report an entity's transactions to provide complete, accurate, and timely
financial information. The control procedures of a company are additional policies and procedures that
management establishes to provide reasonable assurance that the company achieves its specific objectives. These
control procedures may pertain to proper authorization, segregation of duties, design and use of adequate
documents and records, adequate safeguards over access to assets, and independent checks on performance.
Internal control not only prevents theft and fraud but also serves many purposes:
(1) Companies must implement policies requiring compliance with federal law; (2) personnel must perform their
assigned duties to promote efficiency of operations; and (3) correct accounting records must supply accurate and
reliable information in the accounting reports.
This chapter discusses the internal control structure that a company establishes to protect its assets and
promote the accuracy of its accounting records.
You will learn how to establish internal control through control of cash receipts and cash disbursements, proper
use of the bank checking account, preparation of the bank reconciliation, and protection of petty cash funds. The
internal control structure is enhanced by hiring competent and trustworthy employees, a fact you will appreciate if
you become a business owner.
Internal control
An effective internal control structure includes a company's plan of organization and all the procedures and
actions it takes to:
• Protect its assets against theft and waste.
• Ensure compliance with company policies and federal law.
• Evaluate the performance of all personnel to promote efficient operations.
• Ensure accurate and reliable operating data and accounting reports.
As you study the basic procedures and actions of an effective internal control structure, remember that even
small companies can benefit from using some internal control measures. Preventing theft and waste is only a part
of internal control.
In general terms, the purpose of internal control is to ensure the efficient operations of a business, thus enabling
the business to effectively reach its goals. Since additional control procedures are necessary in a computer
environment, a discussion of these controls concludes this section on internal control.
27 AICPA, Statement on Auditing Standards No. 55, "Consideration of the Internal Control Structure in a
Financial Statement Audit" (New York, 1988), p. 4. The sixth and seventh editions of this text use the
terminology (internal control structure) of the AICPA. Previous editions referred to the "internal control
system."
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An accounting perspective:
Business insight
When performing an audit, one of an outside auditor's first duties is to examine the internal
control structure of the corporation. To understand the internal control structure, an auditor
focuses mainly on management's attitude and awareness concerning controls and the accounting
system's processing of transactions. To increase understanding, the auditor inspects documents in
the accounting system, discusses external influences on the company with management, reads
accounting manuals, and observes the happenings in the company. This understanding of the
company's control environment helps the auditor to plan the audit and to determine the nature,
timing, and extent of tests.
Companies protect their assets by (1) segregating employee duties, (2) assigning specific duties to each
employee, (3) rotating employee job assignments, and (4) using mechanical devices.
Segregation of employee duties Segregation of duties requires that someone other than the employee
responsible for safeguarding an asset must maintain the accounting records for that asset. Also, employees share
responsibility for related transactions so that one employee's work serves as a check on the work of other
employees.
When a company segregates the duties of employees, it minimizes the probability of an employee being able to
steal assets and cover up the theft. For example, an employee could not steal cash from a company and have the
theft go undetected unless someone changes the cash records to cover the shortage. To change the records, the
employee stealing the cash must also maintain the cash records or be in collusion with the employee who maintains
the cash records.
Assignment of specific duties to each employee When the responsibility for a particular work function is
assigned to one employee, that employee is accountable for specific tasks. Should a problem occur, the company
can quickly identify the responsible employee.
When a company gives each employee specific duties, it can trace lost documents or determine how a particular
transaction was recorded. Also, the employee responsible for a given task can provide information about that task.
Being responsible for specific duties gives people a sense of pride and importance that usually makes them want to
perform to the best of their ability.
Rotation of employee job assignments Some companies rotate job assignments to discourage employees
from engaging in long-term schemes to steal from them. Employees realize that if they steal from the company, the
next employees assigned to their positions may discover the theft.
Frequently, companies have the policy that all employees must take an annual vacation. This policy also
discourages theft because many dishonest schemes collapse when the employee does not attend to the scheme on a
daily basis.
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8. Control of cash
Use of mechanical devices Companies use several mechanical devices to help protect their assets. Check
protectors (machines that perforate the check amount into the check), cash registers, and time clocks make it
difficult for employees to alter certain company documents and records.
Internal control policies are effective only when employees follow them. To ensure that they carry out its
internal control policies, a company must hire competent and trustworthy employees. Thus, the execution of
effective internal control begins with the time and effort a company expends in hiring employees. Once the
company hires the employees, it must train those employees and clearly communicate to them company policies,
such as obtaining proper authorization before making a cash disbursement. Frequently, written job descriptions
establish the responsibilities and duties of employees. The initial training of employees should include a clear
explanation of their duties and how to perform them.
In publicly held corporations, the company's internal control structure must satisfy the requirements of federal
law. In December 1977, Congress enacted the Foreign Corrupt Practices Act (FCPA). This law requires a publicly
held corporation to devise and maintain an effective internal control structure and to keep accurate accounting
records. This law came about partly because company accounting records covered up bribes and kickbacks made to
foreign governments or government officials. The FCPA made this specific type of bribery illegal.
To evaluate how well employees are doing their jobs, many companies use an internal auditing staff. Internal
auditing consists of investigating and evaluating employees' compliance with the company's policies and
procedures. Companies employ internal auditors to perform these audits. Trained in company policies and
internal auditing duties, internal auditors periodically test the effectiveness of controls and procedures throughout
the company.
Internal auditors encourage operating efficiency throughout the company and are alert for breakdowns in the
company's internal control structure. In addition, internal auditors make recommendations for the improvement of
the company's internal control structure. All companies and nonprofit organizations can benefit from internal
auditing. However, internal auditing is especially necessary in large organizations because the owners
(stockholders) cannot be involved personally with all aspects of the business.
Companies should maintain complete and accurate accounting records. The best method to ensure such
accounting records is to hire and train competent and honest individuals. Periodically, supervisors evaluate an
employee's performance to make sure the employee is following company policies. Inaccurate or inadequate
accounting records serve as an invitation to theft by dishonest employees because theft can be concealed more
easily.
One or more business documents support most accounting transactions. These source documents are an
integral part of the internal control structure. For optimal control, source documents should be serially numbered.
(Transaction documentation and related aspects of internal control are presented throughout the text.)
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PURCHASE REQUISITION No. 2416 BRYAN WHOLESALE COMPANY
From; Automotive Supplies Department Date: 2010 November 20 To: Purchasing Department Suggested
supplier: Wi lkes Rad io Company Please purchase the following items; Description Item Number Quantity Estimated Price
Mode l No . 5868- 24393
200 $50 per un i t
Reason for request: To be filled in by purchasing department: Customer order Dated ordered 2010 November 29 Baier Company Purchase order number N-MS
Approved R .S .T.
Exhibit 65: Purchase requisition
Since source documents serve as documentation of business transactions, from time to time firms check the
validity of these documents. For example, to review a purchase transaction, they check the documents used to
record the transaction against the proper accounting records. When the accounting department records a purchase
transaction, it should receive copies of the following four documents:
• A purchase requisition (Exhibit 65) is a written request from an employee inside the company to the
purchasing department to purchase certain items.
• A purchase order (Exhibit 66) is a document sent from the purchasing department to a supplier
requesting that merchandise or other items be shipped to the purchaser.
• An invoice (Exhibit 67) is the statement sent by the supplier to the purchaser requesting payment for the
merchandise shipped.
• A receiving report is a document prepared by the receiving department showing the descriptions and
quantities of all items received from a supplier in a particular shipment. A copy of the purchase order can serve
as a receiving report if the quantity ordered is omitted. Then, because receiving department personnel do not
know what quantity to expect, they will count the quantity received more accurately.
These four documents together serve as authorization to pay for merchandise and should be checked against the
accounting records. Without these documents, a company might fail to pay a legitimate invoice, pay fictitious
invoices, or pay an invoice more than once. Companies can accomplish proper internal control only by periodically
checking the source documents of business transactions with the accounting records of those transactions. In
Exhibit 68 we show the flow of documents and goods in a merchandise transaction.
PURCHASE ORDER No. N-145 BRYAN WHOLESALE COMPANY 476 Mason Street Detroit, Michigan 48823
To: Wilkes Radio Company 2515 West Peachtree Street Date: 2010 November 21 Atlanta, Georgia 30303 Ship by: 2010 December 20 Ship to: Above address FOB terms requested: Destination
Discount terms requested: 2/10, n/30 Please send the foil owing item;
Description Item Number Quantity Price Per Unit
Total Amount
True-tone stereo radios
Model No. 5868-24393
200 $50 $10,000
Ordered by: Jane Knight Please include order number on all invoice and shipments.
Exhibit 66: Purchase order
Unfortunately, even though a company implements all of these features in its internal control structure, theft
may still occur. If employees are dishonest, they can usually figure out a way to steal from a company, thus
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8. Control of cash
circumventing even the most effective internal control structure. Therefore, companies should carry adequate
casualty insurance on assets. This insurance reimburses the company for loss of a nonmonetary asset such as
specialized equipment. Companies should also have fidelity bonds on employees handling cash and other
negotiable instruments. These bonds ensure that a company is reimbursed for losses due to theft of cash and other
monetary assets. With both casualty insurance on assets and fidelity bonds on employees, a company can recover at
least a portion of any loss that occurs.
According to the Committee of Sponsoring Organizations of the Treadway Commission, there are five
components of an internal control structure. When these components are linked to the organization's operations,
they can quickly respond to shifting conditions. The components are:
• Control environment. The control environment is the basis for all other elements of the internal control
structure. The control environment includes many factors such as ethical values, management's philosophy,
the integrity of the employees of the corporation, and the guidance provided by management or the board of
directors.
• Risk assessment. After the entity sets objectives, the risks (such as theft and waste of assets) from
external and internal sources must be assessed. Examining the risks associated with each objective allows
management to develop the means to control these risks.
• Control activities. To address the risks associated with each objective, management establishes control
activities. These activities include procedures that employees must follow. Examples include procedures to
protect the assets through segregation of employee duties and the other means we discussed earlier.
• Information and communication. Information relevant to decision making must be collected and
reported in a timely manner. The events that yield these data may come from internal or external sources.
Communication throughout the entity is important to achieve management's goals. Employees must
understand what is expected of them and how their responsibilities relate to the work of others.
Communication with external parties such as suppliers and shareholders is also important.
• Monitoring. After the internal control structure is in place, the firm should monitor its effectiveness so
that it can make changes before serious problems arise. In testing components of the internal control
structure, companies base their thoroughness on the risk assigned to those components.
Internal control is the general responsibility of all members in an organization. However, the following three
groups have specific responsibilities regarding the internal control structure.
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INVOICE Invoice No. 1574 Date: 2010 Dec. 15
WILXES RADIO COMPANY 2515 West Peachtree Street Atlanta, Georgia 30303
Customer's Orders No. N-14S
Sold to: Bryan Wholesale Co.
Address: 475 Mason Street
Detroit, Michigan 4S823
Terms: 2/10, n/30, FOB destination Date shipped: 2010 December 15
Shipped by: Nagel Trucking Co.
Description Item Number Quantity Price Per Unit
Total Amount
Model No. 5868-24393
200 $50 $10,000
Total $10,000
Exhibit 67: Invoice
Management holds ultimate responsibility for establishing and maintaining an effective internal control
structure. Through leadership and example, management demonstrates ethical behavior and integrity within the
company.
The board of directors provides guidance to management. Because board members have a working knowledge of
the functions of the company, they help shield the company from managers who try to override some control
procedures for dishonest purposes. Often, an efficient board that has access to the company's internal auditors can
discover such fraud.
Auditors within the organization evaluate the effectiveness of the internal control structure and determine
whether company policies and procedures are being followed. All employees are part of a communications network
that enables an internal control structure to work effectively.
Computerized financial records require the same internal control principles of separation of duties and control
over access as a manual accounting system. The exact control steps depend on whether a company is using
mainframe computers and minicomputers or microcomputers.
Large corporations might use all three types of computers in their accounting environments. The size and
complexity of mainframe computers and minicomputers require specially trained persons to keep these systems
operating. While systems specialists operate the computer system itself, programmers develop the programs that
direct the computer to perform specific tasks. In a mainframe or minicomputer environment, internal control
should include the following:
• Control computer access by placing the computer in an easily secured room, and allow only persons
authorized to operate the computer to enter the room.
• Restrict the access of systems specialists (who operate the computer) to software programs and the access
of programmers to the computer. This policy prevents the running of unauthorized, altered programs.
• Require the use of passwords to access sensitive company data and confidential personal data. Change the
passwords as necessary.
Many smaller companies use microcomputers instead of a mainframe or a minicomputer. Also, large companies
might supply certain employees with personal computers. The use of personal computers changes the control
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8. Control of cash
environment somewhat. Small companies generally do not employ systems specialists and programmers. Instead,
these companies use off-the-shelf programs such as accounting, spreadsheet, database management, and word
processing packages. The data created by use of these programs are valuable (e.g. the company's accounting
records) and often sensitive. Thus, controls are also important. In a personal computer environment, the following
controls can be useful:
Exhibit 68: Flow of documents and goods in a merchandising transaction
• Require computer users to have tight control over storage of programs and data. Just as one person
maintains custody over a certain set of records in a manual system, in a computer system one person
maintains custody over certain information (such as the accounts receivable subsidiary ledger). Make backup
copies that are retained in a different secured location.
• Require passwords (kept secret) to gain entry into data files maintained on the hard disk.
• In situations where a local area network (LAN) links the personal computers into one system, permit only
certain computers and persons in the network to have access to some data files (the accounting records, for
example).
Computerized accounting systems do not lessen the need for internal control. In fact, access to a computer by an
unauthorized person could result in significant theft in less time than with a manual system.
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Controlling cash
Since cash is the most liquid of all assets, a business cannot survive and prosper if it does not have adequate
control over its cash. In accounting, cash includes coins; currency; undeposited negotiable instruments such as
checks, bank drafts, and money orders; amounts in checking and savings accounts; and demand certificates of
deposit. A certificate of deposit (CD) is an interest-bearing deposit that can be withdrawn from a bank at will
(demand CD) or at a fixed maturity date (time CD). Only demand CDs that may be withdrawn at any time without
prior notice or penalty are included in cash. Cash does not include postage stamps, IOUs, time CDs, or notes
receivable.
In its general ledger, a company usually maintains two cash accounts—Cash and Petty Cash. On the company's
balance sheet, it combines the balances of these two accounts into one amount reported as Cash.
An accounting perspective:
Business insight
Users of financial data must look to see the real meaning behind the numbers. Reader's Digest
publishes the world's most widely read magazine as well as various other books, home
entertainment products, and special interest magazines. In Reader's Digest's annual report, for
example, the company defines cash and cash equivalents in this footnote:
The company considers all highly liquid debt instruments with original maturities of three months
or less to be cash equivalents.
Since many business transactions involve cash, it is a vital factor in the operation of a business. Of all the
company's assets, cash is the most easily mishandled either through theft or carelessness. To control and manage
its cash, a company should:
• Account for all cash transactions accurately so that correct information is available regarding cash flows
and balances.
• Make certain that enough cash is available to pay bills as they come due.
• Avoid holding too much idle cash because excess cash could be invested to generate income, such as
interest.
• Prevent loss of cash due to theft or fraud.
The need to control cash is clearly evident and has many aspects. Without the proper timing of cash flows and
the protection of idle cash, a business cannot survive. This section discusses cash receipts and cash disbursements.
Later in the chapter, we explain the importance of preparing a bank reconciliation for each bank checking account
and controlling the petty cash fund.
When a merchandising company sells its merchandise inventory, it may receive cash immediately or several
days or weeks later. A clerk receives the cash immediately over the counter, records it, and places it in a cash
register. The presence of the customer as the sale is rung up usually ensures that the cashier enters the correct
amount of the sale in the cash register. At the end of each day, stores reconcile the cash in each cash register with
the cash register tape or computer printout for that register. Payments received later are almost always in the form
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8. Control of cash
of checks. Stores prepare a record of the checks received as soon as they are received. Some merchandising
companies receive all their cash receipts on a delayed basis as payments on accounts receivable. (See the cash
receipts cycle for merchandise transactions in Exhibit 69.)
Although businesses vary their specific procedures for controlling cash receipts, they usually observe the
following principles:
• Prepare a record of all cash receipts as soon as cash is received. Most thefts of cash occur before a record is
made of the receipt. Once a record is made, it is easier to trace a theft.
• Deposit all cash receipts intact as soon as feasible, preferably on the day they are received or on the next
business day. Undeposited cash is more susceptible to misappropriation.
• Arrange duties so that the employee who handles cash receipts does not record the receipts in the
accounting records. This control feature follows the general principle of segregation of duties given earlier in
the chapter, as does the next principle.
• Arrange duties so that the employee who receives the cash does not disburse the cash. This control measure
is possible in all but the smallest companies.
Companies also need controls over cash disbursements. Since a company spends most of its cash by check, many
of the internal controls for cash disbursements deal with checks and authorizations for cash payments. The basic
principle of segregation of duties also applies in controlling cash disbursements. Following are some basic control
procedures for cash disbursements:
• Make all disbursements by check or from petty cash. Obtain proper approval for all disbursements and
create a permanent record of each disbursement. Many retail stores make refunds for returned merchandise
from the cash register. When this practice is followed, clerks should have refund tickets approved by a
supervisor before refunding cash.
• Require all checks to be serially numbered and limit access to checks to employees authorized to write
checks.
• Require two signatures on each check over a material amount so that one person cannot withdraw funds
from the bank account.
Exhibit 69: Cash receipts cycle for merchandise transactions
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• Arrange duties so that the employee who authorizes payment of a bill does not sign checks. Otherwise, the
checks could be written to friends in payment of fictitious invoices.
• Require approved documents to support all checks issued.
• Instruct the employee authorizing cash disbursements to make certain that payment is for a legitimate
purpose and is made out for the exact amount and to the proper party.
• Stamp the supporting documents paid when liabilities are paid and indicate the date and number of the
check issued. These procedures lessen the chance of paying the same debt more than once.
• Arrange duties so that those employees who sign checks neither have access to canceled checks nor prepare
the bank reconciliation. This policy makes it more difficult for an employee to conceal a theft.
• Have an employee who has no other cash duties prepare the bank reconciliation each month, so that errors
and shortages can be discovered quickly.
• Void all checks incorrectly prepared. Mark these checks void and retain them to prevent unauthorized use.
Exhibit 70 shows an overview of some of the internal control considerations relating to cash.
Most companies use checking accounts to handle their cash transactions. The company deposits its cash receipts
in a bank checking account and writes checks to pay its bills. The bank sends the company a statement each month.
The company checks this statement against its records to determine if it must make any corrections or adjustments
in either the company's balance or the bank's balance. You learn how to do bank reconciliations later in this
chapter. In the next section, we discuss the bank checking account. If you have a personal checking account, some
of this information will be familiar to you.
Exhibit 70: Internal control considerations regarding cash
Accounting Principles: A Business Perspective 342 A Global Text
8. Control of cash
An accounting perspective:
Uses of technology
Many companies are using Electronic Data Interchange (EDI) to transmit business documents
such as purchase orders, invoices, and even payments for goods and services. Instead of mailing
paper copies of these documents, the entire transaction is done electronically. This procedure
speeds up the transaction and eliminates the expense of sending paper copies. One concern of such
procedures is the security of the transaction. Since this issue is being successfully addressed by
various methods, including encrypting the data, we can expect the use of EDI to continue to
increase in the future.
The bank checking account
Banks earn income by providing a variety of services to individuals, businesses, and other entities such as
churches or libraries. One of these services is the checking account. A checking account is a money balance
maintained in the bank; it is subject to withdrawal by the depositor, or owner of the money, on demand. To provide
depositors with an accurate record of depositor funds received and disbursed, a bank uses the business documents
discussed in this section.28
A bank requires a new depositor to complete a signature card, which provides the signatures of persons
authorized to sign checks drawn on an account. The bank retains the card and uses it to identify signatures on
checks it pays. The bank does not compare every check with this signature card. Usually, it makes a comparison
only when the depositor disputes the validity of a check paid by the bank or when someone presents a check for an
unusually large sum for payment.
When depositors make a bank deposit, they prepare a deposit ticket or slip. A deposit ticket is a form that
shows the date and the items that make up the deposit (Exhibit 71). Often, the ticket is pre-printed to show the
depositor's name, address, and account number. A depositor enters the items constituting the deposit—cash and a
list of checks—on the ticket when making the deposit. The depositor receives a receipt showing the date of deposit
and the amount deposited.
A check is a written order to a bank to pay a specific sum of money to the party designated as the payee by the
party issuing the check. Thus, every check transaction involves three parties: the bank, the payee (party to whom
the check is made payable), and the drawer (depositor). Most depositors use serially numbered checks pre-printed
with information about the depositor, such as name, address, and telephone number. Often a business check has an
attached remittance advice. A remittance advice informs the payee why the drawer (or maker) of the check is
making this payment. Before cashing or depositing it, the payee detaches the remittance advice from the check
(Exhibit 72).
28 Due to relaxed federal regulations, institutions other than banks—such as savings and loan associations and
credit unions—now offer checking account services. All of these institutions function somewhat similarly; but,
for simplicity's sake, we discuss only banks here.
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Exhibit 71: Deposit ticket
Exhibit 72: Check with attached remittance advice
JOHH DOE'S COMPANY P 0 BOX 216603 C0RVALLIS OR 218803
6141337 2010 September 1THRU 2010/09/29 PAGE 1
ASK US ABOUT REAL ESTATE AHD CONSTRUCTIOH LOANS BUSINESS BASIC ACCOUNT 614153
DESCRIPTION DEBITS CREDIT DATE BALANCE
BALANCE LAST STATEMENT 2010/08/31 3,594.44
CHECK # 1033 68.77 2010/09/08 3,52 5.67
CHECK # 1031 102.41 2010/09/08 3,423.26
DEPOSIT 7,300.00 2010/09/14 10,723.25
CHECK # 1036 38.95 2010/09/18 10,684.31
CHECK # 1037 16.08 2010/09/20 10,668.23
CHECK # 1035 114.50 2010/09/21 10,553.33
CHECK # 1038 7105.00 2010/09/21 3,448,33
CHECK # 1039 137.45 2010/09/25 3,310.88
Accounting Principles: A Business Perspective 344 A Global Text
8. Control of cash
DEPOSIT 1,000.00 2010/09/28 4,310.88
NEF CHECK 102.00 2010/09/30 4,208.88
SERVICE CHARGE 8,00 2010/09/30 4,200.88
SAFE DEPOSIT BOX REMT 15.00 2010/09/30 4,185.38
BALANCE THIS STATEMENT 2010/09/30 4,1S5.3S
TOTAL CREDITS (2) S,300.00 MINIMUM BALANCE 3,195.68
TOTAL DEBITS (7) 7,708.55 AVG AVAILABLE BALAHCE 5,236.31
Average BALANCE 5,23S,31
YOUR CHECKS SEQUENCED
DATE CHECK # AMOUNT DATE CHECK # AMOUNT DATE CHECK # AMOUNT 1031* 102.41 09/18 1036 38.95 03/25 1039 137,45
09/08 1033* 6B. 77 09/20 1037 16.08 09/21 1035 114.90 09/21 1033 7,105,00
Exhibit 73: Bank statement
A bank statement is a statement issued (usually monthly) by a bank describing the activities in a depositor's
checking account during the period. Exhibit 73 shows a bank statement that includes the following data:
• Deposits made to the checking account during the period.
• Checks paid out of the depositor's checking account by the bank during the period. These checks have
cleared the bank and are canceled.
• Other deductions from the checking account for service charges, NSF (not sufficient funds) checks, safe-
deposit box rent, and check printing fees. Banks assess service charges on the depositor to cover the cost of
handling the checking account, such as check clearing charges. An NSF (not sufficient funds) check is Bank
Statement a customer's check returned from the customer's bank to the depositor's bank because the funds in
the customer's checking account balance were insufficient to cover the check. The depositor's bank deducts the
amount of the returned check from the depositor's checking account. Since the customer still owes the
depositor money, the depositor restores the amount of the NSF check to the account receivable for that
customer in the company's books.
• Other additions to the checking account from proceeds of a note collected by the bank for the depositor and
interest earned on the account.
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Exhibit 74: Debit memorandum (top) and credit memorandum (bottom)
In addition to the data in the bank statement in Exhibit 73, bank statements also can show non-routine deposits
made to the depositor's checking account. Such deposits are made by a third party. For example, the bank may have
received a wire transfer of funds for the depositor.
A wire transfer of funds is an interbank transfer of funds by telephone. Companies that operate in many
widely scattered locations and have checking accounts with several different local banks often use interbank
transfers of funds. These companies may set up special procedures to avoid accumulating too much idle cash in
local bank accounts. One such procedure involves the use of special-instruction bank accounts. For example, a
company may set up transfer bank accounts so local banks automatically transfer to a central bank (by wire or
bank draft) all amounts on deposit in excess of a stated amount. In this way, transfers move funds not needed for
local operations quickly to headquarters, where the company can use the funds or invest them.
Accounting Principles: A Business Perspective 346 A Global Text
8. Control of cash
Frequently, the bank returns canceled checks and original deposit tickets with the bank statement. Since it is
expensive to sort, handle, and mail these items, some banks no longer return them to depositors. These banks
usually store the documents on microfilm, with photocopies available if needed. Most depositors need only a
detailed bank statement, as shown in Exhibit 73, and not the original documents to show what transactions
occurred during a given period.
When banks debit or credit a depositor's checking account, they prepare debit and credit memoranda (memos).
Banks may also return these memos with the bank statement. A debit memo is a form used by a bank to explain a
deduction from the depositor's account; a credit memo explains an addition to the depositor's account. The terms
debit memo and credit memo may seem reversed, but remember that the depositor's checking account is a liability
—an account payable—of the bank. So, when the bank seeks to reduce a depositor's balance, it prepares a debit
memo. To increase the balance, it prepares a credit memo. Exhibit 74 contains examples of debit and credit memos.
Some banks no longer mail these documents to the depositor and rely instead on explanations in the bank
statements.
Information that the depositor did not know before receiving the bank statement requires new journal entries on
the company's books. After the entries have been made to record the new information, the balance in the Cash
account is the actual cash available to the company. When the depositor has already received notice of NSF checks
and other bank charges or credits, the needed journal entries may have been made earlier. In this chapter, we
assume no entries have been made for these items unless stated otherwise.
When a company receives its bank statement, it must reconcile the balance shown by the bank with the cash
balance in the company's books. If you have a personal checking account, you also should reconcile your bank
statement with your checkbook. You can use the reconciliation form on the back of the bank statement to list your
checks that have not yet been paid by the bank and your deposits not yet shown on the bank statement. Some small
businesses use this form. Others prepare a separate bank reconciliation, which we discuss in the next section.
Bank reconciliation
A bank reconciliation is a schedule the company (depositor) prepares to reconcile, or explain, the difference
between the cash balance on the bank statement and the cash balance on the company's books. The company
prepares a bank reconciliation to determine its actual cash balance and prepare the entry(ies) to correct the cash
balance in the ledger.
An accounting perspective:
Business insight
Within the internal control structure, segregation of duties is an important way to prevent fraud.
One place to segregate duties is between the cash disbursement cycle and bank reconciliations. To
prevent collusion among employees, the person who reconciles the bank account should not be
involved in the cash disbursement cycle. Also, the bank should mail the statement directly to the
person who reconciles the bank account each month. Sending the statement directly limits the
number of employees who would have an opportunity to tamper with the statement.
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Look at Exhibit 75; the bank reconciliation has two main sections. The top section begins with the balance on the
bank statement. The bottom section begins with the balance on the company's books. After the company makes
adjustments to both the bank and book balances, both adjusted balances should be the same. The steps in
preparing a bank reconciliation are as follows:
Deposits. Compare the deposits listed on the bank statement with the deposits on the company's books. To
make this comparison, place check marks in the bank statement and in the company's books by the deposits that
agree. Then determine the deposits in transit. A deposit in transit is typically a day's cash receipts recorded in
the depositor's books in one period but recorded as a deposit by the bank in the succeeding period. The most
common deposit in transit is the cash receipts deposited on the last business day of the month. Normally, deposits
in transit occur only near the end of the period covered by the bank statement. For example, a deposit made in a
bank's night depository on May 31 would be recorded by the company on May 31 and by the bank on June 1. Thus,
the deposit does not appear on a bank statement for the month ended May 31. Also check the deposits in transit
listed in last month's bank reconciliation against the bank statement. Immediately investigate any deposit made
during the month but missing from the bank statement (unless it involves a deposit made at the end of the period).
Paid checks. If canceled checks are returned with the bank statement, compare them to the statement to be
sure both amounts agree. Then, sort the checks in numerical order. Next, determine which checks are outstanding.
Outstanding checks are those issued by a depositor but not paid by the bank on which they are drawn. The party
receiving the check may not have deposited it immediately. Once deposited, checks may take several days to clear
the banking system. Determine the outstanding checks by comparing the check numbers that have cleared the bank
with the check numbers issued by the company. Use check marks in the company's record of checks issued to
identify those checks returned by the bank. Checks issued that have not yet been returned by the bank are the
outstanding checks. If the bank does not return checks but only lists the cleared checks on the bank statement,
determine the outstanding checks by comparing this list with the company's record of checks issued. Sometimes
checks written long ago are still outstanding. Checks outstanding as of the beginning of the month appear on the
prior month's bank reconciliation. Most of these have cleared during the current month; list those that have not
cleared as still outstanding on the current month's reconciliation.
Bank debit and credit memos. Verify all debit and credit memos on the bank statement. Debit memos
reflect deductions for such items as service charges, NSF checks, safe-deposit box rent, and notes paid by the bank
for the depositor. Credit memos reflect additions for such items as notes collected for the depositor by the bank and
wire transfers of funds from another bank in which the company sends funds to the home office bank. Check the
bank debit and credit memos with the depositor's books to see if they have already been recorded. Make journal
entries for any items not already recorded in the company's books.
Errors. List any errors. A common error by depositors is recording a check in the accounting records at an
amount that differs from the actual amount. For example, a USD 47 check may be recorded as USD 74. Although
the check clears the bank at the amount written on the check (USD 47), the depositor frequently does not catch the
error until reviewing the bank statement or canceled checks.
Deposits in transit, outstanding checks, and bank service charges usually account for the difference between the
company's Cash account balance and the bank balance. (These same items can cause a difference between your
personal checkbook balance and the balance on your bank statement.) Remember that all items shown on the bank
reconciliation as adjustments of the book (ledger) balance require journal entries to adjust the Cash account (items
Accounting Principles: A Business Perspective 348 A Global Text
8. Control of cash
4, 5, and 6 in Exhibit 75 and in the following example). Items appearing as adjustments to the balance per bank
statement do not require entries by the depositor (items 2 and 3). Of course, you should call any bank errors to the
bank's attention.
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R.L. LEE COMPANY Bank Reconciliation
2010 May 31 1 Balance per bank statement, 2010 May 31 $3,252 2 Add: Deposit in transit 452
$3,704 3 Less: Outstanding checks:
No. 9544 $322 No. 9545 168 No. 9546 223 713 Adjusted balance, 2010 May 31, $2,991
1 Balance per ledger, 2010 May 31 $1,891 4 Add: Note collected (including interest of
$25) 1,225
$3,116 5 Less: NSF check (R. Johnson) $102 6 Safe-deposit box rent 15 6 Service charges 8 125
Adjusted balance, 2010 May 31 $2,991
Exhibit 75: Bank reconciliation
To illustrate the preparation of the bank reconciliation in Exhibit 75, assume the following (these items are
keyed to numbers in that illustration):
• On May 31, R. L. Lee Company showed a balance in its Cash account of USD 1,891. On June 2, Lee received
its bank statement for the month ended May 31, which showed an ending balance of USD 3,252.
• A matching of debits to the Cash account on the books with deposits on the bank statement showed that the
USD 452 receipts of May 31 were included in Cash but not included as a deposit on the bank statement. This
deposit was in the bank's night deposit chute on May 31.
• A comparison of checks issued with checks that had cleared the bank showed three checks outstanding:
No. 9544 $322 No. 9545 168 No. 9546 223 Total $713
• Included with the bank statement was a credit memo for USD 1,225 (principal of USD 1,200 + interest of
USD 25) for collection of a note owed to Lee by Shipley Company.
• Included with the bank statement was a USD 102 debit memo for an NSF check written by R. Johnson and
deposited by Lee.
• Charges made to Lee's account include USD 15 for safe-deposit box rent and USD 8 for service charges.
After reconciling the book and bank balances as shown in Exhibit 75, Lee Company finds that its actual cash
balance is USD 2,991. The following entries record information from the bank reconciliation:
Accounting Principles: A Business Perspective 350 A Global Text
8. Control of cash
4 Cash 1,225 Notes Receivable—Shipley Company (-A) 1,200 Interest Receivable (-A) 25 To record note collected from Shipley Company.
5 Accounts Receivable—R. Johnson* (Contra Account) 102 Cash (-A) 102 To charge NSF check back to customer, R. Johnson.
6 Bank Service Charge Expense (-SE) 23 Cash (-A) 23 To record bank service charges.
*This debit would be posted to the Accounts Receivable contrae account in the general ledger and to R.
Johnson's account in the Accounts Receivable subsidiary ledger.
The income statement would include the USD 23 bank service charge as an expense and the USD 25 interest as
revenue. The May 31 balance sheet would show USD 2,991 cash, the actual cash balance. You could combine the
preceding three entries into one compound entry as follows:
Cash (+A) 1,100 Bank Service Charge Expense (-SE) 23 Account Receivable—R. Johnson (+A) 102 Note Receivable (-A) 1,200 Interest Revenue (+SE) 25 To correct the accounts for needed changes identified in the bank reconciliation.
The bank routinely handles the deposit in transit and any outstanding checks already recorded in the depositor's
books. Since these items appear on the bank balance side of the reconciliation, they require no entry in the
company's books. The bank processes these items in the subsequent period.
When a company maintains more than one checking account, it must reconcile each account separately with the
balance on the bank statement for that account. The depositor should also check carefully to see that the bank did
not combine the transactions of the two accounts.
To make sure a check cannot bounce and become an NSF check, a payee may demand a certified or cashier's
check from the maker. Both certified checks and cashier's checks are liabilities of the issuing bank rather than the
depositor. As a result, payees usually accept these checks without question.
• A certified check is a check written, or drawn, by a depositor and taken to the depositor's bank for
certification. The bank stamps certified across the face of the check and inserts the name of the bank and the
date; a bank official signs the certification. The bank certifies a check only when the depositor's balance is large
enough to cover the check. The bank deducts the amount of the check from the depositor's account at the time
it certifies the check.
• A cashier's check is a check made out to either the depositor or a third party and written, or drawn, by a
bank after deducting that amount from the depositor's account or receiving cash from the depositor.
In this section, you learned that all cash receipts should be deposited in the bank and all cash disbursements
should be made by check. However, the next section explains the convenience of having small amounts of cash
(petty cash) available for minor expenditures.
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An accounting perspective:
Uses of technology
Most companies now offer to deposit employees' paychecks directly into their bank accounts. This
process of transferring money by telephone, computer, or wire is called electronic fund
transferring. Often companies prefer this method because it limits the number of employees
involved in the payroll process. Manipulation and fraud can still occur whenever firms do not
separate duties; however, limiting access to the payroll function may eliminate some of the risk
associated with internal control weaknesses.
Petty cash funds
At times, every business finds it convenient to have small amounts of cash available for immediate payment of
items such as delivery charges, postage stamps, taxi fares, supper money for employees working overtime, and
other small items. To permit these cash disbursements and still maintain adequate control over cash, companies
frequently establish a petty cash fund of a round figure such as USD 100 or USD 500.
Usually one individual, called the petty cash custodian or cashier, is responsible for the control of the petty cash
fund and documenting the disbursements made from the fund. By assigning the responsibility for the fund to one
individual, the company has internal control over the cash in the fund.
A business establishes a petty cash fund by writing a check for, say, USD 100. It is payable to the petty cash
custodian. The petty cash fund should be large enough to make disbursements for a reasonable period, such as a
month. The following entry records this transaction as follows:
Petty Cash 100 Cash 100 To establish a petty cash fund.
After the check is cashed, the petty cash custodian normally places the money in a small box that can be locked.
The fund is now ready to be disbursed as needed.
One of the conveniences of the petty cash fund is that payments from the fund require no journal entries at the
time of payment. Thus, using a petty cash fund avoids the need for making many entries for small amounts. Only
when the fund is reimbursed, or when the end of the accounting period arrives, does the firm make an entry in the
journal.
When disbursing cash from the fund, the petty cash custodian prepares a petty cash voucher, which should be
signed by the person receiving the funds. A petty cash voucher (Exhibit 76) is a document or form that shows the
amount of and reason for a petty cash disbursement. The custodian should prepare a voucher for each
disbursement and staple any invoices for expenditures to the petty cash voucher. At all times, the employee
responsible for petty cash is accountable for having cash and petty cash vouchers equal to the total amount of the
fund.
Companies replenish the petty cash fund at the end of the accounting period, or sooner if it becomes low. The
reason for replenishing the fund at the end of the accounting period is that no record of the fund expenditures is in
the accounts until the check is written and a journal entry is made. (Sometimes we refer to this fund as an imprest
Accounting Principles: A Business Perspective 352 A Global Text
8. Control of cash
fund since it is replenished when it becomes low.) The petty cash custodian presents the vouchers to the employee
having authority to order that the fund be reimbursed. After the vouchers are examined, if all is in order, that
employee draws a check to restore the fund to its original amount.
To determine which accounts to debit, an employee summarizes the petty cash vouchers according to the
reasons for expenditure. Next, that person stamps or defaces the petty cash vouchers to prevent reuse. The journal
entry to record replenishing the fund would debit the various accounts indicated by the summary and credit Cash.
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PETTY CASH VOUCHERS NO. 359 To Local Cartage, Inc. Date 2010 June 29
EXPLANATION ACCT NO. AMOUNT Freight on parts 27 12 57
APPROVED B A.E.C. RECEIVED B Ken Black
Exhibit 76: Petty cash voucher
For example, assume the USD 100 petty cash fund currently has a money balance of USD 7.40. A summary of
the vouchers shows payments of USD 22.75 for shipping, USD 50.80 for stamps, and USD 19.05 for an advance to
an employee; these payments total USD 92.60. After the vouchers have been examined and approved, an employee
draws a check for USD 92.60 which, when cashed, restores the cash in the fund to its USD 100 balance. The journal
entry to record replenishment is:
Delivery Expense 22.75 Postage Expense 50.80 Receivable from Employees (or Advances t) Employees) 19.05 Cash 92.60 To replenish a petty cash fund.
Note that the entry to record replenishing the fund does not credit the Petty Cash account. We make entries to
the Petty Cash account only when the fund is established, when the end of the accounting period arrives and the
fund is not replenished, or when the size of the fund is changed.
At the end of an accounting period, the firm records any petty cash disbursements for which the fund has not yet
been replenished. Since the fund has not been replenished, the credit would be to Petty Cash rather than Cash.
Failure to make an entry at the end of an accounting period would cause errors in both the income statement and
balance sheet. The easiest way to record these disbursements is to replenish the fund.
After a time, if the petty cash custodian finds that the petty cash fund is larger than needed, the excess petty cash
should be deposited in the company's checking account. The required entry to record a decrease in the fund debits
Cash and credits Petty Cash for the amount returned and deposited. On the other hand, a petty cash fund may be
too small, requiring replenishment every few days. The entry to record an increase in the fund debits Petty Cash
and credits Cash for the amount of the increase.
To illustrate, the entry to decrease the petty cash fund by USD 50 would be:
Cash 50 Petty Cash 50 To decrease the size of the petty cash fund by $50.
The entry to increase the petty cash fund by USD 600 would be:
Petty Cash 600 Cash 600 To increase the size of the petty cash fund by $600.
The following rules summarize how the Petty Cash account is debited and credited:
Debited to establish
Debited to increase
Credited to decrease
Credited to terminate
Sometimes, the petty cash custodian makes errors in making change from the fund. These errors cause the cash
in the fund to be more or less than the amount of the fund less the total vouchers. When the fund is restored to its
original amount, the credit to Cash is for the difference between the established amount and the actual cash in the
Accounting Principles: A Business Perspective 354 A Global Text
8. Control of cash
fund. We would debit all vouchered items. Any discrepancy should be debited or credited to an account called Cash
Short and Over. The Cash Short and Over account is an expense or a revenue, depending on whether it has a debit
or credit balance.
To illustrate, assume in the preceding example that the balance in the fund was only USD 6.10 instead of USD
7.40. Restoring the fund to USD 100 requires a check for USD 93.90. Since the petty cash vouchers total only USD
92.60, the fund is short USD 1.30. The entry for replenishment is:
Delivery Expense 22.75 Postage Expense 50.80 Receivable from Employees 19.05 Cash Short and Over 1.30 Cash 93.90 To replenish a petty cash fund.
Entries in the Cash Short and Over account also result from other change-making activities. For example,
assume that a clerk accidentally shortchanges a customer USD 1 and that total cash sales for the day are USD
740.50. At the end of the day, actual cash is USD 1 over the sum of the sales tickets or the total of the cash register
tape. The journal entry to record the day's cash sales is:
Cash 741.50 Sales 740.50 Cash Short and Over 1.00 To record cash sales for the day.
Analyzing and using the financial results—The quick ratio
The quick ratio measures a company's short-term debt-paying ability. It is the ratio of quick assets (cash,
marketable securities, and net receivables) to current liabilities. When computing quick assets, we do not include
inventories and prepaid expenses because they might not be readily convertible into cash. A rule of thumb is that
the ratio of quick assets to current liabilities should be 1:1 or higher. However, a lower quick ratio is satisfactory in
companies that generate a steady flow of cash in their operations. Short-term creditors are interested in this ratio
since it relates the pool of cash and immediate cash inflows to immediate cash outflows. The formula for the quick
ratio is:
Quick ratio= Quick assets
Current liabilities
Based on the following information, we can determine that the 2010 and 2009 quick ratios are 6.85 and 6.84,
respectively:
2010 2009 Cash $315,064 $283,913 Short-term investments 119,093 314,872 Net receivables 320,892 177,300 Total quick assets $755,049 $776,085 Current liabilities $110,147 $113,430 Total quick assets Current liabilities
$755,049 = 6.85 $110,147
$776,085 = 6.84 $113,430
An ethical perspective:
City club restaurant
The City Club Restaurant is a member-owned entity in Carson City. For 20 years, John Blue has
managed the restaurant and received only minimal salary increases. He believes he is grossly
underpaid in view of the significant inflation that has occurred. A few years ago he began
supplementing his income by placing phony invoices in the petty cash box, writing a petty cash
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voucher for the amount of each invoice, withdrawing cash equal to the amount of each invoice for
his personal use, and later approving the vouchers for reimbursement. Through this mechanism,
John increased his income by about USD 12,000 per year, an amount that he considered fair. No
one else knows what is happening, and the manager feels fully justified in supplementing his
income in this way.
Now that you have learned how to control a company's most liquid asset, cash, in the next chapter you are ready
to study receivables and payables. As you realize, the backbone of our economy is credit. In all probability, the next
automobile you plan to buy will be financed. Companies are anxious to offer credit to worthy customers and
prospective customers. The many offers of credit we receive from various businesses are evidence of the importance
companies place on credit as a method of stimulating sales and expanding their business.
Understanding the learning objectives
• The internal control structure of a company includes its plan of organization and all the procedures and
actions taken by the company to protect its assets against theft and waste, ensure compliance with company
policies and federal law, evaluate the performance of all personnel in the company to promote efficiency of
operations, and ensure accurate and reliable operating data and accounting records.
• The purpose of internal control is to ensure the efficient operation of a business.
• Cash includes coins; currency; undeposited negotiable instruments such as checks, bank drafts, and money
orders; amounts in checking and saving accounts; and demand certificates of deposit.
• To protect their cash, companies should account for all cash transactions accurately, make certain enough
cash is available to pay bills as they come due, avoid holding too much idle cash, and prevent loss of cash due
to theft or fraud.
• Procedures for controlling cash receipts include such basic principles as recording all cash receipts as soon
as cash is received; depositing all cash receipts on the day they are received or on the next business day; and
preventing the employee who handles cash receipts from also recording the receipts in the accounting records
or from disbursing cash.
• Procedures for controlling cash disbursements include, among others, making all disbursements by check
or from petty cash, using checks that are serially numbered, requiring two signatures on each check, and
having a different person authorize payment of a bill than the persons allowed to sign checks.
• A bank reconciliation is prepared to reconcile, or explain, the difference between the cash balance on the
bank statement and the cash balance on the company's books and to make the required entry(ies) to correct
the cash balance in the ledger.
• A bank reconciliation is shown in Exhibit 75.
• Journal entries are needed for all items that appear in the bank reconciliation as adjustments to the balance
per ledger to arrive at the adjusted cash balance.
• Companies establish a petty cash fund to permit minor cash disbursements and still maintain adequate
control over cash.
• When the cash in the petty cash fund becomes low, the fund should be replenished. A journal entry is
necessary to record the replenishment.
Accounting Principles: A Business Perspective 356 A Global Text
8. Control of cash
• Quick ratio equals cash, marketable securities, and net receivables divided by current liabilities.
• The quick ratio measures a company's short-term debt-paying ability.
Demonstration problem
Demonstration problem A You are the manager of a restaurant that has an ice cream parlor as a separate
unit. Your accountant comes in once a year to prepare financial statements and the tax return. In the current year,
you have a feeling that even though business seems good, net income is going to be lower. You ask the accountant to
prepare condensed statements on a monthly basis. All sales are priced to yield an estimated gross margin of 40 per
cent. You, your accountant, and several of the accountant's assistants take physical inventories at the end of each of
the following four months. The resulting sales, cost of goods sold, and gross margins are:
March April May June Ice Ice Ice Ice Cream Cream Cream Cream
Restaurant Parlor Restaurant Parlor Restaurant Parlor Restaurant Parlor Sales $36,300 $53,000 $39,050 $42,750 $38,100 $39,000 $41,250 $35,500 Cost of goods sold 22,275 31,500 23,800 31,000 22,975 30,750 25,500 31,125 Gross Margin $13,025 $21,500 $15,250 $11,750 $15,125 $8,250 $15,750 $4,375
What would you suspect after analyzing these reports? What sales control procedures would you recommend to
correct the situation? All of the points in this problem were not specifically covered in the chapter, although the
principles were. Use logic, common sense, and knowledge gained elsewhere in coming up with some of the control
procedures.
Demonstration problem B The following data pertains to Carr Company:
• Balance per bank statement, dated 2010 March 31, is USD 4,450.
• Balance of the Cash account on the company's books as of 2010 March 31, is USD 4,459.
• The USD 1,300 deposit of March 31 was not on the bank statement.
• Of the checks recorded as cash disbursements in March, some checks, totaling USD 1,050, have not yet
cleared the bank.
• Service and collection charges for the month were USD 10.
• The bank erroneously charged the Carr Company account for the USD 200 check of another company. The
check was included with the canceled checks returned with the bank statement.
• The bank credited the company's account with the USD 1,000 proceeds of a non interest-bearing note that
it collected for the company.
• A customer's USD 75 check marked NSF was returned with the bank statement.
• As directed, the bank paid and charged to the company's account a USD 507.50 non interest-bearing note
of Carr Company. This payment has not been recorded by the company.
• An examination of the cash receipts and the deposit tickets revealed that the bookkeeper erroneously
recorded a customer's check of USD 148.50 as USD 135.00.
The bank credited the company's checking account for USD 20 interest earned.
a. Prepare a bank reconciliation as of 2010 March 31.
b. Prepare the necessary journal entry or entries to adjust the Cash account.
Solution to demonstration problem
Solution to demonstration problem A The gross margin percentages are as follows:
March April May June
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Restaurant 35.88 per cent 39.05 per cent 39.70 per cent 38.18 per cent Ice cream parlor 40.57 per cent 27.49 per cent 21.15 per cent 12.32 per cent
Either cash or inventory is being stolen or given away in the ice cream parlor. Employees or outsiders may be
pocketing cash. Or the employees may be giving extra-large ice cream cones to friends, or eating the ice cream
themselves. Several things could be done to improve the sales control procedures:
• The manager could hire an investigator to come in and watch the employees in action. If cash is being
pocketed, the employees could be fired.
• The prices of ice cream cones could be changed to odd amounts so that employees would not be as able to
make change without going to the cash register. Also, the No Sale lever could be removed from the cash
register.
• The customers could be encouraged to ask for their cash register receipts by having a monthly drawing (for
some prize) by cash register receipt number.
• The cash register should be placed in a prominent position so that each customer could see the amount
recorded for each sale. No customer is going to be willing to pay USD 1.75 when the employee rings up USD
1.00.
• The cash register tapes should be inaccessible to the employees. The manager (and possibly assistant
manager) should have the only keys to the cash registers.
• Pay the employees a competitive wage.
• Require that all sales be rung up immediately after the sale.
• The manager or assistant manager should reconcile the cash register tapes at the end of each day.
a. Solution to demonstration problem B
CARR COMPANY Bank Reconciliation
2010 March 31 Balance per bank statement, 2010 March 31 $4,450.00 Add: Deposit in transit $1,300.00 Check charged in error 200.00 1,500.00
$5,950.00 Less: Outstanding checks 1,050.00 Adjusted balance, 2010 March 31 $4,900.00 Balance per ledger, 2010 March 31 $4,459.00 Add: Note collected $1,000.00 Interest earned on checking account 20.00 Error in recording customer's check 13.50 1,033.50
$5,492.50 Less: Service and collection charges $10.00 NSF check 75.00 Carr Company noted charged against account 507.50 592.50 Adjusted balance, 2010 March 31 $4,900.00
b.
Mar. 31 Cash 441.00 Bank Service Charge Expense 10.00 Accounts Receivable 75.00 Notes Payable 507.50 Notes Receivable 1,000.00 Interest Revenue 20.00 Accounts Receivable 13.50 To record adjustments to Cash account
Alternatively:
Mar. 31 Cash 1,033.50 Notes Receivable 1,000.00 Interest Revenue 20.00
Accounting Principles: A Business Perspective 358 A Global Text
8. Control of cash
Accounts Receivable 13.50 To record additions to Cash account.
Bank Service Charge Expense 10.00 Accounts Receivable 75.00 Notes Payable 507.50 Cash 592.50 To record deductions from Cash account.
Key terms Accounting system Methods and records established to identify, assemble, analyze, classify, record, and report an entity's transactions to provide complete, accurate, and timely financial information.
Bank reconciliation A schedule the company (depositor) prepares to reconcile, or explain, the difference between the cash balance on the bank statement and the cash balance on the company's books; often called a bank reconciliation statement or schedule.
Bank statement A statement issued (usually monthly) by a bank describing the activities in a depositor's checking account during the period.
Cash Includes coins; currency; certain undeposited negotiable instruments such as checks, bank drafts, and money orders; amounts in checking and savings accounts; and demand certificates of deposit.
Cashier's check A check made out to either the depositor or a third party and written, or drawn, by a bank after deducting the amount of the check from the depositor's account or receiving cash from the depositor.
Certificate of deposit (CD) An interest-bearing deposit that can be withdrawn from a bank at will (demand CD) or at a fixed maturity date (time CD).
Certified check A check written, or drawn, by a depositor and taken to the depositor's bank for certification. The check is deducted from the depositor's balance immediately and becomes a liability of the bank. Thus, it usually is accepted without question.
Check A written order to a bank to pay a specific sum of money to the party designated as the payee by the party issuing the check.
Checking account A money balance maintained in a bank that is subject to withdrawal by the depositor, or owner of the money, on demand.
Control environment Reflects the overall attitude, awareness, and actions of the board of directors, management, and stockholders.
Control procedures Policies and procedures in addition to the control environment and the accounting system that management has established to provide reasonable assurance that the company will achieve its specific objectives.
Credit memo A form used by a bank to explain an addition to the depositor's account.
Debit memo A form used by a bank to explain a deduction from the depositor's account.
Deposit in transit Typically, a day's cash receipts recorded in the depositor's books in one period but recorded as a deposit by the bank in the succeeding period.
Deposit ticket A form that shows the date and the items that make up the deposit.
Drawer The party (depositor) writing a check.
Fidelity bonds Ensure that a company is reimbursed for losses due to theft of cash and other monetary assets.
Internal auditing Consists of investigating and evaluating employees' compliance with the company's policies and procedures. Internal auditing is performed by company personnel.
Internal auditors Auditors employed by the company to perform internal audits. These auditors are trained in company policies and in internal auditing duties such as testing effectiveness of controls and procedures involving cash receipts and cash disbursements.
Internal control structure Policies and procedures established to provide reasonable assurance that specific entity objectives will be achieved.
Invoice Statement sent by the supplier to the purchaser requesting payment for the merchandise shipped.
NSF (not sufficient funds) check A customer's check returned from the customer's bank to the depositor's bank because the funds in the customer's checking account balance were insufficient to cover the check.
Outstanding checks Checks issued by a depositor that have not yet been paid by the bank on which they are drawn.
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Payee The party to whom a check is made payable.
Petty cash fund A nominal sum of money established as a separate fund from which minor cash disbursements for valid business purposes are made. The cash in the fund plus the vouchers covering disbursements should always equal the balance at which the fund was established and at which it is carried in the Petty Cash account.
Petty cash voucher A document or form that shows the amount of, and reason for, a petty cash disbursement.
Purchase order A document sent from the purchasing department to a supplier requesting that merchandise or other items be shipped to the purchaser.
Purchase requisition A written request from an employee inside the company to the purchasing department to purchase certain items.
Quick ratio The ratio of quick assets (cash, marketable securities, and net receivables) to current liabilities. The quick ratio measures a company's short-term debt-paying ability.
Receiving report A document prepared by the receiving department showing the descriptions and quantities of all items received from a supplier in a particular shipment.
Remittance advice Informs the payee why the drawer (or maker) of the check is making this payment.
Segregation of duties Having one employee responsible for safeguarding an asset and a second employee responsible for maintaining the accounting records for that asset.
Service charges Charges assessed by the bank on the depositor to cover the cost of handling the checking account.
Signature card Provides the signatures of persons authorized to sign checks drawn on an account.
Transfer bank accounts Bank accounts set up so that local banks automatically transfer to a central bank (by wire or written bank draft) all amounts on deposit in excess of a stated amount.
Wire transfer of funds Interbank transfer of funds by telephone.
Self-test
True-false
Indicate whether each of the following statements is true or false.
Cash includes coin, currency, postdated checks, money orders, and money on deposit with banks.
To effectively manage its cash, a company should make certain that enough cash is available to pay bills as they
come due.
The cash balance on the bank statement is usually equal to the cash balance in the depositor's books.
A deposit in transit requires an entry in the depositor's books after the bank reconciliation is prepared.
For control purposes, a company should issue checks for every payment, regardless of its amount.
Multiple-choice
Select the best answer for each of the following questions.
The objectives of the internal control structure of a company include all of the following except:
a. Compliance with company policies and federal law.
b. Protection of its assets.
c. Increase in accuracy and reliability of accounting data.
d. Guarantee of a certain level of profit.
e. Evaluation of personnel performance to promote efficiency of operations.
Use the following information to answer the next three questions:
Balance per bank statement USD 1,951.20
Balance per ledger 1,869.60
Deposits in transit 271.20
Accounting Principles: A Business Perspective 360 A Global Text
8. Control of cash
Outstanding checks 427.80
NSF check 61.20
Service charges 13.80
The adjusted cash balance is:
a. USD 1,794.60.
b. USD 1,719.60.
c. USD 1,638.00.
d. USD 1,713.00.
e. USD 1,876.20.
In a bank reconciliation, deposits in transit should be:
a. Deducted from the balance per books.
b. Deducted from the balance per bank statement.
c. Added to the balance per ledger.
d. Added to the balance per bank statement.
e. Disregarded in the bank reconciliation.
After the bank reconciliation is prepared, the entry to record bank service charges would have a credit to:
a. Bank Service Charge Expense.
b. Cash.
c. Petty Cash.
d. Cash Short and Over.
e. None of the above.
The entry to replenish the petty cash fund for disbursements made for stamps includes:
a. A credit to Petty Cash.
b. A credit to Postage Expense.
c. A debit to Accounts Payable.
d. A credit to Cash.
e. None of the above.
Now turn to “Answers to self-test” at the end of the chapter to check your answers.
Questions
➢ Why should a company establish an internal control structure?
➢ Why are mechanical devices used in an internal control structure?
➢ Identify some features that could strengthen an internal control structure.
➢ Name several control documents used in merchandise transactions.
➢ What are the four objectives sought in effective cash management?
➢ List four essential features of internal control over cash receipts.
➢ The bookkeeper of a given company was stealing cash received from customers in payment of their
accounts. To conceal the theft, the bookkeeper made out false credit memos indicating returns and
allowances made by or granted to customers. What feature of internal control would have prevented
the thefts?
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➢ List six essential features of internal control over cash disbursements.
➢ What types of items cause the balance per ledger and the balance per bank statement to disagree?
➢ "The difference between a company's Cash account balance and the balance on its bank statement is
usually a matter of timing." Do you agree or disagree? Why?
➢ Explain how transfer bank accounts can help bring about effective cash management.
➢ Describe the operation of a petty cash fund and its advantages. Indicate how control is maintained
over petty cash transactions.
➢ When are entries made to the Petty Cash account?
➢ The Limited, Inc. Based on the financial statements of The Limited, Inc., in the Annual report
appendix, what was the quick ratio for each of the two years shown?
➢ The Limited, Inc. Based on the financial statements of The Limited, Inc., in the Annual report
appendix, what was the ending cash and equivalents balance? What percentage of current assets
does the amount of cash and equivalents represent for each of the two years shown?
Exercises
Exercise A State whether each of the following statements about internal control is true or false:
a. Those employees responsible for safeguarding an asset should maintain the accounting records for that asset.
b. Complete, accurate, and up-to-date accounting records should be maintained.
c. Whenever possible, responsibilities should be assigned and duties subdivided in such a way that only one
employee is responsible for a given function.
d. Employees should be assigned to one job and should remain in that job so that skill levels will be as high as
possible.
e. The use of check protectors, cash registers, and time clocks is recommended.
f. An internal auditing function should not be implemented because it leads the employees to believe that
management does not trust them.
g. One of the best protections against theft is to hire honest, competent employees.
h. A foolproof internal control structure can be devised if management puts forth the effort.
Exercise B Concerning internal control, which one of the following statements is correct? Explain.
a. Broadly speaking, an internal control structure is only necessary in large organizations.
b. The purposes of internal control are to check the accuracy of accounting data, safeguard assets against theft,
promote efficiency of operations, and ensure that management's policies are being followed.
c. Once an internal control structure has been established, it should be effective as long as the formal
organization remains unchanged.
d. An example of internal control is having one employee count the day's cash receipts and compare the total
with the total of the cash register tapes.
Exercise C The bank statement for Yarley Company at the end of August showed a balance of USD 12,862.
Checks outstanding totaled USD 3,937, and deposits in transit were USD 5,990. If these amounts are the only
pertinent data available to you, what was the adjusted balance of cash at the end of August?
Exercise D From the following data, prepare a bank reconciliation and determine the correct available cash
balance for Reed Company as of 2010 October 31.
Balance per bank statement, 2010 October 31 $13,974
Accounting Principles: A Business Perspective 362 A Global Text
8. Control of cash
Ledger account balance. 2010 October 31 8,088 Proceeds of a note collected by bank not yet entered in ledger (includes $500 of interest) 6,000 Bank service charges not yet entered by Reed Company 18 Deposit in transit 1,680 Outstanding checks: No. 327 654 No. 328 288 No. 329 390 No. 331 252
Exercise E The following is a bank reconciliation for Brian company as of August 31.
Balance per bank statement, August 31 $ 7,470 Add: Deposit in transit 5,676
$13,146 Less: Outstanding checks 6,024 Adjusted balance, August 31 $ 7,122 Balance per ledger, August 31 $ 7,248 Add: Error correction* 54
$ 7,302 Less: NSF check $150 Service and collection charges 30 180 Adjusted balance, August 31 $ 7,122
Prepare the journal entry or entries needed to adjust or correct the Cash account.
Exercise F On March 1 of the current year, Shelbey Company had outstanding checks of USD 15,000. During
March, the company issued an additional USD 57,000 of checks. As of March 31, the bank statement showed USD
48,000 of checks had cleared the bank during the month. What is the amount of outstanding checks on March 31?
Exercise G Matson Company's bank statement as of August 31, shows total deposits into the company's
account of USD 15,000 and a total of 14 separate deposits. On July 31, deposits of USD 410 and USD 330 were in
transit. The total cash receipts for August were USD 19,000, and the company's records show 13 deposits made in
August. What is the amount of deposits in transit at August 31?
Exercise H Holder Company deposits all cash receipts intact each day and makes all payments by check. On
October 31, after all posting was completed, its Cash account had a debit balance of USD 4,325. The bank statement
for the month ended on October 31 showed a balance of USD 3,988. Other data are:
Outstanding checks total USD 425.
October 31 cash receipts of USD 838 were placed in the bank's night depository and do not appear on the bank
statement.
Bank service charges for October are USD 14.
Check No. 772 for store supplies on hand was entered at USD 405, but paid by the bank at its actual amount of
USD 315.
Prepare a bank reconciliation for Holder Company as of October 31. Also prepare any necessary journal entry or
entries.
Exercise I On August 31, Brighton Company's petty cash fund contained coins and currency of USD 260, an
IOU from an employee of USD 30, and vouchers showing expenditures of USD 120 for postage, USD 52 for taxi
fare, and USD 138 to entertain a customer. The Petty Cash account shows a balance of USD 600. The fund is
replenished on August 31 because financial statements are to be prepared. What journal entry is required on August
31?
Exercise J Use the data in the previous exercise. What entry would have been required if the amount of coin
and currency had been USD 247.20? Which of the accounts debited would not appear in the income statement?
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Exercise K Rock Company has a USD 450 petty cash fund. The following transactions occurred in December:
Dec. 2 The petty cash fund was increased to USD 1,350.
8 Petty Cash Voucher No. 318 for USD 14.20 delivery expense was prepared and paid. The fund was not
replenished at this time.
20 The company decided that the fund was too large and reduced it to USD 1,120.
Prepare any necessary journal entries for these transactions.
Problems
The following 2010 June 30, bank reconciliation pertains to Tiffany Company:
Cash Bank Amount Statement
Balance , June 30 $29,143.36 $28,644.31 Add: Deposit not credited by bank 942.60 Total $29,586.91 Less: Outstanding checks: No. 724 $18.45 No. 886 15.00 No. 896 143.55 No. 897 187.65 No. 898 78.90 443.55 Adjusted cash balance, June 30 $29,143.36 $29,143.36
Tiffany's July bank statement follows:
Balance, July 1 $28,644.31 Deposits during July 5,441.94 $34,086.25 Canceled checks returned: No. 724 $ 18.45 No. 896 143.55 No. 897 187.65 No. 898 78.90 No. 899 18.86 No. 900 1,349.55 No. 902 946.92 No. 904 44.01 $2,787.89 NSF Check of Starr Company 139.98 2,927.87 Bank statement balance, July 31 $31,158.38
The cash receipts deposited in July, including receipts of July 31, amounted to USD 5,178.30. Tiffany wrote
these checks in July:
No. 899 $ 18.86 No. 900 1,349.55 No. 901 27.75 No. 902 946.92 No. 903 59.70 No. 904 44.01 No. 905 1,093.50 No. 906 15.00
The cash balance per the ledger on 2010 July 31, was USD 30,766.37.
Prepare a bank reconciliation as of 2010 July 31, and any necessary journal entry or entries to correct the
accounts.
Problem B The following information pertains to Hughes Company as of 2010 May 31:
• Balance per bank statement as of 2010 May 31, was USD 59,410.
• Balance per Hughes Company's Cash account at 2010 May 31, was USD 60,904.
• A late deposit on May 31 did not appear on the bank statement, USD 4,275.
• Outstanding checks as of May 31 totaled USD 7,614.
Accounting Principles: A Business Perspective 364 A Global Text
8. Control of cash
• During May, the bank credited Hughes Company with the proceeds, USD 6,795, of a note which it had
collected for the company. Interest revenue was USD 45 of the total.
• Bank service and collection charges for May amounted to USD 18.
• Comparison of the canceled checks with the check register revealed that one check in the amount as USD
1,458 had been recorded in the books as USD 1,539. The check had been issued in payment of an account
payable.
• A review of the deposit slips with the bank statement showed that a deposit for USD 2,250 of a company
with a similar account number had been credited to the Hughes Company account in error.
• A USD 270 check received from a customer, R. Petty, was returned with the bank statement marked NSF.
• During May, the bank paid a USD 13,500 note of Hughes Company plus interest of USD 135 and charged it
to the company's account per instructions received. Hughes Company had not recorded the payment of this
note.
• An examination of the cash receipts and the deposit tickets revealed that the bookkeeper erroneously
recorded a check from a customer, C. Parker, of USD 1,458 as USD 1,944.
• The bank statement showed a credit to the company's account for interest earned on the account balance in
May of USD 450.
a. Prepare a bank reconciliation as of 2010 May 31.
b. Prepare the journal entry or entries necessary to adjust the accounts as of 2010 May 31.
Problem C The following transactions pertain to the petty cash fund of Carrington Company:
Nov. 2 A USD 450 check is drawn, cashed, and the cash placed in the care of the assistant office manager to be
used as a petty cash fund.
Dec. 17 The fund is replenished. An analysis of the fund shows:
Coins and currency $147.40 Petty cash vouchers for: Delivery expenses 173.48 Transportation-In 111.12 Postage stamps purchased 15.00
31 The end of the accounting period falls on this date. The fund was not replenished. The fund's contents on this
date consist of:
Coins and currency $ 352.05 Petty cash vouchers for: Delivery expenses 31.65 Postage stamps purchased 36.30 Employee's IOU 30.00
Present journal entries to record these transactions. Use the Cash Short and Over account for any shortage or
overage in the fund.
Problem D The following transactions relate to the petty cash fund of Jarvis Wrecking Company
Apr. 1 The petty cash fund is set up with a USD 350 cash balance.
19 Because the money in the fund is down to USD 70.20, the fund is replenished.
Petty cash vouchers as follows: Flowers for hospitalized employee (miscellaneous expense) $84.38 Postage stampls 135.00 Office supplies 46.71
30 The cash in the fund is USD 193.07. The fund is replenished to include petty cash payments in this period's
financial statements. The petty cash vouchers are for the following:
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Transportation-in $64.12 Office supplies 92.81
May 1 The petty cash fund balance is increased to USD 400.
Prepare the journal entries to record these transactions.
Alternate problems
Alternate problem A The following data pertains to England Company:
Balance per the bank statement dated 2010 June 30, is USD 30,000.
Balance of the Cash in Bank account on the company books as of 2010 June 30, is USD 8,795.
Outstanding checks as of 2010 June 30, total USD 14,300.
Bank deposit of June 30 for USD 2,735 was not included in the deposits per the bank statement.
The bank had collected proceeds of a note, USD 22,612 (of which USD 112 was interest), that it credited to the
England Company account. The bank charged the company a collection fee of USD 15 on the note.
The bank erroneously charged the England Company account for a USD 10,500 debit memo of another company
that has a similar name.
Bank service charges for June, exclusive of the collection fee, amounted to USD 95.
Among the canceled checks was one for USD 700 given in payment of an account. The bookkeeper had recorded
the check at USD 920 in the company records.
A check of Crosby, a customer, for USD 2,447, deposited on June 20, was returned by the bank marked NSF. No
entry has been made to reflect the returned check on the company records.
A check for USD 1,435 of Malcolm, a customer, which had been deposited in the bank, was erroneously recorded
by the bookkeeper as USD 1,570. The check had been received as a payment on the customer's account receivable.
Prepare a bank reconciliation as of 2010 June 30, and any necessary journal entry or entries to correct the
accounts.
Alternate problem B The bank statement of Irish Company's checking account with the 2nd National Bank
shows:
Balance, 2010 June 30 $166,118 Deposits 245,700
411,818 Less: Checks deducted $243,001 Service charges 67 243,068 Balance, 2010 July 31 $168,750
The following additional data are available:
Balance per ledger account as of July 31 was USD 128,209.
A credit memo included with the bank statement indicated the collection of a note by the bank for Irish
Company. Proceeds were USD 13,500, of which USD 375 was interest.
An NSF check in the amount of USD 6,210 was returned by the bank and included in the total of checks
deducted on the bank statement.
Deposits in transit as of July 31 totaled USD 33,750.
Checks outstanding as of July 31 were USD 55,350.
The bank added the USD 29,025 deposit of another company to Irish's account in error.
The bank deducted one of Irish's checks as USD 20,250 instead of the correct amount of USD 2,025.
Accounting Principles: A Business Perspective 366 A Global Text
8. Control of cash
Deposit of July 21 was recorded by the company as USD 4,299.75 and by the bank at the actual amount of USD
4,542.75. The receipts for the day were from collections on account.
The deposits amount shown on the bank statement includes USD 675 of interest earned by Irish on its checking
account with the bank.
a. Prepare a bank reconciliation as of 2010 July 31, for Irish Company.
b. Prepare any journal entry or entries needed at 2010 July 31.
Alternate problem C Transactions involving the petty cash fund of Sonar Company are as follows:
Mar. 1 Established a petty cash fund of USD 750, which will be under the control of the assistant office manager.
31 Fund was replenished on this date. Prior to replenishment, the fund consisted of the following:
Coins and currency $ 491.50 Petty cash voucher indicating disbursements for: Postage stamps $82.00 Suppliers money for office employees working overtime 36.00 Office supplies 32.70 Window washing service 60.00 Flowers for wedding employee 15.00 Flower for hospitalized employee 15.00 Employee's IOU 15.00
Present journal entries for these transactions. Use the Cash Short and Over account for any shortage or overage
in the fund.
Alternate problem D Sun Company has decided to use a petty cash fund. Transactions involving this fund
follow:
June 4 Set up a petty cash fund of USD 225.
22 When the fund had a cash amount of USD 31.35, the custodian of the fund was reimbursed for expenditures
made, including:
Transportation-in $ 82.50 Postage 27.00 Office supplies 81.75
30 The fund was reimbursed to include petty cash items in the financial statement prepared for the fiscal year
ending on this date. The fund had the following cash and vouchers before reimbursement:
Coins and currency $174.00 Petty cash vouchers for: Employee's IOU 15.00 Postage 27.00 Office supplies 11.10
July 1 The petty cash fund balance is increased to USD 300.
Prepare journal entries for all of these transactions.
Beyond the numbers—Critical thinking
Business decision case A During a national emergency, a managerial accountant was called back to active
duty with the US Army. An acquaintance of the accountant forged papers and assumed the identity of the
accountant. He obtained a position in a small company as the only accountant. Eventually he took over from the
manager the functions of approving bills for payment, preparing and signing checks, and almost all other financial
duties. On one weekend, he traveled to some neighboring cities and mailed invoices made out to the company for
which he worked. On Monday morning, he returned to work and began receiving, approving, and paying the
invoices he had prepared. The following weekend he returned to the neighboring cities and cashed and deposited
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the checks in bank accounts under his own name. After continuing this practice for several months, he withdrew all
of the funds and never was heard from again.
Prepare a written list of the steps you would have taken to prevent this theft. Remember that this small company
had limited financial resources.
Business decision case B John Billings was set up in business by his father, who purchased the business of
an elderly acquaintance wishing to retire. One of the few changes in personnel made by Billings was to install a
college classmate as the office manager-bookkeeper-cashier-sales manager. During the course of the year, Billings
borrowed money from the bank with his father as cosigner. Although his business seemed profitable, there was a
shortage of cash. The company's investments in inventories and receivables grew substantially. Finally, after a year
had elapsed, Billings's father employed you, a certified public accountant, to audit the records of his business. You
reported that the office manager-bookkeeper-cashier-sales manager had been misappropriating funds and had
been using a variety of schemes to cover his actions. More specifically, he had:
• Pocketed cash receipts from sales and understated the cash register readings at the end of the day or altered
the copies of the sales tickets retained.
• Stolen checks mailed to the company in payment of accounts receivable, credited the proper accounts, and
then debited fictitious receivables to keep the records in balance.
• Issued checks to fictitious suppliers and deposited them in accounts bearing these names with himself as
signer of checks drawn on these accounts; the books were kept in balance by debiting the Purchases account.
• Stolen petty cash funds by drawing false vouchers purporting to cover a variety of expenses incurred.
• Prepared false sales returns vouchers indicating the return of cash sales to cover further thefts of cash
receipts.
For each item in the preceding list, describe in writing at least one feature of good internal control that would
have prevented the losses due to dishonesty.
Business decision case C The outstanding checks of Brothers Company at 2010 November 30, were:
No. 229 $ 1,000 No. 263 $ 1,089 No. 3678 $ 679 No. 3679 $809 No. 3680 $ 1,400
During December, Brothers issued checks numbered 3681-3720; and all of these checks cleared the bank except
3719 and 3720 for USD 963 and USD 726, respectively. Checks 3678, 3679, and 3680 also cleared the bank.
The bank statement on December 31 showed a balance of USD 23,944. Service charges amounted to USD 20,
and two checks were returned by the bank, one marked NSF in the amount of USD 114 and the other marked “No
account" in the amount of USD 2,000.
Brian Askew recently retired as the office manager-cashier-bookkeeper for Brothers Company and was replaced
by Fred Hannah. Hannah noted the absence of an internal control structure but was momentarily deterred from
embezzling for lack of a scheme of concealment. Finally, he hit upon several schemes. The USD 2,000 check
marked “No account" by the bank is the product of one scheme. Hannah took cash receipts and replaced them with
a check drawn on a nonexistent account to make it appear that a customer had given the company a worthless
check.
Accounting Principles: A Business Perspective 368 A Global Text
8. Control of cash
The other scheme was more subtle. Hannah pocketed cash receipts in an amount equal to two unlisted
outstanding checks and prepared the following bank reconciliation:
Balance per bank statement, 2010 December 31 $23,944.00 Add: Deposit in transit 2,837.80
$26,781.80 Less: Outstanding checks No. 3719 $ 963.00 No. 3720 726.00 1,689.00 Adjusted balance, December 2010 $25,092.80 Balance per ledger, 2010 December 31 $27,226.80 Add: Worthless check $2,000.00 NSF check 114.00 Service charges 20.00 2,134.00 Adjusted balance, 2010 December 31 $25,092.80
a. State the nature of the second scheme hit on by Hannah. How much in total does it appear he has stolen by
use of the two schemes together?
b. Prepare a correct bank reconciliation as of 2010 December 31.
c. After your analysis in (a) and (b), describe several procedures that would have defeated Fred Hannah's
attempts to misappropriate funds and conceal these actions.
*Note: This challenging problem was not specifically illustrated in the chapter, but it can be worked by applying
the principles discussed in the chapter.
Annual report analysis D In Reader's Digest's Annual Report, under Report of Management, the chairman
and chief executive officer and the executive vice president and chief financial officer stated:
The company maintains a system of internal accounting controls designed to provide reasonable
assurance, at reasonable cost, that transactions and events are recorded properly and that assets
are safeguarded. The internal control system is supported by written policies and procedures and by
the careful selection, training, and supervision of qualified personnel, and is monitored by an
internal audit function.
What is the purpose of this statement? To which basic elements of the internal control structure does the
statement refer?
Annual report analysis E Obtain an annual report for a company (your library may have some annual
reports). Determine the quick ratios for the two most recent years for the company. Comment on the results.
Ethics case – Writing experience F After reading the ethics case, discuss the ethical situation at the City
Club Restaurant. Describe the steps the owners could take to end John Blue's wage supplement scheme.
Group project G With a small group of students, visit a large local company to inquire about its internal
control structure. Specifically, discover how it protects its assets against theft and waste, ensures compliance with
company policies and federal laws, evaluates performance of its personnel, and ensures accurate and reliable
operating data and accounting reports. If an internal audit staff exists, inquire about some of its activities. Write a
report to your instructor summarizing your findings and be prepared to make a short presentation to the class.
Group project H With one or two other students, locate and visit two companies that maintain petty cash
funds. Interview the custodians of those funds to identify the controls that are used to manage those funds. Write a
report to your instructor comparing the controls used, pointing out any differences between the control systems
and any deficiencies in the systems. Be prepared to make a short presentation to the class.
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Group project I "Kiting" of bank accounts has been used to conceal shortages in bank accounts. With one or
two other students, research this topic in the library. Write a paper to your instructor describing how this technique
works and the steps that can be taken to detect it once it occurs and to prevent it in the future.
Using the Internet—A view of the real world
Visit the following site:
http://www.vfauditmall.com/
This is the internet site for the Vanity Fair Audit Mall. Click on the visitors center, CCA Studio, Tool Box, Job
Shop, Tek Shak, Risk Depot, Contact Plaza, and Arcade. After browsing the site write a one page memo as to what
you learned about internal audit.
Visit the Securities and Exchange website and find the EDGAR database at:
http://www.sec.gov/edgar.shtml
EDGAR stands for the Electronic Data Gathering, Analysis, and Retrieval system. What is its purpose? What
kinds of information can be found at this site? Select a company of your choice and search the EDGAR database for
information on that company. Write a report to your instructor summarizing your findings.
Answers to self-test
True-false
False. Postdated checks are not included as cash.
True. A company should make sure that enough cash is available to pay bills as they come due.
False. The cash balance on a bank statement is not usually the same as the cash balance in the depositor's
books because of deposits in transit, outstanding checks, and bank service charges.
False. A deposit in transit is one of the items that has been correctly recorded as a debit to the Cash account of
the depositor and will be recorded as a deposit by the bank after the bank employees open the night deposit chute.
False. For convenience, a company may use a petty cash fund for small amounts of cash payments such as
delivery charges or postage stamps.
Multiple-choice
d. An effective internal control structure does not necessarily guarantee a certain level of profits.
a.
Balance per bank statement $1,951.20 Add: Deposit in transit 271.20 Less: Outstanding checks (427.80) Adjusted balance $1,794.60 Balance per ledger $1,869.60 Less: NSF check (61.20) Service charges (13.80) Adjusted balance $1,794.60
d. Deposits in transit have been recorded in the company's accounting records but have not yet been recorded in
the bank's records.
b. The entry to record bank service charges on the books is:
Bank Service Charge Expense 13.80 Cash 13.80
d. The entry to replenish the petty cash fund has a credit to Cash, not Petty Cash.
Postage Expense xxx Cash xxx
Accounting Principles: A Business Perspective 370 A Global Text
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9. Receivables and payables Learning objectives
After studying this chapter, you should be able to:
• Account for uncollectible accounts receivable under the allowance method.
• Record credit card sales and collections.
• Define liabilities, current liabilities, and long-term liabilities.
• Define and account for clearly determinable, estimated, and contingent liabilities.
• Account for notes receivable and payable, including calculation of interest.
• Account for borrowing money using an interest-bearing note versus a non interest-bearing note.
• Analyze and use the financial results—accounts receivable turnover and the number of days' sales in accounts
receivable.
A career in litigation support
What is litigation support? It does not mean working in an attorney's office. It involves assisting legal counsel in
attempting to gain favorable verdicts in a court of law. Persons involved in litigation support generally work for a
public accounting firm, a consulting firm, or as a sole proprietor or in partnership with others. An experienced
litigation support person can expect to earn an income well into six figures.
Litigation support in a broad sense encompasses fraud auditing, valuation analysis, investigative accounting,
and forensic accounting. The practice of litigation support involves assisting legal counsel in such things as product
liability disputes, shareholder disputes, contract breaches, and major losses reported by entities. These
investigations require the accountant to gather and evaluate evidence to assess the integrity and dollar amounts
surrounding the aforementioned situations.
The accountant can be, and often is, requested to serve as an expert witness in a court of law. This experience
requires knowledge of accounting and auditing in addition to possessing good communication skills, appropriate
credentials, relevant experience, and critical information that could result in successful resolution of the issue.
What kind of person pursues litigation support as a career? It takes a very special individual. The person must
be part accountant, part auditor, part lawyer, and part skilled businessperson. An undergraduate accounting
degree, an MBA, and a law degree would be the perfect educational background needed for such a career. Many
universities offer a combined MBA/JD program. Such a program fulfills the graduate needs of the litigation support
person.
In addition to the degree, work experience in the business sector is essential. A career in public accounting,
industry, or with a government agency would serve as valuable experience in pursuing a career in litigation support.
Much of the growth of business in recent years is due to the immense expansion of credit. Managers of
companies have learned that by granting customers the privilege of charging their purchases, sales and profits
increase. Using credit is not only a convenient way to make purchases but also the only way many people can own
high-priced items such as automobiles.
Accounting Principles: A Business Perspective 371 A Global Text
9. Receivables and payables
This chapter discusses receivables and payables. For a company, a receivable is any sum of money due to be
paid to that company from any party for any reason. Similarly, a payable describes any sum of money to be paid by
that company to any party for any reason.
Primarily, receivables arise from the sale of goods and services. The two types of receivables are accounts
receivable, which companies offer for short-term credit with no interest charge; and notes receivable, which
companies sometimes extend for both short-and long-term credit with an interest charge. We pay particular
attention to accounting for uncollectible accounts receivable.
Like their customers, companies use credit, which they show as accounts payable or notes payable. Accounts
payable normally result from the purchase of goods or services and do not carry an interest charge. Short-term
notes payable carry an interest charge and may arise from the same transactions as accounts payable, but they can
also result from borrowing money from a bank or other institution. Chapter 4 identified accounts payable and
short-term notes payable as current liabilities. A company also incurs other current liabilities, including payables
such as sales tax payable, estimated product warranty payable, and certain liabilities that are contingent on the
occurrence of future events. Long-term notes payable usually result from borrowing money from a bank or other
institution to finance the acquisition of plant assets. As you study this chapter and learn how important credit is to
our economy, you will realize that credit in some form will probably always be with us.
Accounts receivable
In Chapter 3, you learned that most companies use the accrual basis of accounting since it better reflects the
actual results of the operations of a business. Under the accrual basis, a merchandising company that extends credit
records revenue when it makes a sale because at this time it has earned and realized the revenue. The company has
earned the revenue because it has completed the seller's part of the sales contract by delivering the goods. The
company has realized the revenue because it has received the customer's promise to pay in exchange for the goods.
This promise to pay by the customer is an account receivable to the seller. Accounts receivable are amounts that
customers owe a company for goods sold and services rendered on account. Frequently, these receivables resulting
from credit sales of goods and services are called trade receivables.
When a company sells goods on account, customers do not sign formal, written promises to pay, but they agree
to abide by the company's customary credit terms. However, customers may sign a sales invoice to acknowledge
purchase of goods. Payment terms for sales on account typically run from 30 to 60 days. Companies usually do not
charge interest on amounts owed, except on some past-due amounts.
Because customers do not always keep their promises to pay, companies must provide for these uncollectible
accounts in their records. Companies use two methods for handling uncollectible accounts. The allowance method
provides in advance for uncollectible accounts. The direct write-off method recognizes bad accounts as an expense
at the point when judged to be uncollectible and is the required method for federal income tax purposes. However,
since the allowance method represents the accrual basis of accounting and is the accepted method to record
uncollectible accounts for financial accounting purposes, we only discuss and illustrate the allowance method in
this text.
Even though companies carefully screen credit customers, they cannot eliminate all uncollectible accounts.
Companies expect some of their accounts to become uncollectible, but they do not know which ones. The matching
principle requires deducting expenses incurred in producing revenues from those revenues during the accounting
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period. The allowance method of recording uncollectible accounts adheres to this principle by recognizing the
uncollectible accounts expense in advance of identifying specific accounts as being uncollectible. The required entry
has some similarity to the depreciation entry in Chapter 3 because it debits an expense and credits an allowance
(contra asset). The purpose of the entry is to make the income statement fairly present the proper expense and the
balance sheet fairly present the asset. Uncollectible accounts expense (also called doubtful accounts expense
or bad debts expense) is an operating expense that a business incurs when it sells on credit. We classify
uncollectible accounts expense as a selling expense because it results from credit sales. Other accountants might
classify it as an administrative expense because the credit department has an important role in setting credit terms.
To adhere to the matching principle, companies must match the uncollectible accounts expense against the
revenues it generates. Thus, an uncollectible account arising from a sale made in 2010 is a 2010 expense even
though this treatment requires the use of estimates. Estimates are necessary because the company sometimes
cannot determine until 2008 or later which 2010 customer accounts will become uncollectible.
Recording the uncollectible accounts adjustment A company that estimates uncollectible accounts
makes an adjusting entry at the end of each accounting period. It debits Uncollectible Accounts Expense, thus
recording the operating expense in the proper period. The credit is to an account called Allowance for Uncollectible
Accounts.
As a contra account to the Accounts Receivable account, the Allowance for Uncollectible Accounts (also
called Allowance for doubtful accounts or Allowance for bad debts) reduces accounts receivable to their net
realizable value. Net realizable value is the amount the company expects to collect from accounts receivable.
When the firm makes the uncollectible accounts adjusting entry, it does not know which specific accounts will
become uncollectible. Thus, the company cannot enter credits in either the Accounts Receivable control account or
the customers' accounts receivable subsidiary ledger accounts. If only one or the other were credited, the Accounts
Receivable control account balance would not agree with the total of the balances in the accounts receivable
subsidiary ledger. Without crediting the Accounts Receivable control account, the allowance account lets the
company show that some of its accounts receivable are probably uncollectible.
To illustrate the adjusting entry for uncollectible accounts, assume a company has USD 100,000 of accounts
receivable and estimates its uncollectible accounts expense for a given year at USD 4,000. The required year-end
adjusting entry is:
Dec. 31 Uncollectible Accounts Expense (-SE) 4,000 Allowance for Uncollectible Accounts (-A) 4,000 To record estimated uncollectible accounts.
The debit to Uncollectible Accounts Expense brings about a matching of expenses and revenues on the income
statement; uncollectible accounts expense is matched against the revenues of the accounting period. The credit to
Allowance for Uncollectible Accounts reduces accounts receivable to their net realizable value on the balance sheet.
When the books are closed, the firm closes Uncollectible Accounts Expense to Income Summary. It reports the
allowance on the balance sheet as a deduction from accounts receivable as follows:
Brice Company Balance Sheet
2010 December 31 Current assets Cash $21,200 Accounts receivable $ 100,000 Less: Allowance for uncollectible accounts 4,000 96,000
Accounting Principles: A Business Perspective 373 A Global Text
9. Receivables and payables
Estimating uncollectible accounts Accountants use two basic methods to estimate uncollectible accounts
for a period. The first method—percentage-of-sales method—focuses on the income statement and the relationship
of uncollectible accounts to sales. The second method—percentage-of-receivables method—focuses on the balance
sheet and the relationship of the allowance for uncollectible accounts to accounts receivable.
Percentage-of-sales method The percentage-of-sales method estimates uncollectible accounts from the
credit sales of a given period. In theory, the method is based on a percentage of prior years' actual uncollectible
accounts to prior years' credit sales. When cash sales are small or make up a fairly constant percentage of total
sales, firms base the calculation on total net sales. Since at least one of these conditions is usually met, companies
commonly use total net sales rather than credit sales. The formula to determine the amount of the entry is:
Amount of journal entry for uncollectible accounts – Net sales (total or credit) x Percentage estimated as
uncollectible
To illustrate, assume that Rankin Company's uncollectible accounts from 2008 sales were 1.1 per cent of total
net sales. A similar calculation for 2009 showed an uncollectible account percentage of 0.9 per cent. The average
for the two years is 1 per cent [(1.1 +0.9)/2]. Rankin does not expect 2010 to differ from the previous two years.
Total net sales for 2010 were USD 500,000; receivables at year-end were USD 100,000; and the Allowance for
Uncollectible Accounts had a zero balance. Rankin would make the following adjusting entry for 2010:
Dec. 31 Uncollectible Accounts Expense (-SE) 5,000 Allowance for Uncollectible Accounts (-A) 5,000 To record estimated uncollectible accounts ($500,000 X 0.01).
Using T-accounts, Rankin would show:
Uncollectible Accounts Expense Allowance for Uncollectible Accounts Dec. 31 Bal. before Adjustment 5,000 adjustment -0-
Dec. 31 Adjustment 5,000 Bal. after adjustment 5,000
Rankin reports Uncollectible Accounts Expense on the income statement. It reports the accounts receivable less
the allowance among current assets in the balance sheet as follows:
Accounts receivable $ 100,000 Less: Allowance for uncollectible accounts 5,000 $ 95,000 Or Rankin's balance sheet could show: Accounts receivable (less estimated uncollectible accounts, $5,000) $95,000
On the income statement, Rankin would match the uncollectible accounts expense against sales revenues in the
period. We would classify this expense as a selling expense since it is a normal consequence of selling on credit.
The Allowance for Uncollectible Accounts account usually has either a debit or credit balance before the year-
end adjustment. Under the percentage-of-sales method, the company ignores any existing balance in the allowance
when calculating the amount of the year-end adjustment (except that the allowance account must have a credit
balance after adjustment).
For example, assume Rankin's allowance account had a USD 300 credit balance before adjustment. The
adjusting entry would still be for USD 5,000. However, the balance sheet would show USD 100,000 accounts
receivable less a USD 5,300 allowance for uncollectible accounts, resulting in net receivables of USD 94,700. On the
income statement, Uncollectible Accounts Expense would still be 1 per cent of total net sales, or USD 5,000.
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In applying the percentage-of-sales method, companies annually review the percentage of uncollectible accounts
that resulted from the previous year's sales. If the percentage rate is still valid, the company makes no change.
However, if the situation has changed significantly, the company increases or decreases the percentage rate to
reflect the changed condition. For example, in periods of recession and high unemployment, a firm may increase
the percentage rate to reflect the customers' decreased ability to pay. However, if the company adopts a more
stringent credit policy, it may have to decrease the percentage rate because the company would expect fewer
uncollectible accounts.
Percentage-of-receivables method The percentage-of-receivables method estimates uncollectible
accounts by determining the desired size of the Allowance for Uncollectible Accounts. Rankin would multiply the
ending balance in Accounts Receivable by a rate (or rates) based on its uncollectible accounts experience. In the
percentage-of-receivables method, the company may use either an overall rate or a different rate for each age
category of receivables.
To calculate the amount of the entry for uncollectible accounts under the percentage-of-receivables method
using an overall rate, Rankin would use:
Amount of entry for uncollectible accounts – (Accounts receivable ending balance x percentage estimated as
uncollectible) – Existing credit balance in allowance for uncollectible accounts or existing debit balance in
allowance for uncollectible accounts
Using the same information as before, Rankin makes an estimate of uncollectible accounts at the end of 2010.
The balance of accounts receivable is USD 100,000, and the allowance account has no balance. If Rankin estimates
that 6 per cent of the receivables will be uncollectible, the adjusting entry would be:
Dec. 31 Uncollectible Accounts Expense (-SE) 6,000 Allowance for Uncollectible Accounts (-A) 6,000 To record estimated uncollectible accounts ($100,000 X 0.06).
Using T-accounts, Rankin would show:
Uncollectible Accounts Expense Allowance for Uncollectible Accounts Dec. 31 Bal. before Adjustment 6,000 Adjustment -0-
Dec. 31 Adjustment 6,000 Bal. after Adjustment 6,000
If Rankin had a USD 300 credit balance in the allowance account before adjustment, the entry would be the
same, except that the amount of the entry would be USD 5,700. The difference in amounts arises because
management wants the allowance account to contain a credit balance equal to 6 per cent of the outstanding
receivables when presenting the two accounts on the balance sheet. The calculation of the necessary adjustment is
[(USD 100,000 X 0.06)-USD 300] = USD 5,700. Thus, under the percentage-of-receivables method, firms consider
any existing balance in the allowance account when adjusting for uncollectible accounts. Using T-accounts, Rankin
would show:
Uncollectible Accounts Expense Allowance for Uncollectible Accounts Dec. 31 Bal. before Adjustment 5,700 Adjustment 300
Dec. 31 Adjustment 5,700 Bal. after Adjustment 6,000
Accounting Principles: A Business Perspective 375 A Global Text
9. Receivables and payables
ALLEN COMPANY Accounts Receivable Aging Schedule
2010 December 31
Customer
Accounts Receivable Balance
Not Yet Due
Days Past Due
1-30 31-60 61-90 Over 90
X $ 5,000 $ 5,000 Y 14,000 $ 12,000 $2,000 Z 400 $200 200 All others 808,600 $ 560,000 240,000 2,000 600 6,000
$ 828,000 $ 560,000 $252,000 $4,000 $800 $11,200
Percentage estimated as uncollectible Estimated amount uncollectible
1% 5% 10% 25% 50%
$ 24,400 $ 5,600 $ 12,600 $ 400 $200 $ 5,600
Exhibit 77: Accounts receivable aging schedule
As another example, suppose that Rankin had a USD 300 debit balance in the allowance account before
adjustment. Then, a credit of USD 6,300 would be necessary to get the balance to the required USD 6,000 credit
balance. The calculation of the necessary adjustment is [(USD 100,000 X 0.06) + USD 300] = USD 6,300. Using T-
accounts, Rankin would show:
Uncollectible Accounts Expense Allowance for Uncollectible Accounts Dec. 31 Bal. before Dec. 31 Adjustment 6,300 Adjustment 300 Adjustment 6,300
Bal. after Adjustment 6,000
No matter what the pre-adjustment allowance account balance is, when using the percentage-of-receivables
method, Rankin adjusts the Allowance for Uncollectible Accounts so that it has a credit balance of USD 6,000—
equal to 6 per cent of its USD 100,000 in Accounts Receivable. The desired USD 6,000 ending credit balance in the
Allowance for Uncollectible Accounts serves as a "target" in making the adjustment.
So far, we have used one uncollectibility rate for all accounts receivable, regardless of their age. However, some
companies use a different percentage for each age category of accounts receivable. When accountants decide to use
a different rate for each age category of receivables, they prepare an aging schedule. An aging schedule classifies
accounts receivable according to how long they have been outstanding and uses a different uncollectibility
percentage rate for each age category. Companies base these percentages on experience. In Exhibit 77, the aging
schedule shows that the older the receivable, the less likely the company is to collect it.
Classifying accounts receivable according to age often gives the company a better basis for estimating the total
amount of uncollectible accounts. For example, based on experience, a company can expect only 1 per cent of the
accounts not yet due (sales made less than 30 days before the end of the accounting period) to be uncollectible. At
the other extreme, a company can expect 50 per cent of all accounts over 90 days past due to be uncollectible. For
each age category, the firm multiplies the accounts receivable by the percentage estimated as uncollectible to find
the estimated amount uncollectible.
The sum of the estimated amounts for all categories yields the total estimated amount uncollectible and is the
desired credit balance (the target) in the Allowance for Uncollectible Accounts.
Since the aging schedule approach is an alternative under the percentage-of-receivables method, the balance in
the allowance account before adjustment affects the year-end adjusting entry amount recorded for uncollectible
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accounts. For example, the schedule in Exhibit 77 shows that USD 24,400 is needed as the ending credit balance in
the allowance account. If the allowance account has a USD 5,000 credit balance before adjustment, the adjustment
would be for USD 19,400.
The information in an aging schedule also is useful to management for other purposes. Analysis of collection
patterns of accounts receivable may suggest the need for changes in credit policies or for added financing. For
example, if the age of many customer balances has increased to 61-90 days past due, collection efforts may have to
be strengthened. Or, the company may have to find other sources of cash to pay its debts within the discount
period. Preparation of an aging schedule may also help identify certain accounts that should be written off as
uncollectible.
An accounting perspective:
Business insight
According to the Fair Debt Collection Practices Act, collection agencies can call persons only
between 8 am and 9 pm, and cannot use foul language. Agencies can call employers only if the
employers allow such calls. And, they can threaten to sue only if they really intend to do so.
Write-off of receivables As time passes and a firm considers a specific customer's account to be uncollectible,
it writes that account off. It debits the Allowance for Uncollectible Accounts. The credit is to the Accounts
Receivable control account in the general ledger and to the customer's account in the accounts receivable subsidiary
ledger. For example, assume Smith's USD 750 account has been determined to be uncollectible. The entry to write
off this account is:
Allowance for Uncollectible Accounts (-SE) 750 Accounts Receivable—Smith (-A) 750 To write off Smith's account as uncollectible.
The credit balance in Allowance for Uncollectible Accounts before making this entry represented potential
uncollectible accounts not yet specifically identified. Debiting the allowance account and crediting Accounts
Receivable shows that the firm has identified Smith's account as uncollectible. Notice that the debit in the entry to
write off an account receivable does not involve recording an expense. The company recognized the uncollectible
accounts expense in the same accounting period as the sale. If Smith's USD 750 uncollectible account were
recorded in Uncollectible Accounts Expense again, it would be counted as an expense twice.
A write-off does not affect the net realizable value of accounts receivable. For example, suppose that Amos
Company has total accounts receivable of USD 50,000 and an allowance of USD 3,000 before the previous entry;
the net realizable value of the accounts receivable is USD 47,000. After posting that entry, accounts receivable are
USD 49,250, and the allowance is USD 2,250; net realizable value is still USD 47,000, as shown here:
Before Entry for After Write-Off Write-Off Write-Off
Accounts receivable $ 50,000 Dr. $750 Cr. $ 49,250 Dr. Allowance for uncollectible accounts 3,000 Cr. 750 Dr. 2,250 Cr. Net realizable value $47,000 $ 47,000
You might wonder how the allowance account can develop a debit balance before adjustment. To explain this,
assume that Jenkins Company began business on 2009 January 1, and decided to use the allowance method and
Accounting Principles: A Business Perspective 377 A Global Text
9. Receivables and payables
make the adjusting entry for uncollectible accounts only at year-end. Thus, the allowance account would not have
any balance at the beginning of 2009. If the company wrote off any uncollectible accounts during 2009, it would
debit Allowance for Uncollectible Accounts and cause a debit balance in that account. At the end of 2009, the
company would debit Uncollectible Accounts Expense and credit Allowance for Uncollectible Accounts. This
adjusting entry would cause the allowance account to have a credit balance. During 2010, the company would again
begin debiting the allowance account for any write-offs of uncollectible accounts. Even if the adjustment at the end
of 2009 was adequate to cover all accounts receivable existing at that time that would later become uncollectible,
some accounts receivable from 2010 sales may be written off before the end of 2010. If so, the allowance account
would again develop a debit balance before the end-of-year 2010 adjustment.
Uncollectible accounts recovered Sometimes companies collect accounts previously considered to be
uncollectible after the accounts have been written off. A company usually learns that an account has been written
off erroneously when it receives payment. Then the company reverses the original write-off entry and reinstates the
account by debiting Accounts Receivable and crediting Allowance for Uncollectible Accounts for the amount
received. It posts the debit to both the general ledger account and to the customer's accounts receivable subsidiary
ledger account. The firm also records the amount received as a debit to Cash and a credit to Accounts Receivable.
And it posts the credit to both the general ledger and to the customer's accounts receivable subsidiary ledger
account.
To illustrate, assume that on May 17 a company received a USD 750 check from Smith in payment of the account
previously written off. The two required journal entries are:
May 17 Accounts Receivable—Smith (+A) Allowance for Uncollectible Accounts (-A) To reverse original write-off of Smith account.
750 750
May 17 Cash (+A) Accounts Receivable—Smith (-A) To record collection of account.
750 750
The debit and credit to Accounts Receivable—Smith on the same date is to show in Smith's subsidiary ledger
account that he did eventually pay the amount due. As a result, the company may decide to sell to him in the future.
When a company collects part of a previously written off account, the usual procedure is to reinstate only that
portion actually collected, unless evidence indicates the amount will be collected in full. If a company expects full
payment, it reinstates the entire amount of the account.
Because of the problems companies have with uncollectible accounts when they offer customers credit, many
now allow customers to use bank or external credit cards. This policy relieves the company of the headaches of
collecting overdue accounts.
A broader perspective:
GECS allowance for losses on financing receivables
Recognition of losses on financing receivables. The allowance for losses on small-balance
receivables reflects management's best estimate of probable losses inherent in the portfolio
determined principally on the basis of historical experience. For other receivables, principally the
larger loans and leases, the allowance for losses is determined primarily on the basis of
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management's best estimate of probable losses, including specific allowances for known troubled
accounts.
All accounts or portions thereof deemed to be uncollectible or to require an excessive collection
cost are written off to the allowance for losses. Small-balance accounts generally are written off
when 6 to 12 months delinquent, although any such balance judged to be uncollectible, such as an
account in bankruptcy, is written down immediately to estimated realizable value. Large-balance
accounts are reviewed at least quarterly, and those accounts with amounts that are judged to be
uncollectible are written down to estimated realizable value.
When collateral is repossessed in satisfaction of a loan, the receivable is written down against the
allowance for losses to estimated fair value of the asset less costs to sell, transferred to other assets
and subsequently carried at the lower of cost or estimated fair value less costs to sell. This
accounting method has been employed principally for specialized financing transactions.
(In millions) 2000 1999 1998 Balance at January 1 $3,708 $3,223 $2,745 Provisions charged To operations 2,045 1,671 1,603 Net transfers related to companies acquired or sold 22 271 386 Amounts written off-net
(1,741) (1,457) (1,511)
Balance at December 31 $4,034 $3,708 $3,223 Source: General Electric Company, 2000 Annual Report.
An accounting perspective:
Uses of technology
Auditors use expert systems to review a client's internal control structure and to test the
reasonableness of a client's Allowance for Uncollectible Accounts balance. The expert system
reaches conclusions based on rules and information programmed into the expert system software.
The rules are modeled on the mental processes that a human expert would use in addressing the
situation. In the medical field, for instance, the rules constituting the expert system are derived
from modeling the diagnostic decision processes of the foremost experts in a given area of
medicine. A physician can input information from a remote location regarding the symptoms of a
certain patient, and the expert system will provide a probable diagnosis based on the expert model.
In a similar fashion, an accountant can feed client information into the expert system and receive
an evaluation as to the appropriateness of the account balance or internal control structure.
Credit cards are either nonbank (e.g. American Express) or bank (e.g. VISA and MasterCard) charge cards that
customers use to purchase goods and services. For some businesses, uncollectible account losses and other costs of
extending credit are a burden. By paying a service charge of 2 per cent to 6 per cent, businesses pass these costs on
Accounting Principles: A Business Perspective 379 A Global Text
9. Receivables and payables
to banks and agencies issuing national credit cards. The banks and credit card agencies then absorb the
uncollectible accounts and costs of extending credit and maintaining records.
Usually, banks and agencies issue credit cards to approved credit applicants for an annual fee. When a business
agrees to honor these credit cards, it also agrees to pay the percentage fee charged by the bank or credit agency.
When making a credit card sale, the seller checks to see if the customer's card has been canceled and requests
approval if the sale exceeds a prescribed amount, such as USD 50. This procedure allows the seller to avoid
accepting lost, stolen, or canceled cards. Also, this policy protects the credit agency from sales causing customers to
exceed their established credit limits.
The seller's accounting procedures for credit card sales differ depending on whether the business accepts a
nonbank or a bank credit card. To illustrate the entries for the use of nonbank credit cards (such as American
Express), assume that a restaurant American Express invoices amounting to USD 1,400 at the end of a day.
American Express charges the restaurant a 5 per cent service charge. The restaurant uses the Credit Card
Expense account to record the credit card agency's service charge and makes the following entry:
Accounts Receivable—American Express (+A) 1,330 Credit Card Expense (-SE) 70 Sales (+SE) 1,400 To record credit card sales.
The restaurant mails the invoices to American Express. Sometime later, the restaurant receives payment from
American Express and makes the following entry:
Cash (+A) 1,330 Accounts Receivable – American Express (-A) 1,330 To record remittance from American Express.
To illustrate the accounting entries for the use of bank credit cards (such as VISA or MasterCard), assume that a
retailer has made sales of USD 1,000 for which VISA cards were accepted and the service charge is USD 30 (which
is 3 per cent of sales). VISA sales are treated as cash sales because the receipt of cash is certain. The retailer deposits
the credit card sales invoices in its VISA checking account at a bank just as it deposits checks in its regular checking
account. The entry to record this deposit is:
Cash (+A) 970 Credit Card Expense (-SE) 30 Sales (+SE) 1,000 To record credit Visa card sales.
An accounting perspective:
Business insight
Recent innovations in credit cards include picture IDs on cards to reduce theft, credits toward
purchases of new automobiles (e.g. General Motors cards), credit toward free trips on airlines, and
cash rebates on all purchases. Discover Card, for example, remits a percentage of all charges back
to credit card holders. Also, some credit card companies have reduced interest rates on unpaid
balances and have eliminated the annual fee.
Just as every company must have current assets such as cash and accounts receivable to operate, every company
incurs current liabilities in conducting its operations. Corporations (IBM and General Motors), partnerships (CPA
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firms), and single proprietorships (corner grocery stores) all have one thing in common—they have liabilities. The
next section discusses some of the current liabilities companies incur.
Current liabilities
Liabilities result from some past transaction and are obligations to pay cash, provide services, or deliver goods
at some future time. This definition includes each of the liabilities discussed in previous chapters and the new
liabilities presented in this chapter. The balance sheet divides liabilities into current liabilities and long-term
liabilities. Current liabilities are obligations that (1) are payable within one year or one operating cycle,
whichever is longer, or (2) will be paid out of current assets or create other current liabilities. Long-term
liabilities are obligations that do not qualify as current liabilities. This chapter focuses on current liabilities and
Chapter 15 describes long-term liabilities.
Note the definition of a current liability uses the term operating cycle. An operating cycle (or cash cycle) is the
time it takes to begin with cash, buy necessary items to produce revenues (such as materials, supplies, labor, and/or
finished goods), sell goods or services, and receive cash by collecting the resulting receivables. For most companies,
this period is no longer than a few months. Service companies generally have the shortest operating cycle, since
they have no cash tied up in inventory. Manufacturing companies generally have the longest cycle because their
cash is tied up in inventory accounts and in accounts receivable before coming back. Even for manufacturing
companies, the cycle is generally less than one year. Thus, as a practical matter, current liabilities are due in one
year or less, and long-term liabilities are due after one year from the balance sheet date.
The operating cycles for various businesses follow:
Type of Business Operating Cycle Service company selling for cash only Instantaneous Service company selling on credit Cash -> Accounts Receivable -> Cash Merchandising company selling for cash Cash -> Inventory -> Cash Merchandising company selling on credit Cash -> Inventory -> Accounts receivable -> Cash Manufacturing company selling for cash Cash -> Materials inventory -> Work in process
inventory -> Finished goods inventory -> Accounts Receivable -> Cash
Current liabilities fall into these three groups:
• Clearly determinable liabilities. The existence of the liability and its amount are certain. Examples
include most of the liabilities discussed previously, such as accounts payable, notes payable, interest payable,
unearned delivery fees, and wages payable. Sales tax payable, federal excise tax payable, current portions of
long-term debt, and payroll liabilities are other examples.
• Estimated liabilities. The existence of the liability is certain, but its amount only can be estimated. An
example is estimated product warranty payable.
• Contingent liabilities. The existence of the liability is uncertain and usually the amount is uncertain
because contingent liabilities depend (or are contingent) on some future event occurring or not occurring.
Examples include liabilities arising from lawsuits, discounted notes receivable, income tax disputes, penalties
that may be assessed because of some past action, and failure of another party to pay a debt that a company
has guaranteed.
The following table summarizes the characteristics of current liabilities:
Is the Is the Existence Amount
Type of Liability Certain? Certain? Clearly determinable liabilities Yes Yes
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9. Receivables and payables
Estimated liabilities Yes No Contingent liabilities No No
Clearly determinable liabilities have clearly determinable amounts. In this section, we describe liabilities not
previously discussed that are clearly determinable—sales tax payable, federal excise tax payable, current portions of
long-term debt, and payroll liabilities. Later in this chapter, we discuss clearly determinable liabilities such as notes
payable.
Sales tax payable Many states have a state sales tax on items purchased by consumers. The company selling
the product is responsible for collecting the sales tax from customers. When the company collects the taxes, the
debit is to Cash and the credit is to Sales Tax Payable. Periodically, the company pays the sales taxes collected to the
state. At that time, the debit is to Sales Tax Payable and the credit is to Cash.
To illustrate, assume that a company sells merchandise in a state that has a 6 per cent sales tax. If it sells goods
with a sales price of USD 1,000 on credit, the company makes this entry:
Accounts Receivable (+A) 1,060
Sales (+SE) 1,000
Sales Tax Payable (+L) 60
To record sales and sales tax payable.
Now assume that sales for the entire period are USD 100,000 and that USD 6,000 is in the Sales Tax Payable
account when the company remits the funds to the state taxing agency. The following entry shows the payment to
the state:
Sales Tax Payable (-L) 6,000
Cash (-A) 6,000
An alternative method of recording sales taxes payable is to include these taxes in the credit to Sales. For
instance, the previous company could record sales as follows:
Accounts Receivable (+A) 1,060 Sales (+SE) 1,060
When recording sales taxes in the same account as sales revenue, the firm must separate the sales tax from sales
revenue at the end of the accounting period. To make this separation, it adds the sales tax rate to 100 per cent and
divides this percentage into recorded sales revenue. For instance, assume that total recorded sales revenues for an
accounting period are USD 10,600, and the sales tax rate is 6 per cent. To find the sales revenue, use the following
formula:
Sales= Amount recorded forsales account
100 per centsales tax rate
= USD10,600
106 per cent =USD10,000
The sales revenue is USD 10,000 for the period. Sales tax is equal to the recorded sales revenue of USD 10,600
less actual sales revenue of USD 10,000, or USD 600.
Federal excise tax payable Consumers pay federal excise tax on some goods, such as alcoholic beverages,
tobacco, gasoline, cosmetics, tires, and luxury automobiles. The entries a company makes when selling goods
subject to the federal excise tax are similar to those made for sales taxes payable. For example, assume that the
Dixon Jewelry Store sells a diamond ring to a young couple for USD 2,000. The sale is subject to a 6 per cent sales
tax and a 10 per cent federal excise tax. The entry to record the sale is:
Accounts Receivable (+A) 2,320 Sales (+L) 2,000 Sales Tax Payable (+L) 120
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Federal Excise Tax Payable 200 To record the sale of a diamond ring.
The company records the remittance of the taxes to the federal taxing agency by debiting Federal Excise Tax
Payable and crediting Cash.
Current portions of long-term debt Accountants move any portion of long-term debt that becomes due
within the next year to the current liability section of the balance sheet. For instance, assume a company signed a
series of 10 individual notes payable for USD 10,000 each; beginning in the 6th year, one comes due each year
through the 15th year. Beginning in the 5th year, an accountant would move a USD 10,000 note from the long-term
liability category to the current liability category on the balance sheet. The current portion would then be paid
within one year.
An accounting perspective:
Uses of technology
Many companies use service bureaus to process their payrolls because these bureaus keep up to
date on rates, bases, and changes in the laws affecting payroll. Companies can either send their
data over the Internet or have the service bureaus pick up time sheets and other data. Managers
instruct service bureaus either to print the payroll checks or to transfer data back to the company
over the Internet so it can print the checks.
Payroll liabilities In most business organizations, accounting for payroll is particularly important because (1)
payrolls often are the largest expense that a company incurs, (2) both federal and state governments require
maintaining detailed payroll records, and (3) companies must file regular payroll reports with state and federal
governments and remit amounts withheld or otherwise due. Payroll liabilities include taxes and other amounts
withheld from employees' paychecks and taxes paid by employers.
Employers normally withhold amounts from employees' paychecks for federal income taxes; state income taxes;
FICA (social security) taxes; and other items such as union dues, medical insurance premiums, life insurance
premiums, pension plans, and pledges to charities. Assume that a company had a payroll of USD 35,000 for the
month of April 2010. The company withheld the following amounts from the employees' pay: federal income taxes,
USD 4,100; state income taxes, USD 360; FICA taxes, USD 2,678; and medical insurance premiums, USD 940. This
entry records the payroll:
2010 April 30 Salaries Expense (-SE) 35,000
Employees' Federal Income Taxes Payable (+L) 4,100 Employees' State Income Taxes Payable (+L) 360 FICA Taxes Payable (+L) 2,678 Employees' Medical Insurance Premiums Payable (+L)
940
Salaries Payable (+L) 26,922 To record the payroll for the month ending April 30.
All accounts credited in the entry are current liabilities and will be reported on the balance sheet if not paid prior
to the preparation of financial statements. When these liabilities are paid, the employer debits each one and credits
Cash.
Accounting Principles: A Business Perspective 383 A Global Text
9. Receivables and payables
Employers normally record payroll taxes at the same time as the payroll to which they relate. Assume the payroll
taxes an employer pays for April are FICA taxes, USD 2,678; state unemployment taxes, USD 1,890; and federal
unemployment taxes, USD 280. The entry to record these payroll taxes would be:
2010 April 30 Payroll Taxes Expense (-SE)
FICA Taxes Payable (+L) State Unemployment Taxes Payable (+L) Federal Unemployment Taxes Payable (+L) To record employer's payroll taxes.
4,848 2,678 1,890 280
These amounts are in addition to the amounts withheld from employees' paychecks. The credit to FICA Taxes
Payable is equal to the amount withheld from the employees' paychecks. The company can credit both its own and
the employees' FICA taxes to the same liability account, since both are payable at the same time to the same agency.
When these liabilities are paid, the employer debits each of the liability accounts and credits Cash.
An accounting perspective:
Uses of technology
One of the basic components in accounting software packages is the payroll module. As long as
companies update this module each time rates, bases, or laws change, they can calculate
withholdings, print payroll checks, and complete reporting forms for taxing agencies. In addition
to calculating the employer's payroll taxes, this software maintains all accounting payroll records.
Managers of companies that have estimated liabilities know these liabilities exist but can only estimate the
amount. The primary accounting problem is to estimate a reasonable liability as of the balance sheet date. An
example of an estimated liability is product warranty payable.
Estimated product warranty payable When companies sell products such as computers, often they must
guarantee against defects by placing a warranty on their products. When defects occur, the company is obligated to
reimburse the customer or repair the product. For many products, companies can predict the number of defects
based on experience. To provide for a proper matching of revenues and expenses, the accountant estimates the
warranty expense resulting from an accounting period's sales. The debit is to Product Warranty Expense and the
credit to Estimated Product Warranty Payable.
To illustrate, assume that a company sells personal computers and warrants all parts for one year. The average
price per computer is USD 1,500, and the company sells 1,000 computers in 2010. The company expects 10 per
cent of the computers to develop defective parts within one year. By the end of 2010, customers have returned 40
computers sold that year for repairs, and the repairs on those 40 computers have been recorded. The estimated
average cost of warranty repairs per defective computer is USD 150. To arrive at a reasonable estimate of product
warranty expense, the accountant makes the following calculation:
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9. Receivables and payables
Number of computers sold 1,000 Percent estimated to develop defects X 10% Total estimated defective computers 100 Deduct computers returned as defective to date 40 Estimated additional number to become defective during warranty period 60 Estimated average warranty repair cost per compute: X $ 150 Estimated product warranty payable $9,000
The entry made at the end of the accounting period is:
Product Warranty Expense (-SE) 9,000 Estimated Product Warranty Payable (+L) 9,000 To record estimated product warranty expense.
When a customer returns one of the computers purchased in 2010 for repair work in 2008 (during the warranty
period), the company debits the cost of the repairs to Estimated Product Warranty Payable. For instance, assume
that Evan Holman returns his computer for repairs within the warranty period. The repair cost includes parts, USD
40, and labor, USD 160. The company makes the following entry:
Estimated Product Warranty Payable (-L) 200 Repair Parts Inventory (-A) 40 Wages Payable (+L) 160 To record replacement of parts under warranty.
An accounting perspective:
Business insight
Another estimated liability that is quite common relates to clean-up costs for industrial pollution.
One company had the following note in its recent financial statements:
In the past, the Company treated hazardous waste at its chemical facilities. Testing of the ground
waters in the areas of the treatment impoundments at these facilities disclosed the presence of
certain contaminants. In compliance with environmental regulations, the Company developed a
plan that will prevent further contamination, provide for remedial action to remove the present
contaminants, and establish a monitoring program to monitor ground water conditions in the
future. A similar plan has been developed for a site previously used as a metal pickling facility.
Estimated future costs of USD 2,860,000 have been accrued in the accompanying financial
statements...to complete the procedures required under these plans.
When liabilities are contingent, the company usually is not sure that the liability exists and is uncertain about
the amount. FASB Statement No. 5 defines a contingency as "an existing condition, situation, or set of
circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved
when one or more future events occur or fail to occur".29
According to FASB Statement No. 5, if the liability is probable and the amount can be reasonably estimated,
companies should record contingent liabilities in the accounts. However, since most contingent liabilities may not
29 FASB, Statement of Financial Accounting Standards No. 5, "Accounting for Contingencies" (Stamford, Conn.,
1975). Copyright © by Financial Accounting Standards Board, High Ridge Park, Stamford, Connecticut 06905,
USA.
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occur and the amount often cannot be reasonably estimated, the accountant usually does not record them in the
accounts. Instead, firms typically disclose these contingent liabilities in notes to their financial statements.
Many contingent liabilities arise as the result of lawsuits. In fact, 469 of the 957 companies contacted in the
AICPA's annual survey of accounting practices reported contingent liabilities resulting from litigation.30
The following two examples from annual reports are typical of the disclosures made in notes to the financial
statements. Be aware that just because a suit is brought, the company being sued is not necessarily guilty. One
company included the following note in its annual report to describe its contingent liability regarding various
lawsuits against the company:
Contingent liabilities:
Various lawsuits and claims, including those involving ordinary routine litigation incidental to its business, to
which the Company is a party, are pending, or have been asserted, against the Company. In addition, the Company
was advised...that the United States Environmental Protection Agency had determined the existence of PCBs in a
river and harbor near Sheboygan, Wisconsin,USA, and that the Company, as well as others, allegedly contributed to
that contamination. It is not presently possible to determine with certainty what corrective action, if any, will be
required, what portion of any costs thereof will be attributable to the Company, or whether all or any portion of
such costs will be covered by insurance or will be recoverable from others. Although the outcome of these matters
cannot be predicted with certainty, and some of them may be disposed of unfavorably to the Company,
management has no reason to believe that their disposition will have a materially adverse effect on the consolidated
financial position of the Company.
Another company dismissed an employee and included the following note to disclose the contingent liability
resulting from the ensuing litigation:
Contingencies:
...A jury awarded USD 5.2 million to a former employee of the Company for an alleged breach of contract and
wrongful termination of employment. The Company has appealed the judgment on the basis of errors in the judge's
instructions to the jury and insufficiency of evidence to support the amount of the jury's award. The Company is
vigorously pursuing the appeal.
The Company and its subsidiaries are also involved in various other litigation arising in the ordinary course of
business.
Since it presently is not possible to determine the outcome of these matters, no provision has been made in the
financial statements for their ultimate resolution. The resolution of the appeal of the jury award could have a
significant effect on the Company's earnings in the year that a determination is made; however, in management's
opinion, the final resolution of all legal matters will not have a material adverse effect on the Company's financial
position.
Contingent liabilities may also arise from discounted notes receivable, income tax disputes, penalties that may
be assessed because of some past action, and failure of another party to pay a debt that a company has guaranteed.
The remainder of this chapter discusses notes receivable and notes payable. Business transactions often involve
one party giving another party a note.
30 AICPA, Accounting Trends & Techniques (New York, 2000), p. 100.
Accounting Principles: A Business Perspective 386 A Global Text
9. Receivables and payables
Notes receivable and notes payable
A note (also called a promissory note) is an unconditional written promise by a borrower (maker) to pay a
definite sum of money to the lender (payee) on demand or on a specific date. On the balance sheet of the lender
(payee), a note is a receivable; on the balance sheet of the borrower (maker), a note is a payable. Since the note is
usually negotiable, the payee may transfer it to another party, who then receives payment from the maker. Look at
the promissory note in Exhibit 78.
A customer may give a note to a business for an amount due on an account receivable or for the sale of a large
item such as a refrigerator. Also, a business may give a note to a supplier in exchange for merchandise to sell or to a
bank or an individual for a loan. Thus, a company may have notes receivable or notes payable arising from
transactions with customers, suppliers, banks, or individuals.
Companies usually do not establish a subsidiary ledger for notes. Instead, they maintain a file of the actual notes
receivable and copies of notes payable.
Most promissory notes have an explicit interest charge. Interest is the fee charged for use of money over a
period. To the maker of the note, or borrower, interest is an expense; to the payee of the note, or lender, interest is a
revenue. A borrower incurs interest expense; a lender earns interest revenue. For convenience, bankers sometimes
calculate interest on a 360-day year; we calculate it on that basis in this text. (Some companies use a 365-day year.)
Exhibit 78: Promissory note
The basic formula for computing interest is:
Interest=Principal×Rate×Time , or I=P×R×T
Principal is the face value of the note. The rate is the stated interest rate on the note; interest rates are
generally stated on an annual basis. Time, which is the amount of time the note is to run, can be either days or
months.
To show how to calculate interest, assume a company borrowed USD 20,000 from a bank. The note has a
principal (face value) of USD 20,000, an annual interest rate of 10 per cent, and a life of 90 days. The interest
calculation is:
Interest=USD20,000×0.10× 90
360
Interest = USD 500
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Note that in this calculation we expressed the time period as a fraction of a 360-day year because the interest
rate is an annual rate.
The maturity date is the date on which a note becomes due and must be paid. Sometimes notes require
monthly installments (or payments) but usually all of the principal and interest must be paid at the same time as in
Exhibit 78. The wording in the note expresses the maturity date and determines when the note is to be paid. A note
falling due on a Sunday or a holiday is due on the next business day. Examples of the maturity date wording are:
• On demand. "On demand, I promise to pay..." When the maturity date is on demand, it is at the option of
the holder and cannot be computed. The holder is the payee, or another person who legally acquired the note
from the payee.
• On a stated date. "On 2010 July 18, I promise to pay..." When the maturity date is designated, computing
the maturity date is not necessary.
• At the end of a stated period.
(a) "One year after date, I promise to pay..." When the maturity is expressed in years, the note matures
on the same day of the same month as the date of the note in the year of maturity.
(b)"Four months after date, I promise to pay..." When the maturity is expressed in months, the note
matures on the same date in the month of maturity. For example, one month from 2010 July 18, is 2010
August 18, and two months from 2010 July 18, is 2010 September 18. If a note is issued on the last day
of a month and the month of maturity has fewer days than the month of issuance, the note matures on
the last day of the month of maturity. A one-month note dated 2010 January 31, matures on 2010
February 28.
(c) “Ninety days after date, I promise to pay..." When the maturity is expressed in days, the exact
number of days must be counted. The first day (date of origin) is omitted, and the last day (maturity
date) is included in the count. For example, a 90-day note dated 2010 October 19, matures on 2008
January 17, as shown here:
Life of note (days) 90 days Days remaining in October not counting date of origin of note: Days to count in October (31 - 19) 12 Total days in November 30 Total Days in December 31 73 Maturity date in January 17 days
Sometimes a company receives a note when it sells high-priced merchandise; more often, a note results from the
conversion of an overdue account receivable. When a customer does not pay an account receivable that is due, the
company (creditor) may insist that the customer (debtor) gives a note in place of the account receivable. This action
allows the customer more time to pay the balance due, and the company earns interest on the balance until paid.
Also, the company may be able to sell the note to a bank or other financial institution.
To illustrate the conversion of an account receivable to a note, assume that Price Company (maker) had
purchased USD 18,000 of merchandise on August 1 from Cooper Company (payee) on account. The normal credit
period has elapsed, and Price cannot pay the invoice. Cooper agrees to accept Price's USD 18,000, 15 per cent, 90-
day note dated September 1 to settle Price's open account. Assuming Price paid the note at maturity and both
Cooper and Price have a December 31 year-end, the entries on the books of the payee and the maker are:
Accounting Principles: A Business Perspective 388 A Global Text
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Aug. 1
Cooper Company, Payee Accounts Receivable—Price Company (+A) Sales (+SE) To record sale of merchandise on account.
18,000 18,000
Sept. 1 Notes Receivable (+A) Accounts Receivable—Price Company (-A) To record exchange of a note from Price Company for open account.
18,000 18,000
Nov. 30 Cash (+A) Notes Receivable (-A) Interest Revenue ($18,000 X 0.15 X 90/
360 ). (+SE)
To record receipt of Price Company note principal and interest.
18,675 18,000 675
Aug. 1
Price Company, Maker Purchase (+A) Accounts Payable—Cooper Company (+L) To record purchase of merchandise on account.
18,000 18,000
Sept. 1 Accounts Payable—Cooper Company (-L) Notes Payable (+L) To record exchange of a note to Cooper Company for open account.
18,000 18,000
Nov. 30 Notes Payable (-L) Interest Expense ($18,000 X 0.15 X 90/360). (-SE) Cash (-A) To record payment of note principal and interest.
18,000 675
18,675
The USD 18,675 paid by Price to Cooper is called the maturity value of the note. Maturity value is the amount
that the maker must pay on a note on its maturity date; typically, it includes principal and accrued interest, if any.
Sometimes the maker of a note does not pay the note when it becomes due. The next section describes how to
record a note not paid at maturity.
A dishonored note is a note that the maker failed to pay at maturity. Since the note has matured, the holder or
payee removes the note from Notes Receivable and records the amount due in Accounts Receivable (or Dishonored
Notes Receivable).
At the maturity date of a note, the maker should pay the principal plus interest. If the interest has not been
accrued in the accounting records, the maker of a dishonored note should record interest expense for the life of the
note by debiting Interest Expense and crediting Interest Payable. The payee should record the interest earned and
remove the note from its Notes Receivable account. Thus, the payee of the note should debit Accounts Receivable
for the maturity value of the note and credit Notes Receivable for the note's face value and Interest Revenue for the
interest. After these entries have been posted, the full liability on the note—principal plus interest—is included in
the records of both parties. Interest continues to accrue on the note until it is paid, replaced by a new note, or
written off as uncollectible. To illustrate, assume that Price did not pay the note at maturity. The entries on each
party's books are:
Cooper Company, Payee
Nov. 30 Accounts Receivable—Price Company (+A) 18,675 Notes Receivable (-A) 18,000 Interest Revenue (+SE) 675 To record dishonor of Price Company note. Price Company, Maker
Nov. 30 Interest Expense (-SE) 675 Interest Payable (+L) 675 To record interest on note payable.
When unable to pay a note at maturity, sometimes the maker pays the interest on the original note or includes
the interest in the face value of a new note that replaces the old note. Both parties account for the new note in the
same manner as the old note. However, if it later becomes clear that the maker of a dishonored note will never pay,
Accounting Principles: A Business Perspective 389 A Global Text
9. Receivables and payables
the payee writes off the account with a debit to Uncollectible Accounts Expense (or to an account with a title such as
Loss on Dishonored Notes) and a credit to Accounts Receivable. The debit should be to the Allowance for
Uncollectible Accounts if the payee made an annual provision for uncollectible notes receivable.
Assume that Price Company pays the interest at the maturity date and issues a new 15 per cent, 90-day note for
USD 18,000. The entries on both sets of books would be:
Cooper Company, Payee Price Company, Maker Cash (+A) Interest Revenue (+SE) To record the receipt of interest on Price Company note.
675 675
Interest Expense (-SE) Cash (-A) To record the payment of interest on note to Cooper Company.
675 675
(Optional entry) Notes Receivable (+A) Notes Receivable (-A) To replace old 15%, 90-day note from Price Company with new 15%, 90-day note.
18,000 18,000
(Optional entry) Notes Payable (-L) Notes Payable (+L) To replace old 15%, 90-day note to Cooper Company with new 15%, 90-day note.
18,000 18,000
Although the second entry on each set of books has no effect on the existing account balances, it indicates that
the old note was renewed (or replaced). Both parties substitute the new note, or a copy, for the old note in a file of
notes.
Now assume that Price Company does not pay the interest at the maturity date but instead includes the interest
in the face value of the new note. The entries on both sets of books would be:
Cooper Company, Payee Price Company, Maker Notes Receivable (+A) 18,675 Interest Expense (-SE) 675 Interest Revenue (+SE) 675 Notes Payable (-L) 18,000 Notes Receivable (-A) 18,000 Notes Payable (+L) 18,675 To record the To record the replacement of the replacement of the old Price Company old $18,000, 15%, $18,000, 15%, 90- 90-day note to day note with a Cooper Company with new $18,675, 15%, a new $18,675, 15%, 90-day note. 90-day note.
On an interest-bearing note, even though interest accrues, or accumulates, on a day-to-day basis, usually both
parties record it only at the note's maturity date. If the note is outstanding at the end of an accounting period,
however, the time period of the interest overlaps the end of the accounting period and requires an adjusting entry at
the end of the accounting period. Both the payee and maker of the note must make an adjusting entry to record the
accrued interest and report the proper assets and revenues for the payee and the proper liabilities and expenses for
the maker. Failure to record accrued interest understates the payee's assets and revenues by the amount of the
interest earned but not collected and understates the maker's expenses and liabilities by the interest expense
incurred but not yet paid.
Payee's books To illustrate how to record accrued interest on the payee's books, assume that the payee, Cooper
Company, has a fiscal year ending on October 31 instead of December 31. On October 31, Cooper would make the
following adjusting entry relating to the Price Company note:
Oct. 3 1 Interest Receivable (+A) 450
Interest Revenue ($18,000 X 0.15 X 60/360) (+SE)
450
To record interest earned on Price Company
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note for the period September 1 through October 31.
The Interest Receivable account shows the interest earned but not yet collected. Interest receivable is a
current asset in the balance sheet because the interest will be collected in 30 days. The interest revenue appears in
the income statement. When Price pays the note on November 30, Cooper makes the following entry to record the
collection of the note's principal and interest:
Nov. 3 0
Cash (+A) 18,675
Notes Receivable (-A) 18,000 Interest Receivable (-A) 450 Interest Revenue (+SE) 225 To record collection of Price Company note and interest.
Note that the entry credits the Interest Receivable account for the USD 450 interest accrued from September 1
through October 31, which was debited to the account in the previous entry, and credits Interest Revenue for the
USD 225 interest earned in November.
Maker's books Assume Price Company's accounting year also ends on October 31 instead of December 31.
Price's accounting records would be incomplete unless the company makes an adjusting entry to record the liability
owed for the accrued interest on the note it gave to Cooper Company. The required entry is:
Oct. 3 1
Interest Expense ($18,000 X 0.15 X 60/360) (- SE)
450
Interest Payable (+L) 450 To record accrued interest on note to Cooper Company for the period September 1 through October 31.
The Interest Payable account, which shows the interest expense incurred but not yet paid, is a current
liability in the balance sheet because the interest will be paid in 30 days. Interest expense appears in the income
statement. When the note is paid, Price makes the following entry:
Nov. 3 0
Notes Payable (-L) 18,000
Interest Payable (-L) 450 Interest Expense (-SE) 225 Cash (-A) 18,675 To record payment of principal and interest on note to Cooper Company.
In this illustration, Cooper's financial position made it possible for the company to carry the Price note to the
maturity date. Alternatively, Cooper could have sold, or discounted, the note to receive the proceeds before the
maturity date. This topic is reserved for a more advanced text.
Short-term financing through notes payable
A company sometimes needs short-term financing. This situation may occur when (1) the company's cash
receipts are delayed because of lenient credit terms granted customers, or (2) the company needs cash to finance
the buildup of seasonal inventories, such as before Christmas. To secure short-term financing, companies issue
interest-bearing or non interest-bearing notes.
Interest-bearing notes To receive short-term financing, a company may issue an interest-bearing note to a
bank. An interest-bearing note specifies the interest rate charged on the principal borrowed. The company receives
Accounting Principles: A Business Perspective 391 A Global Text
9. Receivables and payables
from the bank the principal borrowed; when the note matures, the company pays the bank the principal plus the
interest.
Accounting for an interest-bearing note is simple. For example, assume the company's accounting year ends on
December 31. Needham Company issued a USD 10,000, 90-day, 9 per cent note on 2009 December 1. The
following entries would record the loan, the accrual of interest on 2009 December 31 and its payment on 2010
March 1:
2009 Dec.
1 Cash (+A) Notes Payable (+L) To record 90-day bank loan.
10,000 10,000
31 Interest Expense (-SE) Interest Payable (+L) To record accrued interest on a note payable at year-end ($10,000 X 0.09 X 30/360).
75 75
2010 Mar.
1 Notes Payable (-L) Interest Expense ($10,000 X 0.09 X 60/360) (-SE) Interest Payable (-L) Cash (-A) To record principal and interest paid on bank loan.
10,000 150 75
10,225
Non interest-bearing notes (discounting notes payable) A company may also issue a non interest-
bearing note to receive short-term financing from a bank. A non interest-bearing note does not have a stated
interest rate applied to the face value of the note. Instead, the note is drawn for a maturity amount less a bank
discount; the borrower receives the proceeds. A bank discount is the difference between the maturity value of the
note and the cash proceeds given to the borrower. The cash proceeds are equal to the maturity amount of a note
less the bank discount. This entire process is called discounting a note payable. The purpose of this process is to
introduce interest into what appears to be a non interest-bearing note. The meaning of discounting here is to
deduct interest in advance.
Because interest is related to time, the bank discount is not interest on the date the loan is made; however, it
becomes interest expense to the company and interest revenue to the bank as time passes. To illustrate, assume that
on 2009 December 1, Needham Company presented its USD 10,000, 90-day, non interest-bearing note to the bank,
which discounted the note at 9 per cent. The discount is USD 225 (USD 10,000 X 0.09 X 90/360), and the proceeds
to Needham are USD 9,775. The entry required on the date of the note's issue is:
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2009 Dec. 1 Cash (+A)
Discount on Notes Payable (-L) Notes Payable (+L) Issued a 90-day note to bank.
9,775 225
10,000
Needham credits Notes Payable for the face value of the note. Discount on notes payable is a contra account
used to reduce Notes Payable from face value to the net amount of the debt. The balance in the Discount on Notes
Payable account appears on the balance sheet as a deduction from the balance in the Notes Payable account.
Over time, the discount becomes interest expense. If Needham paid the note before the end of the fiscal year, it
would charge the entire USD 225 discount to Interest Expense and credit Discount on Notes Payable. However, if
Needham's fiscal year ended on December 31, an adjusting entry would be required as follows:
2009 Dec. 3
1 Interest Expense (-SE) Discount on Notes Payable (+L) To record accrued interest on note payable at year-end.
75 75
This entry records the interest expense incurred by Needham for the 30 days the note has been outstanding. The
expense can be calculated as USD 10,000 X 0.09 X 30/360, or 30/90 X USD 225. Notice that for entries involving
discounted notes payable, no separate Interest Payable account is needed. The Notes Payable account already
contains the total liability that will be paid at maturity, USD 10,000. From the date the proceeds are given to the
borrower to the maturity date, the liability grows by reducing the balance in the Discount on Notes Payable contra
account. Thus, the current liability section of the 2009 December 31, balance sheet would show:
Current Liabilities: Notes payable $ 10,000 Less: Discount on notes payable 150 $ 9,850
When the note is paid at maturity, the entry is:
2010 Mar. 1 Notes Payable (-L) 10,000
Interest Expense (-SE) 150 Cash (-A) 10,000 Discount on Notes Payable (+L) 150 To record note payment and interest expense.
The T-accounts for Discount on Notes Payable and for Interest Expense appear as follows:
Discount on Notes Payable Interest Expense
2009 Dec. 1 225
2009 Dec. 31 75
2009 Dec. 31 75
2009 Dec. 31 To close 75
Dec. 31
Balance 150 2010 2010
Mar. 1 150 Mar. 1 150
In Exhibit 79, we compare the journal entries for interest-bearing notes and non-interest-bearing notes used by
Needham Company.
Accounting Principles: A Business Perspective 393 A Global Text
9. Receivables and payables
Interest-Bearing Notes Non interest-Bearing Notes 2009 2009 Dec. 1 Cash (+A) 10,000 Dec. 1 Cash (+A) 9,775
Notes Payable (+L) 10,00 0
Discount on Notes Payable (-L) 225
To record 90-day bank loan, Notes Payable (+L) To record 90-day bank loan.
10,000
31 Interest Expense (-SE) 75 31 Interest Expense (-SE) 75 Interest Payable (+L) 75 Discount on Notes Payable (+L) 75 To record accrued interest on a note payable at year-end.
To record accrued interest on a note payable at year-end.
2010 2010 Mar. 1 Notes Payable (-L) 10,000 Mar. 1 Notes Payable (-L) 10,000
Interest Expense (-SE) 150 Interest Expense (-SE) 150 Interest Payable (-L) 75 Cash (-A) 10,000 Cash (-A) To record note principal and interest payment.
10,22 5
Discount on Notes Payable (+L) To record note payment and interest expense.
150
Exhibit 79: Comparison between interest-bearing notes and noninterest-bearing notes
Analyzing and using the financial results—Accounts receivable turnover and number of days' sales in accounts receivable
Accounts receivable turnover is the number of times per year that the average amount of accounts
receivable is collected. To calculate this ratio divide net credit sales, or net sales, by the average net accounts
receivable (accounts receivable after deducting the allowance for uncollectible accounts):
Accounts receivable turnover= Net credit sales net sales
Average net accounts receivable
Ideally, average net accounts receivable should represent weekly or monthly averages; often, however, beginning
and end-of-year averages are the only amounts available to users outside the company. Although analysts should
use net credit sales, frequently net credit sales are not known to those outside the company. Instead, they use net
sales in the numerator.
Generally, the faster firms collect accounts receivable, the better. A company with a high accounts receivable
turnover ties up a smaller proportion of its funds in accounts receivable than a company with a low turnover. Both
the company's credit terms and collection policies affect turnover. For instance, a company with credit terms of
2/10, n/30 would expect a higher turnover than a company with terms of n/60. Also, a company that aggressively
pursues overdue accounts receivable has a higher turnover of accounts receivable than one that does not.
For example, we calculated these accounts receivable turnovers for the following hypothetical companies:
Accounts Receivable Net Sales Average (millions) Net Turnover
Abercrombie & Fitch $ 1,238 $ 14 88.43 The Limited, Inc. 10,105 1,012 10.00
We calculate the number of days' sales in accounts receivable (also called the average collection period
for accounts receivable) as follows:
Numberof days ' sales per accounts receivable= Number of days per a year 365
Accounts receivable turnover
This ratio measures the average liquidity of accounts receivable and gives an indication of their quality. The
faster a firm collects receivables, the more liquid (the closer to being cash) they are and the higher their quality. The
longer accounts receivable remain outstanding, the greater the probability they never will be collected. As the time
period increases, so does the probability that customers will declare bankruptcy or go out of business.
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Based on 365 days, we calculated the number of days' sales for each of these hypothetical companies:
Accounts Receivable Company Turnover Number of
Day's Sales in Abercrombie & Fitch 88.43 4.1 The Limited, Inc. 10.00 36.5
These companies have collection periods ranging from 4.1 to 36.5 days. Assuming credit terms of 2/10, n/30,
one would expect the average collection period to be under 30 days. If customers do not pay within 10 days and take
the discount offered, they incur an annual interest rate of 36.5 per cent on these funds. (They lose a 2 per cent
discount and get to use the funds another 20 days, which is equivalent to an annual rate of 36.5 per cent.)
Having studied receivables and payables in this chapter, you will study plant assets in the next chapter. These
long-term assets include land and depreciable assets such as buildings, machinery, and equipment.
Understanding the learning objectives
• Companies use two methods to account for uncollectible accounts receivable: the allowance method, which
provides in advance for uncollectible accounts; and the direct write-off method, which recognizes uncollectible
accounts as an expense when judged uncollectible. The allowance method is the preferred method and is the
only method discussed and illustrated in this text.
• The two basic methods for estimating uncollectible accounts under the allowance method are the
percentage-of-sales method and the percentage-of-receivables method.
• The percentage-of-sales method focuses attention on the income statement and the relationship of
uncollectible accounts to sales. The debit to Uncollectible Accounts Expense is a certain per cent of credit sales
or total net sales.
• The percentage-of-receivables method focuses attention on the balance sheet and the relationship of the
allowance for uncollectible accounts to accounts receivable. The credit to the Allowance for Uncollectible
Accounts is the amount necessary to bring that account up to a certain percentage of the Accounts Receivable
balance. Either one overall percentage or an aging schedule may be used.
• Credit cards are charge cards used by customers to charge purchases of goods and services. These cards are
of two types—nonbank credit cards (such as American Express) and bank credit cards (such as VISA).
• The sale is recorded at the gross amount of the sale, and the cash or receivable is recorded at the net
amount the company will receive.
• Liabilities result from some past transaction and are obligations to pay cash, provide services, or deliver
goods at some time in the future.
• Current liabilities are obligations that (1) are payable within one year or one operating cycle, whichever is
longer, or (2) will be paid out of current assets or create other current liabilities.
• Long-term liabilities are obligations that do not qualify as current liabilities.
• Clearly determinable liabilities are those for which the existence of the liability and its amount are certain.
An example is accounts payable.
• Estimated liabilities are those for which the existence of the liability is certain, but its amount can only be
estimated. An example is estimated product warranty payable.
Accounting Principles: A Business Perspective 395 A Global Text
9. Receivables and payables
• Contingent liabilities are those for which the existence, and usually the amount, are uncertain because these
liabilities depend (or are contingent) on some future event occurring or not occurring. An example is a liability
arising from a lawsuit.
• A promissory note is an unconditional written promise by a borrower (maker) to pay the lender (payee) or
someone else who legally acquired the note a certain sum of money on demand or at a definite time.
• Interest is the fee charged for the use of money through time.
Interest=Principal×Rateof interest×Time.
• Companies sometimes need short-term financing. Short-term financing may be secured by issuing interest-
bearing notes or by issuing non interest-bearing notes.
• An interest-bearing note specifies the interest rate that will be charged on the principal borrowed.
• A non interest-bearing note does not have a stated interest rate applied to the face value of the note.
• Calculate accounts receivable turnover by dividing net credit sales, or net sales, by average net accounts
receivable.
• Calculate the number of days' sales in accounts receivable (or average collection period) by dividing the
number of days in the year by the accounts receivable turnover.
• Together, these ratios show the liquidity of accounts receivable and give some indication of their quality.
Generally, the higher the accounts receivable turnover, the better; and the shorter the average collection
period, the better.
Demonstration problem
Demonstration problem A a. Prepare the journal entries for the following transactions:
As of the end of 2010, Post Company estimates its uncollectible accounts expense to be 1 per cent of sales. Sales
in 2010 were USD 1,125,000.
On 2011 January 15, the company decided that the account for John Nunn in the amount of USD 750 was
uncollectible.
On 2011 February 12, John Nunn's check for USD 750 arrived.
b. Prepare the journal entries in the records of Lyle Company for the following:
On 2010 June 15, Lyle Company received a USD 22,500, 90-day, 12 per cent note dated 2010 June 15, from
Stone Company in payment of its account.
Assume that Stone Company did not pay the note at maturity. Lyle Company decided that the note was
uncollectible.
Demonstration problem B a. Prepare the entries on the books of Cromwell Company assuming the company
borrowed USD 10,000 at 7 per cent from First National Bank and signed a 60-day non interest-bearing note
payable on 2009 December 1, accrued interest on 2009 December 31, and paid the debt on the maturity date.
b. Prepare the entries on the books of Cromwell Company assuming it purchased equipment from Jones
Company for USD 5,000 and signed a 30-day, 9 per cent interest-bearing note payable on 2010 February 24.
Cromwell paid the note on its maturity date.
Solution to demonstration problem
Solution to demonstration problem A
a.
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1. 2010 Dec.
31 Uncollectible Accounts Expense (-SE) Allowance for Uncollectible Accounts (-A) To record estimated Uncollectible accounts for the year.
11,250 11,250
2. 2011 Jan.
15 Allowance for Uncollectible Accounts (+A) Accounts Receivable—John Nunn (-A) To write off the account of John Nunn as Uncollectible.
750 750
3. Feb. 12 Accounts Receivable—John Nunn (+A) Allowance for Uncollectible Accounts (-A) To correct the write-off of John Nunn's account on January 15.
750 750
12 Cash (+A) Accounts Receivable—John Nunn (-A) To record the collection of John Nunn's account receivable.
750 750
b.
1. 2010 June
15 Notes Receivable (+A) Accounts Receivable—Stone Company (-A) To record receipt of a note from Stone Company.
22,500 22,500
2. Sept 13 Accounts Receivable—Stone Company (+A) Notes Receivable (-A) Interest Revenue(+SE) To record the default of the Stone Company note of $22,500. Interest revenue was $675.
23,175 22,500 675
13 Allowance for Uncollectible Accounts* (+A) Accounts Receivable—Stone Company (-A) To write off the Stone Company as uncollectible.
23,175 23,175
*This debt assumes that Notes Receivable were taken into consideration when an allowance was established. If
not, the debit should be to Loss from Dishonored Notes Receivable.
Solution to demonstration problem B
a.
2009 Dec.
1 Cash (+A) Bank Discount ($10,000 X 0.07 X '0'/36)) (+A) Notes Payable (+L)
9,883.33 116.67
10,000.00 31 Interest Expense (-SE)
Bank Discount (-A) ($10,000 X 0.07 X ^/36))
58.33 58.33
2010 Jan.
30 Notes Payable (-L) Interest Expense (-SE) Bank Discount (-A) Cash (-A)
10,000.00 58.33
58.33 10,000.00
b. 2010 Feb
2 4
Equipment (+A) Notes Payable (+L)
5,000.00 5,000.00
Mar 2 6
Notes Payable (-L) Interest Expense (-SE) Cash (-A) ($5,000 X 0.09 X 30/360) = $37.50
5,000.00 37.50
5,037.50 675
Key terms Accounts receivable turnover Net credit sales (or net sales) divided by average net accounts receivable.
Aging schedule A means of classifying accounts receivable according to their age; used to determine the necessary balance in an Allowance for Uncollectible Accounts. A different uncollectibility percentage rate is used for each age category.
Allowance for Uncollectible Accounts A contra-asset account to the Accounts Receivable account; it reduces accounts receivable to their net realizable value. Also called Allowance for Doubtful Accounts or Allowance for Bad Debts.
Bad debts expense See Uncollectible accounts expense.
Bank discount The difference between the maturity value of a note and the actual amount—the note's proceeds—given to the borrower.
Accounting Principles: A Business Perspective 397 A Global Text
9. Receivables and payables
Cash proceeds The maturity amount of a note less the bank discount.
Clearly determinable liabilities Liabilities whose existence and amount are certain. Examples include accounts payable, notes payable, interest payable, unearned delivery fees, wages payable, sales tax payable, federal excise tax payable, current portions of long-term debt, and various payroll liabilities.
Contingent liabilities Liabilities whose existence is uncertain. Their amount is also usually uncertain. Both their existence and amount depend on some future event that may or may not occur. Examples include liabilities arising from lawsuits, discounted notes receivable, income tax disputes, penalties that may be assessed because of some past action, and failure of another party to pay a debt that a company has guaranteed.
Credit Card Expense account Used to record credit card agency's service charges for services rendered in processing credit card sales.
Credit cards Nonbank charge cards (e.g. American Express) and bank charge cards (e.g. VISA and MasterCard) that customers use to charge their purchases of goods and services.
Current liabilities Obligations that (1) are payable within one year or one operating cycle, whichever is longer, or (2) will be paid out of current assets or result in the creation of other current liabilities.
Discount on Notes Payable A contra account used to reduce Notes Payable from face value to the net amount of the debt.
Discounting a note payable The act of borrowing on a non interest-bearing note drawn for a maturity amount, from which a bank discount is deducted, and the proceeds are given to the borrower.
Dishonored note A note that the maker failed to pay at maturity.
Estimated liabilities Liabilities whose existence is certain, but whose amount can only be estimated. An example is estimated product warranty payable.
Interest The fee charged for use of money over a period of time (I = P X R X T).
Interest Payable account An account showing the interest expense incurred but not yet paid; reported as a current liability in the balance sheet.
Interest Receivable account An account showing the interest earned but not yet collected; reported as a current asset in the balance sheet.
Liabilities Obligations that result from some past transaction and are obligations to pay cash, perform services, or deliver goods at some time in the future.
Long-term liabilities Obligations that do not qualify as current liabilities.
Maker (of a note) The party who prepares a note and is responsible for paying the note at maturity.
Maturity date The date on which a note becomes due and must be paid.
Maturity value The amount that the maker must pay on the note on its maturity date.
Net realizable value The amount the company expects to collect from accounts receivable.
Number of days' sales in accounts receivable The number of days in a year (365) divided by the accounts receivable turnover.
Operating cycle The time it takes to start with cash, buy necessary items to produce revenues (such as materials, supplies, labor, and/or finished goods), sell goods or services, and receive cash by collecting the resulting receivables.
Payable Any sum of money due to be paid by a company to any party for any reason.
Payee (of a note) The party who receives a note and will be paid cash at maturity.
Percentage-of-receivables method A method for determining the desired size of the Allowance for Uncollectible Accounts by basing the calculation on the Accounts Receivable balance at the end of the period.
Percentage-of-sales method A method of estimating the uncollectible accounts from the sales of a given period's total net credit sales or net sales.
Principal (of a note) The face value of a note.
Promissory note An unconditional written promise by a borrower (maker) to pay a definite sum of money to the lender (payee) on demand or at a specific date.
Rate (of a note) The stated interest rate on the note.
Receivable Any sum of money due to be paid to a company from any party for any reason.
Time (of a note) The amount of time the note is to run; can be expressed in days, months, or years.
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Trade receivables Amounts customers owe a company for goods sold or services rendered on account. Also called accounts receivable or trade accounts receivable.
Uncollectible accounts expense An operating expense that a business incurs when it sells on credit; also called doubtful accounts expense or bad debts expense.
Self test
True-false
Indicate whether each of the following statements is true or false.
The percentage-of-sales method estimates the uncollectible accounts from the ending balance in Accounts
Receivable.
Under the allowance method, uncollectible accounts expense is recognized when a specific customer's account is
written off.
Bank credit card sales are treated as cash sales because the receipt of cash is certain.
Liabilities result from some future transaction.
Current liabilities are classified as clearly determinable, estimated, and contingent.
A dishonored note is removed from Notes Receivable, and the total amount due is recorded in Accounts
Receivable.
When an interest-bearing note is given to a bank when taking out a loan, the difference between the cash
proceeds and the maturity amount is debited to Discount on Notes Payable.
Multiple-choice
Select the best answer for each of the following questions.
Which of the following statements is false?
a. Any existing balance in the Allowance for Uncollectible Accounts is ignored in calculating the uncollectible
accounts expense under the percentage-of-sales method except that the allowance account must have a credit
balance after adjustment.
b. The percentage-of-receivables method may use either an overall rate or a different rate for each age category.
c. The Allowance for Uncollectible Accounts reduces accounts receivable to their net realizable value.
d. A write-off of an account reduces the net amount shown for accounts receivable on the balance sheet.
e. None of the above.
Hunt Company estimates uncollectible accounts using the percentage-of-receivables method and expects that 5
per cent of outstanding receivables will be uncollectible for 2010. The balance in Accounts Receivable is USD
200,000, and the allowance account has a USD 3,000 credit balance before adjustment at year-end. The
uncollectible accounts expense for 2010 will be:
a. USD 7,000.
b. USD 10,000.
c. USD 13,000.
d. USD 9,850.
e. None of the above.
Which type of company typically has the longest operating cycle?
a. Service company.
b. Merchandising company.
c. Manufacturing company.
Accounting Principles: A Business Perspective 399 A Global Text
9. Receivables and payables
d. All equal.
Maxwell Company records its sales taxes in the same account as sales revenues. The sales tax rate is 6 per cent.
At the end of the current period, the Sales account has a balance of USD 265,000. The amount of sales tax payable
is:
a. USD 12,000.
b. USD 15,000.
c. USD 15,900.
d. USD 18,000.
Dawson Company sells fax machines. During 2010, the company sold 2,000 fax machines. The company
estimates that 5 per cent of the machines require repairs under warranty. To date, 30 machines have been repaired.
The estimated average cost of warranty repairs per defective fax machine is USD 200. The required amount of the
adjusting entry to record estimated product warranty payable is:
a. USD 400,000.
b. USD 6,000.
c. USD 14,000.
d. USD-0-.
To compute interest on a promissory note, all of the following elements must be known except:
a. The face value of the note.
b. The stated interest rate.
c. The name of the payee.
d. The life of the note.
e. None of the above.
Keats Company issued its own USD 10,000, 90-day, non interest-bearing note to a bank. If the note is
discounted at 10 per cent, the proceeds to Keats are:
a. USD 10,000.
b. USD 9,000.
c. USD 9,750.
d. USD 10,250.
e. None of the above.
Now turn to “Answers to self-test” at the back of the chapter to check your answers.
Questions
➢ In view of the difficulty in estimating future events, would you recommend that accountants wait
until collections are made from customers before recording sales revenue? Should they wait until
known accounts prove to be uncollectible before charging an expense account?
➢ The credit manager of a company has established a policy of seeking to completely eliminate all
losses from uncollectible accounts. Is this policy a desirable objective for a company? Explain.
➢ What are the two major purposes of establishing an allowance for uncollectible accounts?
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➢ In view of the fact that it is impossible to estimate the exact amount of uncollectible accounts
receivable for any one year in advance, what exactly does the Allowance for Uncollectible Accounts
account contain after a number of years?
➢ What must be considered before adjusting the allowance for uncollectible accounts under the
percentage-of-receivables method?
➢ How might information in an aging schedule prove useful to management for purposes other than
estimating the size of the required allowance for uncollectible accounts?
➢ For a company using the allowance method of accounting for uncollectible accounts, which of the
following directly affects its reported net income: (1) the establishment of the allowance, (2) the
writing off of a specific account, or (3) the recovery of an account previously written off as
uncollectible?
➢ Why might a retailer agree to sell by credit card when such a substantial discount is taken by the
credit card agency in paying the retailer?
➢ Define liabilities, current liabilities, and long-term liabilities.
➢ What is an operating cycle? Which type of company is likely to have the shortest operating cycle, and
which is likely to have the longest operating cycle? Why?
➢ Describe the differences between clearly determinable, estimated, and contingent liabilities. Give one
or more examples of each type.
➢ In what instances might a company acquire notes receivable?
➢ How is the maturity value of a note calculated?
➢ What is a dishonored note receivable and how is it reported in the balance sheet?
➢ Under what circumstances does the account Discount on Notes Payable arise? How is it reported in
the financial statements? Explain why.
➢ Real world question Refer to "A Broader Perspective: GECS allowance for losses on financing
receivables". What factors are taken into account by the General Electric Company in determining
the adjusting entry to establish the desired balance in the Allowance for Losses?
➢ Real world question Refer to "A Broader Perspective: GECS allowance for losses on financing
receivables". Explain how the General Electric Company writes off uncollectibles.
Exercises
Exercise A The accounts of Stackhouse Company as of 2010 December 31, show Accounts Receivable, USD
190,000; Allowance for Uncollectible Accounts, USD 950 (credit balance); Sales, USD 920,000; and Sales Returns
and Allowances, USD 12,000. Prepare journal entries to adjust for possible uncollectible accounts under each of the
following assumptions:
a. Uncollectible accounts are estimated at 1 per cent of net sales.
b. The allowance is to be increased to 3 per cent of accounts receivable.
Exercise B Compute the required balance of the Allowance for Uncollectible Accounts for the following
receivables:
Accounts Age Probability Receivable (months) of Collection $180,000 Less than 1 95% 90,000 1-3 85
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9. Receivables and payables
39,000 3-6 75 12,000 6-9 35 2,250 9-12 10
Exercise C On 2009 April 1, Kelley Company, which uses the allowance method of accounting for uncollectible
accounts, wrote off Bob Dyer's USD 400 account. On 2009 December 14, the company received a check in that
amount from Dyer marked "in full payment of account". Prepare the necessary entries.
Exercise D Jamestown Furniture Mart, Inc., sold USD 80,000 of furniture in May to customers who used their
American Express credit cards. Such sales are subject to a 3 per cent discount by American Express (a nonbank
credit card),
a. Prepare journal entries to record the sales and the subsequent receipt of cash from the credit card company.
b. Do the same as requirement (a), but assume the credit cards used were VISA cards (a bank credit card).
Exercise E Dunwoody Discount Toys, Inc., sells merchandise in a state that has a 5 per cent sales tax. Rather
than record sales taxes collected in a separate account, the company records both the sales revenue and the sales
taxes in the Sales account. At the end of the first quarter of operations, when it is time to remit the sales taxes to the
state taxing agency, the company has USD 420,000 in the Sales account. Determine the correct amount of sales
revenue and the amount of sales tax payable.
Exercise F Assume the following note appeared in the annual report of a company:
In 2009, two small retail customers filed separate suits against the company alleging misrepresentation,
breach of contract, conspiracy to violate federal laws, and state antitrust violations arising out of their purchase
of retail grocery stores through the company from a third party. Damages sought range up to USD 10 million in
each suit for actual and treble damages and punitive damages of USD 2 million in one suit and USD 10 million in
the other. The company is vigorously defending the actions and management believes there will be no adverse
financial effect.
What kind of liability is being reported? Why is it classified this way? Do you think it is possible to calculate a
dollar amount for this obligation? How much would the company have to pay if it lost the suit and had to pay the
full amount?
Exercise G Determine the maturity date for each of the following notes:
Issue Date Life 2010 January 13 30 days 2010 January 31 90 days 2010 June 4 1 year 2010 December 2 1 month
Exercise H Crawford, Inc., gave a USD 20,000, 120-day, 12 per cent note to Dunston, Inc., in exchange for
merchandise. Crawford uses periodic inventory procedure. Prepare journal entries to record the issuance of the
note and the entries needed at maturity for both parties, assuming payment is made.
Exercise I Based on the facts in the previous exercise, prepare the entries that Crawford, Inc., and Dunston,
Inc., would make at the maturity date, assuming Crawford defaults.
Exercise J John Wood is negotiating a bank loan for his company, Wood, Inc., of USD 16,000 for 90 days. The
bank's current interest rate is 10 per cent. Prepare Wood's entries to record the loan under each of the following
assumptions:
a. Wood signs a note for USD 16,000. Interest is deducted in calculating the proceeds turned over to him.
b. Wood signs a note for USD 16,000 and receives that amount. Interest is to be paid at maturity.
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Exercise K Based on the previous exercise, prepare the entry or entries that would be made at the maturity
date for each alternative, assuming the loan is paid before the end of the accounting period.
Exercise L Pistol Pete provides communication services and products, as well as network equipment and
computer systems, to businesses, consumers, communications services providers, and government agencies. The
following amounts were included in its 2010 annual report:
(Millions)
Net sales USD 79,609
Receivables, net, 2009 December 31 29,275
Receivables, net, 2008 December 31 28,623
Calculate the accounts receivable turnover and the number of days' sales in accounts receivable. Use net sales
instead of net credit sales in the calculation. Comment on the results.
Problems
Problem A As of 2009 December 31, Fargo Company's accounts prior to adjustment show:
Allowance for uncollectible accounts (credit balance)
Accounts receivable $ 40,000 Allowance for uncollectible accounts (credit balance) 750 Sales 250,000
Fargo Company estimates uncollectible accounts at 1 per cent of sales.
On 2010 February 23, the account of Dan Hall in the amount of USD 300 was considered uncollectible and
written off. On 2010 August 12, Hall remitted USD 200 and indicated that he intends to pay the balance due as
soon as possible. By 2010 December 31, no further remittance had been received from Hall and no further
remittance was expected.
a. Prepare journal entries to record all of these transactions and adjusting entries.
b. Give the entry necessary as of 2009 December 31, if Fargo Company estimated its uncollectible accounts at 8
per cent of outstanding receivables rather than at 1 per cent of sales.
Problem B At the close of business, Jim's Restaurant had credit card sales of USD 12,000. Of this amount,
USD 4,000 were VISA (bank credit card) sales invoices, which can be deposited in a bank for immediate credit, less
a discount of 3 per cent. The balance of USD 8,000 consisted of American Express (nonbank credit card) charges,
subject to a 5 per cent service charge. These invoices were mailed to American Express. Shortly thereafter, a check
was received.
Prepare journal entries for all these transactions.
Problem C Ruiz Company sells merchandise in a state that has a 5 per cent sales tax. On 2010 January 2, Ruiz
sold goods with a sales price of USD 80,000 on credit. Sales taxes collected are recorded in a separate account.
Assume that sales for the entire month were USD 900,000. On 2010 January 31, the company remitted the sales
taxes collected to the state taxing agency.
a. Prepare the general journal entries to record the January 2 sales revenue. Also prepare the entry to show the
remittance of the taxes on January 31.
b. Now assume that the merchandise sold on January 2 also is subject to federal excise taxes of 12 per cent. The
federal excise taxes collected are remitted to the proper agency on January 31. Show the entries on January 2 and
January 31.
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9. Receivables and payables
Problem D Honest Tim's Auto Company sells used cars and warrants all parts for one year. The average price
per car is USD 10,000, and the company sold 900 in 2009. The company expects 30 per cent of the cars to develop
defective parts within one year of sale. The estimated average cost of warranty repairs per defective car is USD 600.
By the end of the year, 80 cars sold that year had been returned and repaired under warranty. On 2010 January 4, a
customer returned a car purchased in 2009 for repairs under warranty. The repairs were made on January 8. The
cost of the repairs included parts, USD 400, and labor, USD 210.
a. Calculate the amount of the estimated product warranty payable.
b. Prepare the entry to record the estimated product warranty payable on 2009 December 31.
c. Prepare the entry to record the repairs made on 2010 January 8.
Problem E Celoron Power Boat Company is in the power boat manufacturing business. As of 2010 September
1, the balance in its Notes Receivable account is USD 256,000. The balance in Dishonored Notes Receivable is USD
60,660 (includes the interest of USD 600 and the protest fee of USD 60). A schedule of the notes (including the
dishonored note) is as follows:
Face Date Interest Amount Maker of Note Life Rate $ 100,000 C. Glass Co. 2009/6/01 120 days 12% 72,000 A. Lamp Co. 2009/6/15 90 8 84,000 C. Wall Co. 2009/7/01 90 10 60,000 N. Case Co. 2009/7/01 60 6 $316,000
Following are Celoron Power Boat Company's transactions for September:
Sept. 10 Received USD 36,660 from N. Case Company as full settlement of the amount due from it. The
company does not charge losses on notes to the Allowance for Uncollectible Accounts account.
? The A. Lamp Company note was collected when due.
? The C. Glass Company note was not paid at maturity.
? C. Wall Company paid its note at maturity.
30 Received a new 60-day, 12 per cent note from C. Glass Company for the total balance due on the dishonored
note. The note was dated as of the maturity date of the dishonored note. Celoron Power Boat Company accepted the
note in good faith.
Prepare dated journal entries for these transactions.
Problem F Premium Office Equipment, Inc., discounted its own USD 30,000, non interest-bearing, 180-day
note on 2009 November 16, at Niagara County Bank at a discount rate of 12 per cent.
Prepare dated journal entries for:
a. The original discounting on November 16.
b. The adjustment required at the end of the company's calendar-year accounting period.
c. Payment at maturity.
Alternate problems
Alternate problem A The following selected accounts are for Keystone, Inc., a name brand shoe wholesale
store, as of 2009 December 31. Prior to closing the accounts and making allowance for uncollectible accounts
entries, the USD 5,000 account of Morgan Company is to be written off (this was a credit sale of 2009 February 12).
Accounts receivable $ 360,000 Allowance for uncollectible accounts (credit) 6,000
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Sales 1,680,000
Sales returns and allowances 30,000
a. Prepare journal entries to record all of these transactions and the uncollectible accounts expense for the
period. Assume the estimated expense is 2 per cent of net sales.
b. Give the entry to record the estimated expense for the period if the allowance account is to be adjusted to 5
per cent of outstanding receivables instead of as in (a).
Alternate problem B The cash register at Frank's Restaurant at the close of business showed cash sales of
USD 7,500 and credit card sales of USD 10,000 (USD 6,000 VISA and USD 4,000 American Express). The VISA
(bank credit card) invoices were discounted 5 per cent when they were deposited. The American Express (nonbank
credit card) charges were mailed to the company and were subject to a 5 per cent service charge. A few days later,
Frank received a check for the net amount of the American Express credit card charges.
Prepare journal entries for all of these transactions.
Alternate problem C Beacham Hardware, Inc., sells merchandise in a state that has a 6 per cent sales tax. On
2010 July 1, it sold goods with a sales price of USD 20,000 on credit. Sales taxes collected are recorded in a separate
account. Assume that sales for the entire month were USD 400,000. On 2010 July 31, the company remitted the
sales taxes collected to the state taxing agency.
a. Prepare the general journal entries to record the July 1 sales revenue and sales tax payable. Also prepare the
entry to show the remittance of the taxes on July 31.
b. Now assume that the merchandise sold also is subject to federal excise taxes of 10 per cent in addition to the 6
per cent sales tax. The company remitted the federal excise taxes collected to the proper agency on July 31. Show
the entries on July 1 and July 31.
Alternate problem D Quick Wheels, Inc., sells racing bicycles and warrants all parts for one year. The average
price per bicycle is USD 560, and the company sold 4,000 in 2009. The company expects 20 per cent of the bicycles
to develop defective parts within one year of sale. The estimated average cost of warranty repairs per defective
bicycle is USD 40. By the end of the year, 500 bicycles sold that year had been returned and repaired under
warranty. On 2010 January 2, a customer returned a bicycle purchased in 2009 for repairs under warranty. The
repairs were made on January 3. The cost of the repairs included parts, USD 25, and labor, USD 15.
a. Calculate the amount of the estimated product warranty payable.
b. Prepare the entry to record the estimated product warranty payable on 2009 December 31.
c. Prepare the entry to record the repairs made on 2010 January 3.
Alternate problem E Vance Commercial Properties, Inc., has an accounting period of one year, ending on
July 31. On 2009 July 1, the balances of certain ledger accounts are Notes Receivable, USD 654,000; and Notes
Payable, USD 900,000. A schedule of the notes receivable is as follows:
Face Date Interest Amount Maker of Note Life Rate $ 270,000 Parker Co. 2009/5/15 60 days 12% 120,000 Dot Co. 2009/5/31 60 12 264,000 Fixx Co. 2009/6/15 30 10 $654,000
The note payable is a 60-day bank loan dated 2009 May 20. Notes Payable—Discount was debited for the
discount of USD 6,000. Following are the company's transactions during July:
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9. Receivables and payables
July 1 Vance Commercial Properties, Inc., discounted its own USD 90,000, 60-day, non interest-bearing note at
Key Bank. The discount rate is 10 per cent, and the note was dated today.
3 Received a 20-day, 12 per cent note, dated today, from Sox Company in settlement of an account receivable of
USD 36,000.
6 Purchased merchandise from Link Company, USD 288,000, and issued a 60-day, 12 per cent note, dated
today, for the purchase.
8 Sold merchandise to Fan Company, USD 360,000. A 30-day, 12 per cent note, dated today, is received to cover
the sale.
14 Received payment on the Parker Company note dated 2009 June 15.
15 Fixx Company sent a USD 120,000, 30-day, 12 per cent note, dated today, and a check to cover the part of the
old note not covered by the new note, plus all interest expense incurred on the prior note.
19 The note payable dated 2009 May 20, was paid in full.
23 Sox Company dishonored its note of July 3 and sent a check for the interest on the dishonored note and a
new 30-day, 12 per cent note dated 2009 July 23.
30 The Dot Company note dated 2009 May 31, was paid with interest in full.
Prepare dated journal entries for these transactions and necessary July 31 adjusting entries.
Alternate problem F On 2010 November 1, Grand Strand Property Management, Inc., discounted its own
USD 50,000, 180-day, non interest-bearing note at its bank at 18 per cent. The note was paid on its maturity date.
The company uses a calendar-year accounting period.
Prepare dated journal entries to record (a) the discounting of the note, (b) the year-end adjustment, and (c) the
payment of the note.
Beyond the numbers—Critical thinking
Business decision case A Sally Stillwagon owns a hardware store; she sells items for cash and on account.
During 2009, which seemed to be a typical year, some of her company's operating data and other data were as
follows:
Sales: For cash $1,200,000 On credit 2,200,000 Cost of obtaining credit reports on customers 3,600 Cost incurred in paying a part-time bookkeeper to keep the accounts receivable subsidiary ledger up to date 12,000 Cost associated with preparing and mailing invoices to customers and other collection activities 18,000 Uncollectible accounts expense 45,000 Average outstanding accounts receivable balance (on which Stillwagon estimates she could have earned 10 per cent if it had been invested in other assets) 180,000
A national credit card agency has tried to convince Stillwagon that instead of carrying her own accounts
receivable, she should accept only the agency's credit card for sales on credit. The agency would pay her two days
after she submits sales charges, deducting 6 per cent from the amount and paying her 94 per cent.
a. Using the data given, prepare an analysis showing whether or not Stillwagon would benefit from switching to
the credit card method of selling on credit.
b. What other factors should she take into consideration?
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Business decision case B Jim Perry operates a large fruit and vegetable stand on the outskirts of a city. In a
typical year he sells USD 600,000 of goods to regular customers. His sales are 40 per cent for cash and 60 per cent
on credit. He carries all of the credit himself. Only after a customer has a USD 300 unpaid balance on which no
payments have been made for two months does he refuse that customer credit for future purchases. His income
before taxes is approximately USD 95,000. The total of uncollectible accounts for a given year is USD 48,000.
You are one of Perry's regular customers. He knows that you are taking a college course in accounting and has
asked you to tell him your opinion of several alternatives recommended to him to reduce or eliminate the USD
48,000 per year uncollectible accounts expense. The alternatives are as follows:
• Do not sell on credit.
• Sell on credit by national credit card only.
• Allow customers to charge only until their account balances reach USD 50.
• Allow a bill collector to go after uncollectible accounts and keep half of the amount collected.
Write a report for Perry about the advisability of following any of these alternatives.
Annual report analysis C Visit the Internet site:
http://www.cocacola.com
Locate the most recent annual reports of The Coca-Cola Company. Calculate accounts receivable turnover and
the number of days' sales in accounts receivable and prepare a written comment on the results.
Group project D In groups of two or three students, write a two-page, double-spaced paper on one of the
following topics:
Which is better—the percentage-of-sales method or the percentage-of-receivables method?
Why not eliminate bad debts by selling only for cash?
Why allow customers to use credit cards when credit card expense is so high?
Should banks be required to use 365 days instead of 360 days in interest calculations?
Present your analysis in a convincing manner, without spelling or grammatical errors. Include a cover page with
the title and authors' names.
Group project E "Lapping" of accounts receivable has been used to conceal the fact that payments received on
accounts receivable have been "borrowed" and used by an employee for personal use. With one or two other
students, research this topic in the library. Write a paper to your instructor describing how this technique works
and the steps that can be taken to detect it once it occurs and to prevent it in the future.
Group project F In a group of two or three students, visit a fairly large company in your community to
investigate the effectiveness of its management of accounts receivable. Inquire about its credit and sales discount
policies, collection policies, and how it establishes the amount for the adjusting entry for uncollectible accounts at
year-end. Also ask about how it decides to write off accounts as uncollectible. Calculate its accounts receivable
turnover and average collection period for each of the last two years. In view of its credit policies, does its collection
period seem reasonable?
Using the Internet—A view of the real world
Visit one of the following Internet sites:
http://www.federatedinvestors.com
http://www.dreyfus.com
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9. Receivables and payables
http://www.invesco.com
Follow some of the other options available at the site. Write a report to your instructor on your experience,
describing some of the things you learned at this site. You may want to pretend that you invested in one or more of
these funds for the duration of the quarter or semester and see how your investment would have fared during that
period. Many investors with a limited amount to invest can have a diversified portfolio by investing in mutual
funds. Thus, they spread their risk by investing in a mutual fund that, in turn, invests in many different companies.
Visit Procter & Gamble's site at:
http://www.pg.com
Procter & Gamble markets more than 250 brands to nearly five billion consumers in over 140 countries. Click on
any items that deal with financial news, annual report summary, stock quote, and anything else that looks
interesting. Write a memo to your instructor summarizing your findings. Include in your memo some of the
financial highlights contained in the annual report summary.
Answers to self test
True-false
False. The percentage-of-sales method estimates the uncollectible accounts from the net credit sales or net
sales of a given period.
False. Uncollectible accounts expense is recognized at the end of the accounting period in an adjusting entry.
True. The retailer deposits the credit card invoices directly in a special checking account.
False. Liabilities result from a past transaction.
True. Current liabilities are classified into those three categories.
True. The note has passed its maturity date and should be removed from the Notes Receivable account. The
maturity value plus any protest fee should be debited to Accounts Receivable.
False. Discount on Notes Payable is recorded when a non interest-bearing note is issued.
Multiple-choice
d. A write-off of an account receivable results in a debit to Allowance for Uncollectible Accounts and a credit to
Accounts Receivable for the same amount. The net amount (accounts receivable minus allowance for uncollectible
accounts) does not change.
a. The uncollectible accounts expense for 2010 is computed as follows:
Allowance balance after adjustment ($200,000 X 0.05) $ 10,000 Balance before adjustment ( 3,000) Uncollectible accounts expense $7,000
c. Manufacturing companies tend to have the longest operating cycle. They must invest cash in raw materials,
convert these raw materials into work in process and then finished goods, sell the items on account, and then collect
the accounts receivable.
b. USD265,000
1.06 =USD 250,000;
USD 265,000 - USD 250,000 = USD 15,000.
c. 2,000×5 per cent=100 machines isdefective.
100 - 30 already returned = 70 more expected to be returned.
70×USD200=USD 14,000estimated product warranty payable.
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c. The name of the payee is not needed to compute interest expense on a promissory note.
c. The proceeds from a bank are computed as follows:
Discount amount=USD10,000 X 0.10× 90
360 =USD250
Proceeds = USD 10,000 - USD 250 = USD 9,750
Accounting Principles: A Business Perspective 409 A Global Text
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10. Property, plant, and equipment
Learning objectives
After studying this chapter, you should be able to:
• List the characteristics of plant assets and identify the costs of acquiring plant assets.
• List the four major factors affecting depreciation expense.
• Describe the various methods of calculating depreciation expense.
• Distinguish between capital and revenue expenditures for plant assets.
• Describe the subsidiary records used to control plant assets.
• Analyze and use the financial results—rate of return on operating assets.
A company accountant's role in managing plant assets
Property, plant, and equipment (fixed assets or operating assets) compose more than one-half of total assets in
many corporations. These resources are necessary for the companies to operate and ultimately make a profit. It is
the efficient use of these resources that in many cases determines the amount of profit corporations will earn.
Accountants employed by a company are deeply involved in nearly all decisions regarding the company's fixed
assets, from pre-acquisition planning to the ultimate disposal or sale of those assets. Companies do not view an
asset acquisition as merely a purchase, but as an investment. For example, should your company or client purchase
an airplane to visit clients? Accountants will investigate all the benefits, both financial and intangible, and compare
these benefits to the costs. By determining whether or not the airplane will be a good investment for the company,
the accountant can assist the company in making sound strategic business decisions.
Since these assets are so closely related to profits, good management is required. In accounting terms, a good
return on operating assets is crucial to the success of the corporation. Many corporations have a staff of accountants
whose primary task is to manage operating assets. This task involves making decisions concerning the purchase,
use, and disposal of said assets. Once an asset has been acquired, accountants are responsible for determining the
original value of the asset, the period over which it will extend benefits to the company, and its current market
value while owned by the entity. The accountant must ultimately determine when and how to dispose of such an
asset. The decision can range from trading the asset for a new asset to selling the asset to a salvage dealer.
Recently, The Williams Companies, Inc. had over USD 10 billion dollars in property, plant, and equipment. In
addition, the company also had approximately USD 530 million in commitments for construction and acquisition
of property, plant, and equipment. Managing a portfolio of assets of this magnitude takes both accounting
knowledge and analytical skills. Successful management of these assets can be financially rewarding to both the
company and the accountant.
On a classified balance sheet, the asset section contains: (1) current assets; (2) property, plant, and equipment;
and (3) other categories such as intangible assets and long-term investments. Previous chapters discussed current
Accounting Principles: A Business Perspective 410 A Global Text
10. Property, plant, and equipment
assets. This chapter begins a discussion of property, plant, and equipment that is concluded in Chapter 11. Property,
plant, and equipment are often called plant and equipment or simply plant assets. Plant assets are long-lived
assets because they are expected to last for more than one year. Long-lived assets consist of tangible assets and
intangible assets. Tangible assets have physical characteristics that we can see and touch; they include plant
assets such as buildings and furniture, and natural resources such as gas and oil. Intangible assets have no
physical characteristics that we can see and touch but represent exclusive privileges and rights to their owners.
Nature of plant assets
To be classified as a plant asset, an asset must: (1) be tangible, that is, capable of being seen and touched; (2)
have a useful service life of more than one year; and (3) be used in business operations rather than held for resale.
Common plant assets are buildings, machines, tools, and office equipment. On the balance sheet, these assets
appear under the heading "Property, plant, and equipment".
Plant assets include all long-lived tangible assets used to generate the principal revenues of the business.
Inventory is a tangible asset but not a plant asset because inventory is usually not long-lived and it is held for sale
rather than for use. What represents a plant asset to one company may be inventory to another. For example, a
business such as a retail appliance store may classify a delivery truck as a plant asset because the truck is used to
deliver merchandise. A business such as a truck dealership would classify the same delivery truck as inventory
because the truck is held for sale. Also, land held for speculation or not yet put into service is a long-term
investment rather than a plant asset because the land is not being used by the business. However, standby
equipment used only in peak or emergency periods is a plant asset because it is used in the operations of the
business.
Accountants view plant assets as a collection of service potentials that are consumed over a long time. For
example, over several years, a delivery truck may provide 100,000 miles of delivery services to an appliance
business. A new building may provide 40 years of shelter, while a machine may perform a particular operation on
400,000 parts. In each instance, purchase of the plant asset actually represents the advance payment or
prepayment for expected services. Plant asset costs are a form of prepaid expense. As with short-term prepayments,
the accountant must allocate the cost of these services to the accounting periods benefited.
Accounting for plant assets involves the following four steps:
• Record the acquisition cost of the asset.
• Record the allocation of the asset's original cost to periods of its useful life through depreciation.
• Record subsequent expenditures on the asset.
• Account for the disposal of the asset.
In Exhibit 80, note how the asset's life begins with its procurement and the recording of its acquisition cost,
which is usually in the form of a dollar purchase. Then, as the asset provides services through time, accountants
record the asset's depreciation and any subsequent expenditures related to the asset. Finally, accountants record
the disposal of the asset. We discuss the first three steps in this chapter and the disposal of an asset in Chapter 11.
The last section in this chapter explains how accountants use subsidiary ledgers to control assets.
Remember that in recording the life history of an asset, accountants match expenses related to the asset with the
revenues generated by it. Because measuring the periodic expense of plant assets affects net income, accounting for
property, plant, and equipment is important to financial statement users.
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Initial recording of plant assets
When a company acquires a plant asset, accountants record the asset at the cost of acquisition (historical cost).
This cost is objective, verifiable, and the best measure of an asset's fair market value at the time of purchase. Fair
market value is the price received for an item sold in the normal course of business (not at a forced liquidation
sale). Even if the market value of the asset changes over time, accountants continue to report the acquisition cost in
the asset account in subsequent periods.
The acquisition cost of a plant asset is the amount of cash or cash equivalents given up to acquire and place
the asset in operating condition at its proper location. Thus, cost includes all normal, reasonable, and necessary
expenditures to obtain the asset and get it ready for use. Acquisition cost also includes the repair and
reconditioning costs for used or damaged assets. Unnecessary costs (such as traffic tickets or fines) that must be
paid as a result of hauling machinery to a new plant are not part of the acquisition cost of the asset.
The next sections discuss which costs are capitalized (debited to an asset account) for: (1) land and land
improvements; (2) buildings; (3) group purchases of assets; (4) machinery and other equipment; (5) self-
constructed assets; (6) noncash acquisitions; and (7) gifts of plant assets.
The cost of land includes its purchase price and other costs such as option cost, real estate commissions, title
search and title transfer fees, and title insurance premiums. Also included are an existing mortgage note or unpaid
taxes (back taxes) assumed by the purchaser; costs of surveying, clearing, and grading; and local assessments for
sidewalks, streets, sewers, and water mains. Sometimes land purchased as a building site contains an unusable
building that must be removed. Then, the accountant debits the entire purchase price to Land, including the cost of
removing the building less any cash received from the sale of salvaged items while the land is being readied for use.
Exhibit 80: Recording the life history of a depreciable asset
To illustrate, assume that Spivey Company purchased an old farm on the outskirts of San Diego, California,USA,
as a factory site. The company paid USD 225,000 for the property. In addition, the company agreed to pay unpaid
property taxes from previous periods (called back taxes) of USD 12,000. Attorneys' fees and other legal costs
relating to the purchase of the farm totaled USD 1,800. Spivey demolished (razed) the farm buildings at a cost of
USD 18,000. The company salvaged some of the structural pieces of the building and sold them for USD 3,000.
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10. Property, plant, and equipment
Because the firm was constructing a new building at the site, the city assessed Spivey Company USD 9,000 for
water mains, sewers, and street paving. Spivey computed the cost of the land as follows:
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Land Cost of factory site $225,000 Back taxes 12,000 Attorneys' fees and other legal costs 1,800 Demolition 18,000 Sale of salvaged parts (3,000) City assessment 9,000
$262,800
Accountants assigned all costs relating to the farm purchase and razing of the old buildings to the Land account
because the old buildings purchased with the land were not usable. The real goal was to purchase the land, but the
land was not available without the buildings.
Land is considered to have an unlimited life and is therefore not depreciable. However, land improvements,
including driveways, temporary landscaping, parking lots, fences, lighting systems, and sprinkler systems, are
attachments to the land. They have limited lives and therefore are depreciable. Owners record depreciable land
improvements in a separate account called Land Improvements. They record the cost of permanent landscaping,
including leveling and grading, in the Land account.
When a business buys a building, its cost includes the purchase price, repair and remodeling costs, unpaid taxes
assumed by the purchaser, legal costs, and real estate commissions paid.
Determining the cost of constructing a new building is often more difficult. Usually this cost includes architect's
fees; building permits; payments to contractors; and the cost of digging the foundation. Also included are labor and
materials to build the building; salaries of officers supervising the construction; and insurance, taxes, and interest
during the construction period. Any miscellaneous amounts earned from the building during construction reduce
the cost of the building. For example, an owner who could rent out a small completed portion during construction
of the remainder of the building, would credit the rental proceeds to the Buildings account rather than to a revenue
account.
Sometimes a company buys land and other assets for a lump sum. When land and buildings purchased together
are to be used, the firm divides the total cost and establishes separate ledger accounts for land and for buildings.
This division of cost establishes the proper balances in the appropriate accounts. This is especially important later
because the depreciation recorded on the buildings affects reported income, while no depreciation is taken on the
land.
Returning to our example of Spivey Company, suppose one of the farm buildings was going to be remodeled for
use by the company. Then, Spivey would determine what portion of the purchase price of the farm, back taxes, and
legal fees (USD 225,000 + USD 12,000 + USD 1,800 = USD 238,800) it could assign to the buildings and what
portion to the land. (The net cost of demolition would not be incurred, and the city assessment would be incurred at
a later time.) Spivey would assign the USD 238,800 to the land and the buildings on the basis of their appraised
values. For example, assume that the land was appraised at USD 162,000 and the buildings at USD 108,000. Spivey
would determine the cost assignable to each of these plant assets as follows:
Appraised Per cent of Total Asset Value Value Land $162,000 60% (162/270) Buildings 108,000 40 (108/270)
$270,000 100% (270/270) Per cent of Total Value
X Purchase Price =
Cost Assigned
Land 60% X $238,800* = $ 143,280 Buildings 40 X $238,800 = 95,520
$ 238,800
*The purchase price is the sum of the cash price, back taxes, and legal fees.
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The journal entry to record the purchase of the land and buildings would be:
Land (+A) 143,280 Buildings (+A) 95,520 Cash (-A) 238,800 To record the purchase of land and buildings.
When the city eventually assessed the charges for the water mains, sewers, and street paving, the company
would still debit these costs to the Land account as in the previous example.
Often companies purchase machinery or other equipment such as delivery or office equipment. Its cost includes
the seller's net invoice price (whether the discount is taken or not), transportation charges incurred, insurance in
transit, cost of installation, costs of accessories, and testing and break-in costs. Also included are other costs needed
to put the machine or equipment in operating condition in its intended location. The cost of machinery does not
include removing and disposing of a replaced, old machine that has been used in operations. Such costs are part of
the gain or loss on disposal of the old machine, as discussed in Chapter 11.
To illustrate, assume that Clark Company purchased new equipment to replace equipment that it has used for
five years. The company paid a net purchase price of USD 150,000, brokerage fees of USD 5,000, legal fees of USD
2,000, and freight and insurance in transit of USD 3,000. In addition, the company paid USD 1,500 to remove old
equipment and USD 2,000 to install new equipment. Clark would compute the cost of new equipment as follows:
Net purchase price $150,000 Brokerage fees 5,000 Legal fees 2,000 Freight and insurance in transit 3,000 Installation costs 2,000 Total cost $162,000
If a company builds a plant asset for its own use, the cost includes all materials and labor directly traceable to
construction of the asset. Also included in the cost of the asset are interest costs related to the asset and amounts
paid for utilities (such as heat, light, and power) and for supplies used during construction. To determine how much
of these indirect costs to capitalize, the company compares utility and supply costs during the construction period
with those costs in a period when no construction occurred. The firm records the increase as part of the asset's cost.
For example, assume a company normally incurred a USD 600 utility bill for June. This year, the company
constructed a machine during June, and the utility bill was USD 975. Thus, it records the USD 375 increase as part
of the machine's cost.
To illustrate further, assume that Tanner Company needed a new die-casting machine and received a quote from
Smith Company for USD 23,000, plus USD 1,000 freight costs. Tanner decided to build the machine rather than
buy it. The company incurred the following costs to build the machine: materials, USD 4,000; labor, USD 13,000;
and indirect services of heat, power, and supplies, USD 3,000. Tanner would record the machine at its cost of USD
20,000 (USD 4,000 + USD 13,000 + USD 3,000) rather than USD 24,000, the purchase price of the machine. The
USD 20,000 is the cost of the resources given up to construct the machine. Also, recording the machine at USD
24,000 would require Tanner to recognize a gain on construction of the assets. Accountants do not subscribe to the
idea that a business can earn revenue (or realize a gain), and therefore net income, by dealing with itself.
You can apply the general guidelines we have just discussed to other plant assets, such as furniture and fixtures.
The accounting methods are the same.
When a plant asset is purchased for cash, its acquisition cost is simply the agreed on cash price. However, when
a business acquires plant assets in exchange for other noncash assets (shares of stock, a customer's note, or a tract
of land) or as gifts, it is more difficult to establish a cash price. This section discusses three possible asset valuation
bases.
415
The general rule on noncash exchanges is to value the noncash asset received at its fair market value or the fair
market value of what was given up, whichever is more clearly evident. The reason for not using the book value of
the old asset to value the new asset is that the asset being given up is often carried in the accounting records at
historical cost or book value. Neither amount may adequately represent the actual fair market value of either asset.
Therefore, if the fair market value of one asset is clearly evident, a firm should record this amount for the new asset
at the time of the exchange.
Appraised value Sometimes, neither of the items exchanged has a clearly determinable fair market value.
Then, accountants record exchanges of items at their appraised values as determined by a professional appraiser.
An appraised value is an expert's opinion of an item's fair market price if the item were sold. Appraisals are used
often to value works of art, rare books, and antiques.
Book value The book value of an asset is its recorded cost less accumulated depreciation. An old asset's book
value is usually not a valid indication of the new asset's fair market value. If a better basis is not available, however,
a firm could use the book value of the old asset.
Occasionally, a company receives an asset without giving up anything for it. For example, to attract industry to
an area and provide jobs for local residents, a city may give a company a tract of land on which to build a factory.
Although such a gift costs the recipient company nothing, it usually records the asset (Land) at its fair market value.
Accountants record gifts of plant assets at fair market value to provide information on all assets owned by the
company. Omitting some assets may make information provided misleading. They would credit assets received as
gifts to a stockholders' equity account titled Paid-in Capital—Donations.
An accounting perspective:
Use of technology
How can CPA firms sell services on the Web other than by advertising their services? Ernst &
Young has developed a website for nonaudit consulting clients in which they charge an annual
fixed fee for nonaudit clients to obtain advice from the firm's consultants. The site is secure in that
it can only be accessed by those who have paid the fee. The subscribers type in their questions on
any business topic and get a response from an expert within two working days. Another firm,
PricewaterhouseCoopers, has an on-line service for tax professionals to seek advice. The other
large accounting firms undoubtedly have developed or are developing secure websites for
providing similar types of services.
Depreciation of plant assets
Companies record depreciation on all plant assets except land. Since the amount of depreciation may be
relatively large, depreciation expense is often a significant factor in determining net income. For this reason, most
financial statement users are interested in the amount of, and the methods used to compute, a company's
depreciation expense.
Depreciation is the amount of plant asset cost allocated to each accounting period benefiting from the plant
asset's use. Depreciation is a process of allocation, not valuation. Eventually, all assets except land wear out or
become so inadequate or outmoded that they are sold or discarded; therefore, firms must record depreciation on
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every plant asset except land. They record depreciation even when the market value of a plant asset temporarily
rises above its original cost because eventually the asset is no longer useful to its current owner.
Exhibit 81: Factors affecting depreciation
Major causes of depreciation are (1) physical deterioration, (2) inadequacy for future needs, and (3)
obsolescence. Physical deterioration results from the use of the asset—wear and tear—and the action of the
elements. For example, an automobile may have to be replaced after a time because its body rusted out. The
inadequacy of a plant asset is its inability to produce enough products or provide enough services to meet current
demands. For example, an airline cannot provide air service for 125 passengers using a plane that seats 90. The
obsolescence of an asset is its decline in usefulness brought about by inventions and technological progress. For
example, the development of the xerographic process of reproducing printed matter rendered almost all previous
methods of duplication obsolete.
The use of a plant asset in business operations transforms a plant asset cost into an operating expense.
Depreciation, then, is an operating expense resulting from the use of a depreciable plant asset. Because
depreciation expense does not require a current cash outlay, it is often called a noncash expense. The purchaser
gave up cash in the period when the asset was acquired, not during the periods when depreciation expense is
recorded.
To compute depreciation expense, accountants consider four major factors:
• Cost of the asset.
• Estimated salvage value of the asset. Salvage value (or scrap value) is the amount of money the company
expects to recover, less disposal costs, on the date a plant asset is scrapped, sold, or traded in.
• Estimated useful life of the asset. Useful life refers to the time the company owning the asset intends to
use it; useful life is not necessarily the same as either economic life or physical life. The economic life of a car
may be 7 years and its physical life may be 10 years, but if a company has a policy of trading cars every 3 years,
the useful life for depreciation purposes is 3 years. Various firms express useful life in years, months, working
hours, or units of production. Obsolescence also affects useful life. For example, a machine capable of
producing units for 20 years, may be expected to be obsolete in 6 years. Thus, its estimated useful life is 6 years
—not 20. Another example, on TV you may have seen a demolition crew setting off explosives in a huge
building (e.g. The Dunes Hotel and Casino in Las Vegas, Nevada, USA) and wondering why the owners decided
to destroy what looked like a perfectly good building. The building was destroyed because it had reached the
end of its economic life. The land on which the building stood could be put to better use, possibly by
constructing a new building.
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• Depreciation method used in depreciating the asset. We describe the four common depreciation methods in
the next section.
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10. Property, plant, and equipment
Number of Companies
Method 2003 2002 2001 2000 Straight-line 580 579 579 576 Declining Balance 22 22 22 22 Sum of year's digits 5 5 6 7 Accelerated method-not specified 41 44 49 53 Units of production 30 32 32 34 Other 4 7 9 10 Source: Based on American Institute of Certified Public Accountants, Accounting Trends & Techniques (New York: AICPA, 2004), p. 409.
Exhibit 82: Depreciation method used
In Exhibit 81, note the relationship among these factors. Assume Ace Company purchased an office building for
USD 100,000. The building has an estimated salvage value of USD 15,000 and a useful life of 20 years. The
depreciable cost of the building is USD 85,000 (cost less estimated salvage value). Ace would allocate this
depreciable base over the useful life of the building using the proper depreciation method under the circumstances.
Today, companies can use many different methods to calculate depreciation on assets.31 This section discusses
and illustrates the most common methods—straight-line, units-of-production, and accelerated depreciation method
(double-declining-balance).
As is true for inventory methods, normally a company is free to adopt the most appropriate depreciation method
for its business operations. According to accounting theory, companies should use a depreciation method that
reflects most closely their underlying economic circumstances. Thus, companies should adopt the depreciation
method that allocates plant asset cost to accounting periods according to the benefits received from the use of the
asset. Exhibit 82 shows the frequency of use of these methods for 600 companies. You can see that most companies
use the straight-line method for financial reporting purposes. Note that some companies use one method for certain
assets and another method for other assets. In practice, measuring the benefits from the use of a plant asset is
impractical and often not possible. As a result, a depreciation method must meet only one standard: the
depreciation method must allocate plant asset cost to accounting periods in a systematic and rational manner. The
following four methods meet this requirement.
An accounting perspective:
Business insight
Regardless of the method or methods of depreciation chosen, companies must disclose their
depreciation methods in the footnotes to their financial statements. They include this information
in the first footnote, which summarizes significant accounting policies.
The disclosure is generally straightforward: Sears, Roebuck & Co. operates department stores,
paint and hardware stores, auto supply stores, and eye wear stores. Its annual report states
simply that "depreciation is provided principally by the straight-line method". Companies may
use different depreciation methods for different assets. General Electric Company is a highly
diversified multinational corporation that develops, manufactures, and markets aerospace
31 Because depreciation expense is an estimate, calculations may be rounded to the nearest dollar.
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products, major appliances, industrial products, and high-performance engineered plastics. It
uses an accelerated method for most of its property, plant, and equipment; however, it
depreciates some assets on a straight-line basis, while the company's mining properties are
depreciated under the units-of-production method.
In the illustrations of the four depreciation methods that follow, we assume the following: On 2010 January 1, a
company purchased a machine for USD 54,000 with an estimated useful life of 10 years, or 50,000 units of output,
and an estimated salvage value of USD 4,000.
Straight-line method Straight-line depreciation has been the most widely used depreciation method in
the United States for many years because, as you saw in Chapter 3, it is easily applied. To apply the straight-line
method, a firm charges an equal amount of plant asset cost to each accounting period. The formula for calculating
depreciation under the straight-line method is:
Deprecation per period= Asset cost – Estimated salvage value
Number of accounting periods forestimated useful life
Using our example of a machine purchased for USD 54,000, the depreciation is:
$54,000−$4,000 10 years
=$5,000 per year
In Exhibit 83, we present a schedule of annual depreciation entries, cumulative balances in the accumulated
depreciation account, and the book (or carrying) values of the USD 54,000 machine.
Using the straight-line method for assets is appropriate where (1) time rather than obsolescence is the major
factor limiting the asset's life and (2) the asset produces relatively constant amounts of periodic services. Assets that
possess these features include items such as pipelines, fencing, and storage tanks.
Units-of-production (output) method The units-of-production depreciation method assigns an equal
amount of depreciation to each unit of product manufactured or service rendered by an asset. Since this method of
depreciation is based on physical output, firms apply it in situations where usage rather than obsolescence leads to
the demise of the asset. Under this method, you would compute the depreciation charge per unit of output. Then,
multiply this figure by the number of units of goods or services produced during the accounting period to find the
period's depreciation expense. The formula is:
Deprecation per unit= Asset cost – Estimated salvage value
Estimated total units of production service during useful life of asset
Depreciation per period=Deprecation per unit×Number of units of goods /services produced
You would determine the deprecation charge for the USD 54,000 machine as:
USD54,000 – USD4,000
50,000 units =$1per unit
Accounting Principles: A Business Perspective 420 A Global Text
10. Property, plant, and equipment
End of Depreciation Year Expense Dr.; Total
Accumulated Accumulated Depreciation Cr. Depreciation Book Value
$54,000 1 $ 5,000 $ 5,000 49,000 2 5,000 10,000 44,000 3 5,000 15,000 39,000 4 5,000 20,000 34,000 5 5,000 25,000 29,000 6 5,000 30,000 24,000 7 5,000 35,000 19,000 8 5,000 40,000 14,000 9 5,000 45,000 9,000 10 5,000 50,000 4,000*
$50,000 * Estimated salvage value.
Exhibit 83: Straight-line depreciation schedule
If the machine produced 1,000 units in 2010 and 2,500 units in 2011, depreciation expense for those years
would be USD 1,000 and USD 2,500, respectively.
Accelerated depreciation methods record higher amounts of depreciation during the early years of an
asset's life and lower amounts in the asset's later years. A business might choose an accelerated depreciation
method for the following reasons:
• The value of the benefits received from the asset decline with age (for example, office buildings).
• The asset is a high-technology asset subject to rapid obsolescence (for example, computers).
• Repairs increase substantially in the asset's later years; under this method, the depreciation and repairs
together remain fairly constant over the asset's life (for example, automobiles).
The most common accelerated method of depreciation is the double-declining-balance (DDB) method.
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Depreciation Expense Dr.; Total Accumulated Accumulated
End of Year Depreciation Cr. Depreciation Book Value $54,000
1. (20% of $54,000) $10,800 $10,800 43,200 2. (20% of $43,200) 8,640 19,440 34,560 3. (20% of $34,560) 6,912 26,352 27,648 4. (20% of $27,648) 5,530 31,882 22,118 5. (20% of $22,118) 4,424 36,306 17,694 6. (20% of $17,694) 3,539 39,845 14,155 7. (20% of $14,155) 2,831 42,676 11,324 8. (20% of $11,324) 2,265 44,941 9,059 9. (20% of $9,059) 1,812 46,753 7,247 10. (20% of $7,247) 1,449* 48,202 5,798 * This amount could be $3,247 to reduce the book value to the estimated salvage value of $4,000. Then, accumulated depreciation would be $50,000.
Exhibit 84: Double-declining-balance (DDB) depreciation schedule
Double-declining-balance method To apply the double-declining-balance (DDB) method of
computing periodic depreciation charges you begin by calculating the straight-line depreciation rate. To do this,
divide 100 per cent by the number of years of useful life of the asset. Then, multiply this rate by 2. Next, apply the
resulting double-declining rate to the declining book value of the asset. Ignore salvage value in making the
calculations. At the point where book value is equal to the salvage value, no more depreciation is taken. The formula
for DDB depreciation is:
Deprecation per period=2×Straight−line rate×Asset cost – Accumulateddepreciation
Accounting Principles: A Business Perspective 422 A Global Text
10. Property, plant, and equipment
Method Base Calculation
Straight-line Asset Estimated Cost - salvage value
Number of accounting periods in Base estimated useful life
Double-declining balance Asset - Accumulated% %Cost - Depreciation
Base X (2 X Straight-line rate)
Exhibit 85: Summary of depreciation methods
Look at the calculations for the USD 54,000 machine using the DDB method in Exhibit 84. The straight-line rate
is 10 per cent (100 per cent/10 years), which, when doubled, yields a DDB rate of 20 per cent. (Expressed as
fractions, the straight-line rate is 1/10, and the DDB rate is 2/10.) Since at the beginning of year 1 no accumulated
depreciation has been recorded, cost is the basis of the calculation. In each of the following years, book value is the
basis of the calculation at the beginning of the year.
In the 10th year, you could increase depreciation to USD 3,247 if the asset is to be retired and its salvage value is
still USD 4,000. This higher depreciation amount for the last year (USD 3,247) would reduce the book value of USD
7,247 down to the salvage value of USD 4,000. If an asset is continued in service, depreciation should only be
recorded until the asset's book value equals its estimated salvage value.
For a summary of the three depreciation methods, see Exhibit 85.
In Exhibit 86, we compare two of the depreciation methods just discussed—straight line and double-declining
balance—using the same example of a machine purchased on 2010 January 1, for USD 54,000. The machine has an
estimated useful life of 10 years and an estimated salvage value of USD 4,000.
An accounting perspective:
Uses of technology
Corporations are subject to corporate income taxes. Also, CPA firms hire many tax professionals to
address the tax matters of their clients. If you have an interest in taxes, you may want to visit the
following website to learn more about taxes:
http://webcast.ey.com/thoughtcenter/default.aspx
This site was created by the CPA firm, Ernst & Young, and has many interesting features. For
instance, you can see highlights of what is new in the world of tax, accounting and legal issues.
So far we have assumed that the assets were put into service at the beginning of an accounting period and
ignored the fact that often assets are put into service during an accounting period. When assets are acquired during
an accounting period, the first recording of depreciation is for a partial year. Normally, firms calculate the
depreciation for the partial year to the nearest full month the asset was in service. For example, they treat an asset
purchased on or before the 15th day of the month as if it were purchased on the 1st day of the month. And they treat
an asset purchased after the 15th of the month as if it were acquired on the 1st day of the following month.
To compare the calculation of partial-year depreciation, we use a machine purchased for USD 7,600 on 2010
September 1, with an estimated salvage value of USD 400, an estimated useful life of five years, and an estimated
total units of production of 25,000 units.
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Exhibit 86: Comparison of straight-line and double-declining-balance depreciation methods
Straight-line method Partial-year depreciation calculations for the straight-line depreciation method are
relatively easy. Begin by finding the 12-month charge by the normal computation explained earlier. Then, multiply
this annual amount by the fraction of the year for which the asset was in use. For example, for the USD 7,600
machine purchased 2010 September 1 (estimated salvage value, USD 400; and estimated useful life, five years), the
annual straight-line depreciation is [(USD 7,600 - USD 400)/5 years] = USD 1,440. The machine would operate for
four months prior to the end of the accounting year, December 31, or one-third of a year. The 2010 depreciation is
(USD 1,440 X 1/3) = USD 480.
Units-of-production method The units-of-production method requires no unusual computations to record
depreciation for a partial year. To compute the partial-year depreciation, multiply the depreciation charge per unit
by the units produced. The charge for a partial year would be less than for a full year because fewer units of goods or
services are produced.
Double-declining-balance method Under the double-declining-balance method, it is relatively easy to
determine depreciation for a partial year and then for subsequent full years. For the partial year, simply multiply
the fixed rate times the cost of the asset times the fraction of the partial year. For example, DDB depreciation on the
USD 7,600 asset for 2010 is (USD 7,600 X 0.4 X 1/3) = USD 1,013. For subsequent years, compute the depreciation
using the regular procedure of multiplying the book value at the beginning of the period by the fixed rate. The 2011
depreciation would be [(USD 7,600 - USD 1,013) X 0.4] = USD 2,635.
An accounting perspective:
Uses of technology
Most companies report property, plant, and equipment as one amount in the balance sheet in their
annual report; however, that account is made up of many items. Computers and accounting
software have simplified record keeping for all of a company's depreciable assets. When
depreciable plant assets are purchased, employees enter in the computer the cost, estimated useful
life, and estimated salvage value of the assets. In addition, they enter the method of depreciation
Accounting Principles: A Business Perspective 424 A Global Text
10. Property, plant, and equipment
that the company decides to use on the assets. After processing this information, the computer
calculates the company's depreciation expense and accumulates depreciation for each type of asset
and each individual asset (e.g. a machine).
After depreciating an asset down to its estimated salvage value, a firm records no more depreciation on the asset
even if continuing to use it. At times, a firm finds the estimated useful life of an asset or its estimated salvage value
is incorrect before the asset is depreciated down to its estimated salvage value; then, it computes revised
depreciation charges for the remaining useful life. These revised charges do not correct past depreciation taken;
they merely compensate for past incorrect charges through changed expense amounts in current and future
periods. To compute the new depreciation charge per period, divide the book value less the newly estimated salvage
value by the estimated periods of useful life remaining.
For example, assume that a machine cost USD 30,000, has an estimated salvage value of USD 3,000, and
originally had an estimated useful life of eight years. At the end of the fourth year of the machine's life, the balance
in its accumulated depreciation account (assuming use of the straight-line method) was (USD 30,000 - USD 3,000)
X 4/8 = USD 13,500. At the beginning of the fifth year, a manager estimates that the asset will last six more years.
The newly estimated salvage value is USD 2,700. To determine the revised depreciation per period:
Original cost $ 30,000 Less: Accumulated deprecation at end of 4th year 13,500 Book value at the beginning of 5th year 16,500 Less: Revised salvage value 2,700 Remaining depreciable cost $13,800 Revised deprecation per period $ 13,000/6 = $2,300
Had this company used the units-of-production method, its revision of the life estimate would have been in
units. Thus, to determine depreciation expense, compute a new per-unit depreciation charge by dividing book value
less revised salvage value by the estimated remaining units of production. Multiply this per unit charge by the
periodic production to determine depreciation expense.
Using the double-declining-balance method, the book value at the beginning of year 5 would be USD 9,492.19
(cost of USD 30,000 less accumulated depreciation of USD 20,507.81). Depreciation expense for year 5 would be
twice the new straight-line rate times book value. The straight-line rate is 100 per cent/6 = 16.67 per cent. So twice
the straight-line rate is 33.33 per cent, or 1/3. Thus, 1/3 X USD 9,492.19 = USD 3,164.06.
APB Opinion No. 12 requires that companies separately disclose the methods of depreciation they use and the
amount of depreciation expense for the period in the body of the income statement or in the notes to the financial
statements. Major classes of plant assets and their related accumulated depreciation amounts are reported as
shown in Exhibit 87.
Showing cost less accumulated depreciation in the balance sheet gives statement users a better understanding of
the percentages of a company's plant assets that have been used up than reporting only the book value (remaining
undepreciated cost) of the assets. For example, reporting buildings at USD 75,000 less USD 45,000 of accumulated
depreciation, resulting in a net amount of USD 30,000, is quite different from merely reporting buildings at USD
30,000. In the first case, the statement user can see that the assets are about 60 per cent used up. In the latter case,
the statement user has no way of knowing whether the assets are new or old.
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10. Property, plant, and equipment
Reed Company Partial Balance Sheet
2010 June 30 Property, plant, and equipment Land $ 30,000 Buildings $ 75,000 Less: Accumulated depreciation 45,000 30,000 Equipment $ 9,000 Less: Accumulated depreciation 1,500 7,500 Total property, plant, and equipment $ 67,500
Exhibit 87: Partial balance sheet
An accounting perspective:
Business insight
In their financial statements, companies often provide one amount for property, plant, and
equipment that is net of accumulated depreciation. Nonetheless, notes (footnotes) actually provide
the additional information regarding the separate types of assets. The Limited, Inc. is a world
leader in the design and distribution of numerous lines of women's and men's clothing. For
instance, its 2001 Feb 3, balance sheet showed property, plant, and equipment, net, equal to USD
1,394,619. In a note to the financial statements (slightly modified to clarify), management
explained this amount as follows:
(Dollar amounts in thousands)
Property and Equipment, Net Property and Equipment, at cost 2000 1999 Land, buildings and improvements $ 362,997 $ 390,121 Furniture, fixtures and equipment 2,079,567 2,020,651 Leaseholds and improvements 655,736 498,232 Construction in progress 46,748 35,823 Total $3,145,048 $2,944,827 Less: accumulated depreciation and amortization 1,750,429 1,715,215 Property and equipment, net $1,394,619 $1,229,612
A misconception Some mistaken financial statement users believe that accumulated depreciation represents
cash available for replacing old plant assets with new assets. However, the accumulated depreciation account
balance does not represent cash; accumulated depreciation simply shows how much of an asset's cost has been
charged to expense. Companies use the plant asset and its contra account, accumulated depreciation, so that data
on the total original acquisition cost and accumulated depreciation are readily available to meet reporting
requirements.
Costs or market values in the balance sheet In the balance sheet, firms report plant assets at original cost
less accumulated depreciation. One of the justifications for reporting the remaining undepreciated costs of the asset
rather than market values is the going-concern concept. As you recall from Chapter 5, the going-concern concept
assumes that the company will remain in business indefinitely, which implies the company will use its plant assets
rather than sell them. Generally, analysts do not consider market values relevant for plant assets in primary
financial statements, although they may be reported in supplemental statements.
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A broader perspective:
Wolverine World Wide, Inc.
Accounting Principles: A Business Perspective 427 A Global Text
10. Property, plant, and equipment
(Dollars in Thousands) 2002 2001 Total current assets $ 349,301 $ 340,978 Property, Plant and Equipment Land 1,177 1,177 Buildings and improvements 64,848 63,006 Machinery and equipment 117,524 108,094 Software 29,217 22,097
$212,766 $194,374 Less accumulated depreciation 96,483 83,239 Total plant assets $ 116,283 $ 111,135 Other Assets Goodwill and other intangibles, less accumulated amortization (2002-$3,565; 2001-$2,447) 16,178 19,931 Cash value of life insurance 16,443 14,725 Prepaid pension costs 19,099 15,242 Assets held for exchange 7,706 7,942 Notes receivable 4,736 4,921 Other 4,649 6,604 Total other assets $ 68,811 $ 69,365 Total Assets $534,395 $521,478
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1 (In Part): Summary of Significant Accounting Policies
Property, Plant and Equipment
Property, plant and equipment are stated on the basis of cost and include expenditures for new
facilities, major renewals, betterments and software. Normal repairs and maintenance are
expensed as incurred.
Depreciation of plant, equipment and software is computed using the straight-line method. The
depreciable lives for buildings and improvements range from five to forty years; from three to ten
years for machinery and equipment; and from three to ten years for software.
As required, the Company adopted the American Institute of Certified Public Accountants
Statement of Position (SoP) 98-1, Accounting for the Costs of Computer Software Developed and
Obtained for Internal Use, in 1999. The SOP provides guidelines for determining whether costs
should be expensed or capitalized for computer software developed or purchased for internal use.
The Company's accounting policies for such items were already in substantial compliance with SOP
98-1 and, therefore, the adoption did not have a material effect on its 1999 consolidated financial
position or results of operations.
Subsequent expenditures (capital and revenue) on assets
Companies often spend additional funds on plant assets that have been in use for some time. They debit these
expenditures to: (1) an asset account; (2) an accumulated depreciation account; or (3) an expense account.
Expenditures debited to an asset account or to an accumulated depreciation account are capital
expenditures. Capital expenditures increase the book value of plant assets. Revenue expenditures, on the
other hand, do not qualify as capital expenditures because they help to generate the current period's revenues
rather than future periods' revenues. As a result, companies expense these revenue expenditures immediately and
report them in the income statement as expenses.
Betterments or improvements to existing plant assets are capital expenditures because they increase the
quality of services obtained from the asset. Because betterments or improvements add to the service-rendering
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ability of assets, firms charge them to the asset accounts. For example, installing an air conditioner in an
automobile that did not previously have one is a betterment. The debit for such an expenditure is to the asset
account, Automobiles.
Occasionally, expenditures made on plant assets extend the quantity of services beyond the original estimate but
do not improve the quality of the services. Since these expenditures benefit an increased number of future periods,
accountants capitalize rather than expense them. However, since there is no visible, tangible addition to, or
improvement in, the quality of services, they charge the expenditures to the accumulated depreciation account, thus
reducing the credit balance in that account. Such expenditures cancel a part of the existing accumulated
depreciation; firms often call them extraordinary repairs.
To illustrate, assume that after operating a press for four years, a company spent USD 5,000 to recondition the
press. The reconditioning increased the machine's life to 14 years instead of the original estimate of 10 years. The
journal entry to record the extraordinary repair is:
Accumulated Depreciation-Machinery (+A) 5,000
Cash (for Accounts Payable) (-A) 5,000
To record the cost of reconditioning a press.
Originally, the press cost USD 40,000, had an estimated useful life of 10 years, and had no estimated salvage
value. At the end of the fourth year, the balance in its accumulated depreciation account under the straight-line
method is [(USD 40,000/10) X 4] = USD 16,000. After debiting the USD 5,000 spent to recondition the press to
the accumulated depreciation account, the balances in the asset account and its related accumulated depreciation
account are as shown in the last column:
Before After Extraordinary Extraordinary Repair Repair
Press $40,000 $40,000 Accumulated depreciation 16,000 11,000 Book value (end of four years) $24,000 $29,000
In effect, the expenditure increases the carrying amount (book value) of the asset by reducing its contra account,
accumulated depreciation. Under the straight-line method, we would divide the new book value of the press, USD
29,000, equally among the 10 remaining years in amounts of USD 2,900 per year (assuming that the estimated
salvage value is still zero).
As a practical matter, expenditures for major repairs not extending the asset's life are sometimes charged to
accumulated depreciation. This avoids distorting net income by expensing these expenditures in the year incurred.
Then, firms calculate a revised depreciation expense, and spread the cost of major repairs over a number of years.
This treatment is not theoretically correct.
To illustrate, assume the same facts as in the previous example except that the USD 5,000 expenditure did not
extend the life of the asset. Because of the size of this expenditure, the company still charges it to accumulated
depreciation. Now, it would spread the USD 29,000 remaining book value over the remaining six years of the life of
the press. Under the straight-line method, annual depreciation would then be (USD 29,000/6) = USD 4,833.
Accounting Principles: A Business Perspective 429 A Global Text
10. Property, plant, and equipment
Exhibit 88: Expenditures on plant assets after acquisition
Accountants treat as expenses those recurring and/or minor expenditures that neither add to the asset's service-
rendering quality nor extend its quantity of services beyond its original estimated useful life. Thus, firms
immediately expense regular maintenance (lubricating a machine) and ordinary repairs (replacing a broken fan belt
on an automobile) as revenue expenditures. For example, a company that spends USD 190 to repair a machine after
using it for some time, debits Maintenance Expense or Repairs Expense.
Low-cost items Most businesses purchase low-cost items that provide years of service, such as
paperweights, hammers, wrenches, and drills. Because of the small dollar amounts involved, it is impractical to use
the ordinary depreciation methods for such assets, and it is often costly to maintain records of individual items.
Also, the effect of low-cost items on the financial statements is not significant. Accordingly, it is more efficient to
record the items as expenses when they are purchased. For instance, many companies charge any expenditure less
than an arbitrary minimum, say, USD 100, to expense regardless of its impact on the asset's useful life. This
practice of accounting for such low unit cost items as expenses is an example of the modifying convention of
materiality that was discussed in Chapter 5. In Exhibit 88, we summarize expenditures on plant assets after
acquisition.
In practice, it is difficult to decide whether to debit an expenditure to the asset account or to the accumulated
depreciation account. For example, some expenditures seem to affect both the quality and quantity of services.
Even if the wrong account were debited for the expenditure, the book value of the plant asset at that point would be
the same amount it would have been if the correct account had been debited. However, both the asset and
accumulated depreciation accounts would be misstated.
As an example of the effect of misstated asset and accumulated depreciation accounts, assume Watson Company
had an asset that had originally cost USD 15,000 and had been depreciated to a book value of USD 6,000 at the
beginning of 2010. At that time, Watson estimated the equipment had a remaining useful life of two years. The
company spent USD 4,000 in early January 2010 to install a new motor in the equipment. This motor extended the
useful life of the asset four years beyond the original estimate. Since the expenditure extended the life, the firm
should capitalize it by a debit to the accumulated depreciation account. We show the calculations for depreciation
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expense if the entry was made correctly and if the expenditure had been improperly charged (debited) to the asset
account in Exhibit 89.
After Expenditure Entry 2010 Jan 1 Correct Incorrect
Cost $15,000 $15,000 $19,000T Accumulated depreciation 9,000 5,000* 9,000 Book value $ 6,000 $10,000 $10,000 Remaining life 2 years 6 years 6 years Depreciation expense per year $ 3,000 $ 1,667 $1,667 * ($9,000 - $4,000) T ($15,000 + $4,000)
Exhibit 89: Expenditure extending plant asset life
If an expenditure that should be expensed is capitalized, the effects are more significant. Assume now that USD
6,000 in repairs expense is incurred for a plant asset that originally cost USD 40,000 and had a useful life of four
years and no estimated salvage value. This asset had been depreciated using the straight-line method for one year
and had a book value of USD 30,000 (USD 40,000 cost—USD 10,000 first-year depreciation) at the beginning of
2010. The company capitalized the USD 6,000 that should have been charged to repairs expense in 2010. The
charge for depreciation should have remained at USD 10,000 for each of the next three years. With the incorrect
entry, however, depreciation increases.
Regardless of whether the repair was debited to the asset account or the accumulated depreciation account, the
firm would change the depreciation expense amount to USD 12,000 for each of the next three years [(USD 30,000
book value + USD 6,000 repairs expense)/3 more years of useful life]. These errors would cause net income for the
year 2010 to be overstated USD 4,000: (1) repairs expense is understated by USD 6,000, causing income to be
overstated by USD 6,000; and (2) depreciation expense is overstated by USD 2,000, causing income to be
understated by USD 2,000. In 2011, the overstatement of depreciation by USD 2,000 would cause 2011 income to
be understated by USD 2,000.
Note that the USD 6,000 recording error affects more than just the expense accounts and net income. Plant
asset and Retained Earnings accounts on the balance sheet also reflect the impact of this error. To see the effect of
incorrectly capitalizing the USD 6,000 to the asset account rather than correctly expensing it, look at Exhibit 90.
Subsidiary records used to control plant assets
Most companies maintain formal records (ranging from handwritten documents to computer tapes) to ensure
control over their plant assets. These records include an asset account and a related accumulated depreciation
account in the general ledger for each major class of depreciable plant assets, such as buildings, factory machinery,
office equipment, delivery equipment, and store equipment.
Because the general ledger account has no room for detailed information about each item in a major class of
depreciable plant assets, many companies use plant asset subsidiary ledgers. Subsidiary ledgers for Accounts
Receivable and Accounts Payable were explained briefly in An accounting perspective in Chapter 4. A company
may also use subsidiary ledgers for plant assets. For instance, assume a company has a general ledger account for
office furniture. The subsidiary ledger for office furniture might contain four separate accounts entitled: Desks,
Chairs, File Cabinets and Bookshelves. Alternatively, a company could even have a separate subsidiary account for
each piece of furniture. The total of all the subsidiary account balances must equal the total of the general ledger
"control" account for Office Furniture at the end of the accounting period. Each general ledger account for each
class of depreciable asset, such as Buildings, Delivery Equipment, and so on, could have a subsidiary ledger backing
Accounting Principles: A Business Perspective 431 A Global Text
10. Property, plant, and equipment
it up and showing information such as the description, cost, and purchase date for each asset. These subsidiary
ledgers and detailed records provide more information and allow the company to maintain better control over plant
and equipment.
2010 Correctly Expensing
Incorrectly Expensing
Depreciation expense $10,000 $12,000 Repair Expense 6,000 -0- Net in come overstated by $4,000, which affects retained earnings
$16,000 $12,000
Asset cost $40,000 $46,000 Accumulated depreciation 20,000 22,000 Book value $20,000 $24,000
2011 Correctly Expensing
Incorrectly Expensing
Depreciation expense $10,000 $12,000 Repair Expense -0- -0- Net in come understated by $2,000, which affects retained earnings
$10,000 $12,000
Asset cost $40,000 $46,000 Accumulated depreciation 30,000 34,000 Book value $10,000 $12,000
Exhibit 90: Effect of revenue expenditure treated as capital expenditure
When they are kept for each major class of plant and equipment, a company may have subsidiary ledgers for
factory machinery, office equipment, and other classes of depreciable plant assets. Then there may be an additional
subsidiary ledger for each type of asset within each category. For example, the subsidiary office equipment ledger
may contain accounts for microcomputers, printers, fax machines, copying machines, and so on. Companies also
keep a detailed record for each item represented in a subsidiary ledger account. For example, there may be a
separate detailed record for each microcomputer represented in the Microcomputer subsidiary ledger account.
Each detailed record should include a description of the asset, identification or serial number, location of the asset,
date of acquisition, cost, estimated salvage value, estimated useful life, annual depreciation, accumulated
depreciation, insurance coverage, repairs, date of disposal, and gain or loss on final disposal of the asset. Note the
detailed record for one particular microcomputer as of 2010 December 31, in Exhibit 91.
To enhance control over plant and equipment, companies stencil on or attach the identification or serial number
to each asset. Periodically, firms must take a physical inventory to determine whether all items in the accounting
records actually exist, whether they are located where they should be, and whether they are still being used. A
company that does not use detailed records and identification numbers or take physical inventories finds it difficult
to determine whether assets have been discarded or stolen.
The general ledger control account balance for each major class of plant and equipment should equal the total of
the amounts in the subsidiary ledger accounts for that class of plant assets. Also, the totals in the detailed records
for a specific subsidiary ledger account (such as Microcomputers) should equal the balance of that account. Each
time a plant asset is acquired, exchanged, or disposed of, the firm posts an entry to both a general ledger control
account and the appropriate subsidiary ledger account. It also updates the detailed record for the items affected.
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Item Dell Precision M40 Insurance coverage: Id. No. Z-43806 United Ins. Co. Location Rm. 403, Adm. bldg. Pol. No. 0052-61481-24 Date acquired 2009 Jan. 1 Amt. $3,000 Cost $3,000 Repairs: Estimated salvage value $200 2010/6/13 $140 Estimated useful life 4 yrs. Deprecation per year $700 Accumulated depreciation: ' Disposal date 2009/12/31 $ 700 Gain or loss 2010/12/31 1,400 2011/12/31 2012/12/31
Exhibit 91: Detailed record of a specific plant asset
DEMENT & PEERY, INC. Consolidated Balance Sheets
2010 December 31 and 2009 (Dollars in millions) 2010 2009
ASSETS Current Assets: Cash $ 121 $ 192 Accounts receivable, net of allowance for doubtful accounts of $15 in both 2010 and 2009 379 491 Inventories 247 175 Deposits, prepaid expenses and other 120 58 Total Current Assets $ 867 $ 916 Investments Equity affiliates 170 277 Other assets 87 63 Property and Equipment - Net 4,153 3,919 Deferred Charges 164 154 Total Assets $5,441 $5,329 Net Operating Earnings $ 560 $ 433
Exhibit 92: Consolidated balance sheets
Analyzing and using the financial results—Rate of return on operating assets
Analyzing the ratios of income statement and balance sheet items from one year to the next can reveal important
trends. Management uses these ratios to measure performance by establishing targets and evaluating results. As an
example, look at Exhibit 92. Analysts use these figures to calculate the ratios and to explain the importance of this
information to management and investors.
To determine the rate of return on operating assets for Dement & Peery for 2009 and 2010, use the
following formula:
Rate of return on operating assets= Net operating income
Operating assets
2009: USD 433,000/USD 5,329,000 = 8.13 per cent
2010: USD 560,000/USD 5,441,000 = 10.29 per cent
Net operating income is also called net operating earnings or income before interest and taxes. In calculating
Dement & Peery's ratio, we have assumed that all assets are operating assets used in producing operating revenues.
This ratio measures the profitability of the company in carrying out its primary business function. For Dement &
Peery, these figures indicate a slight increase in the earning power of the company in 2010. Net operating income
increased more than proportionately compared to the increase in operating assets. Perhaps this performance
justifies the increase in operating assets.
In this chapter, you learned how to account for the acquisition of plant assets and depreciation. The next chapter
discusses how to record the disposal of plant assets and how to account for natural resources and intangible assets.
Accounting Principles: A Business Perspective 433 A Global Text
10. Property, plant, and equipment
Understanding the learning objectives
• To be classified as a plant asset, an asset must: (1) be tangible; (2) have a useful service life of more than
one year; and (3) be used in business operations rather than held for resale.
• In accounting for plant assets, accountants must:
(a) Record the acquisition cost of the asset.
(b)Record the allocation of the asset's original cost to periods of its useful life through depreciation.
(c) Record subsequent expenditures on the asset.
(d)Account for the disposal of the asset.
• Accountants consider four major factors in computing depreciation: (1) cost of the asset; (2) estimated
salvage value of the asset; (3) estimated useful life of the asset; and (4) depreciation method to use in
depreciating the asset.
• Straight-line method: Assigns an equal amount of depreciation to each period. The formula for
calculating straight-line depreciation is:
Depreciation per period= Assetcost – Estimated salvage value
Number of accounting periods∈estimated useful life
• Units-of-production method: Assigns an equal amount of depreciation to each unit of product
manufactured by an asset. The units-of-production depreciation formulas are:
Deprecation per period= Asset cost – Estimated salvage value
Estimated total units of production serviceduring useful lifeof asset
Depreciation per period=Depreciation per unit×Number of unitsof goods /servicesproduced
• Double-declining-balance method: DDB is an accelerated deprecation method. Salvage value is
ignored in making annual calculations. The formula for DDB deprecation is:
Deprecation per period=2×straight−line rate×Asset cost – Accumulated deprecation
• Capital expenditures are debited to an asset account or an accumulated depreciation account and increase
the book value of plant assets. Expenditures that increase the quality of services or extend the quantity of
services beyond the original estimate are capital expenditures.
• Revenue expenditures are expensed immediately and reported in the income statement as expenses.
Recurring and or minor expenditures that neither add to the asset's quality of service-rendering abilities nor
extend its quantity of services beyond the asset's original estimated useful life are expenses.
• Plant asset subsidiary ledgers contain detailed information that cannot be maintained in the general ledger
account about each item in a major class of depreciable plant assets.
• Control over plant and equipment is enhanced by plant asset subsidiary ledgers and other detailed records.
Information in a detailed record may include a description of the asset, identification or serial number,
location of the asset, date of acquisition, cost, estimated salvage value, estimated useful life, annual
depreciation, accumulated depreciation, insurance coverage, repairs, date of disposal, and gain or loss on final
disposal of the asset. A periodic physical inventory should be taken to determine whether items in accounting
records actually exist and are still being used at the proper location.
• To calculate the rate of return on operating assets, divide net operating income by operating assets. This
ratio helps management determine how effectively it used assets to produce a profit.
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Demonstration problem
Demonstration problem A Cleveland Company purchased a 2-square-mile farm under the following terms:
cash paid, USD 486,000; mortgage note assumed, USD 240,000; and accrued interest on mortgage note assumed,
USD 6,000. The company paid USD 55,200 for brokerage and legal services to acquire the property and secure
clear title. Cleveland planned to subdivide the property into residential lots and to construct homes on these lots.
Clearing and leveling costs of USD 21,600 were paid. Crops on the land were sold for USD 14,400. A house on the
land, to be moved by the buyer of the house, was sold for USD 5,040. The other buildings were torn down at a cost
of USD 9,600, and salvaged material was sold for USD 10,080.
Approximately 6 acres of the land were deeded to the township for roads, and another 10 acres was deeded to
the local school district as the site for a future school. After the subdivision was completed, this land would have an
approximate value of USD 7,680 per acre. The company secured a total of 1,200 salable lots from the remaining
land.
Present a schedule showing in detail the composition of the cost of the 1,200 salable lots.
Demonstration problem B Calvin Company acquired and put into use a machine on 2010 January 1, at a
total cost of USD 45,000. The machine was estimated to have a useful life of 10 years and a salvage value of USD
5,000. It was also estimated that the machine would produce one million units of product during its life. The
machine produced 90,000 units in 2010 and 125,000 units in 2011.
Compute the amounts of depreciation to be recorded in 2010 and 2011 under each of the following:
a. Straight-line method.
b. Units-of-production method.
c. Double-declining-balance method.
d. Assume 30,000 units were produced in the first quarter of 2010. Compute depreciation for this quarter under
each of the three methods.
Solution to demonstration problem
Solution to demonstration problem A
CLEVELAND COMPANY Schedule of Cost of 1,200 Residential Lots
Costs incurred: Cash paid $486,000 Mortgage note assumed 240,000 Interest accrued on mortgage note assumed 6,000 Broker and legal services 55,200 Clearing and leveling costs incurred 21,600 Tearing down costs 9,600 $818,400 Less proceeds from sale of: Crops $ 14,400 House 5,040 Salvaged materials 10,080 29,520 Net cost of land to be subdivided into 1,200 lots $788,880
Solution to demonstration problem B
a. Straight-line method:
2010: USD 45,000 – USD5,000
10 =USD 4,000
2011: USD 45,000 – USD5,000
10 =USD 4,000
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10. Property, plant, and equipment
b. Units-of-production method:
2010: USD 45,000 – USD5,000
1,000,000 ×90,000=USD3,600
2011: USD 45,000 – USD5,000
1,000,000 ×125,000=USD5,000
c. Double-declining-balance method:
2010: USD 45,000×20 per cent=USD9,000
2011: USD 45,000 – USD9,000×20 per cent=USD7,200
d. Straight-line: USD 45,000 – USD5,000
10 ×
1
4 =USD1,000
Units-of-production: (USD 30,000 – USD 0.04) = USD 1,200
Double-declining-balance: USD 45,000 – USD9,000 – USD7,000×0.2× 1
4 =USD1,440
Key terms Accelerated depreciation methods Record higher amounts of depreciation during the early years of an asset's life and lower amounts in later years.
Acquisition cost Amount of cash and/or cash equivalents given up to acquire a plant asset and place it in operating condition at its proper location.
Appraised value An expert's opinion as to what an item's market price would be if the item were sold.
Betterments (improvements) Capital expenditures that are properly charged to asset accounts because they add to the service-rendering ability of the assets; they increase the quality of services obtained from an asset.
Book value An asset's recorded cost less its accumulated depreciation.
Capital expenditures Expenditures debited to an asset account or to an accumulated depreciation account.
Depreciation The amount of plant asset cost allocated to each accounting period benefiting from the plant asset's use. The straight-line depreciation method charges an equal amount of plant asset cost to each period. The units-of-production depreciation method assigns an equal amount of depreciation for each unit of product manufactured or service rendered by an asset. The double-declining-balance (DDB) method assigns decreasing amounts of depreciation to successive periods of time.
Double-declining-balance (DDB) depreciation See depreciation.
Extraordinary repairs Expenditures that cancel a part of the existing accumulated depreciation because they increase the quantity of services expected from an asset.
Fair market value The price that would be received for an item being sold in the normal course of business (not at a forced liquidation sale).
Inadequacy The inability of a plant asset to produce enough products or provide enough services to meet current demands.
Land improvements Attachments to land, such as driveways, landscaping, parking lots, fences, lighting systems, and sprinkler systems, that have limited lives and therefore are depreciable.
Low-cost items Items that provide years of service at a relatively low unit cost, such as hammers, paperweights, and drills.
Obsolescence Decline in usefulness of an asset brought about by inventions and technological progress.
Physical deterioration Results from use of the asset—wear and tear—and the action of the elements.
Plant and equipment A shorter title for property, plant, and equipment; also called plant assets. Included are land and manufactured or constructed assets such as buildings, machinery, vehicles, and furniture.
Rate of return on operating assets Net operating income/Operating assets. This ratio helps management determine how effectively it used assets to produce a profit.
Revenue expenditures Expenditures (on a plant asset) that are immediately expensed.
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Salvage value The amount of money the company expects to recover, less disposal costs, on the date a plant asset is scrapped, sold, or traded in. Also called scrap value or residual value.
Straight-line depreciation See depreciation.
Tangible assets Assets that we can see and touch such as land, buildings, and equipment.
Units-of-production depreciation See depreciation.
Useful life Refers to the length of time the company owning the asset intends to use it.
Self-test
True-false
Indicate whether each of the following statements is true or false.
The cost of land includes its purchase price and other related costs, including the cost of removing an old
unusable building that is on the land.
Depreciation is the process of valuation of an asset to arrive at its market value.
The purpose of depreciation accounting is to provide the cash required to replace plant assets.
Expenditures made on plant assets that increase the quality of services are debited to the accumulated
depreciation account.
Plant asset subsidiary ledgers are used to increase control over plant assets.
Multiple-choice
Select the best answer for each of the following questions.
On 2010 January 1, Jackson Company purchased equipment for USD 400,000, and installation and testing
costs totaled USD 40,000. The equipment has an estimated useful life of 10 years and an estimated salvage value of
USD 40,000. If Jackson uses the straight-line depreciation method, the depreciation expense for 2010 is:
a. USD 36,000.
b. USD 40,000.
c. USD 44,000.
d. USD 80,000.
e. USD 88,000.
In Question 1, if the equipment were purchased on 2010 July 1, and Jackson used the double-declining-balance
method, the depreciation expense for 2010 would be:
a. USD 88,000.
b. USD 72,000.
c. USD 36,000.
d. USD 44,000.
e. USD 40,000.
Hatfield Company purchased a computer on 2008 January 2, for USD 10,000. The computer had an estimated
salvage value of USD 3,000 and an estimated useful life of five years. At the beginning of 2010, the estimated
salvage value changed to USD 1,000, and the computer is expected to have a remaining useful life of two years.
Using the straight-line method, the depreciation expense for 2010 is:
a. USD 1,400.
b. USD 1,750.
c. USD 2,250.
d. USD 1,800.
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10. Property, plant, and equipment
e. USD 3,100.
The result of recording a capital expenditure as a revenue expenditure is an:
a. Overstatement of current year's expense.
b. Understatement of current year's expense.
c. Understatement of subsequent year's net income.
d. Overstatement of current year's net income.
e. None of the above.
Now turn to “Answers to self-test” at the end of the chapter to check your answers.
Questions
➢ What is the main distinction between inventory and a plant asset?
➢ Which of the following items are properly classifiable as plant assets on the balance sheet?
➢ Advertising that will appear in the future to inform the public about new energy-saving programs
at a manufacturing plant.
➢ A truck acquired by a manufacturing company to be used to deliver the company's products to
wholesalers.
➢ An automobile acquired by an insurance company to be used by one of its salespersons.
➢ Adding machines acquired by an office supply company to be sold to customers.
➢ The cost of constructing and paving a driveway that has an estimated useful life of 10 years.
➢ In general terms, what does the cost of a plant asset include?
➢ In what way does the purchase of a plant asset resemble the prepayment of an expense?
➢ Brown Company purchased an old farm with a vacant building as a factory site for USD 1,040,000.
Brown decided to use the building in its operations. How should Brown allocate the purchase price
between the land and the building? How should this purchase be handled if the building is to be torn
down?
➢ Describe how a company may determine the cost of a self-constructed asset.
➢ In any exchange of noncash assets, the accountant's task is to find the most appropriate valuation for
the asset received. What is the general rule for determining the most appropriate valuation in such a
situation?
➢ Why should periodic depreciation be recorded on all plant assets except land?
➢ Define the terms inadequacy and obsolescence as used in accounting for depreciable plant assets.
➢ What four factors must be known to compute depreciation on a plant asset? How objective is the
calculation of depreciation?
➢ A friend, Mindy Jacobs, tells you her car depreciated USD 5,000 last year. Explain whether her
concept of depreciation is the same as the accountant's concept.
➢ What does the term accelerated depreciation mean? Give an example showing how depreciation is
accelerated.
➢ Provide a theoretical reason to support using an accelerated depreciation method.
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➢ Nancy Company purchased a machine that originally had an estimated eight years of useful life. At
the end of the third year, Nancy determined that the machine would last only three more years. Does
this revision affect past depreciation taken?
➢ What does the balance in the accumulated depreciation account represent? Does this balance
represent cash that can be used to replace the related plant asset when it is completely depreciated?
➢ What is the justification for reporting plant assets on the balance sheet at undepreciated cost (book
value) rather than market value?
➢ Distinguish between capital expenditures and revenue expenditures.
➢ For each of the following, state whether the expenditure made should be charged to an expense, an
asset, or an accumulated depreciation account:
➢ Cost of installing air-conditioning equipment in a building that was not air-conditioned.
➢ Painting of an owned factory building every other year.
➢ Cost of replacing the roof on a 10-year-old building that was purchased new and has an
estimated total life of 40 years. The expenditure did not extend the life of the asset beyond the
original estimate.
➢ Cost of repairing an electric motor. The expenditure extended the estimated useful life beyond
the original estimate.
➢ Indicate which type of account (asset, accumulated depreciation, or expense) would be debited for
each of the following expenditures:
➢ Painting an office building at a cost of USD 1,000. The building is painted every year.
➢ Adding on a new plant wing at a cost of USD 24,000,000.
➢ Expanding a paved parking lot at a cost of USD 144,000.
➢ Replacing a stairway with an escalator at a cost of USD 20,000.
➢ Replacing the transmission in an automobile at a cost of USD 1,600, thus extending its useful life
two years beyond the original estimate.
➢ Replacing a broken fan belt at a cost of USD 600.
➢ How do subsidiary records provide control over a company's plant assets?
➢ What advantages can accrue to a company that maintains plant asset subsidiary records?
➢ Real world question Based on the financial statements and the notes to those statements of The
Limited, Inc., contained in the Annual report appendix, what was the 2000 ending net property and
equipment balance? Did the company acquire any of these assets in 2000? What depreciation
method did the company use?
Exercises
Exercise A Stephon Company paid USD 640,000 cash for a tract of land on which it plans to erect a new
warehouse, and paid USD 8,000 in legal fees related to the purchase. Stephon also agreed to assume responsibility
for USD 25,600 of unpaid taxes on the property. The company incurred a cost of USD 28,800 to remove an old
apartment building from the land. Prepare a schedule showing the cost of the land acquired.
Exercise B Laural Company paid USD 840,000 cash for real property consisting of a tract of land and a
building. The company intended to remodel and use the old building. To allocate the cost of the property acquired,
Accounting Principles: A Business Perspective 439 A Global Text
10. Property, plant, and equipment
Laural had the property appraised. The appraised values were as follows: land, USD 576,000, and office building,
USD 384,000. The cost of clearing the land was USD 18,000. The building was remodeled at a cost of USD 76,800.
The cost of a new identical office building was estimated to be USD 432,000. Prepare a schedule showing the cost of
the assets acquired.
Exercise C Fine Company purchased a heavy machine to be used in its factory for USD 720,000, less a 2 per
cent cash discount. The company paid a fine of USD 3,600 because an employee hauled the machine over city
streets without securing the required permits. The machine was installed at a cost of USD 21,600, and testing costs
of USD 7,200 were incurred to place the machine in operation. Prepare a schedule showing the recorded cost of the
machine.
Exercise D A machine is acquired in exchange for 50 shares of Marley Corporation capital stock. The stock
recently traded at USD 400 per share. The machine cost USD 30,000 three years ago. At what amount should the
machine be recorded?
Exercise E Keely Company purchased some office furniture for USD 29,760 cash on 2009 March 1. It also paid
USD 480 cash for freight costs incurred. The furniture is being depreciated over four years under the straight-line
method, assuming a salvage value of USD 1,440. The company employs a calendar-year accounting period. On 2010
July 1, it spent USD 192 to refinish the furniture. Prepare journal entries for the Keely Company to record all of the
data, including the annual depreciation adjustments through 2010.
Exercise F On 2009 January 2, a new machine was acquired for USD 900,000. The machine has an estimated
salvage value of USD 100,000 and an estimated useful life of 10 years. The machine is expected to produce a total of
500,000 units of product throughout its useful life. Compute depreciation for 2009 and 2010 using each of the
following methods:
a. Straight line.
b. Units of production (assume 30,000 and 60,000 units were produced in 2009 and 2010, respectively).
c. Double-declining balance.
Exercise G Terrill Company finds its records are incomplete concerning a piece of machinery used in its plant.
According to the company records, the machinery has an estimated useful life of 10 years and an estimated salvage
value of USD 24,000. It has recorded USD 12,000 in depreciation each year using the straight-line method. If the
accumulated depreciation account shows a balance of USD 72,000, what is the original cost of the machinery and
how many years remain to be depreciated?
Exercise H Katherine Company purchased a machine on 2009 April 1, for USD 72,000. The machine has an
estimated useful life of five years with no expected salvage value. The company's accounting year ends on December
31.
Compute the depreciation expense for 2009 and 2010 under the double-declining-balance method.
Exercise I Australia Company purchased a machine for USD 3,200 and incurred installation costs of USD 800.
The estimated salvage value of the machine is USD 200. The machine has an estimated useful life of four years.
Compute the annual depreciation charges for this machine under the double-declining-balance method.
Exercise J Regal Company acquired a delivery truck on 2009 January 2, for USD 107,200. The truck had an
estimated salvage value of USD 4,800 and an estimated useful life of eight years. At the beginning of 2009, a
revised estimate shows that the truck has a remaining useful life of six years. The estimated salvage value changed
to USD 1,600.
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Compute the depreciation charge for 2009 and the revised depreciation charge for 2009 using the straight-line
method.
Exercise K Assume that the truck described in the previous exercise was used 40 per cent of the time in 2010
to haul materials used in the construction of a building by Regal Company for its own use. (Remember that 2010 is
before the revision was made on estimated life.) During the remaining time, Regal used the truck to deliver
merchandise to its customers.
Prepare the journal entry to record straight-line depreciation on the truck for 2010.
Exercise L Vineland Company purchased a computer for USD 60,000 and placed it in operation on 2008
January 2. Depreciation was recorded for 2008 and 2009 using the straight-line method, a six-year life, and an
expected salvage value of USD 2,400. The introduction of a new model of this computer in 2010 caused the
company to revise its estimate of useful life to a total of four years and to reduce the estimated salvage value to zero.
Compute the depreciation expense on the computer for 2010.
Exercise M On 2009 January 2, a company purchased and placed in operation a new machine at a total cost of
USD 60,000. Depreciation was recorded on the machine for 2009 and 2010 under the straight-line method using
an estimated useful life of five years and no expected salvage value. Early in 2011, the machine was overhauled at a
cost of USD 20,000. The estimated useful life of the machine was revised upward to a total of seven years.
Compute the depreciation expense on the machine for 2011.
Exercise N Lasky Company purchased a machine on 2009 January 3, at a cost of USD 50,000. It debited
freight and installation charges of USD 10,000 to Repairs Expense. It recorded straight-line depreciation on the
machine in 2009 and 2010 using an estimated life of 10 years and no expected salvage value.
Compute the amount of the error in net income for 2009 and 2010, and state whether net income is understated
or overstated.
Exercise O Bragg Company owns a plant asset that originally cost USD 240,000 in 2006 The asset has been
depreciated for three years assuming an eight-year useful life and no salvage value. During 2009, Bragg incorrectly
capitalized USD 120,000 in repairs on the plant asset rather than expensing them. Describe the impact of this error
on the asset's cost and Bragg's net income over the next five years.
Problems
Problem A Bolt Company purchased a machine for use in its operations that had an invoice price of USD
80,000 excluding sales tax. A 4 per cent sales tax was levied on the sale. Terms were net 30. The company
estimated the total cost of hauling the machine from the dealer's warehouse to the company's plant at USD 5,600,
which did not include a fine of USD 1,600 for failure to secure the necessary permits to use city streets in
transporting the machine. In delivering the machine to its plant, a Bolt employee damaged the truck used; repairs
cost USD 3,600. The machine was also slightly damaged with repair costs amounting to USD 1,600.
Bolt incurred installation costs of USD 32,000 that included the USD 4,000 cost of shoring up the floor under
the machine. Testing costs amounted to USD 2,400. Safety guards were installed on the machine at a cost of USD
640, and the machine was placed in operation.
Prepare a schedule showing the amount at which the machine should be recorded in Bolt's accounts.
Problem B Pressler Company planned to erect a new factory building and a new office building in Atlanta,
Georgia, USA. A report on a suitable site showed an appraised value of USD 180,000 for land and orchard and USD
120,000 for a building.
Accounting Principles: A Business Perspective 441 A Global Text
10. Property, plant, and equipment
After considerable negotiation, the company and the owner reached the following agreement: Pressler Company
was to pay USD 216,000 in cash, assume a USD 90,000 mortgage note on the property, assume the interest of USD
1,920 accrued on the mortgage note, and assume unpaid property taxes of USD 13,200. Pressler Company paid
USD 18,000 cash for brokerage and legal services in acquiring the property.
Shortly after acquisition of the property, Pressler Company sold the fruit on the trees for USD 2,640, remodeled
the building into an office building at a cost of USD 38,400, and removed the trees from the land at a cost of USD
9,000. Construction of the factory building was to begin in a week.
Prepare schedules showing the proper valuation of the assets acquired by Pressler Company.
Problem C Timothy Company acquired and placed into use a heavy factory machine on 2009 October 1. The
machine had an invoice price of USD 360,000, but the company received a 3 per cent cash discount by paying the
bill on the date of acquisition. An employee of Timothy Company hauled the machine down a city street without a
permit. As a result, the company had to pay a USD 1,500 fine. Installation and testing costs totaled USD 35,800.
The machine is estimated to have a USD 35,000 salvage value and a seven-year useful life. (A fraction should be
used for the DDB calculation rather than a percentage.)
a. Prepare the journal entry to record the acquisition of the machine.
b. Prepare the journal entry to record depreciation for 2009 under the double-declining balance method.
c. Assume Timothy Company used the straight-line depreciation method. At the beginning of 2009, it estimated
the machine will last another six years. Prepare the journal entry to record depreciation for 2009. The estimated
salvage value would not change.
Problem D Peach Company has the following entries in its Building account:
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Debits
2009
May 5 Cost of land and building purchased $200,000
5 Broker fees incident to purchase of land and building 12,000
2010
Jan. 3 Contract price of new wing added to south end 84,000
15 Cost of new machinery, estimated life 10 years 160,000
June 10 Real estate taxes for six months ended 2010/6/30 3,600
Aug. 10 Cost of building parking lot for employees in back of building 4,960
Sept. 6 Replacement of windows broken in August 160
Oct. 10 Repairs due to regular usage 2,240
Credits
2009
May 24 Transfer to Land account, per allocation of purchase cost
authorized in minutes of board of directors 32,000
2010
Jan. 5 Proceeds from leases of second floor for six months ended
2009/12/31 8,000
Peach acquired the original property on 2009 May 5. Orange immediately engaged a contractor to construct a
new wing on the south end of the building. While the new wing was being constructed, the company leased the
second floor as temporary warehouse space to Kellett Company. During this period (July 1 to 2009 December 31),
the company installed new machinery costing USD 160,000 on the first floor of the building. Regular operations
began on 2010 January 2.
a. Compute the correct balance for the Buildings account as of 2010 December 31. The company employs a
calendar-year accounting period.
b. Prepare the necessary journal entries to correct the records of Peach Company at 2010 December 31. No
depreciation entries are required.
Problem E Cardine Company acquired and placed into use equipment on 2009 January 2, at a cash cost of
USD 935,000. Transportation charges amounted to USD 7,500, and installation and testing costs totaled USD
55,000.
The equipment was estimated to have a useful life of nine years and a salvage value of USD 37,500 at the end of
its life. It was further estimated that the equipment would be used in the production of 1,920,000 units of product
during its life. During 2009, 426,000 units of product were produced.
Compute the depreciation to the nearest dollar for the year ended December 31, using:
a. Straight-line method.
b. Units-of-production method.
c. Double-declining-balance method (use a fraction rather than a percentage).
Problem F Goodrich Company purchased a machine on 2009 October 1 for USD 100,000. The machine has an
estimated salvage value of USD 30,000 and an estimated useful life of eight years.
Compute to the nearest dollar the amount of depreciation Goodrich should record on the machine for the years
ending 2009 December 31, and 2010, under each of the following methods:
Accounting Principles: A Business Perspective 443 A Global Text
10. Property, plant, and equipment
a. Straight-line.
b. Double-declining-balance.
Alternate problems
Alternate problem A Brite Company purchased a machine that had an invoice price of USD 400,000
excluding sales tax. Terms were net 30. A 4 per cent sales tax was levied on the sale. The company incurred and
paid freight costs of USD 10,000. Special electrical connections were run to the machine at a cost of USD 14,000
and a special reinforced base for the machine was built at a cost of USD 18,000. The machine was dropped and
damaged while being mounted on this base. Repairs cost USD 4,000. Raw materials with a cost of USD 1,000 were
consumed in testing the machine. Safety guards were installed on the machine at a cost of USD 1,400, and the
machine was placed in operation. In addition, USD 500 of costs were incurred in removing an old machine.
Prepare a schedule showing the amount at which the machine should be recorded in Brite Company's account.
Alternate problem B Maxwell Company purchased 2 square miles of farmland under the following terms:
USD 968,000 cash; and liability assumed on mortgage note of USD 320,000 and interest accrued on mortgage note
assumed, USD 12,800. The company paid USD 67,200 of legal and brokerage fees and also paid USD 3,200 for a
title search on the property.
The company planned to use the land as a site for a new office building and a new factory. Maxwell paid clearing
and leveling costs of USD 28,800. It sold crops on the land for USD 7,360 and sold one of the houses on the
property for USD 19,200. The other buildings were torn down at a cost of USD 14,400; sale of salvaged materials
yielded cash proceeds of USD 13,600. Approximately 1 per cent of the land acquired was deeded to the county for
roads. The cost of excavating a basement for the office building amounted to USD 9,120.
Prepare a schedule showing the amount at which the land should be carried on Maxwell Company's books.
Alternate problem C Dawson Towing Company purchased a used panel truck for USD 28,800 cash. The next
day the company's name and business were painted on the truck at a total cost of USD 1,488. The truck was then
given a minor overhaul at a cost of USD 192, and new "super" tires were mounted on the truck at a cost of USD
1,920, less a trade-in allowance of USD 240 for the old tires. The truck was placed in service on 2009 April 1, at
which time it had an estimated useful life of five years and a salvage value of USD 3,360.
a. Prepare a schedule showing the cost to be recorded for the truck.
b. Prepare the journal entry to record depreciation at the end of the calendar-year accounting period, 2009
December 31. Use the double-declining-balance method.
c. Assume that the straight-line depreciation method has been used. At the beginning of 2009 it is estimated the
truck will last another four years. The estimated salvage value changed to USD 1,920. Prepare the entry to record
depreciation for 2012.
Alternate problem D You are the new controller for Jayson Company, which began operations on 2009
October 1, after a start-up period that ran from the middle of 2008. While reviewing the accounts, you find an
account entitled "Fixed Assets", which contains the following items:
Cash paid to previous owner of land and old buildings $ 192,000 Cash given to construction company as partial payment for the new building 72,000 Legal and title search fees 2,400 Real estate commission 14,400 Cost of demolishing old building 16,800 Cost of leveling and grading 9,600 Architect's fee (90% of building and 10% improvements) 6,000 Cost of excavating (digging) basement for new building 21,600
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Cash paid to construction company for new building 288,000 Repair damage done by vandals 7,200 Sprinkler system for lawn 31,200 Lighting system for parking lot 40,800 Paving of parking lot 60,000 Net invoice price of machinery 1,152,000 Freight cost incurred on machinery 50,400 Installation and testing of machinery 19,200 Medical bill paid for employee injured in installing machinery 3,600 Landscaping (permanent) 38,400 Repair damage to building in installation of machinery 4,800 Special assessment paid to city for water mains and sewer line 45,600 Account balance $2,106,000
In addition, you discover that cash receipts of USD 1,200 from selling materials salvaged from the old building
were credited to Miscellaneous Revenues in 2009. Digging deeper, you find that the plant manager spent all of his
time for the first nine months of 2009 supervising installation of land improvements (10 per cent), building
construction (40 per cent), and installation of machinery (50 per cent). The plant manager's nine-month salary of
USD 108,000 was debited to Officers' Salaries Expense.
a. List all items on a form containing columns for Land, Land Improvements, Building, and Machinery. Sort the
items into the appropriate columns, omitting those items not properly included as an element of asset cost. Show
negative amounts in parentheses. Total your columns.
b. Prepare one compound journal entry to reclassify and adjust the accounts and to eliminate the Fixed Assets
account. Do not attempt to record depreciation for the partial year.
Alternate problem E Land Company acquired and put into use a machine on 2009 January 1, at a cash cost
of USD 120,000 and immediately spent USD 5,000 to install it. The machine had an estimated useful life of eight
years and an estimated salvage value of USD 15,000 at the end of this time. It was further estimated that the
machine would produce 500,000 units of product during its life. In the first year, the machine produced 100,000
units.
Prepare journal entries to record depreciation to the nearest dollar for 2009, using:
a. Straight-line method.
b. Units-of-production method.
c. Double-declining-balance method.
Alternate problem F Crawford Company paid USD 60,000 for a machine on 2009 April 1, and placed it in
use on that same date. The machine has an estimated life of 10 years and an estimated salvage value of USD 10,000.
Compute the amount of depreciation to the nearest dollar the company should record on this asset for the years
ending 2009 December 31, and 2010, under each of the following methods:
a. Straight-line.
b. Double-declining-balance.
Beyond the numbers—Critical thinking
Business decision case A You are a new staff auditor assigned to audit Cray Company's Buildings account.
You determine that Cray Company made the following entries in its Buildings account in 2009:
Debits 2009 Jan. 2 Cost of land and old buildings purchased $ 720,000 2 Legal fees incident to purchase 9,600 2 Fee for title search 1,200 12 Cost of demolishing old buildings on land 19,200 June 16 Cost of insurance during construction of new building 4,800
Accounting Principles: A Business Perspective 445 A Global Text
10. Property, plant, and equipment
July 30 Payment to contractor on completion of new building 1,080,000 Aug. 5 Architect's fees for design of new building 48,000 Sept. 15 City assessment for sewers and sidewalks (considered permanent) 16,800 Oct. 6 Cost of landscaping (considered permanent) 9,600 Nov. 1 Cost of driveways and parking lots 60,000
Credits Jan. 15 Proceeds received upon sale of salvaged materials from old
buildings 4,800
In addition to the entries in the account, you obtained the following information in your interview with the
accountant in charge of the Buildings account:
The company began using the new building on 2009 September 1. The building is estimated to have a 40-year
useful life and no salvage value.
The company began using the driveways and parking lots on 2009 November 1. The driveways and parking lots
have an estimated 10-year useful life and no salvage value.
The company uses the straight-line depreciation method to depreciate all of its plant assets.
Using all of this information, do the following:
a. Prepare a schedule that shows the separate cost of land, buildings, and land improvements.
b. Compute the amount of depreciation expense for 2009.
c. Complete the journal entries required to correct the accounts at 2009 December 31. Assume that closing
entries have not been made.
d. Write a brief statement describing to management why depreciation must be recorded and how recording
depreciation affects net income.
Business decision case B On 2010 October 1, Besler Company acquired and placed into use new equipment
costing USD 504,000. The equipment has an estimated useful life of five years and an estimated salvage value of
USD 24,000. Besler estimates that the equipment will produce 2 million units of product during its life. In the last
quarter of 2010, the equipment produced 120,000 units of product. As the company's accountant, management has
asked you to do the following:
a. Compute the depreciation for the last quarter of 2010, using each of the following methods:
Straight-line.
Units-of-production.
Double-declining-balance.
b. Prepare a written report describing the conditions in which each of these four methods would be most
appropriate.
Business decision case C The notes to the financial statements of Wolverine World Wide, Inc., in "A Broader
Perspective", stated that substantially all fixed assets are depreciated using the straight-line method. Explain why
the straight-line method of depreciation may be appropriate for this company.
Business decision case D Discuss the meaning of rate of return on operating assets, its elements, and what it
means to investors and management.
Calculate the rate of return on operating assets for The Limited in the Annual report appendix for the two most
recent years. Assume all assets are operating assets. Comment on the results.
Annual report analysis E The following footnote excerpted from a recent annual report of Kerr-McGee
Corporation describes the company's accounting policies for property, plant, and equipment:
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Property, plant, and equipment is depreciated over its estimated life by the unit-of-production or the straight-
line-method.
a. How many different depreciation methods are used by Kerr-McGee Corporation? Does this practice conform
with generally accepted accounting principles?
b. Discuss why management might select each of these methods to depreciate plant assets.
Group project F In a group of two or three students, visit a large company in your community and inquire
about the subsidiary records it maintains to establish accounting control over its plant assets. Also inquire about
physical controls used to protect its equipment that is movable, such as computers, copy machines, and so on.
Write a report to your instructor summarizing your findings and be prepared to give a short report to your class.
Group project G With a team of two or three students, visit two companies in your community to inquire
about why they use certain depreciation methods. Try to locate companies that use several depreciation methods in
accounting for various depreciable fixed assets. Interview those who made the decision as to methods to use to find
out the reasons for their choices. Write a report to your instructor summarizing your findings.
Group project H In a small group of students, visit a large company in your community to determine how it
decides to account for expenditures on fixed assets made after the assets have been in use for some time. In other
words, how does it decide whether to debit the asset account, the accumulated depreciation account, or an expense
account? What role does materiality play in the decision? Evaluate the reasonableness of the decision model used.
Write a report to your instructor summarizing your findings and be prepared to make a short presentation to your
class.
Using the Internet—A view of the real world
Visit the CPA Review site at:
http://www.beckerconviser.com
Investigate this site. Identify the major types of employers. Make note of any interesting information at this site.
Write a report to your instructor summarizing your findings. Be prepared to make a short presentation to the class.
Visit the Best Software website at:
http://www.bestsoftware.com
What types of software does the company sell? Why might a company buy a software package from Best
Software? Study any other aspect of the information that looks interesting. Write a report to your instructor
summarizing your findings.
Answers to self-test
True-false
True. The cost of land includes all normal, reasonable, and necessary expenditures to obtain the land and get it
ready for use.
False. Depreciation is a process of allocation, not valuation, and the book value of an asset has little to do with
its market value.
False. Depreciation accounting does not provide funds required to replace plant assets. Instead, accumulated
depreciation simply shows how much of an asset's cost has been charged to expense since the asset was acquired.
False. Expenditures that improve the quality of services are charged to the asset account.
Accounting Principles: A Business Perspective 447 A Global Text
10. Property, plant, and equipment
True. Plant asset subsidiary ledgers provide detailed information that the general ledger account cannot
provide and thus give better control over plant assets.
Multiple-choice
b. The depreciation expense for 2010 using the straight-line method is computed as follows:
USD 440,000−USD40,000
10 =USD 40,000
d. Double-declining balance rate = 2× 100 per cent
10 =20 per cent
Depreciation expense for 2010 = 2 per cent×USD 440,000× 6
12 =USD 44,000
e. At the beginning of 2010, the balance of accumulated depreciation is USD 2,800 (annual depreciation of USD
1,400 X 2) and book value is USD 7,200, or (USD 10,000 - USD 2,800). The revised annual depreciation expense is
USD 3,100, or [ USD7,200−USD1,000
2 ¿ .
a. The error in recording a capital expenditure as a revenue expenditure results in an overstatement of current
year's expense, as well as an understatement of current year's net income.
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11. Plant asset disposals, natural resources, and intangible assets
Learning objectives
After studying this chapter, you should be able to:
• Calculate and prepare entries for the sale, retirement, and destruction of plant assets.
• Describe and record exchanges of nonmonetary assets.
• Determine the periodic depletion cost of a natural resource and calculate depreciation of plant assets located
on extractive industry property.
• Prepare entries for the acquisition and amortization of intangible assets.
• Analyze and use the financial results-total assets turnover.
A company accountant's role in measuring intangibles
Many assets have no physical substance. These assets are referred to as intangible. Even though these assets
have no substance, the accountant still must spend time measuring the value of these assets to corporation and how
these assets contribute to the cash flow of the entity.
The accountant must first place a value on something that cannot be seen by the naked eye. Then the accountant
must determine if the asset is making a contribution toward cash flow of the entity (if so and how long) and finally,
the accountant must determine if and when this benefit has indeed expired.
As we move ever more toward an information based economy, the per cent of intangible assets to total assets
also increases. In many cases, intangible assets compose a significant majority of total assets. Thus, the earning
power of such companies is primarily based on the valuation of assets that cannot be seen or touched. Some
intangible assets, such as human assets and internally generated intangibles, are not even recorded on the
company's books. This makes it even more difficult to value the assets and determine their contribution to earnings.
Investors and analysts often compare book value per share with the market price per share for a corporation.
This ratio is referred to as the price to book ratio (PB). It measures the market's beliefs about the value of net assets
as compared to the recorded amount of net assets. In 1998 Tootsie Roll had a PB ratio of approximately 5.2. The
recorded net assets were approximately USD 400 million, yet the market perceived Tootsie Roll to have net assets
worth over USD 2,000 million. What is the nature of those unrecorded (intangible) assets? In 1998, Microsoft had a
PB ratio of approximately 12.4. The real value of Microsoft's net assets exceeded those reported in the accounting
records by a factor of 12.4. It is reasonable to assume that a large portion of the unrecorded assets of Microsoft must
be intangible. How does the accountant value something that has no physical substance and in many cases has not
been recorded? It is similar to walking around in a dark closet wearing a blindfold.
Accounting Principles: A Business Perspective 449 A Global Text
11. Plant asset disposals, natural resources, and intangible assets
This function is closely related to the work of the plant asset accountant. Many of the same questions must be
addressed when accounting for intangible assets. The question still remains, how can you measure something you
cannot see?
Your study of long-term assets—plant assets, natural resources, and intangible assets—began in Chapter 10,
which focused on determining plant asset cost, computing depreciation, and distinguishing between capital and
revenue expenditures. This chapter begins by discussing the disposal of plant assets. The next topic is accounting
for natural resources such as ores, minerals, oil and gas, and timber. The final topic is accounting for intangible
assets such as patents, copyrights, franchises, trademarks and trade names, leases, and goodwill.
Note that accounting for all the long-term assets discussed in these chapters is basically the same. A company
that purchases a long-term asset records it at cost. As the company receives benefits from the asset and its future
service potential decreases, the accountant transfers the cost from an asset account to an expense account. Finally,
the asset is sold, retired, or traded in on a new asset. Because the lives of long-term assets can extend for many
years, the methods accountants use in reporting such assets can have a dramatic effect on the financial statements
of many accounting periods.
Disposal of plant assets
All plant assets except land eventually wear out or become inadequate or obsolete and must be sold, retired, or
traded for new assets. When disposing of a plant asset, a company must remove both the asset's cost and
accumulated depreciation from the accounts. Overall, then, all plant asset disposals have the following steps in
common:
• Bring the asset's depreciation up to date.
• Record the disposal by:
(a) Writing off the asset's cost.
(b)Writing off the accumulated depreciation.
(c) Recording any consideration (usually cash) received or paid or to be received or paid.
(d)Recording the gain or loss, if any.
As you study this section, remember these common procedures accountants use to record the disposal of plant
assets. In the paragraphs that follow, we discuss accounting for the (1) sale of plant assets, (2) retirement of plant
assets without sale, (3) destruction of plant assets, (4) exchange of plant assets, and (5) cost of dismantling and
removing plant assets.
Sale of plant assets
Companies frequently dispose of plant assets by selling them. By comparing an asset's book value (cost less
accumulated depreciation) with its selling price (or net amount realized if there are selling expenses), the company
may show either a gain or loss. If the sales price is greater than the asset's book value, the company shows a gain. If
the sales price is less than the asset's book value, the company shows a loss. Of course, when the sales price equals
the asset's book value, no gain or loss occurs.
To illustrate accounting for the sale of a plant asset, assume that a company sells equipment costing USD 45,000
with accumulated depreciation of USD 14,000 for USD 35,000. The firm realizes a gain of USD 4,000:
Equipment cost $ 45,000 Accumulated depreciation 14,000 Book value $ 31,000
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Sales price 35,000 Gain realized $ 4,000
The journal entry to record the sale is:
Cash (+A) 35,000
Accumulated Depreciation—Equipment (+A) 14,000
Equipment (-A) 45,000
Gain on Disposal of Plant Assets (+SE) 4,000
To record sale of equipment at a price greater than
book value.
If on the other hand, the company sells the equipment for USD 28,000, it realizes a loss of USD 3,000 (USD
31,000 book value—USD 28,000 sales price). The journal entry to record the sale is:
Cash (+A) 28,000
Accumulated Depreciation—Equipment (+A) 14,000
Loss from Disposal of Plant Asset (-SE) 3,000
Equipment (-A) 45,000
To record the sale of equipment at a price less than
book value.
If a firm sells the equipment for USD 31,000, no gain or loss occurs. The journal entry to record the sale is:
Cash (+A) 31,000
Accumulated Depreciation—Equipment (+A) 14,000
Equipment (-A) 45,000
To record sale of equipment at a price equal to book value.
Accounting for depreciation to date of disposal When selling or otherwise disposing of a plant asset, a
firm must record the depreciation up to the date of sale or disposal. For example, if it sold an asset on April 1 and
last recorded depreciation on December 31, the company should record depreciation for three months (January 1-
April 1). When depreciation is not recorded for the three months, operating expenses for that period are
understated, and the gain on the sale of the asset is understated or the loss overstated.
To illustrate, assume that on 2011 August 1, Ray Company sold a machine for USD 1,500. When purchased on
2003 January 2, the machine cost USD 12,000; Ray was depreciating it at the straight-line rate of 10 per cent per
year. As of 2010 December 31, after closing entries were made, the machine's accumulated depreciation account
had a balance of USD 9,600. Before determining a gain or loss and before making an entry to record the sale, the
firm must make the following entry to record depreciation for the seven months ended 2011 July 31:
July 31 Depreciation Expense—Machinery (-SE) 700
Accumulated Depreciation—Machinery (-A) 700
To record depreciation for seven months
[$12,000 X 0.10 X (7/12)]
An accountant would compute the USD 200 loss on the sale as follows:
Machine cost $ 12,00 0
Accumulated depreciation ($9,600 + $700)
10,30 0
Book value $ 1,700 Sales price 1,500
Accounting Principles: A Business Perspective 451 A Global Text
11. Plant asset disposals, natural resources, and intangible assets
Loss realized $ 200
The journal entry to record the sale is:
Cash (+A) 1,500
Accumulated Depreciation—Machinery (+A) 10,300
Loss from Disposal of Plant Assets (-SE) 200
Machinery(-A) 12,000
To record the sale of machinery at a price less than book value.
When retiring a plant asset from service, a company removes the asset's cost and accumulated depreciation from
its plant asset accounts. For example, Hayes Company would make the following journal entry when it retired a
fully depreciated machine that cost USD 15,000 and had no salvage value:
Accumulated Depreciation—Machinery (+A) 15,000
Machinery (-A) 15,000
To record the retirement of a fully depreciated machine.
Occasionally, a company continues to use a plant asset after it has been fully depreciated. In such a case, the
firm should not remove the asset's cost and accumulated depreciation from the accounts until the asset is sold,
traded, or retired from service. Of course, the company cannot record more depreciation on a fully depreciated
asset because total depreciation expense taken on an asset may not exceed its cost.
Sometimes a business retires or discards a plant asset before fully depreciating it. When selling the asset as
scrap (even if not immediately), the firm removes its cost and accumulated depreciation from the asset and
accumulated depreciation accounts. In addition, the accountant records its estimated salvage value in a Salvaged
Materials account and recognizes a gain or loss on disposal. To illustrate, assume that a firm retires a machine with
a USD 10,000 original cost and USD 7,500 of accumulated depreciation. If the machine's estimated salvage value is
USD 500, the following entry is required:
Salvaged materials (+A) 500
Accumulated Depreciation—Machinery (+A) 7,500
Loss from Disposal of Plant Assets (-SE) 2,000
Machinery (-A) 10,000
To record the retirement of machinery, which will be sold for scrap at a later time.
An accounting perspective:
Uses of technology
The main advantages that companies give for having a home page on the Internet are (1) increased
efficiency in the work environment, (2) increased revenue, and (3) faster customer access. A home
page can be developed for a small company for a few hundred dollars and can be maintained for a
fairly low monthly fee. The Small Business Administration has a website at http://www.sba.gov
that provides helpful information to small businesses. One concern that companies have regarding
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Internet use by their employees is that they might visit interesting nonbusiness related sites on
company time.
Sometimes accidents, fires, floods, and storms wreck or destroy plant assets, causing companies to incur losses.
For example, assume that fire completely destroyed an uninsured building costing USD 40,000 with up-to-date
accumulated depreciation of USD 12,000. The journal entry is:
Fire Loss (-SE) 28,000
Accumulated Depreciation—Buildings (+A) 12,000
Buildings (-A) 40,000
To record fire loss.
If the building was insured, the company would debit only the amount of the fire loss exceeding the amount to
be recovered from the insurance company to the Fire Loss account. To illustrate, assume the company partially
insured the building and will recover USD 22,000 from the insurance company. The journal entry is:
Receivable from Insurance Company (+A) 22,000
Fire Loss (-SE) 6,000
Accumulated Depreciation—Buildings (+A) 12,000
Buildings (-A) 40,000
To record fire loss and amount recoverable from
insurance company.
Exchanges of nonmonetary assets Until late 2004, the rules according to APB Opinion No. 29 for
recording exchanges of nonmonetary assets depended on whether they were exchanges of dissimilar assets such as
a truck for a machine or were similar assets such as a truck for a truck32. If the exchange classified as an exchange of
dissimilar assets, the acquired asset would be recorded at its fair value and any gain or loss would be recognized. In
late 2004, the FASB issued a new standard, Statement of Financial Accounting Standards No. 153, "Exchanges of
Nonoperating Assets: an amendment of APB Opinion No. 29"33. This new standard was issued to bring about
greater agreement between US Generally Accepted Accounting Principles and International Financial Reporting
Standards and is effective for exchanges occurring during fiscal periods beginning after 2005 June 15.
This change allows the financial statements of US companies to be more comparable to the financial statements
of companies utilizing International Financial Reporting Standards.
The new FASB standard no longer distinguishes between dissimilar and similar asset exchanges. Instead it
differentiates between exchanges that have commercial substance and those that do not have commercial
substance. An exchange has commercial substance if, as a result of the exchange, future cash flows are expected
to change significantly. For instance, if a company exchanges a building for land (a dissimilar exchange), the timing
and the future cash flows are likely to be different than if the exchange had not occurred. Most exchanges qualify as
having commercial substance. However, if the exchange is not expected to create a significant change in future cash
flows, the exchange does not result in commercial substance. For example, if a company exchanges one truck for
another truck (a similar exchange) that will perform the same function as the old truck and for the same time
period so that the future cash flows are not significantly different, then the exchange does not result in commercial
32 APB, APB Opinion No. 29, "Accounting for Nonmonetary Transactions" (New York: AICPA, May 1973).
33 FASB, FASB Statement No. 153, "Exchanges of Nonmonetary Assets: an amendment of APB Opinion No. 29"
(Norwalk, CT: FASB Board, December 2004).
Accounting Principles: A Business Perspective 453 A Global Text
11. Plant asset disposals, natural resources, and intangible assets
substance. However, if the future cash flows are likely to be significantly different, then the exchange of similar
assets has commercial substance.
Exchanges of nonmonetary assets having commercial substance For exchanges of nonmonetary assets
that have commercial substance, accountants record the new asset at the fair market value of the asset received or
the asset(s) given up, whichever is more clearly evident. When the cash price of the new asset is stated, they use the
cash price to record the new asset. If the cash price is not stated, they assume that the fair market value of the old
asset plus any cash paid would equate to the cash price of the new asset and use that value to record the new asset.
Thus, accountants would normally record the asset received at either (1) the stated cash price of the new asset or (2)
a known fair market value of the asset given up plus any cash paid.
Debiting accumulated depreciation and crediting the old asset removes the book value of the old asset from the
accounts. The firm credits the Cash account for any amount paid. If the amount at which the new asset is recorded
exceeds the book value of the old asset plus any cash paid, a company records a gain to balance the journal entry. If
the situation is reversed, it records a loss to balance the journal entry. To illustrate such an exchange having
commercial substance, assume a company exchanges an old machine for a new delivery truck. The future cash flows
from the exchange are expected to be significantly different and, therefore, the exchange has commercial substance.
The machine cost USD 45,000 and had an up-to-date accumulated depreciation balance of USD 38,000. The truck
had a USD 55,000 cash price and was acquired by trading in the machine with a fair value of USD 3,000 and paying
USD 52,000 cash. The journal entry to record the exchange is:
Trucks (+A) 55,000
Accumulated Depreciation—Machinery (+A) 38,000
Loss from Disposal of Plant Assets (-SE) 4,000
Machinery (-A) 45,000
Cash (-A) 52,000
To record loss on exchange of dissimilar plant assets.
Another way to compute the USD 4,000 loss on the exchange is to use the book value of the old asset less the fair
market value of the old asset. The calculation is as follows:
Machine cost $ 45,000 Accumulated depreciation 38,000 Book value $ 7,000 Fair market value of old asset
(trade-in allowance) 3,000 Loss realized $ 4,000
To illustrate the recognition of a gain from such an exchange having commercial substance, assume that the fair
market value of the machine was USD 9,000 instead of USD 3,000, and that only USD 46,000 was paid in cash.
The journal entry to record the exchange would be:
Trucks (+A) 55,000
Accumulated Depreciation—Machinery (+A) 38,000
Machinery (-A) 45,000
Cash (-A) 46,000
Gain on Disposal of Plant Assets(+SE) 2,000
To record gain on exchange of dissimilar assets.
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Another way to compute the gain of USD 2,000 on the exchange is to use the fair market value of the old asset
less the book value of the old asset. The calculation is as follows:
Machine cost $ 45,000 Accumulated depreciation 38,000 Book value $ 7,000 Fair market value of old asset
(trade-in allowance) 9,000 Gain realized $ 2,000
Remember, when the book value and the market value of the old asset are different, companies always recognize
a gain or a loss on an exchange of nonmonetary assets having commercial substance. As discussed earlier, they do
not recognize a gain or loss on an exchange of nonmonetary assets not having commercial substance.
Exchanges of nonmonetary assets not having commercial substance Often firms exchange plant
assets such as automobiles, trucks, and office equipment by trading the old asset for a similar new one. Once in a
while, such an exchange does not result in an expected change in future cash flows and therefore lacks commercial
substance. When such an exchange occurs, the company receives a trade-in allowance for the old asset, and pays
the balance in cash.34 Usually, the cash price of the new asset is stated. If not, accountants assume the cash price of
the new asset is the fair market value of the old asset plus the cash paid.
When such assets are exchanged, we must modify the general rule that new assets are recorded at the fair
market value of what is given up or received, whichever is clearer. Thus, companies record the new asset at the book
value of the old asset plus the cash paid. When applying this rule to exchanges of assets where no commercial
substance results, firms recognize no losses or gains.
To illustrate the accounting for exchanges of nonmonetary assets that do not have commercial substance,
assume that a delivery service exchanged USD 50,000 cash and truck No. 1—which cost USD 45,000, had USD
38,000 of up-to-date accumulated depreciation, and had a USD 5,000 fair market value—for truck No. 2. The new
truck has a cash price (fair market value) of USD 55,000. The delivery service realized a loss of USD 2,000 on the
exchange which cannot be recorded. The loss is calculated as follows:
The journal entry to record the exchange is:
Cost of trunk No. 1 $ 45,000 Accumulated depreciation 38,000 Book value $ 7,000 Fair market value of old asset
(trade-in allowance) 5,000 Loss indicated (but not recorded) $ 2,000
However, if a loss is indicated and is added to the recorded value of the new asset, the asset may later be written
down because of rules of impairment (as required by FASB Standard No. 144), a topic left to Intermediate
Accounting texts.
34 Trade-in allowance is sometimes expressed as the difference between list price and cash paid, but we choose to
define it as the difference between cash price and cash paid because this latter definition seems to agree with
current practice for exchange transactions.
Accounting Principles: A Business Perspective 455 A Global Text
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Truck (cost of No. 2) (+A) 57,000
Accumulated Depreciation—Trucks (+A) 38,000
Trucks (cost of No. 1) (-A) 45,000
Cash (-A) 50,000
To record the exchange of non-monetary assets with no commercial substance (no loss recorded).
Accounting for any gain resulting from exchanges of nonmonetary assets having no commercial substance is
similar to the case where a loss is present but unrecorded. To illustrate, assume that in the preceding example, the
delivery service gave truck No. 1 (now with a fair market value of USD 9,000) and USD 46,000 cash in exchange for
truck No. 2. The gain on the exchange is USD 2,000, but would be unrecorded.
Book value of old truck (No. 1) Cash paid Cost of new truck (No. 2)
$ 7,000 46,000 $ 53,000
1
Fair market value of new truck (No. 2) Less: Gain indicated
$ 55,000 2,000
1
(equal)
Cost of new truck (No. 2) $ 53,000 1
The company would record the new asset at the book value of the old asset (USD 7,000) plus cash paid (USD
46,000). The company deducts the gain from the cost of the new asset (USD 55,000). Thus, the cost basis of the
new delivery truck is equal to USD 55,000 less than the USD 2,000 gain, or USD 53,000. The delivery service uses
this USD 53,000 cost basis in recording depreciation on the truck and determining any gain or loss on its disposal.
The journal entry to record the exchange is:
Cost of trunk No. 1 $ 45,000 Accumulated depreciation 38,000 Book value $ 7,000 Fair market value of old asset (trade-in allowance) 5,000 Loss indicated (but not recorded) $ 2,000
Firms would realize the gain on an exchange of nonmonetary assets not having commercial substance in future
accounting periods as increased net income resulting from smaller depreciation charges on the newly acquired
asset. In the preceding example, annual depreciation expense is less if it is based on the truck's USD 53,000 cost
basis than if it is based on the truck's USD 55,000 cash price. Thus, future net income per year will be larger.
Trucks (cost of No. 2) (+A) 53,000 Accumulated Depreciation—Trucks (+A) 38,000 Trucks (cost of No. 1) (-A) 45,000 Cash (-A) 46,000 To record exchange of nonmonetary assets with no commercial substance (no gain recorded).
In Exhibit 93, we summarize the rules for recording nonmonetary asset exchanges.
An accounting perspective:
Uses of technology
Although sophisticated computer systems automatically compute the gain or loss on the disposal of
assets, such programs depend on human input. If an error was made in inputting the type of
Accounting Principles: A Business Perspective 456 A Global Text
11. Plant asset disposals, natural resources, and intangible assets
disposal or exchange, or if the life of the asset was estimated inaccurately, the calculated gain or
loss would be incorrect.
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Exchanges Having Commercial Substance
Exchanges NOT Having Commercial Substance
Recognize Gains? Yes No Recognize Losses? Yes No Record New Asset At:
Fair market value of asset received (new asset) or fair market value of asset given up (old asset), whichever is more clearly evident
Book value of old asset plus cash paid
Exhibit 93: Summary of rules for recording exchanges of plant assets
Companies incur removal costs when dismantling and removing old plant assets. They deduct these costs from
salvage proceeds to determine the asset's net salvage value. (The removal costs could be greater than the salvage
proceeds.) Accountants associate removal costs with the old asset, not the new asset acquired as a replacement.
The next section discusses natural resources. Note the underlying accounting principle of matching the expenses
with the revenues earned in that same accounting period.
Natural resources
Resources supplied by nature, such as ore deposits, mineral deposits, oil reserves, gas deposits, and timber
stands, are natural resources or wasting assets. Natural resources represent inventories of raw materials that
can be consumed (exhausted) through extraction or removal from their natural setting (e.g. removing oil from the
ground).
On the balance sheet, we classify natural resources as a separate group among noncurrent assets under headings
such as "Timber stands" and "Oil reserves". Typically, we record natural resources at their cost of acquisition plus
exploration and development costs; on the balance sheet, we report them at total cost less accumulated depletion.
(Accumulated depletion is similar to the accumulated depreciation used for plant assets.) When analyzing the
financial condition of companies owning natural resources, exercise caution because the historical costs reported
for the natural resources may be only a small fraction of their current value.
An accounting perspective:
Business insight
Kerr-McGee Corporation is a global energy and chemical company engaged in oil and gas
exploration and production, and the production and marketing of titanium dioxide pigment. In
notes to its financial statements, Kerr-McGee states that the company's geologists and engineers in
accordance with the Securities and Exchange Commission definitions have prepared estimates of
proved reserves. These estimates include reserves that may be obtained in the future by improved
recovery methods now in operation or for which successful testing has been exhibited.
Depletion is the exhaustion that results from the physical removal of a part of a natural resource. In each
accounting period, the depletion recognized is an estimate of the cost of the natural resource that was removed
from its natural setting during the period. To record depletion, debit a Depletion account and credit an
Accumulated Depletion account, which is a contra account to the natural resource asset account.
Accounting Principles: A Business Perspective 458 A Global Text
11. Plant asset disposals, natural resources, and intangible assets
By crediting the Accumulated Depletion account instead of the asset account, we continue to report the original
cost of the entire natural resource on the financial statements. Thus, statement users can see the percentage of the
resource that has been removed. To determine the total cost of the resource available, we combine this depletion
cost with other extraction, mining, or removal costs. We can assign this total cost to either the cost of natural
resources sold or the inventory of the natural resource still on hand. Thus, we could expense all, some, or none of
the depletion and removal costs recognized in an accounting period, depending on the portion sold. If all of the
resource is sold, we expense all of the depletion and removal costs. The cost of any portion not yet sold is part of the
cost of inventory.
Computing periodic depletion cost To compute depletion charges, companies usually use the units-of-
production method. They divide total cost by the estimated number of units—tons, barrels, or board feet—that can
be economically extracted from the property. This calculation provides a per-unit depletion cost. For example,
assume that in 2010 a company paid USD 650,000 for a tract of land containing ore deposits. The company spent
USD 100,000 in exploration costs. The results indicated that approximately 900,000 tons of ore can be removed
economically from the land, after which the land will be worth USD 50,000. The company incurred costs of USD
200,000 to develop the site, including the cost of running power lines and building roads. Total cost subject to
depletion is the net cost assignable to the natural resource plus the exploration and development costs. When the
property is purchased, a journal entry assigns the purchase price to the two assets purchased—the natural resource
and the land. The entry would be:
Land (+A) 50,000
Ore Deposits (+A) 600,000
Cash (-A) 650,000
To record purchase of land and mine.
After the purchase, an entry debits all costs to develop the site (including exploration) to the natural resource
account. The entry would be:
Ore Deposits ($100,000 + $200,000) (+A) 300,000
Cash (-A) 300,000
To record costs of exploration and development.
The formula for finding depletion cost per unit is:
Depletion cost per unit= Cost of site – Residual valueof land if owned Costsdevelop site
Estimated number of units that can beeconomicallyextracted
In some instances, companies buy only the right to extract the natural resource from someone else's land. When
the land is not purchased, its residual value is irrelevant and should be ignored. If there is an obligation to restore
the land to a usable condition, the firm adds these estimated restoration costs to the costs to develop the site.
In the example where the land was purchased, the total costs of the mineral deposits equal the cost of the site
(USD 650,000) minus the residual value of land (USD 50,000) plus costs to develop the site (USD 300,000), or a
total of USD 900,000. The unit (per ton) depletion charge is USD 1 (or USD 900,000/900,000 tons). The formula
to compute the depletion cost of a period is:
Depletion cost of a period=Depletion cost per unit×Number of unitsextracted during period
In this example, if 100,000 tons are mined in 2010, this entry records the depletion cost of USD 100,000 (USD 1
X 100,000) for the period:
Depletion (-SE) 100,000
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Accumulated Depletion—Ore Deposits 4 (-A) 100,000
To record depletion for 2010.
35
The Depletion account contains the "in the ground" cost of the ore or natural resource mined. Combined with
other extractive costs, this cost determines the total cost of the ore mined. To illustrate, assume that in addition to
the USD 100,000 depletion cost, mining labor costs totaled USD 320,000, and other mining costs, such as
depreciation, property taxes, power, and supplies, totaled USD 60,000. If 80,000 tons were sold and 20,000
remained on hand at the end of the period, the firm would allocate the total cost of USD 480,000 as follows:
Depletion cost USD 100,000 Mining labor costs 320,000 Other mining costs 60,000 Total cost of 100,000 tons mined (USD 4.80 per ton) USD 480,000 Less: One inventory (20,000 tons at USD 4.80) 96,000 Cost of ore sold (80,000 tons at USD 4.80) USD 384,000
Note that the average cost per ton to mine 100,000 tons was USD 4.80 (or USD 480,000/100,000). The income
statement would show cost of ore sold of USD 384,000. The mining company does not report depletion separately
as an expense because depletion is included in cost of ore sold. The balance sheet would show inventory of ore on
hand (a current asset) at USD 96,000 (or USD 4.80 X 20,000). Also, it would report the cost less accumulated
depletion of the natural resource as follows:
One deposits $900,000 Less: Accumulated depletion 100,000 $ 800,000
Another method of calculating depletion cost is the percentage of revenue method. Because firms use this
method only for income tax purposes and not for financial statements, we do not discuss it in this text.
Companies depreciate plant assets erected on extractive industry property the same as other depreciable assets.
If such assets will be abandoned when the natural resource is exhausted, they depreciate these assets over the
shorter of the (a) physical life of the asset or (b) life of the natural resource. In many cases, firms compute periodic
depreciation charges using the units-of-production method. Using this method matches the life of the plant asset
with the life of the natural resource. This method is recommended where the physical life of the plant asset equals
or exceeds the resource's life but its useful life is limited to the life of the natural resource.
Assume a mining company acquires mining property with a building it plans to use only in the mining
operations. Also assume that the firm uses the units-of-production method for computing building depreciation.
Relevant facts are:
Building cost $310,000
Estimated physical life of building 20 year s
Estimated salvage value of building (after mine is exhausted)
$ 10,000
Capacity of mine 1,000,000 tons Expected life of mine 10 year
s
35 Instead of crediting the accumulated depletion account, the Ore Deposits account could have been credited
directly. But for reasons indicated earlier, the credit is usually to an accumulated depletion account.
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11. Plant asset disposals, natural resources, and intangible assets
Because the life of the mine (10 years or 1,000,000 tons) is shorter than the life of the building (20 years), the
building should be depreciated over the life of the mine. The basis of the depreciation charge is tons of ore rather
than years because the mine's life could be longer or shorter than 10 years, depending on how rapidly the ore is
removed.
Suppose that during the first year of operations, workers extracted 150,000 tons of ore. Building depreciation
for the first year is USD 45,000, computed as follows:
Depreciation per unit= Asset cost – Estimated salvage value
Total tons of ore∈minethat can beeconomicallyextracted
= $310,000−$10,000
1,000,000 tons=$0.30 per ton
Depreciation for year=Depreciation per unit X Unitsextracted
USD 0.30 per ton X150,000 tons=USD 45,000
On the income statement, depreciation on the building appears as part of the cost of ore sold and is carried as
part of inventory cost for ore not sold during the period. On the balance sheet, accumulated depreciation on the
building appears with the related asset account.
Plant assets and natural resources are tangible assets used by a company to produce revenues. A company also
may acquire intangible assets to assist in producing revenues.
Intangible assets
Although they have no physical characteristics, intangible assets have value because of the advantages or
exclusive privileges and rights they provide to a business. Intangible assets generally arise from two sources: (1)
exclusive privileges granted by governmental authority or by legal contract, such as patents, copyrights, franchises,
trademarks and trade names, and leases; and (2) superior entrepreneurial capacity or management know-how and
customer loyalty, which is called goodwill.
All intangible assets are nonphysical, but not all nonphysical assets are intangibles. For example, accounts
receivable and prepaid expenses are nonphysical, yet classified as current assets rather than intangible assets.
Intangible assets are generally both nonphysical and noncurrent; they appear in a separate long-term section of the
balance sheet entitled "Intangible assets".
Initially, firms record intangible assets at cost like most other assets. However, computing an intangible asset's
acquisition cost differs from computing a plant asset's acquisition cost. Firms may include only outright purchase
costs in the acquisition cost of an intangible asset; the acquisition cost does not include cost of internal
development or self-creation of the asset. If an intangible asset is internally generated in its entirety, none of its
costs are capitalized. Therefore, some companies have extremely valuable assets that may not even be recorded in
their asset accounts. To explain the reasons for this practice, we discuss the history of accounting for research and
development costs next.
Research and development (R&D) costs are costs incurred in a planned search for new knowledge and in
translating such knowledge into new products or processes. Prior to 1975, businesses often capitalized research and
development costs as intangible assets when future benefits were expected from their incurrence. Due to the
difficulty of determining the costs applicable to future benefits, many companies expensed all such costs as
incurred. Other companies capitalized those costs that related to proven products and expensed the rest as
incurred.
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As a result of these varied accounting practices, in 1974 the Financial Accounting Standards Board in Statement
No. 2 ruled that firms must expense all research and development costs when incurred, unless they were directly
reimbursable by government agencies and others. Immediate expensing is justified on the grounds that (1) the
amount of costs applicable to the future cannot be measured with any high degree of precision; (2) doubt exists as
to whether any future benefits will be received; and (3) even if benefits are expected, they cannot be measured.
Thus, research and development costs no longer appear as intangible assets on the balance sheet. The Board applies
the same line of reasoning to other costs associated with internally generated intangible assets, such as the internal
costs of developing a patent.
Amortization is the systematic write-off of the cost of an intangible asset to expense. A portion of an intangible
asset's cost is allocated to each accounting period in the economic (useful) life of the asset. All intangible assets are
not subject to amortization. Only recognized intangible assets with finite useful lives are amortized. The finite
useful life of such an asset is considered to be the length of time it is expected to contribute to the cash flows of the
reporting entity. (Pertinent factors that should be considered in estimating useful life include legal, regulatory, or
contractual provisions that may limit the useful life). The method of amortization should be based upon the pattern
in which the economic benefits are used up or consumed. If no pattern is apparent, the straight-line method of
amortization should be used by the reporting entity.
Recognized intangible assets deemed to have indefinite useful lives are not to be amortized. Amortization will
however begin when it is determined that the useful life is no longer indefinite. The method of amortization would
follow the same rules as intangible assets with finite useful lives.36
Straight-line amortization is calculated the same was as straight-line depreciation for plant assets. Generally, we
record amortization by debiting Amortization Expense and crediting the intangible asset account. An accumulated
amortization account could be used to record amortization. However, the information gained from such accounting
would not be significant because normally intangibles do not account for as many total asset dollars as do plant
assets.
A patent is a right granted by the federal government. This exclusive right enables the owner to manufacture,
sell, lease, or otherwise benefit from an invention for a limited period. The value of a patent lies in its ability to
produce revenue. Patents have a legal life of 17 years. Protection for the patent owner begins at the time of patent
application and lasts for 17 years from the date the patent is granted.
When purchasing a patent, a company records it in the Patents account at cost. The firm also debits the Patents
account for the cost of the first successful defense of the patent in lawsuits (assuming an outside law firm was hired
rather than using internal legal staff). Such a lawsuit establishes the validity of the patent and thereby increases its
service potential. In addition, the firm debits the cost of any competing patents purchased to ensure the revenue-
generating capability of its own patent to the Patents account.
The firm would amortize the cost of a purchased patent over its finite life which reasonably would not exceed its
legal life. If a patent cost USD 40,000 and has a useful life of 10 years, the journal entries to record the patent and
periodic amortization are:
Patents (+A) 40,000
Cash (-A) 40,000
To record purchases of patent.
36 FASB, SFAS No. 142. " Goodwill and Other Intangible Assets" (CT: FASB, June 2001), par. 11.
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11. Plant asset disposals, natural resources, and intangible assets
Patient Amortization Expense (-SE) 4,000
Patents (-A) 4,000
To record annual patent amortization.
For a patent that becomes worthless before it is fully amortized, the company expenses the unamortized balance
in the Patents account.
As noted earlier, all R&D costs incurred in the internal development of a product, process, or idea that is later
patented must be expensed, rather than capitalized. In the previous example, the company amortized the cost of the
purchased patent over its useful life of 10 years. If the patent had been the result of an internally generated product
or process, the firm would have expensed its cost of USD 40,000 as incurred, in accordance with Statement No. 2
of the Financial Accounting Standards Board.
A copyright is an exclusive right granted by the federal government giving protection against the illegal
reproduction by others of the creator's written works, designs, and literary productions. The finite useful life for a
copyright extends to the life of the creator plus 50 years.37 Most publications have a limited (finite) life; a creator
may amortize the cost of the copyright to expense on a straight-line basis or based upon the pattern in which the
economic benefits are used up or consumed.
A franchise is a contract between two parties granting the franchisee (the purchaser of the franchise) certain
rights and privileges ranging from name identification to complete monopoly of service. In many instances, both
parties are private businesses. For example, an individual who wishes to open a hamburger restaurant may
purchase a McDonald's franchise; the two parties involved are the individual business owner and McDonald's
Corporation. This franchise would allow the business owner to use the McDonald's name and golden arch, and
would provide the owner with advertising and many other benefits. The legal life of a franchise may be limited by
contract.
The parties involved in a franchise arrangement are not always private businesses. A government agency may
grant a franchise to a private company. A city may give a franchise to a utility company, giving the utility company
the exclusive right to provide service to a particular area.
In addition to providing benefits, a franchise usually places certain restrictions on the franchisee. These
restrictions generally are related to rates or prices charged; also they may be in regard to product quality or to the
particular supplier from whom supplies and inventory items must be purchased.
If periodic payments to the grantor of the franchise are required, the franchisee debits them to a Franchise
Expense account. If a lump-sum payment is made to obtain the franchise, the franchisee records the cost in an asset
account entitled Franchise and amortizes it over the finite useful life of the asset. The legal life (if limited by
contract) and the economic life of the franchise may limit the finite useful life.
A trademark is a symbol, design, or logo used in conjunction with a particular product or company. A trade
name is a brand name under which a product is sold or a company does business. Often trademarks and trade
names are extremely valuable to a company, but if they have been internally developed, they have no recorded asset
cost. However, when a business purchases such items from an external source, it records them at cost and
amortizes them over their finite useful life.
37 In 1998 Congress changed the period from 50 to 70 years. At this writing, the Supreme Court was reviewing the
constitutionality of this change.
463
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A lease is a contract to rent property. The property owner is the grantor of the lease and is the lessor. The
person or company obtaining rights to possess and use the property is the lessee. The rights granted under the lease
are a leasehold. The accounting for a lease depends on whether it is a capital lease or an operating lease.
Capital leases A capital lease transfers to the lessee virtually all rewards and risks that accompany
ownership of property. A lease is a capital lease if, among other provisions, it (1) transfers ownership of the leased
property to the lessee at the end of the lease term or (2) contains a bargain purchase option that permits the lessee
to buy the property at a price significantly below fair market value at the end of the lease term.
A capital lease is a means of financing property acquisitions; it has the same economic impact as a purchase
made on an installment plan. Thus, the lessee in a capital lease must record the leased property as an asset and the
lease obligation as a liability. Because a capital lease is an asset, the lessee depreciates the leased property over its
useful life. The lessee records part of each lease payment as interest expense and the balance as a payment on the
lease liability.
The proper accounting for capital leases for both lessees and lessors has been an extremely difficult problem. We
leave further discussion of capital leases for an intermediate accounting text.
Operating leases A lease that does not qualify as a capital lease is an operating lease. A one-year lease on an
apartment and a week's rental of an automobile are examples of operating leases. Such leases make no attempt to
transfer any of the rewards and risks of ownership to the lessee. As a result, there may be no recordable transaction
when a lease is signed.
In some situations, the lease may call for an immediate cash payment that must be recorded. Assume that a
business signed a lease requiring the immediate payment of the annual rent of USD 15,000 for each of the first and
fifth years of a five-year lease. The lessee would record the payment as follows:
Prepaid Rent (+A) 15,000
Leasehold (+A) 15,000
Cash (-A) 30,000
To record first and fifth years' rent on a five-year lease.
Since the Leasehold account is actually a long-term prepaid rent account for the fifth year's annual rent, it is an
intangible asset until the beginning of the fifth year. Then the Leasehold account becomes a current asset and may
be transferred into a Prepaid Rent account. Accounting for the balance in the Leasehold account depends on the
terms of the lease. In the previous example, the firm would charge the USD 15,000 in the Leasehold account to
expense over the fifth year only. It would charge the balance in Prepaid Rent to expense in the first year. Thus,
assuming the lease year and fiscal year coincide, the entry for the first year is:
Rent Expense (-SE) 15,000
Prepaid Rent (-A) 15,000
To record rent expense.
The entry in the fifth year is:
Rent Expense (-SE) 15,000
Leasehold (-A) 15,000
To record rent expense.
The accounting for the second, third, and fourth years would be the same as for the first year. The lessee records
the rent in Prepaid Rent when paid in advance for the year and then expenses it. As stated above, the lessee may
Accounting Principles: A Business Perspective 464 A Global Text
11. Plant asset disposals, natural resources, and intangible assets
transfer the amount in the Leasehold account to Prepaid Rent at the beginning of the fifth year by debiting Prepaid
Rent and crediting Leasehold. If this entry was made, the previous entry would have credited Prepaid Rent.
In some cases, when a lease is signed, the lump-sum payment does not cover a specific year's rent. The lessee
debits this payment to the Leasehold account and amortizes it over the life of the lease. The straight-line method is
required unless another method can be shown to be superior. Assume the USD 15,000 rent for the fifth year in the
example was, instead, a lump-sum payment on the lease in addition to the annual rent payments. An annual
adjusting entry to amortize the USD 15,000 over five years would read:
Rent Expense (-SE) 3,000
Leasehold (-A) 3,000
To amortize leasehold.
In this example, the annual rental expense is USD 18,000: USD 15,000 annual cash rent plus USD 3,000
amortization of leasehold (USD 15,000/5).
The lessee may base periodic rent on current-year sales or usage rather than being a constant amount. For
example, if a lease called for rent equal to 5 per cent of current-year sales and sales were USD 400,000 in 2010, the
rent for 2010 would be USD 20,000. The rent would either be paid or an adjusting entry would be made at the end
of the year.
A leasehold improvement is any physical alteration made by the lessee to the leased property in which
benefits are expected beyond the current accounting period. Leasehold improvements made by a lessee usually
become the property of the lessor after the lease has expired. However, since leasehold improvements are an asset
of the lessee during the lease period, the lessee debits them to a Leasehold Improvements account. The lessee then
amortizes the leasehold improvements to expense over the period benefited by the improvements. The amortization
period for leasehold improvements should be the shorter of the life of the improvements or the life of the lease. If
the lease can (and probably will) be renewed at the option of the lessee, the life of the lease should include the
option period.
As an illustration, assume that on 2010 January 2, Wolf Company leases a building for 20 years under a
nonrenewable lease at an annual rental of USD 20,000, payable on each December 31. Wolf immediately incurs a
cost of USD 80,000 for improvements to the building, such as interior walls for office separation, ceiling fans, and
recessed lighting. The improvements have an estimated life of 30 years. The company should amortize the USD
80,000 over the 20-year lease period, since that period is shorter than the life of the improvements, and Wolf
cannot use the improvements beyond the life of the lease. If only annual financial statements are prepared, the
following journal entry properly records the rental expense for the year ended 2010 December 31:
Rent Expense (or Leasehold Improvement Expense) (-SE)
4,000
Leasehold Improvements (-A) 4,000
To record amortization of leasehold improvement.
Rent Expense (-SE) 20,000
Cash (-A) 20,000
To record annual rent.
Thus, the total cost to rent the building each year equals the USD 20,000 cash rent plus the amortization of the
leasehold improvements.
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Although leaseholds are intangible assets, leaseholds and leasehold improvements sometimes appear in the
property, plant, and equipment section of the balance sheet.
In accounting, goodwill is an intangible value attached to a company resulting mainly from the company's
management skill or know-how and a favorable reputation with customers. A company's value may be greater than
the total of the fair market value of its tangible and identifiable intangible assets. This greater value means that the
company generates an above-average income on each dollar invested in the business. Thus, proof of a company's
goodwill is its ability to generate superior earnings or income.
A goodwill account appears in the accounting records only if goodwill has been purchased. A company cannot
purchase goodwill by itself; it must buy an entire business or a part of a business to obtain the accompanying
intangible asset, goodwill.
To illustrate, assume that Lenox Company purchased all of Martin Company's assets for USD 700,000. Lenox
also agreed to assume responsibility for a USD 350,000 mortgage note payable owed by Martin. Goodwill is the
difference between the amount paid for the business including the debt assumed (USD 700,000 + USD 350,000 =
USD 1,050,000) and the fair market value of the assets purchased. Notice that Lenox would use the fair market
value of the assets rather than book value to determine the amount of goodwill. The following computation is for
the goodwill purchased by Lenox:
Cash paid $ 700,000
Mortgage note payable 350,000
Total price paid $1,050,000
Less fair market values of individually identifiable assets:
Accounts receivable $ 95,000
Merchandise inventory 100,000
Land 240,000
Buildings 275,000
Equipment 200,000
Patents 65,000 975,000 Goodwill $ 75,000
The USD 75,000 is the goodwill Lenox records as an intangible asset; it records all of the other assets at their
fair market values, and the liability at the amount due.
Accounting Principles: A Business Perspective 466 A Global Text
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ANY COMPANY Partial Balance Sheet 2010 June 30
Property, plant, and equipment Land Buildings $ 75,000
$ 30,000
Less: Accumulated depreciation 45,000 30,000
Equipment $ 9,000 Less: Accumulated depreciation 1,500 7,500 Total property, plant, and equipment $ 67,500
Natural resources: Mineral deposits Less: Accumulated depreciation
$300,000 100,000
Total natural resources $200,00 0
Intangible assets: Patents Goodwill Total intangible assets
$ 10,000 20,000 $ 30,000
Exhibit 94: Partial balance sheet
Specific reasons for a company's goodwill include a good reputation, customer loyalty, superior product design,
unrecorded intangible assets (because they were developed internally), and superior human resources. Since these
positive factors are not individually quantifiable, when grouped together they constitute goodwill. The journal entry
to record the purchase is:
Accounts Receivable (+A) 95,000
Merchandise Inventory (+A) 100,000
Land (+A) 240,000
Buildings (+A) 275,000
Equipment(+A) 200,000
Patents (+A) 65,000
Goodwill(+A) 75,000
Cash (-A) 700,000
Mortgage Note Payable (+L) 350,000
To record the purchase of Martin Company's assets and assumption of mortgage note payable.
The intangible asset goodwill is not amortized. Goodwill is to be tested periodically for impairment. The amount
of any goodwill impairment loss is to be recognized in the income statement as a separate line before the subtotal
income from continuing operations (or similar caption).38 The goodwill account would be reduced by the same
amount.39
Look at Exhibit 94, a partial balance sheet for ANY company. Unlike plant assets or natural resources, intangible
assets usually are a net amount in the balance sheet.
38 Discussion of testing for impairment is beyond the scope of this text. For more information on such testing see
SFAS No. 142.
39 SFAS No. 142. par. 18.
Accounting Principles: A Business Perspective 467 A Global Text
11. Plant asset disposals, natural resources, and intangible assets
Analyzing and using the financial results—Total assets turnover
In determining the productivity of assets, management may compare one year's assets turnover ratio to a
previous year's. Total assets turnover shows the relationship between the dollar volume of sales and the average
total assets used in the business. To calculate this ratio:
Total assets turnover= Net sales
Average totalassets
This ratio indicates the efficiency with which a company uses its assets to generate sales. When the ratio is low
relative to industry standards or the company's ratio in previous years, it could indicate an over-investment in
assets, a slow year in sales, or both. Thus, if the ratio is relatively low and there was no significant decrease in sales
during the current year, management should identify and dispose of any inefficient equipment.
The total assets turnover in a recent year for several actual companies was as follows:
Total Assets ($ thousands)
Net Sales Beginning
Company ($ thousands) of Year End of Year Average Turnover
Procter & Gamble
$ 39,244,000 $ 34,366,000 $ 37,374,300
$ 35,870,150
109.41%
Tyco International
28,931,900 32,344,300 40,404,300
36,374,300 79.54%
Kimball International
1,261,171 723,651 678,984 701,318 179.83%
These three companies compete in very different industries. However, they are all manufacturers. To see if each
of these companies is performing above standard, management should compare its company's percentage to the
industry's standard. In addition, calculating this ratio over approximately five years would help management see
any trends indicating problems or confirm successful asset management.
This chapter concludes your study of accounting for long-term assets. In Chapter 12, you learn about classes of
capital stock.
Understanding the learning objectives
• By comparing an asset's book value (cost less up-to-date accumulated depreciation) with its sales price, the
company may show either a gain or a loss. If sales price is greater than book value, the company shows a gain.
If sales price is less than book value, the company shows a loss. If sales price equals book value, no gain or loss
results.
• When a plant asset is retired from service, the asset's cost and accumulated depreciation must be removed
from the plant asset accounts.
• Plant assets are sometimes wrecked in accidents or destroyed by fire, flood, storm, and other causes. If the
asset was not insured, the loss is equal to the book value. If the asset was insured, only the amount of the loss
exceeding the amount to be recovered from the insurance company would be debited to a loss account.
• In exchanges of nonmonetary assets having commercial substance, the firm records the asset received at
either (1) the stated cash price of the new asset or (if the cash price is not stated) (2) the known fair market
value of the asset given up plus any cash paid.
• In exchanges of nonmonetary assets not having commercial substance, the firm records the new asset at the
book value of the old asset plus the cash paid.
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An ethical perspective:
ABC corporation
In 2010, prior to the tax law change permitting the amortization of goodwill for tax purposes, ABC
Corporation acquired XYZ Company for USD 10,000,000 cash. ABC acquired the following assets:
Accounts receivable $80,000 Old Book Fair Market
Value Value
Merchandise inventory $ 200,000 $ 300,000 Buildings 3,000,000 4,000,000 Land 1,000,000 3,000,000 Equipment 500,000 700,000
An experienced appraiser with an excellent reputation established the fair market value of the
assets. ABC also assumed the liability for paying XYZ's USD 50,000 of accounts payable.
John Gilbert, ABC's accountant, prepared the following journal entry to record the purchase: In
explaining the entry to ABC's president, Gilbert said that the assets had to be recorded at their fair
market values. He also stated that the goodwill could not be amortized for accounting purposes or
tax purposes.
Accounts Receivable (+A)
80,000
Merchandise Inventory (+A)
300,000
Buildings (+A) 4,000,000
Land (+A) 3,000,000
Equipment (+A) 700,000
Goodwill (+A) 1,970,000
Accounts Payable (+L) 50,000
Cash (-A) 10,000,000
To record the
purchase of XYZ
Company.
The president reacted with, "It is not fair that we are prohibited from amortizing goodwill when it is
a part of the cost of the purchase. Besides, appraisals are very inexact, and maybe some of our other
assets are worth more than the one appraiser indicated. I want you to reduce goodwill down to USD
470,000 and assign the other USD 1,500,000 to the buildings and equipment. Then, we can benefit
from the depreciation on these assets. If I need to find an appraiser who will support the new
allocations, I will."
When Gilbert protested, the president stated, "If you are going to have a future with us, you need to
be a team player. We just cannot afford to lose those tax deductions." Gilbert feared that if he did
not go along, he would soon be unemployed.
Accounting Principles: A Business Perspective 469 A Global Text
11. Plant asset disposals, natural resources, and intangible assets
• Depletion charges usually are computed by the units-of-production method. Total cost is divided by the
estimated number of units that are economically extractable from the property. This calculation provides a per
unit depletion cost that is multiplied by the units extracted each year to obtain the depletion cost for that year.
• Depreciable assets located on extractive industry property should be depreciated over the shorter of the (1)
physical life of the asset or (2) life of the natural resource. The periodic depreciation charges usually are
computed using the units-of-production method. Using this method matches the life of the plant asset with the
life of the natural resource.
• Only outright purchase costs are included in the acquisition cost of an intangible asset. If an intangible
asset is internally generated, its cost is immediately expensed.
• Intangibles should be amortized over their finite useful lives. The method of amortization should be based
upon the pattern in which the economic benefits are used up. If no pattern is apparent, straight-line
amortization should be used.
• Total assets turnover= Net sales
Average total assets
• This ratio indicates the efficiency with which a company uses its assets to generate sales.
Demonstration problem
Demonstration problem A On 2007 January 2, Darton Company purchased a machine for USD 36,000
cash. The machine has an estimated useful life of six years and an estimated salvage value of USD 1,800. Darton
uses the straight-line method of depreciation.
a. Compute the book value of the machine as of 2010 July 1.
b. Assume the machine was disposed of on 2010 July 1. Prepare the journal entries to record the disposal of the
machine under each of the following unrelated assumptions:
• The machine was sold for USD 12,000 cash.
• The machine was sold for USD 18,000 cash.
• The machine and USD 24,000 cash were exchanged for a new machine that had a cash price of USD
39,000. The exchange has commercial substance.
• The machine was completely destroyed by fire. Darton expects to recover cash of USD 10,800 from the
insurance company.
Demonstration problem B Howard Company acquired on 2010 January 1, a tract of property containing
timber at a cost of USD 8,000,000. After the timber is removed, the land will be worth about USD 3,200,000 and
will be sold to another party. Costs of developing the site were USD 800,000. A building was erected at a cost of
USD 160,000. The building had an estimated physical life of 20 years and will have an estimated salvage value of
USD 80,000 when the timber is gone. It was expected that 50,000,000 board feet of timber can be economically
cut. During the first year, 16,000,000 board feet were cut. Howard uses the units-of-production basis to depreciate
the building.
Prepare the entries to record:
a. The acquisition of the property.
b. The development costs.
c. Depletion cost for the first year.
d. Depreciation on the building for the first year.
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Demonstration problem C On 2010 January 2, Bedford Company purchased a 10-year sublease on a
warehouse for USD 30,000. Bedford will also pay annual rent of USD 6,000. Bedford immediately incurred costs of
USD 20,000 for improvements to the warehouse, such as lighting fixtures, replacement of a ceiling, heating system,
and loading dock. The improvements have an estimated life of 12 years and no residual value.
Prepare the entries to record:
a. The payment for the sublease on a warehouse.
b. The rent payment for the first year.
c. The payment for the improvements.
d. Amortization of the leasehold for the first year.
e. Amortization of the leasehold improvements for the first year.
Solution to demonstration problem
Solution to demonstration problem A
a. DARTON COMPANY Schedule to Compute Book Value 2010 July 1
Cost Less accumulated depreciation: ($35,000 - $1,800)/6 years= $5,700 per year $5,700 X 31 1/2 years = $19,950 Book value
$ 36,000
19,950 $ 16,050
b. (1) Cash (+A) Accumulated Depreciation—Machinery (+A) Loss from Disposal of Plant Assets (-SE) Machinery (-A) To record the sale of machinery at loss.
12,000 19,950 4,050 36,000
(2) Cash (+A) Accumulated Depreciation—Machinery (+A) Machinery (-A) Gain on Disposal of Plant Assets (+SE) To record sale of machinery at a gain.
18,000 19,950 36,000
1,950
Accounting Principles: A Business Perspective 471 A Global Text
11. Plant asset disposals, natural resources, and intangible assets
Machinery (new) (+A) 39,000
Accumulated Depreciation—Machinery (+A) 19,950
Loss from Disposal of Plant Asset (-SE) 1,050
Machinery (old) (-A) 36,000
Cash (-A) 24,000
To record exchange of machines.
The exchange has commercial substance.
Receivable from Insurance Company (+A) 10,800
Accumulated Depreciation—Machinery (+A) 19,950
Fire Loss (-SE) 5,250
Machinery (-A) 36,000
To record loss of machinery.
Solution to demonstration problem B
a. Land (+A) Timber Stands (+A) Cash (-A) To record purchase of land and timber.
3,200,00 0 4,800,00 0
8,000,00 0
b. Timber Stands (+A) Cash (-A) To record costs of development of the site.
800,000 800,000
c. Depletion (-SE) Accumulated Depletion—Timber Stands (-A) To record depletion for 2007. ($4,800,000 + $800,000/50,000,000 = $0.112 per board foot. $0.112 X 16,000,000 = $1,792,000.)
1,792,00 0 1,792,00
0
d. Depreciation Expense—Buildings (-SE) Accumulated Depreciation—Buildings (-A) To record depreciation expense: ($160,000 - $80,000)/50,000,000 board feet = $0.0016 per board foot. $0.0016 X 16,000,000 = $25,600.
25,600 25,600
Solution to demonstration problem C
a. Leasehold (+A) Cash (-A) To record purchase of sublease on warehouse.
30,000 30,000
b. Rent Expense (-SE) Cash (-A) To record annual rent payment.
6,000 6,000
c. Leasehold Improvements (+A) Cash (-A) To record payment for leasehold improvements.
20,000 20,000
d. Rent Expense(-SE) Leasehold (-A) To record leasehold amortization for 2007: Annual amortization = $30,000/10 years = $3,000
3,000 3,000
e. Rent Expense (-SE) Leasehold Improvements (+A) To amortize leasehold improvements: Annual amortization = $20,000/10years = $2,000
2,000 2,000
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Key terms Amortization The term used to describe the systematic write-off of the cost of an intangible asset to expense.
Capital lease A lease that transfers to the lessee virtually all of the rewards and risks that accompany ownership of property.
Commercial substance The result if an exchange of nonmonetary assets causes future cash flows to differ significantly.
Copyright An exclusive right granted by the federal government giving protection against the illegal reproduction by others of the creator's written works, designs, and literary productions.
Depletion The exhaustion of a natural resource; an estimate of the cost of the resource that was removed from its natural setting during the period.
Finite Useful Life Length of time an intangible asset is expected to contribute to the cash flows of the entity.
Franchise A contract between two parties granting the franchisee (the purchaser of the franchise) certain rights and privileges ranging from name identification to complete monopoly of service.
Goodwill An intangible value attached to a company resulting mainly from the company's management skill or know-how and a favorable reputation with customers. Evidenced by the ability to generate an above- average rate of income on each dollar invested in the business.
Intangible assets Items that have no physical characteristics but are of value because of the advantages or exclusive privileges and rights they provide to a business.
Lease A contract to rent property. Grantor of the lease is the lessor; the party obtaining the rights to possess and use property is the lessee.
Leasehold The rights granted under a lease.
Leasehold improvement Any physical alteration made by the lessee to the leased property in which benefits are expected beyond the current accounting period.
Natural resources Resources supplied by nature, such as ore deposits, mineral deposits, oil reserves, gas deposits, and timber stands supplied by nature.
Operating lease A lease that does not qualify as a capital lease.
Patent A right granted by the federal government giving the owner the exclusive right to manufacture, sell, lease, or otherwise benefit from an invention for a limited period.
Research and development (R&D) costs Costs incurred in a planned search for new knowledge and in translating such knowledge into a new product or process.
Total assets turnover Equal to Net sales/Average total assets. This ratio indicates the efficiency with which a company uses its assets to generate sales.
Trademark A symbol, design, or logo used in conjunction with a particular product or company.
Trade name A brand name under which a product is sold or a company does business.
Wasting assets See Natural resources.
Self-test
True-false
Indicate whether each of the following statements is true or false.
When a plant asset is still being used after it has been fully depreciated, depreciation can be taken in excess of its
cost.
In an exchange of nonmonetary assets having commercial substance, the new asset is recorded at the fair market
value of the asset received or the fair market value of the asset given up plus cash paid, whichever is more clearly
evident.
In calculating depletion, the residual value of acquired land containing an ore deposit is included in total costs
subject to depletion.
All recorded intangible assets are subject to amortization.
Accounting Principles: A Business Perspective 473 A Global Text
11. Plant asset disposals, natural resources, and intangible assets
Multiple-choice
Select the best answer for each of the following questions.
When a fully depreciated asset is still in use:
a. Prior years' depreciation should be adjusted.
b. The cost should be adjusted to market value.
c. Part of the depreciation should be reversed.
d. The cost and accumulated depreciation should remain in the ledger and no more depreciation should be
taken.
e. It should be written off the books.
A truck costing USD 45,000 and having an estimated salvage value of USD 4,500 and an original life of five
years is exchanged for a new truck. The cash price of the new truck is USD 57,000, and a trade-in allowance of USD
22,500 is received. The old truck has been depreciated for three years using the straight-line method. The new truck
would be recorded at:
a. USD 55,200.
b. USD 57,000.
c. USD 34,500.
d. USD 43,200.
e. None of the above.
Land containing a mine having an estimated 1,000,000 tons of economically extractable ore is purchased for
USD 375,000. After the ore deposit is removed, the land will be worth USD 75,000. If 100,000 tons of ore are
mined and sold during the first year, the depletion cost charged to expense for the year is:
a. USD 300,000.
b. USD 37,500.
c. USD 30,000.
d. USD 375,000.
e. None of the above.
Bren Company purchased a patent for USD 36,000. The patent is expected to have a finite life of 10 years even
though its legal life is 17 years. The amortization for the first year is:
a. USD 36,000.
b. USD 3,600.
c. USD 2,118.
d. USD 3,240.
e. None of the above.
Now turn to “Answers to self-test” at the end of the chapter to check your answers.
Questions
➢ When depreciable plant assets are sold for cash, how is the gain or loss measured?
➢ A plant asset that cost USD 27,000 and has a related accumulated depreciation account balance of
USD 27,000 is still being used in business operations. Would it be appropriate to continue recording
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depreciation on this asset? Explain. When should the asset's cost and accumulated depreciation be
removed from the accounting records?
➢ A machine and USD 22,500 cash were exchanged for a delivery truck. The exchange has commercial
substance. How should the cost basis of the delivery truck be measured?
➢ A plant asset was exchanged for a new asset of a similar type. How is the cost of the new asset
determined?
➢ When nonmonetary assets not having commercial substance are exchanged, a resulting gain is not
recognized. Discuss why this is so.
➢ What is the proper accounting treatment for the costs of removing or dismantling a company's old
plant assets?
➢ Distinguish between depreciation, depletion, and amortization. Name two assets that are subject
to depreciation, to depletion, and to amortization.
➢ Distinguish between tangible and intangible assets, and classify the assets named in part (a)
accordingly.
➢ A building with an estimated physical life of 40 years was constructed at the site of a coal mine. The
coal mine is expected to be completely exhausted within 20 years. Over what length of time should
the building be depreciated, assuming the building will be abandoned after all the coal has been
extracted?
➢ What are the characteristics of intangible assets? Give an example of an asset that has no physical
existence but is not classified as an intangible asset.
➢ What reasons justify the immediate expensing of most research and development costs?
➢ Over what length of time should intangible assets be amortized?
➢ Should costs incurred on internally generated intangible assets be capitalized in asset accounts?
➢ Describe the typical accounting for a patent.
➢ During 2010, Hardy Company incurred USD 123,000 of research and development costs in its
laboratory to develop a patent that was granted on 2010 December 29. Legal fees (outside counsel)
and other costs associated with registration of the patent totaled USD 22,800. What amount should
be recorded as a patent on 2010 December 29?
➢ What is a capital lease? What features may characterize a capital lease?
➢ What is the difference between a leasehold (under an operating lease contract) and a leasehold
improvement? Is there any difference in the accounting procedures applicable to each?
➢ Walt Company leased a tract of land for 40 years at an agreed annual rental fee of USD 18,000. The
effective date of the lease was 2009 July 1. During the last six months of 2009, Walt constructed a
building on the land at a cost of USD 450,000. The building was placed in operation on 2010
January 2, at which time it was estimated to have a physical life of 50 years. Over what period should
the building be depreciated? Why?
➢ You note that a certain store seems to have a steady stream of regular customers, a favorable
location, courteous employees, high-quality merchandise, and a reputation for fairness in dealing
with customers, employees, and suppliers. Does it follow automatically that this business should
have goodwill recorded as an asset? Explain.
Accounting Principles: A Business Perspective 475 A Global Text
11. Plant asset disposals, natural resources, and intangible assets
Exercises
Exercise A Plant equipment originally costing USD 32,400, on which USD 21,600 of up-to-date depreciation
has been accumulated, was sold for USD 8,100.
a. Prepare the journal entry to record the sale.
b. Prepare the entry to record the sale of the equipment if USD 90 of removal costs were incurred to allow the
equipment to be moved.
Exercise B On 2009 August 31, Hutch Company sold a truck for USD 6,900 cash. The truck was acquired on
2006 January 1, at a cost of USD 17,400. Depreciation of USD 10,800 on the truck has been recorded through 2008
December 31, using the straight-line method, four-year expected useful life, and an expected salvage value of USD
3,000.
Prepare the journal entries to update the depreciation on the truck on 2009 August 31, and to record the sale of
the truck.
Exercise C A machine costing USD 120,000, on which USD 90,000 of up-to-date depreciation has been
accumulated, was completely destroyed by fire. What journal entry should record the machine's destruction and the
resulting fire loss under each of the following unrelated assumptions?
a. The machine was not insured.
b. The machine was insured, and it is estimated that USD 22,500 will be recovered from the insurance company.
Exercise D Kale Company owned an automobile acquired on 2007 January 1, at a cash cost of USD 35,100; at
that time, the automobile was estimated to have a useful life of four years and a USD 2,700 salvage value.
Depreciation has been recorded through 2009 December 31, on a straight-line basis. On 2010 January 1, the
automobile was traded for a new automobile. The old automobile had a fair market value (trade-in allowance) of
USD 6,750. Cash of USD 31,050 was paid. The exchange has commercial substance.
Prepare the journal entry to record the trade-in under generally accepted accounting principles.
Exercise E Equipment costing USD 330,000, on which USD 225,000 of up-to-date accumulated depreciation
has been recorded, was disposed of on 2009 January 2. What journal entries are required to record the equipment's
disposal under each of the following unrelated assumptions?
a. The equipment was sold for USD 120,000 cash.
b. The equipment was sold for USD 87,000 cash.
c. The equipment was retired from service and hauled to the junkyard. No material was salvaged.
d. The equipment was exchanged for similar equipment having a cash price of USD 450,000. A trade-in
allowance of USD 150,000 from the cash price was received, and the balance was paid in cash. The exchange has no
commercial substance.
e. The equipment was exchanged for similar equipment having a cash price of USD 450,000. A trade-in
allowance of USD 75,000 was received, and the balance was paid in cash. The exchange has commercial substance.
Exercise F Nola Mining Company purchased a tract of land containing ore for USD 630,000. After spending
USD 90,000 in exploration costs, the company determined that 600,000 tons of ore existed on the tract but only
500,000 tons could be economically removed. No other costs were incurred. When the company finishes with the
tract, it estimates the land will be worth USD 180,000. Determine the depletion cost per ton.
Exercise G Boyd Company paid USD 7,200,000 for the right to extract all of the mineral-bearing ore,
estimated at 10 million tons, that can be economically extracted from a certain tract of land. During the first year,
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Boyd Company extracted 1,000,000 tons of the ore and sold 800,000 tons. What part of the USD 7,200,000
should be charged to expense during the first year?
Exercise H The Slate Mining Company acquired a tract of land for mining purposes and erected a building on-
site at a cost of USD 675,000 and having no salvage value. Though the building has a useful life of 10 years, the
mining operations are expected to last only 6 years. The company has determined that 800,000 tons of ore exist on
the tract but only 600,000 tons can be economically removed. If 100,000 tons of ore are extracted in the first year
of operations, what is the appropriate depreciation charge using the units-of-production method?
Exercise I Talse Company purchased a patent on 1995 January 1, at a total cost of USD 61,200. In 2006
January, the company hired an outside law firm and successfully defended the patent in a lawsuit. The legal fees
amounted to USD 13,500. What will be the amount of patent cost amortized in 2009? (The finite useful life of the
patent is the same as its legal life—17 years.)
Exercise J Don Jackson paid Hungry Hannah's Hamburgers USD 54,000 for the right to operate a fast-food
restaurant in Thomasville under the Hungry Hannah's name. Jackson also agreed to pay an operating fee of 0.5 per
cent of sales for advertising and other services rendered by Hungry Hannah's. Jackson began operations on 2009
January 2. Sales for 2009 amounted to USD 540,000. The finite useful life of the franchise is 40 years.
Give the entries to record the payment of the USD 54,000 and to record expenses incurred relating to the right
to use the Hungry Hannah's name.
Exercise K Lem Company leased the first three floors in a building under an operating lease contract for a 10-
year period beginning 2009 January 1. The company paid USD 240,000 in cash (not representing a specific
period's rent) and agreed to make annual payments equal to 1 per cent of the first USD 1,500,000 of sales and 0.5
per cent of all sales over USD 1,500,000. Sales for 2009 amounted to USD 4,500,000. Payment of the annual
amount will be made in January 2010.
Prepare journal entries to record the cash payment of 2009 January 1, and the proper expense to be recognized
for the use of the space in the leased building for 2009.
Exercise L Rye Company purchased all of the assets of Shef Company for USD 900,000. Rye Company also
agreed to assume responsibility for Shef Company's liabilities of USD 90,000. The fair market value of the assets
acquired was USD 810,000. How much goodwill should be recorded in this transaction? Give the journal entry to
record this transaction.
Problems
Problem A Orr Company traded in an automobile that cost USD 18,000 and on which USD 15,000 of up-to-
date depreciation has been recorded for a new automobile with a cash price of USD 34,500. The company received
a trade-in allowance (its fair value) for the old automobile of USD 2,100 and paid the balance in cash. The exchange
has commercial substance.
Record the exchange of automobiles.
Problem B On 2007 January 2, Blake Company purchased a delivery truck for USD 78,750 cash. The truck has
an estimated useful life of six years and an estimated salvage value of USD 6,750. The straight-line method of
depreciation is being used.
a. Prepare a schedule showing the computation of the book value of the truck on 2009 December 31.
b. Assume the truck is to be disposed of on 2010 July 1. Prepare the journal entry to record depreciation for the
six months ended 2010 June 30.
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11. Plant asset disposals, natural resources, and intangible assets
c. Prepare the journal entries to record the disposal of the truck on 2010 July 1, under each of the following
unrelated assumptions:
i. The truck was sold for USD 26,250 cash.
ii. The truck was sold for USD 48,000 cash.
iii. The truck was retired from service, and it is expected that USD 20,625 will be received from the
sale of salvaged materials.
iv. The truck and USD 60,000 cash were exchanged for office equipment that had a cash price of
USD 105,000. The exchange has commercial substance.
v. The truck and USD 67,500 cash were exchanged for a new delivery truck that had a cash price of
USD 112,500. The exchange has no commercial substance.
vi. The truck was completely destroyed in an accident. Cash of USD 25,500 is expected to be
recovered from the insurance company.
Problem C Eagle Moving Company purchased a new moving van on 2009 October 1. The cash price of the new
van was USD 33,750, and the company received a trade-in allowance of USD 5,600 for a 2007 model. The balance
was paid in cash. The 2007 model had been acquired on 2007 January 1, at a cost of USD 22,500. Depreciation has
been recorded through 2008 December 31, on a straight-line basis, with three years of expected useful life and no
expected salvage value. The exchange has no commercial substance.
Prepare journal entries to update the depreciation and to record the exchange of the moving vans.
Problem D On 2009 January 1, Moyer Company had the following balances in some of its accounts:
Accumulated
Asset Depreciation
Land $ 624,000
Leasehold 780,000
Buildings 3,425,760 $ 286,650 Equipment 2,995,200 1,389,960 Trucks 449,280 158,790
• The leasehold covers a plot of ground leased on 2005 January 1, for a period of 20 years.
• Building No. 1 is on the owned land and was completed on 2008 July 1, at a cost of USD 1,965,600; its life is
set at 40 years with no salvage value. Building No. 2 is on the leased land and was completed on 2005 July 1, at
a cost of USD 1,460,160; its life is also set at 40 years with no expected salvage value.
• The equipment had an expected useful life of eight years with no estimated salvage value.
• Truck A, purchased on 2007 January 1, at a cost of USD 149,760, had an expected useful life of 2 1/2 years
and a salvage value of USD 9,360. Truck B, purchased on 2007 July 1, at a cost of USD 131,040, had an
expected life of two years and an estimated salvage value of USD 21,840. Truck C, purchased on 2008 July 1, at
a cost of USD 168,480, had an expected life of three years and an estimated salvage value of USD 21,060.
The following transactions occurred in 2009:
Jan. 2 Rent for 2009 on leased land was paid, USD 87,360.
April 1 Truck B was traded in for truck D. The cash price of the new truck was USD 149,760. A trade-in
allowance of USD 28,080 was granted from the cash price. The balance was paid in cash. Truck D has an expected
life of 20 years and an estimated salvage value of USD 9,360. The exchange has commercial substance.
1 Truck A was sold for USD 28,080 cash.
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Prepare journal entries to record the 2009 transactions and the necessary 2009 December 31, adjusting entries,
assuming a calendar-year accounting period. Use the straight-line depreciation method.
Problem D On 2009 January 2, York Mining Company acquired land with ore deposits at a cash cost of USD
1,800,000. Exploration and development costs amounted to USD 192,000. The residual value of the land is
expected to be USD 360,000. The ore deposits contain an estimated 6 million tons. Present technology will allow
the economical extraction of only 85 per cent of the total deposit. Machinery, equipment, and temporary sheds were
installed at a cost of USD 255,000. The assets will have no further value to the company when the ore body is
exhausted; they have a physical life of 12 years. In 2007, 200,000 tons of ore were extracted. The company expects
the mine to be exhausted in 10 years, with sharp variations in annual production.
a. Compute the depletion charge for 2009. Round to the nearest cent.
b. Compute the depreciation charge for 2009 under the units-of-production method.
c. If all other mining costs, except depletion, amounted to USD 1,260,000, what was the average cost per ton
mined in 2009? (The depreciation calculated in b is included in the USD 1,260,000.)
Problem E East Company spent USD 249,900 to purchase a patent on 2009 January 2. Management assumes
that the patent's finite useful life is 17 years. In January 2010, the company hired an outside law firm and
successfully defended the patent in a lawsuit at a cost of USD 48,000. Also, in January 2010, the company paid
USD 72,000 to obtain patents that could, if used by competitors, make the earlier East patent useless. The
purchased patents will never be used.
Give the entries for 2009 and 2010 to record the information relating to the patents.
Problem F Following are selected transactions and other data relating to Long Company for the year ended
2009 December 31.
a. The company rented the second floor of a building for five years on 2009 January 2, and paid the annual rent
of USD 18,000 for the first and fifth years in advance.
b. In 2008, the company incurred legal fees of USD 54,000 paid to an outside law firm in applying for a patent
and paid a fee of USD 18,000 to a former employee who conceived a device that substantially reduced the cost of
manufacturing one of the company's products. The patent on the device has a market value of USD 540,000 and is
expected to be useful for 10 years.
c. In 2008, the company entered into a 10-year operating lease on several floors of a building, paying USD
36,000 in cash immediately and agreeing to pay USD 18,000 at the end of each of the 10 years of life in the lease.
The company then incurred costs of USD 72,000 to install partitions, shelving, and fixtures. These items would
normally last 25 years.
d. The company spent USD 21,600 promoting a trademark in a manner that it believed enhanced the value of
the trademark considerably. The trademark has an indefinite life.
e. The company incurred costs amounting to USD 180,000 in 2008 and USD 234,000 in 2009 for research and
development of new products that are expected to enhance the company's revenues for at least five years.
f. The company paid USD 180,000 to the author of a book that the company published on 2009 July 2. Sales of
the book are expected to be made over a two-year period from that date.
For each of the situations just described, prepare only the journal entries to record the expense applicable to
2009.
Accounting Principles: A Business Perspective 479 A Global Text
11. Plant asset disposals, natural resources, and intangible assets
Alternate problems
Alternate problem A Ray, Inc., purchased a new 2010 model automobile on 2010 December 31. The cash
price of the new automobile was USD 28,080, from which Ray received a trade-in allowance of USD 4,320 for a
2008 model traded in. The 2008 model had been acquired on 2008 January 1, at a cost of USD 20,700.
Depreciation has been recorded on the 2008 model through 2009 December 31, using the straight-line method, an
expected four-year useful life, and an expected salvage value of USD 2,700. The exchange has commercial
substance.
a. Record depreciation expense for 2010.
b. Prepare the journal entries needed to record the exchange of automobiles.
Alternate problem B On 2007 January 1, Wood Company purchased a truck for USD 43,200 cash. The truck
has an estimated useful life of six years and an expected salvage value of USD 5,400. Depreciation on the truck was
computed using the straight-line method.
a. Prepare a schedule showing the computation of the book value of the truck on 2009 December 31.
b. Prepare the journal entry to record depreciation for the six months ended 2010 June 30.
c. Prepare journal entries to record the disposal of the truck on 2010 June 30, under each of the following
unrelated assumptions:
(a) The truck was sold for USD 3,600 cash.
(b)The truck was sold for USD 25,200 cash.
(c) The truck was scrapped. Used parts valued at USD 6,660 were salvaged.
(d)The truck (which has a fair market value of USD 10,800) and USD 32,400 of cash were exchanged
for a used back hoe that did not have a known market value. The transaction has commercial substance.
(e) The truck and USD 29,700 cash were exchanged for another truck that had a cash price of USD
51,300. The exchange has no commercial substance.
(f) The truck was stolen July 1, and insurance proceeds of USD 7,560 were expected.
Alternate problem C Kine Company purchased a new Model II computer 2009 October 1. Cash price of the
new computer was USD 24,960; Jackson received a trade-in allowance of USD 9,300 from the cash price for a
Model I computer. The old computer was acquired on 2007 January 1, at a cost of USD 23,040. Depreciation has
been recorded through 2008 December 31, on a straight-line basis, with an estimated useful life of four years and
USD 3,840 expected salvage value. The exchange has commercial substance.
Prepare the journal entries to record the exchange.
Alternate problem D On 2009 July 1, Morgan Company had the following balances in some of its accounts:
Accumulated
Asset Depreciation
Land $ 672,000
Leasehold 252,000
Buildings 3,151,680 $369,768 Equipment 1,370,880 436,800 Trucks 238,560 71,652
The leasehold covers a plot of ground leased on 2004 July 1, for a period of 25 years under an operating lease.
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The office building is on the leased land and was completed on 2005 July 1, at a cost of USD 967,680; its
physical life is set at 40 years. The factory building is on the owned land and was completed on 2004 July 1, at a
cost of USD 2,184,000; its life is also set at 40 years with no expected salvage value.
The equipment has a 15-year useful life with no expected salvage value.
The company owns three trucks—A, B, and C. Truck A, purchased on 2007 July 1, at a cost of USD 53,760, had
an expected useful life of three years and a salvage value of USD 3,360. Truck B, purchased on 2008 January 2, at a
cost of USD 84,000, had an expected life of four years and an estimated salvage value of USD 6,720. Truck C,
purchased on 2009 January 2, at a cost of USD 100,800, had an expected life of five years and an estimated salvage
value of USD 10,080.
The following transactions occurred in the fiscal year ended 2010 June 30:
2009
July 1 Rent for2009 July 1, through 2010 June 30, on leased land was paid, USD 31,920.
Oct. 1 Truck A was traded in on truck D. Cash price of the new truck was USD 107,520. Cash of USD 90,720 was
paid. Truck D has an expected life of four years and a salvage value of USD 5,880. The exchange has no commercial
substance.
2010
Feb. 2 Truck B was sold for USD 47,040 cash.
June 1 Truck C was completely demolished in an accident. The truck was not insured.
Prepare journal entries to record these transactions and the necessary 2010 June 30, adjusting entries. Use the
straight-line depreciation method.
Alternate problem E In December 2008, Brown Company acquired a mine for USD 2,700,000. The mine
contained an estimated 10 million tons of ore. It was also estimated that the land would have a value of USD
240,000 when the mine was exhausted and that only 4 million tons of ore could be economically extracted. A
building was erected on the property at a cost of USD 360,000. The building had an estimated useful life of 35 years
and no salvage value. Specialized mining equipment was installed at a cost of USD 495,000. This equipment had an
estimated useful life of seven years and an estimated USD 33,000 salvage value. The company began operating on
2009 January 1, and put all of its assets into use on that date. During the year ended 2009 December 31, 400,000
tons of ore were extracted. The company decided to use the units-of-production method to record depreciation on
the building and the straight-line method to record depreciation on the equipment.
Prepare journal entries to record the depletion and depreciation charges for the year ended 2009 December 31.
Show calculations.
Alternate problem F Trask Company purchased a patent for USD 108,000 on 2009 January 2. The patent
was estimated to have a finite life of 10 years. The USD 108,000 cost was properly charged to an asset account and
amortized in 2009. On 2010 January 1, the company incurred legal and court costs of USD 32,400 in a successful
defense of the patent in a lawsuit. The legal work was performed by an outside law firm.
a. Compute the patent amortization expense for 2009 and give the entry to record it.
b. Compute the patent amortization expense for 2010 and give the entry to record it.
Alternate problem G Selected transactions and other data for Grant Company:
Accounting Principles: A Business Perspective 481 A Global Text
11. Plant asset disposals, natural resources, and intangible assets
a. The company purchased a patent in early January 2006 for USD 144,000 and began amortizing it over its
finite life of 10 years. In early January 2008, the company hired an outside law firm and successfully defended the
patent in an infringement suit at a cost of USD 38,400.
b. Research and development costs incurred in 2008 of USD 43,200 were expected to provide benefits over the
three succeeding years.
c. On 2009 January 2, the company rented space in a warehouse for five years at an annual fee of USD 9,600.
Rent for the first and last years was paid in advance.
d. A total of USD 96,000 was spent uniformly throughout 2009 by the company in promoting its lesser known
trademark, which is expected to have a finite useful life of 20 years.
e. In January 2007, the company purchased all of the assets and assumed all of the liabilities of another
company, paying USD 192,000 more than the fair market value of all identifiable assets acquired, less the liabilities
assumed. The company expects the cash flow benefits for which it paid the USD 192,000 to last 10 years (finite
useful life).
For each of these unrelated transactions, prepare journal entries to record only those entries (required for 2009.
Note any items that do not require an entry in 2009.
Beyond the numbers-Critical thinking
Business decision case A During your audit examination of the Shirley Company's Plant, Property, and
Equipment accounts, the following transaction came to your attention. On 2009 January 2, machine A was
exchanged for machine B. Shirley Company acquired machine A for USD 90,000 on 2007 January 2. Machine A
had an estimated useful life of four years and no salvage value, and the machine was depreciated on the straight-
line basis. Machine B had a cash price of USD 108,000. In addition to machine A, cash of USD 30,000 was given up
in the exchange. Machine B has an estimated useful life of five years and no salvage value, and the machine is being
depreciated using the straight-line method. The exchange has no commercial substance. Upon further analysis, you
discover that the company recorded the transaction as an exchange of nonmonetary assets having commercial
substance instead of one not having commercial substance. You must now determine the following:
a. What journal entry did the Shirley Company make when it recorded the exchange of machines? (Show
computations.)
b. What journal entry should the Shirley Company have made to record the exchange of machines?
c. Assume the error was discovered on 2010 December 31, before adjusting journal entries have been made.
What journal entries should be made to correct the accounting records? (Adjustments of prior years' net income
because of errors should be debited or credited to Retained Earnings.) What adjusting journal entry should be
made to record depreciation for 2010? (Ignore income taxes.)
d. What effect did the error have on reported net income for 2009? (Ignore income taxes.)
e. How should machine B be reported on the 2010 December 31, balance sheet?
Business decision case B Currently, many corporations are looking for acquisition opportunities. Tyre, Inc.,
is trying to decide whether to buy Amite Company or Beauman Company. Tyre, Inc., has hired you as a consultant
to analyze the two companies' financial information and to determine the more advantageous acquisition. Your
review of the companies' books has revealed that both Amite and Beauman have assets with the following book
values and fair market values:
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11. Plant asset disposals, natural resources, and intangible assets
Fair Market
Book Value Value
Accounts receivable $150,000 $ 150,000 Inventories 450,000 750,000 Land 375,000 675,000 Buildings 450,000 1,050,000 Equipment 180,000 300,000 Patents 120,000 150,000
Liabilities assumed on the purchase of either company include accounts payable, USD 300,000, and notes
payable, USD 75,000.
The only difference between the companies is that Amite has net income that is about average for the industry,
while Beauman's net income is greatly above average for the industry.
Top-level management at Tyre, Inc., has asked you to respond in writing to the following possible situations:
a. Assume Tyre, Inc., can buy Amite Company for USD 2,700,000 or Beauman Company for USD 3,450,000.
Prepare the journal entries to record the acquisition of Amite Company and Beauman Company. What accounts for
the difference between the purchase price of the two companies?
b. Assume Tyre, Inc, can buy either company for USD 2,700,000. Write a report for Tyre, Inc., advising which
company to buy.
Annual report analysis C The mission of Rational Software Corporation is to ensure the success of customers
constructing the software systems that they depend on.
Using the following excerpts from Rational Software's annual reports, calculate the firm's total assets turnover
for 2004 and 2003. (Amounts are in USD thousands.)
2004 2003 2002
Net sales $ 814,935 $ 572,190 $ 411,816 Total assets 1,709,323 1,225,776 453,956
In a written report, discuss the meaning of the total assets turnover ratio and what the ratio means to
management and investors. Use the total assets turnover ratios you computed for Rational Software as an example
in your report.
Ethics case D Based on the situation described in the ethics case regarding ABC Corporation, respond in
writing to the following questions.
a. Depending on his actions, what are the possible consequences for John Gilbert in this situation?
b. Assuming that the president cannot find another appraiser to support the new allocations, what would you do
if you were Gilbert?
c. If the president can find a reputable appraiser to support these new allocations, what would you do if you were
Gilbert?
Group project E In teams of two or three students, find a recent annual report that includes intangible assets
on the balance sheet. Select one member of each team to give an informal presentation discussing intangible asset
disclosures on the face of the statements and in the notes to the financial statements. All members should be
prepared to discuss intangible asset disclosures from their annual report in detail.
Group project F In a group of one or two other students, go to the library and locate Statement of Financial
Accounting Standards No. 2, "Accounting for Research and Development Costs", published by the Financial
Accounting Standards Board. Write a report to your instructor giving the highlights of the standard. For instance,
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what alternatives were considered and why did the board conclude that all research and development costs should
be expensed when incurred?
Group project G In a group of one or two other students, go to the library and locate Statement of Financial
Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of", published by the Financial Accounting Standards Board. Write a report to your instructor giving
the highlights of the standard. For instance, what does "impairment" mean and what are its causes? How can one
determine that impairment of an asset has possibly occurred? Also review some of the background information as
to why this was important enough for the FASB to act.
Using the Internet—A view of the real world
Visit the Accounting News Network at Microsoft's website:
http://sba.microsoft.com/apnews/default.asp
Click on each icon to investigate the information available at this site. Browse any of the areas that look
interesting. How would accounting practitioners make good use of this site? In a report to your instructor,
summarize the features available at this site.
Visit the Small Business Administration site at:
http://www.sba.gov
Suppose you wanted to start a small business. What helpful information would you find at this site? Would this
site provide information on how to finance the business? Browse around this site to see what it offers. Then write a
report to your instructor summarizing the types of helpful information this site provides.
Answers to self-test
True-false
False. No more depreciation can be taken on a fully depreciated plant asset.
True. The new asset is recorded at the fair market value of the asset received or given up, whichever is more
clearly evident.
False. The residual value of land should be deducted from total costs subject to depletion.
False. Only intangible assets with finite useful lives should be amortized.
Multiple-choice
d. The cost and accumulated depreciation should not be removed from the accounts until the disposal of the
asset.
a. On the date of exchange, the book value of the old truck is USD 20,700 (USD 45,000 minus accumulated
depreciation of USD 24,300). The trade-in allowance of USD 22,500 indicates a gain on exchange of USD 1,800. In
an exchange of nonmonetary assets not having commercial substance, a gain is not recognized, but reduces the cost
of a new asset. Therefore, the cost of the new truck is USD 55,200 (USD 57,000 minus USD 1,800), and no gain is
recognized.
c. The depletion charge for the first year is:
Depletion charger per ton= USD375,000 – USD75,000
1,000,000
= USD 0.30
Depletion charge for the year=USD 0.30×100,000
= USD 30,000
Accounting Principles: A Business Perspective 484 A Global Text
11. Plant asset disposals, natural resources, and intangible assets
Since all of the ore that was extracted was sold, all of the USD 30,000 is expensed as cost of ore sold.
b. The patent is amortized over 10 years:
Annual amortization expense= USD 36,000
10
= USD 3,600
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12. Stockholders' equity: Classes of capital stock
Learning objectives
After studying this chapter, you should be able to:
• State the advantages and disadvantages of the corporate form of business.
• List the values commonly associated with capital stock and give their definitions.
• List the various kinds of stock and describe the differences between them.
• Present in proper form the stockholders' equity section of a balance sheet.
• Account for the issuances of stock for cash and other assets.
• Determine book values of both preferred and common stock.
• Analyze and use the financial results—return on average common stockholders' equity.
The accountant as a corporate treasurer
Most people think of the stock market as a place to buy and sell stock. However, few people give much thought
to the other side of this transaction. The original purpose of the stock market is to allow corporations to raise the
money needed to expand into new markets, invent new products, open new stores, and create new jobs. The initial
public issuance of stock (i.e. going public) is one of the most significant milestones in the life of a public company.
For most individual investors, trading is done by stockbrokers. Who handles the stock transactions within a
company? The treasurer or the person that performs the treasury functions is this person. This role requires
someone with a strong background in accounting and finance.
When a company decides to issue bonds or additional shares of stock, the treasurer is the person responsible for
executing the transaction at the lowest cost to the entity. The treasurer works closely with investment bankers and
lawyers to get the stocks or bonds marketed and issued in accordance with state and federal laws. When a company
issues stock for the first time (initial public offering, or IPO), the task requires a thorough review of the financial
position of the company and the public disclosure of this information for perhaps the first time. The
treasurer/accountant must prepare what is called a prospectus. Among other things, the prospectus includes
financial accounting information that is used in setting the price of the IPO.
The treasurer maintains custody of, or has access to, stocks owned by an entity and stock that is under the
control of the entity. The treasurer also plays a pivotal role in the distribution of cash and stock dividends. The
primary function of this position is controlling the cash inflows and outflows of the entity. A career as a corporate
treasurer can involve the oversight of billions of dollars of stock, and the individual can earn a six-figure salary.
In this chapter, you study the corporate form of business organization in greater detail than in preceding
chapters. Although corporations are fewer in number than single proprietorships and partnerships, corporations
possess the bulk of our business capital and currently supply us with most of our goods and services.
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12. Stockholders' equity: Classes of capital stock
This chapter discusses the advantages and disadvantages of the corporation, how to form and direct a
corporation, and some of the unique situations encountered in accounting for and reporting on the different classes
of capital stock. It is written from a US perspective, so you should be aware that laws and common practices may be
different in other countries.
The corporation
A corporation is an entity recognized by law as possessing an existence separate and distinct from its owners;
that is, it is a separate legal entity. Endowed with many of the rights and obligations possessed by a person, a
corporation can enter into contracts in its own name; buy, sell, or hold property; borrow money; hire and fire
employees; and sue and be sued.
Corporations have a remarkable ability to obtain the huge amounts of capital necessary for large-scale business
operations. Corporations acquire their capital by issuing shares of stock; these are the units into which
corporations divide their ownership. Investors buy shares of stock in a corporation for two basic reasons. First,
investors expect the value of their shares to increase over time so that the stock may be sold in the future at a profit.
Second, while investors hold stock, they expect the corporation to pay them dividends (usually in cash) in return for
using their money. Chapter 13 discusses the various kinds of dividends and their accounting treatment.
Advantages of the corporate form of business
Corporations have many advantages over single proprietorships and partnerships. The major advantages a
corporation has over a single proprietorship are the same advantages a partnership has over a single
proprietorship. Although corporations have more owners than partnerships, both have a broader base for
investment, risk, responsibilities, and talent than do single proprietorships. Since corporations are more
comparable to partnerships than to single proprietorships, the following discussion of advantages contrasts the
partnership with the corporation.
• Easy transfer of ownership. In a partnership, a partner cannot transfer ownership in the business to
another person if the other partners do not want the new person involved in the partnership. In a publicly held
(owned by many stockholders) corporation, shares of stock are traded on a stock exchange between unknown
parties; one owner usually cannot dictate to whom another owner can or cannot sell shares.
• Limited liability. Each partner in a partnership is personally responsible for all the debts of the business.
In a corporation, the stockholders are not personally responsible for its debts; the maximum amount a
stockholder can lose is the amount of his or her investment. However, when a small, closely held corporation
(owned by only a few stockholders) borrows money, banks and lending institutions often require an officer of
the small corporation to sign the loan agreement. Then, the officer has to repay the loan if the corporation does
not.
• Continuous existence of the entity. In a partnership, many circumstances, such as the death of a
partner, can terminate the business entity. These same circumstances have no effect on a corporation because
it is a legal entity, separate and distinct from its owners.
• Easy capital generation. The easy transfer of ownership and the limited liability of stockholders are
attractive features to potential investors. Thus, it is relatively easy for a corporation to raise capital by issuing
shares of stock to many investors. Corporations with thousands of stockholders are not uncommon.
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• Professional management. Generally, the partners in a partnership are also the managers of that
business, regardless of whether they have the necessary expertise to manage a business. In a publicly held
corporation, most of the owners (stockholders) do not participate in the day-to-day operations and
management of the entity. They hire professionals to run the business on a daily basis.
• Separation of owners and entity. Since the corporation is a separate legal entity, the owners do not
have the power to bind the corporation to business contracts. This feature eliminates the potential problem of
mutual agency that exists between partners in a partnership. In a corporation, one stockholder cannot
jeopardize other stockholders through poor decision making.
The corporate form of business has the following disadvantages:
• Double taxation. Because a corporation is a separate legal entity, its net income is subject to double
taxation. The corporation pays a tax on its income, and stockholders pay a tax on corporate income received as
dividends.
• Government regulation. Because corporations are created by law, they are subject to greater regulation
and control than single proprietorships and partnerships.
• Entrenched, inefficient management. A corporation may be burdened with an inefficient
management that remains in control by using corporate funds to solicit the needed stockholder votes to back
its positions. Stockholders scattered across the country, who individually own only small portions of a
corporation's stock, find it difficult to organize and oppose existing management.
• Limited ability to raise creditor capital. The limited liability of stockholders makes a corporation an
attractive means for accumulating stockholder capital. At the same time, this limited liability feature restrains
the amount of creditor capital a corporation can amass because creditors cannot look to stockholders to pay
the debts of a corporation. Thus, beyond a certain point, creditors do not lend some corporations money
without the personal guarantee of a stockholder or officer of the corporation to repay the loan if the
corporation does not.
Corporations are chartered by the state. Each state has a corporation act that permits the formation of
corporations by qualified persons. Incorporators are persons seeking to bring a corporation into existence. Most
state corporation laws require a minimum of three incorporators, each of whom must be of legal age, and a majority
of whom must be citizens of the United States.
The laws of each state view a corporation organized in that state as a domestic corporation and a corporation
organized in any other state as a foreign corporation. If a corporation intends to conduct business solely within
one state, it normally seeks incorporation in that state because most state laws are not as severe for domestic
corporations as for foreign corporations. Corporations conducting interstate business usually incorporate in the
state that has laws most advantageous to the corporation being formed. Important considerations in choosing a
state are the powers granted to the corporation, the taxes levied, the defenses permitted against hostile takeover
attempts by others, and the reports required by the state.
Once incorporators agree on the state in which to incorporate, they apply for a corporate charter. A corporate
charter is a contract between the state and the incorporators, and their successors, granting the corporation its
legal existence. The application for the corporation's charter is called the articles of incorporation.
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12. Stockholders' equity: Classes of capital stock
After supplying the information requested in the incorporation application form, incorporators file the articles
with the proper office in the state of incorporation. Each state requires different information in the articles of
incorporation, but most states ask for the following:
• Name of corporation.
• Location of principal offices.
• Purposes of business.
• Number of shares of stock authorized, class or classes of shares, and voting and dividend rights of each
class of shares.
• Value of assets paid in by the incorporators (the stockholders who organize the corporation).
• Limitations on authority of the management and owners of the corporation.
On approving the articles, the state office (frequently the secretary of state's office) grants the charter and
creates the corporation.
As soon as the corporation obtains the charter, it is authorized to operate its business. The incorporators call the
first meeting of the stockholders. Two of the purposes of this meeting are to elect a board of directors and to adopt
the bylaws of the corporation.
The bylaws are a set of rules or regulations adopted by the board of directors of a corporation to govern the
conduct of corporate affairs. The bylaws must be in agreement with the laws of the state and the policies and
purposes in the corporate charter. The bylaws contain, along with other information, provisions for: (1) the place,
date, and manner of calling the annual stockholders' meeting; (2) the number of directors and the method for
electing them; (3) the duties and powers of the directors; and (4) the method for selecting officers of the
corporation.
Organization costs are the costs of organizing a corporation, such as state incorporation fees and legal fees
applicable to incorporation. The firm debits these costs to an account called Organization Costs. The Organization
Costs account is an asset because the costs yield benefits over the life of the corporation; if the fees had not been
paid, no corporate entity would exist. Since the account is classified on the balance sheet as an intangible asset, it is
amortized over its finite useful life. Most organizations write off these costs fairly rapidly because they are small in
amount.
As an illustration, assume that De-Leed Corporation pays state incorporation fees of USD 10,000 and attorney's
fees of USD 5,000 for services rendered related to the acquisition of a charter with the state. The entry to record
these costs is:
Organization Costs (+A) 15,000 Cash (-A) 15,000 To record costs incurred in organizing corporation.
Assuming the corporation amortizes the organization costs over a 10-year period, this entry records
amortization at the end of the year:
Amortization Expense—Organization Costs (-SE) 1,500 Organization Costs (-A) 1,500 To record organization costs amortization expense. (15,000/10 years = $1,500).
Management of the corporation is through the delegation of authority from the stockholders to the directors to
the officers, as shown in the organization chart in Exhibit 95. The stockholders elect the board of directors. The
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board of directors formulates the broad policies of the company and selects the principal officers, who execute the
policies.
Stockholders Stockholders do not have the right to participate actively in the management of the business
unless they serve as directors and/or officers. However, stockholders do have certain basic rights, including the
right to (1) dispose of their shares, (2) buy additional newly issued shares in a proportion equal to the percentage of
shares they already own (called the preemptive right), (3) share in dividends when declared, (4) share in assets
in case of liquidation, and (5) participate in management indirectly by voting at the stockholders' meeting.
The preemptive right allows stockholders to maintain their percentage of ownership in a corporation when
additional shares are issued. For example, assume Joe Thornton owns 10 per cent of the outstanding shares of
Corporation X. When Corporation X decides to issue 1,000 additional shares of stock, Joe Thornton has the right to
buy 100 (10 per cent) of the new shares. Should he decide to do so, he maintains his 10 per cent interest in the
corporation. If he does not wish to exercise his preemptive right, the corporation may sell the shares to others.40
Exhibit 95: Typical corporation's organization chart
Normally, companies hold stockholders' meetings annually. At the annual stockholders' meeting, stockholders
indirectly share in management by voting on such issues as changing the charter, increasing the number of
authorized shares of stock to be issued, approving pension plans, selecting the independent auditor, and other
related matters.
At stockholders' meetings, each stockholder is entitled to one vote for each share of voting stock held.
Stockholders who do not personally attend the stockholders' meeting may vote by proxy. A proxy is a legal
document signed by a stockholder, giving a designated person the authority to vote the stockholder's shares at a
stockholders' meeting.
Board of directors Elected by the stockholders, the board of directors is primarily responsible for
formulating policies for the corporation. The board appoints administrative officers and delegates to them the
execution of the policies established by the board. The board's more specific duties include: (1) authorizing
contracts, (2) declaring dividends, (3) establishing executive salaries, and (4) granting authorization to borrow
money. The decisions of the board are recorded in the minutes of its meetings. The minutes are an important
40 Some corporations have eliminated the preemptive right because the preemptive right makes it difficult to issue
large blocks of stock to the stockholders of another corporation to acquire that corporation.
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12. Stockholders' equity: Classes of capital stock
source of information to an independent auditor, since they may serve as notice to record transactions (such as a
dividend declaration) or to identify certain future transactions (such as a large loan).
Corporate officers A corporation's bylaws usually specify the titles and duties of the officers of a corporation.
The number of officers and their exact titles vary from corporation to corporation, but most have a president,
several vice presidents, a secretary, a treasurer, and a controller.
The president is the chief executive officer (CEO) of the corporation. He or she is empowered by the bylaws to
hire all necessary employees except those appointed by the board of directors.
Most corporations have more than one vice president. Each vice president is responsible for one particular
corporate operation, such as sales, engineering, or production. The corporate secretary maintains the official
records of the company and records the proceedings of meetings of stockholders and directors. The treasurer is
accountable for corporate funds and may supervise the accounting function within the company. A controller
carries out the accounting function. The controller usually reports to the treasurer of the corporation.
Documents, books, and records relating to capital stock
Capital stock consists of transferable units of ownership in a corporation. Each unit of ownership is called a
share of stock. Typically, traders sell between 100 and 400 million shares of corporate capital stock every business
day on stock exchanges, such as the New York Stock Exchange and the American Stock Exchange, and on the over-
the-counter market. These sales (or trades) seldom involve the corporation issuing the stock as a party to the
exchange. Existing stockholders sell their shares to other individual or institutional investors. The physical transfer
of the stock certificates follows these trades.
A stock certificate is a printed or engraved document serving as evidence that the holder owns a certain
number of shares of capital stock. When selling shares of stock, the stockholder signs over the stock certificate to
the new owner, who presents it to the issuing corporation. When the old certificate arrives, the issuing corporation
cancels the certificate and attaches it to its corresponding stub in the stock certificate book. The issuer prepares a
new certificate for the new owner. To determine the number of shares of stock outstanding at any time, the issuer
sums the shares shown on the open stubs (stubs without certificates attached) in the stock certificate book.
Among the more important records maintained by a corporation is the stockholders' ledger. The stockholders'
ledger contains a group of subsidiary accounts showing the number of shares of stock currently held by each
stockholder. Since the ledger contains an account for each stockholder, in a large corporation this ledger may have
more than a million individual accounts. Each stockholder's account shows the number of shares currently or
previously owned, their certificate numbers, and the dates on which shares were acquired or sold. Entries are made
in the number of shares rather than in dollars.
The stockholders' ledger and the stock certificate book contain the same information, but the stockholders'
ledger summarizes it alphabetically by stockholder. Since a stockholder may own a dozen or more certificates, each
representing a number of shares, this summary enables a corporation to (1) determine the number of shares a
stockholder is entitled to vote at a stockholders' meeting and (2) prepare one dividend check per stockholder rather
than one per stock certificate.
Many large corporations with actively traded shares turn the task of maintaining reliable stock records over to
an outside stock-transfer agent and a stock registrar. The stock-transfer agent, usually a bank or trust company,
transfers stock between buyers and sellers for a corporation. The stock-transfer agent cancels the certificates
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covering shares sold, issues new stock certificates, and makes appropriate entries in the stockholders' ledger. It
sends new certificates to the stock registrar, typically another bank, that maintains separate records of the shares
outstanding. This control system makes it difficult for a corporate employee to issue stock certificates fraudulently
and steal the proceeds.
The minutes book, kept by the secretary of the corporation, is (1) a record book of the actions taken at
stockholders' and board of directors' meetings and (2) the written authorization for many actions taken by
corporate officers. Remember that all actions taken by the board of directors and the stockholders must be in
accordance with the provisions in the corporate charter and the bylaws. The minutes book contains a variety of
data, including:
• A copy of the corporate charter.
• A copy of the bylaws.
• Dividends declared by the board of directors.
• Authorization for the acquisition of major assets.
• Authorization for borrowing.
• Authorization for increases or decreases in capital stock.
Par value and no-par capital stock
Many times, companies issue par value stock. Par value is an arbitrary amount assigned to each share of a
given class of stock and printed on the stock certificate. Par value per share is no indication of the amount for which
the stock sells; it is simply the amount per share credited to the capital stock account for each share issued. Also,
the total par value of all issued stock often constitutes the legal capital of the corporation. The concept of legal
capital protects creditors from losses. Legal capital, or stated capital, is an amount prescribed by law (usually
the par value or stated value of shares issued) below which a corporation may not reduce stockholders' equity
through declaration of dividends or other payments to stockholders. Stated value relates to no-par stock and is
explained below. Legal capital does not guarantee that a company can pay its debts, but it does keep a company
from compensating owners to the detriment of creditors. The formula for determining legal capital is:
Legal Capital=Shares Issued X Par StatedValue
In 1912, the state of New York first enacted laws permitting the issuance of no-par stock (stock without par
value). Many other states have passed similar, but not uniform, legislation.
A corporation might issue no-par stock for two reasons. One reason is to avoid confusion. The use of a par value
may confuse some investors because the par value usually does not conform to the market value. Issuing a stock
with no par value avoids this source of confusion.
A second reason is related to state laws regarding the original issue price per share. A discount on capital
stock is the amount by which the shares' par value exceeds their issue price. Thus, if stock with a par value of USD
100 is issued at USD 80, the discount is USD 20. Most states do not permit the original issuance of stock at a
discount. Only Maryland, Georgia, and California allow its issuance. The original purchasers of the shares are
contingently liable for the discount unless they have transferred (by contract) the discount liability to subsequent
holders. If the contingent liability has been transferred, the present stockholders are contingently liable to creditors
for the difference between par value and issue price. Although this contingent liability seldom becomes an actual
liability, the issuance of no-par stock avoids such a possibility.
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12. Stockholders' equity: Classes of capital stock
The board of directors of a corporation issuing no-par stock may assign a stated value to each share of capital
stock. Stated value is an arbitrary amount assigned by the board to each share of a given class of no-par stock. The
board may set this stated value, like par value, at any amount, although some state statutes specify a minimum
amount, such as USD 5 per share. If not specified by applicable state law, the board may establish stated value
either before or after the shares are issued.
Other values commonly associated with capital stock
Market value is the price of shares of capital stock bought and sold by investors in the market; it is the value of
greatest interest to investors. Market price is directly affected by (1) all the factors that influence general economic
conditions, (2) investors' expectations concerning the corporation, and (3) the corporation's earnings.
Book value per share is the amount per share that each stockholder would receive if the corporation were
liquidated without incurring any further expenses and if assets were sold and liabilities liquidated at their recorded
amounts. A later section discusses book value per share in greater detail.
Liquidation value is the amount a stockholder would receive if a corporation discontinued operations and
liquidated by selling its assets, paying its liabilities, and distributing the remaining cash among the stockholders.
Since the assets might be sold for more or less than the amounts at which they are recorded in the corporation's
accounts, liquidation value may be more or less than book value. If only one class of capital stock is outstanding,
each stockholder would receive, per share, the amount obtained by dividing the remaining cash by the number of
outstanding shares. If two or more classes of stock are outstanding, liquidation value depends on the rights of the
various classes.
A corporation issues certain capital stock with the stipulation that it has the right to redeem it. Redemption
value is the price per share at which a corporation may call in (or redeem) its capital stock for retirement.
Capital stock authorized and outstanding
The corporate charter states the number of shares and the par value, if any, per share of each class of stock that
the corporation is permitted to issue. Capital stock authorized is the number of shares of stock that a
corporation is entitled to issue as designated in its charter.
A corporation might not issue all of its authorized stock immediately; it might hold some stock for future
issuance when additional funds are needed. If all authorized stock has been issued and more funds are needed, the
state of incorporation must consent to an increase in authorized shares.
The authorization to issue stock does not trigger a journal entry. Instead, companies note the authorization in
the capital stock account in the ledger (and often in the general journal) as a reminder of the number of shares
authorized. Capital stock issued is the number of shares of stock sold and issued to stockholders.
Capital stock outstanding is the number of authorized shares of stock issued and currently held by
stockholders. The total ownership of a corporation rests with the holders of the capital stock outstanding. For
example, when a corporation authorized to issue 10,000 shares of capital stock has issued only 8,000 shares, the
holders of the 8,000 shares own 100 per cent of the corporation.
Each outstanding share of stock of a given class carries rights and privileges identical to any other outstanding
share of that class. Shares authorized but not yet issued are referred to as unissued shares (the previous example
had 2,000 unissued shares). No rights or privileges are attached to these shares until they are issued; they are not
entitled to dividends, nor can they be voted at stockholders' meetings.
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The number of shares issued and the number of shares outstanding may be different. Issued stock has been
issued at some time, while outstanding shares are currently held by stockholders. All outstanding stock is issued
stock, but the reverse is not necessarily true. The difference is due to shares returned to the corporation by
stockholders; it is called treasury stock. Chapter 13 discusses treasury stock.
An accounting perspective:
Business insight
SCI Systems, Inc., designs, manufactures, and distributes electronic products for a wide variety of
industries. The following illustration is adapted from the company's balance sheet. The
stockholders' equity section shows the actual number of shares of common stock authorized and
outstanding and shows the dollar amounts in thousands:
June 30 Common stock, USD0.10 par value; authorized 2001 2000 500,000,000 common shares, issued 147,132,428 shares in 2001 and 144,996,374 shares in 2000. USD 14,713 USD 14,500
Classes of capital stock
A corporation may issue two basic classes or types of capital stock—common and preferred.
If a corporation issues only one class of stock, this stock is common stock. All of the stockholders enjoy equal
rights. Common stock is usually the residual equity in the corporation. This term means that all other claims
against the corporation rank ahead of the claims of the common stockholder.
Preferred stock is a class of capital stock that carries certain features or rights not carried by common stock.
Within the basic class of preferred stock, a company may have several specific classes of preferred stock, each with
different dividend rates or other features.
Companies issue preferred stock to avoid: (1) using bonds with fixed interest charges that must be paid
regardless of the amount of net income; (2) issuing so many additional shares of common stock that earnings per
share are less in the current year than in prior years; and (3) diluting the common stockholders' control of the
corporation, since preferred stockholders usually have no voting rights.
Unlike common stock, which has no set maximum or minimum dividend, the dividend return on preferred stock
is usually stated at an amount per share or as a percentage of par value. Therefore, the firm fixes the dividend per
share. Exhibit 96 shows the various classes and combinations of capital stock outstanding for a sample of 600
companies.
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12. Stockholders' equity: Classes of capital stock
2006 2005 2004 2003
Common stock with:
No preferred stock 516 502 507 514
One class of preferred stock 73 81 80 71
Two classes of p referred stock 9 14 10 10
Three or more classes of
preferred stock 2 3 3 5
Total Companies 600 600 600 600
Companies included above with two or more classes of common stock
62 70 59 66
Exhibit 96: Capital structures
Source: Based on American Institute of Certified Public Accountants, Accounting Trends & Techniques (New
York: AICPA, 2004), p. 307.
Types of preferred stock
When a corporation issues both preferred and common stock, the preferred stock may be:
• Preferred as to dividends. It may be noncumulative or cumulative.
• Preferred as to assets in the event of liquidation.
• Convertible or nonconvertible.
• Callable.
A dividend is a distribution of assets (usually cash) that represents a withdrawal of earnings by the owners.
Dividends are normally paid in cash.
Stock preferred as to dividends means that the preferred stockholders receive a specified dividend per
share before common stockholders receive any dividends. A dividend on preferred stock is the amount paid to
preferred stockholders as a return for the use of their money. For no-par preferred stock, the dividend is a specific
dollar amount per share per year, such as USD 4.40. For par value preferred stock, the dividend is usually stated as
a percentage of the par value, such as 8 per cent of par value; occasionally, it is a specific dollar amount per share.
Most preferred stock has a par value.
Usually, stockholders receive dividends on preferred stock quarterly. Such dividends—in full or in part—must be
declared by the board of directors before paid. In some states, corporations can declare preferred stock dividends
only if they have retained earnings (income that has been retained in the business) at least equal to the dividend
declared.
Noncumulative preferred stock Noncumulative preferred stock is preferred stock on which the right
to receive a dividend expires whenever the dividend is not declared. When noncumulative preferred stock is
outstanding, a dividend omitted or not paid in any one year need not be paid in any future year. Because omitted
dividends are lost forever, noncumulative preferred stocks are not attractive to investors and are rarely issued.
Cumulative preferred stock Cumulative preferred stock is preferred stock for which the right to receive
a basic dividend, usually each quarter, accumulates if the dividend is not paid. Companies must pay unpaid
cumulative preferred dividends before paying any dividends on the common stock. For example, assume a company
has cumulative, USD 10 par value, 10 per cent preferred stock outstanding of USD 100,000, common stock
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outstanding of USD 100,000, and retained earnings of USD 30,000. It has paid no dividends for two years. The
company would pay the preferred stockholders dividends of USD 20,000 (USD 10,000 per year times two years)
before paying any dividends to the common stockholders.
Dividends in arrears are cumulative unpaid dividends, including the quarterly dividends not declared for the
current year. Dividends in arrears never appear as a liability of the corporation because they are not a legal liability
until declared by the board of directors. However, since the amount of dividends in arrears may influence the
decisions of users of a corporation's financial statements, firms disclose such dividends in a footnote. An
appropriate footnote might read: "Dividends in the amount of USD 20,000, representing two years' dividends on
the company's 10 per cent, cumulative preferred stock, were in arrears as of 2007 December 31".
Most preferred stocks are preferred as to assets in the event of liquidation of the corporation. Stock preferred
as to assets is preferred stock that receives special treatment in liquidation. Preferred stockholders receive the par
value (or a larger stipulated liquidation value) per share before any assets are distributed to common stockholders.
A corporation's cumulative preferred dividends in arrears at liquidation are payable even if there are not enough
accumulated earnings to cover the dividends. Also, the cumulative dividend for the current year is payable. Stock
may be preferred as to assets, dividends, or both.
Convertible preferred stock is preferred stock that is convertible into common stock of the issuing
corporation. Many preferred stocks do not carry this special feature; they are nonconvertible. Holders of
convertible preferred stock shares may exchange them, at their option, for a certain number of shares of common
stock of the same corporation.
Investors find convertible preferred stock attractive for two reasons: First, there is a greater probability that the
dividends on the preferred stock will be paid (as compared to dividends on common shares). Second, the
conversion privilege may be the source of substantial price appreciation. To illustrate this latter feature, assume
that Olsen Company issued 1,000 shares of 6 per cent, USD 100 par value convertible preferred stock at USD 100
per share. The stock is convertible at any time into four shares of Olsen USD 10 par value common stock, which has
a current market value of USD 20 per share. In the next several years, the company reported much higher net
income and increased the dividend on the common stock from USD 1 to USD 2 per share. Assume that the common
stock now sells at USD 40 per share. The preferred stockholders can: (1) convert each share of preferred stock into
four shares of common stock and increase the annual dividend they receive from USD 6 to USD 8; (2) sell their
preferred stock at a substantial gain, since it sells in the market at approximately USD 160 per share, the market
value of the four shares of common stock into which it is convertible; or (3) continue to hold their preferred shares
in the expectation of realizing an even larger gain at a later date.
If all 1,000 shares of USD 100 par value Olsen Company preferred stock are converted into 4,000 shares of USD
10 par value common stock, the entry is:
Preferred Stock (-SE) 100,000 Common Stock (+SE) 40,000 Paid-In Capital in Excess of Par Value—Common (+SE) 60,000 To record the conversion of preferred stock into common stock.
Accounting Principles: A Business Perspective 496 A Global Text
12. Stockholders' equity: Classes of capital stock
An accounting perspective:
Business insight
In the early 1970s, only about 10 per cent of undergraduate degrees in accounting were awarded to
women. This percentage increased steadily, and by the mid-1980s approximately half of all
undergraduate accounting degrees were earned by women. By 1996, the rate increased to slightly
more than half. This rate is more than twice the rate in the medical and legal professions. For more
information see "Accounting's Big Gender Switch," Business Week, January 20, 1997, p. 20.
Most preferred stocks are callable at the option of the issuing corporation. Callable preferred stock means
that the corporation can inform nonconvertible preferred stockholders that they must surrender their stock to the
company. Also, convertible preferred stockholders must either surrender their stock or convert it to common
shares.
Preferred shares are usually callable at par value plus a small premium of 3 or 4 per cent of the par value of the
stock. This call premium is the difference between the amount at which a corporation calls its preferred stock for
redemption and the par value of the stock.
An issuing corporation may force conversion of convertible preferred stock by calling in the preferred stock for
redemption. Stockholders who do not want to surrender their stock have to convert it to common shares. When
preferred stockholders surrender their stock, the corporation pays these stockholders par value plus the call
premium, any dividends in arrears from past years, and a prorated portion of the current period's dividend. If the
market value of common shares into which the preferred stock could be converted is higher than the amount the
stockholders would receive in redemption, they should convert their preferred shares to common shares. For
instance, assume that a stockholder owns 1,000 shares of convertible preferred stock. Each share is callable at USD
104 per share, convertible to two common shares (currently selling at USD 62 per share), and entitled to USD 10 of
unpaid dividends. If the issuing corporation calls in its preferred stock, it would give the stockholder either (1) USD
114,000 [(USD 104 + USD 10) X 1,000] if the shares are surrendered or (2) common shares worth USD 124,000
(USD 62 X 2,000) if the shares are converted. Obviously, the stockholder should convert these preferred shares to
common shares.
Why would a corporation call in its preferred stock? Corporations call in preferred stock for many reasons: (1)
the outstanding preferred stock may require a 12 per cent annual dividend at a time when the company can secure
capital to retire the stock by issuing a new 8 per cent preferred stock; (2) the issuing company may have been
sufficiently profitable to retire the preferred stock out of earnings; or (3) the company may wish to force conversion
of its convertible preferred stock because the cash dividend on the equivalent common shares is less than the
dividend on the preferred shares.
Balance sheet presentation of stock
The stockholders' equity section of a corporation's balance sheet contains two main elements: paid-in capital
and retained earnings. Paid-in capital is the part of stockholders' equity that normally results from cash or other
assets invested by owners. Paid-in capital also results from services performed for the corporation in exchange for
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capital stock and from certain other transactions discussed in Chapter 13. As stated earlier, retained earnings is
the part of stockholders' equity resulting from accumulated net income, reduced by dividends and net losses. Net
income increases the Retained Earnings account balance and net losses decrease it. In addition, dividends declared
to stockholders decrease Retained Earnings. Since Retained Earnings is a stockholders' equity account and
represents accumulated net income retained by the company, it normally has a credit balance. We discuss retained
earnings in more detail in Chapter 13.
The following illustration shows the proper financial reporting for preferred and common stock. Assume that a
corporation is authorized to issue 10,000 shares of USD 100 par value, 6 per cent, cumulative, convertible preferred
stock (five common for one preferred), all of which have been issued and are outstanding; and 200,000 shares of
USD 10 par value common stock, of which 80,000 shares are issued and outstanding. The stockholders' equity
section of the balance sheet (assuming USD 450,000 of retained earnings) is:
Stockholders' equity: Paid-in capital: Preferred stock – USD 100 par value, 6 per cent cumulative, convertible (5 common for 1 preferred); authorized, issued, and outstanding, 10,000 shares $ 1,000,000 Common stock – USD 10 par value; authorized, 200,000 shares; issued and outstanding 80,000 shares 800,000 Total paid-in capital $ 1,800,000 Retained earnings 450,000 Total stockholders' equity 2,250,000
Notice that the balance sheet lists preferred stock before common stock because the preferred stock is preferred
as to dividends, assets, or both. The company discloses the conversion rate in a parenthetical note within the
description of preferred stock or in a footnote.
An accounting perspective:
Business insight
WHX corporation in its 1999 annual report provided the following presentation of preferred stock
in the stockholders' equity second of its balance sheet:
1999
Stockholders' equity: Preferred stock—$.10 par value: authorized 10,000 shares; issued and outstanding: 5,883 shares $588.3M
Stock issuances for cash
Each share of common or preferred capital stock either has a par value or lacks one. The corporation's charter
determines the par value printed on the stock certificates issued. Par value may be any amount—1 cent, 10 cents, 16
cents, USD 1, USD 5, or USD 100. Low par values of USD 10 or less are common in our economy.
As previously mentioned, par value gives no clue as to the stock's market value. Shares with a par value of USD 5
have traded (sold) in the market for more than USD 600, and many USD 100 par value preferred stocks have
traded for considerably less than par. Par value is not even a reliable indicator of the price at which shares can be
issued. New corporations can issue shares at prices well in excess of par value or for less than par value if state laws
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12. Stockholders' equity: Classes of capital stock
permit. Par value gives the accountant a constant amount at which to record capital stock issuances in the capital
stock accounts. As stated earlier, the total par value of all issued shares is generally the legal capital of the
corporation.
To illustrate the issuance of stock for cash, assume a company issues 10,000 authorized shares of USD 20 par
value common stock at USD 22 per share. The following entry records the issuance:
Cash (+A) 220,00 0
Common Stock (+SE) 200,000 Paid-In Capital in Excess of Par Value—Common (+SE)
20,000
To record the issuance of 10,000 shares of stock for cash.
Notice that the credit to the Common Stock account is the par value (USD 20) times the number of shares
issued. The accountant credits the excess over par value (USD 20,000) to Paid-In Capital in Excess of Par Value; it
is part of the paid-in capital contributed by the stockholders. Thus, paid-in capital in excess of par (or stated)
value represents capital contributed to a corporation in addition to that assigned to the shares issued and recorded
in capital stock accounts. The paid-in capital section of the balance sheet appears as follows:
Paid-in capital: Common stock—par value, $20; 10,000 shares authorized, issued and outstanding $ 200,000 Paid-in capital in excess of par value—common 20,000 Total paid-in capital $ 220,000
When it issues no-par stock with a stated value, a company carries the shares in the capital stock account at the
stated value. Any amounts received in excess of the stated value per share represent a part of the paid-in capital of
the corporation and the company credits them to Paid-In Capital in Excess of Stated Value. The legal capital of a
corporation issuing no-par shares with a stated value is usually equal to the total stated value of the shares issued.
To illustrate, assume that the DeWitt Corporation, which is authorized to issue 10,000 shares of common stock
without par value, assigns a stated value of USD 20 per share to its stock. DeWitt issues the 10,000 authorized
shares for cash at USD 22 per share. The entry to record this transaction is:
Cash (+A) 220,000 Common Stock (+SE) 200,000 Paid-In Capital in Excess of Stated Value— Common (+SE)
20,000
To record issuance of 10,000 shares of stock for cash.
The paid-in capital section of the balance sheet appears as follows:
Paid-in capital: Common stock—par value, $20; 10,000 shares authorized, issued and outstanding $ 200,000 Paid-in capital in excess of stated value— common
20,000
Total paid-in capital $ 220,000
DeWitt carries the USD 20,000 received over and above the stated value of USD 200,000 permanently as paid-
in capital because it is a part of the capital originally contributed by the stockholders. However, the legal capital of
the DeWitt Corporation is USD 200,000.
A corporation that issues no-par stock without a stated value credits the entire amount received to the capital
stock account. For instance, consider the DeWitt Corporation's issuance of no-par stock. If no stated value had been
assigned, the entry would have been as follows:
Cash (+A) 220,000
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Common Stock (+SE) 200,000 To record issuance of 10,000 shares for cash.
Since the company may issue shares at different times and at differing amounts, its credits to the capital stock
account are not uniform amounts per share. This contrasts with issuing par value shares or shares with a stated
value.
To continue our example, the paid-in capital section of the company's balance sheet would be as follows:
Paid-in capital: Common stock—without par or stated value; 10,000 shares authorized, issued and outstanding $ 220,000 Total paid-in capital $ 220,000
The actual capital contributed by stockholders is USD 220,000. In some states, the entire amount received for
shares without par or stated value is the amount of legal capital. The legal capital in this example would then be
equal to USD 220,000.
Capital stock issued for property or services
When issuing capital stock for property or services, companies must determine the dollar amount of the
exchange. Accountants generally record the transaction at the fair value of (1) the property or services received or
(2) the stock issued, whichever is more clearly evident.
To illustrate, assume that the owners of a tract of land deeded it to a corporation in exchange for 1,000 shares of
USD 12 par value common stock. The firm can only estimate the fair market value of the land. At the time of the
exchange, the stock has an established total market value of USD 14,000. The required entry is:
Land (+A) 14,000 Common Stock (+SE) 12,000 Paid-In Capital in Excess of Par Value— Common (+SE)
2,000
To record the receipt of land for capital stock.
As another example, assume a firm issues 100 shares of common stock with a par value of USD 40 per share in
exchange for legal services received in organizing as a corporation. No shares have been traded recently, so there is
no established market value. The attorney previously agreed to a price of USD 5,000 for these legal services but
decided to accept stock in lieu of cash. In this example, the correct entry is:
Organization Costs (+A) 5,000 Common Stock (+SE) 4,000 Paid-In Capital in Excess of Par Value—Common (+SE)
1,000
To record the receipt of legal services for capital stock.
The company should value the services at the price previously agreed on since that value is more clearly evident
than the market value of the shares. It should debit an intangible asset account because these services benefit the
corporation throughout its entire life. The company credits the amount by which the value of the services received
exceeds the par value of the shares issued to a Paid-In Capital in Excess of Par Value—Common account.
Balance sheet presentation of paid-in capital in excess of par (or stated) value— Common or preferred
Accountants credit amounts received in excess of the par or stated value of shares to a Paid-In Capital in Excess
of Par (or Stated) Value—Common (or Preferred) account. They carry the amounts received in excess of par or
stated value in separate accounts for each class of stock issued. Using the following assumed data, the stockholders'
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12. Stockholders' equity: Classes of capital stock
equity section of the balance sheet of a company with both preferred and common stock outstanding would appear
as follows:
Stockholders' equity: Paid-in capital: Preferred stock—$100 par value, 6% cumulative; 1,000 shares authorized, issued, and outstanding $100,000 Common stock—without par value, stated value, $5; 100,000 shares authorized, 80,000 shares; issued and outstanding 400,000 $ 500,000 Paid-in capital in excess of par (or stated) value: From preferred stock issuances $ 5,000 From common stock issuances 20,000 25,000 Total paid-in capital $ 525,000 Retained earnings 200,000 Total stockholders' equity $ 725,000
The total book value of a corporation's outstanding shares is equal to its recorded net asset value—that is, assets
minus liabilities. Quite simply, the amount of net assets is equal to stockholders' equity. When only common stock
is outstanding, companies compute the book value per share by dividing total stockholders' equity by the
number of common shares outstanding. In calculating book value, they assume that (1) the corporation could be
liquidated without incurring any further expenses, (2) the assets could be sold at their recorded amounts, and (3)
the liabilities could be satisfied at their recorded amounts. Assume the stockholders' equity of a corporation is as
follows:
Stockholders' equity: Paid-in capital: Common stock—without par value, stated value, $10; authorized, 20,000 shares; issued and outstanding, 15,000 shares $ 150,000
Paid-in capital in excess of stated value 10,000
Total paid-in capital $ 160,000 Retained earnings 50,000 Total stockholders' equity $ 210,000 To determine the book value per share of the stock: Total stockholders' equity $210,000
Total shares outstanding ÷15,000
Book value per share $ 14
When two or more classes of capital stock are outstanding, the computation of book value per share is more
complex. The book value for each share of stock depends on the rights of the preferred stockholders. Preferred
stockholders typically are entitled to a specified liquidation value per share, plus cumulative dividends in arrears,
since most preferred stocks are preferred as to assets and are cumulative. In each case, the specific provisions in the
preferred stock contract govern. To illustrate, assume the Celoron Corporation's stockholders' equity is as follows:
Stockholders' equity: Paid-in capital: Preferred stock—$100 par value, 6% cumulative; 5,000 shares authorized, issued, and outstanding $ 500,000 Common stock—$10 par value, 200,000 shares authorized, issued and outstanding 2,000,000 Paid-in capital in excess of par value—preferred 200,000 Total paid-in capital $2,700,000 Retained earnings 400,000 Total stockholders' equity $3,100,000
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The preferred stock is 6 per cent, cumulative. It is preferred as to dividends and as to assets in liquidation to the
extent of the liquidation value of USD 100 per share, plus any cumulative dividends on the preferred stock.
Dividends for four years (including the current year) are unpaid. You would calculate the book values of each class
of stock as follows:
Total stockholders' equity Total $3,100,000
Per Share
Book value of preferred stock (5,000 shares) Liquidation value (5,000 shares X $100) Dividends (4 years at $30,000) Book value of common stock (200,000 shares)
$ 500,000 120,000 620,000
$2,480,000 $124.00* 12.40T
* $620,000 ÷ 5,000 shares. T $2,480,000 ÷ 200,000 shares.
Notice that Celoron did not assign the paid-in capital in excess of par value—preferred to the preferred stock in
determining the book values. Celoron assigned only the liquidation value and cumulative dividends on the
preferred stock to the preferred stock.
Assume now that the features attached to the preferred stock are the same except that the preferred
stockholders have the right to receive USD 103 per share in liquidation. The book values of each class of stock
would be:
Total stockholders' equity Total $3,100,000
Per Share
Book value of preferred stock (5,000 shares) Liquidation value (5,000 shares X $103) Dividends (4 years at $30,000) Book value of common stock (200,000 shares)
$ 515,000 120,000 635,000
$2,465,000 $ 127.00 12.33
Book value rarely equals market value of a stock because many of the assets have changed in value due to
inflation. Thus, the market prices of the shares of many corporations traded regularly are different from their book
values.
An accounting perspective:
Business insight
The Wall Street Journal publishes the New York Stock Exchange (NYSE) Composite Transactions
each Monday through Friday except when the exchange is closed. For each stock listed on the
NYSE, it lists the following data. We use data for the Kellogg Company, which produces ready-to-
eat cereals and other food products, as recently reported in The Wall Street Journal as an example:
52 Weeks
The first column reflects the stock price percentage change for the calendar year to date, adjusted
for stock splits and dividends over 10 per cent. The next two columns show the high and low price
Accounting Principles: A Business Perspective 502 A Global Text
12. Stockholders' equity: Classes of capital stock
over the preceding 52 weeks plus the current week. The next two columns show the company name
(Kellogg) and the NYSE's symbol (K) for that company. The Div column is the annual dividend
based on the last quarterly, semiannual, or annual declaration. Yield per cent is calculated as
dividends paid divided by the current market price. The PE ratio is the closing market price divided
by the total earnings per share for the most recent four quarters. The Vol 100s column shows the
unofficial daily total of shares traded, quoted in hundreds. Thus, 995,700 shares of Kellogg's were
traded that day. The next to last column shows the closing price for that day. The final column
shows the change in the closing price as compared to the closing price of the preceding day.
Analyzing and using the financial results—Return on average common stockholders' equity
Stockholders' equity is particularly important to managers, creditors, and investors in determining the return on
equity, which is the return on average common stockholders' equity.
The return on average common stockholders' equity measures what a given company earned for its
common stockholders from all sources as a percentage of the common stockholders' investment. From the common
stockholders' point of view, it is an important measure of the income-producing ability of the company. The ratio's
formula is:
Return on average common stockholders ' equity= Net income available for common stockholders
Averagecommon stockholders 'equity
If preferred stock is outstanding, the numerator is net income minus the annual dividend on preferred stock,
and the denominator is the average total book value of common stock. If no preferred stock is outstanding, the
numerator is net income, and the denominator is average stockholders' equity.
The Procter & Gamble Company reported the following information in its 2001 financial statements (USD
millions):
2001 Net earnings $ 2,922 Stockholders' equity, beginning 12,287 Stockholders' equity, ending 12,010
The return on average common stockholders' equity for Procter & Gamble is 24.1 per cent, or USD 2,922/[(USD
12,287 + USD 12,010)/2]. Investors view any increase from year to year as favorable and any decrease as
unfavorable.
Since the stock market is frequently referred to as an economic indicator, the knowledge you now have on
corporate stock issuances should help you relate to stocks traded in the market. Chapter 13 continues the discussion
of paid-in capital and also discusses treasury stock, retained earnings, and dividends.
An ethical perspective:
Belex corporation
Joe Morrison is the controller for Belex Corporation. He is involved in a discussion with other
members of management concerning how to get rid of some potentially harmful toxic waste
materials that are a by-product of the company's manufacturing process.
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There are two alternative methods of disposing of the materials. The first alternative is to bury the
waste in steel drums on a tract of land adjacent to the factory building. There is currently no legal
prohibition against doing this. The cost of disposing of the materials in this way is estimated to be
USD 50,000 per year. The best estimate is that the steel drums would not leak for at least 50 years,
but probably would begin leaking after that time. The second alternative is to seal the materials in
lead drums that would be disposed of at sea by a waste management company. The cost of this
alternative is estimated to be USD 400,000 per year. The federal government has certified this
method as the preferred method of disposal. The best estimate is that the lead drums would never
rupture or leak.
Belex Corporation has seen some tough economic times. The company suffered losses until last
year, when it showed a profit of USD 750,000 as a result of a new manufacturing project. So far, the
waste materials from that project have been accumulating in two large vats on the company's land.
However, these vats are almost full, so soon management must decide how to dispose of the
materials.
One group of managers is arguing in favor of the first alternative because it is legally permissible
and results in annual profits of about USD 700,000. They point out that using the second
alternative would reduce profits to about USD 350,000 per year and cut managers' bonuses in half.
They also claim that some of their competitors are now using the first alternative, and to use the
second alternative would place the company at a serious competitive disadvantage.
Another group of managers argues that the second alternative is the only safe alternative to pursue.
They claim that when the steel drums start leaking they will contaminate the ground water and
could cause serious health problems. When this contamination occurs, the company will lose public
support and may even have to pay for the cleanup. The cost of that cleanup could run into the
millions.
Understanding the learning objectives
• Advantages:
(a) Easy transfer of ownership.
(b)Limited liability.
(c) Continuous existence of the entity.
(d)Easy capital generation.
(e) Professional management.
(f) Separation of owners and entity.
• Disadvantages:
(a) Double taxation.
(b)Government regulation.
(c) Entrenched, inefficient management.
(d)Limited ability to raise creditor capital.
Accounting Principles: A Business Perspective 504 A Global Text
12. Stockholders' equity: Classes of capital stock
• Par value—an arbitrary amount assigned to each share of a given class of stock and printed on the stock
certificate.
• Stated value—an arbitrary amount assigned by the board of directors to each share of a given class of no-
par stock.
• Market value—the price at which shares of capital stock are bought and sold in the market.
• Book value—the amount per share that each stockholder would receive if the corporation were liquidated
without incurring any further expenses and if assets were sold and liabilities liquidated at their recorded
amounts.
• Liquidation value—the amount a stockholder would receive if a corporation discontinues operations, pays
its liabilities, and distributes the remaining cash among the stockholders.
• Redemption value—the price per share at which a corporation may call in (redeem) its capital stock for
retirement.
• Capital stock authorized—the number of shares of stock that a corporation is entitled to issue as designated
in its charter.
• Capital stock issued—the number of shares of stock that have been sold and issued to stockholders.
• Capital stock outstanding—the number of authorized shares of stock that have been issued and that are still
currently held by stockholders.
• Two basic classes of capital stock:
(a) Common stock—represents the residual equity.
(b)Preferred stock—may be preferred as to dividends and/or assets. Also may be cumulative and/or
callable.
• If the company has paid-in capital in excess of par value, the proper form would be:
Stockholders' equity:
Paid-in capital:
Preferred stock—$100 par value, 6% cumulative; 1,000 shares authorized,issued, and outstanding $ 100,000
Common stock—without par value, stated value, $5; 100,000 shares authorized,80,000 shares; issued and outstanding 400,000 $ 500,000
Paid-in capital in excess of par (or stated)value: From preferred stock issuances $ 5,000
From common stock issuances 20,000 25,000
Total paid-in capital $ 525,000
Retained earnings 200,000
Total stockholders' equity $ 725,000
The following examples illustrate the issuance for cash of: (1) stock with a par value, (2) no-par value stock with
a stated value, and (3) no-par value stock without a stated value.
• Issuance of par value stock for cash—10,000 shares of USD 20 par value common stock issued for USD 22
per share.
Cash (+A) 220,000
Common Stock (+SE) 200,000 Paid-In Capital in Excess of Par 20,000
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Value—Common (+SE)
• Issuance of no-par, stated value stock for cash—10,000 shares (no-par value) with USD 20 per share stated
value issued for USD 22 per share.
Cash (+A) 220,000
Common Stock (+SE) 200,000 Paid-In Capital in Excess of Stated Value—Common (+SE)
20,000
• Issuance of no-par stock without a stated value for cash—10,000 shares (no-par value) issued at USD 22
per share.
Cash (+A) 220,000
Common Stock (+SE)
220,000
• Example: A corporation has 200,000 shares of common stock and 5,000 shares of preferred stock
outstanding. Preferred stock is 6 per cent and cumulative. It is preferred as to dividends and as to assets in
liquidation to the extent of the liquidation value of USD 100 per share, plus any cumulative dividends on the
preferred stock. Dividends for three years are unpaid. Total stockholders' equity is USD 4,100,000.
Calculations are as follows:
Total Per Share
Total stockholders' equity $4,100,000 Book value of preferred stock (5,000 shares) Liquidation value (5,000 shares X $100) $ 500,000 Dividends (3 years at $30,000) 90,000 590,000 $ 118.00 Book value of common stock (200,000 shares) $3,510,000 17.55
• The return on average common stockholders' equity equals net income available to common stockholders
divided by average common stockholders' equity.
• The return on average common stockholders' equity is an important measure of the income-producing
ability of the company.
Demonstration problem
Demonstration problem A Violet Company has paid all required preferred dividends through 2004
December 31. Its outstanding stock consists of 10,000 shares of USD 125 par value common stock and 4,000 shares
of 6 per cent, USD 125 par value preferred stock. During five successive years, the company's dividend declarations
were as follows:
2005 $85,000 2006 52,500 2007 7,500 2008 15,000 2009 67,500
Compute the amount of dividends that would have been paid to each class of stock in each of the last five years
assuming the preferred stock is:
a. Cumulative.
b. Noncumulative.
Demonstration problem B Terrier Company has been authorized to issue 100,000 shares of USD 6 par
value common stock and 1,000 shares of 14 per cent, cumulative, preferred stock with a par value of USD 12.
a. Prepare the entries for the following transactions that all took place in June 2009:
• 50,000 shares of common stock are issued for cash at USD 24 per share.
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12. Stockholders' equity: Classes of capital stock
• 750 shares of preferred stock are issued for cash at USD 18 per share.
• 1,000 shares of common stock are issued in exchange for legal services received in the incorporation
process. The fair market value of the legal services is USD 9,000.
b. Prepare the paid-in capital section of Terrier's balance sheet as of 2009 June 30.
Solution to demonstration problem A
VIOLET COMPANY Assumptions
Year Dividends to a b 2005 Preferred $30,000* $30,000
Common 55,000 55,000 2006 Preferred 30,000 30,000
Common 22,500 22,500 2007 Preferred 7,500 7,500
Common -0- -0- 2008 Preferred 15,000 15,000
Common -0- -0- 2009 Preferred 67,500† 30,000‡
Common -0- 37,500 * 4,000 shares X $125 X 0.06 = $30,000 † $30,000 + $22,500 preferred dividend missed in 2007 + $15,000 preferred dividend missed in 2008. ‡Only the basic $30,000 dividend is paid because the stock is noncumulative.
Solution to demonstration problem B
a. (1) Cash (+A) 1,200,000 Common Stock (+SE) 300,000 Paid-In Capital in Excess of Par Value—Common Stock (+SE)
900,000
To record issuance of 50,000 shares at $24 per share.
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12. Stockholders' equity: Classes of capital stock
(2) Cash (+A) 13,500 Preferred Stock (+SE) 9,000 Paid-In Capital in Excess of Par Value—Preferred (+SE)
4,500
To record the issuance of 750 shares for cash, at $18 per share.
(3) Organization Costs (+A) 9,000 Common Stock (+SE) 6,000 Paid-In Capital in Excess of Par Value—Common (+SE)
3,000
To record the issuance of 1,000 shares in exchange for legal services.
b. TERRIER COMPANY Partial Balance Sheet
2009 June 30 Paid-in Capital: Preferred stock—$12 par value, 14% cumulative; 1,000shares authorized; issued and outstanding, 750 shares
$ 9,000
Common stock—$6 par value per share; 100,000 shares authorized; issued and outstanding, 51,000 shares
306,000 $ 315,000
Paid-in capital in excess of par value:
From preferred stock issuances $ 4,500
From common stock issuances 903,000 907,500
Total paid-in capital $1,222,50 0
Key Terms Articles of incorporation The application for the corporation's charter.
Board of directors Elected by the stockholders to have primary responsibility for formulating policies for the corporation. The board also authorizes contracts, declares dividends, establishes executive salaries, and grants authorization to borrow money.
Book value per share Stockholders' equity per share; the amount per share each stockholder would receive if the corporation were liquidated without incurring any further expenses and if assets were sold and liabilities liquidated at their recorded amounts.
Bylaws A set of rules or regulations adopted by the board of directors of a corporation to govern the conduct of corporate affairs. The bylaws must be in agreement with the laws of the state and the policies and purposes in the corporate charter.
Callable preferred stock If the stock is nonconvertible, it must be surrendered to the company when the holder is requested to do so. If the stock is convertible, it may be either surrendered or converted into common shares when called.
Call premium (on preferred stock) The difference between the amount at which a corporation calls its preferred stock for redemption and the par value of the stock.
Capital stock Transferable units of ownership in a corporation.
Capital stock authorized The number of shares of stock that a corporation is entitled to issue as designated in its charter.
Capital stock issued The number of shares of stock that have been sold and issued to stockholders.
Capital stock outstanding The number of shares of authorized stock issued and currently held by stockholders.
Common stock Shares of stock representing the residual equity in the corporation. If only one class of stock is issued, it is known as common stock. All other claims rank ahead of common stockholders' claims.
Convertible preferred stock Preferred stock that is convertible into common stock of the issuing corporation.
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Corporate charter The contract between the state and the incorporators of a corporation, and their successors, granting the corporation its legal existence.
Corporation An entity recognized by law as possessing an existence separate and distinct from its owners; that is, it is a separate legal entity. A corporation is granted many of the rights, and placed under many of the obligations, of a natural person. In any given state, all corporations organized under the laws of that state are domestic corporations; all others are foreign corporations.
Cumulative preferred stock Preferred stock for which the right to receive a basic dividend accumulates if any dividends have not been paid; unpaid cumulative preferred dividends must be paid before any dividends can be paid on the common stock.
Discount on capital stock The amount by which the par value of shares issued exceeds their issue price. The original issuance of shares at a discount is illegal in most states.
Dividend A distribution of assets (usually cash) that represents a withdrawal of earnings by the owners.
Dividend on preferred stock The amount paid to preferred stockholders as a return for the use of their money; usually a fixed or stated amount expressed in dollars per share or as a percentage of par value per share.
Dividends in arrears Cumulative unpaid dividends, including quarterly dividends not declared for the current year.
Domestic corporation See corporation.
Foreign corporation See corporation.
Incorporators Persons seeking to bring a corporation into existence.
Legal capital (stated capital) An amount prescribed by law (usually the par value or stated value of shares issued) below which a corporation may not reduce stockholders' equity through the declaration of dividends or other payments to stockholders.
Liquidation value The amount a stockholder will receive if a corporation discontinues operations and liquidates by selling its assets, paying its liabilities, and distributing the remaining cash among the stockholders.
Market value The price at which shares of capital stock are bought and sold in the market.
Minutes book The record book in which actions taken at stockholders' and board of directors' meetings are recorded; the written authorization for many actions taken by corporate officers.
Noncumulative preferred stock Preferred stock on which the right to receive a dividend expires if the dividend is not declared.
No-par stock Capital stock without par value, to which a stated value may or may not be assigned.
Organization costs Costs of organizing a corporation, such as incorporation fees and legal fees applicable to incorporation.
Paid-in capital Amount of stockholders' equity that normally results from the cash or other assets invested by owners; it may also result from services provided for shares of stock and certain other transactions.
Paid-in capital in excess of par (or stated) value—common or preferred Capital contributed to a corporation in addition to that assigned to the shares issued and recorded in capital stock accounts.
Par value An arbitrary amount assigned to each share of a given class of stock and printed on the stock certificate.
Preemptive right The right of stockholders to buy additional shares in a proportion equal to the percentage of shares already owned.
Preferred stock Capital stock that carries certain features or rights not carried by common stock. Preferred stock may be preferred as to dividends, as to assets, or as to both dividends and assets. Preferred stock may be callable and/or convertible and may be cumulative or noncumulative.
Proxy A legal document signed by a stockholder, giving another person the authority to vote the stockholder's shares at a stockholders' meeting.
Redemption value The price per share at which a corporation may call in (or redeem) its capital stock for retirement.
Retained earnings The part of stockholders' equity resulting from net income, reduced by dividends and net losses.
Accounting Principles: A Business Perspective 509 A Global Text
12. Stockholders' equity: Classes of capital stock
Return on average common stockholders' equity A measure of the income-producing ability of the company. It is the ratio of net income available to common stockholders divided by average common stockholders' equity.
Shares of stock Units of ownership in a corporation.
Stated value An arbitrary amount assigned by the board of directors to each share of a given class of no-par stock.
Stock certificate A printed or engraved document serving as evidence that the holder owns a certain number of shares of capital stock.
Stockholders' ledger Contains a group of subsidiary accounts showing the number of shares of stock currently held by each stockholder.
Stock preferred as to assets Means that in liquidation, the preferred stockholders are entitled to receive the par value (or a larger stipulated liquidation value) per share before any assets may be distributed to common stockholders.
Stock preferred as to dividends Means that the preferred stockholders are entitled to receive a specified dividend per share before any dividend on common stock is paid.
Stock registrar Typically, a bank that maintains records of the shares outstanding for a company.
Stock-transfer agent Typically, a bank or trust company employed by a corporation to transfer stock between buyers and sellers.
Stock without par value See no-par stock.
Unissued shares Capital stock authorized but not yet issued.
Self-test
True-false
Indicate whether each of the following statements is true or false.
A person may favor the corporate form of organization for a risky business enterprise primarily because a
corporation's shares can be easily transferred.
In the event of corporate liquidation, stockholders whose stock is preferred as to assets are entitled to receive the
par value of their shares before any amounts are distributed to creditors or common stockholders.
The par value of a share of capital stock is no indication of the market value or book value of the share of stock.
When 10,000 shares of USD 20 par value common stock are issued in payment for a parcel of land with a fair
market value of USD 300,000, the Common Stock account is credited for USD 200,000, and the Paid-In Capital in
Excess of Par Value—Common account is credited for USD 100,000.
Multiple-choice
Select the best answer for each of the following questions.
Which of the following is not an advantage of the corporate form of organization?
a. Continuous existence of the entity.
b. Limited liability of stockholders.
c. Government regulation.
d. Easy transfer of ownership.
An arbitrary amount assigned by the board of directors to each share of a given class of no-par stock is:
a. Quasi-par value.
b. Stated value.
c. Redemption value.
d. Liquidation value.
Preferred stock that has dividends in arrears is:
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a. Noncumulative preferred stock.
b. Noncumulative and callable preferred stock.
c. Noncumulative and convertible preferred stock.
d. Cumulative preferred stock.
Quinn Corporation issued 10,000 shares of USD 20 par value common stock at USD 50 per share. The amount
that would be credited to Paid-In Capital in Excess of Par Value—Common is:
a. USD 200,000.
b. USD 300,000.
c. USD 500,000.
d. USD 700,000.
e. None of the above.
You are given the following information: Capital Stock, USD 80,000 (USD 80 par); Paid-In Capital in Excess of
Par Value—Common, USD 200,000; and Retained Earnings, USD 400,000. Assuming only one class of stock, the
book value per share is:
a. USD 680.
b. USD 280.
c. USD 80.
d. USD 400.
e. None of the above.
Now turn to “Answers to self-test” at the end of the chapter to check your answers.
Questions
➢ Cite the major advantages of the corporate form of business organization and indicate why each is
considered an advantage.
➢ What is meant by the statement that corporate income is subject to double taxation? Cite several
other disadvantages of the corporate form of organization.
➢ Why is Organization Expense not a good title for the account that records the costs of organizing a
corporation? Could you justify leaving the balance of an Organization Costs account intact
throughout the life of a corporation?
➢ What are the basic rights associated with a share of capital stock if there is only one class of stock
outstanding?
➢ Explain the purpose or function of: (a) the stockholders' ledger, (b) the minutes book, (c) the stock-
transfer agent, and (d) the stock registrar.
➢ What are the differences between par value stock and stock with no-par value?
➢ Corporate capital stock is seldom issued for less than par value. Give two reasons why this statement
is true.
➢ Explain the terms liquidation value and redemption value.
➢ What are the meanings of the terms stock preferred as to dividends and stock preferred as to assets?
➢ What do the terms cumulative and noncumulative mean in regard to preferred stock?
➢ What are dividends in arrears, and how should they be disclosed in the financial statements?
Accounting Principles: A Business Perspective 511 A Global Text
12. Stockholders' equity: Classes of capital stock
➢ A corporation has 1,000 shares of 8 per cent, USD 200 par value, cumulative, preferred stock
outstanding. Dividends on this stock have not been declared for three years. Is the corporation
legally liable to its preferred stockholders for these dividends? How should this fact be shown in the
balance sheet, if at all?
➢ Explain why a corporation might issue a preferred stock that is both convertible into common stock
and callable.
➢ Explain the nature of the account entitled Paid-In Capital in Excess of Par Value. Under what
circumstances is this account credited?
➢ Blake Corporation issued 5,000 shares of USD 100 par value common stock at USD 120 per share.
What is the legal capital of Blake Corporation, and why is the amount of legal capital important?
➢ What is the general approach of the accountant in determining the dollar amount at which to record
the issuance of capital stock for services or property other than cash?
➢ What assumptions are made in determining book value?
➢ Assuming there is no preferred stock outstanding, how can the book value per share of common
stock be determined? Of what significance is the book value per share? What is the relationship of
book value per share to market value per share?
Exercises
Exercise A Winters Corporation has outstanding 1,000 shares of noncumulative preferred stock and 2,000
shares of common stock. The preferred stock is entitled to an annual dividend of USD 100 per share before
dividends are declared on common stock. What are the total dividends received by each class of stock if Winters
Corporation distributes USD 280,000 in dividends in 2010?
Exercise B Zeff Corporation has 2,000 shares outstanding of cumulative preferred stock and 6,000 shares of
common stock. The preferred stock is entitled to an annual dividend of USD 18 per share before dividends are
declared on common stock. No preferred dividends were paid for last year and the current year. What are the total
dividends received by each class of stock if Zeff Corporation distributes USD 108,000 in dividends?
Exercise C Gordon Company issued 10,000 shares of common stock for USD 1,120,000 cash. The common
stock has a par value of USD 100 per share. Give the journal entry for the stock issuance.
Exercise D Thore Company issued 30,000 shares of USD 20 par value common stock for USD 680,000. What
is the journal entry for this transaction? What would the journal entry be if the common stock had no-par or stated
value?
Exercise E Li & Tu, Inc., needed land for a plant site. It issued 100 shares of USD 480 par value common stock
to the incorporators of their corporation in exchange for land, which cost USD 56,000 one year ago. Experienced
appraisers recently valued the land at USD 72,000. What journal entry would be appropriate to record the
acquisition of the land?
Exercise F Smart Corporation owes a trade creditor USD 30,000 on open account which the corporation does
not have sufficient cash to pay. The trade creditor suggests that Smart Corporation issue to him 750 shares of the
USD 24 par value common stock, which is currently selling on the market at USD 40. Present the entry or entries
that should be made on Smart Corporation's books.
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Exercise G Why would a law firm ever consider accepting stock of a new corporation having a total par value of
USD 320,000 as payment in full of a USD 480,000 bill for legal services rendered? If such a transaction occurred,
give the journal entry the issuing company would make on its books.
Exercise H The stockholders' equity of Graf Company's balance is as follows:
Stockholders' equity: Paid-in capital: Common stock—without par value, $12 stated value; authorized 100,000 shares; issued and outstanding, 70,000 shares $ 840,000 Paid-in capital in excess of stated value 340,000 Total paid-in capital $1,180,00
0 Retained earnings 80,000 Total stockholders' equity $1,260,00
0
Compute the average price at which the 70,000 issued shares of common stock were sold. Compute the book
value per share of common stock.
Problems
Problem A The outstanding capital stock of Robbins Corporation consisted of 3,000 shares of 10 per cent
preferred stock, USD 250 par value, and 30,000 shares of no-par common stock with a stated value of USD 250.
The preferred was issued at USD 412, the common at USD 480 per share. On 2005 January 1, the retained earnings
of the company were USD 250,000. During the succeeding five years, net income was as follows:
2005 $767,500 2006 510,000 2007 48,000 2008 160,000 2009 662,500
No dividends were in arrears as of 2005 January 1, and during the five years 2005-2009, the board of directors
declared dividends in each year equal to net income of the year.
Prepare a schedule showing the dividends declared each year on each class of stock assuming the preferred stock
is:
a. Cumulative.
b. Noncumulative.
Problem B On 2008 December 27, Glade Company was authorized to issue 250,000 shares of USD 24 par
value common stock. It then completed the following transactions:
2009
Jan. 14 Issued 45,000 shares of common stock at USD 30 per share for cash.
29 Gave the promoters of the corporation 25,000 shares of common stock for their services in organizing the
company. The board of directors valued these services at USD 744,000.
19 Exchanged 50,000 shares of common stock for the following assets at the indicated fair market values:
Land USD 216,000 Building 528,000 Machinery 720,000
a. Prepare general journal entries to record the transactions.
b. Prepare the balance sheet of the company as of 2009 March 1.
Accounting Principles: A Business Perspective 513 A Global Text
12. Stockholders' equity: Classes of capital stock
Problem C In the corporate charter that it received on 2009 May 1, Norris Company was authorized to issue
15,000 shares of common stock. The company issued 1,000 shares immediately for USD 82 per share, cash.
On July 2, the company issued 100 shares of stock to a lawyer to satisfy a USD 8,400 bill for legal services
rendered in organizing the corporation.
On July 5, the company issued 1,000 shares to the principal promoter of the corporation in exchange for a
patent. Another 200 shares were issued to this same person for costs incurred and services rendered in bringing the
corporation into existence. The market value of the stock was USD 84 per share.
a. Set up T-accounts, and post these transactions. Then prepare a balance sheet for the Norris Company as of
2009 July 5, assuming the authorized stock has a par value of USD 75 per share.
b. Repeat part (a) for the stockholders' equity accounts, and prepare the stockholders' equity section of the July
5 balance sheet assuming the stock authorized has no par value but has a USD 30 per share stated value.
c. Repeat part (a) for the stockholders' equity accounts assuming the stock authorized has neither par nor stated
value. Prepare the stockholders' equity section of the balance sheet.
Problem D On 2009 May 1, Farmington Company received a charter that authorized it to issue:
• 4,000 shares of no-par preferred stock to which a stated value of USD 12 per share is assigned. The stock is
entitled to a cumulative dividend of USD 9.60, convertible into two shares of common stock, callable at USD
208, and entitled to USD 200 per share in liquidation.
• 1,500 shares of USD 400 par value, USD 20 cumulative preferred stock, which is callable at USD 420 and
entitled to USD 412 in liquidation.
• 60,000 shares of no-par common stock to which a stated value of USD 40 is assigned.
May 1 All of the USD 9.60 cumulative preferred was issued at USD 204 per share, cash.
2 All of the USD 20 cumulative preferred was exchanged for merchandise inventory, land, and buildings valued
at USD 128,000, USD 160,000, and USD 425,000, respectively.
3 Cash of USD 15,000 was paid to reimburse promoters for costs incurred for accounting, legal, and printing
services. In addition, 1,000 shares of common stock were issued to the promoters for their services. The value of all
of the services (including those paid in cash) was USD 55,000.
a. Prepare journal entries for these transactions.
b. Assume that retained earnings were USD 200,000. Prepare the stockholders' equity section of the 2009 May
31, balance sheet.
Problem E On 2008 January 2, the King Company received its charter. It issued all of its authorized 3,000
shares of no-par preferred stock at USD 104 and all of its 12,000 authorized shares of no-par common stock at USD
40 per share. The preferred stock has a stated value of USD 50 per share, is entitled to a basic cumulative dividend
of USD 6 per share, is callable at USD 106 beginning in 2010, and is entitled to USD 100 per share plus cumulative
dividends in the event of liquidation. The common stock has a stated value of USD 10 per share.
On 2009 December 31, the end of the second year of operations, retained earnings were USD 90,000. No
dividends have been declared or paid on either class of stock.
a. Prepare the stockholders' equity section of King Company's 2009 December 31, balance sheet.
b. Compute the book value of each class of stock.
c. If USD 42,000 of dividends were declared as of 2009 December 31, compute the amount paid to each class of
stock.
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Problem F The common stock of Lang Corporation is selling on a stock exchange for USD 90 per share. The
stockholders' equity of the corporation at 2009 December 31, consists of:
Stockholders' equity: Paid-in capital: Preferred stock—9% cumulative, $120 par value, $120 liquidation value, 3,000 shares authorized, issued, and outstanding
$ 360,000
Common stock—$72 par value, 30,000 shares authorized, issued and outstanding
2,160,000
Total paid-in capital $2,520,000 Retained earnings 354,000 Total stockholders' equity $2,874,000
Assume that in liquidation the preferred stock is entitled to par value plus cumulative unpaid dividends.
a. What is the total market value of all of the corporation's common stock?
b. If all dividends have been paid on the preferred stock as of 2009 December 31, what are the book values of the
preferred stock and the common stock?
c. If two years' dividends were due on the preferred stock as of 2009 December 31, what are the book values of
the preferred stock and common stock?
Problem G Haft Corporation has an agreement with each of its 15 preferred and 30 common stockholders that
in the event of the death of a stockholder, it will purchase at book value from the stockholder's estate or heirs the
shares of Haft Corporation stock held by the deceased at the time of death. The book value is to be computed in
accordance with generally accepted accounting principles.
Following is the stockholders' equity section of the Haft Corporation's 2009 December 31, balance sheet.
Stockholders' equity: Paid-in capital: Preferred stock—without par value, $50 stated value, $15 cumulative; 3,000 shares authorized, issued, and outstanding
$ 150,000
Common stock—$62.50 par value, 60,000 shares authorized, issued and outstanding
3,750,000
Paid-in capital in excess of stated value—preferred 840,000 Paid-in capital in excess of par value—common 30,000 Total paid-in capital $4,770,000 Retained earnings 1,800,000 Total stockholders' equity $6,570,000
The preferred stock is cumulative and entitled to USD 300 per share plus cumulative dividends in liquidation.
No dividends have been paid for 1 year.
A stockholder who owned 100 shares of preferred stock and 1,000 shares of common stock died on 2009
December 31. You have been employed by the stockholder's executor to compute the book value of each class of
stock and to determine the price to be paid for the stock held by her late husband.
Prepare a schedule showing the computation of the amount to be paid for the deceased stockholder's preferred
and common stock.
Alternate problems
Alternate problem A On 2005 January 1, the retained earnings of Quigley Company were USD 432,000. Net
income for the succeeding five years was as follows:
2005 $288,000 2006 216,000 2007 4,800 2008 48,000 2009 264,000
Accounting Principles: A Business Perspective 515 A Global Text
12. Stockholders' equity: Classes of capital stock
The outstanding capital stock of the corporation consisted of 2,000 shares of preferred stock with a par value of
USD 480 per share that pays a dividend of USD 19.20 per year and 8,000 shares of no-par common stock with a
stated value of USD 240 per share. No dividends were in arrears as of 2005 January 1.
Prepare schedules showing how the net income for these five years was distributed to the two classes of stock if
in each of the years the entire current net income was distributed as dividends and the preferred stock was:
a. Cumulative.
b. Noncumulative.
Alternate problem B On 2009 January 1, Cowling Company was authorized to issue 500,000 shares of USD
5 par value common stock. It then completed the following transactions:
2009
Jan. 14 Issued 90,000 shares of common stock at USD 24 per share for cash.
29 Gave the promoters of the corporation 50,000 shares of common stock for their services in organizing the
company. The board of directors valued these services at USD 620,000.
Feb. 19 Exchanged 100,000 shares of common stock for the following assets at the indicated fair market values:
Equipment USD 180,000 Building 440,000 Land 600,000
a. Prepare general journal entries to record the transactions.
b. Prepare the balance sheet of the company as of 2009 March 1.
Alternate problem C On 2009 July 3, Barr Company was authorized to issue 15,000 shares of common stock;
3,000 shares were issued immediately to the incorporators of the company for cash at USD 320 per share. On July
5 of that year, an additional 300 shares were issued to the incorporators for services rendered in organizing the
company. The board valued these services at USD 96,000. On 2009 July 6, legal and printing costs of USD 12,000
were paid. These costs related to securing the corporate charter and the stock certificates.
a. Set up T-accounts and post these transactions. Then prepare the balance sheet of the Barr Company as of the
close of 2009 July 10, assuming the authorized stock has a USD 160 par value.
b. Repeat (a) for the T-accounts involving stockholders' equity, assuming the stock is no-par stock with a USD
240 stated value. Prepare the stockholders' equity section of the balance sheet.
c. Repeat (a) for the T-accounts involving stockholders' equity, assuming the stock is no-par stock with no stated
value. Prepare the stockholders' equity section of the balance sheet.
Alternate problem D Tempo Company received its charter on 2009 April 1, authorizing it to issue: (1) 10,000
shares of USD 400 par value, USD 32 cumulative, convertible preferred stock; (2) 10,000 shares of USD 12
cumulative no-par preferred stock having a stated value of USD 20 per share and a liquidation value of USD 100
per share; and (3) 100,000 shares of no-par common stock without a stated value.
On April 2, incorporators of the corporation acquired 50,000 shares of the common stock for cash at USD 80
per share, and 200 shares were issued to an attorney for services rendered in organizing the corporation. On April
3, the company issued all of its authorized shares of USD 32 convertible preferred stock for land valued at USD
1,600,000 and a building valued at USD 4,800,000. The property was subject to a mortgage of USD 2,400,000. On
April 8, the company issued 5,000 shares of the USD 12 preferred stock in exchange for a patent valued at USD
1,040,000. On April 10, the company issued 1,000 shares of common stock for cash at USD 80 per share.
a. Prepare general journal entries for these transactions.
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b. Prepare the stockholders' equity section of the 2009 April 30, balance sheet. Assume retained earnings were
USD 80,000.
c. Assume that each share of the USD 32 convertible preferred stock is convertible into six shares of common
stock and that one-half of the preferred is converted on 2009 September 1. Give the required journal entry.
Alternate problem E Kane Company issued all of its 5,000 shares of authorized preferred stock on 2008
January 1, at USD 100 per share. The preferred stock is no-par stock, has a stated value of USD 5 per share, is
entitled to a cumulative basic preference dividend of USD 6 per share, is callable at USD 110 beginning in 2009,
and is entitled to USD 100 per share in liquidation plus cumulative dividends. On this same date, Kane also issued
10,000 authorized shares of no-par common stock with a USD 10 stated value at USD 50 per share.
On 2009 December 31, the end of its second year of operations, the company's retained earnings amounted to
USD 160,000. No dividends have been declared or paid on either class of stock since the date of issue.
a. Prepare the stockholders' equity section of Kane Company's 2009 December 31, balance sheet.
b. Compute the book value in total and per share of each class of stock as of 2009 December 31.
c. If USD 110,000 of dividends are to be declared as of 2009 December 31, compute the amount payable to each
class of stock.
The stockholders' equity sections from three different corporations' balance sheets follow.
1) Stockholders' equity: Paid-in capital:
Preferred stock—7% cumulative, $240 par value,500 shares authorized, issued, and outstanding $ 120,000 Common stock—$48 par value, 10,000 shares authorized, issued and outstanding 480,000 Total paid-in capital $ 600,000 Retained earnings 422,400 Total stockholders' equity $1,022,400 (All dividends have been paid.)
2) Stockholders' equity: Paid-in capital:
Preferred stock—6% cumulative, $80 par value,10,000 shares authorized, issued, and outstanding $ 800,000 Common stock—$240 par value, 30,000shares authorized, issued and outstanding 7,200,000 Total paid-in capital $8,000,000 Retained earnings 88,000 Total stockholders' equity $8,088,000 (The current year's dividends have not been paid.)
3) Stockholders' equity: Paid-in capital:
Preferred stock—7% cumulative, $480 par value,10,000 shares authorized, issued, and outstanding $ 4,800,000 Common stock—$240 par value, 50,000shares authorized, issued and outstanding 12,000,000 Total paid-in capital $16,800,00
0 Retained earnings deficit (1,872,000) Total stockholders' equity $14,928,00
0 (Dividends have not been paid for 2 previous years or the current year.)
Compute the book values per share of the preferred and common stock of each corporation assuming that in a
liquidation the preferred stock receives par value plus dividends in arrears.
Accounting Principles: A Business Perspective 517 A Global Text
12. Stockholders' equity: Classes of capital stock
Alternate problem G Mendell, Inc., is a corporation in which all of the outstanding preferred and common
stock is held by the four Lehman brothers. The brothers have an agreement stating that the remaining brothers will,
upon the death of a brother, purchase from the estate his holdings of stock in the company at book value.
The stockholders' equity section of the balance sheet for the company on 2009 December 31, the date of the
death of James Lehman, shows:
Stockholders' equity: Paid-in capital: Preferred stock—6%; $320 par value; $320 liquidation value, 4,000 shares authorized, issued, and outstanding
$1,280,000
Paid-in capital in excess of par—preferred 64,000 Common stock—without par value, $16 stated value, 60,000 shares authorized, issued and outstanding 960,000 Paid-in capital in excess of par value—common 960,000 Total paid-in capital $3,264,000 Retained earnings 128,000 Total stockholders' equity $3,392,000
No dividends have been paid for the last year on the preferred stock, which is cumulative. At the time of his
death, James Lehman held 2,000 shares of preferred stock and 10,000 shares of common stock of the company.
a. Compute the book value of the preferred stock.
b. Compute the book value of the common stock.
c. Compute the amount the remaining brothers must pay to the estate of James Lehman for the preferred and
common stock that he held at the time of his death.
Beyond the numbers—Critical thinking
Business decision case A Rudd Company and Clay Company have extremely stable net income amounts of
USD 4,800,000 and USD 3,200,000, respectively. Both companies distribute all their net income as dividends each
year. Rudd Company has 100,000 shares of USD 80 par value, 6 per cent preferred stock, and 500,000 shares of
USD 8 par value common stock outstanding. Clay Company has 50,000 shares of USD 40 par value, 8 per cent
preferred stock, and 400,000 shares of USD 8 par value common stock outstanding. Both preferred stocks are
cumulative.
a. Compute the annual dividend per share of preferred stock and per share of common stock for each company.
b. Based solely on the preceding information, which common stock would you predict to have the higher market
price per share? Why?
c. Which company's stock would you buy? Why?
Business decision case B Jesse Waltrip recently inherited USD 480,000 cash that he wishes to invest in the
common stock of either the West Corporation or the East Corporation. Both corporations have manufactured the
same types of products for five years. The stockholders' equity sections of the two corporations' latest balance
sheets follow:
518
12. Stockholders' equity: Classes of capital stock
WEST CORPORATION Stockholders' equity: Paid-in capital: Common stock—$125 par value, 30,000 shares authorized, issued and outstanding $3,750,000 Retained earnings 3,450,000 Total stockholders' equity $7,200,000 EAST CORPORATION Stockholders' equity: Paid-in capital: Preferred stock—8%, $500 par value, cumulative 4,000 shares authorized, issued and outstanding $2,000,000 Common stock—$125 par value, 40,000 shares authorized, issued and outstanding 5,000,000 $7,000,000 Retained earnings 560,000 Total stockholders' equity $7,560,000
The West Corporation has paid a cash dividend of USD 6 per share each year since its creation; its common
stock is currently selling for USD 590 per share. The East Corporation's common stock is currently selling for USD
480 per share. The current year's dividend and three prior years' dividends on the preferred stock are in arrears.
The preferred stock has a liquidation value of USD 600 per share.
a. What is the book value per share of the West Corporation common stock and the East Corporation common
stock? Is book value the major determinant of market value of the stock?
b. Based solely on the previous information, which investment would you recommend to Waltrip? Why?
Annual report analysis C Determine the 2003 return on average common stockholders' equity for The
Limited in the Annual report appendix. Explain in writing why this information is important to managers,
investors, and creditors.
Ethics case D Refer to the ethics case concerning Joe Morrison to answer the following questions:
a. Which alternative would benefit the company and its management over the next several years?
b. Which alternative would benefit society?
c. If you were Morrison, which side of the argument would you take?
Group project E In teams of two or three students, examine the annual reports of three companies and
calculate each company's return on common shareholders' equity for the most recent two years. At least two years
are needed to observe any changes. As a team, decide in which of the three companies you would invest. Appoint a
spokesperson for the team to explain to the class which company the team would invest in and why.
Group project F In a team of two or three students, locate the annual reports of three companies that have
preferred stock in their stockholders' equity section. Determine the features of the preferred stock. Analyze the data
in the annual report to determine whether dividends have been paid on the preferred stock each year. Are there
dividends in arrears? Write a report to your instructor summarizing your findings. Also be prepared to make a short
presentation to the class.
Group project G In a group of one or two students, contact state officials and/or consult library resources to
inquire about the incorporation laws in your state. Determine your state laws regarding the issuance of stock at an
amount below par value, how legal capital is determined, and the requirements and government fees for
incorporating a company in your state. Write a report to your instructor summarizing the results of your
investigation and be prepared to make a short presentation to your class.
Using the Internet—A view of the real world
Visit the following website for Macromedia:
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http://www.macromedia.com
Pursue choices on the screen until you locate the consolidated statement of stockholders' equity. You will
probably go down some "false paths" to get to this financial statement, but you can get there. This experience is all
part of learning to use the Internet. Note the changes that have occurred in the Common Stock, Additional Paid-In
Capital, and Retained Earnings accounts. Check out the notes to the financial statements for further information.
Write a memo to your instructor summarizing your findings.
Visit the following website for Gartner Group:
http://www.gartner.com
Pursue choices on the screen until you locate the consolidated statement of stockholders' equity. You will
probably go down some "false paths" to get to this financial statement, but you can get there. This experience is all
part of learning to use the Internet. Trace the changes that have occurred in the last three years in the Common
Stock account. Check out the notes to the financial statements for further information. Write a memo to your
instructor summarizing your findings.
Answers to self-test
True-false
False. This is not the primary reason a person may prefer the corporate form of business organization in a
situation involving considerable risk. The primary reason is that stockholders can lose only the amount of capital
they have invested in a corporation.
False. The claims of the creditors rank ahead of the claims of the stockholders, even those stockholders whose
stock is preferred as to assets.
True. Par value is simply the amount per share that is credited to the Capital Stock account for each share
issued and is no indication of the market value or the book value of the stock.
True. When capital stock is issued for property or services, the transaction is recorded at the fair market value
of (1) the property or services received or (2) the stock issued, whichever is more clearly evident.
Multiple-choice
c. This feature of corporations is one of the disadvantages of the corporate form of organization.
b. Stated value is an arbitrary amount assigned by the board of directors to each share of capital stock without a
par value.
d. Dividends in arrears are cumulative unpaid dividends. Only cumulative preferred stock has dividends in
arrears.
b. The amount credited to the Paid-In Capital in Excess of Par Value—Common is computed as follows:
10,000shares X USD50−USD20=USD300,000
a. The book value of common stock is computed as follows:
Total book value of stockholders' equity ($80,000 + $200,000 + $400,000) $680,000 Total shares ÷1,000 Book value per share $ 680
Accounting Principles: A Business Perspective 520 A Global Text
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13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
Learning objectives
After studying this chapter, you should be able to:
• Identify the different sources of paid-in capital and describe how to present them on a balance sheet.
• Account for a cash dividend, a stock dividend, a stock split, and a retained earnings appropriation.
• Account for the acquisition and reissuance of treasury stock.
• Describe the proper accounting treatment of discontinued operations, extraordinary items, and changes in
accounting principle.
• Define prior period adjustments and show their proper presentation in the financial statements.
• Analyze and use the financial results—earnings per share and price-earnings ratio.
The accountant as a financial analyst
The primary purpose of financial reporting is to provide information to investors and creditors. Investors use
financial information in purchasing and selling of stocks, while creditors (such as banks) use financial information
in reviewing the credit-worthiness of companies wishing to obtain loans. In making these types of decisions,
investors and creditors rely on financial analysts to give them accurate assessments of the value and strength of the
company. The role of the financial analysts is to take the financial information reported by a company and translate
that into a rating of company performance. It should therefore be no surprise that a successful financial analyst is
one that has a deep understanding of financial accounting. Who better to analyze the financial statements than the
person who prepared them? Who would have a better understanding of the data and information contained in
financial statements than the accountant? Financial statements are becoming ever more complex and difficult to
interpret by users. Thus, accountants are becoming increasingly important in assisting others to understand and
interpret financial information.
Helping users understand financial information involves such tasks as developing graphs, common-size
statements, and performing horizontal and vertical analysis. Analysis could also involve performing data
comparisons with relevant financial and nonfinancial data. The Altman Z Model is an example of a tool used by
analysts to predict bankruptcy. The model includes such items as retained earnings/total assets and sales/total
assets as variables in the calculation. Based upon this test, Cooper Tire & Rubber Company earned a score of 6.07 in
a recent year. A score below 2.675 was considered an indication of possible bankruptcy. Therefore, analysts
evaluated Cooper as a very healthy company not likely to go bankrupt.
Accounting Principles: A Business Perspective 521 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
Financial analysts make numerous judgments about the financial condition of companies, as in the example
above. These services are essential to the decisions of investors and creditors. Thus, financial analysts with a strong
accounting background are well compensated for their efforts.
As owners of a corporation, stockholders provide much of the capital for its activities. On the balance sheet, we
show the stockholders' capital investment in the corporation as paid-in capital under stockholders' equity. Also
included in stockholders' equity is the capital accumulated through the retention of corporate earnings (retained
earnings). Paid-in capital is a relatively permanent portion of stockholders' equity; the retained earnings balance is
a relatively temporary portion of corporate capital and is the source of stockholders' dividends.
The preceding chapter discussed the paid-in capital obtained by issuing shares of stock for cash, property, or
services. This chapter describes additional sources of paid-in capital and items affecting retained earnings.
Paid-in (or contributed) capital
As you have learned in the preceding chapter, paid-in capital, or contributed capital, refers to all of the
contributed capital of a corporation, including the capital carried in the capital stock accounts. The general ledger
does not contain an account titled "Paid-In Capital". Instead, paid-in capital is a category, and companies establish
a separate account for each source of paid-in capital.
In Exhibit 97, we summarize several sources of stockholders' equity and list general ledger account titles used to
record increases and decreases in capital from each of these sources. Chapter 12 discussed some of these general
ledger accounts. This chapter discusses other general ledger accounts that record sources of stockholders' equity.
The stockholders' equity section of a balance sheet shows the different sources of the corporation's paid-in
capital because these sources are important information. For example, these additional sources may be from stock
dividends, treasury stock transactions, or donations.
Sources of stockholders' equity Illustrative general ledger account titles
I. Capital paid in (or contributed)
A. For, or assigned to, shares:
1. Issued to the extent of par or stated value or the amount received for shares without par or stated value.
Common stock
2. To be distributed as a stock dividend. 5% preferred stock 3. In addition to par or stated value: Stock dividend distributable – common (preferred) a. In excess or par. Paid-In capital in Excess of par value – Common
(preferred) b. In excess of stated value. Paid-In capital in excess of stated value –
Common (preferred) c. Resulting from declaration of stock dividends. Paid-In capital – Stock Dividends d. Resulting from reissue of treasury stock at a price above its acquisition price.
Paid -In capital – Common (preferred) Treasury stock transactions
B. Donations (gifts), whether from stockholders or from others.
Paid-in Capital - Donations
II. Capital accumulated by retention of earnings (retained earnings).
Appropriation per loan agreement
A. Appropriated retained earnings. Retained earnings (Unappropriated)
B. Free and unappropriated retained earnings.
Exhibit 97: Sources of stockholders' equity
Paid-in capital—Stock dividends
When it declares a stock dividend, a corporation distributes additional shares of stock (instead of cash) to its
present stockholders. A later section discusses and illustrates how the issuance of a stock dividend results in a
credit to a Paid-In Capital—Stock Dividends account.
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Paid-in capital—Treasury stock transactions
Another source of capital is treasury stock transactions. Treasury stock is the corporation's own stock, either
preferred or common, that it has issued and reacquired. It is legally available for reissuance. By reacquiring shares
of its own outstanding capital stock at one price and later reissuing them at a higher price, a corporation can
increase its capital by the difference between the two prices. If the reissue price is less than acquisition cost,
however, corporate capital decreases. We discuss treasury stock transactions at length later in this chapter.
Paid-in capital—Donations
Occasionally, a corporation receives a gift of assets, such as a USD 500,000 building. These donated gifts
increase stockholders' equity and are called donated capital. The entry to record the gift of a USD 500,000
building is a debit to Buildings and a credit to Paid-In Capital—Donations. Accountants would make this entry in
the amount of the USD 500,000 fair market value of the gift when received.
Retained earnings
The retained earnings portion of stockholders' equity typically results from accumulated earnings, reduced by
net losses and dividends. Like paid-in capital, retained earnings is a source of assets received by a corporation.
Paid-in capital is the actual investment by the stockholders; retained earnings is the investment by the stockholders
through earnings not yet withdrawn.
The balance in the corporation's Retained Earnings account is the corporation's net income, less net losses, from
the date the corporation began to the present, less the sum of dividends paid during this period. Net income
increases Retained Earnings, while net losses and dividends decrease Retained Earnings in any given year. Thus,
the balance in Retained Earnings represents the corporation's accumulated net income not distributed to
stockholders.
When the Retained Earnings account has a debit balance, a deficit exists. A company indicates a deficit by
listing retained earnings with a negative amount in the stockholders' equity section of the balance sheet. The firm
need not change the title of the general ledger account even though it contains a debit balance. The most common
credits and debits made to Retained Earnings are for income (or losses) and dividends. Occasionally, accountants
make other entries to the Retained Earnings account. We discuss some of these entries later in the chapter.
Paid-in capital and retained earnings on the balance sheet
The following stockholders' equity section of a balance sheet presents the various sources of capital in proper
form:
Stockholders' equity: Paid-in capital: Preferred stock – 6%, $100 par value; authorized, issued, and outstanding, 4,000 shares
$400,000
Common stock – no-par value, $5 stated value; authorized, issued, and outstanding, 400,000 shares 2,000,000
$2,400,000
Paid-in capital - From preferred stock issuances* $ 40,000 From donations 10,000 50,000 Total paid-in capital $2,450,000 Retained earnings 500,000 Total stockholders' equity $2,950,000 * This label is not the exact account title but is representative of the descriptions used on balance sheets. The exact account title could be used, but shorter descriptions are often shown.
Accounting Principles: A Business Perspective 523 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
*This label is not the exact account title but is representative of the descriptions used on balance sheets. The
exact account title could be used, but shorter descriptions are often shown.
In their highly condensed, published balance sheets, companies often omit the details regarding the sources of
the paid-in capital in excess of par or stated value and replace them by a single item, such as:
Paid-in capital in excess of par (or stated) value USD 50,000
Dividends are distributions of earnings by a corporation to its stockholders. Usually the corporation pays
dividends in cash, but it may distribute additional shares of the corporation's own capital stock as dividends.
Occasionally, a company pays dividends in merchandise or other assets. Since dividends are the means whereby the
owners of a corporation share in its earnings, accountants charge them against retained earnings.
Before dividends can be paid, the board of directors must declare them so they can be recorded in the
corporation's minutes book. Three dividend dates are significant:
• Date of declaration. The date of declaration indicates when the board of directors approved a motion
declaring that dividends should be paid. The board action creates the liability for dividends payable (or stock
dividends distributable for stock dividends).
• Date of record. The board of directors establishes the date of record; it determines which stockholders
receive dividends. The corporation's records (the stockholders' ledger) determine its stockholders as of the
date of record.
• Date of payment. The date of payment indicates when the corporation will pay dividends to the
stockholders.
To illustrate how these three dates relate to an actual situation, assume the board of directors of the Allen
Corporation declared a cash dividend on 2010 May 5, (date of declaration). The cash dividend declared is USD 1.25
per share to stockholders of record on 2010 July 1, (date of record), payable on 2010 July 10, (date of payment).
Because financial transactions occur on both the date of declaration (a liability is incurred) and on the date of
payment (cash is paid), journal entries record the transactions on both of these dates. No journal entry is required
on the date of record.
Exhibit 98 shows the frequencies of dividend payments made by a sample of representative companies for the
years 1996-99. Note that cash dividends are far more numerous than stock dividends or dividends in kind (paid in
merchandise or other assets).
An accounting perspective:
Uses of technology
After original issuance, investors may trade the stock of a company on secondary markets, such as
the New York Stock Exchange. The company makes no entry on its books for these outside trades
after issuance. Often, a company uses a spreadsheet or database program to note trades between
shareholders. These computer programs can print a report on the date of record. This information
allows a company that declares a dividend to be certain the money or stock goes to the stockholders
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who own the stock on the date of record rather than to the stockholders who originally purchased
the stock.
Cash dividends are cash distributions of accumulated earnings by a corporation to its stockholders. To
illustrate the entries for cash dividends, consider the following example. On 2010 January 21, a corporation's board
of directors declared a 2 per cent quarterly cash dividend on USD 100,000 of outstanding preferred stock. This
dividend is one-fourth of the annual dividend on 1,000 shares of USD 100 par value, 8 per cent preferred stock. The
dividend will be paid on 2010 March 1, to stockholders of record on 2010 February 5. An entry is not needed on the
date of record; however, the entries at the declaration and payment dates are as follows:
2010 Jan. 21 Retained earnings (-SE) 2,000
Dividends payable (+L) 2,000 Dividends declared: 2% on $100,000 of outstanding preferred stock, payable 2010 March 1, to stockholders of record on 2010 February 5.
Mar. 1 Dividends payable (-L) 2,000 Cash (-A) 2,000 Paid the dividend declared on 2010 January 21.
Often a cash dividend is stated as so many dollars per share. For instance, the quarterly dividend could have
been stated as USD 2 per share. When they declare a cash dividend, some companies debit a Dividends account
instead of Retained Earnings. (Both methods are acceptable.) The Dividends account is then closed to Retained
Earnings at the end of the fiscal year.
Number of Companies 2006 2005 2004 2003
Cash dividends paid to common stock shareholders Per share amount disclosed in retained earnings statements
213 219 229 239
Per share amount not disclosed in retained earning statements
157 135 156 164
Total: 370 354 385 403 Cash dividends paid to preferred stock shareholders Per share amount disclosed in retained earnings statements
22 22 17 25
Per share amount not disclosed in retained earnings statements
32 38 48 44
Total: 54 60 65 69 **Dividends paid by pooled companies X X X X Stock dividends 4 6 4 12 Dividends in kinds 7 10 14 7 Stock purchase rights 1 4 7 9
Exhibit 98: Types of dividends
Once a cash dividend is declared and notice of the dividend is given to stockholders, a company generally cannot
rescind it unless all stockholders agree to such action.41 Thus, the credit balance in the Dividends Payable account
appears as a current liability on the balance sheet.
41 Stockholders might agree to rescind (cancel) a dividend already declared if the company is in difficult financial
circumstances and needs to retain cash to pay bills or acquire assets to continue operations.
Accounting Principles: A Business Perspective 525 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
An accounting perspective:
Business insight
Fleetwood Enterprises, Inc., is the nation's leading producer of manufactured housing and
recreational vehicles. Often investors believe a company that pays dividends is doing well.
Therefore, companies try to maintain a record of paying dividends, as Fleetwood noted in a 2001
press release.
RIVERSIDE, Calif., Sept. 12 /PRNewswire/—The directors of Fleetwood Enterprises, Inc. (NYSE:
FLE) have declared the company's regular quarterly cash dividend of 19 cents per share of
Common stock, payable 2000 November 8, to shareholders of record 2000 October 6.
A company that lacks sufficient cash for a cash dividend may declare a stock dividend to satisfy its
shareholders. Note that in the long run it may be more beneficial to the company and the
shareholders to reinvest the capital in the business rather than paying a cash dividend. If so, the
company would be more profitable and the shareholders would be rewarded with a higher stock
price in the future.
Stock dividends are payable in additional shares of the declaring corporation's capital stock. When declaring
stock dividends, companies issue additional shares of the same class of stock as that held by the stockholders.
Corporations usually account for stock dividends by transferring a sum from retained earnings to permanent
paid-in capital. The amount transferred for stock dividends depends on the size of the stock dividend. For stock
dividends, most states permit corporations to debit Retained Earnings or any paid-in capital accounts other than
those representing legal capital. In most circumstances, however, they debit Retained Earnings when a stock
dividend is declared.
Stock dividends have no effect on the total amount of stockholders' equity or on net assets. They merely decrease
retained earnings and increase paid-in capital by an equal amount. Immediately after the distribution of a stock
dividend, each share of similar stock has a lower book value per share. This decrease occurs because more shares
are outstanding with no increase in total stockholders' equity.
Stock dividends do not affect the individual stockholder's percentage of ownership in the corporation. For
example, a stockholder who owns 1,000 shares in a corporation having 100,000 shares of stock outstanding, owns 1
per cent of the outstanding shares. After a 10 per cent stock dividend, the stockholder still owns 1 per cent of the
outstanding shares—1,100 of the 110,000 outstanding shares.
A corporation might declare a stock dividend for several reasons:
• Retained earnings may have become large relative to total stockholders' equity, so the corporation may
desire a larger permanent capitalization.
• The market price of the stock may have risen above a desirable trading range. A stock dividend generally
reduces the per share market value of the company's stock.
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• The board of directors of a corporation may wish to have more stockholders (who might then buy its
products) and eventually increase their number by increasing the number of shares outstanding. Some of the
stockholders receiving the stock dividend are likely to sell the shares to other persons.
• Stock dividends may silence stockholders' demands for cash dividends from a corporation that does not
have sufficient cash to pay cash dividends.
The percentage of shares issued determines whether a stock dividend is a small stock dividend or a large stock
dividend. Firms use different accounting treatments for each category.
Recording small stock dividends A stock dividend of less than 20 to 25 per cent of the outstanding shares is
a small stock dividend and has little effect on the market value (quoted market price) of the shares. Thus, the firm
accounts for the dividend at the current market value of the outstanding shares.
Assume a corporation is authorized to issue 20,000 shares of USD 100 par value common stock, of which 8,000
shares are outstanding. Its board of directors declares a 10 per cent stock dividend (800 shares). The quoted market
price of the stock is USD 125 per share immediately before the stock dividend is announced. Since the distribution
is less than 20 to 25 per cent of the outstanding shares, the dividend is accounted for at market value. The entry for
the declaration of the stock dividend on 2010 August 10, is:
Aug. 10 Retained earnings (or Stock Dividends) (800shares x $125) (-SE) 100,000 Stock dividend distributable – Common (800 shares x $100) (+SE)
80,000
Paid-In capital – Stock dividends (+SE) 20,000 To record the declaration of a 10% stock dividend; shares to be distributed on 2010 September 20, to stockholders of record on 2010 August 31.
This entry records the issuance of the shares:
Sept. 20 Stock dividends distributable – Common (-SE)
80,000
Common stock (+SE) 80,000 To record the distribution of 800 shares of common stock as authorized in stock dividends declared on 2010 August 10.
The stock dividend distributable—common account is a stockholders' equity (paid-in capital) account
credited for the par or stated value of the shares distributable when recording the declaration of a stock dividend.
Since a stock dividend distributable is not to be paid with assets, it is not a liability. When a balance sheet is
prepared between the date the 10 per cent dividend is declared and the date the shares are issued, the proper
statement presentation of the effects of the stock dividend is:
Stockholders' equity: Paid-in capital: Common stock - $100 par value; authorized, 20,000 shares; issued and outstanding, 8,000 shares
$800,000
Stock dividend distributable on 2010 September 20, 800 shares at par value
80,000
Total par value of shares issued and to be issued
$880,000
Paid-in capital 20,000 Total paid-in capital $900,000 Retained earnings 150,000 Total stockholders' equity $1,050,000
Accounting Principles: A Business Perspective 527 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
Suppose, on the other hand, that the common stock in the preceding example is no-par stock and has a stated
value of USD 50 per share. The entry to record the declaration of the stock dividend (when the market value is USD
125) is:
Retained earnings (800 shares x $125) (-SE) 100,000 Stock dividends distributable – Common (800 shares x $50) (+SE) 40,000 Paid-in capital – stock dividends (800 shares x $75) (+SE)
60,000
To record the declaration of a stock dividend.
The entry to record the issuance of the stock dividend is:
Stock dividend distributable – Common (-SE) 40,000 Common stock (+SE) 40,000 To record the issuance of the stock dividend.
Recording large stock dividends A stock dividend of more than 20 to 25 per cent of the outstanding shares
is a large stock dividend. Since one purpose of a large stock dividend is to reduce the market value of the stock so
the shares can be traded more easily, firms do not use the current market value of the stock in the entry. They
account for such dividends at their par or stated value rather than at their current market value. The laws of the
state of incorporation or the board of directors establish the amounts for stocks without par or stated value.
To illustrate the treatment of a stock dividend of more than 20 to 25 per cent, assume X Corporation has been
authorized to issue 10,000 shares of USD 10 par value common stock, of which 5,000 shares are outstanding. X
Corporation declared a 30 per cent stock dividend (1,500 shares) on 2010 September 20, to be issued on 2010
October 15. The required entries are:
Exhibit 99: Stock dividends
Sept. 20 Retained earnings (or Stock Dividends) (1,500 shares x $10) (-SE)
15,000
Stock dividend distributable – Common (+SE) 15,000 To declare a 30% stock dividend.
Oct. 15 Stock dividend distributable – Common (-SE) 15,000 Common stock (+SE) 15,000 To issue the 30% stock dividend.
Note that although firms account for the small stock dividend at current market value, they account for the 30
per cent stock dividend at par value (1,500 shares X USD 10 = USD 15,000). Because of the differences in
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accounting for large and small stock dividends, accountants must determine the relative size of the stock dividend
before making any journal entries.
To see the effect of small and large stock dividends on stockholders' equity, look at Exhibit 99.
A stock split is a distribution of 100 per cent or more of additional shares of the issuing corporation's stock
accompanied by a corresponding reduction in the par value per share. The corporation receives no assets in this
transaction. A stock split causes a large reduction in the market price per share of the outstanding stock. A two-for-
one split doubles the number of shares outstanding, a three-for-one split triples the number of shares, and so on.
The split reduces the par value per share at the same time so that the total dollar amount credited to Common Stock
remains the same. For instance, a two-for-one split halves the par value per share.42 If the corporation issues 100
per cent more stock without a reduction in the par value per share, the transaction is a 100 per cent stock dividend
rather than a two-for-one stock split.
The entry to record a stock split depends on the particular circumstances. Usually, firms change only the
number of shares outstanding and the par or stated value in the records. (The number of shares authorized may
also change.) Thus, they would record a two-for-one stock split in which the par value of the shares decreases from
USD 20 to USD 10 as follows:
Common stock - $20 par value (-SE) 100,000 Common stock - $10 par value (+SE) 100,000 To record a two- for-one stock split; 5,000 shares of $20 par value common stock were replaced by 10,000 shares of $10 par value common stock.
In Exhibit 100, we summarize the effects of stock dividends and stock splits. Stock dividends and stock splits
have no effect on the total amount of stockholders' equity. In addition, stock splits have no effect on the total
amount of paid-in capital or retained earnings. They merely increase the number of shares outstanding and
decrease the par value per share. Stock dividends increase paid-in capital and decrease retained earnings by equal
amounts.
Total Common Paid-in Retained Number of Par value Stockholders' equity
Stock Capital - common
Earnings Shares outstanding
Per share
Stock dividends: Small No effect Increases Increases* Decreases Increases No effect Large No effect Increases No effect Decreases Increases No effect Stock splits No effect No effect No effect No effect Increases Decreases
Exhibit 100: Summary of effects of stock dividends and stock splits
The preceding chapter discussed how corporate laws differ regarding the legality of a dividend. State law
establishes the legal or stated capital of a corporation as that portion of the stockholders' equity that must be
maintained intact, unimpaired by dividend declarations or other distributions to stockholders. The legal capital
often equals the par or stated value of the shares issued or a minimum price per share issued.
The objective of these state corporate laws is to protect the corporation's creditors, whose claims have priority
over those of the corporation's stockholders. To illustrate the significance of the legal capital concept, assume a
corporation in severe financial difficulty is about to go out of business. If there were no legal capital restrictions on
42 If a corporation reduces the par value of its stock without issuing more shares, say, from USD 100 to USD 60 per
share, then USD 40 per share must be removed from the appropriate capital stock account and credited to Paid-
In Capital Recapitalization. Further discussion of this process, called recapitalization, is beyond the scope of this
text.
Accounting Principles: A Business Perspective 529 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
dividends, the stockholders of that corporation might pay themselves a cash dividend or have the corporation buy
back their stock, leaving no funds available for the corporation's creditors.
The board of directors of a corporation possesses sole power to declare dividends. The legality of a dividend
generally depends on the amount of retained earnings available for dividends—not on the net income of any one
period. Firms can pay dividends in periods in which they incurred losses, provided retained earnings and the cash
position justify the dividend. And in some states, companies can declare dividends from current earnings despite an
accumulated deficit. The financial advisability of declaring a dividend depends on the cash position of the
corporation.
Normally, dividends are reductions of retained earnings since they are distributions of the corporation's net
income. However, dividends may be distributions of contributed capital. These dividends are called liquidating
dividends.
Accountants debit liquidating dividends to a paid-in capital account. Corporations should disclose to
stockholders the source of any dividends that are not distributions of net income by indicating which paid-in capital
account was debited as a result of the dividend. The legality of paying liquidating dividends depends on the source
of the paid-in capital and the laws of the state of incorporation.
An accounting perspective:
Business insight
The Private Securities Litigation Reform Act, passed in 1995, seeks to protect investors against
white-collar crime. Auditors are required by this law to become more aggressive in looking for
fraud in companies they audit. Risk factors that might encourage management to engage in
fraudulent activities include weak internal controls, an aggressive effort to drive up the stock price
by reporting higher earnings, and/or executive bonuses or stock options based on earnings. A
strong company code of ethics and an effective internal control structure can help deter fraud from
occurring.
Retained earnings appropriations
The amount of retained earnings that a corporation may pay as cash dividends may be less than total retained
earnings for several contractual or voluntary reasons. These contractual or voluntary restrictions or limitations on
retained earnings are retained earnings appropriations. For example, a loan contract may state that part of a
corporation's USD 100,000 of retained earnings is not available for cash dividends until the loan is paid. Or a board
of directors may decide to use assets resulting from net income for plant expansion rather than for cash dividends.
An example of a voluntary restriction was General Electric's annual report statement that cash dividends were
limited "to support enhanced productive capability and to provide adequate financial resources for internal and
external growth opportunities".
Companies formally record retained earnings appropriations by transferring amounts from Retained Earnings
to accounts such as "Appropriation for Loan Agreement" or "Retained Earnings Appropriated for Plant Expansion".
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Even though some refer to retained earnings appropriations as retained earnings reserves, using the term reserves
is discouraged.
Other reasons for appropriations of retained earnings include pending litigation, debt retirement, and
contingencies in general. Such appropriations do not reduce total retained earnings. They merely disclose to
balance sheet readers that a portion of retained earnings is not available for cash dividends. Thus, recording these
appropriations guarantees that the corporation limits its outflow of cash dividends while repaying a loan,
expanding a plant, or taking on some other costly endeavor. Recording retained earnings appropriations does not
involve the setting aside of cash for the indicated purpose; it merely divides retained earnings into two parts—
appropriated retained earnings and unappropriated retained earnings. The establishment of a separate fund would
require a specific directive from the board of directors. The only entry required to record the appropriation of USD
25,000 of retained earnings to fulfill the provisions in a loan agreement is:
Retained earnings (-SE) 25,000 Appropriation per loan agreement (+SE) 25,000 To record restriction on retained earnings.
When the retained earnings appropriation has served its purpose of restricting dividends and the loan has been
repaid, the board of directors may decide to return the appropriation intact to Retained Earnings. The entry to do
this is:
Appropriation per loan agreement(-SE) 25,000 Retained earnings (+SE) 25,000 To return balance in appropriation per Loan Agreement account to Retained earnings.
On the balance sheet, retained earnings appropriations appear in the stockholders' equity section as follows:
Stockholders' equity: Paid-in capital: Preferred stock – 8%, $50 par value; 500 shares authorized; issued and outstanding
$25,000
Common stock - $5 par value; 10,000 shares authorized, issued and outstanding
50,000
Total paid-in capital $75,000 Retained earnings: Appropriated: Per loan agreement $25,000 Unappropriated 20,000 Total retained earnings 45,000 Total stockholders' equity $120,000
Note that a retained earnings appropriation does not reduce either stockholders' equity or total retained
earnings but merely earmarks (restricts) a portion of retained earnings for a specific reason.
The formal practice of recording and reporting retained earnings appropriations is decreasing. Footnote
explanations such as the following are replacing these appropriations:
Note 7. Retained earnings restrictions. According to the provisions in the loan agreement, retained earnings
available for dividends are limited to USD 20,000.
Such footnotes appear after the formal financial statements in "Notes to Financial Statements". The Retained
Earnings account on the balance sheet would be referenced as follows: "Retained Earnings (see note 7)...USD
45,000".
Changes in the composition of retained earnings reveal important information about a corporation to financial
statement users. A separate formal statement—the statement of retained earnings—discloses such changes.
Accounting Principles: A Business Perspective 531 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
Statement of retained earnings
A statement of retained earnings is a formal statement showing the items causing changes in
unappropriated and appropriated retained earnings during a stated period of time. Changes in unappropriated
retained earnings usually consist of the addition of net income (or deduction of net loss) and the deduction of
dividends and appropriations. Changes in appropriated retained earnings consist of increases or decreases in
appropriations.
Note Ward Corporation's statement of retained earnings in Exhibit 101. The only new appropriation during 2010
was an additional USD 35,000 for plant expansion. Ward added this new USD 35,000 to the USD 25,000
beginning balance in that account and subtracted that amount from unappropriated retained earnings. An
alternative to the statement of retained earnings is the statement of stockholders' equity.
Ward Corporation Statement of Retained Earnings For Year Ended 2010 December 31
Unappropriated retained earnings: 2010 January 1, balance $180,000 Add: Net income 80,000
$260,000 Less: Dividends $15,000 Appropriation for plant expansion 35,000 50,000 Unappropriated retained earnings, 2010 December 31 $210,000 Appropriated retained earnings: Appropriation for plant expansion, 2010 January 1, balance $25,000 Add: Increase in 2010 35,000 $ 60,000 Appropriation for contract obligation, 2010 January 1, balance
20,000
Appropriated retained earnings, 2010 December 31
$80,000
Total retained earnings, 2010 December 31 $290,000
Exhibit 101: Statement of retained earnings
Statement of stockholders' equity
Most corporations include four financial statements in their annual reports: a balance sheet, an income
statement, a statement of stockholders' equity (in place of a statement of retained earnings), and a statement of
cash flows (discussed in Chapter 16). A statement of stockholders' equity is a summary of the transactions
affecting the accounts in the stockholders' equity section of the balance sheet during a stated period. These
transactions include activities affecting both paid-in capital and retained earnings accounts. Thus, the statement of
stockholders' equity includes the information contained in a statement of retained earnings plus some additional
information. The columns in the statement of stockholders' equity reflect the major account titles within the
stockholders' equity section: the types of stock issued and outstanding, paid-in capital in excess of par (or stated)
value, retained earnings, and treasury stock. Each row indicates the effects of major transactions affecting one or
more stockholders' equity accounts.
Look at Exhibit 102, a statement of stockholders' equity. The first row indicates the beginning balances of each
account in the stockholders' equity section. This summary shows that Larkin Corporation issued 10,000 shares of
common stock, declared a 5 per cent stock dividend on common stock, repurchased 1,200 shares of treasury stock,
earned net income of USD 185,000, and paid cash dividends on both its preferred and common stock. After the
transactions' effects are indicated within each row, Larkin added or subtracted each column's components to
determine the ending balance in each stockholders' equity account.
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Treasury stock
Treasury stock is the corporation's own capital stock that it has issued and then reacquired; this stock has not
been canceled and is legally available for reissuance. Because it has been issued, we cannot classify treasury stock as
unissued stock.
Recall that when a corporation has additional authorized shares of stock that are to be issued after the date of
original issue, in most states the preemptive right requires offering these additional shares first to existing
stockholders on a pro rata basis. However, firms may reissue treasury stock without violating the preemptive right
provisions of state laws; that is, treasury stock does not have to be offered to current stockholders on a pro rata
basis.
Larkin Corporation Statement of stockholders' equity
For the Year ended 2010 December 31 $50 par, value, $20 par value Paid-In capital Retained Treasury 6% preferred stock
Common stock In excess of par value
Earnings Stock
Balance, 2010 January 1 $250,000 $300,000 $200,000 $500,000 $(42,000) Issuance of 10,000 shares of common stock
200,000 100,000
5% stock dividend on common stock, 1,250 shares
25,000 27,500 (52,500)
Purchase of 1,200 shares of treasury stock
(48,000) Net income 185,000 Cash dividends: Preferred stock (15,000) Common stock (25,000) Balance, 2010 December 31 $250,000 $525,000 $327,500 $592,500 $(90,000)
Exhibit 102: Statement of stockholders' equity
A corporation may reacquire its own capital stock as treasury stock to: (1) cancel and retire the stock; (2) reissue
the stock later at a higher price; (3) reduce the shares outstanding and thereby increase earnings per share; or (4)
issue the stock to employees. If the intent of reacquisition is cancellation and retirement, the treasury shares exist
only until they are retired and canceled by a formal reduction of corporate capital.
For dividend or voting purposes, most state laws consider treasury stock as issued but not outstanding, since the
shares are no longer in the possession of stockholders. Also, accountants do not consider treasury shares
outstanding in calculating earnings per share. However, they generally consider treasury shares outstanding for
purposes of determining legal capital, which includes outstanding shares plus treasury shares.
In states that consider treasury stock as part of legal capital, the cost of treasury stock may not exceed the
retained earnings at the date the shares are reacquired. This regulation protects creditors by preventing the
corporation in financial difficulty from using funds to purchase its own stock instead of paying its debts. Thus, if a
corporation is subject to such a law (as is assumed in this text), the retained earnings available for dividends must
exceed the cost of the treasury shares on hand.
When firms reacquire treasury stock, they record the stock at cost as a debit in a stockholders' equity account
called Treasury Stock.43 They credit reissuances to the Treasury Stock account at the cost of acquisition. Thus, the
Treasury Stock account is debited at cost when shares are acquired and credited at cost when these shares are sold.
43 Another acceptable method of accounting for treasury stock transactions is the par value method. We leave
further discussion of the par value method to intermediate accounting texts.
Accounting Principles: A Business Perspective 533 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
Any excess of the reissue price over cost represents additional paid-in capital and is credited to Paid-In Capital—
Common (Preferred) Treasury Stock Transactions.
To illustrate, assume that on 2010 February 18, the Hillside Corporation reacquired 100 shares of its
outstanding common stock for USD 55 each. (The company's stockholders' equity consisted solely of common stock
and retained earnings.) On 2010 April 18, the company reissued 30 shares for USD 58 each. The entries to record
these events are:
2010 Feb. 18 Treasury stock – Common (100 shares x $55) (-SE) 5,500
Cash (-A) 5,500 Acquired 100 shares of treasury stock at $55.
Apr. 18 Cash (30 shares x $58) (+A) 1,740 Treasury stock – Common (30 shares x $55) (+SE) 1,650 Paid-In Capital – Common treasury stock transactions (+SE)
90
Reissued 30 shares of treasury stock at $58; cost is $55 per share.
When the reissue price of subsequent shares is less than the acquisition price, firms debit the difference between
cost and reissue price to Paid-In Capital—Common Treasury Stock Transactions. This account, however, never
develops a debit balance. By definition, no paid-in capital account can have a debit balance. If Hillside reissued an
additional 20 shares at USD 52 per share on 2010 June 12, the entry would be:
June 12 Cash (20 shares x $52) (+A) 1,040 Paid-In Capital – Common treasury stock transactions (-SE) 60 Treasury stock – Common (20 shares x $55) (+SE) 1,100 Reissued 20 shares of treasury stock at $52; cost is $55 per share.
At this point, the credit balance in the Paid-In Capital—Common Treasury Stock Transactions account would be
USD 30. If the remaining 50 shares are reissued on 2010 July 16, for USD 53 per share, the entry would be:
July 16 Cash (50 shares x $53) (+A) 2,650 Paid-In Capital – Common treasury stock transactions (-SE)
30
Retained earnings (-SE) 70 Treasury stock – Common (50 shares x $55) (+SE)
2,750
Reissued 50 shares of treasury stock at $53; cost is $55 per share.
Notice that Hillside has exhausted the Paid-In Capital—Common Treasury Stock Transactions account credit
balance. If more than USD 30 is debited to that account, it would develop a debit balance. Thus, the remaining USD
70 of the excess of cost over reissue price is a special distribution to the stockholders involved and is debited to the
Retained Earnings account.
Sometimes stockholders donate stock to a corporation. Since donated treasury shares have no cost to the
corporation, accountants make only a memo entry when the shares are received.44 The only formal entry required is
to debit Cash and credit the Paid-In Capital—Donations account when the stock is reissued. For example, if donated
treasury stock is sold for USD 5,000, the entry would be:
Cash (+A) 5,000 Paid-In capital – Donations (+SE) 5,000 To record the sale of donated
44 The method illustrated here is called the memo method. Other acceptable methods of accounting for donated
stock are the cost method and par value method. Intermediate accounting texts discuss these latter two
methods.
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treasury stock.
When treasury stock is held on a balance sheet date, it customarily appears at cost, as a deduction from the sum
of total paid-in capital and retained earnings, as follows:
Hypothetical Corporation Partial balance sheet 2010 December 31
Stockholder's equity: Paid-In capital: Preferred stock -8%, $100 par value; 2,000 shares authorized, issued, and outstanding
$200,000
Common stock-$10 par value; authorized, 100,000 shares; issued, 80,000 shares of which 1,000 are held in the treasury
$800,000
Stock dividend distributable on common stock on 2011 January 15, 7,900 shares
79,000 879,000
Paid-in capital- From common stock issuances $40,000 From stock dividends 60,000 From treasury stock transactions 30,000 From donations 50,000 180,000 Total paid-in capital $1,259,000 Retained earnings: Appropriated: Per loan agreement $250,000 Unappropriated (restricted to the extent of $20,000, the cost of treasury shares held)
$150,000
Total retained earnings 400,000 Total paid-in capital and retained earnings $1,659,000 Less: Treasury stock, common, 1,000 shares at cost
20,000
Total stockholders' equity $1,639,000
Exhibit 103: Stockholders' equity section of the balance sheet
Stockholders' equity: Paid-in capital: Common stock-$10 par value; authorized and issued, 20,000 shares, of which 2,000 shares are in the treasury
$200,000
Retained earnings (including $22,000 restricted by acquisition of treasury stock)
80,000
Total paid-in capital and retained earnings $280,000 Less: Treasury stock at cost, 2,000 shares 22,000 Total stockholders' equity $258,000
An accounting perspective:
Business insight
General Mills is a leading producer of ready-to-eat cereals, desserts and baking mixes, snack
products, and dinner and side dish mixes. Popular brand names include Hamburger Helper, Betty
Crocker, and Yoplait. For 2001 and 2000, General Mills reported common stock in the treasury
(treasury stock) of 123,100,000 and 122,900,000 shares, respectively. General Mills deducted the
cost of these shares in the stockholders' equity section of the balance sheet.
To summarize much of what we have discussed in Chapters 12 and 13, we present the stockholders' equity
section of the balance sheet in Exhibit 103. This partial balance sheet shows: (1) the amount of capital assigned to
shares outstanding; (2) the capital contributed for outstanding shares in addition to that assigned to the shares; (3)
other forms of paid-in capital; and (4) retained earnings, appropriated and unappropriated.
Accounting Principles: A Business Perspective 535 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
Anson Company Income Statement
For the Year Ended 2010 December 31 Net sales $41,000,000 Other revenues 2,250,000 Total revenue $43,250,000 Cost of goods sold $22,000,000 Administrative, selling, and general expenses 12,000,000 34,000,000 Income before federal income taxes $9,250,000 Deduct: Federal income taxes (40%) 3,700,000 Income from continuing operations $5,550,000 Discounted operations: Loss from operations of discontinued Cosmetics Division (net of 40% tax effect of $800,000) $(1,200,000) Loss on disposal of Cosmetics Division (net of 40% tax effect of $200,000) (300,000)
(1,500,000)
Income before extraordinary item and the cumulative effect of a change in accounting principle
$4,050,000
Extraordinary item: Gain on sale of subsidiary over book value $40,000 Less: Tax effect (40%) 16,000 24,000 Income after extraordinary item $4,074,000 Net income $4,074,000 Earnings per share of common stock: Income from continuing operations $ 5,550 Discontinued operations (1.500) Extraordinary item 0.024 Net income $4.074
Exhibit 104: Income statement
Net income inclusions and exclusions
Accounting has long faced the problem of what to include in the net income reported for a period. Should net
income include only the revenues and expenses related to normal operations? Or should it include the results of
discontinued operations and unusual, nonrecurring gains and losses? And further, should the determination of net
income for 2010, for example, include an item that can be clearly associated with a prior year, such as additional
federal income taxes for 2009? Or should such items, including corrections of errors, be carried directly to retained
earnings? How are the effects of making a change in accounting principle to be reported?
APB Opinion No. 9 (December 1966) sought to provide answers to some of these questions. The Opinion
directed that unusual and nonrecurring items having an earnings or loss effect are extraordinary items (reported in
the income statement) or prior period adjustments (reported in the statement of retained earnings). Extraordinary
items are reported separately after net income from regular continuing activities.
In Exhibit 104 and Exhibit 106, we show the reporting of discontinued operations, extraordinary items, and
prior period adjustments. For Exhibit 104 and Exhibit 106, assume that the Anson Company has 1,000,000 shares
of common stock outstanding and the company's earnings are taxed at 40 per cent. Also, assume the following:
• Anson sold its Cosmetics Division on 2010 August 1, at a loss of USD 500,000. The net operating loss of
that division through 2010 July 31, was USD 2,000,000.
• Anson had a taxable gain in 2010 of USD 40,000 from a sale of a subsidiary at an amount greater than what
was on the company's balance sheet (extraordinary item).
• In 2010, Anson discovered that the USD 200,000 cost of land acquired in 2009 had been expensed for both
financial accounting and tax purposes. A prior period adjustment was made in 2010.
Next, we explain the effects of these assumptions in greater detail.
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A discontinued operation occurs when a business sells a segment (usually an unprofitable department or
division) to another company or abandons it. When a company discontinues a segment, it shows the relevant
information in a special section of the income statement immediately after income from continuing operations and
before extraordinary items. Two items of information appear:
• The income or loss (net of tax effect) from the segment's operations for the portion of the current year
before it was discontinued.
• The gain or loss (net of tax effect) on disposal of the segment.
To illustrate, Anson's sale of its Cosmetics Division on August 1 led to a before-tax loss of USD 500,000. The
after-tax loss was USD 500,000 X 60 per cent = USD 300,000. The operating loss before taxes through July 31 was
USD 2,000,000. The after-tax operating loss for that period was USD 2,000,000 X 60 per cent = USD 1,200,000.
Note this information on the income statement in Exhibit 104.
Prior to 1973, companies reported a gain or loss as an extraordinary item if it was either unusual in nature or
occurred infrequently. As a result, companies were inconsistent in the financial reporting of certain gains and
losses. This inconsistency led to the issuance of APB Opinion No. 30 (September 1973). Opinion No. 30 redefined
extraordinary items as those unusual in nature and occurring infrequently. Note that both conditions must be
met—unusual nature and infrequent occurrence. Accountants determine whether an item is unusual and infrequent
in light of the environment in which the company operates. Examples of extraordinary items include gains or losses
that are the direct result of a major catastrophe (a flood or hurricane where few have occurred before), a
confiscation of property by a foreign government, or a prohibition under a newly enacted law.
Extraordinary items are included in the determination of periodic net income, but are disclosed separately (net
of their tax effects) in the income statement below "Income from continuing operations". As shown in Exhibit 104,
Anson reported the extraordinary items after reporting the loss from discontinued operations.
Gains or losses related to ordinary business activities are not extraordinary items regardless of their size. For
example, material write-downs of uncollectible receivables, obsolete inventories, and intangible assets are not
extraordinary items. However, such items may be separately disclosed as part of income from continuing
operations.
2006 2005 2004 2003 Nature Debt extinguishments 4 40 70 48 Other* 8 2 8 7 Total Extraordinary Items 12 42 78 55
Number of Companies Presenting extraordinary items 12 42 78 55 Not presenting extraordinary items 588 588 522 545 Total Companies *For the current year, the nature of the other items included casualty losses and gains from asset disposals.
600 600 600 600
Exhibit 105: Extraordinary items
In Exhibit 105, note that in a sample of 600 companies for the years 2000-2003, most companies do not report
extraordinary items.
Accounting Principles: A Business Perspective 537 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
Changes in accounting principle can materially alter a company's reported net income and financial position.
Changes in accounting principle are changes in accounting methods pertaining to such items as inventory.
Such a change includes a change in inventory valuation method from FIFO to LIFO.
According to APB Opinion No. 20, a company should consistently apply the same accounting methods from one
period to another. However, a company may make a change if the newly adopted method is preferable and if the
change is adequately disclosed in the financial statements. In the period in which a company makes a change in
accounting principle, it must disclose on the financial statements the nature of the change, its justification, and its
effect on net income. Also, the company must show on the income statement for the year of the change and the
cumulative effect of the change on prior years' income (net of tax).
According to FASB Statement No. 16, prior period adjustments consist almost entirely of corrections of
errors in previously published financial statements. Corrections of abnormal, nonrecurring errors that may have
been caused by the improper use of an accounting principle or by mathematical mistakes are prior period
adjustments. Normal, recurring corrections and adjustments, which follow inevitably from the use of estimates in
accounting practice, are not treated as prior period adjustments. Also, mistakes corrected in the same year they
occur are not prior period adjustments. To illustrate a prior period adjustment, suppose that Anson purchased land
in 2009 at a total cost of USD 200,000 and recorded this amount in an expense account instead of in the Land
account. Discovery of the error on 2010 May 1, after publication of the 2009 financial statements, would require a
prior period adjustment. The adjustment would be recorded directly in the Retained Earnings account. Assuming
the error had resulted in an USD 80,000 underpayment of taxes in 2009, the entry to correct the error would be:
May 1 Land (+A) 200,000 Federal income taxes payable (+L) 80,000 Retained earnings (or prior period adjustments – Land) (+SE)
120,000
To correct an accounting error expensing land.
An ethical perspective:
Ace chemical company
Ace Chemical Company is a small, privately held manufacturer that has been operating at a profit
for years. The current balance in the Cash account is USD 8 million, and the balance in Retained
Earnings is USD 4 million. The company's plant assets consist of special purpose equipment that
can produce only certain chemicals. The company has long-term debt with a principal balance of
USD 10 million. Its officers (all of whom are stockholders) are concerned about the future prospects
of the company. Many similar firms have been sued by customers and employees claiming that
toxic chemicals produced by the company caused their health problems. No such suits have yet
been filed against Ace, but the officers fully expect them to be filed within the next two years.
The company's stock is not listed on a stock exchange, nor has it recently been traded. The officers
hold 70 per cent of the stock and estimate that their total stockholdings have a current market value
of about USD 8 million (although its value would be much lower if all the facts were known). They
are worried that if suits are filed and the company loses, there will not even be enough remaining
assets to satisfy creditors' claims, and the officers' stock would be worthless. Private legal counsel
has informed the officers that the company is likely to lose any suits that are filed.
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One of the officers suggested that they could at least receive something for their stock by having the
company buy half of the shares held by the officers at a total price of USD 4 million. Another officer
asked if such a treasury stock transaction would be legal. The response was that the transaction
would be legal because it did not dip into the present legal capital of the company. Retained
earnings would be reduced to a zero balance, but would not develop a debit balance as a result of
the transaction.
Prior period adjustments do not appear on the income statements but in the current-year financial statements
as adjustments to the opening balance of retained earnings on the statement of retained earnings (Exhibit 106).
Most discontinued operations, extraordinary items, changes in accounting principle, and prior period
adjustments affect the amount of income taxes a corporation must pay. To report the income tax effect, FASB
Statement No. 96 requires reporting all of these items net of their tax effects, as shown in Exhibit 104 and Exhibit
106.45 Net-of-tax effect means that items appear at the dollar amounts remaining after deducting the income tax
effects. Thus, the total effect of a discontinued operation, an extraordinary item, a change in accounting principle,
or a prior period adjustment appears in one place in the appropriate financial statement. The reference to "Income
from continuing operations" on the income statement represents the results of transactions (including income
taxes) that are normal for the business and may be expected to recur. Note that the tax effect of an item may appear
separately, as it does for the gain on voluntary early retirement of debt in Exhibit 104. Or the company may
mention it parenthetically with only the net amount shown (see loss from discontinued operations and change in
accounting principle in Exhibit 104 and correction of error in Exhibit 106).
Anson Company Statement of Retained Earnings
For the Year Ended 2010 December 31 Retained earnings, 2010 January 1 $5,000,000 Prior period adjustment: Correction of error of expensing land (net of tax effect of $80,000)
120,000
Retained earnings, 2010 January 1, as adjusted $5,120,000 Add: Net income 4,077,600
$9,197,600 Less: Dividends 500,000 Retained earnings, 2010 December 31 $8,687,600
Exhibit 106: Statement of retained earnings
• Income from continuing operations of USD 5,550,000 (Exhibit 104) is more representative of the
continuing earning power of the company than is the net income figure of USD 4,077,600.
• Following income, the special items from continuing operations appear at their actual impact on the
company—that is, net of their tax effect.
• EPS is reported both before (USD 5.550) and after (USD 4.078) the discontinued operations, extraordinary
item, and the cumulative effect of a change in accounting principle (Exhibit 104).
45 FASB, Statement of Financial Accounting Standards No. 96, "Accounting for Income Taxes" (Stamford. Conn.,
1987). Copyright © by the Financial Accounting Standards Board, High Ridge Park, Stamford, Connecticut
06905, U.S.A.
Accounting Principles: A Business Perspective 539 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
• The correction of the USD 200,000 error adds only USD 120,000 to retained earnings (Exhibit 106). This
result occurs because the mistake was included in the 2009 tax return and taxes were underpaid by USD
80,000. In the 2010 return, the USD 80,000 of taxes would have to be paid.
Analyzing and using the financial results—Earnings per share and price-earnings ratio
A major item of interest to investors and potential investors is how much a company earned during the current
year, both in total and for each share of stock outstanding. Firms calculate the earnings per share amount only for
the common shares of ownership. They compute earnings per share (EPS) as net income available to common
stockholders divided by the average number of common shares outstanding during that period. Income available
to common stockholders is net income less any dividends on preferred stock. They deduct the regular preferred
dividend on cumulative preferred stock (but not a dividend in arrears) whether or not declared; however, they
deduct only declared dividends on noncumulative preferred stock.
To illustrate, Sun Microsystems, Incorporated, had 3,417,000,000 weighted-average common shares
outstanding with income available to common shareholders of USD 922,590,000 during a recent year. Sun would
compute EPS as follows:
EPS= Incomeavailable forcommon stockholders
Weighted−average number of common sharesoutstanding
= USD922,590,000
3,417,000,000
= USD 0.27 per share
Firms calculate EPS for each major category on the face of the income statement. In other words, they make an
EPS calculation for income from continuing operations, discontinued operations, extraordinary items, changes in
accounting principle, and net income. Note in Exhibit 104 that Anson reports the EPS amounts at the bottom of its
income statement.
The price-earnings ratio (current market price per share of common stock divided by EPS) provides an index
on whether a stock has future high income potential compared to other stocks. Stocks with future high income
potential tend to have a high price-earnings ratio.
In the financial highlights of Kimball International, Incorporated's, recent annual report, the market price at
year-end was USD 16.00. Earnings per share were USD .93 (average of class A & B common stock). Kimball would
compute its price-earnings ratio that day as follows:
Price−earnings ratio= Current market price per shareof common stock
EPS
= USD16.00
USD0.93
= USD 17.20
This chapter completes the study of stockholders' equity. In Chapter 14, you learn about stock investments and
international accounting.
Understanding the learning objectives
• Paid-in capital is presented in the stockholders' equity section of the balance sheet. Each source of paid-in
capital is listed separately.
• Sources of paid-in capital are:
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(a) Common stock.
(b)Preferred stock.
(c) In excess of par value or stated value (common and preferred).
(d)Stock dividends.
(e) Treasury stock transactions.
(f) Donations.
• Cash dividend of 3 per cent on USD 100,000 of outstanding common stock: declared on July 1 and paid on
September 15.
July 1 Retained earnings (-SE) 3,000 Dividends payable (+L) 3,000
Sept. 15 Dividends payable (-L) 3,000 Cash (-A) 3,000
Ten per cent stock dividend on 10,000 shares of common stock outstanding; par value, USD 100; market value
at declaration, USD 125 per share (declared on January 1 and paid on February 1).
Jan. 1 Retained earnings (1,000 shares x $125) (-SE)
125,000
Stock dividends distributable – Common (1,000 shares x $100) (+SE)
100,000
Paid-in Capital – Stock dividends (1,000 shares x $25) (+SE) 25,000
Feb. 1 Stock dividend distributable – Common (-SE)
100,000
Common stock (+SE) 100,000
• Thirty per cent stock dividend on 10,000 shares of common stock outstanding: declared on January 1 and
payable on February 1; par value, USD 100.
Jan. 1 Retained earnings (3,000 shares x $100) (-SE)
300,000
Stock dividend distributable – Common (+SE)
300,000
Feb. 1 Stock dividend distributable – Common (+SE)
300,000
Common stock (-SE) 300,000
• Stock split: 1,000 shares of USD 50 par value common stock replaced by 2,000 shares of USD 25 par value
common stock.
Common stock - $50 par value (-SE)
50,000
Common stock - $25 par value (+SE)
50,000
• Retained earnings appropriation: USD 75,000 appropriated for plant expansion.
Retained earnings (-SE) 75,000 Retained earnings appropriated for plant expansion (+SE)
75,000
• Treasury stock transactions: 100 shares of common stock were reacquired at USD 100 each and reissued for
USD 105 each.
Treasury stock – Common (100 shares x $100) 10,000 Cash 10,000 Cash (100 shares x $105) 10,500 Treasury stock – Common (100 shares x $100) 10,000 Paid-in Capital – Common treasury stock transactions (100 shares x $5)
500
Accounting Principles: A Business Perspective 541 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
• The income or loss (net of tax effect) from the segment's operations for the portion of the current year
before it was discontinued is reported on the income statement below "Income from continuing operations".
• The gain or loss (net of tax effect) on disposal of the segment is also reported in that same section of the
income statement.
• Extraordinary items are both unusual in nature and infrequent in occurrence. Extraordinary items appear
on the income statement (net-of-tax effect) below "Income from continuing operations".
• In the period in which a change in principle is made, the nature of the change, its justification, and its effect
on net income must be disclosed in the financial statements. Also, the cumulative effect of the change on prior
years' income (net of tax effect) must be shown on the income statement for the year of the change below
"Income from continuing operations".
• Prior period adjustments consist of errors in previously published financial statements. Prior period
adjustments appear (net-of-tax effect) as a correction to the beginning retained earnings balance on the
statement of retained earnings.
• EPS equals the income available to common stockholders divided by the weighted-average number of
common shares outstanding. Income available to common stockholders is net income less any dividends on
preferred stock. EPS provides information on the return of an investment in common stock.
• The price-earnings ratio equals the current market price per share of common stock divided by EPS. The
price-earnings ratio indicates whether a stock has a future high income potential as compared to other stocks.
Demonstration problem
Demonstration problem A Wylie Corporation has outstanding 10,000 shares of USD 150 par value common
stock.
Prepare the entries to record:
a. The declaration of a cash dividend of USD 1.50 per share.
b. The declaration of a stock dividend of 10 per cent at a time when the market value per share is USD 185.
c. The declaration of a stock dividend of 40 per cent at a time when the market value per share is USD 195.
Demonstration problem B Following are selected transactions of Brackett Company:
• The company reacquired 200 shares of its own USD 100 par value common stock, previously issued at USD
105 per share, for USD 20,600.
• Fifty of the treasury shares were reissued at USD 110 per share, cash.
• Seventy of the treasury shares were reissued at USD 95 per share, cash.
• Stockholders of the corporation donated 100 shares of their common stock to the company.
• The 100 shares of treasury stock received by donation were reissued for USD 9,000.
Prepare the necessary journal entries to record these transactions.
Demonstration problem C Selected account balances of Nexis Corporation at 2010 December 31, are:
Common stock (nor par value; 100,000 shares authorized, issued, and outstanding; stated value of USD 20 per share USD 2,000,000 Retained earnings 570,000 Dividends payable (in cash, declared December 15 on preferred stock) 16,000 Preferred stock (8 per cent, par value USD 200; 1,000 shares authorized, issued, and outstanding) 200,000 Paid-In capital from donation of plant site 100,000 Paid-in capital in excess of par value – preferred 8,000
Present in good form the stockholders' equity section of the balance sheet.
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Solution to demonstration problem
Solution to demonstration problem A
a. Retained earnings (or dividends) (-SE) 15,000 Dividends payable (+L) 15,000 To record declaration of a cash dividend.
b. Retained earnings (or stock dividends) (1,000 shares x $185) (-SE) 185,000 Stock dividend distributable – Common (1,000 shares x $150) (+L) 150,000 Paid-in capital – Stock dividends(+SE) 35,000 To record declaration of a small stock dividend (10%).
c. Retained earnings (or stock dividends) (4,000 shares x $150) (-SE)
600,000
Stock dividend distributable – Common (+L) 600,000 To record declaration of a large stock dividend (40%).
Solution to demonstration problem B
1. Treasury stock (-SE) 20,600 Cash (-A) 20,600 Acquired 200 shares at $20,600 ($103 per share).
2. Cash (50 shares x $110) (+A) 5,500 Treasury stock – Common (50 shares x $103) (+SE)
5,150
Paid-in capital – common treasury stock transactions (+SE)
350
Reissued 50 shares at $110 per share; cost is $5,150.
3. Cash (70 shares x $95) (+A) 6,650 Paid-in capital – Common treasury stock transactions (50 shares x $7) (-SE)
350
Retained earnings (-SE) 210 Treasury stock – common (70 shares x $103) (+SE)
7,210
Reissued 70 shares at $95 per share; cost is $7,210.
4. Stockholders donated 100 shares of common stock to the company. (Only memo entry is made.)
5. Cash (+A) 9,000 Paid-in capital – Donations (100 shares x $90) (+SE)
9,000
Reissued donated shares at $90 per share.
Solution to demonstration problem C
Nexis Corporation Partial balance sheet
2010 December 31
Stockholders' equity: Paid-in capital: Preferred stock – 8%, par value $200; 1,000 shares authorized, issued, and outstanding
$200,000
Common stock – no par value, stated value of $20 per share; 100,000 shares authorized, issued, and outstanding
2,000,000
Paid-in capital from donation of plant site 100,000 Paid-in capital in excess of par value – preferred8,000 Total paid-in capital $2,308,0
00 Retained earnings 570,000 Total stockholders' equity $2,878,0
Accounting Principles: A Business Perspective 543 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
00
Key terms Cash dividends Cash distributions of accumulated earnings by a corporation to its stockholders.
Changes in accounting principle Changes in accounting methods pertaining to such items as inventory.
Contributed capital See paid-in capital.
Date of declaration (of dividends) The date the board of directors takes action in the form of a motion that dividends be paid.
Date of payment (of dividends) The date of actual payment of a dividend, or issuance of additional shares for a stock dividend.
Date of record (of dividends) The date of record established by the board that determines the stockholders who will receive dividends.
Deficit A debit balance in the Retained Earnings account.
Discontinued operation When a segment of a business is sold to another company or is abandoned.
Dividends Distribution of earnings by a corporation to its stockholders.
Dividends (cash) See cash dividends.
Dividends (stock) See stock dividends.
Donated capital Results from donation of assets to the corporation, which increases stockholders' equity.
Earnings per share (EPS) Earnings to the common stockholders on a per share basis, computed as income available to common stockholders divided by the weighted-average number of common shares outstanding.
Extraordinary items Items both unusual in nature and infrequent in occurrence; reported in the income statement net of their tax effects, if any.
Income available to common stockholders Net income less any dividends on preferred stock.
Liquidating dividends Dividends that are a return of contributed capital, not a distribution chargeable to retained earnings.
Net-of-tax effect Used for discontinued operations, extraordinary items, changes in accounting principle, and prior period adjustments, whereby items are shown at the dollar amounts remaining after deducting the effects of such items on income taxes, if any, payable currently.
Paid-in capital All of the contributed capital of a corporation, including that carried in capital stock accounts. When the words paid-in capital are included in the account title, the account contains capital contributed in addition to that assigned to the shares issued and recorded in the capital stock accounts.
Paid-In Capital—Common (Preferred) Treasury Stock Transactions The account credited when treasury stock is reissued for more than its cost; this account is debited to the extent of its credit balance when such shares are reissued at less than cost.
Price-earnings ratio The current market price per share of common stock divided by EPS.
Prior period adjustments Consist almost entirely of corrections of errors in previously published financial statements. Prior period adjustments are reported in the statement of retained earnings net of their tax effects, if any.
Retained earnings That part of stockholders' equity resulting from accumulated earnings; the account to which the results of corporate activity, including prior period adjustments, are carried and to which dividends and certain items resulting from capital transactions are charged.
Retained earnings appropriations Contractual or voluntary restrictions or limitations on retained earnings that reduce the amount of dividends that may be declared.
Statement of retained earnings A formal statement showing the items causing changes in unappropriated and appropriated retained earnings during a stated period of time.
Statement of stockholders' equity A summary of the transactions affecting the accounts in the stockholders' equity section of the balance sheet during a stated period of time.
Stock Dividend Distributable—Common account The stockholders' equity (paid-in capital) account that is credited for the par or stated value of the shares distributable when recording the declaration of a stock dividend.
Stock dividends Dividends that are payable in additional shares of the declaring corporation's capital stock.
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Stock split A distribution of 100 per cent or more of additional shares of the issuing corporation's stock, accompanied by a corresponding reduction in the par value per share. The purpose of a stock split is to cause a large reduction in the market price per share of the outstanding stock.
Treasury stock Shares of capital stock issued and reacquired by the issuing corporation; they have not been formally canceled and are available for reissuance.
Self-test
True-false
Indicate whether each of the following statements is true or false.
The retained earnings balance of a corporation is part of its paid-in capital.
The purchase of treasury stock does not affect stockholders' equity.
Dividends are expenses since they decrease stockholders' equity.
A stock dividend reduces the retained earnings balance and permanently capitalizes the reduced portion of the
retained earnings.
A retained earnings appropriation reduces the total stockholders' equity shown on the balance sheet.
Heavy frost damage suffered by a Florida citrus grower's orange trees would probably be reported as an
extraordinary item.
Multiple-choice
Select the best answer for each of the following questions.
Which of the following is not included in paid-in capital?
a. Common Stock.
b. Paid-In Capital—Donations.
c. Stock Dividend Distributable.
d. Appropriation per Loan Agreement.
Bevins Company issued 10,000 shares of USD 20 par value common stock at USD 24 per share. Bevins
reacquired 1,000 shares of its own stock at a cost of USD 30 per share. The entry to record the reacquisition is:
a. Premium on Treasury Stock (-SE) 10,000 Treasury stock (-SE) 20,000 Cash (-A) 30,000
b. Premium on Treasury Stock (-SE) 6,000 Treasury stock (-SE) 24,000 Cash (-A) 30,000
c. Treasury Stock (-SE) 30,000 Cash (-A) 30,000
d. Treasury stock (-SE) 20,000 Paid-In Capital – Treasury Stock Transactions (-SE) 10,000 Cash (-A) 30,000
If the company reissues 500 shares of the treasury stock in (2) for USD 36 per share, the entry is:
a. Cash (+A) 18,000 Treasury Stock (+SE) 15,000 Paid-In Capital – Treasury Stock Transactions (+SE) 3,000
b. Cash (+A) 18,000 Treasury stock (+SE) 18,000
c. Cash (+A) 18,000 Treasury stock (+SE) 15,000 Retained earnings (+SE) 3,000
Accounting Principles: A Business Perspective 545 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
d. Cash (+A) 18,000 Treasury stock (+SE) 10,000 Retained earnings (+SE) 8,000
Treasury stock should be shown on the balance sheet as a:
a. Reduction of the corporation's stockholders' equity.
b. Current asset.
c. Current liability.
d. Investment asset.
An individual stockholder is entitled to receive any dividends declared on stock owned, provided the stock is
held on the:
a. Date of declaration.
b. Date of record.
c. Date of payment.
d. Last day of a fiscal year.
ABC Corporation declared the regular quarterly dividend of USD 2 per share. ABC had issued 12,000 shares and
subsequently reacquired 2,000 shares as treasury stock. What would be the total amount of the dividend?
a. USD 24,000.
b. USD 28,000.
c. USD 20,000.
d. USD 4,000.
Which item is not reported as a separate line item below income from continuing operations, net of tax effects,
in the income statement?
a. Extraordinary items.
b. Prior period adjustments.
c. Discontinued operations.
d. Changes in accounting principle.
Now turn to “Answers to self-test” at the end of the chapter to check your answers.
Questions
➢ What are the two main elements of stockholders' equity in a corporation? Explain the difference
between them.
➢ Name several sources of paid-in capital. Would it suffice to maintain one account called Paid-In
Capital for all sources of paid-in capital? Why or why not?
➢ Does accounting for treasury stock resemble accounting for an asset? Is treasury stock an asset? If
not, where is it properly shown on a balance sheet?
➢ What are some possible reasons for a corporation to reacquire its own capital stock as treasury stock?
➢ What is the purpose underlying the statutes that provide for restriction of retained earnings in the
amount of the cost of treasury stock? Are such statutes for the benefit of stockholders, management,
or creditors?
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➢ What is the effect of each of the following on the total stockholders' equity of a corporation: (a)
declaration of a cash dividend, (b) payment of a cash dividend already declared, (c) declaration of a
stock dividend, and (d) issuance of a stock dividend already declared?
➢ The following dates are associated with a cash dividend of USD 80,000: July 15, July 31, and August
15. Identify each of the three dates, and give the journal entry required on each date, if any.
➢ How should a declared but unpaid cash dividend be shown on the balance sheet? How should a
declared but unissued stock dividend be shown?
➢ On May 8, the board of directors of Park Corporation declared a dividend, payable on June 5, to
stockholders of record on May 17. On May 10, James sold his capital stock in Park Corporation
directly to Benton for USD 20,000, endorsing his stock certificate and giving it to Benton. Benton
placed the stock certificate in her safe. On May 30, Benton sent the certificate to the transfer agent of
Park Corporation for transfer. Who received the dividend? Why?
➢ What are the possible reasons for a corporation to declare a stock dividend?
➢ Why is a dividend consisting of the distribution of additional shares of the common stock of the
declaring corporation not considered income to the recipient stockholders?
➢ What is the difference between a small stock dividend and a large stock dividend?
➢ What are liquidating dividends?
➢ What is the purpose of a retained earnings appropriation?
➢ What is a statement of stockholders' equity?
➢ Describe a discontinued operation.
➢ What are extraordinary items? Where and how are they reported?
➢ Give an example of a change in accounting principle. How are the effects of changes in accounting
principle reported?
➢ What are prior period adjustments? Where and how are they reported?
➢ Why are stockholders and potential investors interested in the amount of a corporation's EPS? What
does the EPS amount reveal that total earnings do not.
Exercises
Exercise A The 2009 December 31, trial balance of Yamey Corporation had the following account balances:
Common stock (no-par value; 200,000 shares authorized, issued, and outstanding; stated value of $20 per share) $4,000,000 Notes payable (12% due 2010 May 1) 500,000 Retained earnings, unappropriated 2,500,000 Dividends payable in cash (declared December 15, on preferred stock) 12,000 Appropriation per loan agreement 480,000 Preferred stock (6%, par value $200; 2,000 shares authorized, issued, and outstanding) 400,000 Paid-In capital in excess of stated value – Common 300,000 Paid-In Capital in Excess of Par Value – Preferred 40,000
Present in proper form the stockholders' equity section of the balance sheet.
Exercise B Fogg Company has issued all of its authorized 5,000 shares of USD 400 par value common stock.
On 2009 February 1, the board of directors declared a dividend of USD 12 per share payable on 2009 March 15, to
stockholders of record on 2009 March 1. Give the necessary journal entries.
Accounting Principles: A Business Perspective 547 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
Exercise C The stockholders' equity section of Jay Company's balance sheet on 2009 December 31, shows
100,000 shares of authorized and issued USD 20 stated value common stock, of which 9,000 shares are held in the
treasury. On this date, the board of directors declared a cash dividend of USD 2 per share payable on 2010 January
21, to stockholders of record on January 10. Give dated journal entries for these.
Exercise D Kevin Company has outstanding 75,000 shares of common stock without par or stated value, which
were issued at an average price of USD 80 per share, and retained earnings of USD 3,200,000. The current market
price of the common stock is USD 120 per share. Total authorized stock consists of 500,000 shares.
a. Give the required entry to record the declaration of a 10 per cent stock dividend.
b. If, alternatively, the company declared a 30 per cent stock dividend, what additional information would you
need before making a journal entry to record the dividend?
Exercise E Grant Corporation's stockholders' equity consisted of 60,000 authorized shares of USD 30 par
value common stock, of which 30,000 shares had been issued at par, and retained earnings of USD 750,000. The
company then split its stock, two for one, by changing the par value of the old shares and issuing new USD 15 par
shares.
a. Give the required journal entry to record the stock split.
b. Suppose instead that the company declared and later issued a 10 per cent stock dividend. Give the required
journal entries, assuming that the market value on the date of declaration was USD 40 per share.
Exercise F The balance sheet of Willis Company contains the following:
Appropriation per loan agreement USD 900,000
a. Give the journal entry made to create this account.
b. Explain the reason for the appropriation's existence and its manner of presentation in the balance sheet.
Exercise G Kelly Company had outstanding 50,000 shares of USD 20 stated value common stock, all issued at
USD 24 per share, and had retained earnings of USD 800,000. The company reacquired 2,000 shares of its stock
for cash at book value from the widow of a deceased stockholder.
a. Give the entry to record the reacquisition of the stock.
b. Give the entry to record the subsequent reissuance of this stock at USD 50 per share.
c. Give the entry required if the stock is instead reissued at USD 30 per share and there were no prior treasury
stock transactions.
Exercise H Evan Company received 200 shares of its USD 200 stated value common stock on 2009 December
1, as a donation from a stockholder. On 2009 December 15, it reissued the stock for USD 62,400 cash. Give the
journal entry or entries necessary for these transactions.
Exercise I Vista Company has revenues of USD 80 million, expenses of USD 64 million, a tax-deductible
earthquake loss (its first such loss) of USD 4 million, and a tax-deductible loss of USD 6 million resulting from the
voluntary early extinguishment (retirement) of debt. The assumed income tax rate is 40 per cent. The company's
beginning-of-the-year retained earnings were USD 30 million, and a dividend of USD 2 million was declared.
a. Prepare an income statement for the year.
b. Prepare a statement of retained earnings for the year.
Exercise J Conner Company had retained earnings of USD 56,000 as of 2009 January 1. In 2009, Conner
Company had sales of USD 160,000, cost of goods sold of USD 96,000, and other operating expenses, excluding
taxes, of USD 32,000. In 2009, Conner Company discovered that it had, in error, depreciated land over the last
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three years resulting in a balance in the accumulated depreciation account of USD 40,000. The assumed tax rate for
Conner Company is 40 per cent. Present in proper form a statement of retained earnings for the year ended 2009
December 31.
Exercise K The following information relates to Perry Corporation for the year ended 2009 December 31:
Common stock outstanding 75,000 shares Income from continuing operations $1,523,200 Loss on discontinued operations (net of tax) 240,000 Extraordinary gain (net of tax) 144,000
Calculate EPS for the year ended 2009 December 31. Present the information in the same format used in the
corporation's income statement.
Exercise L Dean Company had an average number of shares of common stock outstanding of 200,000 in 2009
and 215,000 in 2010. Net income for these two years was as follows:
2009 $2,208,000 2010 2,304,000
a. Calculate EPS for the years ended 2009 December 31, and 2010.
b. What might the resulting figures tell a stockholder or a potential investor?
Problems
Problem A The bookkeeper of Hart Company has prepared the following incorrect statement of stockholders'
equity for the year ended 2009 December 31:
Stockholders' equity: Paid-In Capital: Preferred stock – 6%, cumulative (8,000 shares)
$1,003,200
Common stock – 50,000 shares 2,856,000 Total paid-in capital $3,859,200 Retained earnings 1,636,800 Total stockholders' equity $5,496,000
The authorized stock consists of 12,000 shares of preferred stock with a USD 120 par value and 75,000 shares of
common stock, USD 48 par value. The preferred stock was issued on two occasions: (1) 5,000 shares at par, and (2)
3,000 shares at USD 134.40 per share. The 50,000 shares of common stock were issued at USD 62.40 per share.
Five thousand shares of treasury common stock were reacquired for USD 264,000. The bookkeeper deducted the
cost of the treasury stock from the Common Stock account.
Prepare the correct stockholders' equity section of the balance sheet at 2009 December 31.
Problem B The only stockholders' equity items of Jody Company at 2009 June 30, are:
Stockholders' equity: Paid-in capital: Common stock - $200 par value, 10,000 shares authorized, 6,000 shares issued and outstanding
$1,200,000
Paid-in capital in excess of par value 480,000 Total paid-in capital $1,680,000 Retained earnings 480,000 Total stockholders' equity $2,160,000
On 2009 August 4, a 4 per cent cash dividend was declared, payable on September 3. On November 16, a 10 per
cent stock dividend was declared. The shares were issued on December 1. The market value of the common stock
was USD 360 per share on November 16 and USD 354 per share on December 1.
Prepare journal entries for these dividend transactions.
Problem C Following are selected transactions of White Corporation:
Accounting Principles: A Business Perspective 549 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
2002
Dec. 31 The board of directors authorized the appropriation of USD 50,000 of retained earnings to provide for
the future acquisition of a new plant site and the construction of a new building. (On the last day of the next six
years, the same action was taken. You need not make entries for these six years.)
2007
Jan. 2 Purchased a new plant site for cash, USD 100,000.
Mar. 29 Entered into a contract for construction of a new building, payment to be made within 30 days following
completion.
2009
Feb. 10 Following final inspection and approval of the new building, Dyer Construction Company was paid in
full, USD 500,000.
Mar. 10 The board of directors authorized release of the retained earnings appropriated for the plant site and
building.
Apr. 2 A 5 per cent stock dividend on the 100,000 shares of USD 50 par value common stock outstanding was
declared. The market price on this date was USD 55 per share.
Prepare journal entries for all of these transactions.
Problem D Following are selected data of Kane Corporation at 2009 December 31:
Net income for the year $512,000 Dividends declared on preferred stock 72,000 Retained earnings appropriated during the year for future plant expansion 240,000 Dividends declared on common stock 64,000 Retained earnings, January 1, unappropriated 720,000 Directors ordered that the balance in the “Appropriation per loan agreement”, related to a loan repaid on 2009 March 31, be returned to unappropriated retained earnings 480,000
Prepare a statement of retained earnings for the year ended 2009 December 31.
Problem E The stockholders' equity of Sayers Company at 2009 January 1, is as follows:
Common stock – no-par value, stated value of $20; 100,000 shares authorized, 60,000 shares issued $1,200,000 Paid-in capital in excess of stated value 200,000 Appropriation per loan agreement 75,200 Unappropriated retained earnings 424,000 Treasury stock (3,000 shares at cost) (72,000)
During 2009, the following transactions occurred in the order listed:
• Issued 10,000 shares of stock for USD 368,000.
• Declared a 4 per cent stock dividend when the market price was USD 48 per share.
• Sold 1,000 shares of treasury stock for USD 43,200.
• Issued stock certificates for the stock dividend declared in transaction 2.
• Bought 2,000 shares of treasury stock for USD 67,200.
• Increased the appropriation by USD 43,200 per loan agreement.
Prepare journal entries as necessary for these transactions.
Problem F The stockholders' equity of Briar Company on 2008 December 31, consisted of 1,000 authorized,
issued, and outstanding shares of USD 72 cumulative preferred stock, stated value USD 240 per share, which were
originally issued at USD 1,192 per share; 100,000 shares authorized, issued, and outstanding of no-par, USD 160
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stated value common stock, which were originally issued at USD 160; and retained earnings of USD 1,120,000.
Following are selected transactions and other data relating to 2009. No previous treasury stock transactions had
occurred.
• The company reacquired 2,000 shares of its common stock at USD 336.
• One thousand of the treasury shares were reissued at USD 288.
• Stockholders donated 1,000 shares of common stock to the company. These shares were immediately
reissued at USD 256 to provide working capital.
• The first quarter's dividend of USD 18 per share was declared and paid on the preferred stock. No other
dividends were declared or paid during 2009.
The company suffered a net loss of USD 224,000 for the year 2009.
a. Prepare journal entries for the preceding numbered transactions.
b. Prepare the stockholders' equity section of the 2009 December 31, balance sheet.
Problem G The following stockholders' equity section is from Bell Company's 2008 October 31, balance sheet:
Stockholders' equity: Paid-in capital: Preferred stock - $60 par value, 6%; 1,000 shares authorized; 350 shares issued and outstanding
$ 21,000
Common stock - $6 par value; 100,000 shares authorized; 40,000 shares issued and outstanding
240,000
Paid-in capital from donation of plant site 15,000 Total paid-in capital $276,000 Retained earnings: Appropriated: Appropriation for contingencies $ 12,000 Unappropriated 33,300 Total retained earnings 45,300 Total stockholders' equity $321,300
During the ensuing fiscal year, Bell Company entered into the following transactions:
• The appropriation of USD 12,000 of retained earnings had been authorized in October 2008 because of the
likelihood of an unfavorable court decision in a pending lawsuit. The suit was brought by a customer seeking
damages for the company's alleged breach of a contract to supply the customer with certain products at stated
prices in 2007. The suit was concluded on 2009 March 6, with a court order directing the company to pay USD
10,500 in damages. These damages were not deductible in determining the income tax liability. The board
ordered the damages paid and the appropriation closed. The loss does not qualify as an extraordinary item.
• The company acquired 1,000 shares of its own common stock at USD 9 in May 2009. On June 30, it
reissued 500 of these shares at USD 7.20.
• Dividends declared and paid during the year were 6 per cent on preferred stock and 18 cents per share on
common stock. Both dividends were declared on September 1 and paid on 2009 September 30.
For the fiscal year, the company had net income after income taxes of USD 11,400, excluding the loss of the
lawsuit.
a. Prepare journal entries for the preceding numbered transactions.
b. Prepare a statement of retained earnings for the year ended 2009 October 31.
c. Prepare the stockholders' equity section of the 2009 October 31, balance sheet.
Problem H Selected data for Brinks Company for 2009 are given below:
Accounting Principles: A Business Perspective 551 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
Common stock - $20 par value $2,000,000 Sales, net 1,740,000 Selling and administrative expenses 320,000 Cash dividends declared and paid 120,000 Cost of goods sold 800,000 Depreciation expense 120,000 Interest revenue 20,000 Loss on write-down of obsolete inventory 40,000 Retained earnings (as of 2008/12/31) 2,000,000 Operating less on Candy Division up to point of sale in 2009 40,000 Loss on disposal of Candy Division 200,000 Earthquake loss 96,000 Cumulative negative effect on prior years' income of changing from straight-line to an accelerated method of computing depreciation.
64,000
Assume the applicable federal income tax rate is 40 per cent. All of the items of expense, revenue, and loss are
included in the computation of taxable income. The earthquake loss resulted from the first earthquake experienced
at the company's location. In addition, the company discovered that in 2008 it had erroneously charged to expense
the USD 160,000 cost of a tract of land purchased that year and had made the same error on its tax return for
2008.
a. Prepare an income statement for the year ended 2009 December 31.
b. Prepare a statement of retained earnings for the year ended 2009 December 31.
Alternate problems
Alternate problem A The trial balance of Dex Corporation as of 2009 December 31, contains the following
selected balances:
Notes payable (17%, due 2011 May 1) $4,000,000 Allowance for uncollectible accounts 60,000 Common stock (without par value, $20 stated value; 300,000 shares authorized, issued, and outstanding)
6,000,000
Retained earnings, unappropriated 500,000 Dividends payable (in cash, declared December 15 on preferred stock) 14,000 Appropriation for pending litigation 600,000 Preferred stock (6%, $200 par value; 3,000 shares authorized, issued, and outstanding) 600,000 Paid-In Capital – Donations 400,000 Paid-In Capital in Excess of Par Value – Preferred 10,000
Present the stockholders' equity section of the balance sheet as of 2009 December 31.
Alternate problem B The stockholders' equity section of Carson Company's 2008 December 31, balance sheet
follows:
Stockholders' equity: Paid-In Capital: Common stock - $120 par value; authorized, 2,000 shares; issued and outstanding, 1,000 shares $120,000 Paid-in capital in excess of par value 6,000
Total paid-in capital $126,000 Retained earnings 48,000 Total stockholders' equity $174,000
On 2009 July 15, the board of directors declared a cash dividend of USD 12 per share, which was paid on 2009
August 1. On 2009 December 1, the board declared a stock dividend of 10 per cent, and the shares were issued on
2009 December 15. Market value of the stock was USD 144 on December 1 and USD 168 on December 15.
Prepare journal entries for these dividend transactions.
Alternate problem C The ledger of Falcone Company includes the following account balances on 2009
September 30:
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Appropriation for contingencies $210,000 Appropriation for plant expansion 392,000 Retained earnings, unappropriated 700,000
During October 2009, the company took action to:
• Increase the appropriation for contingencies by USD 60,000.
• Decrease the appropriation for plant expansion by USD 160,000.
• Establish an appropriation per loan agreement, with an annual increase of USD 48,000.
• Declare a cash dividend of USD 140,000.
Prepare the journal entries to record these transactions of Falcone Company.
Alternate problem D Following are selected transactions of Taylor Corporation:
2004
Dec. 31 By action of the board of directors, USD 450,000 of retained earnings was appropriated to provide for
future expansion of the company's main building. (On the last day of each of the next four years, the same action
was taken. You need not make entries for these years.)
2009
Jan. 3 Obtained, at a cost of USD 4,500, a building permit to construct a new wing on the main plant building.
July 30 Paid USD 1,800,000 to Starke Construction Company for completion of the new wing.
Aug. 4 The board of directors authorized the release of the sum appropriated for expansion of the plant building.
4 The board of directors declared a 10 per cent common stock dividend on the 25,000 shares of USD 500 par
value common stock outstanding. The market price on this date was USD 660 per share.
Prepare journal entries to record all of these transactions.
Alternate problem E The following information relates to Dahl Corporation for the year 2009:
Net income for the year $ 1,680,000 Dividends declared on common stock 235,000 Dividends declared on preferred stock 134,000 Retained earnings, January 1, unappropriated 5,040,000 Appropriation for retirement of bonds 672,000 Balance in “Appropriation for possible loss of a lawsuit”, no longer needed on December 31 because of a favorable court decision, is (by directors' order) returned to unappropriated retained earnings 840,000
Prepare a statement of retained earnings for the year ended 2009 December 31.
Alternate problem F The stockholders' equity of Acorn Company as of 2008 December 31, consisted of
20,000 shares of authorized, issued, and outstanding USD 50 par value common stock, paid-in capital in excess of
par of USD 240,000, and retained earnings of USD 400,000. Following are selected transactions for 2009:
May 1 Acquired 3,000 shares of its own common stock at USD 100 per share.
June 1 Reissued 500 shares at USD 120.
30 Reissued 700 shares at USD 90.
Oct. 1 Declared a cash dividend of USD 5 per share.
31 Paid the cash dividend declared on October 1.
Net income for the year was USD 80,000. No other transactions affecting retained earnings occurred during the
year.
a. Prepare general journal entries for these transactions.
b. Prepare the stockholders' equity section of the 2009 December 31, balance sheet.
Accounting Principles: A Business Perspective 553 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
Alternate problem G The stockholders' equity section of Sager Company's 2008 December 31, balance sheet
follows:
Stockholders' equity: Paid-In Capital: Preferred stock - $60 par value, 5%; authorized, 5,000 shares; issued and outstanding, 2,500 shares
$150,000
Common stock – without par or stated value; authorized, 50,000 shares; issued, 25,000 shares of which 500 are held in treasury
225,000
Paid-in capital in excess of par – preferred 3,000 Total paid-in capital $378,000 Retained earnings: Appropriated: For plant expansion $15,000 Unappropriated (restricted as to dividends to the extent of $6,000, the cost of the treasury stock held)
126,000 Total retained earnings 141,000 Total paid-in capital and retained earnings $519,000 Less: Treasury stock, common, at cost (500 shares)
6,000
Total stockholders' equity $513,000
Following are selected transactions that occurred in 2009:
Jan. 13 Cash was received for 550 shares of previously unissued common stock at USD 13.20.
Feb. 4 A plot of land was accepted as payment in full for 500 shares of common stock, and the stock was issued.
Closing market price of the common stock on this date was USD 12 per share.
Mar. 24 All of the treasury stock was reissued at USD 14.40 per share.
June 23 The regular semiannual dividend on the preferred stock was declared.
30 The preferred dividend was paid.
July 3 A 10 per cent stock dividend was declared on the common stock. Market price on this date was USD
16.80.
18 The stock dividend shares were issued.
Oct. 4 The company reacquired 105 shares of its common stock at USD 14.40.
Dec. 18 The regular semiannual dividend on the preferred stock and a USD 0.24 per share dividend on the
common stock were declared.
31 Both dividends were paid.
31 An additional appropriation of retained earnings of USD 3,000 for plant expansion was authorized.
a. Prepare journal entries to record the 2009 transactions.
b. Prepare a statement of retained earnings for the year 2009, assuming net income for the year was USD
25,800.
c. Prepare the stockholders' equity section of the 2009 December 31, balance sheet.
Alternate problem H Selected data of Ace Company for the year ended 2009 December 31, are:
Sales, net $1,000,000 Interest expense 90,000 Cash dividends on common stock 150,000 Selling and administrative expenses 245,000 Cash dividends on preferred stock 70,000 Rent revenue 400,000 Cost of goods sold 650,000 Flood loss (has never occurred before) 200,000 Interest revenue 90,000
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Other revenue 150,000 Depreciation and maintenance on rental equipment 270,000 Stock dividend on common stock 300,000 Operating income on Plastics Division up to point of sale in 2009 50,000 Gain on disposal of Plastics Division 25,000 Litigation loss (has never occurred before) 400,000 Cumulative positive effect on prior years' income of changing to a different depreciation method
80,000
Assume the applicable federal income tax rate is 40 per cent. All of the preceding items of expense, revenue, and
loss are included in the computation of taxable income. The litigation loss resulted from a court award of damages
for patent infringement on a product that the company produced and sold in 2005 and 2006, but was discontinued
in 2006. In addition, the company discovered that in 2005 it had erroneously charged to expense the USD 250,000
cost of a tract of land purchased that year and had made the same error on its tax return for 2008. Retained
earnings as of 2009 January 1, were USD 5,600,000. Assume there were 10,000 shares of common stock and 5,000
shares of preferred stock outstanding for the entire year.
Prepare an income statement and a statement of retained earnings for 2009.
Beyond the numbers—Critical thinking
Business decision case A The stockholders' equity section of the Bates Corporation's balance sheet for 2009
June 30, follows:
Stockholders' equity: Paid-in Capital: Common stock - $20 par value; authorized 200,000 shares; issued and outstanding 80,000 shares
$1,600,000
Paid-in capital in excess of par value 960,000 Total paid-in capital $2,560,000 Retained earnings 1,520,000 Total stockholders' equity $4,080,000
On 2009 July 1, the corporation's directors declared a 10 per cent stock dividend distributable on August 2 to
stockholders of record on July 16. On 2009 November 1, the directors voted a USD 2.40 per share annual cash
dividend payable on December 2 to stockholders of record on November 16. For four years prior to 2009, the
corporation had paid an annual cash dividend of USD 2.52.
As of 2009 July 1, Bob Jones owned 8,000 shares of Bates Corporation's common stock, which he had
purchased four years earlier. The market value of his stock was USD 48 per share on 2009 July 1, and USD 43.64
per share on 2009 July 16.
a. What amount of cash dividends will Jones receive in 2009? How does this amount differ from the amount of
cash dividends Jones received in the previous four years?
b. Jones has asked you, his CPA, to explain why the price of the stock dropped from USD 48 to USD 43.64 on
2009 July 16. Write a memo to Jones explaining your answer.
c. Do you think Jones is better off as a result of the stock dividend and the USD 2.40 cash dividend than he
would have been if he had just received the USD 2.52 cash dividend? Write a memo to Jones explaining your
answer.
Business decision case B The following journal entries are for Keel Corporation:
1. Retained earnings 12,000 Reserve for uncollectible accounts 12,000 To record the adjusting entry for uncollectible accounts.
Accounting Principles: A Business Perspective 555 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
2. Retained earnings 48,000 Reserve for depreciation 48,000 To record depreciation expense.
3. Retained earnings 120,000 Appropriation for plant expansion 120,000 To record retained earnings appropriation.
4. Retained earnings 8,000 Stock dividend distributable – Common 8,000 To record 10% stock dividend declaration (100 shares to be distributed - $80 par value, $120 market value).
5. Stock dividend distributable – Common 8,000 Common stock 8,000 To record distribution of stock dividend.
6. Treasury Stock 32,000 Cash 32,000 To record acquisition of 200 shares of $80 par value common stock at $160 per share.
7. Cash 17,600 Treasury Stock 17,600 To record sale of 100 treasury shares at $176 per share.
8. Cash 6,800 Treasury stock 6,800 To record sale of 50 treasury shares at $136 per share.
9. Common stock 16,000 Dividends payable 16,000 To record declaration of cash dividend.
10. Dividends payable 16,000 Cash 16,000 To record payment of cash dividend.
The management of Keel Corporation has asked you, a CPA, to analyze these journal entries and decide whether
each is correct. The explanations are all correct. Wherever a journal entry is incorrect, prepare the journal entry
that should have been made.
Annual report analysis C The following questions are based on the Coca-Cola Company's 2006 annual
report. To view the report, go to the Coca-Cola web site at www.cocacola.com. After you activate the web site, click
on The Coca-Cola Company. Go to investors and a menu will drop down that has financials as an option with
Financial Statements (select this) to its right. Click on Balance Sheet and then open it to find the total cost of
treasury shares. Then go to Selected Financial Data and open it to find the number of common shares outstanding.
a. Based on the information in the balance sheet and the note, determine the number of common shares
outstanding; and the total cost of treasury stock shares on hand at the end of 2006.
b. In writing, discuss what reasons Coca-Cola might have to acquire treasury stock.
c. Find Coca-Cola's basic EPS for 2006 listed in its Income Statement. If the common stock's market price at
2006 December 31, was USD 30, what was the price-earnings ratio?
Ethics case–Writing experience D Based on the ethics case, answer the following questions concerning Ace
Chemical Company in writing:
a. Is this transaction fair to the creditors?
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b. Why would the officers not merely declare a USD 4 million cash dividend? Is the proposed treasury stock
transaction fair to the other stockholders?
c. If you were one of the officers, would you feel comfortable in going ahead with this proposed treasury stock
transaction?
Group project E In teams of two to three students, go to the library to find articles evaluating accounting
software packages. Use a periodicals index such as the Accounting and Tax Index or the Business Periodicals Index
to locate these articles. Compare the cost and features of three accounting software packages. As a team, prepare a
memorandum to the manager of a small retail business. Compare and contrast the three accounting software
packages so the manager might decide which package to purchase. In the memorandum, cite the sources used in
gathering the data and properly reference any direct quotes or paraphrasing. The heading of the memorandum
should contain the date, to whom it is written, from whom, and the subject matter.
Group project F With a small group of students, go to the library and locate Statement of Financial
Accounting Standards No. 4, "Reporting Gains and Losses from Extinguishing of Debt", published by the Financial
Accounting Standards Board. Write a report to your instructor giving the highlights of the standard. Why are these
gains and losses treated as extraordinary items? Why did the Board act on this topic? Why did one member of the
Board dissent?
Group project G With one or two other students, locate the annual reports of three companies and study their
statements of stockholders' equity. Determine why the number of common shares outstanding changed (if at all)
during the current year. For instance, the number of outstanding shares may have increased due to new issuances,
exercise of stock options, conversion of preferred stock, exercise of warrants, stock dividends, and other causes. The
number of shares outstanding may have decreased because of repurchases of stock (treasury stock transactions).
Write a report to your instructor presenting your findings. Also be prepared to make a short presentation to your
class.
Using the Internet—A view of the real world
Visit the following website for the General Electric Company:
http://www.ge.com
Pursue choices on the screen until you locate the consolidated statement of changes in stockholders' equity. You
will probably go down some "false paths" to get to this financial statement, but you can get there. This experience is
all part of learning to use the Internet. Trace the changes that have occurred in the last three years in the dividends
and other transactions with stockholders. Check out the notes to the financial statements for further information.
Write a memo to your instructor summarizing your findings.
Visit the following website for 3M:
http://www.3m.com
Pursue choices on the screen until you locate the Financial Section. You will probably go down some "false
paths" to get to this information, but you can get there. This experience is all part of learning to use the Internet.
Trace the changes that have occurred in the stockholders' equity section for the most recent two years. Identify the
causes of the changes. Check out the notes to the financial statements for further information. Write a memo to
your instructor summarizing your findings.
Accounting Principles: A Business Perspective 557 A Global Text
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
Answers to self-test
True-false
False. The paid-in capital of a corporation only includes capital contributed by stockholders or others. Thus, it
does not include retained earnings.
False. The purchase of treasury stock reduces total stockholders' equity.
False. Dividends are distributions of earnings in the past and are not expenses.
True. A stock dividend permanently capitalizes a portion of retained earnings by decreasing retained earnings
and increasing paid-in capital by an equal amount.
False. The purpose of a retained earnings appropriation is to disclose that a portion of retained earnings is not
available for cash dividends. Thus, such an appropriation does not reduce total stockholders' equity.
False. Such damage occurs too frequently to be considered nonrecurring.
Multiple-choice
d. Appropriation per Loan Agreement is part of retained earnings.
c. When treasury stock is reacquired, the stock is recorded at cost in a debit-balance stockholders' equity
account, Treasury Stock.
a. The excess of the reissue price over the cost of treasury stock is recorded in the Paid-In Capital—Treasury
Stock Transactions account.
a. Treasury stock is customarily shown as a deduction from total stockholders' equity.
b. The date of record determines who is to receive the dividends.
c. The total amount of dividends is computed as follows:
Total Outstanding shares at declaration:
(12,000 – 2,000) shares 10,0000 Dividend per share X USD 2 Total dividend amount USD 20,000
b. Prior period adjustments are shown as adjustments to the opening balance of retained earnings on the
statement of retained earnings.
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14. Stock investments Learning objectives
After studying this chapter, you should be able to:
• Report stock investments and distinguish between the cost and equity methods of accounting for stock
investments.
• Prepare journal entries to account for short-term stock investments and for long-term stock
• Prepare journal entries to account for long-term stock investments of 20 per cent to 50 per cent.
• Describe the nature of parent and subsidiary corporations.
• Prepare consolidated financial statements through the use of a consolidated statement work sheet.
• Describe the uses and limitations of consolidated financial statements.
• Analyze and use the financial results—dividend yield on common stock and payout ratio on common stock.
The role of accountants in business acquisitions
The number and size of corporate mergers and acquisitions has accelerated at an amazing pace over the last
decade. The combination of these sometimes mega-giant corporations, involves complex strategic alliance
decisions. The potential rewards of mergers and acquisitions can be enormous-increased market share, broadened
product lines, stability for the overall company, strengthened financial position, captured key executive or technical
talent, and cost savings. In 1999, Exxon and Mobil merged in an USD 82 billion deal. The companies originally
estimated that the merger would save the companies USD 2.8 billion, but by the end of 2002 that number had risen
to nearly USD 7 billion.
Not all mergers and acquisitions turn out this well. In fact, many mergers and acquisitions weaken companies
(for example, the acquisition of Skype by eBay). Beyond the need to record accounting transactions after the
combination, accountants are now being asked to play an increasing role in business valuation before the
combination.
When considering the acquisition of a company, the first question is "Do we really want to go into business with
this company?" Target companies may misrepresent their financial position or conceal suspicious behavior in an
attempt to maximize their purchase price. Accountants are used by acquirers to scope out the full details of a
target's financials, operations, and human assets. Accountants are intimately familiar with accounting practices and
recording procedures and therefore are best trained to find financial statement misrepresentations. Discoveries by
accountants have canceled many giant mergers and acquisitions.
The second question to consider is "What is the target worth?" The acquiring company generally requires the
target company to make available its financial statements. Accounting professionals are asked to interpret the
financial statements and other financial data to determine the value of the target. Accounting professionals also
understand how accounting numbers translate into firm value and which aspects of firm value are not captured by
accounting numbers.
Accounting Principles: A Business Perspective 559 A Global Text
14. Stock investments
Business acquisitions are commonplace in every industry. The role of accounting professionals in business
valuation is essential to the success of the company and represents one of the fastest growing areas in accounting.
Often a large company attempts to take over a smaller company by acquiring a controlling interest (more than
50 per cent of the outstanding shares) in that target company. Some of these takeover attempts are friendly (not
resisted by the target company), and some are unfriendly (resisted by the target company). If the attempt is
successful, the two companies become one business entity for accounting purposes, and consolidated financial
statements are prepared. The company that takes over another company is the parent company; the company
acquired is the subsidiary company. This chapter discusses accounting for parent and subsidiary companies.
When a corporation purchases the stock of another corporation, the method of accounting for the stock
investment depends on the corporation's motivation for making the investment and the relative size of the
investment. A corporation's motivation for purchasing the stock of another company may be as: (1) a short-term
investment of excess cash; (2) a long-term investment in a substantial percentage of another company's stock to
ensure a supply of a required raw material (for example, when large oil companies invest heavily in, or purchase
outright, wildcat oil drilling companies); or (3) a long-term investment for expansion (when a company purchases
another profitable company rather than starting a new business operation). On the balance sheet, the first type of
investment is a current asset, and the last two types are long-term (noncurrent) investments. As explained in the
chapter, the purchaser's level of ownership of the investee company determines whether the investment is
accounted for by the cost method or the equity method.
Cost and equity methods
Investors in common stock can use two methods to account for their investments the cost method or the equity
method. Under both methods, they initially record the investment at cost (price paid at acquisition). Under the
cost method, the investor company does not adjust the investment account balance subsequently for its share of
the investee's reported income, losses, and dividends. Instead, the investor company receives dividends and credits
them to a Dividends Revenue account. Under the equity method, the investor company adjusts the investment
account for its share of the investee's reported income, losses, and dividends.
The Accounting Principles Board (the predecessor of the Financial Accounting Standards Board) has identified
the circumstances under which each method must be used. This chapter illustrates each of those circumstances.
The general rules for determining the appropriate method of accounting follow:
Types of Common Stock Investment Method of accounting
required By accounting principles board in most cases
All short-term investments
Cost
Long-term investments of: Less than 20%: If no significant influence
Cost
If significant influence Equity 20% - 50% Equity More than 50% Cost or equity
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Accounting for short-term stock investments and for long-term stock investments of less than 20 per cent
Accountants use the cost method to account for all short-term stock investments. When a company owns less
than 50 per cent of the outstanding stock of another company as a long-term investment, the percentage of
ownership determines whether to use the cost or equity method. A purchasing company that owns less than 20 per
cent of the outstanding stock of the investee company, and does not exercise significant influence over it, uses the
cost method. A purchasing company that owns from 20 per cent to 50 per cent of the outstanding stock of the
investee company or owns less than 20 per cent, but still exercises significant influence over it, uses the equity
method. Thus, firms use the cost method for all short-term stock investments and almost all long-term stock
investments of less than 20 per cent. For investments of more than 50 per cent, they use either the cost or equity
method because the application of consolidation procedures yields the same result.
Cost method for short-term investments and for long-term investments of less than 20 per cent
When a company purchases stock (equity securities) as an investment, accountants must classify the stock
according to management's intent. If management bought the security for the principal purpose of selling it in the
near term, the security would be a trading security. If the stock will be held for a longer term, it is called an
available-for-sale security. Trading securities are always current assets. Available-for-sale securities may be
either current assets or noncurrent assets, depending on how long management intends to hold them. Each
classification is accounted for differently. This topic will be discussed later in this chapter.
Securities can be transferred between classifications; however, there are specific rules that must be met for these
transfers to be allowed. These rules will be addressed in intermediate accounting. Under the cost method, investors
record stock investments at cost, which is usually the cash paid for the stock. They purchase most stocks from other
investors (not the issuing company) through brokers who execute trades in an organized market, such as the New
York Stock Exchange. Thus, cost usually consists of the price paid for the shares, plus a broker's commission.
For example, assume that Brewer Corporation purchased as a near-term investment 1,000 shares of Cowen
Company's USD 10 par value common stock at USD 14.22 per share, plus a USD 180 broker's commission. Brokers
quote most stock prices in dollars and cents. Brewer's entry to record its investment is:
Trading securities [(1,000 shares x $14.22) + $180 commission] (-SE)
14,400
Cash (-A) 14,400 Purchased 1,000 share of Cowen common stock as a near- term investment at 14.22 plus commission.
Accounting for cash dividends received Investments in stock provide dividends revenue. As a general rule,
investors debit cash dividends to Cash and credit Dividends Revenue. The only exception to this general rule is
when a dividend declared in one accounting period is payable in the next. This exception allows a company to
record the revenue in the proper accounting period. Assume that Cowen declared a USD 1 per share cash dividend
on 2010 December 1, to stockholders of record as of December 20, payable on 2011 January 15. Brewer should
make the following entry in 2010:
2010 Dec. 1 Dividends receivable (+A) 1,000
Dividends revenue (+SE) 1,000 To record $1 per share cash dividend on Cowen common stock, payable 2010 January 15.
Accounting Principles: A Business Perspective 561 A Global Text
14. Stock investments
When collecting the dividend on 2011 January 15, Brewer debits Cash and credits Dividends Receivable:
2011 Jan. 15 Cash (+A) 1,000
Dividends receivable (-A) 1,000 To record the receipt of a cash dividend on Cowen common stock.
Stock dividends and stock splits As discussed in Chapter 13, a company might declare a stock dividend
rather than a cash dividend. An investor does not recognize revenue on receipt of the additional shares from a stock
dividend. The investor merely records the number of additional shares received and reduces the cost per share for
each share held. For example, if Cowen distributed a 10 per cent stock dividend in February 2011, Brewer, which
held 1,000 shares at a cost of USD 14,400 (or USD 14.40 per share), would receive another 100 shares and would
then hold 1,100 shares at a cost per share of USD 13.09 (computed as USD 14,400/1,100 shares). Similarly, when a
corporation declares a stock split, the investor would note the shares received and the reduction in the cost per
share.
FASB Statement No. 115 (1993) governs the subsequent valuation of marketable equity securities accounted for
under the fair market value method.46 Marketable refers to the fact that the stocks are readily saleable; equity
securities are common and preferred stocks. The Statement also addresses the subsequent valuation of debt
securities. FASB Statement No. 159 (2007) amends FASB Statement No. 115 and gives a fair value alternative that
allows companies to elect to measure certain items at fair value at a specified date. The subsequent valuation of
debt securities will be addressed in intermediate accounting classes.
CompanyNo. of shares
Cost per Share
Market Price per share 2010/12/31
Total cost
Total market 2007/12/31
Increase/ (decrease) in market value
A 200 $35 $40 $ 7,000 $ 8,000 $ 1,000 B 400 10 15 4,000 6,000 2,000 C 100 90 50 9,000 5,000 (4,000)
$20,000 $19,000 $ (1,000)
Exhibit 107: Stock portfolio of Hanson company
The FASB Statement requires that at year-end, companies adjust the carrying value of each of their two
portfolios (trading securities and available-for-sale securities) to their fair market value. Fair market value is
considered to be the market price of the securities or what a buyer or seller would pay to exchange the securities. An
unrealized holding gain or loss will usually result in each portfolio.
Trading securities To illustrate the application of the fair market value to trading securities, assume that
Hanson Company has the securities shown in Exhibit 107 in its trading securities portfolio. Applying the fair
market value method reveals that the total fair market value of the trading securities portfolio is USD 1,000 less
than its cost. The journal entry required at the end of 2010 is:
2010
46 FASB, Statement of Financial Accounting Standards No. 115, "Accounting for Certain Marketable Securities"
(Stamford, Conn., 1993). Copyright © by the Financial Accounting Standards Board, Stamford, Connecticut
06856, U.S.A. Quoted (or excerpted) with permission. Copies of the complete document are available from the
FASB.
47. FASB, Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and
Financial Liabilities” (Norwalk, Conn., 2007). Copyright © by the Financial Accounting Standards Board,
Norwalk, Connecticut 06856, U.S.A.
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Dec. 31 Unrealized loss on trading securities (-SE) 1,000 Trading securities (-A) 1,000 To record unrealized loss from market decline of trading securities.
Note that the debit is to the Unrealized Loss on Trading Securities account. This loss is unrealized because the
securities have not been sold. However, the loss is reported in the income statement as a deduction in
arriving at net income. The credit in the preceding entry is to the Trading Securities account so as to adjust its
balance to its fair market value. (An unrealized holding gain would be an addition to net income.)
If Hanson sold investment C on 2011 January 1, the company would receive USD 5,000 (assuming no change in
market values from the previous day). The loss on the sale results from market changes in 2010 rather than in 2011;
the fair market value procedure placed that loss in the proper year. The entry for the sale is:
2011 Jan. 1 Cash (+A) 5,000
Trading securities- Company C Stock (-A)
5,000
To record sale of Company C Stock.
No adjustment needs to be made to the unrealized loss account previously debited because the unrealized loss
recorded in 2010 has flowed through the income statement and been closed to retained earnings through the
closing process.
Available-for-sale securities Assume a marketable equity security that management does not intend to sell
in the near term has a cost of USD 32,000 and a current market value on 2010 December 31, of USD 31,000. The
treatment of the loss depends on whether it results from a temporary decline in market value of the stock or a
permanent decline in the value. Assume first that the loss is related to a "temporary" decline in the market value of
the stock. The required entry is:
2010 Dec. 31 Unrealized loss on available-for-sale
securities (-SE) 1,000
Available-for-sale securities (-A) 1,000 To record unrealized loss from market decline of available-for-sale securities.
These accounts would appear on the balance sheet as follows:
Hanson Company Partial Balance Sheet 2010 December 31
Investments (or Current Assets)*: Available-for-sale securities $31,000 Stockholders' equity: Capital stock $xxx,xxx Additional paid-in capital X,xxx Total paid-in capital $xxx,xxx Less: Unrealized loss on available-for-sale securities
1,000
$xxx,xxx Retained earnings Xx,xxx Total stockholders' equity $xxx,xxx *Depending on the length of time management intends to hold the securities.
Note that the unrealized loss for available-for-sale securities appears in the balance sheet as a separate negative
component of stockholders' equity rather than in the income statement (as it does for trading securities). An
unrealized gain would be shown as a separate positive component of stockholders' equity. An unrealized loss or
gain on available-for-sale securities is not included in the determination of net income because it is not expected to
be realized in the near future. These securities will probably not be sold soon.
Accounting Principles: A Business Perspective 563 A Global Text
14. Stock investments
The sale of an available-for-sale security results in a realized gain or loss and is reported on the income
statement for the period. Any unrealized gain or loss on the balance sheet must be recognized at that time. Assume
the stock discussed above is sold on 2011 January 1, for USD 31,000 (assuming no change in market value from the
previous day) after the company had held the stock for three years. The entries to record this sale are:
2011 Jan. 1 Realized loss on available-for-sale
securities (-SE) 1,000
Unrealized loss on available-for-sale securities (+SE)
1,000
Cash 31,000 Available-for-sale securities 31,000
The account debited in the first entry shows that the unrealized loss has been realized with the sale of the
security; the amount is reported in the income statement. The second entry writes off the security and records the
cash received and is similar to the entry for the sale of trading securities.
A loss on an individual available-for-sale security that is considered to be "permanent" is recorded as a realized
loss and deducted in determining net income. The entry to record a permanent loss of USD 1,400 reads:
Realized loss on available-for-sale securities (-SE)
1,400
Available-for-sale securities (-A) 1,400 To record loss in value of available-for-sale securities.
No part of the USD 1,400 loss is subject to reversal if the market price of the stock recovers. The stock's reduced
value is now its "cost". When this stock is later sold, the sale will be treated in the same manner as trading
securities. The loss or gain has already been recognized on the income statement. Therefore, the entry would simply
record the cash received and write off the security sold for its fair market value. If the market value of the security
has fluctuated since the last time the account had been adjusted (end of the year), then an additional gain or loss
may have to be recorded to account for this fluctuation.
An accounting perspective:
Business insight
On Pearl Harbor Day, 1941 December 7, the stock market fell from 116.60 to 112.52. The average
fell to 92.92 by April 1942. By the end of WWII, the average had risen to 119.40. The average has
risen tremendously since that time, although some time in fits and starts. For instance, in 2007 the
Dow-Jones Industrial Average broke through the 14,000 barrier. The Dow was back below 7,000
in the spring of 2009 and then rose to over 10,000 by the end of that year. Over the last 60 years,
investors have averaged about a 10 per cent to 12 per cent return annually by investing in the stock
market. No one knows what will happen in the future, but many people invest in stocks to try to
stay ahead of inflation. You can visit the DJIA site on the Internet at http://www.dowjones.com to
learn more about the stock market.
The equity method for long-term investments of between 20 per cent and 50 per cent
When a company (the investor) purchases between 20 per cent and 50 per cent of the outstanding stock of
another company (the investee) as a long-term investment, the purchasing company is said to have significant
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influence over the investee company. In certain cases, a company may have significant influence even when its
investment is less than 20 per cent. In either situation, the investor must account for the investment under the
equity method.
When using the equity method in accounting for stock investments, the investor company must recognize its
share of the investee company's income, regardless of whether or not it receives dividends. The logic behind this
treatment is that the investor company may exercise influence over the declaration of dividends and thereby
manipulate its own income by influencing the investee's decision to declare (or not declare) dividends.
Thus, when the investee reports income or losses, the investor company must recognize its share of the
investee's income or losses. For example, assume that Tone Company (the investor) owns 30 per cent of Dutch
Company (the investee) and Dutch reports USD 50,000 net income in the current year. Under the equity method,
Tone makes the following entry as of the end of 2010:
Investment in Dutch Company (+A) 15,000 Income from Dutch Company ($50,000 x 0.30) (+SE)
15,000
To record 30% of Dutch Company's Net Income.
The USD 15,000 income from Dutch would be reported on Tone's 2010 income statement. The investment
account is also increased by USD 15,000.
If the investee incurs a loss, the investor company debits a loss account and credits the investment account for
the investor's share of the loss. For example, assume Dutch incurs a loss of USD 10,000 in 2011. Since it still owns
30 per cent of Dutch, Tone records its share of the loss as follows:
Loss from Dutch Company ($10,000 x 0.30) (-SE)
3,000
Investment in Dutch Company (-A) 3,000 To recognize 30% of Dutch Company's loss.
Tone would report the USD 3,000 loss on its 2011 income statement. The USD 3,000 credit reduces Tone's
equity in the investee. Furthermore, because dividends are a distribution of income to the owners of the
corporation, if Dutch declares and pays USD 20,000 in dividends, this entry would also be required for Tone:
Cash (+A) 6,000 Investment in Dutch Company ($20,000 x 0.30) (- A)
6,000
To record receipt of 30% of dividends paid by Dutch Company.
Under the equity method just illustrated, the Investment in the Dutch Company account always reflects Tone's
30 per cent interest in the net assets of Dutch.
Reporting for stock investments of more than 50 per cent
In recent years, many companies have expanded by purchasing a major portion, or all, of another company's
outstanding voting stock. The purpose of such acquisitions ranges from ensuring a source of raw materials (such as
oil), to desiring to enter into a new industry, or seeking income on the investment. Both corporations remain
separate legal entities, regardless of the investment purpose. In this section, you learn how to account for business
combinations.
As stated in the introduction to this chapter, a corporation that owns more than 50 per cent of the outstanding
voting common stock of another corporation is the parent company. The corporation acquired and controlled by
the parent company is the subsidiary company.
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14. Stock investments
A parent company and its subsidiaries maintain their own accounting records and prepare their own financial
statements. However, since a central management controls the parent and its subsidiaries and they are related to
each other, the parent company usually must prepare one set of financial statements. These statements, called
consolidated statements, consolidate the parent's financial statement amounts with its subsidiaries' and show
the parent and its subsidiaries as a single enterprise.
According to FASB Statement No. 94, consolidated statements must be prepared (1) when one company owns
more than 50 per cent of the outstanding voting common stock of another company, and (2) unless control is likely
to be temporary or if it does not rest with the majority owner (e.g. the company is in legal reorganization or
bankruptcy).47 Thus, almost all subsidiaries must be included in the consolidated financial statements under FASB
Statement No. 94. Previously, the consolidated statements did not include subsidiaries in markedly dissimilar
businesses than those of the parents.
An accounting perspective:
Business insight
Procter & Gamble markets more than 300 brands. Examples include Tide, Ariel, Pantene Pro-V,
Pringles, and Folgers. The company's 2000 annual report includes the following information about
presentation of subsidiaries and equity investments:
The consolidated financial statements include The Procter & Gamble Company and its controlled
subsidiaries (the Company). Investments in companies over which the Company exerts
significant influence, but does not control the financial and operating decisions, are accounted
for by the equity method.
Financial transactions involving a parent and one of its subsidiaries or between two of its subsidiaries are
intercompany transactions. In preparing consolidated financial statements, parent companies eliminate the
effects of intercompany transactions by making elimination entries. Elimination entries allow the presentation
of all account balances as if the parent and its subsidiaries were a single economic enterprise. Elimination entries
appear only on a consolidated statement work sheet, not in the accounting records of the parent or subsidiaries.
After elimination entries are prepared, the parent totals the amounts remaining for each account of the work sheet
and prepares the consolidated financial statements.
To illustrate the need for elimination entries, assume Y Company formed the Z Company, receiving all of Z
Company's USD 100,000 par value common stock for USD 100,000 cash. If the stock of an existing company had
been acquired, it would have been purchased from that company's stockholders. The parent records the following
entry on its books:
Investment in Z Company (+A) 100,000 Cash(-A) 100,000 To record an investment in Z Company. Purchased 100% of Z Company stock.
47 FASB, Statement of Financial Accounting Standards No. 94, "Consolidation of All Majority-Owned
Subsidiaries" (Stamford, Conn., 1987), p. 5. Copyright © by the Financial Accounting Standards Board, High
Ridge Park, Stamford, Connecticut 06905, U.S.A.
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Z Company, the subsidiary, records the following entry on its books:
Cash (+A) 100,000 Common stock (+SE) 100,000 To record issuance of all the common stock to Y Company.
An elimination entry can offset the parent company's subsidiary investment account against the stockholders'
equity accounts of the subsidiary. On the consolidated statements work sheet, the required elimination is:
Common stock (Z company) (- SE)
100,000
Investment in Z Company (-A) 100,000
This elimination is required because the parent company's investment in the stock of the subsidiary actually
represents an equity interest in the net assets of the subsidiary. Unless the investment is eliminated, the same
resources appear twice on the consolidated balance sheet—first as the investment account of the parent and second
as the assets of the subsidiary. By eliminating Z Company's common stock, the parent avoids double counting
stockholders' equity. Viewing the two companies as if they were one, the Z Company common stock is really not
outstanding; it is held within the consolidated group.
Consolidated financial statements present financial data as though the companies were a single entity. Since no
entity can owe an amount to itself or be due an amount from itself, Z Company must eliminate intercompany
receivables and payables (amounts owed to and due from companies within the consolidated group) during the
preparation of consolidated financial statements. For example, assume the parent company purchased USD 5,000
of bonds issued by its subsidiary company. Because no debt is owed to or due from any entity outside the
consolidated enterprise, Y Company would eliminate those balances by an entry like the following that offsets the
Investment in Bonds against the Bonds Payable:
Bonds payable (subsidiary company) (-L) 5,000 Investment in bonds (parent company) (-A) 5,000 To eliminate intercompany bonds and bond investment.
P Company and Subsidiary S Company Work Sheet for Consolidated balance sheet 2010 January 1 (date of acquisition) P S Eliminations Consolidated
Assets Company Company Debit Credit Amounts Cash 26,000 12,000 38,000 Notes receivable 5,000 (2) 5,000 Accounts receivable, net
24,000 15,000 39,000
Merchandise inventory
35,000 30,000 65,000
Investment in S Company
106,000 (1) 106,000
Equipment, net 41,000 15,000 56,000 Building, net 65,000 35,000 100,000 Land 20,000 10,000 30,000
322,000 117,000 328,000 Liabilities and stockholders' equity Accounts payable 18,000 6,000 24,000 Notes payable 5,000 (2) 5,000 Common stock 250,000 100,000 (1) 100,000 Paid-in capital excess of par value - common 4,000 (1) 4,000 Retained earnings 54,000 2,000 (1) 2,000
322,000 117,000 111,000 111,000 328,000
Exhibit 108: Consolidated balance sheet work sheet (stock acquired at book value)
Accounting Principles: A Business Perspective 567 A Global Text
14. Stock investments
When preparing consolidated statements, the parent would similarly eliminate other intercompany balances.
Consolidated balance sheet at time of acquisition
A parent company may acquire a subsidiary at its book value or at a cost above or below book value. Also, the
parent may acquire 100 per cent of the outstanding voting common stock of the subsidiary or some lesser
percentage exceeding 50 per cent.
To consolidate its assets and liabilities with those of its subsidiaries, a parent company prepares a consolidated
statement work sheet similar to the one in Exhibit 108. A consolidated statement work sheet is an informal
record on which elimination entries are made for the purpose of showing account balances as if the parent and its
subsidiaries were a single economic enterprise. The first two columns of the work sheet show assets, liabilities, and
stockholders' equity of the parent and subsidiary as they appear on each corporation's balance sheet. The pair of
columns labeled Eliminations allows intercompany items to be offset and consequently eliminated from the
consolidated statement. The final column shows the amounts that will appear on the consolidated balance sheet.
The work sheet in Exhibit 108 consolidates the accounts of P Company and its subsidiary, S Company, on 2010
January 1. P Company acquired S Company on 2010 January 1, by purchasing all of its outstanding voting common
stock for USD 106,000 cash, which was the book value of the stock. Book value is equal to stockholders' equity, or
net assets (assets minus liabilities). Thus, common stock (USD 100,000), paid-in capital in excess of par value—
common (USD 4,000), and retained earnings (USD 2,000) equal USD 106,000. When P Company acquired the S
Company stock, P Company made the following entry in its books:
Investment in S company 106,000 Cash 106,000 To record investment in S Company.
The Investment in S Company account appears as an asset on P Company's balance sheet. By buying the
subsidiary's stock, the parent acquired a 100 per cent equity, or ownership, interest in the subsidiary's net assets.
Thus, if both the investment account and the subsidiary's assets appear on the consolidated balance sheet, the same
resources would be counted twice. The Common Stock and Retained Earnings accounts of the subsidiary also
represent an equity interest in the subsidiary's assets. Therefore, P's investment in S Company must be offset
against S Company's stockholders' equity accounts so that the subsidiary's assets and the ownership interest in
these assets appear only once on the consolidated balance sheet. P Company accomplishes this elimination by entry
1 under Eliminations on the work sheet. The entry debits S Company's Common Stock for USD 100,000, Paid-In
Capital in Excess of Par Value—Common for USD 4,000, and Retained Earnings for USD 2,000 and credits
Investment in S Company for USD 106,000. In journal entry form, the elimination entry made only on the
consolidated work sheet is:
Common stock (-SE) 100,000 Paid-in capital in excess of par value – Common (-SE) 4,000 Retained earnings (-SE) 2,000 Investment in S Company (-A) 106,000 To eliminate investment account and subsidiary stockholder's equity.
Entry 2 eliminates the effect of an intercompany debt. On the date it acquired S Company, P Company loaned S
Company USD 5,000. The loan is a USD 5,000 note receivable on P's books and a USD 5,000 note payable on S's
books. If the elimination entry is not made on the work sheet, the consolidated balance sheet would show USD
5,000 owed to the consolidated enterprise by itself. From the viewpoint of the consolidated equity, neither an asset
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nor a liability exists. Therefore, entry 2 on the work sheet eliminates both the asset and liability. The entry debits
Notes Payable and credits Notes Receivable for USD 5,000. In general journal form, entry 2 is:
Notes payable (-L) 5,000 Notes receivable (-A) 5,000 To eliminate intercompany payable and receivable.
Note that P Company makes elimination entries only on the consolidated statement work sheet; no elimination
entries appear in the accounting records of either P Company or S Company. P Company uses the final work sheet
column to prepare the consolidated balance sheet.
An accounting perspective:
Uses of technology
Computer applications have greatly simplified the preparation of consolidated work sheets.
Spreadsheet programs in particular expedite the process of constructing consolidated financial
statements.
In the previous example, P Company acquired 100 per cent of S Company at a cost equal to book value. In some
cases, firms acquire subsidiaries at a cost greater than or less than book value. For example, assume P Company
purchased 100 per cent of S Company's outstanding voting common stock for USD 125,000 (instead of USD
106,000). The book value of this stock is USD 106,000. Cost exceeds book value by USD 19,000. P Company's
management may have paid more than book value because (1) the subsidiary's earnings prospects justify paying a
price greater than book value or (2) the total fair market value of the subsidiary's assets exceeds their total book
value.
Where cost exceeds book value because of expected above-average earnings, the investor labels the excess
goodwill on the consolidated balance sheet. Goodwill is an intangible value attached to a business primarily due to
above-average earnings prospects (as discussed in Chapter 11). On the other hand, if the excess is attributable to the
belief that assets of the subsidiary are undervalued, then the investor increases the asset values on the consolidated
balance sheet to the extent of the excess. In Exhibit 109, USD 4,000 is due to the undervaluation of land owned by
the company, and the remaining USD 15,000 of the excess of cost over book value is due to expected above-average
earnings. As a result, P Company adds USD 4,000 of the USD 19,000 excess to Land, and identifies the other USD
15,000 as Goodwill on the work sheet (Exhibit 109) and on the balance sheet (Exhibit 110).
P Company establishes Goodwill as part of the first elimination entry. Elimination entry 1 in Exhibit 109
involves debits to the subsidiary's Common Stock for USD 100,000, Paid-In Capital in Excess of Par Value—
Common for USD 4,000, Retained Earnings for USD 2,000, Land for USD 4,000, and Goodwill for USD 15,000,
and a credit to Investment in S Company for USD 125,000. In journal form, entry 1 is:
Common stock (-SE) 100,000 Paid-in capital in excess of par value – common (-SE)
4,000
Retained earnings (-SE) 2,000 Land (+A) 4,000 Goodwill (+A) 15,000 Investment in S Company (-A) 125,000 To eliminate investment and subsidiary
Accounting Principles: A Business Perspective 569 A Global Text
14. Stock investments
stockholder's equity and to establish increased value of land and goodwill.
Entry 2 is the same as elimination entry 2 in Exhibit 108. Entry 2 eliminates the intercompany loan by debiting
Notes Payable and crediting Notes Receivable for USD 5,000.
After these elimination entries are made, the company consolidates and extends the remaining amounts to the
Consolidated Amounts column. It uses the amounts in this column to prepare the consolidated balance sheet in
Exhibit 110. Notice that the firm carries the USD 15,000 debit to Goodwill to the Consolidated Amounts column
and lists it as an asset in the consolidated balance sheet.
As noted earlier, a company may purchase all or part of another company at more than book value and create
goodwill on the consolidated balance sheet. FASB Statement No. 142 (2001) requires goodwill to be recorded at
acquisition cost and to remain at this amount until there is evidence of impairment. We leave a discussion of this
topic to a more advanced text.
Under some circumstances, a parent company may pay less than book value of the subsidiary's net assets. In
such cases, it is highly unlikely that a bargain purchase has been made. The most logical explanation is that some of
the subsidiary's assets are overvalued. Firms use the excess of book value over cost to reduce proportionately the
value of the noncurrent assets acquired (except long-term investments in marketable securities). If noncurrent
assets are reduced to zero, the remaining dollar amount is a deferred credit entitled, Excess of Fair Value Over Cost
of Assets Acquired.
P Company and Subsidiary S Company Work Sheet for consolidation balance sheet 2010 January 1 (date of acquisition)
P S Eliminations Consolidated Assets Company CompanyDebit Credits Amounts Cash 7,000 12,000 19,000 Notes receivable 5,000 (2) 5,000 Accounts receivable, net
24,000 15,000 39,000
Merchandise inventory
35,000 30,000 65,000
Investment in S Company
125,000 (1) 125,000
Equipment, net 41,000 15,000 56,000 Building, net 65,000 35,000 100,000 Land 20,000 10,000 (1) 4,000 34,000 Goodwill (1) 15,000 15,000
322,000 117,000 328,000 Liabilities and stockholders' equity Accounts payable 18,000 6,000 24,000 Notes payable 5,000 (2) 5,000 Common stock 250,000 100,000 (1) 100,000 250,000 Paid-in capital excess of par value – common
4,000 (1) 4,000 -0-
Retained earnings 54,000 2,000 (1) 2,000 54,000 322,000 117,000 130,000 130,000 328,000
Exhibit 109: Consolidated balance sheet work sheet (stock acquired at more than book value)
Sometimes a parent company acquires less than 100 per cent of the outstanding voting common stock of a
subsidiary. For example, assume P Company acquired 80 per cent of S Company's outstanding voting common
stock. P Company is the majority stockholder, but another group of stockholders owns the remaining 20 per cent of
the stock. Stockholders who own less than 50 per cent of a subsidiary's outstanding voting common stock are
minority stockholders, and their claim or interest in the subsidiary is the minority interest. Minority
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stockholders have an interest in the subsidiary's net assets and share the subsidiary's income or loss with the parent
company.
Look at Exhibit 111, which shows the elimination entries required when P Company purchases 80 per cent of S
Company's stock for USD 90,000. The book value of the stock acquired by P Company is USD 84,800 (80 per cent
of USD 106,000). Assuming no assets are undervalued, P Company attributes the excess of cost (USD 90,000) over
book value (USD 84,800) of USD 5,200 to S Company's above-average earnings prospects (goodwill).
Elimination entry 1 eliminates S Company's stockholders' equity by debiting Common Stock for USD 100,000,
Paid-In Capital in Excess of Par Value—Common for USD 4,000, and Retained Earnings for USD 2,000. To
establish minority interest, it credits a Minority Interest account for USD 21,200 (20 per cent of USD 106,000). P
Company eliminates the investment account by crediting Investment in S Company for USD 90,000. The USD
5,200 debited to Goodwill makes the debits equal the credits. In journal form, the elimination entry 1 is:
P Company and Subsidiary S Company Consolidation balance sheet 2010 January 1 Assets Current assets: Cash $19,000 Accounts receivable, net 39,000 Merchandise inventory 65,000 Total current assets $123,000 Property, plant, and equipment: Equipment, net $56,000 Building, net 100,000 Land 34,000 Total property, plant, and equipment 190,000 Goodwill 15,000 Total assets $328,000 Liabilities and stockholders' equity Current liabilities: Account payable $24,000 Stockholders' equity: Common stock $250,000 Retained earnings 54,000 Total stockholders' equity 304,000 Total liabilities and stockholders equity $328,000
Exhibit 110: Consolidated balance sheet
Common stock (-SE) 100,000 Paid-in capital in excess of par value – Common (-SE)
4,000
Retained earnings (-SE) 2,000 Goodwill (+A) 5,200 Investment in S Company (-A) 90,000 Minority interest (+L) 21,200 To eliminate investment and subsidiary stockholder's equity and to establish minority interest and goodwill.
Elimination entry 2 is the same as shown in Exhibit 108. The entry eliminates intercompany debt by debiting
Notes Payable and crediting Notes Receivable for USD 5,000.
On the consolidated balance sheet (Exhibit 112), minority interest appears between the liabilities and
stockholders' equity sections.
Accounting Principles: A Business Perspective 571 A Global Text
14. Stock investments
Accounting for income, losses, and dividends of a subsidiary
When a subsidiary is operating profitably, its net assets and retained earnings increase. The subsidiary pays
dividends to both the parent company and minority stockholders. The subsidiary records all transactions in its
accounting records in a normal manner.
As noted earlier, two different methods used by an investor to account for investments in common stock are the
cost and equity methods. A parent company may use either the cost or equity method of accounting for its
investment in a consolidated subsidiary. This choice is allowed because the investment account is eliminated during
the consolidation process; therefore, the results are identical after consolidation. To illustrate the consolidation
process at a date after acquisition, we assume the parent company uses the equity method.
P Company and Subsidiary S Company Work Sheet for consolidated balance sheet 2010 January 1 (date of acquisition)
P S Eliminations Consolidated Assets Company Company Debit Credit Amounts Cash 42,000 12,000 54,000 Notes receivable 5,000 (2)
5,000 Accounts receivable, net
24,000 15,000 39,000
Merchandise inventory 35,000 30,000 65,000 Investment in S Company
90,000 (1) 90,000
Equipment, net 41,000 15,000 56,000 Building, net 65,000 35,000 100,000 Land 20,000 10,000 30,000 Goodwill (1) 5,200 5,200
322,000 117,000 349,200 Liabilities and stockholders' equity Accounts payable 18,000 6,000 24,000 Notes payable 5,000 (2) 5,000 Common stock 250,000 100,000 (1) 100,000 Paid-in capital excess Of par value- common 4,000 (1) 4,000 -0- Retained earnings 54,000 2,000 (1) 2,000 54,000 Minority interest (1)
21,200 21,200
322,000 117,000 116,200 116,200349,200
Exhibit 111: Consolidated balance sheet work sheet (80 per cent of stock acquired at more than book value)
Consolidated financial statements at a date after acquisition
Under the equity method, the investment account on the parent company's books increases and decreases as the
parent records its share of the income, losses, and dividends reported by the subsidiary. Thus, the balance in the
investment account differs after acquisition from its balance on the date of acquisition. Consequently, the amounts
eliminated on the consolidated statements work sheet differ from year to year. As an illustration, assume the
following facts:
• P Company acquired 100 per cent of the outstanding voting common stock of S Company on 2010 January
1. P Company paid USD 121,000 for stockholders' equity totaling USD 106,000. The excess of cost over book
value is attributable to (a) an undervaluation of land amounting to USD 4,000 and (b) the remainder to S
Company's above-average earnings prospects.
• During 2010, S Company earned USD 20,000 from operations.
• On 2010 December 31, S Company paid a cash dividend of USD 8,000.
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• S Company owes P Company USD 5,000 on a note at December 31.
• Including its share (100 per cent) of S Company's income, P Company earned USD 31,000 during 2010.
• P. Company paid a cash dividend of USD 10,000 during December 2010.
• P Company uses the equity method of accounting for its investment in S Company.
P Company and Subsidiary S Company Consolidation Balance Sheet 2010 January 1
Assets Current assets: Cash $ 54,000 Accounts receivable, net 39,000 Merchandise inventory 65,000 Total current assets $158,000 Property, plant, and equipment: Equipment, net $ 56,000 Building, net 100,000 Land 30,000 Total property, plant, and equipment 186,000 Goodwill 5,200 Total assets $349,200 Liabilities and stockholders' equity Current liabilities: Account payable 24,000 Minority interest 21,200 Stockholders' equity: Common stock $250,000 Retained earnings 54,000 Total stockholders' equity 304,000 Total liabilities and stockholders equity $349,200
Exhibit 112: Consolidated balance sheet
The financial statements for the two companies as of 2010 December 31, are in the first two columns of Exhibit
113.
The work sheet shown in Exhibit 113 allows us to prepare a consolidated income statement, statement of
retained earnings, and balance sheet. Notice that in Exhibit 113, P Company has a balance of USD 20,000 in its
Income of S Company account and a balance of USD 133,000 in its Investment in S Company account. These
balances are the result of the following journal entries made by P Company in 2010:
2010 Jan. 1 Investment in S Company (+A) 121,000
Cash (-A) 121,000 To record 100% investment in subsidiary.
Dec. 31 Investment in S Company (+A) 20,000 Income in S Company (+SE) 20,000 To record income of subsidiary.
31 Cash (+A) 8,000 Investment in S Company (-A) 8,000 To record dividends received from subsidiary.
The explanations for the elimination entries on the work sheet in Exhibit 113 are as follows:
Entry 1: During the year, S Company earned USD 20,000. P Company increased its investment account
balance by USD 20,000. Entry 1 on the work sheet eliminates the subsidiary's income from the Investment in S
Company account and the Income of S Company account (USD 20,000). This entry reverses the entry made on the
books of P Company to recognize the parent's share of the subsidiary's income (the first December 31 journal
entry).
P Company and Subsidiary S Company
Accounting Principles: A Business Perspective 573 A Global Text
14. Stock investments
Work Sheet for Consolidated Balance Sheet 2010 December 31
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P S Elimination Consolidated
Income Statement Company Company Debit Credit Amounts
Revenue from sales 397,000 303,000 700,000
Income of S Company
20,000 (1) 20,000
Cost of goods sold (250,000) (180,000) (430,000)
Expenses (excluding depreciation and taxes)
(100,000) (80,000) (180,000)
Depreciation expense (7,400) (5,000) (12,400)
Federal income tax expense
(28,600) (18,000) (46,000)
Net income, carried forward
31,000 20,000 31,000*
Statement of Retained Earnings
Retained earnings – January 1:
P Company 54,000 54,000
S Company 6,000 (3) 6,000
Net income brought forward
31,000 20,000 31,000*
85,000 26,000 85,000*
Dividends:
P Company (10,000) (10,000)
S Company (8,000) (2) 8,000
Retained earnings – Dec. 31 carried forward
75,000 18,000 75,000*
Balance sheet assets
Cash 38,000 16,000 54,000
Notes receivable 5,000 (4) 5,000
Accounts receivable, net
25,000 18,000 43,000
Merchandise inventory
40,000 36,000 76,000
Investment in S Company
133,000 (2) 8,000 (3) 121,000
(1) 20,000
Equipment, net 35,900 12,000 48,900
Building, net 61,700 33,000 94,700
Land 20,000 10,000 (3) 4,000 34,000
Goodwill (3) 11,000 11,000
359,600 125,000 361,600*
Liabilities and stockholders' equity
Accounts payable 19,600 2,000 21,600
Accounting Principles: A Business Perspective 575 A Global Text
14. Stock investments
Notes payable 15,000 5,000 (4) 5,000 15,000
Common stock 250,000 100,000 (3) 100,000 250,000
Retained earnings 75,000 18,000 75,000*
359,000 125,000 154,000 154,000 361,600*
*Totals are determined vertically, not horizontally
Exhibit 113: Consolidated work sheet one year after acquisition
Entry 2: When S Company paid its cash dividend, P Company debited Cash and credited the investment
account for USD 8,000 (the second December 31 journal entry). Entry 2 restores the investment account to its
balance before the dividends from S Company were deducted. That is, P Company debits its investment account
and credits S Company's dividends account for USD 8,000. On a consolidated basis, a company cannot pay a
dividend to itself.
Entry 3: Entry 3 eliminates the original investment account balance (USD 121,000) and the subsidiary's
stockholders' equity accounts as of the date of acquisition (retained earnings of USD 6,000 and common stock of
USD 100,000). The entry also establishes goodwill of USD 11,000 and increases land by USD 4,000 to account for
the excess of acquisition cost over book value.
Entry 4: Entry 4 eliminates the intercompany debt of USD 5,000.
After the first three entries have been made, the investment account contains a zero balance from the viewpoint
of the consolidated entity.
After making the eliminations, P Company combines the corresponding amounts and places them in the
Consolidated Amounts column. Notice that certain totals in the first two columns do not add across to the total in
the Consolidated Amounts column. For instance, consolidated net income is USD 31,000, not USD 31,000 plus
USD 20,000. The firm carries the net income row in the Income Statement section forward to the net income row
in the Statement of Retained Earnings section. Likewise, it carries the ending retained earnings row in the
Statement of Retained Earnings section forward to the retained earnings row in the Balance Sheet section. P
Company uses the final work sheet column to prepare the consolidated income statement (Exhibit 114), the
consolidated statement of retained earnings (Exhibit 115), and the consolidated balance sheet (Exhibit 116).
Uses and limitations of consolidated statements
Consolidated financial statements are of primary importance to stockholders, managers, and directors of the
parent company. The parent company benefits from the income and other financial strengths of the subsidiary.
Likewise, the parent company suffers from a subsidiary's losses and other financial weaknesses.
Consolidated financial statements are of limited use to the creditors and minority stockholders of the subsidiary.
The subsidiary's creditors have a claim against the subsidiary alone; they cannot look to the parent company for
payment. Minority stockholders in the subsidiary do not benefit or suffer from the parent company's operations.
These minority stockholders benefit from the subsidiary's income and financial strengths; they suffer from the
subsidiary's losses and financial weaknesses. Thus, the subsidiary's creditors and minority stockholders are more
interested in the subsidiary's individual financial statements than in the consolidated statements. Because of these
factors, annual reports always include the financial statements of the consolidated entity, and sometimes include
the financial statements of certain subsidiary companies alone, but never include the parent company's financial
statements alone.
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Analyzing and using the financial results—Dividend yield on common stock and payout ratios
Investors often search for stock that fulfills their needs. To locate this stock, potential stockholders may use the
dividend yield on common stock ratio or the payout ratio on common stock. To demonstrate these ratios, consider
the 2000 annual report of Tyco International.
P Company and Subsidiary S Company Consolidated Income Statement For the year ended 2010 December 31
Revenue from sales $700,000 Cost of goods sold 430,000 Gross margin $270,000 Expenses (excluding depreciation and taxes) $180,000 Depreciation expense 12,400 Federal income tax expense 46,600 239,000 Net sales $31,000
Exhibit 114: Consolidated income statement
P Company and Subsidiary S Company Consolidated statement of Retained Earnings For the Year Ended 2010 December 31
Retained earnings, 2010 January 1 $54,000 Net income 31,000 Subtotal $85,000 Dividends 10,000 Retained earnings, 2010 December 31 $75,000
Exhibit 115: Consolidated statement of retained earnings
P Company and Subsidiary S Company Consolidation Balance Sheet 2010 December 31
Assets Current assets: Cash $54,000 Accounts receivable, net 43,000 Merchandise inventory 76,000 Total current assets $173,000
Property, plant, and equipment: Equipment, net $48,900 Building, net 94,700 Land 34,000 Total property, plant, and equipment 177,600 Goodwill 11,000 Total assets $361,600
Liabilities and stockholders' equity Current liabilities: Account payable $21,600 Notes payable 15,000 Total liabilities $36,600 Stockholders' equity: Common stock $250,000 Retained earnings 75,000 Total stockholders' equity 325,000 Total liabilities and stockholders equity $361,600
Exhibit 116: Consolidated balance sheet (one year after acquisition
2000 1999 Dividend per share of common stock $ 0.05 $ 0.05 Current market price per share 53.81 50.25 Earnings per share 2.68 0.62
Investors use the dividend yield on common stock ratio as a tool to compare stocks. Some investors favor
stocks with a high dividend yield ratio and a high payout ratio. Other investors would rather have the corporation
Accounting Principles: A Business Perspective 577 A Global Text
14. Stock investments
retain more of the funds and use them to attempt to increase future earnings and the market price of the stock. The
formula for the dividend yield on common stock ratio is:
Dividend yield on common stock ratio= Dividend per share of common stock
Current market price per share
For Tyco, the dividend yield on common stock ratios are:
2003: USD 0.05/USD 53.81 =.09 per cent
2002: USD 0.05/USD 50.25 =.10 per cent
To determine the relevance of this ratio, an investor compares these numbers to ratios calculated on other
stocks.
Investors calculate the payout ratio on common stock as follows:
Payout ratio on commonstock= Dividend per share of common stock
Earnings per shareEPS
This ratio indicates whether a company pays out a large percentage of earnings as dividends or reinvests most of
its earnings. When computing the payout ratio, remember that negative earnings per share result in an invalid
calculation. Tyco's payout ratios are:
2003: USD 0.05/USD 2.68 = 1.87 per cent
2002: USD 0.05/USD 0.62 = 8.06 per cent
Now that you have studied consolidated financial statements, you should realize the importance of presenting a
complete picture of the business operations of a company. In Chapter 15 you learn about long-term financing, its
advantages and disadvantages, and how bonds differ from stocks.
Understanding the learning objectives
• Under the cost method, the investor company records its investment at the price paid at acquisition and
does not adjust the investment account balance subsequently. The cost method is used for all short-term
investments, long-term investments of less than 20 per cent where the purchasing company does not exercise
significant influence over the investee company, and may be used for long-term investments of more than 50
per cent.
• Under the equity method, the investment is also initially recorded at acquisition price but is then adjusted
periodically for the investor company's share of the investee's reported income, losses, and dividends. The
equity method is used for all long-term investments of between 20 per cent and 50 per cent and may be used
for investments of more than 50 per cent. This method is also used for investments of less than 20 per cent if
the purchasing company exercises significant influence over the investee company.
• Under the cost method, the initial investment is debited to either Trading Securities or Available-for-Sale
Securities, depending on whether the investment is a near-term or longer-term investment.
• At the end of each accounting period, the company must adjust the carrying value of each investment. The
fair market value method is applied independently to each of these portfolios.
• Under the cost method, dividends received are credited to Dividend Revenue.
• Under the equity method, the initial investment is debited to an Investment in (Company Name) account.
Income, losses, and dividends result in increases or decreases to the investment account.
• The equity method must be used for long-term investments of 20 per cent to 50 per cent and for long-term
investments of less than 20 per cent where significant influence is present.
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• The initial investment is debited to an Investment in (Company Name) account. The purchasing company's
share of the investee's income is debited to the investment account, and the purchaser's share of the investee's
losses and dividends is credited to the investment account as they are reported by the investee.
• A corporation that owns more than 50 per cent of the outstanding voting common stock of another
corporation is called the parent company.
• The corporation acquired and controlled by the parent company is known as the subsidiary company.
• A parent company and its subsidiaries maintain their own accounting records and prepare their own
financial statements, but the parent company must also prepare consolidated financial statements. The
consolidated financial statements consolidate the financial results of the parent and subsidiaries as a single
enterprise.
• Consolidated financial statements must be prepared (1) when one company owns more than 50 per cent of
the outstanding voting stock of another company and (2) unless control is likely to be temporary or if it does
not rest with the majority owner.
• In preparing consolidated financial statements, the effects of intercompany transactions must be
eliminated by making elimination entries. Elimination entries are made only on a consolidated statement work
sheet, not in the accounting records of either company.
• One elimination entry offsets the parent company's subsidiary investment account against the stockholders'
equity accounts of the subsidiary. Intercompany receivables and payables also must be eliminated.
• A consolidated financial statements work sheet is an informal record in which elimination entries are made
for the purpose of showing account balances as if the parent and its subsidiaries were a single economic
enterprise.
• A consolidated balance sheet work sheet is prepared at the time of acquisition. The first two columns of the
work sheet show assets, liabilities, and stockholders' equity of the parent and subsidiary as they appear on each
corporation's individual balance sheet. The next pair of columns shows the eliminations. The final column
shows the amounts that appear on the consolidated balance sheet.
• A consolidated work sheet is prepared at various dates after acquisition. The first two columns show the
income statements, statements of retained earnings, and balance sheets of the parent and subsidiary. The next
pair of columns shows the eliminations. The final column shows the amounts that appear in the consolidated
financial statements.
• Consolidated financial statements are of primary importance to stockholders, managers, and directors of
the parent company. On the other hand, consolidated financial statements are of limited use to the creditors
and minority stockholders of the subsidiary.
• Dividend yield on common stock ratio= Dividend per share of common stock
Current market price per share
• This ratio helps investors to compare stocks.
• Payout ratio on common stock= Dividend per share of common stock
Earnings per shareEPS
• This ratio indicates whether a company pays out a large percentage of earnings as dividends or reinvests
most of its earnings.
Accounting Principles: A Business Perspective 579 A Global Text
14. Stock investments
Demonstration problem
Demonstration problem A Following are selected transactions and other data for Kelly Company for 2010:
Mar. 21 Purchased 600 shares of Sly Company common stock at USD 48.75 per share, plus a USD 450 broker's
commission. Also purchased 100 shares of Rob Company common stock at USD 225 per share, plus a USD 376
broker's commission. Both investments are expected to be temporary.
June 2 Received cash dividends of USD 1.50 per share on the Sly common shares and USD 3 per share on the
Rob common shares.
Aug. 12 Received shares representing a 100 per cent stock dividend on the Rob shares.
30 Sold 100 shares of Rob common stock at USD 120 per share, less a USD 360 broker's commission.
Sept. 15 Received shares representing a 10 per cent stock dividend on the Sly common stock. Market price today
was USD 52.50 per share.
Dec. 31 Per share market values for the two investments in common stock are Sly, USD 45.75, and Rob, USD
106.50. Both investments are considered temporary.
Prepare journal entries to record these transactions and the necessary adjustments for a December 31 closing.
Demonstration problem B Lanford Company acquired all of the outstanding voting common stock of Casey
Company on 2010 January 2, for USD 300,000 cash. After the close of business on the date of acquisition, the
balance sheets for the two companies were as follows:
Landford Company
Casey Company
Assets Cash $75,000 $30,000 Accounts receivable, net 90,000 37,700 Notes receivable 15,000 7,750 Merchandise inventory 112,500 45,000 Investment in Casey Company 300,000 Investment in bonds 30,000 Plant and equipment, net 303,000 195,000 Total assets $895,500 $345,000 Liabilities and stockholders' equity Accounts payable $ 75,000 $ 45,000 Notes payable 22,500 15,000 Bonds payable 225,000 Common stock - $.50 par value 300,000 150,000 Paid-in capital excess of par value – common 60,000 Retained earnings 273,000 75,000 Total liabilities and stockholders' equity $895,500 $345,000
On 2010 January 2, Casey Company borrowed USD 15,000 from Lanford Company by giving a note. On that
same day, Casey Company purchased USD 30,000 of Lanford Company's bonds. The excess of cost over book value
is attributable to Casey Company's above-average earnings prospects.
Prepare a work sheet for a consolidated balance sheet on the date of acquisition.
Solution to demonstration problem A
2010 Mar. 21 Trading securities (+A) 52,576
Cash (-A) 52,576 To record purchase of 600 shares of Sly common stock for $29,700 and 100 of Rob common stock for $22,876
June 2 Cash (+A) 1,200 Dividend revenue (+SE) 1,200 To record cash dividends: $900 Sly and $300 Rob.
Aug. 12 Received 100 shares of Rob common stock as a 100$ stock dividend. The new cost per share is $22,876/200 shares =
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$114.38 30 Cash (+A) 11,640
Trading securities (-A) 11,438 Gain on sale of trading securities (+SE) 202 To record the sale of trading securities: Proceeds = $12,000 -$360; cost = $114.38 x 100 shares.
Sept. 15 Received 60 shares of Sly common stock as a 10% stock dividend. New cost per share is $29,700/660 shares = $45.
Dec. 31 Unrealized loss on trading securities (-SE) 293 Trading securities (-A) 293 To write trading securities down to market value.
Cost Market Inc. (Dec.) in marketable value
Sly common stock $29,700 $30,195* $495 Rob common stock 11,438 10,650† (788) Total $41,138 $40,845 $(293) * $45.75 x 660 shares = $30,195. † $106.50 x 100 shares = $10,650.
Solution to demonstration problem B
Landford Company and Subsidiary Casey Company Work Sheet for Consolidation Balance Sheet 2010 January 2 (date of acquisition)
P S Eliminations Consolidate d
Assets Company Company Debit Credit Amounts
Cash 75,000 30,000 105,000
Accounts receivable, net
90,000 37,500 127,500
Notes receivable 15,000 7,500 (2) 15,000 7,500
Merchandise inventory
112,500 45,000 157,500
Investment in Casey Company
300,000 (1) 300,000 -0-
Investment in bonds 30,000 (3) 30,000 -0-
Plant and equipment, net
303,000 195,000 498,000
Goodwill (1) 15,000 15,000
895,500 345,000 910,500
Liabilities and stockholders' equity
Accounts payable 75,000 45,000 120,000
Notes payable 22,500 15,000 (2) 15,000 22,500
Bonds payable 225,000 (3) 30,000 195,000
Common stock 300,000 150,000 (1) 150,000 300,000
Paid-in capital excess of par value – Common
60,000 (1) 60,000 -0-
Retained earnings 273,000 75,000 (1) 75,000 273,000
895,500 345,000 345,000 345,000 910,500
Key terms Available-for-sale securities Securities purchased that will be held for longer than the near term.
Consolidated statements The financial statements that result from consolidating the parent's financial statement amounts with those of its subsidiaries (after certain eliminations have been made). The
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14. Stock investments
consolidated statements reflect the financial position and results of operations of a single economic enterprise.
Consolidated statement work sheet An informal record on which elimination entries are made to show account balances as if the parent and its subsidiaries were a single economic enterprise.
Cost method A method of accounting for stock investments in which the investor company does not adjust the investment account balance for its share of the investee's reported income, losses, and dividends. Dividends received are credited to Dividends Revenue.
Dividend yield on common stock ratio Equal to dividend per share of common stock divided by the current market price per share. Investors use this ratio to compare stocks.
Elimination entries Entries made on a consolidated statement work sheet to remove certain intercompany items and transactions. Elimination entries allow the presentation of all account balances as if the parent and its subsidiaries were a single economic enterprise.
Equity method A method of accounting for stock investments where the investment account is adjusted periodically for the investor company's share of the investee's income, losses, and dividends as they are reported by the investee.
Goodwill An intangible value attached to a business primarily due to above-average earnings prospects.
Intercompany transactions Financial transactions involving a parent and one of its subsidiaries or between two of the subsidiaries.
Investee A company that has 20 per cent to 50 per cent of its stock purchased by another company (the investor) as a long-term investment.
Investor A company that purchases 20 per cent to 50 per cent of another company (the investee) as a long- term investment.
Marketable equity securities Readily saleable common and preferred stocks of other companies.
Minority interest The claim or interest of the stockholders who own less than 50 per cent of a subsidiary's outstanding voting common stock. The minority stockholders have an interest in the subsidiary's net assets and share the subsidiary's earnings with the parent company.
Parent company A corporation that owns more than 50 per cent of the outstanding voting common stock of another corporation.
Payout ratio on common stock Calculated by dividing dividend per share of common stock by earnings per share (EPS). The ratio indicates whether a company pays out a large percentage of earnings as dividends or reinvests most of its earnings.
Subsidiary company A corporation acquired and controlled by a parent corporation; control is established by ownership of more than 50 per cent of the subsidiary's outstanding voting common stock.
Trading securities Securities bought principally for sale in the near term.
Self-test
True-false
Indicate whether each of the following statements is true or false.
Under the cost method, the investment account is adjusted when dividends are received.
The cost method should be used when a corporation makes a long-term investment of less than 20 per cent, and
there is no significant control.
In a stock split, the investor does not recognize revenue, but reduces the cost per share of stock.
Trading securities and available-for-sale securities should be grouped separately in applying the fair market
value rules.
When making elimination entries, the entries are made only on the consolidated statements work sheet and not
on the accounting records of the parent and subsidiary.
Multiple-choice
Select the best answer for each of the following questions.
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In which of the following cases is the investor company limited to use of the equity method in accounting for its
stock investments?
a. Short-term investments.
b. Long-term investments of less than 20 per cent.
c. Long-term investments of 20 per cent—50 per cent.
d. Long-term investments of more than 50 per cent.
Under the equity method, which of the following is true?
a. Dividends received reduce the investment account.
b. Dividends received increase the investment account.
c. The investor's share of net income decreases the investment account.
d. The investor's share of net loss increases the investment account.
When the fair market value rules are followed, which of the following is true when the market value of the stocks
in the Trading Securities account falls below their cost?
a. The Unrealized Losses on Trading Securities account is credited.
b. The Recovery of Market Value of Trading Securities account is credited.
c. The Allowance for Market Decline of Current Marketable Equity Securities is debited.
d. The Unrealized Loss on Trading Securities is debited.
Under the equity method, the investment account always reflects only the:
a. Dividends paid by the investee corporation.
b. Investor's interest in the net assets of the investee.
c. Investor's share of net income.
d. Historical cost of the investment.
The excess of cost over the book value of an investment that is due to expected above-average earnings is labeled
on the consolidated balance sheet as:
a. Goodwill.
b. Common stock.
c. Retained earnings.
d. Loss on investment.
Now turn to “Answers to self-test” at the end of the chapter to check your answers.
Questions
➢ For what reasons do corporations purchase the stock of other corporations?
➢ Explain how marketable securities should be classified in the balance sheet.
➢ Describe the valuation bases used for marketable equity securities.
➢ Under what circumstances is the equity method used to account for stock investments?
➢ Explain briefly the accounting for stock dividends and stock splits from the investor's point of view.
➢ Of what significance is par value to the investing corporation?
➢ What is the purpose of preparing consolidated financial statements?
➢ Under what circumstances must consolidated financial statements be prepared?
Accounting Principles: A Business Perspective 583 A Global Text
14. Stock investments
➢ Why is it necessary to make elimination entries on the consolidated statement work sheet? Are these
elimination entries also posted to the accounts of the parent and subsidiary? Why or why not?
➢ Why might a corporation pay an amount in excess of the book value for a subsidiary's stock? Why
might it pay an amount less than the book value of the subsidiary's stock?
➢ The item Minority interest often appears as one amount in the consolidated balance sheet. What
does this item represent?
➢ How do a subsidiary's earnings, losses, and dividends affect the investment account of the parent
when the equity method of accounting is used?
➢ Why are consolidated financial statements of limited usefulness to the creditors and minority
stockholders of a subsidiary?
Exercises
Exercise A On 2010 July 1, Tam Company purchased 200 shares of Del Company capital stock as a temporary
investment (trading securities) at USD 676.80 per share plus a commission of USD 720. On July 15, a 10 per cent
stock dividend was received. Tam received a cash dividend of USD 3.60 per share on 2010 August 12. On November
1, Tam sold all of the shares for USD 835.20 per share, less a commission of USD 720. Prepare entries to record all
of these transactions in Tam Company's accounts.
Exercise B Key Company purchased 200 shares of Franklin Company stock at a total cost of USD 7,560 on
2010 July 1. At the end of the accounting year (2010 December 31), the market value for these shares was USD
6,840. By 2011 December 31, the market value had risen to USD 7,920. This stock is the only marketable equity
security that Key Company owns. The company classifies the securities as trading securities. Give the entries
necessary at the date of purchase and at 2010 December 31, and 2011.
Exericse C Corbit Company has marketable equity securities that have a fair market value at year-end that is
USD 13,440 below their cost. Give the required entry if:
a. The securities are current assets classified as trading securities.
b. The securities are noncurrent assets classified as available-for-sale securities, and the loss is considered to be
temporary.
c. The securities are noncurrent assets classified as available-for-sale securities, and the loss is considered to be
permanent.
State where each of the accounts debited in (a), (b), and (c) would be reported in the financial statements.
Exercise D Ruiz Company owns 75 per cent of Sim Company's outstanding common stock and uses the equity
method of accounting. Sim Company reported net income of USD 702,000 for 2010. On 2010 December 31, Sim
Company paid a cash dividend of USD 189,000. In 2011, Sim Company incurred a net loss of USD 125,000. Prepare
entries to reflect these events on Ruiz Company's books.
Exercise E On 2010 February 1, Larkin Company acquired 100 per cent of the outstanding voting common
stock of TRD Company for USD 8,400,000 cash. The stockholders' equity of the TRD Company consisted of
common stock, USD 6,720,000, and retained earnings, USD 1,680,000. Prepare (a) the entry to record the
investment in TRD Company and (b) the elimination entry on the work sheet used to prepare a consolidated
balance sheet as of the date of acquisition.
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Exercise F Given the facts in the previous exercise, how much would be recorded as goodwill in each of the
following instances? The same amount was paid, but the parent company acquired a—
a. 90 per cent interest.
b. 70 per cent interest.
c. 55 per cent interest.
Exercise G Heidi Corporation acquired, for cash, 80 per cent of the outstanding voting common stock of
Sumpter Company. After the close of business on the date of acquisition, Sumpter Company's stockholders' equity
consisted of common stock, USD 5,880,000, and retained earnings, USD 2,184,000. The cost of the investment
exceeded the book value by USD 302,400 and was attributable to above-average earnings prospects. Prepare (a) the
entry to record the investment in Sumpter Company and (b) the elimination entry on the work sheet used to
prepare consolidated financial statements as of the date of acquisition.
Exercise H On 2009 January 1, Company J acquired 85 per cent of the outstanding voting common stock of
Company K. On that date, Company K's stockholders' equity consisted of:
Stockholders' equity: Paid-in capital: Common stock, $90 par; 30,000 shares authorized, issued, and outstanding
$2,700,000
Retained earnings 675,000 Total stockholders' equity $3,375,000
Compute the difference between cost and book value in each of the following cases:
a. Company J pays USD 2,868,750 cash for its interest in Company K.
b. Company J pays USD 3,375,000 cash for its interest in Company K.
c. Company J pays USD 2,610,000 cash for its interest in Company K.
Exercise I The 2010 January 1, stockholders' equity section of Saye Company's balance sheet follows:
Stockholders' equity: Paid-in capital: Common stock, $144 par; authorized, 200,000 shares; issued, and outstanding, 150,000 shares
$21,600,000
Paid-in capital in excess of par value 3,600,000 Total paid-in capital $25,200,000 Retained earnings 2,160,000 Total stockholders' equity $27,360,000
Ninety per cent of Saye Company's outstanding voting common stock was acquired by Tim Company on 2011
January 1, for USD 24,048,000. Compute (a) the book value of the investment, (b) the difference between cost and
book value, and (c) the minority interest.
Exercise J Company S purchased 90 per cent of Company T's outstanding voting common stock on 2010
January 2. The investment is accounted for under the equity method. Company S paid USD 2,790,000 for its
proportionate equity of USD 2,430,000. The difference was due to undervalued land owned by Company T.
Company T earned USD 324,000 during 2010 and paid cash dividends of USD 108,000.
a. Compute the balance in the investment account on 2010 December 31.
b. Compute the amount of the minority interest on (1) 2010 January 2, and (2) 2010 December 31.
Problems
Problem A Paris Company acquired on 2010 July 15, 400 shares of Rome Company USD 720 par value capital
stock at USD 698.40 per share plus a broker's commission of USD 1,728. On 2010 August 1, Paris Company
received a cash dividend of USD 8.64 per share. On 2010 November 3, it sold 200 of these shares at USD 756 per
Accounting Principles: A Business Perspective 585 A Global Text
14. Stock investments
share less a broker's commission of USD 1,152. On 2010 December 1, Rome Company issued shares comprising a
100 per cent stock dividend declared on its capital stock on November 18.
On 2010 December 31, the end of Paris Company's calendar-year accounting period, the market quotation for
Rome Company's common stock was USD 331.20 per share. The decline was considered to be temporary.
a. Prepare journal entries to record all of these data assuming the securities are considered temporary
investments classified as trading securities. Where should the accounts in the last entry appear in the financial
statements?
b. Assume Rome Company has become a major customer so the shares are held for long-term affiliation
purposes. Indicate how the investment should be shown in the balance sheet.
Problem B On 2010 October 17, Strong Company purchased the following common stocks (all trading
securities) at the indicated per share prices that included commissions:
600 shares of X Company common stock @ $216
$129,600
1,000 shares of Y Company common stock @ $144
144,000
1,600 shares of Z Company common stock @ $72
115,200
$388,800
On 2010 December 31, the market prices per share of the above common stocks were X, USD 223.20; Y, USD
136.80; and Z, USD 54.
Summarized, the cash dividends per share received in 2011 were X, USD 14.40; Y, USD 7.20; and Z, USD 5.40.
On 2011 December 31, the per share market prices were X, USD 252.80; Y, USD 115.20; and Z, USD 72.
All of these changes in market prices are considered temporary.
Prepare journal entries for all of these transactions, including calendar year-end adjusting entries, assuming the
shares of common stock acquired are considered trading securities.
If the securities acquired are considered available-for-sale securities, how would the entries differ?
For both parts a and b, give the descriptions (titles) and the dollar amounts of the items that would appear in the
income statements for 2010 and 2011.
Problem C On 2010 January 1, Long Company acquired 80 per cent of the outstanding voting common stock
of Fall Company for USD 4,032,000 cash. Long Company uses the equity method. During 2010, Fall reported USD
672,000 of net income and paid USD 288,000 in dividends. The stockholders' equity section of the 2009 December
31, balance sheet for Fall follows:
Stockholders' equity: Paid-in capital: Common stock - $42 par $4,200,000 Retained earnings 840,000 Total stockholders' equity $5,040,000
a. Prepare the general journal entries to record the investment and the effect of Fall's income and dividends on
Long Company's accounts.
b. Prepare the elimination entry that would be made on the work sheet for a consolidated balance sheet as of the
date of acquisition.
Problem D Pearson Company acquired 75 per cent of the outstanding voting common stock of Frost Company
for USD 1,444,800 cash on 2010 January 1. The investment is accounted for under the equity method. During 2010,
2011, and 2012, Frost Company reported the following:
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Net income (loss)
Dividends Paid
2010 $357,840 $290,640 2011 (45,360) -0- 2012 108,360 72,240
a. Prepare general journal entries to record the investment and the effect of the subsidiary's income, losses, and
dividends on Pearson Company's accounts.
b. Compute the balance in the investment account on 2012 December 31.
Problem E Cord Company acquired 100 per cent of the outstanding voting common stock of Thorpe Company
on 2010 January 2, for USD 2,700,000. At the end of business on the date of acquisition, the balance sheets for the
two companies were as follows:
Cord Company
Thorpe Company
Assets Cash $ 315,000 $ 180,000 Accounts receivable, net 234,000 144,000 Notes receivable 360,000 90,000 Merchandise inventory 495,000 234,000 Investment in Thorpe Company 2,700,000 Equipment, net 648,000 450,000 Building, net 1,890,000 990,000 Land 765,000 405,000 Total assets $7,407,000 $2,493,000 Liabilities and stockholders' equity Accounts payable $ 117,000 $ 135,000 Notes payable 90,000 108,000 Common stock - $45 par value 5,400,000 1,800,000 Retained earnings 1,800,000 450,000 Total liabilities and stockholders' equity $7,407,000 $2,493,000
The excess of cost over book value is attributable to the above-average earnings prospects of Thorpe Company.
On the date of acquisition, Thorpe Company borrowed USD 72,000 from Cord Company by giving a note.
a. Prepare a work sheet for a consolidated balance sheet as of the date of acquisition.
b. Prepare a consolidated balance sheet for 2010 January 2.
Problem F Refer to the previous problem, Cord Company uses the equity method. Assume the following are
from the adjusted trial balances of Cord Company and Thorpe Company on 2010 December 31:
Cord Company
Thorpe Company
Debit balance accounts Cash $ 351,000 $ 315,000 Accounts receivable, net 378,000 180,000 Notes receivable 315,000 45,000 Merchandise inventory, December 31 495,000 287,100 Investment in Thorpe Company 2,790,000 Equipment, net 615,000 427,500 Building, net 1,814,400 950,400 Land 765,000 405,000 Cost of goods sold 1,800,000 630,000 Expense (excluding depreciation and taxes) 720,000 270,900 Depreciation expense 108,000 62,100 Income tax expense 585,000 189,000 Dividends 540,000 108,000 Total of the accounts with debit balances $11,277,000 $3,870,000
Credit balance accounts Accounts payable $ 135,000 $ 180,000 Notes payable 144,000 90,000 Common stock - $45 par value 5,400,000 1,800,000 Retained earnings – January 1 1,800,000 450,000 Revenue from sales 3,600,000 1,350,000 Income from Thorpe Company 198,000
Accounting Principles: A Business Perspective 587 A Global Text
14. Stock investments
Total of the accounts with credit balances $11,277,000 $3,870,000
There is no intercompany debt at the end of the year.
Prepare a work sheet for consolidated financial statements on 2010 December 31.
Problem G Using the work sheet from Problem F, prepare the following items:
a. Consolidated income statement for the year ended 2010 December 31.
b. Consolidated statement of retained earnings for the year ended 2010 December 31.
c. Consolidated balance sheet for 2010 December 31.
Alternate problems
Alternate problems A On 2010 September 1, Ramsey Company purchased the following relatively long-term
investments classified as available-for-sale securities:
• Two thousand shares of Lacey Company capital stock at USD 439.20 plus broker's commission of USD
5,760.
• One thousand shares of Membrow Company capital stock at USD 705.60 plus broker's commission of USD
5,040.
Cash dividends of USD 18.00 per share on the Lacey capital stock and USD 14.40 per share on the Membrow
capital stock were received on December 7 and December 10, respectively.
On 2010 December 31, per share market values are Lacey, USD 460.80; and Membrow, USD 655.20.
a. Prepare journal entries to record these transactions.
b. Prepare the necessary adjusting entry(ies) at 2010 December 31, to adjust the carrying values assuming that
market price changes are believed to be temporary. Where would the accounts appear in the financial statements?
Alternate problem B Kress, Inc., purchased on 2010 July 2, 240 shares of Baker Company USD 180 par value
common stock as a temporary investment at USD 288 per share, plus a broker's commission of USD 432.
On 2010 July 15, a cash dividend of USD 7.20 per share was received. On 2010 September 1, Baker Company
split its USD 180 par value common shares two for one.
On 2010 November 2, Kress sold 200 shares of Baker common stock at USD 180, less a broker's commission of
USD 288.
a. Prepare journal entries to record all of the above transactions.
b. How would you recommend that the remaining shares be classified in the 2010 December 31, balance sheet if
still held at that date?
c. Assume the remaining shares were considered current assets classified as trading securities at the end of
2010, at which time their market value was USD 128 per share. Prepare any necessary adjusting entries for the end
of 2010.
Alternate problem C Prime Company acquired 90 per cent of the outstanding voting common stock of Orr
Company 2010 January 1, for USD 7,560,000 cash. Prime Company uses the equity method. During 2010 Orr
reported USD 1,512,000 of net income and paid USD 504,000 in cash dividends. The stockholders' equity section of
the 2009 December 31, balance sheet for Orr follows:
Stockholders' equity: Paid-in capital: Common stock, $21.00 par
$6,720,000
Retained earnings 1,680,000 Total stockholders' $8,400,000
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equity
a. Prepare general journal entries to record the investment and the effect of Orr's earnings and dividends on
Prime Company's accounts.
b. Prepare the elimination entry that would be made on the work sheet for a consolidated balance sheet as of the
date of acquisition.
Alternate problem D Codd Company acquired 70 per cent of the outstanding voting common stock of Snow
Company for USD 8,568,000 on 2010 January 1. The investment is accounted for under the equity method. During
the years 2010-2012, Snow Company reported the following:
Net Income Dividends (loss) Paid
2007 $1,454,880 $871,920 2008 372,960 223,440 2009 (23,520) 55,860
a. Prepare general journal entries to record the investment and the effect of the subsidiary's income, losses, and
dividends on Codd Company's accounts.
b. Compute the investment account balance on 2011 December 31.
Alternate problem E Maple Company acquired all of the outstanding voting common stock of Dodd Company
on 2010 January 2, for USD 4,320,000. On the date of acquisition, the balance sheets for the two companies were
as follows:
Maple Company
Dodd Company
Assets Cash $ 900,000 $270,000 Accounts receivable, net 432,000 360,000 Notes receivable 180,000 108,000 Merchandise inventory 1,368,000 864,000 Investment in Dodd Company 4,320,000 Equipment, net 1,224,000 738,000 Building, net 3,330,000 1,656,000 Land 1,404,000 450,000 Total assets $13,158,000 $4,446,000
Liabilities and stockholders' equity Accounts payable $792,000 $360,000 Notes payable 216,000 252,000 Common stock - $120 par value 9,540,000 3,564,000 Retained earnings 2,610,000 270,000 Total liabilities and stockholders' equity $12,158,000 $4,446,000
The management of Maple Company thinks that the Dodd Company's land is undervalued by USD 162,000. The
remainder of the excess of cost over book value is due to superior earnings potential.
On the date of acquisition, Dodd Company borrowed USD 180,000 from Maple Company by giving a note.
a. Prepare a work sheet for a consolidated balance sheet as of the date of acquisition.
b. Prepare a consolidated balance sheet for 2010 January 2.
Alternate problem F Refer back to the previous problem. Maple Company uses the equity method. Assume
the following amounts are taken from the adjusted trial balances of Maple Company and Dodd Company on 2010
December 31:
Maple Company
Dodd Company
Debit balance accounts Cash $ 864,000 $ 364,295 Accounts receivable, net 553,536 414,000 Notes receivable 342,000 90,000 Merchandise inventory, December 31 1,530,000 1,008,000
Accounting Principles: A Business Perspective 589 A Global Text
14. Stock investments
Investment in Dodd Company 4,519,356 Equipment, net 1,147,500 691,860 Building, net 3,136,500 1,573,200 Land 1,404,000 450,000 Cost of goods sold 8,064,000 2,160,000 Expense (excluding depreciation and taxes) 2,160,000 810,000 Depreciation expense 243,000 128,940 Income tax expense 569,664 123,504 Dividends 477,000 178,200 Total of the accounts with debit balances $25,037,556 $7,992,000
Credit balance accounts Accounts payable $ 720,000 $ 378,000 Notes payable 270,000 180,000 Common stock - $90 par value 9,540,000 3,564,000 Retained earnings 2,610,000 270,000 Revenue from sales 11,520,000 3,600,000 Income from Dodd Company 377,556 Total of the accounts with credit balances $25,037,556 $7,992,000
There is no intercompany debt at the end of the year.
Prepare a work sheet for consolidated financial statements on 2010 December 31.
Alternate problem G Using the work sheet from the previous problem, prepare the following items:
a. Consolidated income statement for the year ended 2010 December 31.
b. Consolidated statement of retained earnings for the year ended 2010 December 31.
c. Consolidated balance sheet for 2010 December 31.
Beyond the numbers—Critical thinking
Business decision case A You are the CPA engaged to audit the records of Quigley Company. You find that
your client has a portfolio of marketable equity securities that has a total market value of USD 300,000 less than
the total cost of the portfolio. You ask the vice president for finance if the client expects to sell these securities in the
coming year. He answers that he does not know. The securities will be sold if additional cash is needed to finance
operations. When you ask for a cash forecast, you are told that a forecast has been prepared that covers the next
year. It indicates no need to sell the marketable securities.
Write a brief statement in which you explain how you would classify the client's portfolio of marketable
securities in the balance sheet. Does it really make any difference whether the securities are classified as trading
securities or available-for-sale securities? Explain.
Business decision case B On 2010 January 2, Brown Company acquired 60 per cent of the voting common
stock of Cobb Company for USD 720,000 cash. The excess of cost over book value was due to above-average
earnings prospects. Brown has hired you to help it prepare consolidated financial statements and has already
collected the following information for both companies as of 2010 January 2:
Brown Company
Cobb Company
Assets Cash $ 72,000 $ 54,000 Accounts receivable, net 108,000 126,000 Merchandise inventory 288,000 216,000 Investment in Cobb Company 720,000 Plant and equipment, net 936,000 738,000 Total assets $2,124,000 $1,134,000
Liabilities and stockholders' equity Accounts payable $ 144,000 $ 54,000 Common stock 1,440,000 720,000 Retained earnings 540,000 360,000 Total liabilities and stockholders' equity $2,124,000 $1,134,000
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a. Brown believes that consolidated financial statements can be prepared simply by adding together the amounts
in the two individual columns. Is this correct? If not, why not?
b. Prepare a consolidated balance sheet for the date of acquisition without preparing a consolidated statement
work sheet.
Business decision case C International Flavors & Fragrances, Inc., is the leading creator and manufacturer of
flavors and fragrances used by others to impart or improve flavor or fragrance in a wide variety of consumer
products.
Use the following excerpt from International Flavors & Fragrances Inc.'s 2000 annual report to calculate the
dividend yield on common stock and the payout ratios. Then comment on the results.
2000 1999 1998 Earnings per share $1.22 $1.53 $1.90 Dividends per share ($) 1.29 1.52 1.48 Stock price per common share ($) 20.31 37.63 44.19
Group project D In teams of two or three students, select three companies you believe may be profitable
short-term investments. Determine the current market prices for those companies' stocks from today's newspaper
and the market prices six months ago. Calculate the gain or loss that your team would have recorded if it had
purchased 500 shares of each company's stock six months ago and sold all of the shares today. Write a short memo
to your instructor describing why you selected those companies and why you believe the market prices of their
stocks increased or decreased. Also, be prepared to describe your analysis to the class.
Group project E With one or two other students, go to the library and locate Statement of Financial
Standards No. 94, "Consolidation of All Majority-Owned Subsidiaries", published by the Financial Accounting
Standard Board. In a report to your instructor answer questions such as: What does the standard require? Why did
the FASB act on this topic? Why are "nonhomogeneous" subsidiaries included in the consolidated group? Why did
one of the Board members dissent from the statement? Describe some of the important background on this topic as
given in the statement.
Group project F In a small group of students, locate the annual reports of three companies with investments
in other companies. Compare the accounting and reporting for the investments by the three companies. For
instance, by reading the notes to the financial statements, try to determine whether they account for the
investments using the cost or equity methods. Is there goodwill on the balance sheets? What else can you determine
about the investments? Write a report to your instructor summarizing your findings.
Using the Internet—A view of the real world
Visit the following website for General Electric Company:
http://www.ge.com
Pursue choices on the screen until you locate the consolidated statement of financial position. You will probably
go down some "false paths" to get to this financial statement, but you can get there. This experience is all part of
learning to use the Internet. Check to see if there is a minority interest listed on the consolidated statement of
financial position. Check out the notes to the financial statements for further information. Browse around the site
for any other interesting information concerning the company. Write a memo to your instructor summarizing your
findings.
Answers to self-test
True-false
Accounting Principles: A Business Perspective 591 A Global Text
14. Stock investments
False. Under the cost method of accounting for stock investments, the Dividend Revenue account, rather than
the investment account, is adjusted.
True. For long-term investments of less than 20 per cent, the cost method should be used.
True. Revenue is not recognized when there is a stock split. The new number of shares is recorded, and the cost
per share is reduced.
True. Trading securities should be considered separately from available-for-sale securities in applying the fair
market value method.
True. Eliminating entries are not made on the accounting records of the parent and subsidiary. Only the work
sheet is affected by elimination entries made during consolidation.
Multiple-choice
c. The Accounting Principles Board has said that investors must use the equity method when accounting for
long-term investments of 20 per cent to 50 per cent.
a. Under the equity method, dividends received reduce the investment account; the other choices are not true.
d. If the market value of securities falls below their cost, an unrealized loss account is debited.
b. Under the equity method, the investment account always reflects the investor's interest in the net assets of the
investee.
a. If cost is greater than the book value of an investment because of expected above-average earnings, the excess
cost should be labeled goodwill.
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15. Long-term financing: Bonds
Learning objectives
After studying this chapter, you should be able to:
• Describe the features of bonds and tell how bonds differ from shares of stock.
• List the advantages and disadvantages of financing with long-term debt and prepare examples showing how
to employ financial leverage.
• Prepare journal entries for bonds issued at face value.
• Explain how interest rates affect bond prices and what causes a bond to sell at a premium or a discount.
• Apply the concept of present value to compute the price of a bond.
• Prepare journal entries for bonds issued at a discount or a premium.
• Prepare journal entries for bond redemptions and bond conversions.
• Describe the ratings used for bonds.
• Analyze and use the financial results—times interest earned ratio.
• Explain future value and present value concepts and make required calculations (Appendix).
The accountant's role in financial institutions
Companies that require funds to maintain existing operations and expand new operations frequently do not
have the necessary cash available within the company. Therefore, these companies are required to obtain long-term
financing from banks and other financial institutions. The operations of financial institutions are unique from those
of the typical manufacturing or service company. As a result, the accounting measurement and disclosure practices
followed by financial institutions can be quite different from those followed in other industries. In addition to the
more traditional careers in accounting (auditing, professional services, financial reporting, cost accounting, and
taxation), accounting majors with interests in finance may pursue a career in financial institutions.
Accountants in this industry commonly deal with issues related to marketable securities, derivatives, hedging,
sale of receivables, foreign currency exchanges, and loan loss provisions and impairments. In addition, accountants
in this area are being called upon to play an increasing role in the strategic operations of the financial institution.
Not only are accountants needed to account for the institution's transactions, but they are being asked to
recommend new opportunities for growth and to advise on financial risk as well. Some of these new areas include
issues related to asset/liability management, interest rate risk, present value measurements, capital structure, and
key ratio analysis.
Accountants also play a key role in one of the most important decisions of a financial institution—the decision of
whether to lend money to a prospective borrower. The decision to lend money hinges on the ability of the
prospective borrower to pay interest and repay debt. Since accountants have been trained in financial statement
Accounting Principles: A Business Perspective 593 A Global Text
15. Long-term financing: Bonds
preparation and interpretation, accountants are some of the most sought after professionals for understanding the
financial position and risk of a prospective borrower.
In previous chapters, you learned that corporations obtain cash for recurring business operations from stock
issuances, profitable operations, and short-term borrowing (current liabilities). However, when situations arise that
require large amounts of cash, such as the purchase of a building, corporations also raise cash from long-term
borrowing, that is, by issuing bonds. The issuing of bonds results in a Bonds Payable account.
Bonds payable
A bond is a long-term debt, or liability, owed by its issuer. Physical evidence of the debt lies in a negotiable
bond certificate. In contrast to long-term notes, which usually mature in 10 years or less, bond maturities often run
for 20 years or more.
Generally, a bond issue consists of a large number of USD 1,000 bonds rather than one large bond. For example,
a company seeking to borrow USD 100,000 would issue one hundred USD 1,000 bonds rather than one USD
100,000 bond. This practice enables investors with less cash to invest to purchase some of the bonds.
Bonds derive their value primarily from two promises made by the borrower to the lender or bondholder. The
borrower promises to pay (1) the face value or principal amount of the bond on a specific maturity date in the
future and (2) periodic interest at a specified rate on face value at stated dates, usually semiannually, until the
maturity date.
Large companies often have numerous long-term notes and bond issues outstanding at any one time. The
various issues generally have different stated interest rates and mature at different points in the future. Companies
present this information in the footnotes to their financial statements. Exhibit 117 shows a portion of the long-term
borrowings footnote from Dow Chemical Company's 2000 annual report. Promissory notes, debenture bonds, and
foreign bonds are shown, with their amounts, maturity dates, and interest rates.
Promissory notes and debentures at 2000 December 31 Millions 2000 1999
6.95%, final maturity 2002 $ 346 $ --- 7.81%, final maturity 2002 --- 7.13%, final maturity 2003 7.00%, final maturity 2005 300 --- 7.70%, final maturity 2006 2,473 2,448 Subtotal $3,267 $3,135
Foreign bonds at 2000 December 31 Millions 2000 1999
4.63%, final maturity 2000, Swiss Fran $-- $ 95 6.38%, final maturity 2001, Japanese Yen 218 244 5.00%, final maturity 2003, Euro 139 151 Subtotal $357 $490
Exhibit 117: Dow chemical company's long-term notes and bonds (in millions)
Comparison with stock
A bond differs from a share of stock in several ways:
• A bond is a debt or liability of the issuer, while a share of stock is a unit of ownership.
• A bond has a maturity date when it must be paid. A share of stock does not mature; stock remains
outstanding indefinitely unless the company decides to retire it.
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• Most bonds require stated periodic interest payments by the company. In contrast, dividends to
stockholders are payable only when declared; even preferred dividends need not be paid in a particular period
if the board of directors so decides.
• Bond interest is deductible by the issuer in computing both net income and taxable income, while dividends
are not deductible in either computation.
Selling (issuing) bonds
A company seeking to borrow millions of dollars generally is not able to borrow from a single lender. By selling
(issuing) bonds to the public, the company secures the necessary funds.
Usually companies sell their bond issues through an investment company or a banker called an underwriter.
The underwriter performs many tasks for the bond issuer, such as advertising, selling, and delivering the bonds to
the purchasers. Often the underwriter guarantees the issuer a fixed price for the bonds, expecting to earn a profit by
selling the bonds for more than the fixed price.
When a company sells bonds to the public, many purchasers buy the bonds. Rather than deal with each
purchaser individually, the issuing company appoints a trustee to represent the bondholders. The trustee usually
is a bank or trust company. The main duty of the trustee is to see that the borrower fulfills the provisions of the
bond indenture. A bond indenture is the contract or loan agreement under which the bonds are issued. The
indenture deals with matters such as the interest rate, maturity date and maturity amount, possible restrictions on
dividends, repayment plans, and other provisions relating to the debt. An issuing company that does not adhere to
the bond indenture provisions is in default. Then, the trustee takes action to force the issuer to comply with the
indenture.
Bonds may differ in some respects; they may be secured or unsecured bonds, registered or unregistered (bearer)
bonds, and term or serial bonds. We discuss these differences next.
Certain bond features are matters of legal necessity, such as how a company pays interest and transfers
ownership. Such features usually do not affect the issue price of the bonds. Other features, such as convertibility
into common stock, are sweeteners designed to make the bonds more attractive to potential purchasers. These
sweeteners may increase the issue price of a bond.
Secured bonds A secured bond is a bond for which a company has pledged specific property to ensure its
payment. Mortgage bonds are the most common secured bonds. A mortgage is a legal claim (lien) on specific
property that gives the bondholder the right to possess the pledged property if the company fails to make required
payments.
Unsecured bonds An unsecured bond is a debenture bond, or simply a debenture. A debenture is an
unsecured bond backed only by the general creditworthiness of the issuer, not by a lien on any specific property. A
financially sound company can issue debentures more easily than a company experiencing financial difficulty.
Registered bonds A registered bond is a bond with the owner's name on the bond certificate and in the
register of bond owners kept by the bond issuer or its agent, the registrar. Bonds may be registered as to principal
(or face value of the bond) or as to both principal and interest. Most bonds in our economy are registered as to
principal only. For a bond registered as to both principal and interest, the issuer pays the bond interest by check. To
transfer ownership of registered bonds, the owner endorses the bond and registers it in the new owner's name.
Therefore, owners can easily replace lost or stolen registered bonds.
Accounting Principles: A Business Perspective 595 A Global Text
15. Long-term financing: Bonds
Unregistered (bearer) bonds An unregistered (bearer) bond is the property of its holder or bearer
because the owner's name does not appear on the bond certificate or in a separate record. Physical delivery of the
bond transfers ownership.
Coupon bonds A coupon bond is a bond not registered as to interest. Coupon bonds carry detachable
coupons for the interest they pay. At the end of each interest period, the owner clips the coupon for the period and
presents it to a stated party, usually a bank, for collection.
Term bonds and serial bonds A term bond matures on the same date as all other bonds in a given bond
issue. Serial bonds in a given bond issue have maturities spread over several dates. For instance, one-fourth of
the bonds may mature on 2011 December 31, another one-fourth on 2012 December 31, and so on.
Callable bonds A callable bond contains a provision that gives the issuer the right to call (buy back) the
bond before its maturity date. The provision is similar to the call provision of some preferred stocks. A company is
likely to exercise this call right when its outstanding bonds bear interest at a much higher rate than the company
would have to pay if it issued new but similar bonds. The exercise of the call provision normally requires the
company to pay the bondholder a call premium of about USD 30 to USD 70 per USD 1,000 bond. A call premium is
the price paid in excess of face value that the issuer of bonds must pay to redeem (call) bonds before their maturity
date.
Convertible bonds A convertible bond is a bond that may be exchanged for shares of stock of the issuing
corporation at the bondholder's option. A convertible bond has a stipulated conversion rate of some number of
shares for each USD 1,000 bond. Although any type of bond may be convertible, issuers add this feature to make
risky debenture bonds more attractive to investors.
Bonds with stock warrants A stock warrant allows the bondholder to purchase shares of common stock at
a fixed price for a stated period. Warrants issued with long-term debt may be nondetachable or detachable. A bond
with nondetachable warrants is virtually the same as a convertible bond; the holder must surrender the bond to
acquire the common stock. Detachable warrants allow bondholders to keep their bonds and still purchase shares of
stock through exercise of the warrants.
Junk bonds Junk bonds are high-interest rate, high-risk bonds. Many junk bonds issued in the 1980s
financed corporate restructurings. These restructurings took the form of management buyouts (called leveraged
buyouts or LBOs), hostile takeovers of companies by outside parties, or friendly takeovers of companies by outside
parties. In the early 1990s, junk bonds lost favor because many issuers defaulted on their interest payments. Some
issuers declared bankruptcy or sought relief from the bondholders by negotiating new debt terms.
Several advantages come from raising cash by issuing bonds rather than stock. First, the current stockholders do
not have to dilute or surrender their control of the company when funds are obtained by borrowing rather than
issuing more shares of stock. Second, it may be less expensive to issue debt rather than additional stock because the
interest payments made to bondholders are tax deductible while dividends are not. Finally, probably the most
important reason to issue bonds is that the use of debt may increase the earnings of stockholders through favorable
financial leverage.
Favorable financial leverage A company has favorable financial leverage when it uses borrowed funds
to increase earnings per share (EPS) of common stock. An increase in EPS usually results from earning a higher
rate of return than the rate of interest paid for the borrowed money. For example, suppose a company borrowed
money at 10 per cent and earned a 15 per cent rate of return. The 5 per cent difference increases earnings.
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Exhibit 118 provides a more comprehensive example of favorable financial leverage. The two companies in the
illustration are identical in every respect except in the way they are financed. Company A issued only capital stock,
while Company B issued equal amounts of 10 per cent bonds and capital stock. Both companies have USD
20,000,000 of assets, and both earned USD 4,000,000 of income from operations. If we divide income from
operations by assets (USD 4,000,000/USD 20,000,000), we see that both companies earned 20 per cent on assets
employed. Yet B's stockholders fared far better than A's. The ratio of net income to stockholders' equity is 18 per
cent for B, while it is only 12 per cent for A.
Assume that both companies issued their stock at the beginning of 2010 at USD 10 per share. B's USD 1.80 EPS
are 50 per cent greater than A's USD 1.20 EPS. This EPS difference probably would cause B's shares to sell at a
substantially higher market price than A's shares. B's larger EPS would also allow a larger dividend on B's shares.
Company B in Exhibit 118 is employing financial leverage, or trading on the equity. The company is using its
stockholders' equity as a basis for securing funds on which it pays a fixed return. Company B expects to earn more
from the use of such funds than their fixed after-tax cost. As a result, Company B increases its rate of return on
stockholders' equity and EPS.48
Companies A and B Condensed Statements Balance Sheets
2010 December 31 Company A Company B
Total assets $20,000,000 $20,000,000 Bonds payable, 10% $10,000,000 Stockholders' equity (capital stock) $20,000,000 10,000,000 Total equities $20,000,000 $20,000,000 Income statements For the year ended 2010 December 31 Income from operations $4,000,000 $4,000,000 Interest expense 1,000,000 Income before federal income taxes $4,000,000 $3,000,000 Deduct: Federal income taxes (40%) 1,600,000 1,200,000 Net income $2,400,000 $1,800,000 Number of common shares outstanding 2,000,000 1,000,000 Earnings per share (EPS) (Net income/Number of common shares outstanding)
$1.20 $1.80
Rate of return on assets employed (Income from Operations/Total assets; both companies $4,000,000/$20,000,000) 20% 20% Rate of return on stockholders' equity (Net income/Stockholders' equity): Company A ($2,400,000/$20,000,000) 12% Company B ($1,800,000/$10,000,000) 18%
Exhibit 118: Favorable financial leverage
Several disadvantages accompany the use of debt financing. First, the borrower has a fixed interest payment that
must be met each period to avoid default. Second, use of debt also reduces a company's ability to withstand a major
loss. For example, assume that instead of having net income, both Company A and Company B in Exhibit 118
sustain a net loss in 2010 of USD 11,000,000. At the end of 2010, Company A will still have USD 9,000,000 of
stockholders' equity and can continue operations with a chance of recovery. Company B, on the other hand, would
have negative stockholders' equity of USD 1,000,000 and the bondholders could force the company to liquidate if B
could not make interest payments as they came due. The result of sustaining the loss by the two companies is as
follows:
48 Issuing bonds is only one method of using leverage. Other methods of using financial leverage include issuing
preferred stock or long-term notes.
Accounting Principles: A Business Perspective 597 A Global Text
15. Long-term financing: Bonds
Companies A and B Partial Balance Sheets
2010 December 31 Company A Company B
Stockholders' equity: Paid-in capital: Common stock $20,000,000 $10,000,000 Retained earnings (11,000,000)(11,000,000) Total stockholders' equity $ 9,000,000 $ (1,000,000)
A third disadvantage of debt financing is that it also causes a company to experience unfavorable financial
leverage when income from operations falls below a certain level. Unfavorable financial leverage results when
the cost of borrowed funds exceeds the revenue they generate; it is the reverse of favorable financial leverage. In the
previous example, if income from operations fell to USD 1,000,000, the rates of return on stockholders' equity
would be 3 per cent for A and zero for B, as shown in this schedule:
Companies A and B Income Statements
For the year ended 2010 December 31 Company A Company B
Income from operations $1,000,000 $1,000,000 Interest expense 1,000,000 Income before federal income taxes $1,000,000 $ -0- Deduct: Federal income taxes (40%) 400,000 -0- Net income 600,000 $ -0- Rate of return on stockholders' equity: Company A ($600,000/$20,000,000) 3% Company B ($0/$10,000,000) 0%
The fourth disadvantage of issuing debt is that loan agreements often require maintaining a certain amount of
working capital (Current assets - Current liabilities) and place limitations on dividends and additional borrowings.
When a company issues bonds, it incurs a long-term liability on which periodic interest payments must be
made, usually twice a year. If interest dates fall on other than balance sheet dates, the company must accrue interest
in the proper periods. The following examples illustrate the accounting for bonds issued at face value on an interest
date and issued at face value between interest dates.
Bonds issued at face value on an interest date Valley Company's accounting year ends on December 31.
On 2010 December 31, Valley issued 10-year, 12 per cent bonds with a USD 100,000 face value, for USD 100,000.
The bonds are dated 2010 December 31, call for semiannual interest payments on June 30 and December 31, and
mature on 2020 December 31. Valley made the required interest and principal payments when due. The entries for
the 10 years are as follows:
On 2010 December 31, the date of issuance, the entry is:
2010 Dec. 31 Cash (+A) 100,000
Bonds payable (+L) 100,000 To record bonds issued at face value.
On each June 30 and December 31 for 10 years, beginning 2010 June 30 (ending 2020 June 30), the entry
would be:
Each year June 30 And Dec.31 Bond Interest Expense ($100,000 x 0.12 x
½) (-SE) 6,000
Cash (-A) 6,000 To record periodic interest payment.
On 2020 December 31, the maturity date, the entry would be:
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2020 Dec. 31 Bond interest expense (-SE) 6,000
Bonds payable (-L) 100,000 Cash (-A) 106,000 To record final interest and bond redemption payment.
Note that Valley does not need adjusting entries because the interest payment date falls on the last day of the
accounting period. The income statement for each of the 10 years 2010-2018 would show Bond Interest Expense of
USD 12,000 (USD 6,000 X 2); the balance sheet at the end of each of the years 2010-2018 would report bonds
payable of USD 100,000 in long-term liabilities. At the end of 2019, Valley would reclassify the bonds as a current
liability because they will be paid within the next year.
The real world is more complicated. For example, assume the Valley bonds were dated 2010 October 31, issued
on that same date, and pay interest each April 30 and October 31. Valley must make an adjusting entry on
December 31 to accrue interest for November and December. That entry would be:
2010 Dec. 31 Bond interest expense ($100,000 x 0.12 x
2/12) (-SE) 2,000
Bond interest payable (+L) 2,000 To accrue two month's interest expense.
The 2011 April 30, entry would be:
2011 Apr. 30 Bond interest expense ($100,000 x 0.12 x
(4/12)) (-SE) 4,000
Bond interest payable (-L) 2,000 Cash (-A) 6,000 To record semiannual interest payment.
The 2011 October 31, entry would be:
2011 Oct. 31 Bond interest expense (-SE) 6,000
Cash (-A) 6,000 To record semiannual interest payment.
Each year Valley would make similar entries for the semiannual payments and the year-end accrued interest.
The firm would report the USD 2,000 Bond Interest Payable as a current liability on the December 31 balance sheet
for each year.
Bonds issued at face value between interest dates Companies do not always issue bonds on the date they
start to bear interest. Regardless of when the bonds are physically issued, interest starts to accrue from the most
recent interest date. Firms report bonds to be selling at a stated price "plus accrued interest". The issuer must pay
holders of the bonds a full six months' interest at each interest date. Thus, investors purchasing bonds after the
bonds begin to accrue interest must pay the seller for the unearned interest accrued since the preceding interest
date. The bondholders are reimbursed for this accrued interest when they receive their first six months' interest
check.
Using the facts for the Valley bonds dated 2010 December 31, suppose Valley issued its bonds on 2011 May 31,
instead of on 2010 December 31. The entry required is:
2011 May 31 Cash (+A) 105,000
Bonds payable (+L) 100,000 Bond interest payable ($100,000 x 0.12 x (5/12)) (+L)
5,000
To record bonds issued at face value plus accrued interest.
Accounting Principles: A Business Perspective 599 A Global Text
15. Long-term financing: Bonds
This entry records the USD 5,000 received for the accrued interest as a debit to Cash and a credit to Bond
Interest Payable.
The entry required on 2011 June 30, when the full six months' interest is paid, is:
2011 June 30 Bond Interest Expense ($100,000 x 0.12 x
(1/12)) (-SE) 1,000
Bond interest payable (-L) 5,000 Cash (-A) 6,000 To record bond interest payment.
This entry records USD 1,000 interest expense on the USD 100,000 of bonds that were outstanding for one
month. Valley collected USD 5,000 from the bondholders on May 31 as accrued interest and is now returning it to
them.
Bond prices and interest rates
The price of a bond issue often differs from its face value. The amount a bond sells for above face value is a
premium. The amount a bond sells for below face value is a discount. A difference between face value and issue
price exists whenever the market rate of interest for similar bonds differs from the contract rate of interest on the
bonds. The effective interest rate (also called the yield) is the minimum rate of interest that investors accept on
bonds of a particular risk category. The higher the risk category, the higher the minimum rate of interest that
investors accept. The contract rate of interest is also called the stated, coupon, or nominal rate. Firms state this
rate in the bond indenture, print it on the face of each bond, and use it to determine the amount of cash paid each
interest period. The market rate fluctuates from day to day, responding to factors such as the interest rate the
Federal Reserve Board charges banks to borrow from it; government actions to finance the national debt; and the
supply of, and demand for, money.
Market and contract rates of interest are likely to differ. Issuers must set the contract rate before the bonds are
actually sold to allow time for such activities as printing the bonds. Assume, for instance, that the contract rate for a
bond issue is set at 12 per cent. If the market rate is equal to the contract rate, the bonds will sell at their face value.
However, by the time the bonds are sold, the market rate could be higher or lower than the contract rate. As shown
in Exhibit 119, if the market rate is lower than the contract rate, the bonds will sell for more than their face value.
Thus, if the market rate is 10 per cent and the contract rate is 12 per cent, the bonds will sell at a premium as the
result of investors bidding up their price. However, if the market rate is higher than the contract rate, the bonds will
sell for less than their face value. Thus, if the market rate is 14 per cent and the contract rate is 12 per cent, the
bonds will sell at a discount. Investors are not interested in bonds bearing a contract rate less than the market rate
unless the price is reduced. Selling bonds at a premium or a discount allows the purchasers of the bonds to earn the
market rate of interest on their investment.
Computing long-term bond prices involves finding present values using compound interest. The appendix to
this chapter explains the concepts of future value and present value. If you do not understand the present value
concept, read the appendix before continuing with this section.
Buyers and sellers negotiate a price that yields the going rate of interest for bonds of a particular risk class. The
price investors pay for a given bond issue is equal to the present value of the bonds. To compute present value, we
discount the promised cash flows from the bonds—principal and interest—using the market, or effective, rate. We
use the market rate because the bonds must yield at least this rate or investors are attracted to alternative
investments. The life of the bonds is stated in interest (compounding) periods. The interest rate is the effective rate
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per interest period, which is found by dividing the annual rate by the number of times interest is paid per year. For
example, if the annual rate is 12 per cent, the semiannual rate would be 6 per cent.
Issuers usually quote bond prices as percentages of face value—100 means 100 per cent of face value, 97 means
97 per cent of face value, and 103 means 103 per cent of face value. For example, one hundred USD 1,000 face value
bonds issued at 103 have a price of USD 103,000. Regardless of the issue price, at maturity the issuer of the bonds
must pay the investor(s) the face value of the bonds.
Exhibit 119: Bond premiums and discounts
Bonds issued at face value The following example illustrates the specific steps in computing the price of
bonds. Assume Carr Company issues 12 per cent bonds with a USD 100,000 face value to yield 12 per cent. Dated
and issued on 2010 June 30, the bonds call for semiannual interest payments on June 30 and December 31 and
mature on 2013 June 30.49 The bonds would sell at face value because they offer 12 per cent and investors seek 12
per cent. Potential purchasers have no reason to offer a premium or demand a discount. One way to prove the
bonds would be sold at face value is by showing that their present value is USD 100,000:
Cash Flow
X Present value Factor
=Present value
Principal of $100,000 due in six interest periods multiplied by present value factor for 6% from Table A.3 of the Appendix (end of text)
$100,000 X 0.70496 =$70,496
Interest of $6,000 due at the end of six interest periods multiplied by present value factor for 6% from Table A.4 of the Appendix (end of text)
6,000 X 4.91732 =29,504
Total price (present value) $100,000
According to this schedule, investors who seek an effective rate of 6 per cent per six-month period should pay
USD 100,000 for these bonds. Notice that the same number of interest periods and semiannual interest rates occur
in discounting both the principal and interest payments to their present values. The entry to record the sale of these
bonds on 2010 June 30, debits Cash and credits Bonds Payable for USD 100,000.
49 Bonds do not normally mature in such a short time; we use a three-year life for illustrative purposes only.
Accounting Principles: A Business Perspective 601 A Global Text
15. Long-term financing: Bonds
An accounting perspective:
Business insight
Some persons estimate that Social Security will be broke by the year 2025 unless changes are
made. Therefore, you may want to set aside funds during your working career to provide for
retirement.
Over the last 60 years, the inflation rate has averaged about 3 per cent per year, treasury bills have
averaged a little under 4 per cent per year, corporate bonds have averaged about a little over 5 per
cent per year, and stocks have averaged a little over 10 per cent per year. Using the tables at the
end of the text we can determine how much you would have at age 65 if you invested USD 2,000
each year for 45 years in treasury bills, corporate bonds, or stocks, beginning at age 20.
To do this calculation for treasury bills, for instance, we would first use Table A.2 to determine the
future value of an annuity of USD 2,000 for 30 periods at 4 per cent (USD 2,000 X 56.08494 =
USD 112,170). (We would have used 45 periods, but the table only went up to 30 periods.) Then we
would use Table A.1 to find the value of this lump sum of USD 112,170 for another 15 years at 4 per
cent (USD 112,170 X 1.80094 = USD 202,011). Then we cannot forget that we have another 15
years of USD 2,000 annuity to consider. Thus, we go back to Table A.2 and calculate the future
value of an annuity of USD 2,000 for 15 periods at 4 per cent (USD 2,000 X 20.02359 = USD
40,047). Then we add the USD 202,011 and the USD 40,047 to get the total future value of USD
242,058. (You would have invested USD 2,000 X 45 years = USD 90,000.) Would you be pleased?
Not when you see what you could have had at age 65 if you invested in stocks.
If you had invested in corporate bonds at 5 per cent, you would have USD 319,401. However, if you
had invested in stocks at 10 per cent, you would have USD 1,437,810 at age 65. Can you use the
tables in the back of the text to verify these amounts?
Bonds issued at a discount Assume the USD 100,000, 12 per cent Carr bonds are sold to yield a current
market rate of 14% annual interest, or 7 per cent per semiannual period. Carr computes the present value (selling
price) of the bonds as follows:
Cash flow
X Present value factor
=Present value
Principal of $100,000 due in six interest periods multiplied by present value factor for 7% from Table A.3 of the Appendix (end of text)
$100,00 0
X0.66634 =$66,634
Interest of $6,000 due at the end of six interest periods multiplied by present value factor for 7% from Table A.4 of the Appendix (end of text)
6,000 X4.76654 =28,559
Total price (present value) $95,233
Note that in computing the present value of the bonds, Carr uses the actual USD 6,000 cash interest payment
that will be made each period. The amount of cash the company pays as interest does not depend on the market
interest rate. However, the market rate per semiannual period—7 per cent—does change, and Carr uses this new
rate to find interest factors in the tables.
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The journal entry to record issuance of the bonds is:
2010 June 30 Cash (+A) 95,233
Discount on bonds payable (-L; Contra- account)
4,767
Bonds payable (+L) 100,000 To record bonds issued at a discount.
In recording the bond issue, Carr credits Bonds Payable for the face value of the debt. The company debits the
difference between face value and price received to Discount on Bonds Payable, a contra account to Bonds Payable.
Carr reports the bonds payable and discount on bonds payable in the balance sheet as follows:
Long-term liabilities: Bonds payable, 12%, due 2009 June 30 $100,000 Less: Discount on bonds payable 4,767 $95,233
The USD 95,233 is the carrying value, or net liability, of the bonds. Carrying value is the face value of the bonds
minus any unamortized discount or plus any unamortized premium. The next section discusses unamortized
premium on bonds payable.
Bonds issued at a premium Assume that Carr issued the USD 100,000 face value of 12 per cent bonds to
yield a current market rate of 10 per cent. The bonds would sell at a premium calculated as follows:
Cash Flow
X Present value Factor
=Present value
Principal of $100,000 due in six interest periods multiplied by present value factor for 5% from Table A.3 of the Appendix (end of text)
$100,000 X 0.74622 =$74,622
Interest of $6,000 due at the end of six interest periods multiplied by present value factor for 5% from Table A.4 of the Appendix (end of text)
6,000 X 5.07569 =30,454
Total price (present value) $105,076
The journal entry to record the issuance of the bonds is:
2010 June 30 Cash (+A) 105,076
Bonds payable (+L) 100,000 Premium on bonds payable (+L) 5,076 To record bonds issued at a premium.
The carrying value of these bonds at issuance is USD 105,076, consisting of the face value of USD 100,000
and the premium of USD 5,076. The premium is an adjunct account shown on the balance sheet as an addition to
bonds payable as follows:
Long-term liabilities: Bonds payable, 12%, due 2009 June 30 $100,000 Add: Premium on bonds payable 5,076 $105,076
When a company issues bonds at a premium or discount, the amount of bond interest expense recorded each
period differs from bond interest payments. A discount increases and a premium decreases the amount of interest
expense. For example, if Carr issues bonds with a face value of USD 100,000 for USD 95,233, the total interest cost
of borrowing would be USD 40,767: USD 36,000 (which is six payments of USD 6,000) plus the discount of USD
4,767. If the bonds had been issued at USD 105,076, the total interest cost of borrowing would be USD 30,924: USD
36,000 less the premium of USD 5,076. The USD 4,767 discount or USD 5,076 premium must be allocated or
charged to the six periods that benefit from the use of borrowed money. Two methods are available for amortizing a
discount or premium on bonds—the straight-line method and the effective interest rate method.
Accounting Principles: A Business Perspective 603 A Global Text
15. Long-term financing: Bonds
The straight-line method records interest expense at a constant amount; the effective interest rate method
records interest expense at a constant rate. APB Opinion No. 21 states that the straight-line method may be used
only when it does not differ materially from the effective interest rate method. In many cases, the differences are
not material.
An accounting perspective:
Business insight
US government bonds have traditionally offered a fixed rate of interest. In early 1997, the US
Treasury began offering inflation-indexed bonds. The amount of interest on these bonds is tied to
the officially reported rate of inflation. The bonds pay interest every six months, and the interest is
based on the inflation-adjusted value of the principal. These bonds are designed to protect
purchasers against purchasing power loss due to inflation. At that time, there was some concern by
investors that the government had been considering calculating the official rate of inflation
differently than in the past in such a way that it would lower the annual increase as compared to
the then present method of calculation. This change in calculation, if adopted, would lower the
amount of interest earned on these bonds. However, there were some assurances that for this
purpose the official rate of inflation would be calculated the "old way".
The straight-line method The straight-line method of amortization allocates an equal amount of
discount or premium to each month the bonds are outstanding. The issuer calculates the amount by dividing the
discount or premium by the total number of months from the date of issuance to the maturity date. For example, if
it sells USD 100,000 face value bonds for USD 95,233, Carr would charge the USD 4,767 discount to interest
expense at a rate of USD 132.42 per month (equal to USD 4,767/36). Total discount amortization for six months
would be USD 794.52, computed as follows: USD 132.42 X 6. Interest expense for each six-month period then
would be USD 6,794.52, calculated as follows: USD 6,000 + (USD 132.42 X 6). The entry to record the expense on
2010 December 31, would be:
2010 Dec. 31 Bond interest expense (-SE) 6,794.52
Cash (-A) 6,000.00 Discount on bonds payable ($132.42 x 6) (+L)
794.52
To record interest payment and discount amortization.
By the maturity date, all of the discount would have been amortized.
To illustrate the straight-line method applied to a premium, recall that earlier Carr sold its USD 100,000 face
value bonds for USD 105,076. Carr would amortize the USD 5,076 premium on these bonds at a rate of USD 141 per
month, equal to USD 5,076/36. The entry for the first period's semiannual interest expense on bonds sold at a
premium is:
2010 Dec. 31 Bond interest expense (-SE) 5,154
Premium on bonds payable ($141 x 6) (-L) 846 Cash (-A) 6,000 To record interest payable and premium
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amortization.
By the maturity date, all of the premium would have been amortized.
The effective interest rate method APB Opinion No. 21 recommends an amortization procedure called the
effective interest rate method, or simply the interest method. Under the interest method, interest expense
for any interest period is equal to the effective (market) rate of interest on the date of issuance times the carrying
value of the bonds at the beginning of that interest period. Using the Carr example of 12 per cent bonds with a face
value of USD 100,000 sold to yield 14 per cent, the carrying value at the beginning of the first interest period is the
selling price of USD 95,233. Carr would record the interest expense for the first semiannual period as follows:
2010 Dec. 31 Bond interest expense ($95,233 x 0.14 x ½) (-
SE) 6,666
Cash ($100,000 x 0.12 x ½) (-A) 6,000 Discount on bonds payable (+L) 666 To record discount amortization and interest payment.
Note that interest expense is the carrying value times the effective interest rate. The cash payment is the face
value times the contract rate. The discount amortized for the period is the difference between the two amounts.
After the preceding entry, the carrying value of the bonds is USD 95,899, or USD 95,233 + USD 666. Carr
reduced the balance in the Discount on Bonds Payable account by USD 666 to USD 4,101, or USD 4,767 - USD 666.
Assuming the accounting year ends on December 31, the entry to record the payment of interest for the second
semiannual period on 2011 June 30 is:
2011 June 30 Bond interest expense ($95,899 x 0.14 x ½) (-
SE) 6,713
Cash ($100,000 x 0.12 x ½) (-A) 6,000 Discount on bonds payable (+L) 713 To record discount amortization and interest payment.
Carr can also apply the effective interest rate method to premium amortization. If the Carr bonds had been
issued at USD 105,076 to yield 10 per cent, the premium would be USD 5,076. The firm calculates interest expense
in the same manner as for bonds sold at a discount. However, the entry would differ somewhat, showing a debit to
the premium account. The entry for the first interest period is:
2010 Dec. 31 Bond Interest Expense ($105,076 x 0.10 x ½) (-SE) 5,254
Premium on bonds payable (-L) 746 Cash ($100,000 x 0.12 x ½) (-A) 6,000 To record interest payment and premium amortization.
After the first entry, the carrying value of the bonds is USD 104,330, or USD 105,076 - USD 746. The premium
account now carries a balance of USD 4,330, or USD 5,076 - USD 746. The entry for the second interest period is:
2011 June 30 Bond interest expense ($104,330 x 0.10 x ½) (-SE) 5,216*
Premium on bonds payable (-L) 784 Cash ($100,000 x 0.12 x ½) (-A) 6,000 To record interest payment and premium amortization.
*Rounded down.
Accounting Principles: A Business Perspective 605 A Global Text
15. Long-term financing: Bonds
Discount and premium amortization schedules A discount amortization schedule (Exhibit 120) and a
premium amortization schedule (Exhibit 121) aid in preparing entries for interest expense. Usually, companies
prepare such schedules when they first issue bonds, often using computer programs designed for this purpose. The
companies then refer to the schedules whenever they make journal entries to record interest. Note that in each
period the amount of interest expense changes; interest expense gets larger when a discount is involved and smaller
when a premium is involved. This fluctuation occurs because the carrying value to which a constant interest rate is
applied changes each interest payment date. With a discount, carrying value increases; with a premium, it
decreases. However, the actual cash paid as interest is always a constant amount determined by multiplying the
bond's face value by the contract rate.
Recall that the issue price was USD 95,233 for the discount situation and USD 105,076 for the premium
situation. The total interest expense of USD 40,767 for the discount situation in Exhibit 120 is equal to USD 36,000
(which is six USD 6,000 payments) plus the USD 4,767 discount. This amount agrees with the earlier computation
of total interest expense. In Exhibit 121, total interest expense in the premium situation is USD 30,924, or USD
36,000 (which is six USD 6,000 payments) less the USD 5,076 premium. In both illustrations, at the maturity date
the carrying value of the bonds is equal to the face value because the discount or premium has been fully amortized.
Adjusting entry for partial period Exhibit 120 and Exhibit 121 also would be helpful if Carr must accrue
interest for a partial period. Instead of a calendar-year accounting period, assume the fiscal year of the bond issuer
ends on August 31. Using the information provided in the premium amortization schedule (Exhibit 121), the
adjusting entry needed on 2010 August 31 is:
2010 Aug. 31 Bond interest expense ($5,254 x (2/6)) 1,751
Premium on bonds payable ($746 x (2/6)) 249 Bond interest payable ($6,000 x (2/6)) 2,000 To record two months' accrued interest.
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(A) (B) (C) (D) (E) Interest Bond Interest Cash credit Discount on Carrying value of Payment Date
Expense Debit (E x 0.14 x ½)
($100,000 x 0.12 x ½)
Bonds Payable Credit (B-C)
Bonds Payable (previous balance in E+D)
Issued Price $ 95,233 2010/12/31 $6,666 $6,000 $666 95,899 2011/6/30 6,713 6,000 713 96,612 2011/12/31 6,763 6,000 763 97,375 2012/6/30 6,816 6,000 816 98,191 2012/12/31 6,873 6,000 873 99,064 2013/6/30 6,936* 6,000 936 100,000
$40,767 $36,000 $4,767
Exhibit 120: Discount amortization schedule for bonds payable
This entry records interest for two months, July and August, of the six-month interest period ending on 2010
December 31. The first line of Exhibit 121 shows the interest expense and premium amortization for the six months.
Thus, the previous entry records two-sixths (or one-third) of the amounts for this six-month period. Carr would
record the remaining four months' interest when making the first payment on 2010 December 31. That entry reads:
2010 Dec. 31 Bond interest payable (-L) 2,000
Bond interest expense ($5,254 x (4/6)) (-SE) 3,503 Premium on bonds payable ($746 x 4/6) (-L) 497 Cash (-A) 6,000 To record four months' interest expense and semiannual interest payment.
During the remaining life of the bonds, Carr would make similar entries for August 31 and December 31. The
amounts would differ, however, because Carr uses the interest method of accounting for bond interest. The entry
for each June 30 would be as indicated in Exhibit 121.
Redeeming bonds payable
Bonds may be (1) paid at maturity, (2) called, or (3) purchased in the market and retired. Bonds may also be
retired by being converted into stock. Each action is either a redemption of bonds or the extinguishment of debt. A
company that pays its bonds at maturity would have already amortized any related discount or premium and paid
the last interest payment. The only entry required at maturity would debit Bonds Payable and credit Cash for the
face amount of the bonds as follows:
2013 June 30 Bond payable (-L) 100,000
Cash (-A) 100,000 To pay bonds on maturity date.
(A) (B) (C) (D) (E) Interest Payment
Bond Interest Cash credit Discount on bonds Carrying value of
Expense Debit (E x 0.10 x ½)
($100,000 x 0.12 x ½)
Payable credit (B- C)
Bonds payable (previous balance in E-D)
Issue Price $105,076 2010/12/31 $ 5,254 $6,000 $ 746 104,330 2011/6/30 5,216* 6,000 784 103,546 2011/12/31 5,177 6,000 823 102,723 2012/6/30 5,136 6,000 864 101,859 2012/12/31 5,093 6,000 907 100,952 2013/6/30 5,048 6,000 952 100,000
*Rounded down.
$30,924 $36,000 $5,076
Exhibit 121: Premium amortization schedule for bonds payable
Accounting Principles: A Business Perspective 607 A Global Text
15. Long-term financing: Bonds
An issuer may redeem some or all of its outstanding bonds before maturity by calling them. The issuer may also
purchase bonds in the market and retire them. In either case, the accounting is the same. Assume that on 2012
January 1, Carr calls bonds totaling USD 10,000 of the USD 100,000 face value bonds in Exhibit 121 at 103, or USD
10,300. Even though accrued interest would be added to the price, assume that the interest due on this date has
been paid. A look at the last column on the line dated 2011/12/31 in Exhibit 121 reveals that the carrying value of
the bonds is USD 102,723, which consists of Bonds Payable of USD 100,000 and Premium on Bonds Payable of
USD 2,723. Since 10 per cent of the bond issue is being redeemed, Carr must remove 10 per cent from each of these
two accounts. The firm incurs a loss for the excess of the price paid for the bonds, USD 10,300, over their carrying
value, USD 10,272. The required entry is:
2012 Jan. 1 Bond payable (-L) 10,000
Premium on bonds payable ($2,723/10) (-L) 272 Loss on bond redemption 9$10,272 - $10,300) (-SE)
28
Cash (-A) 10,300 To record bonds redeemed.
According to FASB Statement No. 4, gains and losses from voluntary early retirement of bonds are
extraordinary items, if material. We report such gains and losses in the income statement, net of their tax effects, as
described in Chapter 13. The FASB is currently reconsidering the reporting of these gains and losses as
extraordinary items.
To avoid the burden of redeeming an entire bond issue at one time, companies sometimes issue serial bonds
that mature over several dates. Assume that on 2002 June 30, Jasper Company issued USD 100,000 face value, 12
per cent serial bonds at 100. Interest is payable each year on June 30 and December 31. A total of USD 20,000 of
the bonds mature each year starting on 2010 June 30. Jasper has a calendar-year accounting period. Entries
required for 2010 for interest expense and maturing debt are:
2010 June 30 Bond interest expense ($100,000 x 0.12 x ½) (-SE) 6,000
Cash (-A) 6,000 To record interest payment.
30 Serial bonds payable (-L) 20,000 Cash (-A) 20,000 To record retirement of serial debt.
Dec. 31 Bond interest expense ($80,000 x 0.12 x ½) (-SE) 4,800 Cash (-A) 4,800 To record payment of semiannual interest expense.
Note that Jasper calculates the interest expense for the last six months of 2010 only on the remaining
outstanding debt (USD 100,000 original issue less the USD 20,000 that matured on 2010 June 30). Each year after
the bonds maturing that year are retired, interest expense decreases proportionately. Jasper reports the USD
20,000 amount maturing the next year as a current liability on each year-end balance sheet. The remaining debt is
a long-term liability.
Naturally, bond investors are concerned about the safety of their investments. They fear the company may
default on paying the entire principal at the maturity date. This concern has led to provisions in some bond
indentures that require companies to make periodic payments to a bond redemption fund, often called a
sinking fund. The fund trustee uses these payments to redeem a stated amount of bonds annually and pay the
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accrued bond interest. The trustee determines which bonds to call and uses the cash deposited in the fund only to
redeem these bonds and pay their accrued interest.
To illustrate, assume Hand Company has 12 per cent coupon bonds outstanding that pay interest on March 31
and September 30 and were issued at face value. The bond indenture requires that Hand pay a trustee USD 53,000
each September 30. The entry for the payment to the trustee is:
Sept. 30 Sinking fund (+A) 53,000 Cash (-A) 53,000 To record payment to trustee of required deposit.
The trustee calls USD 50,000 of bonds, pays for the bonds and accrued interest, and notifies Hand. The trustee
also bills Hand for its fee and expenses incurred of USD 325. Assuming no interest has been recorded on these
bonds for the period ended September 30, the entries are:
Sept.30 Bonds Payable (-L) 50,000 Bond interest expense (-SE) 3,000 Sinking fund (-A) 53,000 To record bond redemption and interest paid by trustee.
30 Sinking fund expense (-SE) 325 Cash (-A) 325 To record trustee fee and expenses.
If a balance exists in the Sinking Fund account at year-end, Hand includes it in a category labeled Investments
or Other Assets on the balance sheet. Hand would describe the USD 50,000 of bonds that must be retired during
the coming year as "Current maturity of long-term debt" and report it as a current liability on the balance sheet.
The existence of a sinking fund does not necessarily mean that the company has created a retained earnings
appropriation entitled "Appropriation for Bonded Indebtedness". A sinking fund usually is contractual (required by
the bond indenture), and an appropriation of retained earnings is simply an announcement by the board of
directors that dividend payments will be limited over the term of the bonds. The former requires cash to be paid in
to a trustee, and the latter restricts retained earnings available for dividends to stockholders. Also, even if the
indenture does not require a sinking fund, the corporation may decide to (1) pay into a sinking fund and not
appropriate retained earnings, (2) appropriate retained earnings and not pay into a sinking fund, (3) do neither, or
(4) do both.
A company may add to the attractiveness of its bonds by giving the bondholders the option to convert the bonds
to shares of the issuer's common stock. In accounting for the conversions of convertible bonds, a company treats
the carrying value of bonds surrendered as the capital contributed for shares issued.
Suppose a company has USD 10,000 face value of bonds outstanding. Each USD 1,000 bond is convertible into
50 shares of the issuer's USD 10 par value common stock. On May 1, when the carrying value of the bonds was USD
9,800, investors presented all of the bonds for conversion. The entry required is:
May 1 Bond payable (-L) 10,000 Discount bonds payable (+L) 200 Common stock ($10,000/$1,000 = 10 bonds; 10 bonds x 50 share x $10 par) (+SE) 5,000 Paid-in capital in excess of par value – common (+SE)
4,800
To record bonds converted to common stock.
The entry eliminates the USD 9,800 book value of the bonds from the accounts by debiting Bonds Payable for
USD 10,000 and crediting Discount on Bonds Payable for USD 200. It credits Common Stock for the par value of
Accounting Principles: A Business Perspective 609 A Global Text
15. Long-term financing: Bonds
the 500 shares issued (500 shares X USD 10 par). The excess amount (USD 4,800) is credited to Paid-In Capital in
Excess of Par Value—Common.
An accounting perspective:
Business insight
The Securities and Exchange Commission took action to protect the public against abusive
telemarketing calls from sellers of municipal bonds. The residence of any person can only be called
between 8 am and 9 pm, without their prior consent. Callers must clearly disclose the purpose of
the call. Also, a centralized "Do-not-call" list of people who do not wish to receive solicitations must
be maintained and honored.
Source: "SEC Approves Rule Governing Calls From Muni-Bond Sellers to Investors," The Wall
Street Journal, Friday, December 27, 1996, p. A2.
The two leading bond rating services are Moody's Investors Service and Standard & Poor's Corporation. The
bonds are rated as to their riskiness. The ratings used by these services are:
Moody's Standard & Poor's
Highest quality to upper medium Aaa Aa A
AAA AA A
Medium to speculative Baa Ba B
BBB BB B
Poor to lowest quality Caa Ca C
CCC CC C
In default, value is questionable DDD DD D
Normally, Moody's rates junk bonds at Ba or below and Standard & Poor's at BB or below. As a company's
prospects change over time, the ratings of its outstanding bonds change because of the higher or lower probability
that the company can pay the interest and principal on the bonds when due. A severe recession may cause many
companies' bond ratings to decline.
Bond prices appear regularly in certain newspapers. For instance, The Wall Street Journal quoted IBM's bonds
as follows:
Issue Coupon Maturity Yield Price Change IBM 7˚ 2013 6.6 113 -2
The bonds carry a coupon rate of 7° per cent. The bonds mature in 2013. The current price is USD 113 per
hundred, or USD 1,130.00 for a USD 1,000 bond. The price the preceding day was USD 115, since the change was
-2. The current price yields a return to investors of 6.6 per cent. As the market rate of interest changes from day to
day, the market price of the bonds varies inversely. Thus, if the market rate of interest increases, the market price of
bonds decreases, and vice versa.
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An accounting perspective:
Business insight
Companies sometimes invest in the bonds of other companies. According to FASB Statement No.
115 (covered in Chapter 14), investments in these bonds fall into three categories—trading
securities, available-for-sale securities, or held-to-maturity securities. The bonds would be
classified as trading securities if they were acquired principally for the purpose of selling them in
the near future. If the bonds were to be held for a longer period of time, but not until maturity, they
would be classified as available-for-sale securities. Bonds that will be held to maturity are classified
as held-to-maturity securities. All trading securities are current assets. Available-for-sale securities
are either current assets or long-term assets, depending on how long management intends to hold
them. Discounts and premiums on bonds classified as trading and available-for-sale securities are
not amortized because management does not know how long they will be held. Held-to-maturity
securities are long-term assets. Discounts and premiums on bonds classified as held-to-maturity
securities are amortized by the holder of the bonds in the same manner as for the issuer of the
bonds. Further discussion of investments in bonds is reserved for an intermediate accounting
course.
Analyzing and using the financial results—Times interest earned ratio
The times interest earned ratio (or interest coverage ratio) indicates the ability of a company to meet
required interest payments when due. We calculate the ratio as follows:
Time interest earned ratio= Income before interest also taxesIBIT
Interest expense
Income before interest and taxes (IBIT), also called "earnings before interest and taxes (EBIT)", is the
numerator because there would be no income taxes if interest expense is equal to or greater than IBIT. To find IBIT
when the income statement is not complex, take net income and add back interest expense and taxes. However, in
complex situations, when there are discontinued operations, changes in accounting principle, extraordinary items,
interest revenue, and/or other similar items, analysts often use "operating income" to represent IBIT. The higher
the ratio, the more comfortable creditors feel about receiving interest payments in the future.
An ethical perspective:
Rawlings furniture company
The Rawlings brothers inherited 300,000 shares (30 per cent) of the common stock of the Rawlings
Furniture Company from their father, who had founded the company 55 years earlier. One brother
served as president of the company, and the other two brothers served as vice presidents. The
company, which produced a line of fine furniture sold nationwide, earned an average of USD 4
million per year. Located in Jamesville, New York, USA, the company had provided steady
Accounting Principles: A Business Perspective 611 A Global Text
15. Long-term financing: Bonds
employment for approximately 10 per cent of the city's population. The city had benefited from the
revenues the company attracted to the area and from the generous gifts provided by the father.
The remainder of the common stock was widely held and was traded in the over-the-counter
market. No other stockholder held more than 4 per cent of the stock. The stock had recently traded
at USD 30 per share. The company has USD 10 million of 10 per cent bonds outstanding, which
mature in 15 years.
The brothers enjoyed the money they received from the company, but did not enjoy the work. They
also were frustrated by the fact that they did not own a controlling interest (more than 50 per cent)
of the company. If they had a controlling interest, they could make important decisions without
obtaining the agreement of the other stockholders.
With the assistance of a New York City brokerage house, the brothers decided to pursue a plan that
could increase their wealth. The company would offer to buy back shares of common stock at USD
40 per share. These shares would then be canceled, and the Rawlings brothers would have a
controlling interest. The stock buy-back would be financed by issuing 10-year, 14 per cent, high-
interest junk bonds. The brokerage house had located some financial institutions willing to buy the
bonds. The interest payments on the junk bonds would be USD 3 million per year. The brothers
thought the company could make these payments unless the country entered a recession. If need
be, wage increases could be severely restricted or eliminated and the company's pension plan could
be terminated. If the junk bonds could be paid at maturity, the brothers would own a controlling
interest in what could be an extremely valuable company. If the interest payments could not be met
or if the junk bonds were defaulted at maturity, the company could eventually be forced to
liquidate. The risks are high, but so are the potential rewards. If another buyer entered the picture
at this point and bid an even higher amount for the stock, the brothers could sell their shares and
exit the company. Two of the brothers hoped that another buyer might bid as much as USD 50 per
share so they could sell their shares and pursue other interests. The changes a new buyer might
make are unpredictable at this point.
The times interest earned ratios in a recent year for several companies (described in footnotes to the table) were
as follows:
Earnings before Interest and
Interest Expense
Times Interest Earned
Company Taxes (millions) (Millions) Ratio Ford Mother Companya $19,136 $10,902 1.76 Proctor & Gamble Companyb 6,258 722 8.67 AMR Corporationc 1,754 467 3.76 Dell Computer Corporationd 3,241 47 68.96 Hewlett-Packard Companye 4,882 257 19.00 A Ford Motor Company is the world's largest producer of trucks and the second largest producer of cars and trucks combined. B Proctor and Gamble markets more than 300 brands to nearly five billion customers in over 140 countries. cAMR's principal subsidiary is America Airlines. dDell is the world's largest direct computer systems company. eHewlett-Packard Company designs, manufactures, and services products and systems for measurement, computation, and communications.
You can see from these data that a great deal of variability exists in the times interest earned ratios for real
companies. To judge the ability of companies to pay bond interest when due, bondholders would carefully examine
other financial data as well.
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Some companies that issued high-interest junk bonds in the 1980s defaulted on their interest payments and had
to declare Chapter 11 bankruptcy or renegotiate payment terms with bondholders in the 1990s. Other companies
with high-interest bonds issued new low-interest bonds and used the proceeds to retire the high-interest bonds.
Chapter 16 discusses the fourth major financial statement—the statement of cash flows, which we mentioned in
Chapter 1. This statement shows the cash inflows and outflows from operating, investing, and financing activities.
Understanding the learning objectives
• A bond is a liability (with a maturity date) that bears interest that is deductible in computing both net
income and taxable income.
• A stock is a unit of ownership on which a dividend is paid only if declared, and dividends are not deductible
in determining net income or taxable income.
• Bonds may be secured or unsecured, registered or unregistered, callable, and/or convertible.
• Advantages include stockholders retaining control of the company, tax deductibility of interest, and
possible creation of favorable financial leverage.
• Disadvantages include having to make a fixed interest payment each period, reduction in a company's
ability to withstand a major loss, possible limitations on dividends and future borrowings, and possible
reduction in earnings per share caused by unfavorable financial leverage.
• If bonds are issued at face value on an interest date, no accrued interest is recorded.
• If bonds are issued between interest dates, accrued interest must be recorded.
• If the market rate is lower than the contract rate, bonds sell for more than their face value, and a premium
is recorded.
• If the market rate is higher than the contract rate, bonds sell for less than their face value, and a discount is
recorded.
• The present value of the principal plus the present value of the interest payments is equal to the price of the
bond.
• The contract rate of interest is used to determine the amount of future cash interest payments.
• The effective rate of interest is used to discount the future payment of principal and of interest back to the
present value.
• When bonds are issued, Cash is debited, and Bonds Payable is credited. For bonds issued at a discount,
Discount on Bonds Payable is also debited. For bonds issued at a premium, Premium on Bonds Payable is also
credited. For bonds issued between interest dates, Bond Interest Payable is also credited.
• Any premium or discount must be amortized over the period the bonds are outstanding.
• Under the effective interest rate method, interest expense for any period is equal to the effective (market)
rate of interest at date of issuance times the carrying value of the bond at the beginning of that interest period.
• Under the straight-line method of amortization, an equal amount of discount or premium is allocated to
each month the bonds are outstanding.
• When bonds are redeemed before they mature, a loss or gain (an extraordinary item, if material) on bond
redemption may occur.
• A bond sinking fund might be required in the bond indenture.
Accounting Principles: A Business Perspective 613 A Global Text
15. Long-term financing: Bonds
• Bonds may be convertible into shares of stock. The carrying value of the bonds is the capital contributed for
shares of stock issued.
• Bonds are rated as to their riskiness.
• The two leading bond rating services are Moody's Investors Services and Standard & Poor's Corporation.
• Each of these services has its own rating scale. For instance, the highest rating is Aaa (Moody's) and AAA
(Standard & Poor's).
• The times interest earned ratio indicates a company's ability to meet interest payments when due.
• The ratio is equal to income before interest and taxes (IBIT) divided by interest expense.
• The future value of an investment is the amount to which a sum of money invested today will grow in a
stated time period at a specified interest rate.
• Present value is the current worth of a future cash receipt and is the reciprocal of future value. To discount
future receipts is to bring them back to their present values.
Appendix: Future value and present value
Managers apply the concepts of interest, future value, and present value in making business decisions.
Therefore, accountants need to understand these concepts to properly record certain business transactions.
The time value of money
The concept of the time value of money stems from the logical reference for a dollar today rather than a dollar at
any future date. Most individuals prefer having a dollar today rather than at some future date because (1) the risk
exists that the future dollar will never be received; and (2) if the dollar is on hand now, it can be invested, resulting
in an increase in total dollars possessed at that future date.
Most business decisions involve a comparison of cash flows in and out of the company. To be useful in decision
making, such comparisons must be in dollars of the same point in time. That is, the dollars held now must be
accumulated or rolled forward, or future dollars must be discounted or brought back to the present dollar value,
before comparisons are valid. Such comparisons involve future value and present value concepts.
Future value
The future value or worth of any investment is the amount to which a sum of money invested today grows
during a stated period of time at a specified interest rate. The interest involved may be simple interest or compound
interest. Simple interest is interest on principal only. For example, USD 1,000 invested today for two years at 12
per cent simple interest grows to USD 1,240 since interest is USD 120 per year. The principal of USD 1,000, plus 2
X USD 120, is equal to USD 1,240. Compound interest is interest on principal and on interest of prior periods.
For example, USD 1,000 invested for two years at 12 per cent compounded annually grows to USD 1,254.40 as
follows:
Principal or present value $1,000.00 Interest, year 1 = $1,000 x 0.12 = 120.00 Value at end of year 1 $1,120.00 Interest, year 2 = $1,120 x 0.12 = 134.40 Value at end of year 2 (future value) $1,254.40
In Exhibit 122, we graphically portray these computations of future worth and show how USD 1,000 grows to
USD 1,254.40 with a 12 per cent interest rate compounded annually. The effect of compounding is USD 14.40—the
interest in the second year that was based on the interest computed for the first year, or USD 120 X 0.12 = USD
14.40.
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Interest tables ease the task of computing the future worth to which any invested amount will grow at a given
rate for a stated period. An example is Table A.1 in the Appendix at the end of this text. To use the Appendix tables,
first determine the number of compounding periods involved. A compounding period may be any length of time,
such as a day, a month, a quarter, a half-year, or a year, but normally not more than a year. The number of
compounding periods is equal to the number of years in the life of the investment times the number of
compoundings per year. Five years compounded annually is five periods, five years compounded quarterly is 20
periods, and so on.
Second, determine the interest rate per compounding period. Interest rates are usually quoted in annual terms;
in fact, federal law requires statement of the interest rate in annual terms in some situations. Divide the annual rate
by the number of compounding periods per year to get the proper rate per period. Only with an annual
compounding period will the annual rate be the rate per period. All other cases involve a lower rate. For example, if
the annual rate is 12 per cent and interest is compounded monthly, the rate per period (one month) will be 1 per
cent.
To use the tables, find the number of periods involved in the Period column. Move across the table to the right,
stopping in the column headed by the Interest Rate per Period, which yields a number called a factor. The factor
shows the amount to which an investment of USD 1 will grow for the periods and the rate involved. To compute the
future worth of the investment, multiply the number of dollars in the given situation by this factor. For example,
suppose your parents tell you that they will invest USD 8,000 at 12 per cent for four years and give you the amount
to which this investment grows if you graduate from college in four years. How much will you receive at the end of
four years if the interest rate is 12 per cent compounded annually? How much will you receive if the interest rate is
12 per cent compounded quarterly?
To calculate these amounts, look at the end-of-text Appendix, Table A.1. In the intersection of the 4 period row
and the 12 per cent column, you find the factor 1.57352. Multiplying this factor by USD 8,000 yields USD 12,588.16,
the answer to the first question. To answer the second question, look at the intersection of the 16 period row and the
3 per cent column. The factor is 1.60471, and the value of your investment is USD 12,837.68. The more frequent
compounding would add USD 12,837.68 - USD 12,588.16 = USD 249.52 to the value of your investment. The
reason for this difference in amounts is that 12 per cent compounded quarterly is a higher rate than 12 per cent
compounded annually.
An annuity is a series of equal cash flows (often called rents) spaced equally in time. The semiannual interest
payments received on a bond investment are a common example of an annuity. Assume that USD 100 will be
received at the end of each of the next three semiannual periods. The interest rate is 6 per cent per semiannual
period. Using Table A.1 in the Appendix, we find the future value of each of the USD 100 receipts as follows:
Accounting Principles: A Business Perspective 615 A Global Text
15. Long-term financing: Bonds
Exhibit 122: Compound interest and future value
Future value (after three periods) of $100 received at the end of the - First period: 1.12360 x $100=$112.36 Second period: 1.06000 x 100 = 106.00 Third period: 1.00000 x 100 = 100.00 Total future value $318.36
Such a procedure would become quite tedious if the annuity consisted of many receipts. Fortunately, tables are
available to calculate the total future value directly. See the Appendix, Table A.2. For the annuity just described, you
can identify one single factor by looking at the 3 period row and 6 per cent column. The factor is 3.18360 (the sum
of the three factors shown above), and when multiplied by USD 100, yields USD 318.36, which is the same answer.
In Exhibit 123, we graphically present the future value of an annuity.
Present value
Present value is the current worth of a future cash receipt and is the reciprocal of future value. In future value,
we calculate the future value of a sum of money possessed now. In present value, we calculate the current worth of
rights to future cash receipts possessed now. We discount future receipts by bringing them back to their present
values.
Assume that you have the right to receive USD 1,000 in one year. If the appropriate interest rate is 12 per cent
compounded annually, what is the present value of this USD 1,000 future cash receipt? You know that the present
value is less than USD 1,000 because USD 1,000 due in one year is not worth USD 1,000 today. You also know that
the USD 1,000 due in one year is equal to some amount, P, plus interest on P at 12 per cent for one year. Thus, P +
0.12P = USD 1,000, or 1.12P = USD 1,000. Dividing USD 1,000 by 1.12, you get USD 892.86; this amount is the
present value of your future USD 1,000. If the USD 1,000 was due in two years, you would find its present value by
dividing USD 892.86 by 1.12, which equals USD 797.20. Portrayed graphically, present value looks similar to future
value, except for the direction of the arrows (Exhibit 124).
Table A.3 (end-of-text Appendix) contains present value factors for combinations of a number of periods and
interest rates. We use Table A.3 in the same manner as Table A.1. For example, the present value of USD 1,000 due
in four years at 16 per cent compounded annually is USD 552.29, computed as USD 1,000 X 0.55229. The 0.55229
is the present value factor found in the intersection of the 4 period row and the 16 per cent column.
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Exhibit 123: Future value of an annuity
Exhibit 124: Compound interest and present value
As another example, suppose that you wish to have USD 4,000 in three years to pay for a vacation in Europe. If
your investment increases at a 20 per cent rate compounded quarterly, how much should you invest now? To find
the amount, you would use the present value factor found in Table A.3, 12 period row, 5 per cent column. This
factor is 0.55684, which means that an investment of about 55 cents today would grow to USD 1 in 12 periods at 5
per cent per period. To have USD 4,000 at the end of three years, you must invest 4,000 times this factor
(0.55684), or USD 2,227.36.
The semiannual interest payments on a bond are a common example of an annuity. As an example of calculating
the present value of an annuity, assume that USD 100 is received at the end of each of the next three semiannual
periods. The interest rate is 6 per cent per semiannual period. By using Table A.3 (Appendix), you can find the
present value of each of the three USD 100 payments as follows:
Present value of $100 due in: 1 period: 094340 x $100 = $94.34 2 period: 0.89000 x 100 = 89.00 3 period: 0.83962 x 100 = 83.96 Total present value $267.30
Accounting Principles: A Business Perspective 617 A Global Text
15. Long-term financing: Bonds
Exhibit 125: Present value of an annuity
Such a procedure could become quite tedious if the annuity consisted of a large number of payments.
Fortunately, tables are also available showing the present values of an annuity of USD 1 per period for varying
interest rates and periods. See the end-of-text Appendix, Table A.4. For the annuity just described, you can obtain a
single factor from the table to represent the present value of an annuity of USD 1 per period for three (semiannual)
periods at 6 per cent per (semiannual) period. This factor is 2.67301; it is equal to the sum of the present value
factors for USD 1 due in one period, USD 1 in two periods, and USD 1 in three periods found in the Appendix, Table
A.3. When this factor is multiplied by USD 100, the number of dollars in each payment, it yields the present value of
the annuity, USD 267.30. In Exhibit 125, we graphically present the present value of this annuity and show how to
find the present value of the three USD 100 cash flows by multiplying the USD 100 by a present value of an annuity
factor, 2.67301.
Suppose you won a lottery that awarded you a choice of receiving USD 10,000 at the end of each of the next five
years or USD 35,000 cash today. You believe you can earn interest on invested cash at 15 per cent per year. Which
option should you choose? To answer the question, compute the present value of an annuity of USD 10,000 per
period for five years at 15 per cent. The present value is USD 33,521.60, or USD 10,000 X 3.35216. You should
accept the immediate payment of USD 35,000 since it has the larger present value.
Demonstration problem
Jackson Company issued USD 100,000 face value of 15 per cent, 20-year junk bonds on 2010 April 30. The
bonds are dated 2010 April 30, call for semiannual interest payments on April 30 and October 31, and are issued to
yield 16 per cent (8 per cent per period).
a. Compute the amount received for the bonds.
b. Prepare an amortization schedule. Enter data in the schedule for only the first two interest periods. Use the
effective interest rate method.
c. Prepare journal entries to record issuance of the bonds, the first six months' interest expense on the bonds,
the adjustment needed on 2010 December 31 (assuming Jackson's accounting year ends on that date), and the
second six months' interest expense on 2011 April 30.
Solution to demonstration problem
a.
Price received: Present value of principal: $100,000 x 0.04603
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(see Appendix, Table A.3, 40 period row, 8% column) $ 4,603 Present value of interest: $7,500 x 11.92461 (see Appendix, Table A.4, 40 period row, 8% column) 89,435 Total $94,038
b.
(A) (B) (C) (D) (E) Interest Payment Date
Bond Interest Expense Debit (E X 0.16 x ½)
Cash Credit ($100,000 x 0.15 x ½)
Discount on Bonds Payable Credit (B – C)
Carrying Value of Bonds Payable (previous balance in E + D)
Issued price $94,038 2010/10/31 $7,523 $7,500 $23 94,061 2011/4/30 7,525 7,500 25 94,086
c.
2010 Apr. 30 Cash 94,038
Discount on bonds payable 5,962 Bonds payable 100,000 Issued $100,000 face value of 20-year, 15% bonds to yield 16%.
Oct. 31 Bond interest expense 7,523 Discount on bonds payable 23 Cash 7,500 Paid semiannual bond interest expense.
Dec. 31 Bond interest expense ($7,525 x (1/3)) 2,508 Discount on bonds payable 8 Bond interest payable ($7,500 x (1/3)) 2,500 To record accrual of two months' interest expense.
2011 Apr. 30 Bond interest payable 2,500
Bond interest expense ($7,525 x (2/3)) 5,017 Discount on bonds payable 17 cash 7,500 Paid semiannual bond interest expense.
Key terms Annuity A series of equal cash flows spaced in time.
Bearer bond See unregistered bond.
Bond A long-term debt, or liability, owed by its issuer. A bond certificate, a negotiable instrument, is the formal, physical evidence of the debt owed.
Bond indenture The contract or loan agreement under which bonds are issued.
Bond redemption (or sinking) fund A fund used to bring about the gradual redemption of a bond issue.
Callable bond A bond that gives the issuer the right to call (buy back) the bond before its maturity date.
Call premium The price paid in excess of face value that the issuer of bonds must pay to redeem (call) bonds before their maturity date.
Carrying value (of bonds) The face value of bonds minus any unamortized discount or plus any unamortized premium. Sometimes referred to as net liability on the bonds.
Compound interest Interest calculated on the principal and on interest of prior periods.
Contract rate of interest The interest rate printed on the bond certificates and specified on the bond indenture; also called the stated, coupon, or nominal rate.
Convertible bond A bond that may be exchanged for shares of stock of the issuing corporation at the bondholders' option.
Coupon bond A bond not registered as to interest; it carries detachable coupons that are to be clipped and presented for payment of interest due.
Debenture bond An unsecured bond backed only by the general creditworthiness of its issuer.
Discount (on bonds) Amount a bond sells for below its face value.
Accounting Principles: A Business Perspective 619 A Global Text
15. Long-term financing: Bonds
Effective interest rate method (interest method) A procedure for calculating periodic interest expense (or revenue) in which the first period's interest is computed by multiplying the carrying value of bonds payable (bond investments) by the market rate of interest at the issue date. The difference between computed interest expense (revenue) and the interest paid (received), based on the contract rate times face value, is the discount or premium amortized for the period. Computations for subsequent periods are based on the carrying value at the beginning of the period.
Face value Principal amount of a bond.
Favorable financial leverage An increase in EPS and the rate of return on stockholders' equity resulting from earning a higher rate of return on borrowed funds than the fixed cost of such funds. Unfavorable financial leverage results when the cost of borrowed funds exceeds the income they generate, resulting in decreased income to stockholders.
Future value or worth The amount to which a sum of money invested today will grow during a stated period of time at a specified interest rate.
Interest method See effective interest rate method.
Junk bonds High-interest rate, high-risk bonds; many were issued in the 1980s to finance corporate restructurings.
Market interest rate The minimum rate of interest investors will accept on bonds of a particular risk category. Also called effective rate or yield.
Mortgage A legal claim (lien) on specific property that gives the bondholder the right to possess the pledged property if the company fails to make required payments. A bond secured by a mortgage is called a mortgage bond.
Premium (on bonds) Amount a bond sells for above its face value.
Present value The current worth of a future cash receipt(s); computed by discounting future receipts at a stipulated interest rate.
Registered bond A bond with the owner's name on the bond certificate and in the register of bond owners kept by the bond issuer or its agent, the registrar.
Secured bond A bond for which a company has pledged specific property to ensure its payment.
Serial bonds Bonds in a given bond issue with maturities spread over several dates.
Simple interest Interest on principal only.
Sinking fund See Bond redemption fund.
Stock warrant A right that allows the bondholder to purchase shares of common stock at a fixed price for a stated period of time. Warrants issued with long-term debt may be detachable or nondetachable.
Straight-line method of amortization A procedure that, when applied to bond discount or premium, allocates an equal amount of discount or premium to each period in the life of a bond.
Term bond A bond that matures on the same date as all other bonds in a given bond issue.
Times interest earned ratio Income before interest and taxes (IBIT) divided by interest expense. In complex situations, "operating income" is often used to represent IBIT.
Trading on the equity A company using its stockholders' equity as a basis for securing funds on which it pays a fixed return.
Trustee Usually a bank or trust company appointed to represent the bondholders and to enforce the provisions of the bond indenture against the issuer.
Underwriter An investment company or a banker that performs many tasks for the bond issuer in issuing. bonds; may also guarantee the issuer a fixed price for the bonds.
Unfavorable financial leverage Results when the cost of borrowed funds exceeds the revenue they generate; it is the reverse of favorable financial leverage.
Unregistered (bearer) bond Ownership transfers by physical delivery.
Unsecured bond A debenture bond, or simply a debenture.
Self-test
True-false
Indicate whether each of the following statements is true or false.
An unsecured bond is called a debenture bond.
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Callable bonds may be called at the option of the holder of the bonds.
Favorable financial leverage results when borrowed funds are used to increase earnings per share of common
stock.
If the market rate of interest exceeds the contract rate, the bonds are issued at a discount.
The straight-line method of amortization is the recommended method.
Multiple-choice
Select the best answer for each of the following questions.
Harner Company issued USD 100,000 of 12 per cent bonds on 2010 March 1. The bonds are dated 2010 January
1, and were issued at 96 plus accrued interest. The entry to record the issuance would be:
a. Cash 98,000 Discount on bonds payable 4,000 Bonds payable 100,000 Bonds interest payable 2,000
b. Cash 102,000 Bonds payable 100,000 Bond interest payable 2,000
c. Cash 96,000 Discount on bonds payable 4,000 Bonds payable 100,000
d. None of the above.
If the bonds in the first question had been issued at 104, the entry to record the issuance would have been:
a. Cash 104,000 Bonds payable 100,000 Premium on bonds payable 4,000
b. Cash 102,000 Bonds payable 100,000 Bonds interest payable 2,000
c. Cash 106,000 Bonds payable 100,000 Premium on bonds payable 4,000 Bonds interest payable 2,000
d. None of the above.
On 2010 January 1, the Alvarez Company issued USD 400,000 face value of 8 per cent, 10-year bonds for cash
of USD 328,298, a price to yield 11 per cent. The bonds pay interest semiannually and mature on 2020 January 1.
Using the effective interest rate method, the bond interest expense for the first six months of 2010 would be:
a. USD 36,113.
b. USD 18,056.
c. USD 32,000.
d. USD 16,000.
If the straight-line amortization method had been used in the previous question, the interest expense for the
first six months would have been:
a. USD 39,170.
b. USD 32,000.
c. USD 18,000.
Accounting Principles: A Business Perspective 621 A Global Text
15. Long-term financing: Bonds
d. USD 19,585.
Assume a company has net income of USD 100,000, income tax expense of USD 40,000, and interest expense of
USD 20,000. The times interest earned ratio is:
a. 5 times.
b. 7 times.
c. 8 times.
d. 9 times.
Now turn to “Answers to self-test”at the end of the chapter to check your answers.
Questions
➢ What are the advantages of obtaining long-term funds by the issuance of bonds rather than
additional shares of capital stock? What are the disadvantages?
➢ What is a bond indenture? What parties are usually associated with it? Explain why.
➢ Explain what is meant by the terms coupon, callable, convertible, and debenture.
➢ What is meant by the term trading on the equity?
➢ When bonds are issued between interest dates, why should the issuing corporation receive cash equal
to the amount of accrued interest (accrued since the preceding interest date) in addition to the issue
price of the bonds?
➢ Why might it be more accurate to describe a sinking fund as a bond redemption fund?
➢ Indicate how each of the following items should be classified in a balance sheet on 2009 December
31.
➢ Cash balance in a sinking fund.
➢ Accrued interest on bonds payable.
➢ Debenture bonds payable due in 2019.
➢ Premium on bonds payable.
➢ First-mortgage bonds payable, due 2010 July 1.
➢ Discount on bonds payable.
➢ First National Bank—Interest account.
➢ Convertible bonds payable due in 2012.
➢ Why is the effective interest rate method of computing periodic interest expense considered
theoretically preferable to the straight-line method?
➢ Why would an investor whose intent is to hold bonds to maturity pay more for the bonds than their
face value?
➢ Of what use is the times interest earned ratio?
Exercises
Exercise A On 2010 September 30, Domingo's Construction Company issued USD 120,000 face value of 12 per
cent, 10-year bonds dated 2010 August 31, at 100, plus accrued interest. Interest is paid semiannually on February
28 and August 31. Domingo's accounting year ends on December 31. Prepare journal entries to record the issuance
of these bonds, the accrual of interest at year-end, and the payment of the first interest coupon.
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Exercise B On 2009 December 31, East Lansing Office Equipment Company issued USD 1,600,000 face value
of 8 per cent, 10-year bonds for cash of USD 1,400,605, a price to yield 10 per cent. The bonds pay interest
semiannually and mature on 2019 December 31.
a. State which is higher, the market rate of interest or the contract rate.
b. Compute the bond interest expense for the first six months of 2010, using the interest method.
c. Show how the USD 1,400,605 price must have been determined.
Exercise C Compute the annual interest expense on the bonds in the previous exercise, assuming the bond
discount is amortized using the straight-line method.
Exercise D After recording the payment of the interest coupon due on 2010 June 30, the accounts of Myrtle
Beach Sailboat, Inc., showed Bonds Payable of USD 300,000 and Premium on Bonds Payable of USD 10,572.
Interest is payable semiannually on June 30 and December 31. The five-year, 12 per cent bonds have a face value of
USD 300,000 and were originally issued to yield 10 per cent. Prepare the journal entry to record the payment of
interest on 2010 December 31. Use the interest method. (Round all amounts to the nearest dollar.)
Exercise E On 2010 June 30 (a semiannual interest payment date), Holiday Rollerblade Company redeemed
all of its USD 400,000 face value of 10 per cent bonds outstanding by calling them at 106. The bonds were
originally issued on 2006 June 30, at 100. Prepare the journal entry to record the payment of the interest and the
redemption of the bonds on 2010 June 30.
Exercise F On 2009 August 31, as part of the provisions of its bond indenture, Caribbean Cruise Line, Inc.,
acquired USD 480,000 of its outstanding bonds on the open market at 96 plus accrued interest. These bonds were
originally issued at face value and carry a 12 per cent interest rate, payable semiannually. The bonds are dated 2002
November 30, and pay semiannual interest on May 31 and November 30. Prepare the journal entries required to
record the accrual of the interest to the acquisition date on the bonds acquired and the acquisition of the bonds.
Exercise G Cleveland Heating Systems, Inc., is required to make a deposit of USD 18,000 plus semiannual
interest expense of USD 540 on 2009 October 31, to the trustee of its sinking fund so that the trustee can redeem
USD 18,000 of the company's bonds on that date. The bonds were issued at 100. Prepare the journal entries
required on October 31 to record the sinking fund deposit, the bond retirement, payment of interest (due on that
date), and payment of trustee expenses, assuming the latter is USD 100.
Exercise H After interest was paid on 2010 September 30, USD 60,000 face value of Miami Video Rentals,
Inc., outstanding bonds were converted into 8,000 shares of the company's USD 5 par value common stock.
Prepare the journal entry to record the conversion, assuming the bonds were issued at 100.
Exercise I A recent annual report of Wal-Mart Corporation showed the following amounts as of the dates
indicated:
Year Ended January 31 2001 2000 1999
Earnings before interest (and taxes) (millions)
$11,583 $10,162 $8,008
Interest expense (millions) 1,467 1,079 838
Calculate the times interest earned ratio for each year and comment on the results.
Exercise J What is the present value of a lump-sum payment of USD 20,000 due in five years if the market
rate of interest is 10 per cent per year (compounded annually) and the present value of USD 1 due in five periods at
10 per cent is 0.62092?
Accounting Principles: A Business Perspective 623 A Global Text
15. Long-term financing: Bonds
Exercise K What is the present value of a series of semiannual payments of USD 10,000 due at the end of each
six months for the next five years if the market rate of interest is 10 per cent per year and the present value of an
annuity of USD 1 for 10 periods at 5 per cent is 7.72173?
Exercise L Joe Mordino bought a ticket in the Georgia lottery for USD 1, hoping to strike it rich. To his
amazement, he won USD 4,000,000. Payment was to be received in equal amounts at the end of each of the next 20
years. Mordino heard from relatives and friends he had not heard from in years. They all wanted to renew their
relationship with this new millionaire. Federal and state income taxes were going to be about 40 per cent (36 per
cent for federal and 4 per cent for state) on each year's income from the lottery check. The discount rate to use in all
present value calculations is 12 per cent.
a. How much will Mordino actually receive after taxes each year?
b. Is Mordino a multimillionaire according to the present value of his cash inflow after taxes?
c. What is the present value of the net amount the state has to pay out? Remember that the state gets part of the
money back in the form of taxes.
Exercise M After Joe Mordino won USD 4,000,000 in the Georgia lottery, he decided to purchase USD 10,000
of lottery tickets at the end of each year for the next 20 years. He was hoping to hit the lottery again, but he never
did. If the state can earn 12 per cent on ticket revenue received, how much will the annuity of USD 10,000 from
Mordino grow to by the end of 20 years?
Problems
Problem A On 2009 June 1, Economy Auto Parts, Inc., issued USD 180,000 of 10-year, 16 per cent bonds
dated 2009 April 1, at 100. Interest on bonds is payable semiannually on presentation of the appropriate coupon.
All of the bonds are of USD 1,000 denomination. The company's accounting period ends on June 30, with
semiannual statements prepared on December 31 and June 30. The interest payment dates are April 1 and October
1.
All of the first coupons on the bonds are presented to the company's bank and paid on 2009 October 2. All but
two of the second coupons are similarly received and paid on 2010 April 1.
Prepare all necessary journal entries for these transactions through 2010 April 1, including the adjusting entry
needed at 2009 June 30.
Problem B Ecological Water Filtration, Inc., is going to issue USD 400,000 face value of 10 per cent, 15-year
bonds. The bonds are dated 2009 June 30, call for semiannual interest payments, and mature on 2024 June 30.
a. Compute the price investors should offer if they seek a yield of 8 per cent on these bonds. Also, compute the
first six months' interest, assuming the bonds are issued at this price. Use the interest method and calculate all
amounts to the nearest dollar.
b. Repeat part (a), assuming investors seek a yield of 12 per cent.
Problem C On 2009 July 1, South Carolina Table Company issued USD 600,000 face value of 10 per cent, 10-
year bonds. The bonds call for semiannual interest payments and mature on 2019 July 1. The company received
cash of USD 531,180, a price that yields 12 per cent.
Assume that the company's fiscal year ends on March 31. Prepare journal entries (to the nearest dollar) to record
the bond interest expense on 2010 January 1, and the adjustment needed on 2010 March 31, using the interest
method. Calculate all amounts to the nearest dollar.
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Problem D Storall Company issued USD 200,000 face value of 16 per cent, 20-year junk bonds on 2010 July 1.
The bonds are dated 2010 July 1, call for semiannual interest payments on July 1 and January 1, and were issued to
yield 12 per cent (6 per cent per period).
a. Compute the amount received for the bonds.
b. Prepare an amortization schedule similar to that in Exhibit 121. Enter data in the schedule for only the first
two interest periods. Use the interest method.
c. Prepare journal entries to record issuance of the bonds, the first six months' interest expense on the bonds,
and the adjustment needed on 2011 May 31, assuming the company's fiscal year ends on that date.
Problem E Kelly Furniture Company issued USD 400,000 face value of 18 per cent, 20-year junk bonds on
2009 October 1. The bonds are dated 2009 October 1, call for semiannual interest payments on April 1 and October
1, and are issued to yield 16 per cent (8 per cent per period).
a. Compute the amount received for the bonds.
b. Prepare an amortization schedule similar to that in Exhibit 121. Enter data in the schedule for only the first
two interest periods. Use the interest method and make all calculations to the nearest dollar.
c. Prepare entries to record the issuance of the bonds, the first six months' interest on the bonds, and the
adjustment needed on 2010 June 30, assuming the company's fiscal year ends on that date.
Problem F Houston Clothing Company issued USD 600,000 of 12 per cent serial bonds on 2009 July 1, at face
value. The bonds are dated 2009 July 1; call for semiannual interest payments on July 1 and January 1; and mature
at the rate of USD 120,000 per year, with the first maturity date falling on 2010 July 1. The company's accounting
period ends on September 30.
Prepare journal entries to record the interest payment of 2010 July 1; the maturing of USD 120,000 of bonds on
2010 July 1; and the adjusting entry needed on 2010 September 30. Also, show how the bonds would be presented
in the company's balance sheet for 2010 September 30.
Alternate problems
Alternate problem A On 2009 December 1, New Jersey Waste Management Company issued USD 300,000
of 10-year, 9 per cent bonds dated 2009 July 1, at 100. Interest on the bonds is payable semiannually on July 1 and
January 1. All of the bonds are registered. The company's accounting period ends on March 31. Quarterly financial
statements are prepared.
The company deposits a sum of money sufficient to pay the semiannual interest on the bonds in a special
checking account in First National Bank and draws interest payment checks on this account. The deposit is made
the day before the checks are drawn.
Prepare journal entries to record the issuance of the bonds; the December 31 adjusting entry; the 2010 January
1, interest payment; and the adjusting entry needed on 2010 March 31, to prepare quarterly financial statements.
Alternate problem B Safe Toy Company is seeking to issue USD 800,000 face value of 10 per cent, 20-year
bonds. The bonds are dated 2009 June 30, call for semiannual interest payments, and mature on 2029 June 30.
a. Compute the price investors should offer if they seek a yield of 8 per cent on these bonds. Also, compute the
first six months' interest assuming the bonds are issued at that price. Use the interest method and calculate all
amounts to the nearest dollar.
b. Repeat part (a) assuming investors seek a yield of 12 per cent.
Accounting Principles: A Business Perspective 625 A Global Text
15. Long-term financing: Bonds
Alternate problem C On 2009 July 1, Tick-Tock Clock Company issued USD 100,000 face value of 8 per cent,
10-year bonds. These bonds call for semiannual interest payments and mature on 2019 July 1. The company
received cash of USD 87,538, a price that yields 10 per cent.
Assume that the company's fiscal year ends on March 31. Prepare journal entries to record the bond interest
expense on 2010 January 1, and the adjustment needed on 2010 March 31, using the interest method. Calculate all
amounts to the nearest dollar.
Alternate problem D Creative Web Page issued USD 600,000 face value of 15 per cent, 20-year bonds on
2010 October 1. The bonds are dated 2010 October 1, call for semiannual interest payments on April 1 and October
1, and are issued to yield 16 per cent (8 per cent per period).
a. Compute the amount received for the bonds.
b. Prepare an amortization schedule similar to that in Exhibit 120. Enter data in the schedule for only the first
two interest periods. Use the interest method.
c. Prepare journal entries to record issuance of the bonds, the first six months' interest expense on the bonds,
and the adjustment needed on 2011 May 31, assuming Creative Web Page's fiscal year ends on that date.
Alternate problem E Goodhew Software Systems, Inc., issued USD 100,000 face value of 10 per cent, 20-year
bonds on 2009 July 1. The bonds are dated 2009 July 1, call for semiannual interest payments on July 1 and
January 1, and are issued to yield 12 per cent (6 per cent per period).
a. Compute the amount received for the bonds.
b. Prepare an amortization schedule similar to that in Exhibit 120. Enter data in the schedule for only the first
two interest periods. Use the interest method and calculate all amounts to the nearest dollar.
c. Prepare entries to record the issuance of the bonds, the first six months' interest on the bonds, and the
adjustment needed on 2010 June 30, assuming Goodhew's fiscal year ends on that date.
Alternate problem F Western Solar Energy Company issued USD 400,000 of 12 per cent bonds on 2009 July
1, at face value. The bonds are dated 2009 July 1, call for semiannual payments on July 1 and January 1, and mature
at the rate of USD 40,000 per year on July 1, beginning in 2010. The company's accounting period ends on
September 30.
a. Prepare journal entries to record the interest expense and payment for the six months ending 2010 July 1; the
maturing of the bonds on 2010 July 1; and the adjusting entries needed on 2010 September 30.
b. Show how the bonds would be presented in the company's balance sheet for 2010 September 30.
Beyond the numbers—Critical thinking
Business decision case A A company is trying to decide whether to invest USD 2 million on plant expansion
and USD 1 million to finance a related increase in inventories and accounts receivable. The USD 3 million
expansion is expected to increase business volume substantially. Profit forecasts indicate that income from
operations will rise from USD 1.6 million to USD 2.4 million. The income tax rate will be about 40 per cent. Net
income last year was USD 918,000. Interest expense on debt now outstanding is USD 70,000 per year. There are
200,000 shares of common stock currently outstanding. The USD 3 million needed can be obtained in two
alternative ways:
• Finance entirely by issuing additional shares of common stock at an expected issue price of USD 75 per
share.
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• Finance two-thirds with bonds, one-third with additional stock. The bonds would have a 20-year life, bear
interest at 10 per cent, and sell at face value. The issue price of the stock would be USD 80 per share.
Should the investment be made? If so, explain which financing plan you would recommend. (Hint: Calculate
earnings per share for last year and for future years under each of the alternatives.)
Business decision case B An annual report of a company contained the following paragraph in the notes to
the financial statements:
The 9 7/8 per cent Senior Subordinated Debentures are redeemable at the option of [the company] at 103.635
per cent of the principal amount plus accrued interest if redeemed prior to [a certain date], and at decreasing prices
thereafter. Mandatory sinking fund payments of USD 3,000,000 (which [the company] may increase to USD
6,000,000 annually)...and are intended to retire, at par plus accrued interest, 75 per cent of the issue prior to
maturity.
Answer the following questions:
a. What does the term debentures mean?
b. How much is the call premium initially? Does this premium decrease over time?
c. Under what circumstances might the company want to increase the sinking fund payments?
Business decision case C The Wall Street Journal contained a table showing yield comparisons for groups of
corporate bonds. The following data have been adapted from the table:
Yield Percentage As of 52-week
4/28 4/27 High Low Risk category 1-10 year maturities: High quality 7.08% 6.94% 7.16% 5.32% Medium quality 7.41 7.26 7.49 5.76 Over 10 year maturities: High quality 7.91 7.81 8.06 6.93 Medium quality 8.36 8.25 8.49 7.29 High-yield bonds 10.45 10.48 10.53 9.25
Standard & Poor's ratings were: High quality AAA to AA Medium quality A to BBB High yield BB to C
Prepare written answers to the following questions.
a. In each column of numbers, why do the yield rates increase from top to bottom?
b. For the high quality and medium quality bonds, what could account for the increase in the yield rates from
4/27 to 4/28? Take into consideration possible economic events.
c. Which risk class of bonds was closest to its 52-week high on 4/28? What could have been the cause?
Annual report analysis D Refer to the Annual report appendix and determine the times interest earned ratio
for 2003 for The Limited. Use "operating income" to represent IBIT. Prepare written comments on the results of
your analysis.
Annual report analysis E A recent annual report of Emhart Corporation contained the following paragraph
in its notes to the financial statements:
The 6 3/4 per cent convertible subordinated debentures may be converted into shares of common stock at a
price of USD 26.50 per share at any time prior to maturity. They are redeemable at prices decreasing from 105 per
cent of face amount currently to 100 per cent [at a certain future date].
Accounting Principles: A Business Perspective 627 A Global Text
15. Long-term financing: Bonds
Answer the following questions:
a. If you held one USD 1,000 bond, how many shares of stock would you receive if you converted the bond into
shares of stock? (Hint: You can use the principal amount of the bond to buy shares of stock at the stated price.)
b. Assume you held one USD 1,000 bond and the bond was called by the company at a price of 105 per cent of
the face amount. If the current market price per share of the stock was USD 29, would you convert the bond into
shares of stock or would you surrender the bond? Explain.
Ethics case – Writing experience F Refer to "An ethical perspective: Rawlings furniture company”. Write
out the answers to the following questions:
a. What motivates the brothers to pursue this new strategy?
b. Are the brothers the only ones assuming the risks?
c. How will workers, the city, the holders of the original bond issue, and the other present stockholders be
affected if the junk bonds are issued and are then defaulted?
d. How might these parties (stakeholders) be affected if a new buyer outbids the management?
e. What ethical considerations are involved?
Group project G In groups of two or three students, write a two-page, double-spaced paper on one of the
following topics:
The Use of Junk Bonds in the 1980s
Why Market Rates of Interest and Prices of Bonds Are Inversely Related
How a Company Can Force Conversion of Callable, Convertible Bonds
How Bond Sinking Funds Work
Do some library research on your topic and properly cite your sources. Make your analysis convincing. Your
paper should be neat, contain no spelling or grammatical errors, and be the result of several drafts. Use a word
processing program to prepare your paper if possible. Your paper should have a cover page with the title and the
authors' names.
Group project H In a small group of students, locate Accounting Principles Board Opinion No. 21 (from a
faculty member or from the library) relating to the amortization of premiums and discounts on bonds. Investigate
why the Board recommended the effective interest rate method over the straight-line method for amortizing bond
premiums and discounts. Which method do you favor and why? Summarize the highlights of the APB Opinion and
your own opinions in a written report to your instructor.
Group project I With one or two other students, locate the annual reports of three companies with bonds
outstanding as part of their long-term debt. You should read the notes to the financial statements to determine the
composition of the long-term debt. Identify the bonds (e.g. debentures, serial), their interest rates, and any other
information pertaining to them. Compare the bonds outstanding for the three companies. Write a report to your
instructor summarizing your findings.
Using the Internet—A view of the real world
Visit the following site for the Eastman Kodak Company:
http://www.kodak.com
By following the instructions on the screen, locate the notes to the financial statements and find the one
pertaining to long-term debt. In your own words, write a short report to your instructor summarizing the types of
long-term debt held by the company and some of the details of the arrangements with lenders.
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Visit the following website for Eastman Chemical Company:
http://www.eastman.com
Pursue choices on the screen until you locate the financial information. Then investigate long-term borrowings.
You will probably go down some "false paths" to get to this financial information, but you can get there. This
experience is all part of learning to use the Internet. Check to determine the composition of the long-term
borrowings. Check out the notes to the financial statements for further information. Browse around the site for any
other interesting information concerning the company. Write a memo to your instructor summarizing your
findings.
Answers to self-test
True-false
True. These unsecured bonds are called debenture bonds and are backed only by the general creditworthiness
of the issuer.
False. Callable bonds may be called at the option of the issuer.
True. This statement is the definition of favorable financial leverage. However, unfavorable financial leverage
can result when favorable financial leverage was planned. Unfavorable financial leverage will result if income before
interest and taxes is much lower than anticipated. Then earnings per share for the common stockholders would be
lower than they would have been without the borrowing.
True. Purchasers will not be willing to pay the face amount if the market rate of interest exceeds the contract
rate. By paying less than the face value, purchasers can earn the market rate of interest on the bonds.
False. The effective interest rate method is the recommended method. The straight-line method may be used
only when the results are not materially different from the interest method.
Multiple-choice
a. The discount of USD 4,000 must be recorded. Also, the accrued interest must be recognized (USD 100,000 X
12 per cent X 2/12 = USD 2,000).
c. The premium is USD 4,000, and the accrued interest is USD 2,000. Both must be recognized.
b. The interest is (USD 328,298 X 0.11 X 1/2 ) = USD 18,056.
d. The interest would have been (USD 400,000 X 0.04) + (USD 71,702/20) = USD 19,585.
c. Income before interest and taxes is (USD 100,000 + USD 40,000 + USD 20,000) = USD 160,000. This total
of USD 160,000 divided by interest of USD 20,000 = 8 times.
Accounting Principles: A Business Perspective 629 A Global Text
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16. Analysis using the statement of cash flows
Learning objectives
After studying this chapter, you should be able to:
• Explain the purposes and uses of the statement of cash flows.
• Describe the content of the statement of cash flows and where certain items would appear on the statement.
• Describe how to calculate cash flows from operating activities under both the direct and indirect methods.
• Prepare a statement of cash flows, under both the direct and indirect methods, showing cash flows from
operating activities, investing activities, and financing activities.
• Analyze a statement of cash flows of a real company.
• Analyze and use the financial results–cash flow per share of common stock, cash flow margin, and cash flow
liquidity ratios.
• Use working paper to prepare a statement of cash flows (appendix).
A career in external auditing
In 1929 the Dow Jones Industrial Average fell 40 per cent over the period from September 3rd to October 29th.
The Dow bottomed out in July 1932, after losing 89 per cent of its value. Some blamed accounting for the run-up in
prices and the subsequent crash. Stocks may have been overpriced because companies engaged in "window
dressing" to enhance their reported income. At the time, accounting practices and reporting procedures were not
well-established. As investors began to understand this, confidence fell. Investors panicked and sold stocks in a
frenzy. This action contributed to the Great Depression of the 1930s. The Dow did not reach pre-crash levels again
until 1954.
In response to the financial crisis, the Securities and Exchange Commission (SEC) was established in 1934 to
regulate the filing requirements of firms listed on US stock exchanges. The SEC requires all listed firms in each year
to prepare financial statements in accordance with generally accepted accounting principles (GAAP) and to have
those financial statements audited by an independent party. This independent verification was meant to restore
investor confidence and provide ongoing integrity in the capital market system. If a company fails to follow GAAP,
it can be delisted from the stock exchange.
For many reasons, managers have incentives to manipulate income to enhance reported performance. It is the
job of auditors to use their understanding of accounting principles and business practices to provide reasonable
assurance that financial statements are free from such manipulation. One possible indication of income
manipulation occurs when accrual earnings are high relative to cash flows from operating activities, sometimes
referred to as "cash earnings". Accrual earnings are typically easier to manipulate because they employ estimates,
whereas cash earnings are tied to actual cash receipts and payments from operations. Accrual earnings can be
Accounting Principles: A Business Perspective 630 A Global Text
16. Analysis using the statement of cash flows
managed upward by recognizing earnings prematurely (or falsely) or by underestimating expenses such as
depreciation expense or bad debts expense.
In addition to the challenges of verifying the accuracy of financial statements, a career in auditing provides a
variety of options. Students can work for global auditing firms or small local firms, choose to travel frequently or on
a limited basis, and decide to live in any geographic area around the world. A career in auditing also provides an
excellent springboard for future opportunities. Companies realize that their auditors can be a valuable part of the
management team. Auditors have expertise about the firm, its industry, and its accounting practices. Auditors
commonly leave the auditing profession to work for one of their many clients.
The income statement, statement of stockholders' equity (or statement of retained earnings), and the balance
sheet do not answer all the questions raised by users of financial statements. Such questions include: How much
cash was generated by the company's operations? How can the Cash account be overdrawn when my accountant
said the business was profitable? Why is such a profitable company able to pay only small dividends? How much
was spent for new plant and equipment, and where did the company get the cash for the expenditures? How was
the company able to pay a dividend when it incurred a net loss for the year?
In this chapter, you will learn about the statement of cash flows, which answers these questions. The statement
of cash flows is another major required financial statement; it shows important information not shown directly in
the other financial statements.
Purposes of the statement of cash flows
In November 1987, the Financial Accounting Standards Board issued Statement of Financial Accounting
Standards No. 95, "Statement of Cash Flows".50 The Statement became effective for annual financial statements for
fiscal years ending after 1988 July 15. Thus, the statement of cash flows is now one of the major financial
statements issued by a company. The statement of cash flows replaced the statement of changes in financial
position, on which funds were generally defined as working capital. Working capital is equal to current assets
minus current liabilities.
The main purpose of the statement of cash flows is to report on the cash receipts and cash disbursements of an
entity during an accounting period. Broadly defined, cash includes both cash and cash equivalents, such as short-
term investments in Treasury bills, commercial paper, and money market funds. Another purpose of this statement
is to report on the entity's investing and financing activities for the period. As shown in Exhibit 126, the statement
of cash flows reports the effects on cash during a period of a company's operating, investing, and financing
activities. Firms show the effects of significant investing and financing activities that do not affect cash in a
schedule separate from the statement of cash flows.
Uses of the statement of cash flows
The statement of cash flows summarizes the effects on cash of the operating, investing, and financing
activities of a company during an accounting period; it reports on past management decisions on such matters as
issuance of capital stock or the sale of long-term bonds. This information is available only in bits and pieces from
50 FASB, Statement of Financial Accounting Standards No. 95, "Statement of Cash Flows" (Stamford, Conn.,
1987). Copyright by the Financial Accounting Standards Board, High Ridge Park, Stamford, Connecticut 06905.
U.S.A. Quoted (or excerpted) with permission. Copies of the complete document are available from the FASB.
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the other financial statements. Since cash flows are vital to a company's financial health, the statement of cash flows
provides useful information to management, investors, creditors, and other interested parties.
The statement of cash flows presents the effects on cash of all significant operating, investing, and financing
activities. By reviewing the statement, management can see the effects of its past major policy decisions in
quantitative form. The statement may show a flow of cash from operating activities large enough to finance all
projected capital needs internally rather than having to incur long-term debt or issue additional stock.
Alternatively, if the company has been experiencing cash shortages, management can use the statement to
determine why such shortages are occurring. Using the statement of cash flows, management may also recommend
to the board of directors a reduction in dividends to conserve cash.
The information in a statement of cash flows assists investors, creditors, and others in assessing the following:
• Enterprise's ability to generate positive future net cash flows.
• Enterprise's ability to meet its obligations.
• Enterprise's ability to pay dividends.
• Enterprise's need for external financing.
• Reasons for differences between net income and associated cash receipts and payments.
• Effects on an enterprise's financial position of both its cash and noncash investing and financing
transactions during the period (disclosed in a separate schedule).
Information in the statement of cash flows
The statement of cash flows classifies cash receipts and disbursements as operating, investing, and financing
cash flows. Both inflows and outflows are included within each category. Look at Exhibit 127 to see how activities
can be classified to prepare a statement of cash flows.
Operating activities generally include the cash effects (inflows and outflows) of transactions and other events
that enter into the determination of net income. Cash inflows from operating activities affect items that appear on
the income statement and include: (1) cash receipts from sales of goods or services; (2) interest received from
making loans; (3) dividends received from investments in equity securities; (4) cash received from the sale of
trading securities; and (5) other cash receipts that do not arise from transactions defined as investing or financing
activities, such as amounts received to settle lawsuits, proceeds of certain insurance settlements, and cash refunds
from suppliers.
Exhibit 126: Statement of cash flows—Basic content
Accounting Principles: A Business Perspective 632 A Global Text
16. Analysis using the statement of cash flows
Operating activities Cash effect of transactions and other events that enter into the determination of net income Cash inflows from: Cash outflows for: Sales of goods or services Merchandise Inventory Interest Salaries and wages Dividends Interest Sale of trading securities Purchase of trading
securities Other sources not related to investing or financing activities (e.g. insurance settlements)
Other items not related to investing or financing activities (e.g. contributions to charities)
Investing activities Transactions involving the acquisition or disposal of noncurrent assets Cash inflows from: Cash outflows for: Sale of property, plant, and equipment
Purchase of property, plant, and equipment
Sale of available-for-sale and held- to-maturity securities
Purchase of available-for-sale and held-to-maturity securities
Collection of loans Making of loans Financing activities Transactions with creditors and owners Cash inflows from:
Cash outflows for:
Issuing capital stock Purchase of treasury stock Issuing debt (bonds, mortgages, notes, and other short- or long-term borrowing of cash)
Cash dividends
Exhibit 127: Rules for classifying activities in the statement of cash flows
Cash outflows for operating activities affect items that appear on the income statement and include payments:
(1) to acquire inventory; (2) to other suppliers and employees for other goods or services; (3) to lenders and other
creditors for interest; (4) for purchases of trading securities; and (5) all other cash payments that do not arise from
transactions defined as investing or financing activities, such as taxes and payments to settle lawsuits, cash
contributions to charities, and cash refunds to customers.
Investing activities generally include transactions involving the acquisition or disposal of noncurrent assets.
Thus, cash inflows from investing activities include cash received from: (1) the sale of property, plant, and
equipment; (2) the sale of available-for-sale and held-to-maturity securities; and (3) the collection of long-term
loans made to others. Cash outflows for investing activities include cash paid: (1) to purchase property, plant, and
equipment; (2) to purchase available-for-sale and held-to-maturity securities; and (3) to make long-term loans to
others.
Financing activities generally include the cash effects (inflows and outflows) of transactions and other events
involving creditors and owners. Cash inflows from financing activities include cash received from issuing capital
stock and bonds, mortgages, and notes, and from other short- or long-term borrowing. Cash outflows for financing
activities include payments of cash dividends or other distributions to owners (including cash paid to purchase
treasury stock) and repayments of amounts borrowed. Payment of interest is not included because interest expense
appears on the income statement and is, therefore, included in operating activities. Cash payments to settle
accounts payable, wages payable, and income taxes payable are not financing activities. These payments are
included in the operating activities section.
Information about all material investing and financing activities of an enterprise that do not result in cash
receipts or disbursements during the period appear in a separate schedule, rather than in the statement of cash
flows. The disclosure may be in narrative form. For instance, assume a company issued a mortgage note to acquire
land and buildings. A separate schedule might appear as follows:
Schedule of noncash financing also investing activities:
Mortgage note issued for acquiring land also buildings $35,000
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An accounting perspective:
Business insight
In a supplemental schedule of noncash investing and financing activities, Johnson & Johnson
reported one item as follows:
Treasury stock issued for employee compensation and stock option plans, net of cash proceeds
USD 252 million
The company included the cash proceeds amount from the exercise of stock options (USD 149
million) in the cash flows from financing activities section of the statement of cash flows.
Cash flows from operating activities
Cash flows from operating activities show the net amount of cash received or disbursed during a given
period for items that normally appear on the income statement. You can calculate these cash flows using either the
direct or indirect method. The direct method deducts from cash sales only those operating expenses that
consumed cash. This method converts each item on the income statement directly to a cash basis. Alternatively, the
indirect (addback) method starts with accrual basis net income and indirectly adjusts net income for items that
affected reported net income but did not involve cash.
The Statement of Financial Accounting Standards No. 95 encourages use of the direct method but permits use
of the indirect method. Whenever given a choice between the indirect and direct methods in similar situations,
accountants choose the indirect method almost exclusively. The American Institute of Certified Public Accountants
reports that approximately 98 per cent of all companies choose the indirect method of cash flows.
The direct method converts each item on the income statement to a cash basis. For instance, assume that sales
are stated at USD 100,000 on an accrual basis. If accounts receivable increased by USD 5,000, cash collections
from customers would be USD 95,000, calculated as USD 100,000 - USD 5,000. The direct method also converts
all remaining items on the income statement to a cash basis, as we will illustrate later.
The indirect method adjusts net income (rather than adjusting individual items in the income statement) for (1)
changes in current assets (other than cash) and current liabilities, and (2) items that were included in net income
but did not affect cash.
The most common example of an operating expense that does not affect cash is depreciation expense. The
journal entry to record depreciation debits an expense account and credits an accumulated depreciation account.
This transaction has no effect on cash and, therefore, should not be included when measuring cash from operations.
Because accountants deduct depreciation in computing net income, net income understates cash from operations.
Under the indirect method, since net income is a starting point in measuring cash flows from operating activities,
depreciation expense must be added back to net income.
Consider the following example. Company A had net income for the year of USD 20,000 after deducting
depreciation of USD 10,000, yielding USD 30,000 of positive cash flows. Thus, Company A had USD 30,000 of
positive cash flows from operating activities. Company B had a net loss for the year of USD 4,000 after deducting
Accounting Principles: A Business Perspective 634 A Global Text
16. Analysis using the statement of cash flows
USD 10,000 of depreciation. Although Company B experienced a loss, it had USD 6,000 of positive cash flows from
operating activities, as shown here:
Company A
Company B
Net income (loss) $20,000 $(4,000) Add depreciation expense (which did not require use of cash)
10,000 10,000
Positive cash flows from operating activities $30,000 $ 6,000
Company B's loss would have had to exceed USD 10,000 to generate negative cash flows from operating
activities.
Companies add other expenses and losses back to net income because they do not actually use company cash;
they call these addbacks noncash charges or expenses. Besides depreciation, the items added back include
amounts of depletion that were expensed, amortization of intangible assets such as patents and goodwill,
amortization of discount on bonds payable, and losses from disposals of noncurrent assets.
An accounting perspective:
Business insight
Business Insight PSINet, Inc., an Internet-access provider, said it would have a positive cash flow
from operations for the first time in early 1997. The company was the first to provide unlimited
access to the Internet to consumers at a flat rate of USD 19.95 per month. However, it was costing
about USD 22 per month per customer to provide the service. The company decided to abandon
this market and sell only to the more profitable corporate market. Corporate clients can be charged
about USD 200 per month for dial-up access.
Source: "PSINet Sees Positive Cash Flow in '97; Likely Financial Boost Lifts Shares 24 per cent,"
The Wall Street Journal, Friday, December 27, 1996, p. B11.
To illustrate the addback of losses from disposals of noncurrent assets, assume that Quick Company sold a piece
of equipment for USD 6,000. The equipment had cost USD 10,000 and had accumulated depreciation of USD
3,000. The journal entry to record the sale is:
Cash (+A) 6,000 Accumulated depreciation 3,000 Loss on sale of equipment (-SE) 1,000 Equipment (-A) 10,000 To record disposal of equipment at a loss.
Quick would show the USD 6,000 inflow from the sale of the equipment as a cash inflow from investing
activities on its statement of cash flows. Although Quick deducted the loss of USD 1,000 in calculating net income,
it recognized the total USD 6,000 effect on cash (which reflects the USD 1,000 loss) as resulting from an investing
activity. Thus, Quick must add the loss back to net income in converting net income to cash flows from operating
activities to avoid double-counting the loss.
Certain revenues and gains included in arriving at net income do not provide cash; these items are noncash
credits or revenues. Quick should deduct these revenues and gains from net income to compute cash flows from
operating activities. Such items include gains from disposals of noncurrent assets, income from investments carried
under the equity method, and amortization of premiums on bonds payable.
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To illustrate why we deduct the gain on the disposal of a noncurrent asset from net income, assume that Quick
sold the equipment just mentioned for USD 9,000. The journal entry to record the sale is:
Cash (+A) 9,000 Accumulated depreciation 3,000 Equipment (-A) 10,000 Gain on sale of equipment (+SE) 2,000 To record disposal of equipment at a gain.
Quick shows the USD 9,000 inflow from the sale of the equipment on its statement of cash flows as a cash inflow
from investing activities. Thus, it has already recognized the total USD 9,000 effect on cash (including the USD
2,000 gain) as resulting from an investing activity. Since the USD 2,000 gain is also included in calculating net
income, Quick must deduct the gain in converting net income to cash flows from operating activities to avoid
double-counting the gain.
Steps in preparing statement of cash flows
Accountants follow specific procedures when preparing a statement of cash flows. We show these procedures
using the financial statements and additional data for Welby Company in Exhibit 128.
After determining the change in cash, the first step in preparing the statement of cash flows is to calculate the
cash flows from operating activities, using either the direct or indirect method. The second step is to analyze all of
the noncurrent accounts and additional data for changes resulting from investing and financing activities. The third
step is to arrange the information gathered in steps 1 and 2 into the proper format for the statement of cash flows.
The direct method converts the income statement from the accrual basis to the cash basis. Accountants must
consider changes in balance sheet accounts that are related to items on the income statement. The accounts
involved are all current assets or current liabilities. The following schedule shows which balance sheet accounts are
related to the items on Welby's income statement:
Income statement Items
Related balance sheet items
Cash flows from Operating activities
Sales Accounts receivableCash received from customers
Cost of goods sold Accounts payable and merchandise inventory
Cash paid for merchandise
Operating expenses and taxes Accrued liabilities and prepaid expenses
Cash paid for operating expenses
For other income statement items, the relationship is often obvious. For instance, salaries payable relates to
salaries expense, federal income tax payable relates to federal income tax expense, prepaid rent relates to rent
expense, and so on.
The table below shows how income statement items are affected by balance sheet accounts:
Accrual Basis Cash basis (cash flows from operating activities)
Sales + Decrease or – Increase in Accounts Receivable
=Cash received from customers
Cost of goods sold
+ Increase or – Decrease in Merchandise Inventory and =Cash paid for merchandise + Decrease or – Increase in Accounts Payable
Operating expenses Decrease or – Increase in related accrued liability And =Cash paid for operating expense
Accounting Principles: A Business Perspective 636 A Global Text
16. Analysis using the statement of cash flows
Increase or – Decrease in related prepaid expense
Noncash operating expenses (such as depreciation expense and amortization expense), revenues, gains, and
losses are reduced to zero in the cash basis income statement.
Welby Company Comparative balance sheet
2010 December 31 and 2009 2010 2009 Increase/
(Decrease) Assets Cash $21,000 $ 10,000 $11,000 Accounts receivable 30,000 20,000 10,000 Merchandise inventory 26,000 30,000 (4,000) Equipment 70,000 50,000 20,000 Accumulated depreciation – Equipment
(10,000) (5,000) (5,000)
Total assets $137,000$105,000 $32,000 Liabilities and stockholders' equity Accounts payable $9,000 $ 15,000 $(6,000) Accrued liabilities payable 2,000 -0- 2,000 Common stock ($10 par value) 90,000 60,000 30,000 Retained earnings 36,000 30,000 6,000 Total liabilities and stockholders' equity
$137,000$105,000 $32,000
Welby Company Income statement
For the year ended 2010 December 31 Sales $140,000 Cost of goods sold 100,000 Gross margin $ 40,000 Operating expenses (other than depreciation)
$25,000
Depreciation expense 5,000 30,000 Net income $ 10,000
Additional data 1. Equipment purchased for cash during 2010 amounted to $20,000. 2. Common stock with a par value of $30,000 was issued at par for cash. 3. Cash dividends declared and paid in 2010 totaled $4,000.
Exhibit 128: Financial statements and other data
Welby Company Working paper to convert income statement from accrual basis to cash basis
For the year ended 2010 December 31
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Accrual Basis Add Deduct Cash Basis (Cash activities)
Flows from operating
Sales $140,000 $10,000* $130,000 Cost of goods sold $100,00
0 $6,000† 4,000‡ $102,000
Operating expenses 25,000 2,000§ 23,000 Depreciation expense
5,000 5,000
______ -0- $130,000 125,000
Net income $10,000 $ 5,000 * Increase in Accounts Receivable. †Decrease in Accounts Payable. ‡ Decrease in Merchandise Inventory. § Increase in Accrued Liabilities Payable.
Exhibit 129: Working paper to convert income statement from accrual basis to cash basis
As a general rule, an increase in a current asset (other than cash) decreases cash inflow or increases cash
outflow. Thus, when accounts receivable increases, sales revenue on a cash basis decreases (some customers who
bought merchandise have not yet paid for it). When inventory increases, cost of goods sold on a cash basis increases
(increasing cash outflow). When a prepaid expense increases, the related operating expense on a cash basis
increases. (For example, a company not only paid for insurance expense but also paid cash to increase prepaid
insurance.) The effect on cash flows is just the opposite for decreases in these other current assets.
An increase in a current liability increases cash inflow or decreases cash outflow. Thus, when accounts payable
increases, cost of goods sold on a cash basis decreases (instead of paying cash, the purchase was made on credit).
When an accrued liability (such as salaries payable) increases, the related operating expense (salaries expense) on a
cash basis decreases. (For example, the company incurred more salaries than it paid.) Decreases in current
liabilities have just the opposite effect on cash flows.
Welby Company had no prepaid expenses. The current assets and current liabilities affecting the income
statement items changed as follows:
Increase Decrease Accounts receivable $10,000 Merchandise inventory $4,000 Accounts payable 6,000 Accrued liabilities payable 2,000
Thus, Welby converted its income statement to a cash basis as shown in Exhibit 129.
The indirect method makes certain adjustments to convert net income to cash flows from operating activities.
Welby must analyze the effects of changes in current accounts (other than cash) on cash. The firm should also take
into account noncash items such as depreciation that affected net income but not cash. Welby had only one such
item—depreciation expense of USD 5,000. Applying these adjustments to Welby's financial statements and other
data in Exhibit 128 yields the following schedule:
Cash flow from operating activities: Net income $10,000 Adjustments to reconcile net income to net cash provided by operating activities:
Accounting Principles: A Business Perspective 638 A Global Text
16. Analysis using the statement of cash flows
Increase in accounts receivable (10,000) Decrease in merchandise inventory 4,000 Decrease in accounts payable (6,000) Increase in accrued liabilities payable 2,000 Depreciation expense 5,000 Net cash provided by operating activities $5,000
Notice that both the direct and indirect methods result in USD 5,000 net cash provided by operating activities.
You can use the following table to make the adjustments to net income for the changes in current assets and
current liabilities:
For changes in these current assets and current liabilities:
Make these adjustments to convert accrual basis net income to cash basis net income:
Add Deduct Accounts receivable Decrease Increase Merchandise inventory Decrease Increase Prepaid expenses Decrease Increase Accounts payable Increase Decrease Accrued liabilities payable Increase Decrease
Note that you would handle all changes in current asset accounts in a similar manner. All changes in current
liability accounts require the opposite treatment of the current asset changes. Use this table in making these
adjustments:
For changes in- Add the changes to net income
Deduct the changes from net income
Current assets Decreases Increases Current liabilities Increases Decreases
In applying the rules in this table, add a decrease in a current asset to net income, and deduct an increase in a
current asset from net income. For current liabilities, add increases to net income, and deduct decreases from net
income.
Under the indirect method, the amount of cash flows from operating activities is calculated as follows:
Accrual basis net income
+ or - Changes in noncash current asset and current liability accounts
+ Expenses and losses not affecting cash
- Revenues and gains not affecting cash
= Cash flows from operating activities
After analyzing the changes in current accounts for their effect on cash, we examine the noncurrent accounts
and additional data. Remember that a change in a noncurrent account usually comes about because cash is received
or disbursed.
In the Welby example, we must analyze four noncurrent accounts: Retained Earnings, Equipment, Accumulated
Depreciation—Equipment, and Common Stock.
• The analysis of the noncurrent accounts can begin with any of the noncurrent accounts; we begin by
reviewing the Retained Earnings account. Retained Earnings is the account to which net income or loss for the
period was closed. The USD 6,000 increase in this account consists of USD 10,000 of net income less USD
4,000 of dividends paid.
Retained earnings Beg. Bal. 30,000
Dividends 4,000 Net income 10,000 End bal. 36,000
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The net income amount is in the income statement. We enter both net income and dividends on the statement of
cash flows in Exhibit 130, Part B. The USD 10,000 net income is the starting figure in determining cash flows from
operating activities. Thus, we enter the net income of USD 10,000 on the statement in the cash flows from
operating activities section. The dividends are shown as a deduction in the cash flow from financing activities
section.
• The Equipment account increased by USD 20,000. The dividends are shown as a deduction in the cash flow
from financing activities section. The additional data indicate that USD 20,000 of equipment was purchased
during the period. A purchase of equipment is a deduction in the cash flows from investing activities section.
• The USD 5,000 increase in the Accumulated Depreciation—Equipment account equals the amount of
depreciation expense in the income statement for the period. As shown earlier, because depreciation does not
affect cash, under the indirect (addback) method we add it back to net income on the statement of cash flows
to convert accrual net income to a cash basis.
• The USD 30,000 increase in common stock resulted from the issuance of stock at par value, as disclosed in
the additional data (item 2) in Exhibit 128. An issuance of stock in the statement of cash flows is a positive
amount in the cash flows from financing activities section.
After we have analyzed the noncurrent accounts, we can prepare the statement of cash flows from the
information generated. Part A of Exhibit 130 presents the statement of cash flows for Welby using the direct
method. Part B shows the statement of cash flows for Welby using the indirect method. The appendix to this
chapter shows how a working paper can be used to assist in preparing a statement of cash flows for the Welby
Company under the indirect method. However, we believe you will gain a greater conceptual understanding by not
using a working paper.
The statement of cash flows has three major sections: cash flows from operating activities, cash flows from
investing activities, and cash flows from financing activities. The format in the operating activities section differs for
the direct and indirect methods. The direct method adjusts each item in the income statement to a cash basis. The
indirect method makes these same adjustments but to net income rather than to each item in the income statement.
Both methods eliminate not only the effects of noncash items, such as depreciation, but also gains and losses on
sales of plant assets.
The only item in the cash flows from investing activities section is the cash outflow of USD 20,000 for the
purchase of equipment. In a more complex situation, other items could be included in this category.
Two items are under the cash flows from financing activities section: The issuance of common stock resulted in a
cash inflow of USD 30,000 and the payment of dividends resulted in a cash outflow of USD 4,000.
The last line of the statement is the USD 11,000 increase in cash for the year. Other examples could result in a
decrease in cash for the year.
If the direct method is used, the reconciliation of net income to net cash flows from operating activities (the
indirect method) must be shown in a separate schedule. However, if the indirect method is used and the
reconciliation is shown in the statement of cash flows, no such separate schedule is required. Possibly this is one of
the reasons why so many companies use the indirect method.
However, if the indirect method is used, the amount of interest and income taxes paid must be provided in
related disclosures, usually immediately below the statement of cash flows. For instance, if Welby Company had
paid interest of USD 200 and income taxes of USD 8,000, these facts would be reported as follows:
Accounting Principles: A Business Perspective 640 A Global Text
16. Analysis using the statement of cash flows
A. Direct Method Welby Company
Statement of cash flows For the year ended 2010 December 31
Cash flows from operating activities: Cash received from customers $130,000 Cash paid for merchandise (102,000) Cash paid for operating expenses (23,000) Net cash provided by operating activities $5,000 Cash flows from investing activities: Purchase of equipment (20,000) Cash flows from financing activities: Proceeds from issuing common stock $ 30,000 Paid cash dividends (4,000) Net cash provided by financing activities 26,000 Net increase (decrease) in cash $11,000 B. Direct Method
Welby Company Statement of cash flows
For the year ended 2010 December 31
Cash flows from operating activities: Net income $10,000 Adjustments to reconcile net income to net cash Provided by operating activities: Increase in accounts receivable (10,000) Decrease in merchandise inventory 4,000 Decrease in accounts payable (6,000) Increase in accrued liabilities payable 2,000 Depreciation expense 5,000 Net cash provided by operating activities $ 5,000 Cash flows from investing activities: Purchase of equipment (20,000) Cash flows from financing activities: Proceeds from issuing common stock $ 30,000 Paid cash dividends (4,000) Net cash provided by financing activities 26,000 Net increase (decrease) in cash $11,000
Exhibit 130: Statement of cash flows-Welby company
Supplemental cash flow information: Interest paid $ 200 Income taxes paid 8,000
Analysis of the statement of cash flows
Business students will benefit throughout their careers from knowing how to analyze a statement of cash flows.
We will use the consolidated statement of cash flows from Synotech, Inc. to illustrate the analysis. This company
will be used in the next chapter to illustrate the complete analysis and interpretation of all the financial statements.
The example is adapted from a real USA company's recent annual report.
Exhibit 131 shows the consolidated statements of cash flows for the years 2010, 2009, and 2008 for Synotech,
Inc. We also include portions of Management's Discussion and Analysis of the 2010 statement of cash flows. We
will then discuss the statement further, explaining various items and illustrating how the information might be used
for decision making.
Liquidity and capital resources
Net cash provided by operations increased 13 per cent to USD 1,101.0 in 2010 compared with USD 972.3 in
2009 and USD 995.3 in 2008. The increase in cash generated by operating activities in 2010 reflects the Company's
improved profitability and working capital management. Cash generated from operations was used to fund capital
spending, reduce debt levels and increase dividends.
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During 2010, long-term debt decreased from USD 3,634.8 to USD 3,476.6. The Company continued to focus on
enhancing its debt portfolio, resulting in the refinancing of a substantial portion of commercial paper and other
short-term borrowings to longer term instruments. In 2010, the Company entered into a USD 595.6 loan agreement
and obtained a USD 487.2 term loan with foreign commercial banks.
As of 2010 December 31, USD 410.3 of domestic and foreign commercial paper was outstanding. These
borrowings carry a Standard & Poor's rating of A1. The commercial paper as well as other short-term borrowings
are classified as long-term debt at 2010 December 31, as it is the Company's intent and ability to refinance such
obligations on a long-term basis. The Company has additional sources of liquidity available in the form of lines of
credit maintained with various banks. At 2010 December 31, such unused lines of credit amounted to USD 2,142.8.
The ratio of net debt to total capitalization (defined as the ratio of the book values of debt less cash and
marketable securities ["net debt"] to net debt plus equity) decreased to 58 per cent during 2010 from 64 per cent in
2009. The decrease is primarily the result of higher Company earnings in 2010 as well as effective working capital
management and lower acquisitions than in prior years. The ratio of market debt to market capitalization (defined
as above using fair market values) decreased to 17 per cent during 2010 from 23 per cent in 2009. The Company
primarily uses market value analyses to evaluate its optimal capitalization.
Capital expenditures were 5.2 per cent of net sales in both 2010 and 2009 and were 5.3 per cent of net sales in
2008. Capital spending continues to be focused primarily on projects that yield high aftertax returns, thereby
reducing the Company's cost structure. Capital expenditures for 2008 are expected to continue at the current rate
of approximately 5 per cent of net sales.
Other investing activities in 2010, 2009 and 2008 included strategic acquisitions and equity investments
worldwide. The aggregate purchase price of all 2010, 2009 and 2008 acquisitions was USD 46.2, USD 1,586.3 and
USD 179.8, respectively.
During 2008, the Company repurchased a significant amount of common shares in the open market and private
transactions to provide for employee benefit plans and to maintain its targeted capital structure. Aggregate
repurchases for the year approximated 6.9 million shares with a total purchase price of USD 493.3.
Accounting Principles: A Business Perspective 642 A Global Text
16. Analysis using the statement of cash flows
(USD millions) 2010 2009 2008 Operating activities Net income $762.0 $ 206.4 $ 696.2 Adjustments to reconcile net income to net cash provided by operations: Restructured operations, net (126.7) 509.9 (46.9) Depreciation and amortization
379.6 360.4 282.2
Deferred income taxes and other, net
(27.6) (75.5) 77.6
Cash effects of changes in: Receivables (18.5) (52.9) (60.1) Inventories (1.4) (31.3) (53.4) Other current assets -0- (50.9) (9.4) Payables and accruals 133.6 106.2 109.1 Net cash provided by operations
$ 1,101.0 $ 972.3 $ 995.3
Investing activities Capital expenditures $ (550.8) $ (518.2) $ (481.0) Payment for acquisitions, net of cash acquired
(71.2) (1,560.5) (175.7)
Sale of marketable securities and other investments
31.6 7.4 70.1
Other, net (14.4) (20.6) 37.3 Net cash used for investing activities
$ (604.8) $ (2,091.9) $ (549.3)
Financing activities Principal payments on debt $ (1,397.5) $ (20.5) $ (106.0) Proceeds from issuance of debt, net
1,292.9 1,464.0 379.7
Proceeds from outside investors
10.3 36.6 18.2
Dividends paid (355.5) (331.8) (296.3) Purchase of common stock (32.9) (10.8) (429.5) Proceeds from exercise of stock options and other, net
36.8 33.9 22.2
Net cash (used for) provided by financing activities
$ (445.9) $ 1,171.4 $ (411.7)
Effect of exchange rate changes on cash and cash equivalents
$ (2.8) $ (5.2) $ (3.3)
Net increase in cash and cash equivalents
$ 47.5 $ 46.6 $ 31.0
Cash and cash equivalents at beginning of year
250.5 203.9 172.9
Cash and cash equivalents at end of year
$ 298.0 $ 250.5 $ 203.9
Supplemental cash flow information Income taxes paid $ 304.4 $ 351.0 $ 313.3 Interest paid 274.9 274.3 116.3 Non-cash consideration in payment for acquisitions
-0- 58.7 9.6
Principal payments on ESOP debt, guaranteed by the Company
(6.0) (5.3) (4.8)
Exhibit 131: Consolidated statements of cash flows for Synotech, Inc. - Indirect method
Dividend payments were USD 355.5 in 2010, up from USD 331.8 in 2009 and USD 296.3 in 2008.
Internally generated cash flows appear to be adequate to support currently planned business operations,
acquisitions and capital expenditures. Significant acquisitions would require external financing.
The Company is a party to various superfund and other environmental matters and is contingently liable with
respect to lawsuits, taxes and other matters arising out of the normal course of business. Management proactively
reviews and manages its exposure to, and the impact of, environmental matters. While it is possible that the
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Company's cash flows and results of operations in particular quarterly or annual periods could be affected by the
one-time impacts of the resolution of such contingencies, it is the opinion of management that the ultimate
disposition of these matters, to the extent not previously provided for, will not have a material impact on the
Company's financial condition or ongoing cash flows and results of operations.
Refer to Exhibit 131. First we will discuss the items in the operating activities section of the statement of cash
flows, then we will discuss investing activities and financing activities.
Operating activities The company used the indirect method of calculating net cash provided by operations.
Various adjustments were made to convert accrual based net income to cash basis net income.
The "restructured operations, net" item resulted from the fact that many companies restructured their
operations by closing plants and significantly reducing their work forces. Some companies recognized a net loss
from restructuring and others recognized a net gain. Apparently, the company recognized a net gain in 2010
because it deducted the item from net income on the statement of cash flows. The actual cash flows from
restructuring will occur in a later period.
"Depreciation and amortization" includes depreciation on plant assets and amortization of intangible assets.
Depreciation and amortization are noncash charges against revenues and must be added back to net income.
The "deferred income taxes and other, net" item deduction from net income results primarily from the fact that
income tax expense on the income statement was lower than the actual income taxes paid in 2010. This
phenomenon occurs because of using a different method for tax and accounting purposes for such items as
depreciation.
Receivables and inventories increased (causing cash to decrease), while other current assets remained about the
same. Payables and accruals increased (causing cash to increase). These changes are net of any amounts related to
acquisitions, dispositions, or amounts that are included elsewhere, such as in "restructured operations, net". The
changes described may differ from the amounts derived from only analyzing the balance sheets for the last two
years because of certain technical "adjustments" that are beyond the scope of this text.
Investing activities "Capital expenditures" include the purchase of plant assets, such as new machinery and
equipment, to modernize production facilities. Companies normally select those capital expenditures with the
highest rate of return. For instance, if funds are limited (and they normally are) and two capital investments (a
machine and a mainframe computer) are being considered, one yielding a 20 per cent return and the other yielding
a 25 per cent return, the company will normally select the one with the 25 per cent return.
"Payment for acquisitions, net of cash acquired" shows the amount spent in acquiring other companies and
segments of other companies, net of the amount of cash held by those companies and obtained as a part of the
acquisition.
The company sold "marketable securities and other investments". These securities normally consist of stocks,
bonds, and other instruments of other companies. For fiscal years beginning after 1993 December 15, marketable
securities must be identified as trading securities, available-for-sale securities, or held-to-maturity securities.
Trading securities and available-for-sale securities were discussed in some detail in Chapter 14. Held-to-maturity
securities were mentioned briefly in Chapter 15. These held-to-maturity securities are debt securities (such as bonds
of other companies) that the company has purchased and has both the intent and ability to hold to maturity. As
mentioned earlier, the proceeds from sales and purchases of trading securities must be shown as cash flows from
Accounting Principles: A Business Perspective 644 A Global Text
16. Analysis using the statement of cash flows
operating activities, and the proceeds from sales and purchases of available-for-sale and held-to-maturity securities
must be shown as cash flows from investing activities.
Financing activities The company paid off some old debt (USD 1,397.5 million) and incurred new debt (USD
1,292.9 million). Recently many companies are substituting new debt with a low interest rate for old debt with a
high interest rate, just as homeowners refinance their homes to lower their interest rate.
The "proceeds from outside investors" resulted from the other participants in the formation of certain
businesses in which the company holds more than a 50 per cent share.
"Dividends paid" is an item that should be familiar to you. Dividends paid increased each year for the period
2008 through 2010.
The company bought back some of its own stock (treasury stock). Companies often buy back their own shares
because they (1) need the shares to issue to employees or officers under stock option plans, (2) want to bolster the
market price of the stock, or (3) hope to later sell the stock at a substantially higher price.
"Proceeds from exercise of stock options and other, net" represents the proceeds received from employees and
officers who exercised their stock options. Stock options are usually granted to employees to encourage them to
work efficiently to increase profitability, which should increase the market price of the stock. Stock options made
available to officers are for the same purpose or to attract or retain a talented executive. Normally, an option gives
the recipient the right to buy a certain number of shares at a stated price within a given time frame. For instance,
the president of a company may be granted an option to buy 10,000 shares at USD 40 per share any time after two
years from that date and before six years from that date. Assume that the current market price is USD 38. If the
market price of the stock rises to USD 80 at some time during the option period, the president could buy the shares
at USD 40 and then hold them or sell them at the higher market price. Executives of companies have become
multimillionaires by exercising their stock options. The employees and executives of Synotech, Inc., paid the
company between USD 22.2 million and USD 36.8 million per year to exercise their stock options during the three-
year period. The company re-issued some of its treasury stock as a result of the exercise of the stock options.
We will discuss some examples of the ways that the information in the statement of cash flows can be used by
management, stockholders, and creditors to make decisions. Each of these parties would use more than the
statement of cash flows to perform an analysis of the company's performance, but we will restrict ourselves to the
statement of cash flows. The next chapter shows a more complete analysis of the company's performance.
Management Management is the first to see the information contained in the statement of cash flows. You
have already read portions of "Management's Discussion and Analysis" concerning the information contained in
that statement. Management concluded that the amount of internally generated cash flows (net cash provided by
operations) appears adequate to support currently planned business operations, acquisitions, and capital
expenditures. Thus, unless the company engages in a significant acquisition it will not have to sell more stock or
borrow more funds in the foreseeable future. Also, the company apparently replaced some of its high interest rate
debt (USD 1,397.5 million) with lower interest rate debt (USD 1,292.9 million). Many companies are doing this
same thing recently to take advantage of the low interest rates available.
Stockholders Stockholders can see that dividend payments (USD 355.5 million) are comfortably covered by
net cash provided by operations (USD 1,101.0 million). Stockholders are undoubtedly pleased that the per share
dividend rate has increased each year during 2008 through 2010. The company continues to invest in its future by
making capital expenditures (USD 550.8 million) to modernize its productive facilities. The repurchase of its own
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stock (USD 32.9 million) decreases the number of shares outstanding, although some of the stock will undoubtedly
be reissued in the future as employees and executives exercise their stock options. Any net reduction in the number
of shares outstanding will tend to increase earnings per share and help to increase the market price per share in the
future. Also, the company may decide to increase dividends per share in the future. These favorable factors might
induce present stockholders to retain their stock or even increase their holdings. Potential stockholders might also
be attracted to the stock.
A broader perspective:
Johnson & Johnson
Johnson & Johnson and Subsidiaries Consolidated statements of cash flows
For the years ended 2000 June 30, 1999, and 1998 (USD millions)
Cash flows from operating activities 2000 1999 1998 Net earnings $ 4,800 4,167 3,003 Adjustments to reconcile net earnings to cash flows: Depreciation and amortization of property and intangibles 1,515 1,444 1,285 Purchased in-process research and development 54 298 Increase in deferred taxes (167) (7) (297) Accounts receivable reserves 33 11 24 Changes in assets and liabilities, net of effects from acquisition of businesses: Increase in accounts receivable (451) (671) (163) Decrease (increase) in inventories 125 (333) (100) Increase in accounts payable and accrued liabilities 57 242 646 Decrease in other current and non-current assets 143 457 142 Increase in other current and non-current liabilities 454 450 153 Net cash flows from operating activities $ 6,563 $ 5,760 $ 4,991 Cash flows from investing activities Additions to property, plant and equipment $(1,646) $(1,728) $(1,545) Proceeds from the disposal of assets 161 35 108 Acquisitions of businesses, net of cash acquired (68) (271) (3,818) Purchases of investments (5,383) (3,538) (1,005) Sales of investments 4,670 2,817 400 Other (102) (257) (205) Net cash used by investing activities $ (2,368) $ (2,942) $ (6,065) Cash flows from financing activities Dividends to shareowners $(1,724) $(1,479) $(1,305) Repurchase of common stock (973) (840) (930) Proceeds from short-term debt 814 3,208 2,424 Retirement from short-term debt (1,485) (4,063) (226) Proceeds from long-term debt 4 793 535 Retirement from long-term debt (28) (176) (471) Proceeds from the exercise of stock options 292 180 178 Net cash (used by) provided by financing activities $(3,100) $(2,377) $205 Effect of exchange rate changes on cash and cash equivalents
(47) (72) 24
Increase (decrease) in cash and cash equivalents 1,048 369 (845) Cash and equivalents, beginning of year 2,363 1,994 2,839 Cash and cash equivalents, end of year $3,411 $2,363 $ 1,994
Creditors An encouraging factor is the increasing amount of net cash provided by operations in 2010. Also
comforting to creditors is the information in Management's Discussion and Analysis that the company has access to
USD 2,142.8 million in lines of credit.
The preceding discussions are merely examples of how the information contained in the statement of cash flows
might be analyzed to make decisions. The next section describes three ratios that can provide further analyses of
cash flows.
Accounting Principles: A Business Perspective 646 A Global Text
16. Analysis using the statement of cash flows
Analyzing and using the financial results—Cash flow per share of common stock, cash flow margin, and cash flow liquidity ratios
The information in the statement of cash flows provides a basis for analyzing financial results. However, further
analysis is possible through the use of three ratios relating to cash flow: the cash flow per share of common stock,
cash flow margin, and cash flow liquidity ratios. The ratios shown below are results for Synotech, Inc. and recent
results for other companies. All dollar amounts are rounded to the nearest million.
The cash flow per share of common stock ratio is equal to the net cash provided by operations divided by
the average number of shares of common stock outstanding. This ratio indicates the company's ability to pay
dividends and liabilities. The higher the ratio, the greater the ability to pay. The cash flow per share of common
stock ratios for the companies were:
Company Net cash provided by operating activities (millions)
Average shares of common stock outstanding* (millions)
Cash flow per share
Synotech, Inc. $1,101 147 $7.49 J.C. Penney, Inc. 1,598 262 6.10 The Walt Disney Company
6,434 2,092 3.08
General Electric Company
22,690 9,893 2.29
*To determine the average number of shares, add the beginning and ending numbers outstanding and divide by
two.
The cash flow margin ratio is equal to net cash provided by operating activities divided by net sales. This
ratio is a measure of a company's ability to turn sales revenue into cash. The higher the ratio, the better. The cash
flow margin ratios for the companies were:
Company Net Cash provided by operating activities (millions)
Net sales (millions)
Cash flow Margin
Synotech, Inc. $1,101 10,499 10.49% J.C. Penney, Inc. 1,598 31,846 5.02% The Walt Disney Company
6,434 25,402 25.33%
General Electric Company22,690 128,051 17.72%
The cash flow liquidity ratio is equal to the total of cash, marketable securities, and net cash provided by
operating activities divided by current liabilities. This ratio is a test of a company's short-term, debt-paying ability.
The higher the ratio, the better. The cash flow liquidity ratios for the companies were:
Company Cash, marketable securities, and net cash provided by operating activities (millions)
Current liabilities (millions)
Cash flow liquidity ratio
Synotech, Inc. $1,470 $2,285 .64 times J.C. Penney, Inc. 2,542 4,235 .60 times The Walt Disney Company
7,276 8,402 .87 times
General Electric Company
35,913 156,116 .23 times
On the first of these measures, Synotech, Inc., seems to be in the strongest position, although all of the
companies are financially sound. On the second measure, Walt Disney and General Electric have the highest cash
flow margin ratios. On the third measure, Walt Disney seems to be in the strongest position. However, a more valid
comparison on each of these measures would be made if each of these companies was compared with other
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companies in its industry. Dun & Bradstreet's Industry Norms and key business ratios can be used for this purpose.
(This source could also be used for comparisons of ratios in the next chapter.) A complete analysis using the
techniques described in the next chapter would provide additional information about the strengths and weaknesses
of each of these companies.
Understanding the learning objectives
• The statement of cash flows summarizes the effects on cash of the operating, financing, and investing
activities of a company during an accounting period.
• Management can see the effects of its past major policy decisions in quantitative form.
• Investors and creditors can assess the entity's ability to generate positive future net cash flows, to meet its
obligations, and to pay dividends, and can assess the need for external financing.
• Operating activities generally include the cash effects (inflows and outflows) of transactions and other
events that enter into the determination of net income. The cash flows from operating activities can be
measured in two ways. The direct method deducts from cash sales only those operating expenses that
consumed cash. The indirect method starts with net income and adjusts net income for items that affected
reported net income but did not involve cash.
• Investing activities generally include transactions involving the acquisition or disposal of noncurrent assets.
• Financing activities generally include the cash effects (inflows and outflows) of transactions and other
events involving creditors and owners.
• The direct method deducts from cash sales only those operating expenses that consumed cash. The FASB
recommends use of the direct method. The indirect method starts with accrual basis net income and indirectly
adjusts net income for items that affected reported net income but did not involve cash. A large majority of
companies use the indirect method.
• The first step is to determine the cash flows from operating activities. Either the direct or indirect method
may be used.
• The second step is to analyze all the noncurrent accounts for changes in cash resulting from investing and
financing activities.
• The third step is to arrange the information gathered in steps 1 and 2 into the format required for the
statement of cash flows.
• Business students will benefit throughout their careers from knowing how to analyze a statement of cash
flows.
• "Management's Discussion and Analysis" in the annual report provides part of the analysis.
• Inspection of the statement of cash flows together with "Management's Discussion and Analysis" will
provide the most insight as to the cash flow situation.
• The cash flow per share of common stock ratio tests a company's ability to pay dividends and liabilities and
is equal to net cash provided by operating activities divided by the average number of shares of common stock
outstanding.
• The cash flow margin ratio measures a company's ability to turn sales revenue into cash and is equal to net
cash provided by operating activities divided by net sales.
Accounting Principles: A Business Perspective 648 A Global Text
16. Analysis using the statement of cash flows
• The cash flow liquidity ratio tests a company's short-term, debt-paying ability and is equal to the total of
cash, marketable securities, and net cash provided by operating activities divided by current liabilities.
• A work sheet can be used to assist in preparing a statement of cash flows.
• A company's comparative balance sheets, income statement, and additional data are used to prepare the
work sheet.
• The work sheet technique makes the recording of the effects of transactions on cash flows almost a mechanical
process.
Appendix: Use of a working paper to prepare a statement of cash flows
This appendix shows how a work sheet could be used to assist in preparing a statement of cash flows. We use the
comparative balance sheets, income statement, and additional data for the Welby Company, shown on Exhibit 129,
as the basis for this example.
Look at the working paper in Exhibit 132 for Welby Company, which we use to analyze the transactions and
prepare the statement of cash flows. While discussing the steps in preparing the working paper, we describe the
items and trace their effects in the entries.
• Enter the beginning account balances of all balance sheet accounts in the first column and the ending
account balances in the fourth column. Notice that the debit items precede the credit items.
• Total the debits and credits in the first and fourth columns to make sure that debits equal credits in each
column.
• Write "Cash Flows from Operating Activities" immediately below the total of the credit items. Skip
sufficient lines for recording adjustments to convert accrual net income to cash flows from operating activities.
Then write "Cash Flows from Investing Activities" and allow enough space for those items. Finally, write "Cash
Flows from Financing Activities" and allow enough space for those items.
• Enter entries for analyzing transactions in the second and third columns. The entries serve two functions:
(a) they explain the change in each account; and (b) they classify the changes into operating, investing, and
financing activities. We discuss these entries individually in the next section.
• Total the debits and credits in the second and third columns; they should be equal. You will have one pair of
totals for the balance sheet items and another pair for the bottom portion of the working paper. We use the
bottom portion of the working paper to prepare the statement of cash flows.
To complete the working paper in Exhibit 132, we must analyze the change in each noncash balance sheet
account. The focus of this working paper is on cash, and every change in cash means a change in a noncash balance
sheet account. After we have made the proper entries to analyze all changes in noncash balance sheet accounts, the
working paper shows all activities affecting cash flows. The following explanations are keyed to the entry numbers
on the working paper:
Entry 0 In comparing the beginning and ending cash balances, we determine the change in the Cash account
during the year is an USD 11,000 increase. An entry on the working paper debits Cash for USD 11,000 and credits
Increase in Cash for Year near the bottom of the schedule. This 0 entry does not explain the change in cash but is
the "target" of the analysis. The entry sets out the change in cash that the statement seeks to explain. No further
attention need be paid to cash in completing the working paper.
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We now direct our attention toward changes in other balance sheet accounts. These accounts can be dealt with
in any order; first, we record the net income for the period and analyze the current assets (other than cash) and the
current liabilities. Second, we analyze the changes in the noncurrent accounts.
Entry 1 The income statement shows a net income for 2010 of USD 10,000. Entry 1 records the USD 10,000 as
the starting point in measuring cash flows from operating activities and credits Retained Earnings as a partial
explanation of the change in that account.
The next task is to analyze changes in current accounts other than Cash. The current accounts of Welby
Company are closely related to operations, and their changes are included in converting net income to cash flows
from operating activities.
Entry 2 We deduct the USD 10,000 increase in accounts receivable from net income when converting it to cash
flows from operating activities. If accounts receivable increased, sales to customers exceeded cash received from
customers. To convert net income to a cash basis, we must deduct the USD 10,000.
The working paper technique makes the recording of these effects almost mechanical. By debiting Accounts
Receivable for USD 10,000, we increase it from USD 20,000 to USD 30,000. If Accounts Receivable is debited, we
must credit an item that can be entitled "Increase in Accounts Receivable". We deduct the increase from net income
in converting it to cash flows from operating activities.
Entry 3 is virtually a duplicate of entry 2, except it involves merchandise inventory rather than receivables and
is a decrease rather than an increase.
Entry 4 records the effect of a decrease in accounts payable on net income in converting it to cash flows from
operating activities.
Entry 5 records the effect of an increase in accrued liabilities payable in converting net income to cash flows
from operating activities.
Next, we analyze the changes in the noncurrent balance sheet accounts.
Entry 6 We add the USD 5,000 depreciation back to net income and credit the respective accumulated
depreciation account. You can find the depreciation expense (1) on the income statement, or (2) by solving for the
credit needed to balance the accumulated depreciation account on the balance sheet.
Welby Company Working paper for Statement of Cash Flows
For the Year Ending 2010 December 31 Account Balances
Analysis of transactions for 2010
Account balances
2009/12/31 Debit Credit 2010/12/31 Debits
Cash 10,000 (0) 11,000 21,000 Accounts receivable, net
20,000 (2) 10,000 30,000
Merchandise inventory
30,000 (3) 4,000 26,000
Equipment 50,000 (7) 20,000 70,000 Totals 110,000 147,000
Credits Accumulated depreciation – equipment
5,000 (6) 5,000 10,000
Accounts payable 15,000 (4) 6,000 9,000 Accrued liabilities payable
-0- (5) 2,000 2,000
Common stock ($10 par value)
60,000 (8) 30,000 90,000
Accounting Principles: A Business Perspective 650 A Global Text
16. Analysis using the statement of cash flows
Retained earnings 30,000 (9) 4,000 (1) 10,000 36,000 Totals 110,000 51,000 51,000 147,000 Cash flows from operating activities Net income (1) 10,000 Increase in accounts receivable
(2) 10,000
Decrease in merchandise inventory
(3) 4,000
Decrease in accounts payable
(4) 6,000
Increase in accrued liabilities payable
(5) 2,000
Depreciation expense
(6) 5,000
Cash flows from investing activities: Purchase of equipment
(7) 20,000
Cash flows from financing activities: Proceeds from issuing common stock
(8) 30,000
Payment of cash dividends
(9) 4,000
Increase in cash for year
(0) 11,000
51,000 51,000 Accumulated Depreciation - Equipment
Beg. Bal. 5,000 (6) 5,000 End. Bal. 10,000
Exhibit 132: Working paper for statement of cash flows
Entry 7 We debit the Equipment account and credit "Purchase of Equipment" in the investing activities section
for the USD 20,000 cash spent to acquire new plant assets (equipment).
Entry 8 We show the USD 30,000 cash received from sale of common stock as a financing activity. The entry
also explains the change in the Common Stock account. If stock had been sold for more than its stated value of USD
50 per share, we would record the excess in a separate Paid-In Capital in Excess of Stated Value account. However,
we would report the total amount of cash received from the issuance of common stock as a single figure on the
statement of cash flows. Only this total amount received is significant to creditors and other users of the financial
statements trying to judge the solvency of the company.
Entry 9 We debit Retained Earnings and credit Payment of Cash Dividends for the USD 4,000 dividends
declared and paid. The entry also completes the following explanation of the change in Retained Earnings. Notice
that on the statement of cash flows, the dividends must be paid to be included as a cash outflow from financing
activities.
Retained earnings Beg. Bal.
30,000
(9) 4,000 (1) 10,000 End. Bal.
36,000
Using the data in the lower section of the working paper, we would prepare the statement of cash flows under
the indirect method shown in Exhibit 130 (Part B).
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Demonstration problem
The following comparative balance sheets are for Dells Corporation as of 2010 June 30, and 2009 June 30. Also
provided is the statement of income and retained earnings for the year ended 2010 June 30, with additional data.
Dells Company Comparative balance sheet
2010 June 30 and 2009 2010 2009 Increase
(Decrease) Assets
Current assets: Cash $ 30,000 $ 80,000 $ (50,000) Accounts receivable, net 160,000 100,000 60,000 Merchandise inventory 100,000 70,000 30,000 Prepaid rent 20,000 10,000 10,000 Total current assets $310,000 $260,000 $ 50,000 Property, plant, and equipment: Equipment $400,000 $200,000 $200,000 Accumulated depreciation – equipment
(60,000) (50,000) (10,000)
Total property, plant, and equipment
$340,000 $150,000 $190,000
Liabilities and stockholders' equity
Current liabilities: Accounts payable $ 50,000 $ 40,000 $ 10,000 Notes payable – bank -0- 50,000 (50,000) Salaries payable 10,000 20,000 (10,000) Federal income taxes payable 30,000 20,000 10,000 Total current liabilities $ 90,000 $130,000 $ (40,000) Stockholders' equity: Common stock, $10 par $300,000 $100,000 $200,000 Paid-in capital in excess of par 50,000 -0- 50,000 Retained earnings 210,000 180,000 30,000 Total stockholders' equity $560,000 $280,000 $280,000 Total liabilities and stockholders' equity
$650,000 $410,000 $240,000
Dells Corporation Statement of income and retained earnings
For the year ended 2010 June 30 Sales $1,000,000 Cost of goods sold $600,000 Salaries and wages expense 200,000 Rent expense 40,000 Depreciation expense 20,000 Interest expense 3,000 Loss on sale of equipment 7,000 870,000 Income before federal income taxes $ 130,000 Deduct: Federal income taxes 60,000 Net income $ 70,000 Retained earnings, 2009 July 1 180,000
$ 250,000 Deduct: Dividends 40,000 Retained earnings, 2010 June 30 $210,000
Equipment with a cost of USD 20,000, on which USD 10,000 of depreciation had been recorded, was sold for
USD 3,000 cash. Additional equipment was purchased for USD 220,000.
Stock was issued for USD 250,000 cash.
The USD 50,000 bank note was paid.
Using the data given for Dells Corporation:
a. Prepare a statement of cash flows—indirect method.
Accounting Principles: A Business Perspective 652 A Global Text
16. Analysis using the statement of cash flows
b. Prepare a working paper to convert net income from an accrual basis to a cash basis. Then prepare a partial
statement of cash flows—direct method, showing only the cash flows from operating activities section.
Solution to demonstration problem
a.
Dells Company Statement of cash flows
For the year ended 2010 June 30 Cash flows from operating activities: Net income $ 70,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable
(60,000)
Increase in merchandise inventory
(30,000)
Increase in prepaid rent (10,000) Increase in accounts payable
10,000
Decrease in salaries payable(10,000) Increase in federal income taxes payable
10,000
Loss on sale of equipment 7,000 Depreciation expense 20,000 Net cash provided by operating activities
$7,000
Cash flows from investing activities: Proceeds from sale of equipment
$ 3,000
Purchase of equipment (220,000) Net cash used by investing activities
(217,000)
Cash flows from financing activities: Proceeds from issuing common stock
$250,000
Repayment of bank note (50,000) Dividends paid (40,000) Net cash provided by financing activities
160,000
Net increase (decrease) in cash
$(50,000)
b.
Dells Corporation Working paper to convert income statement from accrual basis to cash basis
For the year ended 2010 June 30 Cash basis (Cash flows From operating activities)
Accrual basis
Add Deduct
Sales $1,000,000 $60,000a $940,000 Cost of goods sold $600,000 $30,000b 10,000c $620,000 Salaries and wages expense 200,000 10,000d 210,000 Rent expense 40,000 10,000e 50,000 Depreciation expense 20,000 20,000 -0- Interest expense 3,000 3,000 Loss on sale of equipment 7,000 7,000 -0- Federal income taxes 60,000 10,000f 50,000
930,000 933,000 Net income $70,000 $ 7,000 a Increase in accounts receivable. B Increase in merchandise inventory. C Increase in accounts payable. D Decrease in salaries payable.
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E Increase in prepaid rent. F Increase in Federal Income Taxes Payable.
Dells Corporation Partial Statement of cash flows- Direct Method
For the Year Ended 2010 June 30 Cash flows from operating activities: Cash received from customers $ 940,000 Cash paid for merchandise (620,000) Salaries and wages paid (210,000) Rent paid (50,000) Interest paid (3,000) Federal income taxes paid (50,000) Net cash provided by operating activities $ 7,000
Key terms Cash flow liquidity ratio Cash and marketable securities plus net cash provided by operating activities divided by current liabilities.
Cash flow margin ratio Net cash provided by operating activities divided by net sales.
Cash flow per share of common stock ratio Net cash provided by operating activities divided by the average number of shares of common stock outstanding.
Cash flows from operating activities The net amount of cash received or disbursed during a given period on items that normally appear on the income statement.
Direct method Deducts from cash sales only those operating expenses that consumed cash.
Financing activities Generally include the cash effects of transactions and other events involving creditors and owners. Cash payments made to settle current liabilities such as accounts payable, wages payable, and income taxes payable are not financing activities. These payments are operating activities.
Indirect method A method of determining cash flows from operating activities that starts with net income and indirectly adjusts net income for items that do not involve cash. Also called the addback method.
Investing activities Generally include transactions involving the acquisition or disposal of noncurrent assets. Examples include cash received or paid from the sale or purchase of property, plant, and equipment; available-for-sale and held-to-maturity securities; and loans made to others.
Noncash charges or expenses Expenses and losses that are added back to net income because they do not actually use cash of the company. The items added back include amounts of depreciation on plant assets, depletion that was expensed, amortization of intangible assets such as patents and goodwill, amortization of discount on bonds payable, and losses from disposals of noncurrent assets.
Noncash credits or revenues Revenues and gains included in arriving at net income that do not provide cash; examples include gains from disposals of noncurrent assets, income from investments carried under the equity method, and amortization of premium on bonds payable.
Operating activities Generally include the cash effects of transactions and other events that enter into the determination of net income.
Statement of cash flows A statement that summarizes the effects on cash of the operating, investing, and financing activities of a company during an accounting period. Both inflows and outflows are included in each category. The statement of cash flows must be prepared each time an income statement is prepared.
Working capital Equal to current assets minus current liabilities.
Self-test
True-false
Indicate whether each of the following statements is true or false.
The requirement for a statement of cash flows was preceded by the requirement for the statement of changes in
financial position.
The statement of cash flows is one of the major financial statements.
Investing activities are transactions with creditors and owners.
The direct method of calculating cash flows from operations is encouraged by the FASB and is the predominant
method used.
Accounting Principles: A Business Perspective 654 A Global Text
16. Analysis using the statement of cash flows
Issuance of capital stock and the subsequent reacquisition of some of those shares would both be financing
activities.
Multiple-choice
Select the best answer for each of the following questions.
Which of the following statements is true?
a. The direct method of calculating cash flows from operations starts with net income and adjusts for noncash
revenues and expenses and changes in current assets and current liabilities.
b. The indirect method of calculating cash flows from operations adjusts each item in the income statement to a
cash basis.
c. The descriptions in (a) and (b) should be reversed.
d. The direct method is easier to use than the indirect method.
Investing activities include all of the following except:
a. Payment of debt.
b. Collection of loans.
c. Making of loans.
d. Sale of available-for-sale and held-to-maturity securities.
If sales on an accrual basis are USD 500,000 and accounts receivable increased by USD 30,000, the cash
received from customers would be:
a. USD 500,000.
b. USD 470,000.
c. USD 530,000.
d. Cannot be determined.
Assume cost of goods sold on an accrual basis is USD 300,000, accounts payable increased by USD 20,000, and
inventory increased by USD 50,000. Cash paid for merchandise is:
a. USD 370,000.
b. USD 230,000.
c. USD 270,000.
d. USD 330,000.
Assume net income was USD 200,000, depreciation expense was USD 10,000, accounts receivable increased by
USD 15,000, and accounts payable increased by USD 5,000. The amount of cash flows from operating activities is:
a. USD 200,000.
b. USD 180,000.
c. USD 210,000.
d. USD 190,000.
Now turn to “Answers to self-test” at the end of the chapter to check your answers.
Questions
➢ What are the purposes of the statement of cash flows?
➢ What are some of the uses of the statement of cash flows?
➢ What information is contained in the statement of cash flows?
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➢ Which activities are generally included in operating activities?
➢ Which activities are included in investing activities?
➢ Which activities are included in financing activities?
➢ Where should significant investing and financing activities that do not involve cash flows be
reported?
➢ Explain the difference between the direct and indirect methods for computing cash flows from
operating activities.
➢ What are noncash expenses? How are they treated in computing cash flows from operating
activities?
➢ Describe the treatment of a gain on the sale of equipment in preparing a statement of cash flows
under the indirect method.
➢ Depreciation is sometimes referred to as a source of cash. Is it a source of cash? Explain.
➢ Why is it unlikely that cash flows from operating activities will be equal to net income for the same
period?
➢ If the net income for a given period is USD 25,000, does this mean there is an increase in cash of the
same amount? Why or why not?
➢ Why might a company have positive cash flows from operating activities even though operating at a
net loss?
➢ Indicate the type of activity each of the following transactions represents (operating, investing, or
financing) and whether it is an inflow or an outflow.
➢ Sold goods.
➢ Purchased building.
➢ Issued capital stock.
➢ Received cash dividends.
➢ Paid cash dividends.
➢ Purchased treasury stock.
➢ Sold available-for-sale securities.
➢ Made a loan.
➢ Paid interest on loan.
➢ Paid bond principal.
➢ Received proceeds of insurance settlement.
➢ Made contribution to charity.
➢ Refer to "A broader perspective: Johnson & Johnson". Answer the following questions:
➢ What was the major investing activity in 2003?
➢ Was there a net negative or positive cash flow from investing activities?
➢ Was the positive cash flow from operating activities large enough to pay the cash dividends?
➢ Real world question Refer to The Limited in the Annual report appendix. Does it use the direct
method or indirect method of reporting cash flows from operating activities?
Accounting Principles: A Business Perspective 656 A Global Text
16. Analysis using the statement of cash flows
Exercises
Exercise A Indicate how the following data should be reported in a statement of cash flows. A company paid
USD 500,000 cash for land. A building was acquired for USD 2,500,000 by assuming a mortgage on the building.
Exercise B Cost of goods sold in the income statement for the year ended 2010 was USD 260,000. The
balances in Merchandise Inventory and Accounts Payable were:
2010 January 1 2010 December 31
Merchandise inventory $160,000 $180,000 Accounts payable 44,000 36,000
Calculate the amount of cash paid for merchandise for 2010.
Exercise C Fill in the following chart, showing how increases and decreases in these accounts affect the
conversion of accrual basis income to cash basis income:
Add Deduct Accounts receivable Merchandise inventory Prepaid expenses Accounts payable Accrued liabilities payable
Exercise D The income statement of a company shows net income of USD 200,000; merchandise inventory on
January 1 was USD 76,500 and on December 31 was USD 94,500; accounts payable for merchandise purchases
were USD 57,000 on January 1 and USD 68,000 on December 31. Compute the cash flows from operating activities
under the indirect method.
Exercise E The operating expenses and taxes (including USD 80,000 of depreciation) of a company for a given
year were USD 600,000. Net income was USD 350,000. Prepaid insurance decreased from USD 18,000 to USD
14,000 during the year, while wages payable increased from USD 22,000 to USD 36,000 during the year. Compute
the cash flows from operating activities under the indirect method.
Exercise F Dividends payable increased by USD 20,000 during a year in which total dividends declared were
USD 120,000. What amount appears for dividends paid in the statement of cash flows?
Exercise G Following are balance sheet data for Quality Merchandise, Inc.:
December 31 2011 2010
Cash $ 47,000 $ 26,000 Accounts receivable, net 141,000 134,000 Merchandise inventory 83,000 102,000 Prepaid expenses 9,000 11,000 Plant assets (net of accumulated depreciation) 235,000 230,000 Accounts payable 122,000 127,000 Accrued liabilities payable 40,000 41,000 Capital stock 300,000 300,000 Retained earnings 53,000 35,000
Assume that the depreciation recorded in 2011 was USD 15,000. Compute the cash spent to purchase plant
assets, assuming no assets were sold or scrapped in 2011.
Exercise H Use the data in the previous exercise. Assume the net income for 2011 was USD 24,000,
depreciation was USD 15,000, and dividends declared and paid were USD 6,000. The company paid interest of
USD 2,000 and income taxes of USD 14,000. Prepare a statement of cash flows—indirect method. Also prepare any
necessary supplemental schedule(s).
Exercise I The following data are from a company's Automobile and the Accumulated Depreciation—
Automobile accounts:
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Date Automobile Debit Credit Balance Jan. 1 Balance brought forward 16,000 July 1 Traded for new auto 16,000 -0-
New auto 31,000 Accumulated depreciation - Automobile
Jan. 1 Balance brought forward 12,000 July 1 One-half year's depreciation 2,000 14,000
Auto traded 14,000 -0- Dec. 31 One-half year's depreciation 4,000 4,000
The old auto was traded for a new one, with the difference in values paid in cash. The income statement for the
year shows a loss on the exchange of autos of USD 1,200.
Indicate the dollar amounts, the descriptions of these amounts, and their exact locations in a statement of cash
flows—indirect method.
Problems
Problem A The income statement and other data of Dunbar Carpet Outlet, Inc., follow:
Dunbar Carpet Outlet, Inc. Income statement
For the Year Ended 2010 December 31 Sales $920,000 Cost of goods sold 380,000 Gross margin $540,000 Operating expenses (other than depreciation) $140,000 Depreciation expense 40,000 180,000 Net income $360,000
Changes in current assets (other than cash) and current liabilities during the year were:
Increase Decrease Accounts receivable $20,000 Merchandise inventory $16,000 Prepaid insurance 8,000 Accounts payable 28,000 Accrued liabilities payable 4,000
Depreciation was the only noncash item affecting net income.
a. Prepare a working paper to calculate cash flows from operating activities under the direct method.
b. Prepare the cash flows from operating activities section of the statement of cash flows under the direct
method.
c. Prove that the same cash flows amount will be obtained under the indirect method by preparing the cash flows
from operating activities section of the statement of cash flows under the indirect method. You need not prepare a
working paper.
Problem B The following comparative balance sheets and other data are for Cellular Telephone Sales, Inc.:
Cellular Telephone Sales, Inc. Comparative balance sheets 2011 December 31 and 2010
2011 2010 Assets Cash $76,105 $51,000 Accounts receivable, net 26,075 24,250 Merchandise inventory 30,000 35,000 Supplies on hand 1,750 2,550 Prepaid expenses 1,400 1,200 Land 180,000 142,500 Equipment 270,000 300,000 Accumulated depreciation – equipment (75,000) (67,500) Total assets $510,330 $489,000 Liabilities and stockholders' equity Accounts payable $ 45,330 $ 76,300 Salaries payable 4,000 2,000
Accounting Principles: A Business Perspective 658 A Global Text
16. Analysis using the statement of cash flows
Accrued liabilities payable 2,000 8,250 Long-term note payable 150,000 150,000 Common stock ($5 par) 185,000 165,000 Paid-in capital in excess of par 32,500 -0- Retained earnings 91,500 87,450 Total liabilities and stockholders' equity $510,330 $489,000
Land was bought for USD 37,500 cash. The company intends to build a building on the land. Currently the
company leases a building for its operations.
Equipment costing USD 50,000 with accumulated depreciation of USD 30,000 was sold for USD 23,500 (a gain
of USD 3,500), and equipment costing USD 20,000 was purchased for cash.
Depreciation expense for the year was USD 37,500.
Common stock was issued for USD 52,500 cash.
Dividends declared and paid in 2011 totaled USD 32,950.
Net income was USD 37,000.
The company paid interest of USD 3,000 and income taxes of USD 17,000.
Prepare a statement of cash flows under the indirect method. Also prepare any necessary supplemental
schedule(s).
Problem C Computer Associates International, Inc., is leading business software company. The company was
founded in 1977 with four employees and has grown to 18,200 employees and about 4.2 billion in revenues.
The company's statements of cash flows for the years 2002 through 2004 follow. Then the relevant portion of
Management's Discussion and Analysis of the statement of cash flows is provided.
Consolidated statements of cash flows Year Ended March 31
Operating activities: 2004 2003 2002 (In millions)
Net (loss) income $ (591) $ 696 $ 626 Adjustments to reconcile net (loss) income to net cash provided by operating activities: Depreciation and amortization 1,110 594 325 Provision for deferred income taxes (benefit) (350) 412 107 Charge for purchased research and development--- 795 --- Compensation (gain) expense related to stock pension plants
(146) 30 778
Decrease (increase) in noncurrent installment accounts receivable, net
956 (1,039) (422)
Decrease (increase) in deferred maintenance revenue
(3) 113 43
Foreign currency transaction loss – before taxes 14 5 11 Charge for investment write-off --- 50 --- Gain on sale of property and equipment --- (5) (14) Changes in other operating assets and liabilities, net of effects of acquisitions: Decrease (increase) in trade and installment receivables
418 83 (169)
Other changes in operating assets and liabilities
(25) (168) (18)
Net cash provided by operating activities $ 1,383 $ 1,566 $ 1,267 Investing activities: Acquisitions, primarily purchased software, marketing rights and intangibles, net of cash acquired
$ (174) $ (3,049) $ (610)
Settlements of purchases accounting liabilities (367) (429) (57) Purchases of property and equipment (89) (198) (222) Proceeds from sale of property and equipment 5 12 38 Disposition of businesses 158 --- --- Purchases of marketable securities (48) (95) (2,703) Sales of marketable securities 40 189 2,639
659
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Increase in capitalized development costs and other
(49) (36) (29)
Net cash used in investing activities $ (524) $ (3,606) $ (944) Financing activities: Dividends $ (47) $ (43) $ (44) Purchases of treasury stock (449) --- (1,090) Proceeds from borrowings 1,049 3,672 2,141 Repayment of borrowings (1,981) (776) (1,216) Exercise of common stock options and other 50 96 38 Net cash provided by (used in) financing activities
$ (1,378) $ 2,949 $ (171)
(Decrease) Increase in cash and cash equivalents before effect of exchange rate changes on cash
$ (519) $ 909 $ 152
Effect of exchange rate changes on cash (25) (1) (4) (Decrease) Increase in cash and cash equivalents
$ (544) $ 908 $ 148
Cash and cash equivalents – Beginning of year
1,307 399 251
Cash and cash equivalents – End of the year
$ 763 $ 1,307 $ 399
Management's discussion and analysis
Liquidity and capital resources
Cash, cash equivalents and marketable securities totaled USD 850 million at 2004 March 31, a decrease of USD
537 million from the 2003 March 31 balance of USD 1,387 million. During fiscal year 2004, the Company used cash
on hand to repay over USD 900 million in debt and repurchase approximately USD 450 million in treasury stock.
Cash generated from operations for fiscal year 2001 was USD 1,383 million, a decrease of USD 183 million from the
prior year's cash from operations of USD 1,566 million. Cash from operations was unfavorably impacted this
current fiscal year due to higher costs associated with increased headcount and other expenses related to the
Sterling acquisition.
The Company's bank credit facilities consist of a USD 1 billion four-year revolving credit facility, a USD 2 billion
four-year term loan, and a 75 million British Pound Sterling denominated 364-day term loan. During the year, the
Company repaid all outstanding amounts under both its USD 1.3 billion 364-day and four-year revolving credit
agreements. As a reflection of its continued reduced need for bank borrowings, emphasis on debt reduction, and
overall expected ability to generate cash from operations, the Company did not renew its USD 1.3 billion 364-day
revolving credit facility when it expired in May 2004.
As of 2004 March 31, USD 2 billion remained outstanding under the four-year term loan and approximately
USD 124 million was outstanding under the pound sterling term loan at various interest rates. There are no
drawings under the Company's USD 1 billion four-year revolving credit facility. The interest rates on such debt are
determined based on a ratings grid, which applies a margin to the prevailing London InterBank Offered Rate
("LIBOR"). In addition, the Company established a USD 1 billion US Commercial Paper ("CP") program in the first
quarter of this year to refinance some of its debt at more attractive interest levels. As of 2004 March 31, USD 340
million was outstanding under the CP program.
The Company also utilizes other financial markets in order to maintain its broad sources of liquidity. In fiscal
2002, USD 1.75 billion of unsecured Senior Notes were issued in a transaction governed by Rule 144A of the
Securities Act of 1933. Amounts borrowed, rates and maturities for each issue were USD 575 million at 6.25 per
cent due 2006 April 15, USD 825 million at 6.375 per cent due 2008 April 15 and USD 350 million at 6.5 per cent
due 2011 April 15. As of 2004 March 31, USD 192 million was outstanding under the Company's 6.77 per cent
Senior Notes. These Notes call for annual repayment of USD 64 million each April until final maturity in 2006.
Accounting Principles: A Business Perspective 660 A Global Text
16. Analysis using the statement of cash flows
Unsecured and uncommitted multicurrency lines of credit are available to meet any short-term working capital
needs for subsidiaries operating outside the US. These lines total USD 56 million, of which USD 14 million was
drawn as of 2004 March 31.
Debt ratings for the Company's senior unsecured notes and its bank credit facilities are BBB+ and Baa1 from
Standard & Poor's and Moody's Investor Services, respectively. The Company's Commercial Paper program is rated
A-2 from Standard & Poor's and P-2 from Moody's. Peak borrowings under all debt facilities during fiscal year 2004
totaled approximately USD 5.4 billion with a weighted-average interest rate of 7.2 per cent.
As of 2004 March 31, the cumulative number of shares purchased under the Company's various open market
Common Stock repurchase programs, including almost 16 million shares purchased in the current fiscal year, was
166 million. The remaining number of shares authorized for repurchase is approximately 34 million.
Capital resource requirements as of 2004 March 31 consisted of lease obligations for office space, computer
equipment, mortgage or loan obligations and amounts due as a result of product and company acquisitions. It is
expected that existing cash, cash equivalents, marketable securities, the availability of borrowings under credit lines
and cash provided from operations will be sufficient to meet ongoing cash requirements.
The Company expects its long-standing history of providing extended payment terms to customers to continue
under the new business model and thus does not expect a change to its future cash flow, since customers are
expected to continue to finance their purchases over the contract period.
a. Explain how the company could have a net loss in 2004 and yet have a positive net cash provided by operating
activities.
b. What was the reason given by management for repaying all outstanding amounts under revolving credit
agreements.
c. What is the interest rate on borrowings?
d. What information would normally appear immediately below the statement of cash flows that seems to be
missing?
e. Does the amount of cash provided by operating activities seem large enough to continue the present dividend
payments?
f. Given the following data, calculate the cash flow per share of common stock ratio, the cash flow margin ratio,
and cash flow liquidity ratio.
(in millions) Average number of shares of common stock outstanding 583 Net sales 4,198 Cash and marketable securities 850 Current liabilities 2,286
Problem D Mechan Company develops, manufactures, markets, installs and supports a wide range of
standards-based LAN and WAN connectivity hardware and software products. The company's statements of cash
flow for the years 2008-2010 follow. Then the relevant portion of Management's Discussion and Analysis of the
statement of cash flows is provided.
Consolidated statements of cash flows Years ended 2010 February 29, and 2009 February 28 and 2008
(In thousands) 2010 2009 2008
Cash flows from operating activities: Net income $ 164,418 $ 161,974 $ 119,218 Adjustments to reconcile net income to net cash provided by operating activities:
661
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Depreciation and amortization 32,061 26,832 17,335 Provision for losses on accounts receivable 356 72 1,734 Loss on disposals of property, plant and equipment 93 174 113 Deferred taxes (38,766) (4,434) (6,151) Changes in assets and liabilities: Accounts receivables (55,101) (27,698) (17,707) Inventories (50,483) (23,080) (8,758) Prepaid expenses and other assets (18,844) (3,123) 1,211 Accounts payable and accrued expenses 62,908 11,336 22,003 Income taxes payable 3,705 10,476 (3,924) Net cash provided by operating activities $100,347 $152,529 $125,074 Cash flows from investing activities: Capital expenditures $ (65,035) $ (63,091) $ (39,399) Purchase of available-for-sale securities (79,427) (71,598) (30,097) Purchase of held-to-maturity securities (205,852) (282,712) (258,517) Materials of marketable securities 208,922 323,682 197,406 Net cash used in investing activities $(141,392) $ (93,719) $(130,607) Cash flows from financing activities: Repayment of notes receivable from stockholders $ 174 $ 131 $ 66 Repurchase of common stock (1,173) (13,070) --- Tax benefit of options exercised 7,215 5,712 6,980 Common stock issued to employee stock purchase plan 3,323 2,287 1,637 Proceeds from stock option exercise 16,021 4,887 7,185 Net cash provided by (used for) financing activities $ 25,560 $ (53) $ 15,868 Effect of exchange rate changes on cash $ 166 $ 712 $ 161 Net increase (decrease) in cash and cash equivalents $ (15,319) $ 59,469 $ 10,469 Cash and cash equivalents, beginning of year 114,032 54,563 44,067 Cash and cash equivalents, end of year $ 98,713 $ 114,032 $ 54,563 Cash paid during the year for: Income taxes $ 105,233 $ 68,420 $ 67,263
Management's discussion and analysis
Net cash provided by operating activities was USD 100.3 million in fiscal 2010, compared to USD 152.5 million
in fiscal 2009 and USD 125.1 million in fiscal 2008.
Capital investment for fiscal 2010 of USD 65.0 million included USD 9.8 million for building costs of which USD
3.4 was for the purchase of an engineering building, USD 21.4 million for engineering computer and computer
related software and equipment, USD 5.5 million for manufacturing and related equipment and USD 19.0 million
for expanding global sales operations. During fiscal 2009, capital expenditures of USD 63.1 million included
approximately USD 8.2 million for building costs related to expanding manufacturing and distribution capacities
and enlarging worldwide sales operations, USD 12.5 million for manufacturing and manufacturing support
equipment and USD 15.0 million for engineering computer and computer related equipment. Another USD 15.0
million was spent in support of expanded global sales activities. During fiscal 2008, capital expenditures of USD
39.4 million included USD 3.9 million on buildings, USD 10.1 million on engineering equipment, USD 7.8 million
on manufacturing capacity expansions and USD 2.0 million to equip new sales offices.
Cash, cash equivalents and marketable securities increased during fiscal 2010 to USD 407.0 million, from USD
345.9 million in the prior fiscal year. State and local municipal bonds of approximately USD 264.2 million,
maturing in approximately 1.5 years, were being held by the Company at 2010 February 29.
At 2010 February 29, the Company did not have any short or long term borrowing or any significant financial
commitments outstanding, other than those required in the normal course of business.
In the opinion of management, internally generated funds from operations and existing cash, cash equivalents
and marketable securities will be adequate to support the Company's working capital and capital expenditures
requirements for both short and long term needs.
a. Which method did the company use in arriving at net cash flows from operating activities?
Accounting Principles: A Business Perspective 662 A Global Text
16. Analysis using the statement of cash flows
b. Did current assets other than cash increase or decrease during the year ended 2010 February 29?
c. Did current liabilities increase or decrease during the year ended 2010 February 29?
d. What were the main investing activities during this three-year period?
e. What was the main source of cash from financing activities during the three-year period?
f. Did the company pay any interest expense during the year ended 2010 February 19?
g. Given the following data, calculate the cash flow per share of common stock ratio, the cash flow margin ratio,
and the cash flow liquidity ratio. How do these ratios compare with the ratios shown for other companies in the
chapter?
(in thousands) Average number of shares of common stock outstanding 71,839 Net sales $ 1,069,715 Cash and marketable securities 253,540 Current liabilities 164,352
Problem E The following comparative balance sheets and other data are for Dayton Tent & Awning Sales, Inc.:
Dayton Tent & Awning Sales, Inc. Comparative Balance Sheets
2011 June 30 and 2010 2011 2010
Assets Cash $ 441,800 $ 332,600 Accounts receivable, net 750,750 432,900 Merchandise inventory 819,000 850,200 Prepaid insurance 3,900 5,850 Land 312,000 351,000 Buildings 2,184,000 1,209,000 Machinery and tools 858,000 468,000 Accumulated depreciation – machinery and tools
(809,250) (510,900)
Total assets $ 4,560,200
$ 3,138,650
Liabilities and stockholders' equity Accounts payable $ 226,750 $ 275,500 Accrued liabilities payable 185,800 111,700 Bank loans (due in 2009) 56,550 66,300 Mortgage bonds payable 382,200 185,250 Common stock - $100 par 1,755,000 585,000 Paid-in capital in excess of par 58,500 -0- Retained earnings 1,895,400 1,914,900 Total liabilities and stockholders' equity $
4,560,200 $ 3,138,650
Net income for the year was USD 128,000.
Depreciation for the year was USD 356,850.
There was a gain of USD 7,800 on the sale of land. The land was sold for USD 46,800.
The additional mortgage bonds were issued at face value as partial payment for a building valued at USD
975,000. The amount of cash paid was USD 778,050.
Machinery and tools were purchased for USD 448,500 cash.
Fully depreciated machinery with a cost of USD 58,500 was scrapped and written off.
Additional common stock was issued at USD 105 per share. The total proceeds were USD 1,228,500.
Dividends declared and paid were USD 147,500.
A payment was made on the bank loan, USD 9,750.
The company paid interest of USD 9,000 and income taxes of USD 75,000.
a. Prepare a working paper for a statement of cash flows.
663
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b. Prepare a statement of cash flows under the indirect method. Also prepare any necessary supplemental
schedule(s).
Alternate problems
Alternate problem A The following income statement and other data are for Kennesaw Auto Glass
Specialists, Inc..
Kennesaw auto glass specialists, Inc. Income Statement
For the year ended 2010 December 31 Sales $450,000 Cost of goods sold 125,000 Gross margin $325,000 Operating expenses (other than depreciation) $60,000 Depreciation expense 20,000 80,000 Net income $245,000
Changes in current assets (other than cash) and current liabilities during the year were:
Increase Decrease Accounts receivable $15,000 Merchandise inventory $25,000 Prepaid insurance 8,000 Accounts payable 15,000 Accrued liabilities payable 4,000
Depreciation was the only noncash item affecting net income.
a. Prepare a working paper to calculate cash flows from operating activities under the direct method.
b. Prepare the cash flows from operating activities section of the statement of cash flows under the direct
method.
c. Prove that the same cash flows amount is obtained under the indirect method by preparing the cash flows
from operating activities section of the statement of cash flows under the indirect method. You need not prepare a
working paper.
Alternate problem B The following information relates to Dunwoody Nursery & Garden Center, Inc. The
company leases a building adjacent to its land.
Dunwoody Nursery & Garden Center, Inc. Comparative Balance Sheets 2011 December 31 and 2010
2011 2010 Assets
Cash $44,500 $ 52,000 Accounts receivable, net 59,000 60,000 Merchandise inventory 175,000 120,000 Equipment 412,500 315,000 Accumulated depreciation – equipment (120,000) (105,000
) Land 75,000 15,000 Total assets $646,000 $457,000
Liabilities and stockholders' equity Accounts payable $ 43,750 $40,750 Accrued liabilities payable 2,250 3,750 Capital stock – common - $10 par 375,000 300,000 Paid-in capital in excess of par 150,000 75,000 Retained earnings 75,000 37,500 Total liabilities and stockholders' equity $646,000 $457,000
Net income was USD 97,500 for the year.
Fully depreciated equipment costing USD 15,000 was sold for USD 3,750 (a gain of USD 3,750), and equipment
costing USD 112,500 was purchased for cash.
Depreciation expense for the year was USD 30,000.
Accounting Principles: A Business Perspective 664 A Global Text
16. Analysis using the statement of cash flows
Land was purchased, USD 60,000.
An additional 7,500 shares of common stock were issued for cash at USD 20 per share (total proceeds, USD
150,000).
Cash dividends of USD 60,000 were declared and paid.
The company paid interest of USD 6,000 and income taxes of USD 65,000. Prepare a statement of cash flows
under the indirect method. Also prepare any necessary supplemental schedule(s).
Alternate problem C Drexler, Inc., is an independent service organization that markets and services
electronic credit card authorization and payment systems to small retail, wholesale, and professional businesses
located throughout the United States. Prior to installing the company's electronic system, most of these businesses
have used manual, paper-based systems to process credit card transactions or have not accepted credit cards at all.
As the use of credit cards has significantly expanded, electronic processing has proven more convenient by
accelerating customer purchases, lowering processing expenses, and reducing losses from fraudulent cards.
The company's account portfolio has grown through the purchase of account portfolios as well as through the
internal development of accounts using telemarketing and field sales. With approximately 90,000 accounts at 2010
July 31, the company is one of the largest independent service organizations in the country.
The company's statements of cash flows for the years 2008-2010 follow. Then the relevant portion of
Management's Discussion and Analysis of the statement of cash flows is provided.
Consolidated statement of cash flows
Year ended July 31, 2008 2009 2010
Cash flows from operating activities: Net cash received from merchants
$ 19,657,697 $ 34,353,326 $ 67,313,124
Cash paid to vendors and employees
(14,758,040) (28,467,472) (49,128,150)
Interest received 22,262 310,136 1,672,714 Interest paid (268,586) (198,485) (505,856) Income taxes paid (994,969) (1,600,405) (5,630,881) Net cash provided by operating activities
$ 3,658,354 $ 4,397,100 $ 13,720,951
Cash flows from investing activities: Purchase of merchant portfolios
$ (8,415,055) $(24,576,426) $(31,787,725)
Purchase of property and equipment
(1,465,984) (1,917,395) (1,777,955)
Net cash used in investing activities
$(9,881,039) $(26,493,821) $(33,565,680)
Cash flows from financing activities: Proceeds from issuance of long-term debt
$ 7,650,000 $ 16,450,000 $ 305,000
Payments on long-term debt (1,163,170) (12,828,503) (16,545,500) Proceeds from issuance of common stock
--- 17,098,894 140,963,115
Payments to repurchase treasury stock
(45,000) (32,500) (12,000)
Proceeds from minority shareholder contribution
--- --- 120,000
Net cash provided by financing activities
$6,441,830 $ 20,687,891 $124,830,615
Net increase (decrease) in cash and cash equivalents
$ 219,145 $ (1,408,830) $(104,985,886)
Cash and cash equivalents at beginning of year
1,664,830 1,883,975 475,145
665
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Cash and cash equivalents at end of year
$ 1,883,975 $ 475,145 $105,461,031
Supplemental schedule of noncash activities:
In connection with the purchase of merchant portfolios in fiscal years 2008 and 2009, the Company issued
promissory notes totaling USD 5,061,804 and USD 80,500, respectively.
The company recognized a tax benefit of USD 318,517 for the year ended 2010 July 31, for the excess of the fair
market value at the exercise date over that at the award date for stock options exercised.
In connection with the purchase of merchant portfolio in March 2008, the Company issued 312,500 shares of
common stock.
In connection with an agreement between the Company and a processing back entered into simultaneously with
the purchase of a merchant portfolio in March 2008, the Company issued warrants to purchase 120,000 shares of
common stock.
Reconciliation of net income to net cash provided by operating activities: Net income $2,592,444 $3,640,155 $ 8,625,376 Martin Howe fiscal year converstion --- --- (356,914) Adjustments: Depreciation and amortization expense 1,648,023 3,517,852 7,509,630 Provision for merchant losses 484,993 483,245 654,705 Stock award compensation and other 239,659 241,477 120,395 Deferred income taxes (453,658) 35,982 (761,705) Changes in assets and liabilities: Accounts receivable (1,562,961) (1,459,799) (2,125,510) Inventory (50,235) (157,087) (186,289) Other assets (1,716,464) (1,895,097) (501,353) Accounts payable 1,557,611 44,106 587,784 Accrued liabilities 975,065 (223,411) 210,064 Deferred revenues (56,123) 169,677 (55,232) Net cash provided by operating activities $ 3,658,354 $ 4,397,100 $ 13,720,951
Management's discussion and analysis
Capital expenditures and investing activities
Capital expenditures were approximately USD 1.8 million for fiscal year 2010 as compared to USD 1.9 million
for fiscal year 2009 and USD 1.5 million for fiscal year 2008. The increase in capital expenditures was primarily the
result of additional expenditures related to the Company's management information system, the purchase of
additional credit card terminals, the Company's relocation of its office facilities and the purchase of peripheral
equipment for lease to merchants. In addition to the increase in capital expenditures, the Company used USD 8.4
million, USD 24.6 million and USD 31.8 million for the purchase of merchant portfolios in fiscal years 2008, 2009
and 2010, respectively. The Company purchased five merchant portfolios in fiscal 2008, nine merchant portfolios
in fiscal year 2009 and five in fiscal year 2010.
Financing activities
The significant increase in cash provided by financing activities for fiscal year 2009 resulted from the
consummation of the Company's initial public offering in August 2008. Cash provided by financing activities for
fiscal year 2009 was USD 20.7 million which reflects the net proceeds of the initial public offering after retirement
of the Company's outstanding indebtedness. Additionally, the Company issued USD 15.3 million of long-term debt
in connection with three of the nine merchant portfolios purchased in fiscal year 2009.
The cash provided by financing activities for fiscal 2010 reflects the Company's consummation of its second and
third public offerings in October 2009 and April 2010, respectively. Net cash provided by financing activities was
Accounting Principles: A Business Perspective 666 A Global Text
16. Analysis using the statement of cash flows
USD 124.8 million in fiscal 2010 which reflects the net proceeds from the offerings after retirement of the
Company's outstanding bank indebtedness.
Future capital needs
Management believes that significant expenditures for the purchase of additional merchant portfolios may be
required for the Company to sustain its growth in the future. Management expects to fund such purchases primarily
through cash generated from operations and additional bank borrowings. Management believes the combination of
these sources will be sufficient to meet the Company's anticipated liquidity needs and its growth plans through
fiscal year 2008. The Company, however, may pursue additional expansion opportunities, including purchases of
additional merchant portfolios, which may require additional capital, and the Company may incur, from time to
time, additional short-term and long-term indebtedness or issue, in public or private transactions, equity or debt
securities, the availability and terms of which will depend upon then prevailing market and other conditions.
The Company's revolving credit facility was amended and restated during fiscal year 2009 to increase the line of
credit to USD 17.5 million. The Company repaid all outstanding debt related to this credit facility with the proceeds
from its second public offering during fiscal year 2010. The amended agreement expires 2010 November 1, with all
amounts then outstanding under the agreement due on 2010 November 1, unless the agreement is extended or the
outstanding amounts have been converted to a term loan requiring equal monthly payments for 48 months.
Borrowings under the amended revolving credit facility are used to finance purchases of merchant portfolios
and equipment and for working capital purposes. Borrowings are secured by substantially all the Company's assets
and life insurance policies on the lives of two of the Company's executive officers.
a. Which method is the company using to determine net cash provided by operating activities?
b. Why does the company show the indirect method below the statement of cash flows?
c. What is the trend of net cash provided by operating activities over the three years?
d. How has the company increased its merchant portfolios?
e. What items of property and equipment were acquired during the three-year period?
f. What was the major source of the huge increase in cash and cash equivalents over the three-year period? How
were the proceeds used?
g. How does the company expect to finance future expenditures to acquire additional merchant portfolios?
h. How are amounts secured that are borrowed under the line of credit?
i. Given the following data, calculate the cash flow per share of common stock ratio, the cash flow margin ratio,
and the cash flow liquidity ratio. (Round the net cash provided from operating activities to the nearest thousand
before you calculate the ratios.) How do the ratios compare with the ones for companies illustrated in the chapter?
(in thousands) Average number of shares of common stock outstanding 28,539 Net sales $149,840 Cash and marketable securities 105,461 Current liabilities 6,862
Alternate problem D Founded in 1901, The Gillette Company is the world leader in male grooming products,
a category that includes blades and razors, shaving preparations and electric shavers. Gillette also holds the number
one position worldwide in selected female grooming products, such as wet shaving products and hair epilation
devices. The Company is the world's top seller of writing instruments and correction products, toothbrushes and
oral care appliances. In addition, the Company is the world leader in alkaline batteries.
667
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Gillette manufacturing operations are conducted at 38 facilities in 19 countries, and products are distributed
through wholesalers, retailers, and agents in over 200 countries and territories.
The company's statements of cash flows for the years 2001-2003 follow. Then the relevant portion of
Management's Discussion and Analysis of the statement of cash flows is provided.
Consolidated statement of cash flows (millions of dollars) Years ended 2003,2002, 2001 December 31 2003 2002 2001 Operating activities Income from continuing operations $ 832 $1,248 $1,073 Adjustments to reconcile net income to net cash provided by operating activities: Provision of restructuring and asset impairment 572 --- 440 Depreciation and amortization 535 464 421 Other 5 (7) (46) Changes in assets and liabilities, excluding effects from acquisition and divestitures: Accounts receivable (100) (48) (442) Inventories 149 (140) (62) Accounts payable and accrued liabilities (45) 65 72 Other working capital items (136) 97 (104) Other noncurrent assets and liabilities (197) (252) (142) Funding German pension plans --- --- (252) Net cash provided by operating activities $ 1,604 $1,427 $ 958 Investing activities Additions to property, plant and equipment $ (793) $ (889) $ (952) Disposals of property, plant and equipment 41 124 65 Acquisitions of businesses, less cash acquired --- --- (91) Sale of businesses 539 --- 200 Other (1) 2 5 Net cash used in investing act $(214) $ (763) $ (773) Financing activities Purchase of treasury stock $ (944) $(2,021) $(1,066) Proceeds from sale of put options 23 72 56 Proceeds from exercise of stock options and purchase plans
36 149 126
Proceeds from long-term debt 494 1,105 500 Repayment of long-term debt (365) --- (12) Increase (decrease) in loans payable (385) 484 708 Dividends paid (671) (626) (552) Settlements of debt-related derivative contracts 279 42 9 Net cash used in financing activities $ (1,553) $ (795) $ (231) Effect of exchange rate changes on cash $ (5) $ (2) $ (2) Net cash provided by discontinued operations 130 111 45 Decrease in cash and cash equivalents $ (18) $ (22) $ (3) Cash and cash equivalents at beginning of year 80 102 105 Cash and cash equivalents at end of year $ 62 $ 80 $ 102 Supplemental disclosure of cash paid for: Interest $ 243 $ 126 $ 120 Income taxes $ 480 $ 457 $ 473 Noncash investing and financing activities: Acquisition of businesses Fair value of assets acquired $--- $--- $ 100 Cash paid --- --- 91 Liabilities assumed $ --- $ ---- $ 9
Management's discussion and analysis*
Financial condition
The Company's financial condition continued to be strong in 2003. Net debt (total debt net of associated swaps,
less cash and cash equivalents) decreased USD 82 million during 2003, despite additional spending under the
Company's share repurchase program, due to improved cash flow from operations, proceeds from the sale of the
Stationery Products business and the favorable exchange impact on foreign currency debt. Net debt at 2003
December 31, amounted to USD 4.45 billion, compared with USD 4.53 billion and USD 3.18 billion at 2002
December 31 and 2001, respectively. The market value of Gillette equity was USD 38 billion at the end of 2003,
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16. Analysis using the statement of cash flows
compared with USD 43 billion at the end of 2002. The Company's book equity position amounted to USD 1.92
billion at the end of 2003, compared with USD 3.06 billion at the end of 2002 and USD 4.54 billion at the end of
2001. The decreases in book equity in 2003 and 2002 were due primarily to the Gillette share repurchase program,
as well as to the effect of foreign currency translation.
Net cash provided by operating activities in 2003 was USD 1.60 billion, compared with USD 1.43 billion in 2002
and USD .96 billion in 2001. The current ratio of the Company was .86 for 2003, compared with ratios of 1.39 for
2002 and 1.40 for 2001. The decrease in the 2003 current ratio was primarily attributable to the Company's
reclassification of all commercial paper borrowings to short-term debt, due to the Company's credit facility
agreements expiring within 2001. Capital spending in 2003 amounted to USD 793 million, compared with USD
889 million in 2002 and USD 952 million in 2001. Spending in all three years reflected substantial investments in
the blade and razor, Duracell and Braun Products segments.
In 2003, the Company sold the Stationery Products business for USD 528 million. In 2001, the Company made
acquisitions in the Duracell Products segment for USD 100 million and sold the Jafra business for USD 200
million.
Share repurchase funding in 2003, net of proceeds received from the sale of put options on Company stock,
amounted to USD 921 million, compared with USD 1,949 million in 2002 and USD 1,010 million in 2001.
Strong cash inflows from operations, proceeds from the sale of the Stationery Products business and alternate
financing sources enabled the Company to reduce its USD 2.0 billion revolving credit facility in 2003 to USD 1.4
billion, expiring October 2004, and its USD 1.1 billion credit facility, expiring December 2004, to USD 550 million
in January 2004. Both facilities are used by the Company to complement its commercial paper program.
In order to increase flexibility in sourcing short-term borrowing, the Company launched a USD 1 billion Euro
commercial paper program in 2003. At year-end 2003, there was USD 586 million outstanding under this program
and USD 1.45 billion outstanding under the US program, compared with USD 2.41 billion at the end of 2002 and
USD 1.66 billion at the end of 2001.
During 2003, the Company issued Euro-denominated notes for USD 228 million, due December 2005, and
entered into a USD 264 million Euro-denominated debt obligation, with redemption rights in December 2004.
During 2002, the Company issued Euro-denominated notes for USD 343 million, due February 2007, and entered
into a USD 325 million Euro-denominated debt obligation, with redemption rights in March 2005, and a USD 437
million Euro-denominated debt obligation, with redemption rights in January 2007. The net proceeds were used to
refinance existing short-term debt associated with the Company's share repurchase program.
During 2003, both Standard & Poor's and Moody's maintained the Company's current credit ratings. Standard &
Poor's rates the Company's long-term debt at AA, while Moody's rating is Aa3. The commercial paper rating is A1+
by Standard & Poor's and P1 by Moody's.
Gillette will continue to have capital available for growth through both internally generated funds and significant
credit resources. The Company has substantial unused lines of credit and access to worldwide financial market
sources for funds.
Source: The Gillette Company's 2000 annual report, p. 22.
a. Does the company use the direct or indirect method of calculating net cash provided by operating activities?
b. Determine whether each of the current assets (other than cash) and current liabilities increased or decreased
during 2003.
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c. How is the company expanding its asset base?
d. How much greater is the total market value of the company's outstanding shares of common stock than the
book equity (stockholders; equity)?
e. What is the likelihood that the company will be able to pay at least the current level of dividends in the future?
f. Do you expect to see purchases of treasury stock increase or decrease in the future?
g. Given the following data, calculate the cash flow per share of common stock ratio, the cash flow margin ratio,
and the cash flow liquidity ratio. (Round the net cash provided by operating activities to the nearest million before
you calculate the ratios.) How do the ratios compare with the ones for companies illustrated in the chapter?
(in millions) Average number of shares of common stock outstanding
1,059
Net sales 9,295 Cash and marketable securities 62 Current liabilities 5,471
Alternate problem E The following information is from the accounting records of Wescott Office Supplies,
Inc., for the fiscal years 2011 and 2010:
2011 2010 Assets
Cash $ 66,250 $ 61,000 Accounts receivable, net 84,000 42,000 Merchandise inventory 42,000 48,250 Prepaid expenses 7,875 12,125 Land 94,500 78,750 Buildings 199,500 147,000 Accumulated depreciation – buildings (31,500) (26,250) Equipment 257,250 210,000 Accumulated depreciation- equipment (78,750) (63,000) Total assets $641,125 $509,875
Liabilities and stockholders' equity Accounts payable $73,500 $ 47,250 Accrued liabilities payable 50,500 55,750 Five-year note payable 52,500 -0- Capital stock -$50 par 420,000 367,500 Retained earnings 39,375 Total liabilities and stockholders' equity $641,125 $509,875
Net income for year ended 2011 June 30, was USD 56,250.
Additional land was acquired for cash, USD 15,750.
No equipment or building retirements occurred during the year.
Equipment was purchased for cash, USD 47,250.
The five-year note for USD 52,500 was issued to pay for a building erected on land leased by the company.
Stock was issued at par for cash, USD 52,500.
Dividends declared and paid were USD 51,000.
The company paid interest of USD 10,000 and income taxes of USD 40,000.
a. Prepare a working paper for a statement of cash flows.
b. Prepare a statement of cash flows under the indirect method. Also prepare any necessary supplemental
schedule(s).
Beyond the numbers—Critical thinking
Business decision A National Sports, Inc., is a sports equipment sales company. During 2011, the company
replaced USD 18,000 of its fully depreciated equipment with new equipment costing USD 23,000. Although a
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16. Analysis using the statement of cash flows
midyear dividend of USD 5,000 was paid, the company found it necessary to borrow USD 5,000 from its bank on a
two-year note. Further borrowing may be needed since the Cash account is dangerously low at year-end.
Following are the income statement and "cash flow statement", as the company's accountant calls it, for 2011.
National sports, Inc. Income Statements
For the year ended 2011 December 31 Sales $195,000 Cost of goods sold $140,000 Operating expense and taxes 49,700 189,700 Net income $5,300
National Sports, Inc. Cash flow Statement
For the Year ended 2011 December 31 Cash received: From operations: Net income $5,300 Depreciation 5,000 Total cash from operations
$10,300
Note issued to back 5,000 Mortgage note issued 16,000 Total funds provided $31,300 Cash paid: New equipment $23,000 Dividends 5,000 28,000 Increase in cash $ 3,300
The company's president is very concerned about what he sees in these statements and how it relates to what he
knows has actually happened. He turns to you for help. Specifically, he wants to know why the cash flow statement
shows an increase in cash of USD 3,300 when he knows the cash balance decreased from USD 15,000 to USD 500
during the year. Also, why is depreciation shown as providing cash?
You believe you can answer the president's questions after receiving the following condensed balance sheet data:
National Sports, Inc. Comparative Balance Sheets 2011 December 31, and 2010
December 31 2011 2010
Assets Current assets: Cash $ 500 $ 15,000 Accounts receivable, net 17,800 13,200 Merchandise inventory 28,500 17,500 Prepaid expenses 700 300 Total current assets $ 47,500 $ 46,000 Property, plant, and equipment: Equipment $40,000 $35,000 Accumulated depreciation – equipment (11,000) (24,000) Total property, plant, and equipment $ 29,000 $ 11,000 Liabilities and stockholders' equity
Current liabilities: Accounts payable $ 8,700 $ 10,000 Accrued liabilities payable 600 1,100 Total current liabilities $ 9,300 $ 11,100 Long-term liabilities: Notes payable 5,000 -0- Mortgage note payable 16,000 -0- Total liabilities $ 30,300 $ 11,100 Stockholders' equity: Common stock $ 40,000 $ 40,000 Retained earnings 6,200 5,900 Total stockholders' equity $ 46,200 $ 45,900 Total liabilities and stockholders' equity $ 76,500 $ 57,000
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Prepare a correct statement of cash flows using the indirect method that shows why National Sports, Inc., is
having such a difficult time keeping sufficient cash on hand. Also, answer the president's questions. The company
paid interest of USD 400 and income taxes of USD 3,000.
Business decision case B Following are comparative balance sheets for Hardiplank Siding, Inc.:
Hardiplank Siding, Inc. Comparative Balance Sheets
2011 December 31, and 2010 2011 2010
Assets Cash $ 80,000 $ 57,500 Accounts receivable, net 60,000 45,000 Merchandise inventory 90,000 52,500 Land 67,500 60,000 Buildings 90,000 90,000 Accumulated depreciation- buildings
(30,000) (27,000)
Equipment 285,000 225,000 Accumulated depreciation – equipment
(52,500) (48,000)
Goodwill 120,000 150,000 Total assets $710,000 $605,000 Liabilities and stockholders' equity Accounts payable $ 95,000 $ 65,000 Accrued liabilities payable 30,000 22,500 Capital stock 315,000 300,000 Paid-in capital – stock dividends 75,000 67,500 Paid-in capital – land donations 15,000 -0- Retained earnings 180,000 150,000 Total liabilities and stockholders' equity
$710,000 $605,000
An analysis of the Retained Earnings account for the year reveals the following:
Balance, 2011 January 1 $150,000 Add: Net income for the year 107,500
$257,500 Less: cash dividends $55,000 Stock dividends 22,500 77,500 Balance, 2011 December 31 $180,000
a. Equipment with a cost of USD 30,000 on which USD 27,000 of depreciation had been accumulated was sold
during the year at a loss of USD 1,500. Included in net income is a gain on the sale of land of USD 9,000.
b. The president of the company has set two goals for 2012: (1) increase cash by USD 40,000 and (2) increase
cash dividends by USD 35,000. The company's activities in 2012 are expected to be quite similar to those of 2011,
and no new fixed assets will be acquired.
Prepare a schedule showing cash flows from operating activities under the indirect method for 2011. Can the
company meet its president's goals for 2012? Explain.
Annual report analysis C Refer to the Annual report appendix. Evaluate the ease with which The Limited
will be able to maintain its dividend payments in the future at 2006 amounts. (Hint: Compare current dividend
amount with net cash provided by operating activities.)
Annual report analysis D Refer to "A broader perspective: Johnson & Johnson" and answer the following
questions:
a. Over the last three years from which major activities (operations, investing, financing) has Johnson &
Johnson received net cash inflows and on which major activities have they spent the funds?
b. What relationship do you see between "Depreciation and amortization of property and intangibles" and
"Additions of property, plant, and equipment"?
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16. Analysis using the statement of cash flows
c. What were the two major sources of cash outflows to stockholders and which was larger?
d. By how much did the investments in marketable securities grow or shrink over the three-year period?
e. By how much did long-term debt grow or shrink over the three-year period?
f. If you were a stockholder, would you feel uncertain or confident that this company will be able to pay future
dividends at the same rate as in the past?
g. For what reason or reasons might the company be buying back its own stock?
h. For the latest year, did the current assets (other than cash) and current liabilities go up or down?
i. From the information that is available, does it appear that the company is performing well or poorly?
Group project E In groups of two or three students write a two-page, double-spaced paper on one of the
following topics:
Which Is Better, the Direct or Indirect Method (of calculating net cash provided by operating activities)?
Analysis of the Johnson & Johnson Cash Flow Statement (shown in "A broader perspective" in this chapter)
Analysis of Cash Flow Statement for The Limited (shown in the Annual Report Appendix)
Your analysis should be convincing and have no spelling or grammatical errors. Your paper should be neat and
the result of several drafts. The paper should have a cover page with the title and the authors' names. Use a word
processing program if possible.
Group project F In a group of one or two other students, go to the library and locate Statement of Financial
Accounting Standards No. 95, "Statement of Cash Flows", published by the Financial Accounting Standards Board.
Write a report to your instructor answering the following questions:
Why did the Board settle on cash flows instead of working capital flows?
Why did the Board strongly recommend use of the direct method?
Why did some members of the Board dissent from the final statement?
Group project G In a group of one or two other students, go to the library and locate Statement of Financial
Accounting Standards No. 95, "Statement of Cash Flows", published by the Financial Accounting Standards Board.
Write a report to your instructor covering the following points:
Describe the controversy over how to treat interest and dividends received.
What is the Board's position on reporting cash flow per share? Why did they take that position?
What is the Board's position on noncash transactions? Why did they take that position?
Using the Internet—A view of the real world
Visit the following website for the Eastman Kodak Company:
http://www.kodak.com
By following the instructions on the screen, locate the latest statement of cash flows and then print it. Analyze
the statement and write a report to your instructor summarizing your analysis.
Visit the following website for Verizon:
http://www.verizon.com
By following the information on the screen, locate the latest statement of cash flows and then print it. Analyze
the statement and then write a report to your instructor summarizing your analysis.
Answers to self-test
True-false
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True. Before July 1988, the statement of changes in financial position was required. This statement emphasized
changes in working capital rather than changes in cash.
True. The statement of cash flows must be published every time an income statement is published.
False. Investing activities are transactions involving the acquisition or disposal of noncurrent assets.
Transactions with creditors and owners are financing activities.
False. While the direct method is the method encouraged by the FASB, it is not the predominant method in use.
In a recent study, only about 3 per cent of the companies surveyed used the direct method.
True. Both of these transactions are with owners and, therefore, would be financing activities.
Multiple-choice
c. The descriptions in (a) and (b) would be correct if they were reversed. The indirect method is easier to use,
and this characteristic is probably the main reason why it is used by most companies.
a. Payment of debt is a financing activity because it is a transaction with creditors. All of the others are investing
activities because they are transactions involving the acquisition or disposal of noncurrent assets.
b. Sales of USD 500,000 minus the increase in accounts receivable of USD 30,000 = USD 470,000.
d. Cost of goods sold of USD 300,000, less the increase in accounts payable of USD 20,000, plus the increase in
inventory of USD 50,000 = USD 330,000.
a. Net income of USD 200,000, plus depreciation of USD 10,000, less the increase in accounts receivable of
USD 15,000, plus the increase in accounts payable of USD 5,000 = USD 200,000.
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17. Analysis and interpretation of financial statements
Learning objectives
After studying this chapter, you should be able to:
• Describe and explain the objectives of financial statement analysis.
• Describe the sources of information for financial statement analysis.
• Calculate and explain changes in financial statements using horizontal analysis, vertical analysis, and trend
analysis.
• Perform ratio analysis on financial statements using liquidity ratios, long-term solvency ratios, profitability
tests, and market tests.
• Describe the considerations used in financial statement analysis.
Accountants as investment analysts
More than ever, accounting students are being hired as securities analysts, portfolio managers, strategists,
consultants, or other investment specialists. Duties in these fields involve understanding the operations of the
company, assessing the value of the company, and predicting its future performance. These fields can be
enormously exciting and may reap tremendous monetary rewards to those who are successful. For example,
Apple's stock closed at USD 21.82 per share in January 2002, and at USD 218.95 in March 2010. So, if you had
invested in Apple stock in 2002 your investment would have been worth ten times as much in 2010. Not bad!
Of course, failure to understand the relationship between financial accounting information and company value can
result in negative consequences as well. For example, during the dot.com boom, the stock of Webvan, an online
grocer, plummeted from a high of USD 40 to just six cents within a few months as investors realized that the
company could not meet expected earnings projections and was therefore highly overvalued. (Later, however,
framed Webvan stock certificates were selling on Ebay for over USD 100.oo as stark symbols of the dot.com bust).
In the area of investing, what accounting information can be used to separate the winners from the losers?
This is the goal of investment analysts—to understand the current value of a company and then use available
information in predicting future performance. Investment analysts rely heavily on financial statements as a source
of information in predicting stock price movements. Since financial statements are prepared by accountants, it is no
surprise that accountants are being hired for purposes of interpreting financial information and making
predictions. Given the complexity of business organizations and business transactions in today's global markets,
accounting professionals no longer are solely responsible for preparing financial statements, but are being asked to
interpret these statements as well.
Accounting Principles: A Business Perspective 675 A Global Text
17. Analysis and interpretation of financial statements
The two primary objectives of every business are solvency and profitability. Solvency is the ability of a company
to pay debts as they come due; it is reflected on the company's balance sheet. Profitability is the ability of a
company to generate income; it is reflected on the company's income statement. Generally, all those interested in
the affairs of a company are especially interested in solvency and profitability.
This chapter discusses several common methods of analyzing and relating the data in financial statements and,
as a result, gaining a clear picture of the solvency and profitability of a company. Internally, management analyzes a
company's financial statements as do external investors, creditors, and regulatory agencies. Although these users
have different immediate goals, their overall objective in financial statement analysis is the same—to make
predictions about an organization as an aid in decision making.
Objectives of financial statement analysis
Management's analysis of financial statements primarily relates to parts of the company. Using this approach,
management can plan, evaluate, and control operations within the company. Management obtains any information
it wants about the company's operations by requesting special-purpose reports. It uses this information to make
difficult decisions, such as which employees to lay off and when to expand operations. Our primary focus in this
chapter, however, is not on the special reports accountants prepare for management. Rather, it is on the
information needs of persons outside the firm.
Investors, creditors, and regulatory agencies generally focus their analysis of financial statements on the
company as a whole. Since they cannot request special-purpose reports, external users must rely on the general-
purpose financial statements that companies publish. These statements include a balance sheet, an income
statement, a statement of stockholders' equity, a statement of cash flows, and the explanatory notes that accompany
the financial statements.
Users of financial statements need to pay particular attention to the explanatory notes, or the financial review,
provided by management in annual reports. This integral part of the annual report provides insight into the scope
of the business, the results of operations, liquidity and capital resources, new accounting standards, and geographic
area data. Moreover, this section provides an economic outlook that an analyst may find very helpful when
considering the possible future profitability of the company.
Financial statement analysis consists of applying analytical tools and techniques to financial statements and
other relevant data to obtain useful information. This information reveals significant relationships between data
and trends in those data that assess the company's past performance and current financial position. The
information shows the results or consequences of prior management decisions. In addition, analysts use the
information to make predictions that may have a direct effect on decisions made by users of financial statements.
Present and potential investors are interested in the future ability of a company to earn profits—its profitability.
These investors wish to predict future dividends and changes in the market price of the company's common stock.
Since both dividends and price changes are likely to be influenced by earnings, investors may predict earnings. The
company's past earnings record is the logical starting point in predicting future earnings.
Some outside parties, such as creditors, are more interested in predicting a company's solvency than its
profitability. The liquidity of the company affects its short-term solvency. The company's liquidity is its state of
possessing liquid assets, such as cash and other assets easily converted to cash. Because companies must pay short-
term debts soon, liquid assets must be available for their payment. For example, a bank asked to extend a 90-day
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loan to a company would want to know the company's projected short-term liquidity. Of course, the company's
predicted ability to repay the 90-day loan is likely to be based at least partially on its past ability to pay off debts.
Long-term creditors are interested in a company's long-term solvency, which is usually determined by the
relationship of a company's assets to its liabilities. Generally, we consider a company to be solvent when its assets
exceed its liabilities so that the company has a positive stockholders' equity. The larger the assets are in relation to
the liabilities, the greater the long-term solvency of the company. Thus, the company's assets could shrink
significantly before its liabilities would exceed its assets and destroy the company's solvency.
Investors perform several types of analyses on a company's financial statements. All of these analyses rely on
comparisons or relationships of data that enhance the utility or practical value of accounting information. For
example, knowing that a company's net income last year was USD 100,000 may or may not, by itself, be useful
information. Some usefulness is added when we know that the prior year's net income was USD 25,000. And even
more useful information is gained if we know the amounts of sales and assets of the company. Such comparisons or
relationships may be expressed as:
• Absolute increases and decreases for an item from one period to the next.
• Percentage increases and decreases for an item from one period to the next.
• Percentages of single items to an aggregate total.
• Trend percentages.
• Ratios.
Earlier chapters have discussed and illustrated many of these analysis techniques. However, in this chapter we
apply all of these techniques in analyzing Synotech, Inc.'s performance. This was the company introduced in
Chapter 16.
Items 1 and 2 make use of comparative financial statements. Comparative financial statements present the
same company's financial statements for one or two successive periods in side-by-side columns. The calculation of
dollar changes or percentage changes in the statement items or totals is horizontal analysis. This analysis detects
changes in a company's performance and highlights trends.
Analysts also use vertical analysis of a single financial statement, such as an income statement. Vertical
analysis (item 3) consists of the study of a single financial statement in which each item is expressed as a
percentage of a significant total. Vertical analysis is especially helpful in analyzing income statement data such as
the percentage of cost of goods sold to sales.
Financial statements that show only percentages and no absolute dollar amounts are common-size
statements. All percentage figures in a common-size balance sheet are percentages of total assets while all the
items in a common-size income statement are percentages of net sales. The use of common-size statements
facilitates vertical analysis of a company's financial statements.
Trend percentages (item 4) are similar to horizontal analysis except that comparisons are made to a selected
base year or period. Trend percentages are useful for comparing financial statements over several years because
they disclose changes and trends occurring through time.
Ratios (item 5) are expressions of logical relationships between items in the financial statements of a single
period. Analysts can compute many ratios from the same set of financial statements. A ratio can show a relationship
between two items on the same financial statement or between two items on different financial statements (e.g.
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17. Analysis and interpretation of financial statements
balance sheet and income statement). The only limiting factor in choosing ratios is the requirement that the items
used to construct a ratio have a logical relationship to one another.
Sources of information
Financial information about publicly owned corporations can come from different sources such as published
reports, government reports, financial service information, business publications, newspapers, and periodicals.
Public corporations must publish annual financial reports. The Annual report appendix gives such data for The
Limited, Inc.. The major sections of an annual report are (not necessarily in this order):
• Consolidated financial statements Consolidated financial statements include a balance sheet
containing two years of comparative data; an income statement containing three years of comparative data; a
statement of cash flows containing three years of comparative data; and a statement of shareholders' equity
containing three years of comparative data. For examples of each statement, refer to the annual report booklet.
• Notes to consolidated financial statements Notes to consolidated financial statements provide an in-
depth look into the numbers contained in the financial statements. The notes usually contain sections on
significant accounting policies, long-term debt, leases, stock option plans, etc. These explanations allow
stockholders to look beyond the numbers to the events that triggered the dollar amounts recorded in the
financial statements.
• Letters to stockholders Most annual reports are introduced with a letter to the stockholders. The letter
often includes information about the company's past history, its mission, current year operating results, and
the company's future goals.
• Reports of independent accountants The Securities and Exchange Commission (SEC) requires the
financial statements of certain companies to be audited. The report of independent accountants, found at the
end of the financial statements, provides assurance that the financial statements prepared by the company
have been audited and are free of material misstatements. The report also may include a paragraph
highlighting the significant accounting policies that the company has changed recently.
• Management discussion and analysis The management discussion and analysis section of the annual
report provides management's view of the performance of the company. The analysis is based on the financial
statements, the conditions of the industry, and ratios.
Publicly held companies must file detailed annual reports (Form 10-K), quarterly reports (Form 10-Q), and
special events reports (Form 8-K) with the Securities and Exchange Commission. These reports are available to the
public for a small charge and sometimes contain more detailed information than the published reports.
Financial statement information is often more meaningful when users compare it with industry norms. Two
firms that provide information on individual companies and industries are Moody's Investors Service and Standard
& Poor's. Dun & Bradstreet Companies, Inc., publishes Key Business Ratios and Robert Morris Associates publishes
Annual Statement Studies; both provide information for specific industries. Standard & Poor's Industry Surveys
contains background descriptions and the economic outlook for different industries.
Business publications such as The Wall Street Journal, Barron's, Forbes, and Fortune also report industry
financial news. Because financial statement users must be knowledgeable about current developments in business,
the information in financial newspapers and periodicals is very valuable to them.
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Horizontal analysis and vertical analysis: An illustration
The comparative financial statements of Synotech, Inc., will serve as a basis for an example of horizontal
analysis and vertical analysis of a balance sheet and a statement of income and retained earnings. Recall that
horizontal analysis calculates changes in comparative statement items or totals, whereas vertical analysis consists of
a comparison of items on a single financial statement.
Imagine that you are a prospective investor interested in Synotech, Inc.. You have acquired the 2010 Annual
Report of the company and want to perform some horizontal and vertical analyses of the financial statements.
First, we begin with the balance sheets. Exhibit 133 shows the comparative balance sheets for 2010 and 2009 in
Columns (1) and (2). Take a few minutes to study the balance sheets. Then review Columns (3) and (4), which show
the horizontal analysis that would be performed on the comparative balance sheets.
Column (3) shows the change that occurred in each item between 2009 December 31, and 2010 December 31. If
the change between the two dates is an increase from 2009 to 2010, the change is a positive figure. If the change is
a decrease, the change is a negative figure and is shown in parentheses. Column (4) shows the percentage change in
each item. You can calculate the percentage change by dividing the dollar change by the dollar balance of the earlier
year (2009). While examining the horizontal analysis in Exhibit 133 note that:
• Total current assets have increased USD 14.3 million, consisting largely of increases in cash, marketable
securities, and other current assets despite a USD 63.0 million decrease in net receivables, while total current
liabilities have increased USD 181.4 million, largely as a result of increases in the current portion of long-term
debt and other accruals.
• Total liabilities have decreased USD 114.1 million, while total assets increased by USD 311.0 million.
Next, study Column (4), which expresses as a percentage the dollar change in Column (3). Frequently, these
percentage increases are more informative than absolute amounts, as illustrated by the current asset and current
liability changes. Although the absolute amount of current liabilities has increased tremendously over the amount
of current assets, the percentages reveal that current assets increased .5 per cent, while current liabilities increased
8.6 per cent. Thus, current liabilities are increasing at a faster rate than current assets. Current assets still exceed
current liabilities. This fact indicates that the company will be able to pay its debts as they come due.
Studying the percentages in Column (4) could lead to several other observations. For instance, the 6.9 per cent
decrease in long-term debt indicates that interest charges will be lower in the future, having a positive effect on
future net income. The 14.2 per cent increase in retained earnings could be a sign of increased dividends in the
future; in addition, the increase in cash of 19 per cent could support this conclusion.
Now examine Columns (5) and (6) to see the vertical analysis that would be performed. A vertical analysis of the
company's balance sheet discloses each account's significance to total assets or total equities. This comparison aids
in assessing the importance of the changes in each account. Columns (5) and (6) in Exhibit 133 express the dollar
amount of each item in Columns (1) and (2) as a percentage of total assets or equities. For example, although other
assets declined USD 6.3 million in 2010, the decrease of 1.4 per cent in the account represents only approximately
4.8 per cent of total assets and, therefore, probably does not have great significance. Vertical analysis also shows
that total debt financing decreased from 78.0 per cent of total equities (liabilities and stockholders' equity) in 2009,
to 74.3 per cent in 2010. At the same time, the percentage of stockholder financing to total assets of the company
increased from 22.0 per cent to 25.7 per cent.
Synotech, Inc.
Accounting Principles: A Business Perspective 679 A Global Text
17. Analysis and interpretation of financial statements
Comparative balance sheets
2010 December 31, and 2009
Horizontal Analysis Vertical Analysis December 31
Increase or (Decrease)
2010 over 2009
Per cent of Total Assets
(1) (2) (3) (4) (5) (6) Assets 2010 2009 Dollars* Per cent* 2010 2009
Current assets Cash and cash equivalents
$ 298.0 $ 250,5 $47.5 19.0% 3.1 % 2.7 %
Marketable securities 71.3 57.5 13.8 24.0 0.8 0.6 Receivables, net 1,277.3 1,340.3 (63.0) (4.7) 13.5 14.6 Inventories 924.8 929.8 (5.0) (0.5) 9.8 10.1 Other current assets 275.3 254.3 21.0 8.3 2.9 2.8 Total current assets $2,846.7 $2,832.4 $14.3 0.5 30.0 30.9 Property, plant and equipment, net
2,914.7 2,586.2 328.5 12.7 30.7 28.2
Goodwill and other intangibles, net
3,264.5 3,290.0 (25.5) (0.8) 34.4 35.9
Other assets 455.9 462.2 (6.3) (1.4) 4.8 5.0 Total assets $9,481.8 $9,170.8 $311.0 3.4 100.0 100.0 Liabilities and shareholders' equity Current liabilities Notes and loans payable
$ 206.8 $ 245.3 $ (38.5) (15.7) 2.2 2.7
Current portion of long-term debt
132.5 44.4 88.1 198.4 1.4 0.5
Accounts payable 902.0 886.4 15.6 1.8 9.5 9.7 Accrued income taxes 111.7 92.1 19.6 21.3 1.2 1.0 Other accruals 932.2 835.6 96.6 11.6 9.8 9.1 Total current liabilities
$2,285.2 $2,103.8 $181.4 8.6 24.1 22.9
Long-term debt 3,344.2 3,590.4 (246.2) (6.9) 35.3 39.2 Deferred income taxes 281.2 284.8 (3.6) (1.3) 3.0 3.1 Other liabilities 1,130.4 1,176.1 (45.7) (3.9) 11.9 12.8 Total liabilities $7,041.0 $7,155.1 $(114.1) (1.6) 74.3 78.0 Shareholders' equity Preferred stock $ 471.2 $ 484.2 $ (13.0) (2.7) 5.0 5.3 Common stock, $1.20 par value (500,000,000 shares authorized, 183,213,295 shares issued)
219.9 219.9 0.0 0.0 2.3 2.4
Additional paid-in capital
1,321.9 1,240.4 81.5 6.6 13.9 13.5
Retained earnings 3,277.1 2,870.6 406.5 14.2 34.6 31.3 Cumulative translation adjustments
(641.6) (615.6) (26.0) 4.2 -6.8 -6.7
$4,648.5 $4,199.5 $449.0 10.7 49.0 45.8 Unearned compensation
(445.1) (453.6) 8.5 (1.9) -4.7 -4.9
Treasury stock, at cost(1,762.6) (1,30.2) (32.4) 1.9 -18.6 -18.9 Total shareholders' equity
$2,440.8 $2,015.7 $425.1 21.1 25.7 22.0
Total liabilities and stockholders equity $9,481.8 $9,170.8 $311.0 3.4 100.0 100.0
*Dollars = (1) – (2); Per cent = (3)/(2)
Exhibit 133: Comparative balance sheets
Exhibit 134 provides the information needed to analyze Synotech's comparative statements of income and
retained earnings. Such a statement merely combines the income statement and the statement of retained earnings.
Columns (7) and (8) in Exhibit 134 show the dollar amounts for the years 2010 and 2009, respectively. Study these
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statements for a few minutes. Then examine Columns (9) and (10) which show the horizontal analysis that would
be performed on the company's comparative statements of income and retained earnings. Columns (9) and (10)
show the absolute and percentage increase or decrease in each item from 2009 to 2010. The absolute change is
determined by deducting the 2009 amount from the 2010 amount. If the change between two dates is an increase
from 2009 to 2010, the change is a positive figure. If the change is a decrease, the change is a negative figure and is
shown in parentheses. You calculate the percentage change by dividing the dollar change by the dollar amount for
2009.
Synotech, Inc. Comparative statements of income and retained earnings
For the years ended 2010 December 31, and 2009 (USD millions)
Horizontal analysis Vertical analysis Year ended
December 31Increase or 2010 over
(decrease) 2009
Per cent of
net sales
(7) (8) (9) (10) (11) (12) 2007 2006 Dollars* Per cent* 2010 2009
Net sales $10,498.8 $10,029.8 $469.0 4.7% 100.0% 100.0% Cost of goods sold 5,341.3 5,233.7 117.6 2.3 50.9 52.1 Gross profit $5,157.5 $4,806.1 $351.4 7.3 49.1 47.9 Selling, general and administrative expenses
3,662.5 3,455.5 207.0 6.0 34.9 34.5
Provision for restructured operations
--- 552.6 (552.6) (100.0) 0.0 5.5
Other expense, net 112.6 115.3 (2.7) (2.3) 1.1 1.1 Interest expense, net of interest income of $41.2 and $36.7, respectively
236.9 246.5 (9.6) (3.9) 2.3 2.5
Income before income taxes $1,145.5 $436.2 $709.3 162.6 10.9 4.3 Provision for income taxes 383.5 229.8 153.7 66.9 3.7 2.3 Net income $762.0 $206.4 $555.6 269.2 7.3 2.1 Retained earnings, January 1 2,870.6 2,996.0 (125.4) (4.2) Total $3,632.6 $3,202.4 $430.2 13.4 Dividends declared: Series B convertible preference stock, net of income taxes
25.1 25.3 (0.2) (0.8)
Preferred stock 0.6 0.6 0.0 0.0 Common stock 329.8 305.9 23.9 7.8 Retained earnings, December 31
$3,277.1 $2,870.6 $406.5 14.2
*Dollars = (7) – (8); Per cent = (9)/(8)
Exhibit 134: Comparative statements of income and retained earnings
Having completed the horizontal analysis and vertical analysis of Synotech's balance sheet and statement of
income and retained earnings, you are ready to study trend percentages and ratio analysis. The last section in this
chapter discusses some final considerations in financial statement analysis. Professional financial statement
analysts use several tools and techniques to determine the solvency and profitability of companies.
The horizontal analysis shows that sales increased a total of USD 469.0 million, an increase of 4.7 per cent. Since
cost of goods sold increased by a much smaller amount (USD 117.6 million), gross profit increased by USD 351.4, or
7.3 per cent. The USD 552.6 million expense in 2009 was the result of a provision for restructured operations.
Although this is not a recurring expense, it does not classify as an extraordinary expense and is treated as part of
income from continuing operations.
Now look at Columns (11) and (12) to see the vertical analysis that would be performed. Columns (11) and (12)
express the dollar amount of each item in Columns (7) and (8) as a percentage of net sales. Even though cost of
goods sold increased in 2010, it remained a fairly constant percentage of net sales. Therefore, gross profit as a
Accounting Principles: A Business Perspective 681 A Global Text
17. Analysis and interpretation of financial statements
percentage of net sales increased only slightly. The percentage of expenses to net sales decreased somewhat, thus
yielding an increase in income before income taxes as a percentage of net sales.
Trend percentages
Trend percentages, also referred to as index numbers, help you to compare financial information over time to a
base year or period. You can calculate trend percentages by:
• Selecting a base year or period.
• Assigning a weight of 100 per cent to the amounts appearing on the base-year financial statements.
• Expressing the corresponding amounts on the other years' financial statements as a percentage of base-year
or period amounts. Compute the percentages by dividing nonbase-year amounts by the corresponding base-
year amounts and then multiplying the result by 100.
The following information for Synotech illustrates the calculation of trend percentages:
(USD millions) 2008 2009 2010 Net sales $ 9,105.5 $10,029.8 $10,498.8 Cost of goods sold 4,696.0 5,223.7 5,341.3 Gross profit $ 4,409.5 $ 4,806.1 $ 5,157.5 Operating expenses 3,353.6 4,369.9 4,012.0 Income before income taxes $ 1,055.9 $ 436.2 $ 1,145.5
If 2008 is the base year, to calculate trend percentages for each year divide net sales by USD 9,105.5 million;
cost of goods sold by USD 4,696.0 million; gross profit by USD 4,409.5 million; operating expenses by USD 3,353.6
million; and income before income taxes by USD 1,055.9 million. After all divisions have been made, multiply each
result by 100. The resulting percentages reflect trends as follows:
2008 2009 2010 Net sales 100.0% 119.2% 115.3% Cost of goods sold 100.0 111.2 113.7 Gross profit 100.0 109.0 117.0 Operating expenses 100.0 130.3 119.6 Income before income taxes 100.0 41.3 108.5
These trend percentages indicate the changes taking place in the organization and highlight the direction of
these changes. For instance, the percentage of sales is increasing each year compared to the base year. Cost of goods
sold increased at a lower rate than net sales in 2008 and 2010, causing gross profit to increase at a higher rate than
net sales. Operating expenses in 2009 increased due to the provision for restructured operations, causing a
significant decrease in income before income taxes. Percentages provide clues to an analyst about which items need
further investigation or analysis. In reviewing trend percentages, a financial statement user should pay close
attention to the trends in related items, such as the cost of goods sold in relation to sales. Trend analysis that shows
a constantly declining gross margin (profit) rate may be a signal that future net income will decrease.
As useful as trend percentages are, they have one drawback. Expressing changes as percentages is usually
straightforward as long as the amount in the base year or period is positive—that is, not zero or negative. Analysts
cannot express a USD 30,000 increase in notes receivable as a percentage if the increase is from zero last year to
USD 30,000 this year. Nor can they express an increase from a loss last year of USD 10,000 to income this year of
USD 20,000 in percentage terms.
Proper analysis does not stop with the calculation of increases and decreases in amounts or percentages over
several years. Such changes generally indicate areas worthy of further investigation and are merely clues that may
lead to significant findings. Accurate predictions depend on many factors, including economic and political
conditions; management's plans regarding new products, plant expansion, and promotional outlays; and the
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expected activities of competitors. Considering these factors along with horizontal analysis, vertical analysis, and
trend analysis should provide a reasonable basis for predicting future performance.
Ratio analysis
Logical relationships exist between certain accounts or items in a company's financial statements. These
accounts may appear on the same statement or on two different statements. We set up the dollar amounts of the
related accounts or items in fraction form called ratios. These ratios include: (1) liquidity ratios; (2) equity, or long-
term solvency, ratios; (3) profitability tests; and (4) market tests.
Liquidity ratios indicate a company's short-term debt-paying ability. Thus, these ratios show interested parties
the company's capacity to meet maturing current liabilities.
Current (or working capital) ratio Working capital is the excess of current assets over current liabilities.
The ratio that relates current assets to current liabilities is the current (or working capital) ratio. The current
ratio indicates the ability of a company to pay its current liabilities from current assets and, thus, shows the
strength of the company's working capital position.
You can compute the current ratio by dividing current assets by current liabilities:
Current ratio= Current assets
Current liabilities
The ratio is usually stated as a number of dollars of current assets to one dollar of current liabilities (although
the dollar signs usually are omitted). Thus, for Synotech in 2010, when current assets totaled USD 2,846.7 million
and current liabilities totaled USD 2,285.2 million, the ratio is 1.25:1, meaning that the company has USD 1.25 of
current assets for each USD 1.00 of current liabilities.
The current ratio provides a better index of a company's ability to pay current debts than does the absolute
amount of working capital. To illustrate, assume that we are comparing Synotech to Company B. For this example,
use the following totals for current assets and current liabilities:
Synotech Company B Current assets (a) $ 2,846.7 $120.0 Current liabilities (b) 2,285.2 53.2 Working capital (a – b) $ 561.5 $ 66.8 Current ratio (a/b) 1.25:1 2.26:1
Synotech has eight times as much working capital as Company B. However, Company B has a superior debt-
paying ability since it has USD 2.26 of current assets for each USD 1.00 of current liabilities.
Short-term creditors are particularly interested in the current ratio since the conversion of inventories and
accounts receivable into cash is the primary source from which the company obtains the cash to pay short-term
creditors. Long-term creditors are also interested in the current ratio because a company that is unable to pay
short-term debts may be forced into bankruptcy. For this reason, many bond indentures, or contracts, contain a
provision requiring that the borrower maintain at least a certain minimum current ratio. A company can increase
its current ratio by issuing long-term debt or capital stock or by selling noncurrent assets.
A company must guard against a current ratio that is too high, especially if caused by idle cash, slow-paying
customers, and/or slow-moving inventory. Decreased net income can result when too much capital that could be
used profitably elsewhere is tied up in current assets.
Accounting Principles: A Business Perspective 683 A Global Text
17. Analysis and interpretation of financial statements
Refer to Exhibit 133. The Synotech data in Column (4) indicate that current liabilities are increasing more
rapidly than current assets. We could also make such an observation directly by looking at the change in the current
ratio. Synotech's current ratios for 2010 and 2009 follow:
December 31 (USD millions) 2010 2009 Amount of
increase Current assets (a) $2,846.7 $,2832.4 14.3 Current liabilities (b) 2,285.6 2,103.8 181.4 Working capital (a – b) $ 561.5 $ 728.6 $(167.1) Current ratio (a/b) 1.25:1 1.35:1
Synotech's working capital decreased by USD 167.1 million, or 22.9 per cent (USD 167.1/USD 728.6), and its
current ratio decreased from 1.35:1 to 1.25:1. Together, these figures reflect that its current liabilities increased
faster than its current assets.
Acid-test (quick) ratio The current ratio is not the only measure of a company's short-term debt-paying
ability. Another measure, called the acid-test (quick) ratio, is the ratio of quick assets (cash, marketable
securities, and net receivables) to current liabilities. Analysts exclude inventories and prepaid expenses from
current assets to compute quick assets because they might not be readily convertible into cash. The formula for the
acid-test ratio is:
Acid− test ratio= Quickassets
Current liabilities
Short-term creditors are particularly interested in this ratio, which relates the pool of cash and immediate cash
inflows to immediate cash outflows.
The acid-test ratios for 2010 and 2009 for Synotech are:
December 31 (USD millions) 2010 2009 Amount of
increase or (decrease)
Quick assets (a) $1,646.6 $1,648.3 $ (1.7) Current liabilities (b) 2,285.6 2,103.8 181.8 Net quick assets (a – b) $ (639.0) $ (455.5) $(183.5) Acid-test ratio (a/b) .72:1 .78:1
In deciding whether the acid-test ratio is satisfactory, investors consider the quality of the marketable securities
and receivables. An accumulation of poor-quality marketable securities or receivables, or both, could cause an acid-
test ratio to appear deceptively favorable. When referring to marketable securities, poor quality means securities
likely to generate losses when sold. Poor-quality receivables may be uncollectible or not collectible until long past
due. The quality of receivables depends primarily on their age, which can be assessed by preparing an aging
schedule or by calculating the accounts receivable turnover. (Covered in Chapter 9.)
Cash flow liquidity ratio Another approach to measuring short-term liquidity is the cash flow liquidity
ratio. The numerator, as an approximation of cash resources, consists of (1) cash and marketable securities, or
liquid current assets, and (2) net cash provided by operating activities, or the cash generated from the company's
operations. This reflects the company's ability to sell inventory and collect accounts receivable. The formula for the
cash flow liquidity ratio is:
Cash also marketable securitiesNet cash provided byoperating activities Current liabilities
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For 2010, Synotech has USD 298.0 million in cash and cash equivalents, USD 71.3 million in marketable
securities, USD 2,285.2 million in current liabilities, and USD 1,101.0 million in cash provided by operating
activities (taken from the statement of cash flows in its annual report). Its cash flow liquidity ratio is:
USD298.0USD 71.3USD1,101.0
USD2,285 :2 =.64 time
This indicates that the company is going to have to rely on some other sources of funding to pay its current
liabilities. The company's liquid current assets will only cover about two-thirds of the current liabilities. Possibly
net cash provided by operations will be substantially higher in 2011.
Accounts receivable turnover Turnover is the relationship between the amount of an asset and some
measure of its use. Accounts receivable turnover is the number of times per year that the average amount of
receivables is collected. To calculate this ratio, divide net credit sales (or net sales) by average net accounts
receivable; that is, accounts receivable after deducting the allowance for uncollectible accounts:
Accounts receivable turnover= Net credit sales net sales
Average net accounts receivable
When a ratio compares an income statement item (like net credit sales) with a balance sheet item (like net
accounts receivable), the balance sheet item should be an average. Ideally, analysts calculate average net accounts
receivable by averaging the end-of-month balances or end-of-week balances of net accounts receivable outstanding
during the period. The greater the number of observations used, the more accurate the resulting average. Often,
analysts average only the beginning-of-year and end-of-year balances because this information is easily obtainable
Accounting Principles: A Business Perspective 685 A Global Text
17. Analysis and interpretation of financial statements
from comparative financial statements. Sometimes a formula calls for the use of an average balance, but only the
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year-end amount is available. Then the analyst must use the year-end amount.51
In theory, the numerator of the accounts receivable turnover ratio consists of only net credit sales because those
are the only sales that generate accounts receivable. However, if cash sales are relatively small or their proportion to
total sales remains fairly constant, analysts can obtain reliable results by using total net sales. In most cases, the
analyst may have to use total net sales because the separate amounts of cash sales and credit sales are not reported
on the income statement.
Synotech's accounts receivable turnover ratios for 2010 and 2009 follow. Net accounts receivable on 2009
January 1, totaled USD 1,259.5 million.
December 31 (USD millions) 2010 2009 Amount of increase Net sales (a) $10,498.8 $10,029.8 $469.0 Net accounts receivable: January 1 $ 1,340.3 $ 1,259.5 $ 80.8 December 31 1,277.3 1,340.3 (63.0) Total (b) $ 2,617.6 $ 2,599.8 $ 17.8 Average net receivables (c) (b/2 = c) $ 1,308.8 $1,299.9 Turnover of accounts receivable (a/c) 8.02 7.72
The accounts receivable turnover ratio provides an indication of how quickly the company collects receivables.
The accounts receivable turnover ratio for 2010 indicates that Synotech collected, or turned over, its accounts
receivable slightly more than eight times. The ratio is better understood and more easily compared with a
company's credit terms if we convert it into a number of days, as is illustrated in the next ratio.
Number of days' sales in accounts receivable The number of days' sales in accounts receivable
ratio is also called the average collection period for accounts receivable. Calculate it as follows:
Number of days ' sales per accounts receivable= Number of daysper year 365
Accounts receivable turnover
The turnover ratios for Synotech show that the number of days' sales in accounts receivable decreased from
about 47 days (365/7.72) in 2009 to 46 days (365/8.02) in 2010. The change means that the average collection
period for the company's accounts receivable decreased from 47 to 46 days.
An accounting perspective:
Business insight
The number of days' sales in accounts receivable ratio measures the average liquidity of accounts
receivable and indicates their quality. Generally, the shorter the collection period, the higher the
quality of receivables. However, the average collection period varies by industry; for example,
collection periods are short in utility companies and much longer in some retailing companies. A
comparison of the average collection period with the credit terms extended customers by the
company provides further insight into the quality of the accounts receivable. For example,
receivables with terms of 2/10, n/30 and an average collection period of 75 days need to be
investigated further. It is important to determine why customers are paying their accounts much
later than expected.
Accounting Principles: A Business Perspective 687 A Global Text
17. Analysis and interpretation of financial statements
Inventory turnover A company's inventory turnover ratio shows the number of times its average inventory is
sold during a period. You can calculate inventory turnover as follows:
Inventory turnover= Cost of goods sold
Average inventory
When comparing an income statement item and a balance sheet item, measure both in comparable dollars.
Notice that we measure the numerator and denominator in cost rather than sales dollars. (Earlier, when calculating
accounts receivable turnover, we measured both numerator and denominator in sales dollars.) Inventory turnover
relates a measure of sales volume to the average amount of goods on hand to produce this sales volume.
Synotech's inventory on 2009 January 1, was USD 856.7 million. The following schedule shows that the
inventory turnover decreased slightly from 5.85 times per year in 2009 to 5.76 times per year in 2010. To convert
these turnover ratios to the number of days it takes the company to sell its entire stock of inventory, divide 365 by
the inventory turnover. Synotech's average inventory sold in about 63 and 62 (365/5.76 and 365/5.85) in 2010 and
2009, respectively.
December31 (USD millions) 2010 2009 Amount of
increase or (decrease)
Cost of goods sold (a) $5,341.3 $5,223.7 $117.6 Merchandise inventory: January 1 $929.8 $856.7 $ 73.1 December 31 924.8 929.8 (5.0) Total (b) $1,854.6 $1,786.5 $ 68.1 Average inventory (c) (b/2 = c) $927.3 $893.3 Turnover of inventory (a/c) 5.76 5.85
Other things being equal, a manager who maintains the highest inventory turnover ratio is the most efficient.
Yet, other things are not always equal. For example, a company that achieves a high inventory turnover ratio by
keeping extremely small inventories on hand may incur larger ordering costs, lose quantity discounts, and lose sales
due to lack of adequate inventory. In attempting to earn satisfactory income, management must balance the costs of
inventory storage and obsolescence and the cost of tying up funds in inventory against possible losses of sales and
other costs associated with keeping too little inventory on hand.
An accounting perspective:
Business insight
Cabletron Systems develops, manufactures, installs, and supports a wide range of standards-based
LAN and WAN connectivity hardware and software products. For the year ended 2009December
31, , both its number of day's sales in accounts receivable and its inventory turnover rate increased
as compared to the prior year. In its 2009 annual report, the company explained these increases as
follows:
Accounts receivable, net of allowance for doubtful accounts, were USD 210.9 million, or 66 days of
sales outstanding, at 2009 December 31 compared to USD 228.4 million at 2008 December 31, or
54 days sales outstanding. The increase in days of sales outstanding was a result of the timing of
sales and related collections.
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Worldwide inventories were USD 98.1 million at 2009 December 31 or 63 days of inventory,
compared to USD 85.0 million, or 37 days of inventory, at 2008 December 31. The increase of days
in inventory was due to the increase in finished goods inventory purchased to protect against an
anticipated shortage of supply components.
Total assets turnover Total assets turnover shows the relationship between the dollar volume of sales and
the average total assets used in the business. We calculate it as follows:
Total assets turnover= Net sales
Average totalassets
This ratio measures the efficiency with which a company uses its assets to generate sales. The larger the total
assets turnover, the larger the income on each dollar invested in the assets of the business. For Synotech, the total
asset turnover ratios for 2010 and 2009 follow. Total assets as of 2009 January 1, were USD 7,370.9 million.
(USD millions) 2010 2009 Amount of increase
Net sales (a) $ 10,498.8 $ 10,029.8 $ 469.0 Total assets: January 1 $9,170.8 $7,370.9 $1,799.9 December 31 9,481.8 9,170.8 311.0 Total (b) $18,652.6 $16,541.7 $2,110.9 Average total assets (c) (b/2 = c) $9,331.8 $8,270.9 Turnover of total assets (a/c) 1.13:1 1.21:1
Each dollar of total assets produced USD 1.21 of sales in 2009 and USD 1.13 of sales in 2010. In other words,
between 2009 and 2010, the company had a decrease of USD .08 of sales per dollar of investment in assets.
Equity, or long-term solvency, ratios show the relationship between debt and equity financing in a company.
Equity (stockholders' equity) ratio The two basic sources of assets in a business are owners (stockholders)
and creditors; the combined interests of the two groups are total equities. In ratio analysis, however, the term
equity generally refers only to stockholders' equity. Thus, the equity (stockholders' equity) ratio indicates the
proportion of total assets (or total equities) provided by stockholders (owners) on any given date. The formula for
the equity ratio is:
Equity ratio= Stockholders ' equity
Total assets totalequities
Synotech's liabilities and stockholders' equity from Exhibit 133 follow. The company's equity ratio increased
from 22.0 per cent in 2009 to 25.7 per cent in 2010. Exhibit 133 shows that stockholders increased their
proportionate equity in the company's assets due largely to the retention of earnings (which increases retained
earnings).
2010 December 31
2009 December 31
(USD millions) Amount Per cent Amount Per cent Current liabilities $2,285.2 24.1% $2,103.8 22.9% Long-term liabilities 4,755.8 50.2 5,051.3 55.1 Total liabilities $7,041.0 74.3 $7,155.1 78.0 Total stockholders' equity 2,440.8 25.7 2,015.7 22.0 Total equity (equal to total assets)
$9,481.8 100% $9,170.8 100.0%
The equity ratio must be interpreted carefully. From a creditor's point of view, a high proportion of stockholders'
equity is desirable. A high equity ratio indicates the existence of a large protective buffer for creditors in the event a
Accounting Principles: A Business Perspective 689 A Global Text
17. Analysis and interpretation of financial statements
company suffers a loss. However, from an owner's point of view, a high proportion of stockholders' equity may or
may not be desirable. If the business can use borrowed funds to generate income in excess of the net after-tax cost
of the interest on such funds, a lower percentage of stockholders' equity may be desirable.
To illustrate the effect of higher leveraging (i.e. a larger proportion of debt), assume that Synotech could have
financed an increase in its productive capacity with USD 40 million of 6 per cent bonds instead of issuing 5 million
additional shares of common stock. The effect on income for 2010 would be as follows, assuming a federal income
tax rate of 40 per cent:
Net income as presently stated (Exhibit 134) $762,000,000 Deduct additional interest on debt (0.06 x $40 million) 2,400,000
$759,600,000 Add reduced taxes due to interest deduction (.4 x 2,400,000) 960,000 Adjusted net income $760,560,000
As shown, increasing leverage by issuing bonds instead of common stock reduces net income. However, there
are also fewer shares of common stock outstanding. Assume the company has 183 million shares of common stock
outstanding. Earnings per share (EPS) with the additional debt would be USD 4.16 (or USD 760,560,000/183
million shares), and EPS with the additional stock would be USD 4.05 (or USD 762,000,000/188 million shares).
Since investors place heavy emphasis on EPS amounts, many companies in recent years have introduced large
portions of debt into their capital structures to increase EPS, especially since interest rates have been relatively low
in recent years.
We should point out, however, that too low a percentage of stockholders' equity (too much debt) has its dangers.
Financial leverage magnifies losses per share as well as EPS since there are fewer shares of stock over which to
spread the losses. A period of business recession may result in operating losses and shrinkage in the value of assets,
such as receivables and inventory, which in turn may lead to an inability to meet fixed payments for interest and
principal on the debt. As a result, the company may be forced into liquidation, and the stockholders could lose their
entire investments.
Stockholders' equity to debt (debt to equity) ratio Analysts express the relative equities of owners and
creditors in several ways. To say that creditors held a 74.3 per cent interest in the assets of Synotech on 2010
December 31, is equivalent to saying stockholders held a 25.7 per cent interest. Another way of expressing this
relationship is the stockholders' equity to debt ratio:
Stockholders ' equity fordebt ratio= Stockholders ' equity
Total debt
Such a ratio for Synotech would be .28:1 (or USD 2,015.7 million/USD 7,155.1 million) on 2009 December 31,
and .35:1 (or USD 2,440.8 million/USD 7,041.0 million) on 2010 December 31. This ratio is often inverted and
called the debt to equity ratio. Some analysts use only long-term debt rather than total debt in calculating these
ratios. These analysts do not consider short-term debt to be part of the capital structure since it is paid within one
year.
Profitability is an important measure of a company's operating success. Generally, we are concerned with two
areas when judging profitability: (1) relationships on the income statement that indicate a company's ability to
recover costs and expenses, and (2) relationships of income to various balance sheet measures that indicate the
company's relative ability to earn income on assets employed. Each of the following ratios utilizes one of these
relationships.
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Rate of return on operating assets The best measure of earnings performance without regard to the
sources of assets is the relationship of net operating income to operating assets, the rate of return on operating
assets. This ratio shows the earning power of the company as a bundle of assets. By disregarding both
nonoperating assets and nonoperating income elements, the rate of return on operating assets measures the
profitability of the company in carrying out its primary business functions. We can break the ratio down into two
elements—the operating margin and the turnover of operating assets.
Operating margin reflects the percentage of each dollar of net sales that becomes net operating income. Net
operating income excludes nonoperating income elements such as extraordinary items, cumulative effect on
prior years of changes in accounting principle, losses or gains from discontinued operations, interest revenue, and
interest expense. Another name for net operating income is "income before interest and taxes" (IBIT). The
formula for operating margin is:
Operating margin= Net operatingincome
Net sales
Turnover of operating assets shows the amount of sales dollars generated for each dollar invested in
operating assets. Operating assets are all assets actively used in producing operating revenues. Typically, we use
year-end operating assets, even though in theory an average would be better. Nonoperating assets are owned by
a company but not used in producing operating revenues, such as land held for future use, a factory building rented
to another company, and long-term bond investments. Analysts do not use these nonoperating assets in evaluating
earnings performance. Nor do they use total assets that include nonoperating assets not contributing to the
generation of sales. The formula for the turnover of operating assets is:
Turnover of operatingassets= Net sales
Operatingassets
The rate of return on operating assets of a company is equal to its operating margin multiplied by turnover of
operating assets. The more a company earns per dollar of sales and the more sales it makes per dollar invested in
operating assets, the higher is the return per dollar invested. To find the rate of return on operating assets, use the
following formulas:
Operating margin×Turnover of operatingassets=Rate of return on operatingassets
or
Rate of return onoperatingassets= Net operating income
Net sales ×
Net sales
Operatingassets
Because net sales appears in both ratios (once as a numerator and once as a denominator), we can cancel it out,
and the formula for rate of return on operating assets becomes:
Rate of return onoperatingassets= Net operating income
Operatingassets
For analytical purposes, the formula should remain in the form that shows margin and turnover separately,
since it provides more information.
The rates of return on operating assets for Synotech for 2010 and 2009 are:
(USD millions) 2010 2009 Amount of increase or (decrease)
Net operating income (a)* $ 1,382.4 $ 682.7 $699.7 Net sales (b) $10,498.8 $10,029.8 $469.0 Operating assets (c) † $9,481.8 $ 9,170.8 $311.0 Operating margin (a/b) 13.17% 6.81%
Accounting Principles: A Business Perspective 691 A Global Text
17. Analysis and interpretation of financial statements
Turnover of operating assets (b/c) 1.11 times 1.09 times Rate of return on operating assets (a/c)
14.58% 7.44%
*Calculated as income before income taxes plus net interest expense. This method excludes nonoperating items.
†When companies have no nonoperating assets, total assets are used in the calculation
Net income to net sales (return on sales) ratio Another measure of a company's profitability is the net
income to net sales ratio, calculated as follows:
Net income by net sales= Net income
Net sales
This ratio measures the proportion of the sales dollar that remains after deducting all expenses. The
computations for Synotech for 2010 and 2009 are:
An accounting perspective:
Business insight
Companies that are to survive in the economy must attain some minimum rate of return on
operating assets. However, they can attain this minimum rate of return in many different ways. To
illustrate, consider a grocery store and a jewelry store, each with a rate of return of 8 per cent on
operating assets. The grocery store normally would attain this rate of return with a low margin and
a high turnover, while the jewelry store would have a high margin and a low turnover, as shown
here:
Margin x Turnover = Rate of return on operating assets
Grocery store 1% x 8.0 times = 8% Jewelry store 20 x 0.4 = 8
(USD millions) 2010 2009 Amount of increase or (decrease)
Net income (a) $ 762.0 $206.4 $555.6 Net sales (b) $10,498.
8 $10,029. 8
$469.0
Ratio of net income to net sales (a/b)
7.26% 2.06%
Although the ratio of net income to net sales indicates that the net amount of profit increased on each sales
dollar, exercise care in using and interpreting this ratio. The net income includes all nonoperating items that may
occur only in a particular period; therefore, net income includes the effects of such things as extraordinary items,
changes in accounting principle, effects of discontinued operations, and interest charges. Thus, a period that
contains the effects of an extraordinary item is not comparable to a period that contains no extraordinary items.
Also, since interest expense is deductible in the determination of net income while dividends are not, the methods
used to finance a company's assets affect net income.
Return on average common stockholders' equity From the stockholders' point of view, an important
measure of the income-producing ability of a company is the relationship of return on average common
stockholders' equity, also called rate of return on average common stockholders' equity, or simply the
return on equity (ROE). Although stockholders are interested in the ratio of operating income to operating
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assets as a measure of management's efficient use of assets, they are even more interested in the return the
company earns on each dollar of stockholders' equity. The formula for return on average common stockholders'
equity if no preferred stock is outstanding is:
Return onaveragecommon stockholders ' equity= Net income
Averagecommon stockholders ' equity
When a company has preferred stock outstanding, the numerator of this ratio becomes net income minus the
annual preferred dividends, and the denominator becomes the average book value of common stock. As described
in Chapter 12, the book value of common stock is equal to total stockholders' equity minus (1) the liquidation value
(usually equal to par value) of preferred stock and (2) any dividends in arrears on cumulative preferred stock. Thus,
the formula becomes:
Return onaveragecommon stockholders ' equity= Net income−Preferredstock dividends
Average book value of commonstock
Synotech has preferred stock outstanding. The ratios for the company follow. Total common stockholders'
equity on 2009 January 1, was USD 1,697.4 million. Preferred dividends were USD 25.7 million in 2010 and USD
25.9 million in 2009.
(USD millions) 2010 2009 Amount of increase or (decrease)
Net income – Preferred stock dividends (a)
$ 736.3 $ 180.5 $ 555.8
Total common stockholders' equity (book value of common stock):* January 1 $1,531.5 $1,697.4 $(165.9) December 31 1,969.6 1,531.5 438.1 Total (b) $3,501.1 $3,228.9 $ 272.2 Average common stockholders' equity: (c) (b/2 = c)
$1,750.6 $1,614.5
Return on common stockholders' equity (a/c)
42.06% 11.18%
*Total stockholders' equity – par value of preferred stock
The stockholders would regard the increase in the ratio from 11.18 per cent to 42.06 per cent favorably. This
ratio indicates that for each dollar of capital invested by a common stockholder, the company earned approximately
42 cents in 2010.
An accounting perspective:
Business insight
Sometimes, two companies have the same return on assets but have different returns on
stockholders' equity, as shown here:
Company 1Company 2 Return on assets 12.0% 12.0% Return on stockholders' equity
6.4 8.0
The difference of 1.6 per cent in Company 2's favor is the result of Company 2's use of borrowed
funds, particularly long-term debt, in its capital structure. Use of these funds (or preferred stock
Accounting Principles: A Business Perspective 693 A Global Text
17. Analysis and interpretation of financial statements
with a fixed return) is called trading on the equity. When a company is trading profitably on the
equity, it is generating a higher rate of return on its borrowed funds than it is paying for the use of
the funds. The excess, in this case 1.6 per cent, is accruing to the benefit of the common
stockholders, because their earnings are being increased.
Companies that magnify the gains from this activity for the stockholders are using leverage. Using
leverage is a risky process because losses also can be magnified, to the disadvantage of the common
stockholders. We discussed trading on the equity and leverage in Chapter 15.
Cash flow margin The cash flow margin measures a company's overall efficiency and performance. The cash
flow margin indicates the ability of a company to translate sales into cash. Measuring the amount of cash a
company generates from every dollar of sales is important because a company needs cash to service debt, pay
dividends, and invest in new capital assets. The formula for the cash flow margin is:
Cash flow margin= Net cash provided by operatingactivities
Net sales
Thus, we calculate Synotech's 2010 cash flow margin as follows:
USD1,101.0 million net cash provided by operatingactivities
USD10,498.8 million net sales =10.49 per cent
Earnings per share of common stock Probably the measure used most widely to appraise a company's
operations is earnings per share (EPS) of common stock. EPS is equal to earnings available to common
stockholders divided by the weighted average number of shares of common stock outstanding. The financial press
regularly publishes actual and forecasted EPS amounts for publicly traded corporations, together with period-to-
period comparisons. The Accounting Principles Board noted the significance attached to EPS by requiring that such
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amounts be reported on the face of the income statement.52 (Chapter 13 illustrates how earnings per share should
be presented on the income statement.)
The calculation of EPS may be fairly simple or highly complex depending on a corporation's capital structure. A
company has a simple capital structure if it has no outstanding securities (e.g. convertible bonds, convertible
preferred stocks, warrants, or options) that can be exchanged for common stock. If a company has such securities
outstanding, it has a complex capital structure. Discussion of EPS for a corporation with a complex capital structure
is beyond the scope of this text.
A company with a simple capital structure reports a single basic EPS amount, which is calculated as follows:
EPS of common stock= Earnings available for common stockholders
Weighted−averagenumber of common sharesoutstanding
The amount of earnings available to common stockholders is equal to net income minus the current year's
preferred dividends, whether such dividends have been declared or not.
Determining the weighted-average number of common shares The denominator in the EPS fraction is
the weighted-average number of common shares outstanding for the period. If the number of common shares
outstanding did not change during the period, the weighted-average number of common shares outstanding would,
of course, be the number of common shares outstanding at the end of the period. The balance in the Common Stock
account of Synotech (Exhibit 133) was USD 219.9 million on 2010 December 31. The common stock had a USD 1.20
par value. Assuming no common shares were issued or redeemed during 2010, the weighted-average number of
common shares outstanding would be 183.2 million (or USD 219.9 million/USD 1.20 per share). (Normally,
common treasury stock reacquired and reissued are also included in the calculation of the weighted-average
number of common shares outstanding. We ignore treasury stock transactions to simplify the illustrations.)
If the number of common shares changed during the period, such a change increases or decreases the capital
invested in the company and should affect earnings available to stockholders. To compute the weighted-average
number of common shares outstanding, we weight the change in the number of common shares by the portion of
the year that those shares were outstanding. Shares are outstanding only during those periods that the related
capital investment is available to produce income.
To illustrate, assume that during 2009 Synotech's common stock balance increased by USD 14.0 million (11.7
million shares). Assume that the company issued 9.5 million of these shares on 2009 April 1, and the other 2.2
million shares on 2009 October 1. The computation of the weighted-average number of common shares
outstanding would be:
171,5 million shares x 1 year 171.500 million 9.5 million shares x ¾ year (April – December) 7.125 million 2.2 million shares x ¼ year (October – December) .550 Weighted-average number of common shares outstanding 179.125 million
An alternate method looks at the total number of common shares outstanding, weighted by the portion of the
year that the number of shares was outstanding, as follows:
171.5 million shares x ¼ year (January – March) 42.875 million 181.0 million shares x ½ year (April – September) 90.500 million 183.2 million shares x 1/3 year (October – December) 45.800 million Weighted-average number of shares outstanding 179.175 million
Another alternate method is:
171.5 million shares x 3 months = 514.5 million share-months 181.0 million shares x 6 months = 1,086.0 million share-months 183.2 million shares x 3 months = 549.6 million share-months
Accounting Principles: A Business Perspective 695 A Global Text
17. Analysis and interpretation of financial statements
12 months 2,150.1 million share-months
2,150.1 million share-months/12 months = 179.175 million
Note that all three methods yield the same result. In 2010, the balance in the common stock account did not
change as it had during 2009. Therefore, the weighted-average number of common shares outstanding during 2010
is equal to the number of common shares issued, 183.2 million. The EPS of common stock for the Synotech are:
(USD millions) 2010 2009 Amount of increase or (decrease)
Net income-preferred dividends (a)
USD 736.30 USD 180.50 USD 555.80
Average number of shares of common stock (b)
183.2 179.13 4.03
EPS of common stock (a,b) USD 4.02 USD 1.01
Synotech's stockholders would probably view the increase of approximately 298.0 per cent ([USD 4.02 - USD
1.01]/USD 1.01) in EPS from USD 1.01 to USD 4.02 favorably.
EPS and stock dividends or splits Increases in shares outstanding as a result of a stock dividend or stock
split do not require weighting for fractional periods. Such shares do not increase the capital invested in the business
and, therefore, do not affect income. All that is required is to restate all prior calculations of EPS using the
increased number of shares. For example, assume a company reported EPS for 2010 as USD 1.20 (or USD
120,000/100,000 shares) and earned USD 180,000 in 2011. The only change in common stock over the two years
was a two-for-one stock split on 2011 December 1, which doubled the shares outstanding to 200,000. The firm
would restate EPS for 2010 as USD 0.60 (or USD 120,000/200,000 shares) and as USD 0.90 (USD
180,000/200,000 shares) for 2011.
Basic EPS and diluted EPS In the merger wave of the 1960s, corporations often issued securities to finance
their acquisitions of other companies. Many of the securities issued were calls on common or possessed equity
kickers. These terms mean that the securities were convertible to, or exchangeable for, shares of their issuers'
common stock. As a result, many complex problems arose in computing EPS. Until 1997, APB Opinion No. 15
provided guidelines for solving these problems. In 1997, FASB Statement No. 128, "Earnings per Share" replaced
APB Opinion No. 15. A company with a complex capital structure must present at least two EPS calculations, basic
EPS and diluted EPS. Because of the complexities involved in the calculations, we reserve further discussion of
these two EPS calculations for an intermediate accounting text.
Times interest earned ratio Creditors, especially long-term creditors, want to know whether a borrower can
meet its required interest payments when these payments come due. The times interest earned ratio, or
interest coverage ratio, is an indication of such an ability. It is computed as follows:
Time interest earned ratio= Income beforeinterest including taxesIBIT
Interest expense
The ratio is a rough comparison of cash inflows from operations with cash outflows for interest expense. Income
before interest and taxes (IBIT) is the numerator because there would be no income taxes if interest expense is
equal to or greater than IBIT. (To find income before interest and taxes, take net income from continuing
operations and add back the net interest expense and taxes.) Analysts disagree on whether the denominator should
be (1) only interest expense on long-term debt, (2) total interest expense, or (3) net interest expense. We will use
net interest expense in the Synotech illustration.
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For Synotech, the net interest expense is USD 236.9 million. With an IBIT of USD 1,382.4 million, the times
interest earned ratio is 5.84, calculated as:
USD1,382.4
USD236.9 =5.84 time
The company earned enough during the period to pay its interest expense almost 6 times over.
Low or negative interest coverage ratios suggest that the borrower could default on required interest payments.
A company is not likely to continue interest payments over many periods if it fails to earn enough income to cover
them. On the other hand, interest coverage of 5 to 10 times or more suggests that the company is not likely to
default on interest payments.
Times preferred dividends earned ratio Preferred stockholders, like bondholders, must usually be
satisfied with a fixed-dollar return on their investments. They are interested in the company's ability to make
preferred dividend payments each year. We can measure this ability by computing the times preferred
dividends earned ratio as follows:
Time preferred dividendsearned ratio= Net income
Annual preferred dividends
Synotech has a net income of USD 762.0 million and preferred dividends of USD 25.7 million. The number of
times the annual preferred dividends are earned for 2010 is:
USD762.0
USD 25.7 =29.65 :1 , or 29.65 times
The higher this rate, the higher is the probability that the preferred stockholders will receive their dividends
each year.
Analysts compute certain ratios using information from the financial statements and information about the
market price of the company's stock. These tests help investors and potential investors assess the relative merits of
the various stocks in the marketplace.
The yield on a stock investment refers to either an earnings yield or a dividends yield.
Earnings yield on common stock You can calculate a company's earnings yield on common stock as
follows:
Earnings yield oncommon stock= EPS
Current market price per share of common stock
Assume Synotech has common stock with an EPS of USD 5.03 and that the quoted market price of the stock on
the New York Stock Exchange is USD 110.70. The earnings yield on common stock would be:
USD5.03
USD110.7 =4.54 per cent
Price-earnings ratio When inverted, the earnings yield on common stock is the price-earnings ratio. To
compute the price-earnings ratio:
Price−earnings ratio= Current market price per share of commonstock
EPS
USD110.7
USD5.03 =22.01:1
Investors would say that this stock is selling at 22 times earnings, or at a multiple of 22. These investors might
have a specific multiple in mind that indicates whether the stock is underpriced or overpriced. Different investors
have different estimates of the proper price-earnings ratio for a given stock and also different estimates of the
Accounting Principles: A Business Perspective 697 A Global Text
17. Analysis and interpretation of financial statements
future earnings prospects of the company. These different estimates may cause one investor to sell stock at a
particular price and another investor to buy at that price.
Payout ratio on common stock Using dividend yield, investors can compute the payout ratio on common
stock. Assume that Synotech's dividends per share were USD 1.80 and earnings per share were USD 5.03. To
calculate payout ratio on common stock, divide the dividend per share of common stock by EPS. The payout
ratio of stock in 2010 is:
Payout ratioon commonstock= Dividend per share of common stock
EPS
USD1.80
USD5.03 =35.8per cent
A payout ratio of 35.8 per cent means that the company paid out 35.8 per cent of its earnings in the form of
dividends. Some investors are attracted by the stock of companies that pay out a large percentage of their earnings.
Other investors are attracted by the stock of companies that retain and reinvest a large percentage of their earnings.
The tax status of the investor has a great deal to do with this preference. Investors in high tax brackets often prefer
to have the company reinvest the earnings with the expectation that this reinvestment results in share price
appreciation.
Dividend yield on common stock The dividend paid per share of common stock is also of much interest to
common stockholders. When the current annual dividend per share of common stock is divided by the current
market price per share of common stock, the result is called the dividend yield on common stock. Synotech's
2010 December 31, common stock price was USD 110.70 per share. Its dividends per share were USD 1.80. The
company's dividend yield on common stock was:
Dividend yieldon of commonstock= Dividend per share of common stock
Current market price per share of commonstock
USD1.80
USD110.7 =1.63per cent
Dividend yield on preferred stock Preferred stockholders, as well as common stockholders, are interested
in dividend yields. The computation of the dividend yield on preferred stock is similar to the common stock
dividend yield computation. Assume that Synotech's dividend per share of preferred stock is USD 5.10 with a
current market price of USD 84.00 per share. We compute the dividend yield on preferred stock as follows:
Dividend yieldon preferred stock= Dividend per share of preferredstock
Current market price per share of preferred stock
USD5.10
USD84.00 =6.07per cent
Through the use of dividend yield rates, we can compare different preferred stocks having different annual
dividends and different market prices.
Cash flow per share of common stock Investors calculate the cash flow per share of common stock
ratio as follows:
Cash flowper shareof common stock= Net cash provided by operating activities
Average number of shares of common stock outstanding
Currently, FASB Statement No. 95 does not permit the use of this ratio for external reporting purposes.
However, some mortgage and investment banking firms do use this ratio to judge the company's ability to pay
dividends and pay liabilities. The cash flow per share of common stock ratio for Synotech is as follows:
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Fiscal Year 2010 2009
Cash provided by operating activities (a) $1,101.0 $972.3 Average shares outstanding (b) (assumed) 146.6 145.2 Cash flow per share of common stock (a)/(b) $7.51 $6.70
Final considerations in financial statement analysis
Standing alone, a single financial ratio may not be informative. Investors gain greater insight by computing and
analyzing several related ratios for a company. Exhibit 135 summarizes the ratios presented in this chapter, and
Exhibit 136 presents them graphically.
Financial analysis relies heavily on informed judgment. As guides to aid comparison, percentages and ratios are
useful in uncovering potential strengths and weaknesses. However, the financial analyst should seek the basic
causes behind changes and established trends.
An accounting perspective:
Uses of technology
Most companies calculate some of the ratios we have discussed, if not all of them. To efficiently and
effectively perform these calculations, accountants use computers. Some programs that gather
information in the preparation of financial statements calculate the ratios at the end of a period.
Accountants also create spreadsheets to perform this task. Remember, to interpret the numbers
correctly, investors and management must compare these ratios with the industry in which the
company operates.
Accounting Principles: A Business Perspective 699 A Global Text
17. Analysis and interpretation of financial statements
Liquidity ratios Formula Significance Current, or working capital, ratio Current assets + Current liabilities Test of debt-paying ability Acid-test (quick) ratio Quick assets (cash + marketable securities + net
receivables) + Current liabilities Test of immediate debt-paying ability
Cash flow liquidity ratio (Cash and marketable securities + Net cash provided by operating activities) + Current liabilities
Test of short-term, debt-paying ability
Accounts receivable turnover Net credit sales (or net sales) + Average net accounts receivable
Test of quality of accounts receivable
Number of days' sales in accounts receivable (average collection period of accounts receivable)
Number of days in year (365) + Accounts receivable turnover
Test of quality of accounts receivable
Inventory turnover Cost of goods sold + Average inventory Test of whether or not a sufficient volume of business is being generated relative to inventory
Total assets turnover Net sales + Average total assets Test of whether or not the volume of business generated is adequate relative to amount of capital invested in the business
Equity, or Long-term Solvency, Ratios Equity (stockholders' equity) ratio Stockholders' equity + Total assets (or total
equities) Index of long-run solvency and safety
Stockholders' equity to debt (debt to equity) ratio
Stockholders' equity + Total debt Measure of the relative proportion of stockholders' and of creditors' equities
Profitability Tests Rate of return on operating assets Net operating income + Operating assets or Measure of managerial
Operating margin x Turnover operating assets Net income to net sales (return on sales)
Net income + Net sales Indicator of the amount of net profit on each dollar of sales
Return on average common stockholders' equity
Net income + Average common stockholders' equity
Measure of what a given company earned for its stockholders from all sources as a percentage of common stockholders' investment
Cash flow margin Net cash provided by operating activities + Net sales
Measure of the ability of a firm to translate sales into cash
EPS of common stock Earnings available to common stockholders' + Weighted- average number of common shares outstanding
Measure of the return to investors
Times interest earned ratio Income before interest and taxes + Interest expense
Test of the likelihood that creditors will continue to receive their interest payments
Time preferred dividends earned ratio Net income + Annual preferred dividends Test of the likelihood that preferred stockholders will receive their dividend each year
Market Tests Earnings yield on common stock EPS + Current market price per share of
common stock Comparison with other common stocks
Price-earnings ratio Current market price per share of common stock + EPS
Index of whether a stock is relatively cheap or expensive based on the ratio
Pay cut ratio on common stock Dividend per share of common stock + EPS Index of whether company pays out a large percentage of earnings as dividends or reinvests most of its earnings
Dividend yield on common stock Dividend per share of common stock + Current market price per share of common stock
Comparisons with other common stocks
Dividend yield on preferred stock Dividend per share of preferred stock + Current market price per share of preferred stock
Comparison with other preferred stocks
Cash flow per share of common stock Net cash provided by operating activities + Average number of share of common stock outstanding
Test of ability to pay dividends and liabilities
Exhibit 135: Summary of ratios
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Analysts must be sure that their comparisons are valid—especially when the comparisons are of items for
different periods or different companies. They must follow consistent accounting practices if valid interperiod
comparisons are to be made. Comparable intercompany comparisons are more difficult to secure. Accountants
cannot do much more than disclose the fact that one company is using FIFO and another is using LIFO for
inventory and cost of goods sold computations. Such a disclosure alerts analysts that intercompany comparisons of
inventory turnover ratios, for example, may not be comparable.
Also, when comparing a company's ratios to industry averages provided by an external source such as Dun &
Bradstreet, the analyst should calculate the company's ratios in the same manner as the reporting service. Thus, if
Dun & Bradstreet uses net sales (rather than cost of goods sold) to compute inventory turnover, so should the
analyst. Net sales is sometimes preferable because all companies do not compute and report cost of goods sold
amounts in the same manner.
Facts and conditions not disclosed by the financial statements may, however, affect their interpretation. A single
important event may have been largely responsible for a given relationship. For example, competitors may put a
new product on the market, making it necessary for the company under study to reduce the selling price of a
product suddenly rendered obsolete. Such an event would severely affect the percentage of gross margin to net
sales. Yet there may be little chance that such an event will happen again.
Analysts must consider general business conditions within the industry of the company under study. A
corporation's downward trend in earnings, for example, is less alarming if the industry trend or the general
economic trend is also downward.
Investors also need to consider the seasonal nature of some businesses. If the balance sheet date represents the
seasonal peak in the volume of business, for example, the ratio of current assets to current liabilities may be much
lower than if the balance sheet date is in a season of low activity.
Potential investors should consider the market risk associated with the prospective investment. They can
determine market risk by comparing the changes in the price of a stock in relation to the changes in the average
price of all stocks.
Potential investors should realize that acquiring the ability to make informed judgments is a long process and
does not occur overnight. Using ratios and percentages without considering the underlying causes may lead to
incorrect conclusions.
Relationships between financial statement items also become more meaningful when standards are available for
comparison. Comparisons with standards provide a starting point for the analyst's thinking and lead to further
investigation and, ultimately, to conclusions and business decisions. Such standards consist of (1) those in the
analyst's own mind as a result of experience and observations, (2) those provided by the records of past
performance and financial position of the business under study, and (3) those provided about other enterprises.
Examples of the third standard are data available through trade associations, universities, research organizations
(such as Dun & Bradstreet and Robert Morris Associates), and governmental units (such as the Federal Trade
Commission).
In financial statement analysis, remember that standards for comparison vary by industry, and financial
analysis must be carried out with knowledge of specific industry characteristics. For example, a wholesale grocery
company would have large inventories available to be shipped to retailers and a relatively small investment in
Accounting Principles: A Business Perspective 701 A Global Text
17. Analysis and interpretation of financial statements
property, plant, and equipment, while an electric utility company would have no merchandise inventory (except for
repair parts) and a large investment in property, plant, and equipment.
Even within an industry, variations may exist. Acceptable current ratios, gross margin percentages, debt to
equity ratios, and other relationships vary widely depending on unique conditions within an industry. Therefore, it
is important to know the industry to make comparisons that have real meaning.
Exhibit 136: Graphic depiction of financial statement analysis utilizing financial rations
The bankruptcies of companies like General Motors and Lehman Brothers, with the resulting significant losses
to employees, stockholders, and other members of the general public, have caused important changes in corporate
governance, standards of accounting, and auditing procedures and standards. These changes have come about as a
result of self-regulation, oversight by the Public Company Accounting Oversight Board, regulation by the Securities
and Exchange Commission, regulation by the stock exchanges, and legislation passed by Congress, and by some
combination of these actions. Further changes are likely.
Financial statements are likely to become more "transparent". This means they will reveal more clearly the
results of operations and the financial condition of the company. There is likely to be an increased focus on the
balance sheet and on the quality and measurement of assets and the extent and nature of liabilities as well as on a
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proper identification of other risks. The quality of earnings will continue to be of paramount importance. There
have been too many situations where companies have had to restate their earnings for prior years because they did
not properly disclose material facts or properly implement the revenue recognition and/or expense recognition
principles that were covered in Chapter 5.
An accounting perspective:
Business insight
The Enron situation was the focus of a massive investigation that led to significant changes in
corporate governance, accounting rules, and auditing procedures. Enron was formed in 1985 and
became a major player in the energy industry. Its stock reached a high of about USD 90 per share
in August 2000. Top executives began selling stock shortly thereafter, while at least for a short
period during the ensuing fall in the stock's price, employees were prevented from doing so. In
October of 2001, the disclosure of off-balance sheet partnerships, with attendant liabilities for
Enron, resulted in a USD 1.2 billion write-off in stockholder's equity. In November of 2001, Enron
revealed that it had overstated earnings by USD 586 million since 1997. In December 2001, Enron
filed for bankruptcy. Enron stock became almost worthless, selling for under USD 1. Employees of
Enron not only lost their jobs, but many also lost their retirement savings because they consisted
largely of Enron stock. Individual and pension fund investors as a group lost billions of dollars. The
state of Florida's pension fund lost about USD 340 million. Enron's external auditor, Arthur
Andersen & Co., was accused of shredding documents pertaining to Enron after the US Justice
Department confirmed its investigation and was indicated in March of 2002 for that action. (For
more information about the Enron situation see, for instance: U.S. News & World Report, March
18 2002, pp, 26-36)
External auditors, internal auditors, audit committee members, and members of Boards of Directors are likely to
ask much tougher questions of management. They are also more likely to investigate questionable transactions.
Audit committees may be required to publicly disclose their activities that were performed to carry out their duties.
Management's letter to the stockholders contained in the annual report, and usually signed by the CEO, contains
the views of management regarding current operations, operating results, and plans for the future. This letter is
likely to become even more important in the future than it is now. There could be financial penalties if this letter is
purposely misleading in that its contents are not supported by the financial statements or they misrepresent
significant facts. To the extent these letters are more conservative rather than being unrealistic, individuals
analyzing financial statements will be able to rely on their content to a greater extent in the future. The Sarbanes-
Oxley Act of 2002 in the US sets more stringent standards for financial reporting for public companies and their
managers. Boards, and independent auditors, along with strict penalties for non-compliance.
Financial statement analysis is going to have increasing importance. There will be more focus on the cash flow
statement, covered in Chapter 16, and its "cash flow from operating activities", since this amount is considered by
some to be "cash earnings". Some consider this amount to be less susceptible to manipulation than is net income.
Accounting Principles: A Business Perspective 703 A Global Text
17. Analysis and interpretation of financial statements
Management may disclose in an accounting policy statement, its policies regarding their business practices and
those accounting policies that were followed in preparing the financial statements. Conflicts of interest will be
identified and discouraged.
Professional financial analysts, such as those working for stock brokerage firms and those employed to help
evaluate possible merger and acquisition candidates, typically go "beyond the numbers" in analyzing a company.
They usually visit the company, interview management, and assess the physical facilities and plans for the future.
They are interested in evaluating such factors as the competence and integrity of management. Professional
financial analysts form an overall impression of the company by giving all of the data and other information the
"smell test". In other words, does everything seem legitimate or are there possible significant hidden factors that
have not yet been identified which makes one think that something is not right.
The future looks bright. Needed changes will be made to maintain public confidence in financial reporting.
Protecting the public interest should be paramount in the future.
This chapter concludes our coverage of financial accounting. It is likely you will continue on with studies in
managerial accounting. It is important to realize that it is impossible to completely separate financial and
managerial accounting information into neat packages. Managers use both the published financial statements and
managerial accounting information in making decisions. Also, some of the concepts covered in managerial
accounting (e.g. job costing and process costing) have a direct impact on the formal financial statements. Many
accountants are attracted to managerial accounting because it is not constrained by having to conform to generally
accepted accounting principles. Instead, management accountants can provide to management whatever
information in whatever form management requests.
An accounting perspective:
Uses of technology
The Journal of Accountancy peridically publishes articles on Internet resources to encourage
greater use of technology by accountants. One of the best in this category is called “Smart Stops on
the Web”, a series authored by Megan Pinkston. (For example, see this one from 2007):
http://www.journalofaccountancy.com/Issues/2007/Jun/SmartStopsOnTheWebArticle.
You may want to investigate this article and some of the others in the series and then visit some of
the websites they list. There is no doubt that the Internet will only grow in importance in the
future. The more you know about it, the more marketable you will be upon graduation.
Understanding the learning objectives
• A company's financial statements are analyzed internally by management and externally by investors,
creditors, and regulatory agencies.
• Management's analysis of financial statements primarily relates to parts of the company. Management is
able to obtain specific, special-purpose reports to aid in decision making.
• External users focus their analysis of financial statements on the company as a whole. They must rely on
the general-purpose financial statements that companies publish.
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• Financial statement analysis consists of applying analytical tools and techniques to financial statements
and other relevant data to obtain useful information.
• This information is the significant relationships between data and trends in those data assessing the
company's past performance and current financial position.
• The information is useful for making predictions that may have a direct effect on decisions made by many
users of financial statements.
• Present and potential company investors use this information to assess the profitability of the firm.
• Outside parties and long-term creditors sometimes are interested in a company's solvency, and thus use the
information in predicting the company's solvency.
• Published reports are one source of financial information. Published reports include financial statements,
explanatory notes, letters to stockholders, reports of independent accountants, and management's discussion
and analysis (MDA).
• Government reports are another source of financial information and include Form 10-K, Form 10-Q, and
Form 8-K. These reports are available to the public for a small charge.
• Financial service information, business publications, newspapers, and periodicals offer meaningful
financial information to external users. Moody's Investors Services; Standard & Poor's; Dun & Bradstreet, Inc.;
and Robert Morris Associates all provide useful industry information. Business publications, such as The Wall
Street Journal and Forbes, also report industry financial news.
• Horizontal analysis is the calculation of dollar changes or percentage changes in comparative statement
items or totals. Use of this analysis helps detect changes in a company's performance and highlights trends.
• Vertical analysis consists of a study of a single financial statement in which each item is expressed as a
percentage of a significant total. Use of this analysis is especially helpful in analyzing income statement data
such as the percentage of cost of goods sold to sales or the percentage of gross margin to sales.
• Trend analysis compares financial information over time to a base year. The analysis is calculated by:
(a) Selecting a base year or period.
(b)Assigning a weight of 100 per cent to the amounts appearing on the base-year financial statements.
(c) Expressing the corresponding amounts shown on the other years' financial statements as a
percentage of base-year or period amounts. The percentages are computed by dividing nonbase-year
amounts by the corresponding base-year amounts and then multiplying the results by 100.
Trend analysis indicates changes that are taking place in an organization and highlights the direction of these
changes.
• Liquidity ratios indicate a company's short-term debt-paying ability. These ratios include (1) current, or
working capital, ratio; (2) acid-test (quick) ratio; (3) cash flow liquidity ratio; (4) accounts receivable turnover;
(5) number of days' sales in accounts receivable; (6) inventory turnover; and (7) total assets turnover.
• Equity, or long-term solvency, ratios show the relationship between debt and equity financing in a
company. These ratios include (1) equity (stockholders' equity) ratio and (2) stockholders' equity to debt ratio.
• Profitability tests are an important measure of a company's operating success. These tests include (1)
rate of return on operating assets, (2) net income to net sales, (3) net income to average common stockholders'
equity, (4) cash flow margin, (5) earnings per share of common stock, (6) times interest earned ratio, and (7)
times preferred dividends earned ratio.
Accounting Principles: A Business Perspective 705 A Global Text
17. Analysis and interpretation of financial statements
• Market tests help investors and potential investors assess the relative merits of the various stocks in the
marketplace. These tests include (1) earnings yield on common stock, (2) price-earnings ratio, (3) dividend
yield on common stock, (4) payout ratio on common stock, (5) dividend yield on preferred stock, and (6) cash
flow per share of common stock.
• For a complete summary and a graphic depiction of all liquidity, long-term solvency, profitability, and
market test ratios, see Exhibit 135 and Exhibit 136.
• Need for comparative data: Analysts must be sure that their comparisons are valid—especially when
the comparisons are of items for different periods or different companies.
• Influence of external factors: A single important event, such as the unexpected placing of a product on
the market by a competitor, may affect the interpretation of the financial statements. Also, the general
business conditions and the possible seasonal nature of the business must be taken into consideration, since
these factors could have an impact on the financial statements.
• Impact of inflation: Since financial statements fail to reveal the impact of inflation on the reporting
entity, one must make sure that the items being compared are all comparable; that is, the impact of inflation
has been taken into consideration.
• Need for comparative standards: In financial statement analysis, remember that standards for
comparison vary by industry, and financial analysis must be carried out with knowledge of specific industry
characteristics.
Demonstration problem
Demonstration problem A Comparative financial statements of Kellogg Company for 2003 and 2002 follow:
Kellogg Company Comparative income statements
Fore the years ended 2003 December 31, and 2002 (USD millions)
2003 2002 Net revenues $6,954.7 $6,984.2 Cost of goods sold 3,327.0 3,325.1 Gross margin $3,627.7 $3,659.1 Operating expense 2,551.4 2,585.7 Nonoperating expense (interest) 137.5 118.8 Income before income taxes $ 938.8 $ 954.6 Income taxes 280.0 198.4 Net earnings $ 658.8 $ 756.2
Kellogg Company Comparative Balance sheets 2003 December 31, and 2002
(USD millions
2003 2002 Assets
Cash and temporary investments $ 204.4 $ 150.6 Accounts receivable, net 685.3 678.5 Inventories 443.8 503.8 Other current assets 273.3 236.3 Property, net 2,526.9 2,640.9 Other assets 762.6 589.6 Total assets $4,896.3 $4,808.7
Liabilities and stockholders' equity Current liabilities $2,492.6 $1,587.8 Long-term liabilities 1,506.2 2,407.7 Common stock 103.8 103.8 Capital in excess of par value 102.0 104.5 Retained earnings 1,501.0 1,317.2 Treasury stock (374.0) (380.9)
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Currency translation adjustment (435.3) (331.4) Total liabilities and stockholders' equity $4,896.3 $4,808.7
a. Prepare comparative common-size income statements for 2003 and 2002.
b. Perform a horizontal analysis of the comparative balance sheets.
Demonstration problem B The balance sheet and supplementary data for Xerox Corporation follow:
Xerox corporation Balance sheet with IOFS on an equity basis
2003 December 31 (USD millions)
2003 Assets
Cash $ 1,741 Accounts receivable, net 2,281 Finance receivables, net 5,097 Inventories 1,932 Deferred taxes and other current assets 1,971 Total current assets $ 13,022 Finance receivables due after one year, net 7,957 Land, buildings, and equipment, net 2,495 Investments in affiliates, at equity 1,362 Goodwill 1,578 Other assets 3,061 Total assets $ 29,475
Liabilities and stockholders' equity Short-term debt and current portion of long-term debt
$ 2,693
Accounts payable 1,033 Accrued compensation and benefit costs 662 Unearned income 250 Other current liabilities 1,630 Total current liabilities $ 6,268 Long-term debt 15,404 Liabilities for post-retirement medical benefits 1,197 Deferred taxes and other liabilities 1,876 Discontinued policyholders' deposits and other operations liabilities
670
Deferred ESOP benefits (221) Minorities' interests in equity of subsidiaries 141 Preferred stock 647 Common shareholders' equity (108.1 million) 3,493 Total liabilities and shareholders' equity $ 29,475
• Cost of goods sold, USD 6,197.
• Net sales, USD 18,701.
• Inventory, January 1, USD 2,290.
• Net interest expense, USD 1,031.
• Net income before interest and taxes, USD 647.
• Net accounts receivable on January 1, USD 2,633.
• Total assets on January 1, USD 28,531.
Compute the following ratios:
a. Current ratio.
b. Acid-test ratio.
c. Accounts receivable turnover.
d. Inventory turnover.
e. Total assets turnover.
f. Equity ratio.
Accounting Principles: A Business Perspective 707 A Global Text
17. Analysis and interpretation of financial statements
g. Times interest earned ratio.
Solution to demonstration problem
Solution to demonstration problem A
a.
Kellogg Company
Common-size comparative income statements
For the year ended 2003 December 31, and 2002
Per cent 2003 2002
Net revenues 100.00 % 100.00% Cost of goods sold 47.84 47.61 Gross margin 52.16 52.39 Operating expenses 36.69 37.02 Nonoperating expense (interest) 1.98 1.70 Income before income taxes 13.49 %* 13.67 % Income taxes 4.03 2.84 Net earnings 9.46 %* 10.83%
*Difference due to rounding.
b.
Kellogg company Comparative balance sheets 2003 December 31, and 2002
(USD millions) Increase or Decrease
2003 2002 2003 amount
2002 per cent
Assets Cash and temporary investments $204.4 $150.6 $ 53.8 35.72 % Accounts receivable, net 685.3 678.5 6.8 1.00 Inventories 443.8 503.8 (60.0) (11.91) Other current assets 273.3 236.3 37.0 15.66 Property, net 2,526.9 2,640.9 (114.0) (4.32) Other assets 762.9 589.6 164.0 27.40 Total assets $4,896.3 $4,808.7 $ 87.6 1.82 % Liabilities and stockholders' equity Current liabilities $2,492.6 $ 1,587.8 $ 904.8 56.98% Long-term liabilities 1,506.2 2,407.7 (901.5) (37.44) Common stock 103.8 103.8 0.0 0.0 Capital in excess of par value 102.0 104.5 (2.5) (2.39) Retained earnings 1,501.0 1,317.2 183.8 13.95 Treasury stock (374.0) (380.9) 6.9 (1.81) Currency translation adjustment (435.3) (331.4) (103.9) 31.35 Total liabilities and stockholders' equity
$4,896.3 $4,808.7 $ 87.6 1.82 %
Solution to demonstration problem B
a. Current ratio:
Currentassets
Current liabilities =
USD13,022,000,000
USD6,268,000,000 =2.08 :1
b. Acid-test ratio:
Quick assets
Current liabilities =
USD9,119,000,000
USD6,268,000,000 =1.45 :1
c. Accounts receivable turnover:
Net sales
Average net accounts receivable =
USD18,701,000,000
USD2,457,000,000 =7.61 time
d. Inventory turnover:
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Cost of goods sold
Average inventory =
USD 6,197,000,000
USD 2,111,000,000 =2.94 time
e. Total assets turnover:
Net sales
Average total assets =
USD18,701,000,000
USD29,003,000,000 =.64 time
f. Equity ratio:
Stockholders ' equity
Total assets =
USD 4,140,000,000
USD 29,475,000,000 =14.05 per cent
g. Times interest earned ratio:
Income beforeinterest also taxes
Interest expense =
USD647,000,000
USD1,031,000,000 =.63 time
Key terms Accounts receivable turnover Net credit sales (or net sales) divided by average net accounts receivable.
Acid-test (quick) ratio Ratio of quick assets (cash, marketable securities, and net receivables) to current liabilities.
Cash flow liquidity ratio Cash and marketable securities plus net cash provided by operating activities divided by current liabilities.
Cash flow margin Net cash provided by operating activities divided by net sales.
Cash flow per share of common stock Net cash provided by operating activities divided by the average number of shares of common stock outstanding.
Common-size statements Show only percentages and no absolute dollar amounts.
Comparative financial statements Present the same company's financial statements for two or more successive periods in side-by-side columns.
Current ratio Also called working capital ratio. Current assets divided by current liabilities.
Debt to equity ratio Total debt divided by stockholders' equity.
Dividend yield on common stock Dividend per share of common stock divided by current market price per share of common stock.
Dividend yield on preferred stock Dividend per share of preferred stock divided by current market price per share of preferred stock.
Earnings per share (EPS) The amount of earnings available to common stockholders (which equals net income less preferred dividends) divided by weighted-average number of shares of common stock outstanding.
Earnings yield on common stock Ratio of current EPS to current market price per share of common stock.
Equity (stockholders' equity) ratio The ratio of stockholders' equity to total assets (or total equities).
Horizontal analysis Analysis of a company's financial statements for two or more successive periods showing percentage and/or absolute changes from prior year. This type of analysis helps detect changes in a company's performance and highlights trends.
Inventory turnover Cost of goods sold divided by average inventory.
Liquidity Company's state of possessing liquid assets, such as (1) cash and (2) other assets that will soon be converted to cash.
Net income to net sales Net income divided by net sales.
Net operating income Income before interest and taxes.
Nonoperating assets Assets owned by a company but not used in producing operating revenues.
Nonoperating income elements Elements excluded from net operating income because they are not directly related to operations; includes such elements as extraordinary items, cumulative effect on prior year of changes in accounting principle, losses or gains from discontinued operations, interest revenue, and interest expense.
Number of days' sales in accounts receivable The number of days in a year (365) divided by the accounts receivable turnover. Also called the average collection period for accounts receivable.
Accounting Principles: A Business Perspective 709 A Global Text
17. Analysis and interpretation of financial statements
Operating assets All assets actively used in producing operating revenues.
Operating margin Net operating income divided by net sales.
Payout ratio on common stock The ratio of dividends per share of common stock divided by EPS.
Price-earnings ratio The ratio of current market price per share of common stock divided by the EPS of the stock.
Rate of return on operating assets Net operating income
Net sales ×
Net sales
Operating assets . Result is equal to net
operating income divided by operating assets.
Return on average common stockholders' equity Net income divided by average common stockholders' equity; often called rate of return on average common stockholders' equity, or simply return on equity (ROE).
Return on equity (ROE) Net income divided by average common stockholders' equity.
Stockholders' equity to debt ratio Stockholders' equity divided by total debt; often used in inverted form and called the debt to equity ratio.
Times interest earned ratio A ratio computed by dividing income before interest and taxes by interest expense (also called interest coverage ratio).
Times preferred dividends earned ratio Net income divided by annual preferred dividends.
Total assets turnover Net sales divided by average total assets.
Trend percentages Similar to horizontal analysis except that a base year or period is selected, and comparisons are made to the base year or period.
Turnover The relationship between the amount of an asset and some measure of its use. See accounts receivable turnover, inventory turnover, and total assets turnover.
Turnover of operating assets Net sales divided by operating assets.
Vertical analysis The study of a single financial statement in which each item is expressed as a percentage of a significant total; for example, percentages of sales calculations.
Yield (on stock) The yield on a stock investment refers to either an earnings yield or a dividend yield. Also see Earnings yield on common stock and Dividend yield on common stock and preferred stock.
Self-test
True-false
Indicate whether each of the following statements is true or false.
An objective of financial statement analysis is to provide information about the company's past performance and
current financial position.
Vertical analysis helps detect changes in a company's performance over several periods and highlights trends.
Common-size statements provide information about changes in dollar amounts relative to the previous periods.
Liquidity ratios show a company's capacity to pay maturing current liabilities.
A company that is quite profitable may find it difficult to pay its accounts payable.
Financial statement analysts must be sure that comparable data are used among companies to make the
comparisons valid.
Multiple-choice
Select the best answer for each of the following questions.
The following data were abstracted from the 2007 December 31, balance sheet of Andrews Company (use for the
first two questions questions):
Cash $136,000 Marketable securities 64,000 Accounts and notes receivable, net
184,000
Merchandise inventory 244,000 Prepaid expenses 12,000 Accounts and notes payable, 256,000
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short-term Accrued liabilities 64,000 Bonds payable, long-term 400,000
The current ratio is:
a. 1:2.
b. 2:1.
c. 1.2:1.
d. 3:1.
The acid-test ratio is:
a. 1:2.
b. 2:1.
c. 1.2:1.
d. 3:1.
Benson Company shows the following data on its 2011 financial statements (use for the rest of the questions ):
Accounts receivable, January 1 $720,000 Accounts receivable, December 31 960,000 Merchandise inventory, January 1 900,000 Merchandise inventory, December 31
1,020,000
Gross sales 4,800,000 Sales returns and allowances 180,000 Net sales 4,620,000 Cost of goods sold 3,360,000 Income before interest and taxes 720,000 Interest on bonds 192,000 Net income 384,000
The accounts receivable turnover is:
a. 5.5 times per year.
b. 5.714 times per year.
c. 5 times per year.
d. 6.667 times per year.
The inventory turnover is:
a. 5 times per year.
b. 4.8125 times per year.
c. 3.5 times per year.
d. 4 times per year.
The times interest earned ratio is:
a. 4.75 times per year.
b. 3.75 times per year.
c. 2 times per year.
d. 3 times per year.
Now turn to “Answers to self-test” at the end of the chapter to check your answers.
Questions
➢ What are the major sources of financial information for publicly owned corporations?
➢ The higher the accounts receivable turnover rate, the better off the company is. Do you agree? Why?
Accounting Principles: A Business Perspective 711 A Global Text
17. Analysis and interpretation of financial statements
➢ Can you think of a situation where the current ratio is very misleading as an indicator of short-term,
debt-paying ability? Does the acid-test ratio offer a remedy to the situation you have described?
Describe a situation where the acid-test ratio does not suffice either.
➢ Before the Marvin Company issued USD 20,000 of long-term notes (due more than a year from the
date of issue) in exchange for a like amount of accounts payable, its current ratio was 2:1 and its acid-
test ratio was 1:1. Will this transaction increase, decrease, or have no effect on the current ratio and
acid-test ratio? What would be the effect on the equity ratio?
➢ Through the use of turnover rates, explain why a firm might seek to increase the volume of its sales
even though such an increase can be secured only at reduced prices.
➢ Indicate which of the relationships illustrated in the chapter would be best to judge:
➢ The short-term debt-paying ability of the firm.
➢ The overall efficiency of the firm without regard to the sources of assets.
➢ The return to owners (stockholders) of a corporation.
➢ The safety of long-term creditors' interest.
➢ The safety of preferred stockholders' dividends.
➢ Indicate how each of the following ratios or measures is calculated:
➢ Payout ratio.
➢ Earnings per share of common stock.
➢ Price-earnings ratio.
➢ Earnings yield on common stock.
➢ Dividend yield on preferred stock.
➢ Times interest earned.
➢ Times preferred dividends earned.
➢ Return on average common stockholders' equity.
➢ Cash flow margin.
➢ How is the rate of return on operating assets determined? Is it possible for two companies with
operating margins of 5 per cent and 1 per cent, respectively, to both have a rate of return of 20 per
cent on operating assets? How?
➢ Cite some of the possible deficiencies in accounting information, especially regarding its use in
analyzing a particular company over a 10-year period.
➢ Real world question From the Consolidated Statements of Income of The Limited in the Annual
report appendix, determine the percentage change in operating income from 2002 to 2003.
➢ Real world question From the Consolidated Statements of Income of The Limited in the Annual
report appendix, determine the 2003 net income per common share.
➢ Real world question From the financial statements of The Limited in the Annual report appendix,
determine the 2003 cash dividends per common share.
➢ Real world question From the financial statements of The Limited in the Annual report appendix,
determine the 2003 cash flow margin.
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Exercises
Exercise A Income statement data for Boston Company for 2009 and 2010 follow:
2009 2010 Net sales $2,610,000 $1,936,000 Cost of goods sold 1,829,600 1,256,400 Selling expenses 396,800 350,000 Administrative expenses 234,800 198,400 Federal income taxes 57,600 54,000
Prepare a horizontal and vertical analysis of the income data in a form similar to Exhibit 134. Comment on the
results of this analysis.
Exercise B A company engaged in the following three independent transactions:
• Merchandise purchased on account, USD 2,400,000.
• Machinery purchased for cash, USD 2,400,000.
• Capital stock issued for cash, USD 2,400,000.
a. Compute the current ratio after each of these transactions assuming current assets were USD 3,200,000 and
the current ratio was 1:1 before the transactions occurred.
b. Repeat part (a) assuming the current ratio was 2:1.
c. Repeat part (a) assuming the current ratio was 1:2.
Exercise C A company has sales of USD 3,680,000 per year. Its average net accounts receivable balance is USD
920,000.
a. What is the average number of days accounts receivable are outstanding?
b. By how much would the capital invested in accounts receivable be reduced if the turnover could be increased
to 6 without a loss of sales?
Exercise D Columbia Corporation had the following selected financial data for 2009 December 31: Net cash
provided by operating activities
Net sales $1,800,000 Cost of goods sold 1,080,000 Operating expenses 315,000 Net income 195,000 Total assets 1,000,000 Net cash provided by operating activities
25,000
Compute the cash flow margin.
Exercise E From the following partial income statement, calculate the inventory turnover for the period.
Net sales $2,028,000 Cost of goods sold: Beginning inventory $ 234,000 Purchases 1,236,000 Cost of goods available for sale $1,560,000 Less: Ending inventory 265,200 Cost of goods sold 1,294,800 Gross margin $ 733,200 Operating expenses 327,600 Net operating income $ 405,600
Exercise F Eastern, Inc., had net sales of USD 3,520,000, gross margin of USD 1,496,000, and operating
expenses of USD 904,000. Total assets (all operating) were USD 3,080,000. Compute Eastern's rate of return on
operating assets.
Accounting Principles: A Business Perspective 713 A Global Text
17. Analysis and interpretation of financial statements
Exercise G Nelson Company began the year 2010 with total stockholders' equity of USD 2,400,000. Its net
income for 2010 was USD 640,000, and USD 106,800 of dividends were declared. Compute the rate of return on
average stockholders' equity for 2010. No preferred stock was outstanding.
Exercise H Rogers Company had 60,000 shares of common stock outstanding on 2010 January 1. On 2010
April 1, it issued 20,000 additional shares for cash. The amount of earnings available for common stockholders for
2010 was USD 600,000. What amount of EPS of common stock should the company report?
Exercise I Smith Company started 2011 with 800,000 shares of common stock outstanding. On March 31, it
issued 96,000 shares for cash, and on September 30, it purchased 80,000 shares of its own stock for cash.
Compute the weighted-average number of common shares outstanding for the year.
Exercise J A company reported EPS of USD 2 (or USD2,400,000
1,200,000 shares ) for 2009, ending the year with
1,200,000 shares outstanding. In 2010, the company earned net income of USD 7,680,000, issued 320,000 shares
of common stock for cash on September 30, and distributed a 100 per cent stock dividend on 2010 December 31.
Compute EPS for 2010, and compute the adjusted earnings per share for 2009 that would be shown in the 2010
annual report.
Exercise K A company paid interest of USD 32,000, incurred federal income taxes of USD 88,000, and had
net income (after taxes) of USD 112,000. How many times was interest earned?
Exercise L John Company had 20,000 shares of USD 600 par value, 8 per cent preferred stock outstanding.
Net income after taxes was USD 5,760,000. The market price per share was USD 720.
a. How many times were the preferred dividends earned?
b. What was the dividend yield on the preferred stock assuming the regular preferred dividends were declared
and paid?
Exercise M A company had 80,000 weighted-average number of shares of USD 320 par value common stock
outstanding. The amount of earnings available to common stockholders was USD 800,000. Current market price
per share is USD 720. Compute the EPS and the price-earnings ratio.
Problems
Problem A Loom's comparative statements of income and retained earnings for 2010 and 2009 are given
below.
Loom Consolidated statement of earnings
For the years ended 2010 December 31, and 2009 (USD thousands, except per data share)
December 31 (1) (2) 2010 2009
Net sales $ 2,403,100 $ 2,297,800 Cost of sales 1,885,700 1,651,300 Gross earnings $ 517,400 $ 646,500 Selling, general and administrative expenses 429,700 376,300 Goodwill amortization 37,300 35,200 Impairment write down of goodwill 158,500 0 Operating earnings (loss) $ (108,100) $235,000 Interest expense (116,900) (95,400) Other expense-net (21,700) (6,100) Earnings (loss) before income tax (benefit) expense, extraordinary item and cumulative effect of change in accounting principles
$ (246,700) $133,500
Income tax (benefit) expense (19,400) 73,200 Earnings (loss) before cumulative effect of $ (227,300) $60,300
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change in account principles Cumulative effect of change in accounting principles: Pre-operating costs (5,200) 0 Net earnings (loss) $ (232,500) $60,300 Retained earnings, January 1 680,600 620,300
$ 448,100 $680,600 Dividends 0 0 Retained earnings, December 31 $ 448,100 $680,600
Loom consolidated balance sheet
As of 2010 December 31, and 2009
(USD thousands)
December 31 (1) (2) 2010 2009
Assets Current assets Cash and cash equivalents $ 26,500 $ 49,400 Notes and accounts receivable (less allowance for possible losses of $26,600,000 and $20,700,000, respectively)
261,000 295,600
Inventories Finished goods 522,300 496,200 Work in process 132,400 141,500 Materials and supplies 44,800 39,100 Other 72,800 54,800 Total current assets $ 1,059,800 $ 1,076,600 Property, plant, and equipment Land $ 20,100 $ 19,300 Buildings, structures and improvements 486,400 435,600 Machinery and equipment 1,076,600 1,041,300 Construction in progress 24,200 35,200 Total property, plant and equipment $ 1,607,300 $ 1,531,400 Less accumulated depreciation 578,900 473,200 Net property, plant and equipment $ 1,028,400 $ 1,058,200 Other assets Goodwill (less accumulated amortization of $257,800,000 and $242,400,000, respectively).
$ 771,100 $ 965,800
Other 60,200 62,900 Total other assets $831,300 $ 1,028,700 Total assets $ 2,919,500 $ 3,163,500 Liabilities and stockholders' equity Current liabilities Current maturities of long-term debt $ 14,600 $ 23,100 Trade accounts payable 60,100 113,300 Accrued insurance obligations 38,800 23,600 Accrued advertising and promotion 23,800 23,400 Interest payable 16,000 18,300 Accrued payroll and vacation pay 15,300 33,100 Accrued pension 11,300 19,800 Other accounts payable and accrued expenses 123,900 77,200 Total current liabilities $ 303,800 $ 331,800 Noncurrent liabilities Long-term debt 1,427,200 1,440,200 Net deferred income taxes 0 43,400 Other 292,900 222,300 Total noncurrent liabilities $ 1,720,000 $ 1,705,900 Total liabilities $ 2,023,900 $ 2,037,700 Common stockholders' equity Common stock and capital in excess of par value, $.01 par value; authorized, Class A, 200,000,000 shares, Class B, 30,000,000 shares; issued and outstanding: Class A Common Stock, 69,268,701 and 69,160,349 shares, respectively
$ 465,600 $ 463,700
Class B Common Stock, 6,690,976 shares 4,400 4,400 Retained earnings 448,100 680,600
Accounting Principles: A Business Perspective 715 A Global Text
17. Analysis and interpretation of financial statements
Currency translation and minimum pension liability adjustments
(22,500) (22,900)
Total common stockholders' equity $ 895,600 $ 1,125,800 Total liabilities and stockholders' equity $ 2,919,500 $ 3,163,500
Perform a horizontal and vertical analysis of Loom's financial statements in a manner similar to those illustrated
in this chapter. Comment on the results of the analysis in (a).
Problem B Deere & Company manufactures, distributes, and finances a full range of agricultural equipment; a
broad range of industrial equipment for construction, forestry, and public works; and a variety of lawn and grounds
care equipment. The company also provides credit, health care, and insurance products for businesses and the
general public. Consider the following information from the Deere & Company 2000 Annual Report:
(in millions) 1997 1998 1999 2000 Sales $12,791 $13,822 $11,751 $13,137 Cost of goods sold 8,481 9,234 8,178 8,936 Gross margin 4,310 4,588 3,573 4,201 Operating expenses 2,694 2,841 3,021 3,236 Net operating income $ 1,616 $ 1,747 $ 552 $ 965
a. Prepare a statement showing the trend percentages for each item using 1997 as the base year.
b. Comment on the trends noted in part (a).
Problem C The following data are for Toy Company:
December 31 2011 2010
Allowance for uncollectible accounts $72,000 $57,000 Prepaid expenses 34,500 45,000 Accrued liabilities 210,000 186,000 Cash in Bank A 1,095,000 975,000 Wages payable -0- 37,500 Accounts payable 714,000 585,000 Merchandise inventory 1,342,500 1,437,000 Bonds payable, due in 2005 615,000 594,000 Marketable securities 217,500 147,000 Notes payable (due in six months) 300,000 195,000 Accounts receivable 907,500 870,000 Cash flow from operating activities 192,000 180,000
a. Compute the amount of working capital at both year-end dates.
b. Compute the current ratio at both year-end dates.
c. Compute the acid-test ratio at both year-end dates.
d. Compute the cash flow liquidity ratio at both year-end dates.
e. Comment briefly on the company's short-term financial position.
Problem D On 2011 December 31, Energy Company's current ratio was 3:1 before the following transactions
were completed:
• Purchased merchandise on account.
• Paid a cash dividend declared on 2011 November 15.
• Sold equipment for cash.
• Temporarily invested cash in trading securities.
• Sold obsolete merchandise for cash (at a loss).
• Issued 10-year bonds for cash.
• Wrote off goodwill to retained earnings.
• Paid cash for inventory.
• Purchased land for cash.
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• Returned merchandise that had not been paid for.
• Wrote off an account receivable as uncollectible. Uncollectible amount is less than the balance in the
Allowance for Uncollectible Accounts.
• Accepted a 90-day note from a customer in settlement of customer's account receivable.
• Declared a stock dividend on common stock.
Consider each transaction independently of all the others.
a. Indicate whether the amount of working capital will increase, decrease, or be unaffected by each of the
transactions.
b. Indicate whether the current ratio will increase, decrease, or be unaffected by each of the transactions.
Problem E Digital Company has net operating income of USD 500,000 and operating assets of USD
2,000,000.
Its net sales are USD 4,000,000.
The accountant for the company computes the rate of return on operating assets after computing the operating
margin and the turnover of operating assets.
a. Show the computations the accountant made.
b. Indicate whether the operating margin and turnover increase or decrease after each of the following changes.
Then determine what the actual rate of return on operating assets would be. The events are not interrelated;
consider each separately, starting from the original earning power position. No other changes occurred.
(a) Sales increased by USD 160,000. There was no change in the amount of operating income and no
change in operating assets.
(b)Management found some cost savings in the manufacturing process. The amount of reduction in
operating expenses was USD 40,000. The savings resulted from the use of less materials to manufacture
the same quantity of goods. As a result, average inventory was USD 16,000 lower than it otherwise
would have been. Operating income was not affected by the reduction in inventory.
(c) The company invested USD 80,000 of cash (received on accounts receivable) in a plot of land it
plans to use in the future (a nonoperating asset); income was not affected.
(d)The federal income tax rate increased and caused income tax expense to increase by USD 20,000.
The taxes have not yet been paid.
(e) The company issued bonds and used the proceeds to buy USD 400,000 of machinery to be used in
the business. Interest payments are USD 20,000 per year. Net operating income increased by USD
100,000 (net sales did not change).
Problem F Polaroid Corporation designs, manufactures, and markets worldwide instant photographic cameras
and films, electronic imaging recording devices, conventional films, and light polarizing filters and lenses. The
following information is for Polaroid:
(in millions) 2000 1999 Net sales $13,994 $14,089 Income before interest and taxes 2,310 2,251 Net income 1,407 1,392 Interest expense 178 142 Stockholders' equity (on 1998 December 31, $3,988)
3,428 3,912
Common stock, par value $1, December 31 978 978
Compute the following for both 2000 and 1999. Then compare and comment.
Accounting Principles: A Business Perspective 717 A Global Text
17. Analysis and interpretation of financial statements
a. EPS of common stock.
b. Net income to net sales.
c. Net income to average common stockholders' equity.
d. Times interest earned ratio.
Problem G The Walt Disney Company operates several ranges of products from theme parks and resorts to
broadcasting and other creative content. The following balance sheet and supplementary data are for The Walt
Disney Company for 2000.
The Walt Disney Company Consolidated balance sheet For 2000 September 30
(USD millions) Assets Cash and cash equivalents $ 842 Receivables 3,599 Inventories 702 Film and television costs 1,162 Other 1,258 Total current costs $7,563 Film and television costs 5,339 Investments 2,270 Theme parks, resorts, and other property, at cost Attractions, buildings, and equipment $16,160 Accumulated depreciation (6,892)
9,718 Project in process 1,995 Land 597 Intangibles assets, net 16,117 Other assets 1,428 Total assets $25,027 Liabilities and stockholders' equity Accounts payable and accrued liabilities $ 5,161 Current portion of borrowing 2,502 Unearned royalties 739 Total current liabilities $ 8,402 Borrowings 6,959 Deferred income taxes 2,833 Other long-term liabilities 2,377 Minority interest 356 Common shareholders' equity Common shares ($.01 par value) $12,101 Retained earnings 12,767 Cumulative translation and other adjustments (28) Treasury shares (740) 24,100 Total liabilities and stockholders' equity $45,027
• Net income, USD 920.
• Income before interest and taxes, USD 3,231.
• Cost of goods sold, USD 21,321.
• Net sales, USD 25,402.
• Inventory on 1999 September 30, USD 796.
• Total interest expense for the year, USD 598.
Calculate the following ratios and show your computations. For calculations normally involving averages, such
as average stockholders' equity, use year-end amounts unless the necessary information is provided.
a. Current ratio.
b. Net income to average common stockholders' equity.
c. Inventory turnover.
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d. Number of days' sales in accounts receivable (assume 365 days in 2000).
e. EPS of common stock (ignore treasury stock).
f. Times interest earned ratio.
g. Equity ratio.
h. Net income to net sales.
i. Total assets turnover.
j. Acid-test ratio.
Problem H Cooper Company currently uses the FIFO method to account for its inventory but is considering a
switch to LIFO before the books are closed for the year. Selected data for the year are:
Merchandise inventory, January 1 $1,430,000 Current assets 3,603,600 Total assets (operating) 5,720,000 Cost of goods sold (FIFO) 2,230,800 Merchandise inventory, December 31 (LIFO)
1,544,400
Merchandise inventory, December 31 (FIFO)
1,887,600
Current liabilities 1,144,000 Net sales 3,832,400 Operating expenses 915,200
a. Compute the current ratio, inventory turnover ratio, and rate of return on operating assets assuming the
company continues using FIFO.
b. Repeat part (a) assuming the company adjusts its accounts to the LIFO inventory method.
Alternate problems
Alternate problem A Steel Corporation's comparative statements of income and retained earnings and
consolidated balance sheet for 2010 and 2009 follow:
Steel Corporation Consolidated statement of Earnings
For the years ended 2010 December 31, 2009 (USD thousands)
December31 (1) (2) 2010 2009
Net sales $4,876.5 $4,819.4 Costs and expenses: Cost of sales $4,202.8 $4,287.3 Depreciation 284.0 261.1 Estimated restructuring losses 111.8 137.4 Total costs $4,598.6 $4,685.8 Income from operations $268.9 $ 133.6 Financing income (expense): Interest and other income 7.7 7.1 Interest and other financing costs (60.0) (46.2) Loss before income taxes and cumulative effect of changes in accounting
$ 216.6 $ 94.5
Benefit (provision) for income taxes (37.0) (14.0) Net earning (loss) $ 179.6 $ 80.5 Retained earnings, January 1 (859.4) (939.9)
$ (679.8) $ (859.4) Dividends 0.0 0.0 Retained earnings, December 31 $ (679.8) (859.4)
Steel Corporation Consolidated balance sheet
As of 2010 December 31, and 2009 December 31 (1) (2) 2010 2009
Accounting Principles: A Business Perspective 719 A Global Text
17. Analysis and interpretation of financial statements
Assets Current Assets Cash and cash equivalents $ 180.0 $ 159.5 Receivables 374.6 519.5 Total $ 554.6 $ 679.0 Inventories Raw materials and supplies $ 335.5 $ 331.9 Finished and semifinished products 604.9 534.9 Contract work in process less billings of $10.9 and $2.3
17.8 16.1
Total inventories $ 958.2 $ 882.9 Other current assets $ 13.0 $ 7.2 Total current assets $ 1,525.8 $ 1,569.1 Property, plant and equipment less accumulated depreciation of $4329.5 and $4167.8
$ 2,714.2 $ 2,759.3
Investments and miscellaneous assets 112.3 124.2 Deferred income tax asset – net 885.0 903.2 Intangible asset – Pensions 463.0 426.6 Total assets $ 5,700.3 $ 5,782.4 Liabilities and stockholders' equity Current liabilities Accounts payable $ 381.4 $ 387.0 Accrued employment costs 208.0 165.8 Postretirement benefits other than pensions 150.0 138.0 Accrued taxes 72.4 67.6 Debt and capital lease obligations 91.5 88.9 Other current liabilities 146.3 163.9 Total current liabilities $ 1,049.6 $ 1,011.2 Pension liability $ 1,115.0 $ 1,117.1 Postretirement benefits other than pensions 1,415.0 1,441.4 Long-term debt and capital lease obligations 546.8 668.4 Other 335.6 388.5 Total noncurrent liabilities $ 3,412.4 # 3,615.4 Total liabilities $ 4,462.0 $ 4,626.6 Common stockholders' equity Preferred stock – at $1 per share par value (aggregate liquidation preference of $481.2); Authorized 20,000,000 shares
$ 11.6 $ 11.6
Preference stock – at $1 per share par value (aggregate liquidation preference of $88.2); Authorized 20,000,000 shares
2.6 2.6
Common stock – at $1 per share par value/Authorized 250,000,000 and 150,000,000 shares; Issued 112,699,869 and 111,882,276 shares
112.7 111.9
Held in treasury, 1,992,189 and 1,996,715 shares at cost
(59.4) (59.5)
Additional paid-in capital 1,850.6 1,948.6 Accumulated deficit (679.8) (859.4) Total common stockholders' equity $ 1,238.3 $ 1,155.8 Total liabilities and stockholders' equity $ 5,700.3 $ 5,782.4
a. Perform a horizontal and vertical analysis of Steel's financial statements in a manner similar to Exhibit 133
and Exhibit 134.
b. Comment on the results obtained in part (a).
Alternate problem B Ford Motor Company is the world's second-largest producer of cars and trucks and
ranks among the largest providers of financial services in the United States. The following information pertains to
Ford: (in millions)
(in millions) 1998 1999 2000 Sales $118.017 $135,073 $141,230 Cost of goods sold 104,616 118,985 126,120 Gross margin $ 13,401 $ 16,088 $ 15,110 Operating expenses 7,834 8,874 9,884 Net operating income $ 5,567 $ 7,214 $ 5,226
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a. Prepare a statement showing the trend percentages for each item, using 1998 as the base year.
b. Comment on the trends noted in part (a).
Alternate problem C The following data are for Clock Company: Allowance for uncollectible accounts
December 31 2011 2010
Notes payable (due in 90 days) $75,200 $60,000 Merchandise inventory 240,000 208,000 Cash 100,000 128,000 Marketable securities 49,600 30,000 Accrued liabilities 19,200 22,000 Accounts receivable 188,000 184,000 Accounts payable 112,000 72,000 Allowance for uncollectible accounts 24,000 15,200 Bonds payable, due 2008 156,000 160,000 Prepaid expenses 6,400 7,360 Cash flow from operating activities 60,000 40,000
a. Compute the amount of working capital at both year-end dates.
b. Compute the current ratio at both year-end dates.
c. Compute the acid-test ratio at both year-end dates.
d. Compute the cash flow liquidity ratio at both year-end dates.
e. Comment briefly on the company's short-term financial position.
Alternate problem D Tulip Products, Inc., has a current ratio on 2010 December 31, of 2:1 before the
following transactions were completed:
• Sold a building for cash.
• Exchanged old equipment for new equipment. (No cash was involved.)
• Declared a cash dividend on preferred stock.
• Sold merchandise on account (at a profit).
• Retired mortgage notes that would have matured in 2011.
• Issued a stock dividend to common stockholders.
• Paid cash for a patent.
• Temporarily invested cash in government bonds.
• Purchased inventory for cash.
• Wrote off an account receivable as uncollectible. Uncollectible amount is less than the balance of the
Allowance for Uncollectible Accounts.
• Paid the cash dividend on preferred stock that was declared earlier.
• Purchased a computer and gave a two-year promissory note.
• Collected accounts receivable.
• Borrowed from the bank on a 120-day promissory note.
• Discounted a customer's note. Interest expense was involved.
Consider each transaction independently of all the others.
a. Indicate whether the amount of working capital will increase, decrease, or be unaffected by each of the
transactions.
b. Indicate whether the current ratio will increase, decrease, or be unaffected by each of the transactions.
Alternate problem E The following selected data are for three companies:
Operating Net Net
Accounting Principles: A Business Perspective 721 A Global Text
17. Analysis and interpretation of financial statements
Assets Operating Income
Sales
Company 1 $ 1,404,000 $ 187,200 $ 2,059,200 Company 2 8,424,000 608,400 18,720,000 Company 3 37,440,000 4,914,000 35,100,000
a. Determine the operating margin, turnover of operating assets, and rate of return on operating assets for each
company.
b. In the subsequent year, the following changes took place (no other changes occurred):
Company 1 bought some new machinery at a cost of USD 156,000. Net operating income increased by USD
12,480 as a result of an increase in sales of USD 249,600.
Company 2 sold some equipment it was using that was relatively unproductive. The book value of the equipment
sold was USD 624,000. As a result of the sale of the equipment, sales declined by USD 312,000, and operating
income declined by USD 6,240.
Company 3 purchased some new retail outlets at a cost of USD 6,240,000. As a result, sales increased by USD
9,360,000, and operating income increased by USD 499,200.
• Which company has the largest absolute change in:
a. Operating margin ratio?
b. Turnover of operating assets?
c. Rate of return on operating assets?
• Which one realized the largest dollar change in operating income? Explain this change in relation to the
changes in the rate of return on operating assets.
Alternate problem F One of the largest spice companies in the world, McCormick & Company, Inc., produces
a diverse array of specialty foods. The following information is for McCormick & Company, Inc.:
2000 1999 (USD thousands) Net sales $2,123,500 $2,006,900 Income before interest and taxes 225,700 174,700 Net income 137,500 98,500 Interest expense 39,700 32,400 Stockholders' equity 359,300 382,400 Common stock, no par value, November 30 175,300 173,800
Assume average common shares outstanding for 2000 and 1999 are 69,600 and 72,000 (in thousands),
respectively.
Compute the following for both 2000 and 1999. Then compare and comment. Assume stockholders' equity for
1998 was USD 388,100.
a. EPS of common stock.
b. Net income to net sales.
c. Return on average common stockholders' equity.
d. Times interest earned ratio.
Alternate problem G Parametric Technology Corporation is in the CAD/CAM/CAE industry and is the top
supplier of software tools used to automate a manufacturing company. The following consolidated balance sheet
and supplementary data are for Parametric for 2003:
Parametric Technology Corporation Consolidated balance sheet
For 2003 September 30 (in thousands) Assets
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Current assets Cash and cash equivalents $ 325,872 Short-term investments 22,969 Accounts receivable, net of allowances for doubtful account of $6,270 183,804 Other current assets 95,788 Total current assets $ 628,433 Marketable investments 26,300 Property and equipment, net 66,879 Other assets 203,271 Total assets $ 924,883
Liabilities and stockholders' equity Current liabilities Accounts payable and accrued expenses $ 77,144 Accrued compensation 52,112 Deferred revenue 231,495 Income taxes 1,601 Total currents liabilities $ 362,352 Other liabilities 33,989 Stockholders' equity Preferred stock, $.01 par value; 5,000 shares authorized; none issued Common stock, $.01 par value; 500,000 shares authorized; 276,053 (2000) and 272,277 (1999) shares issued
2,761
Additional paid-in capital 1,641,513 Foreign currency translation adjustment (12,629) Accumulated deficit (1,036,456) Treasury stock, at cost, 6,456 (2000) and 2,113 (1999) shares (66,647) Total liabilities and stockholders' equity $ 924,883
• Net loss, (USD 3,980).
• Loss before interest and taxes, (USD 4,700).
• Cost of goods sold, USD 244,984.
• Net sales, USD 928,414.
• Total interest expense for the year, USD 367.
• Weighted-average number of shares outstanding, 273,081.
Calculate the following ratios and show your computations. For calculations normally involving averages, such
as average accounts receivable or average stockholders' equity, use year-end amounts if the information is not
available to use averages.
a. Current ratio.
b. Net income to average common stockholders' equity.
c. Number of days' sales in accounts receivable (assume 365 days in 2003).
d. EPS of common stock.
e. Times interest earned ratio.
f. Equity ratio.
g. Net income to net sales.
h. Total assets turnover.
i. Acid-test ratio.
Alternate problem H Paper Company is considering switching from the FIFO method to the LIFO method of
accounting for its inventory before it closes its books for the year. The January 1 merchandise inventory was USD
864,000. Following are data compiled from the adjusted trial balance at the end of the year:
Merchandise inventory, December 31 (FIFO)
$1,008,000
Current liabilities 720,000 Net sales 2,520,000 Operating expenses 774,000
Accounting Principles: A Business Perspective 723 A Global Text
17. Analysis and interpretation of financial statements
Current assets 1,890,000 Total assets (operating) 2,880,000 Cost of goods sold 1,458,000
If the switch to LIFO takes place, the December 31 merchandise inventory would be USD 900,000.
a. Compute the current ratio, inventory turnover ratio, and rate of return on operating assets assuming the
company continues using FIFO.
b. Repeat (a) assuming the company adjusts its accounts to the LIFO inventory method.
Beyond the numbers – Critical thinking
Business decision case A The comparative balance sheets of the Darling Corporation for 2011 December 31,
and 2010 follow:
Darling Corporation Comparative balance sheets
2011 December 31, and 2010
(USD millions)
2011 2010 Assets Cash $ 480,000 $ 96,000 Accounts receivable, net 86,400 115,200 Merchandise inventory 384,000 403,200 Plant and equipment, net 268,800 288,000 Total assets $ 1,219,200 $902,400 Liabilities and stockholders' equity Accounts payable $ 96,000 $ 96,000 Common stock 672,000 672,000 Retained earnings 451,200 134,400 Total liabilities and stockholders' equity $1,219,200 $902,400
Based on your review of the comparative balance sheets, determine the following:
a. What was the net income for 2011 assuming there were no dividend payments?
b. What was the primary source of the large increase in the cash balance from 2010 to 2011?
c. What are the two main sources of assets for Darling Corporation?
d. What other comparisons and procedures would you use to complete the analysis of the balance sheet?
Business decision case B As Miller Manufacturing Company's internal auditor, you are reviewing the
company's credit policy. The following information is from Miller's annual reports for 2008, 2009, 2010, and 2011:
2008 2009 2010 2011 Nets accounts receivable $ 1,080,000$ 2,160,000 $ 2,700,000 $ 3,600,000 Net sales 10,800,000 13,950,000 17,100,000 19,800,000
Management has asked you to calculate and analyze the following in your report:
a. If cash sales account for 30 per cent of all sales and credit terms are always 1/10, n/60, determine all turnover
ratios possible and the number of days' sales in accounts receivable at all possible dates. (The number of days' sales
in accounts receivable should be based on year-end accounts receivable and net credit sales.)
b. How effective is the company's credit policy?
Business decision case C Wendy Prince has consulted you about the possibility of investing in one of three
companies (Apple, Inc., Baker Company, or Cookie Corp.) by buying its common stock. The companies' investment
shares are selling at about the same price. The long-term capital structures of the companies alternatives are as
follows:
Apple, Inc.
Baker Company
Cookie Corp.
Bonds with a 10% interest rate $2,400,000 Preferred stock with an 8% $2,400,000
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dividend rate Common stock, $10 par value $4,800,000 2,400,000 2,400,000 Retained earnings 384,000 384,000 384,000 Total long-term equity $5,184,000 $5,184,000 $5,184,000 Number of common shares outstanding
480,000 240,000 240,000
Prince has already consulted two investment advisers. One adviser believes that each of the companies will earn
USD 300,000 per year before interest and taxes. The other adviser believes that each company will earn about USD
960,000 per year before interest and taxes. Prince has asked you to write a report covering these points:
a. Compute each of the following, using the estimates made by the first and second advisers.
(a) Earnings available for common stockholders assuming a 40 per cent tax rate.
(b)EPS of common stock.
(c) Rate of return on total stockholders' equity.
b. Which stock should Prince select if she believes the first adviser?
c. Are the stockholders as a group (common and preferred) better off with or without the use of long-term debt
in the companies?
Annual Report analysis D The following selected financial data excerpted from the annual report of
Appliance Corporation represents the summary information which management presented for interested parties to
review:
Appliance Corporation Selected Financial Data
(USD thousands except per share data) 2010 2009 2008 2007 2006
Net sales $3,049,524 $3,372,515 $2,987,054 $3,041,223 $2,970,626 Cost of sales 2,250,616 2,496,065 2,262,942 2,339,406 2,254,221 Income taxes 74,800 90,200 38,600 15,900 44,400 Income (loss) from continuing operations
(14,996) 151,137 51,270 (8,254) 79,017
Per cent of income (loss) from continuing operations to net sales
(0.5%) 4.5% 1.7% (0.3%) 2.7% Income (loss) from continuing operations per share $ (0.14) 1.42 0.48 (0.08) $ 0.75 Dividends paid per share 0.515 0.50 0.50 0.50 0.50 Average shares outstanding (in thousands) 107,062 106,795 106,252 106,077 105,761 Working capital $ 543,431 $ 595,703 $ 406,181 $452,626 $ 509,025 Depreciation of property, plant and equipment 102,572 110,044 102,459 94,032 83,352 Additions to property, plant and equipment 152,912 84,136 99,300 129,891 143,372 Total assets 2,125,066 2,504,327 2,469,498 2,501,490 2,535,068 Long-term debt 536,579 663,205 724,65 789,232 809,480 Total debt to capitalization 45.9% 50.7% 60.0% 58.7% 45.9% Shareowners' equity per share of common stock $ 6.05 $ 6.82 $ 5.50 $ 9.50
a. As a creditor, what do you believe management's objectives should be? Which of the preceding items of
information would assist a creditor in judging management's performance?
b. As an investor, what do you believe management's objectives should be? Which of the preceding items of
information would assist an investor in judging management's performance?
c. What other information might be considered useful?
Group project E Choose a company the class wants to know more about and obtain its annual report. In
groups of two or three students, calculate either the liquidity, equity, profitability, or market test ratios. Each group
Accounting Principles: A Business Perspective 725 A Global Text
17. Analysis and interpretation of financial statements
should select a spokesperson to tell the rest of the class the results of the group's calculations. Finally, the class
should decide whether or not to invest in the corporation based on the ratios they calculated.
Group project F In a group of two or three students, go to the library and attempt to locate Dun & Bradstreet's
Industry Norms and Key Business Ratios. You may have to ask the reference librarian for assistance to see if this
item is available at your institution. If it is not available at your institution, ask if it is available through an
interlibrary loan. (Obviously, if you cannot obtain this item, you cannot do this project.) Then select and obtain the
latest annual report of a company of your choice. Determine the company's SIC Code (a code that indicates the
industry in which that company operates). SIC Codes for specific companies are available on COMPACT
DISCLOSURE, an electronic source that may be available at your library. As an alternative, you could call the
company's home office to inquire about its SIC Code. The annual report often contains the company's phone
number. From the annual report, determine various ratios for the company, such as the current ratio, debt to equity
ratio, and net income to net sales. Then compare these ratios to the industry norms for the company's SIC Code as
given in the Dun & Bradstreet source. Write a report to your instructor summarizing the results of your
investigation.
Group project G In a group of two or three students, obtain the annual report of a company of your choice
Identify the major sections of the annual report and the order in which they appear. Would you recommend the
order be changed to emphasize the most useful and important information? If so, how? Then describe some specific
useful information in each section. Comment on your perceptions of the credibility that a reader of the annual
report could reasonably assign to each section of the report. For instance, if such a discussion appears in the annual
report you select, would you assign high credibility to everything that appears in the Letter to Stockholders
regarding the company's future prospects? Write a report to your instructor summarizing the results of your
investigation.
Using the Internet—A view of the real world
Visit the following website for Eastman Kodak Company:
http://www.kodak.com
By following choices on the screen, locate the income statements and balance sheets for the latest two years.
Calculate all of the ratios illustrated in the chapter for which the data are available. Compare the ratios to those
shown for Synotech as presented in the chapter. Write a report to your instructor showing your calculations and
comment on the results of your comparison of the two companies.
Visit the following website for General Electric Company:
http://www.ge.com
By following choices on the screen, locate the income statements and balance sheets for the latest two years.
Calculate all of the ratios illustrated in the chapter for which the data are available. Compare the ratios to those
shown for Synotech as presented in the chapter. Write a report to your instructor showing your calculations and
comment on the results of your comparison of the two companies.
Answers to self-test
True-false
True. Financial statement analysis consists of applying analytical tools and techniques to financial statements
and other relevant data to obtain useful information.
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False. Horizontal analysis provides useful information about the changes in a company's performance over
several periods by analyzing comparative financial statements of the same company for two or more successive
periods.
False. Common-size statements show only percentage figures, such as percentages of total assets and
percentages of net sales.
True. Liquidity ratios such as the current ratio and acid-test ratio indicate a company's short-term debt-paying
ability.
True. The accrual net income shown on the income statement is not cash basis income and does not indicate
cash flows.
True. Analysts must use comparable data when making comparisons of items for different periods or different
companies.
Multiple-choice
b. Current assets: USD 136,000 + USD 64,000 + USD 184,000 + USD 244,000 + USD 12,000 = USD 640,000
Current liabilities: USD 256,000 + USD 64,000 = USD 320,000
Current ratio: USD640,000
USD320,000 =2:1
c. Quick assets:
USD 136,000 + USD 64,000 + USD 184,000 = USD 384,000
Current liabilities:
256,000 + USD 64,000 = USD 320,000
Acid-test ratio: USD384,000
USD320,000 =1.2 :1
a. Net sales:
USD 4,620,000
Average accounts receivable: USD 720,000USD960,000
2 =USD840,000
Accounts receivable turnover: USD4,620,000
USD840,000 =5.5
c. Cost of goods sold:
USD 3,360,000
Average inventory:
USD900,000USD 1,020,000
2 =USD960,000
Inventory turnover: USD3,360,000
USD960,000 =3.5
b. Income before interest and taxes, USD 720,000
Interest on bonds, 192,000
Times interest earned ratio: USD 720,000/USD 192,000 = 3.75 times
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18. Managerial accounting concepts/job costing
Learning objectives
After studying this chapter, you should be able to:
• Compare and contrast managerial accounting and financial accounting.
• Describe the basic components of a products cost.
• Explain the difference between product costs and period costs.
• Compare financial reporting by a merchandiser to that of a manufacturer and prepare a statement of cost of
goods manufactured, an income statement, and a balance sheet for a manufacturer.
• Explain the pattern of cost flows for a company.
• Compare and contrast different production methods and accounting systems.
• Describe job cost flows and determine the cost of jobs.
• Explain how and why predetermined overhead rates are computed.
• Describe the differences in net income under absorption costing and variable costing (appendix).
A manager's perspective
Ann Francis
Manager, Consumer Affairs Administration
The Coca-Cola Company
Regardless of the area of business in which they choose to make their careers, students, especially when they
reach the management level, will inevitably have financial responsibilities. As a manager, I need to understand
some basic accounting information in order to make decisions and to process the information flow in and out of my
office.
For example, I manage a department budget, and it is my responsibility to track cash inflow and outflow on a
regular basis to ensure that the budget is administered appropriately. I track all our invoices, then reconcile them
with a "Deck" report, which we receive from accounting. I also order supplies for our department, and that needs to
be managed within a budget as well.
Every year we review our department's past expenditures and our anticipated expenditures, then establish a
budget for the next year. At this point, we also make decisions about capital expenditures such as purchasing new
computer equipment, and those plans are worked into the capital budget.
Aside from general administration, I am also responsible for a program called "Coca-Cola Cares", an employee
hotline set up in 1992 to provide a vehicle for employees to report any problems they notice in the marketplace such
as broken vending machines or inappropriate use of our trademark. I receive weekly and monthly reports to assess
improvements based on increases and decreases in the number of calls we receive.
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18. Managerial accounting concepts/job costing
Another group under my management is telemarketing services, an internal service set up to help Coca-Cola
associates with market research and customer service projects. Since independent telemarketing services can be
very expensive, this system allows us to maintain high quality service to Coca-Cola customers in the most
economically feasible way.
Have you ever considered starting or running a business, or know someone who has? Have you considered
providing management skills to a nonprofit organization? If so, then you realize that good decisions are based on
good information.
Managerial accounting helps managers make good decisions. Managerial accounting provides information
about the cost of goods and services, whether a product is profitable, whether to invest in a new business venture,
and how to budget. It compares actual performance to planned performance and facilitates many other important
decisions critical to the success of organizations.
The remaining chapters in this book focus on managerial accounting. This chapter provides an overview of
managerial accounting, defines cost terms, and shows how to determine the cost of a particular type of product
known as a job.
Compare managerial accounting with financial accounting
Whereas financial accounting provides financial information primarily for external use, managerial
accounting information is for internal use. By reporting on the financial activities of the organization, financial
accounting provides information needed by investors and creditors.
Most managerial decisions require more detailed information than that provided by external financial reports.
For instance, in their external financial statements, large corporations such as General Electric Company show
single amounts on their balance sheets for inventory. However, managers need more detailed information about the
cost of each of several hundred products.
We show the fundamental differences between managerial and financial accounting in the chart.
Financial accounting Managerial accounting Users External users of information – usually shareholders, financial analysts, and creditors
Internal users of information – usually managers.
Compliance with generally accepted Accounting Principles Must comply with generally accepted accounting principles. Need not comply with generally accepted
accounting principles. Internal cost/benefit evaluation determines how much information is enough.
Future versus past Uses historical data. May use estimates of the future for budgeting and
decision making. Detail presented Presents summary data, costs, revenues, and profits. More detailed data are presented about product.
Accountants currently face a big challenge: designing information systems that provide information for multiple
purposes. Some people at lower levels in the organization need detailed information, but not the big picture
provided by a company's income statement. However, managers at top levels need to see the big picture.
All of you will use accounting information in your careers. Therefore, you need to know enough about
accounting to get the information you need for decision making.
Managerial accountants face many choices involving ethics. For example, managers are responsible for
achieving financial targets such as net income. Managers who fail to achieve these targets may lose their jobs. If a
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division or company is having trouble achieving financial performance targets, managers may be tempted to
manipulate the accounting numbers.
In its Standards of Ethical Conduct for Management Accountants, the Institute of Management Accountants
(IMA) states that management accountants have an obligation to maintain the highest levels of ethical conduct by
maintaining professional competency, refraining from disclosing confidential information, and maintaining
integrity and objectivity in their work.58
The standards recommend that people faced with ethical conflicts follow the company's established policies that
deal with such conflicts. If the policies do not resolve the conflict, accountants should consider discussing the
matter with their superiors, potentially going as high as the audit committee of the board of directors. In extreme
cases, the accountants may have no alternative but to resign.
Merchandiser and manufacturer accounting: Differences in cost concepts
Cost is a financial measure of the resources used or given up to achieve a stated purpose. Product costs are the
costs a company assigns to units produced. Product costs are the costs of making a product, such as an
automobile; the cost of making and serving a meal in a restaurant; or the cost of teaching a class in a university.
Manufacturing companies use the most complex product costing methods. To ensure that you understand how
and why product costing is done in manufacturing companies, we use many manufacturing company examples.
However, since many of you could have careers in service or merchandising companies, we also use
nonmanufacturing examples.
An ethical perspective:
High pressure sales tactics and creative accounting
The most common financial fraud is premature recording of revenues. For instance, a manager or
accountant recorded a sale before the end of Year 1 when, in fact, the sale occurred in Year 2. That
sale and its profits appear on the Year 1 financial statements, instead of the Year 2 financial
statements. A company known as Comserv provides an example of this type of fraud.
Comserv was a software development company that installed specialized software for companies.
Comserv recorded revenue for a software installation as follows: First, it recorded a portion of the
revenue when the customer signed a contract. Second, it recorded the rest of the revenue when the
installation was complete. This approach complied with generally accepted accounting principles
for external reporting and with company policy for internal reporting.
Using this method, salespeople had incentives to pressure customers to sign contracts before the
end of the fiscal year. Subsequent investigations by Comserv's external auditors and the Securities
and Exchange Commission uncovered several fraudulent activities. For instance, employees
backdated sales contracts by recording a contract signed on January 28 of Year 2 as being signed on
December 28 of Year 1. (The end of the fiscal year was December 31.)
58 See Standards of Ethical Conduct for Management Accountants (Montvale, N.J.: Institute of Management
Accountants, June 1, 1983.)
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18. Managerial accounting concepts/job costing
Comserv salespeople also persuaded customers to sign contracts for software installations before
the end of the fiscal year while providing a separate side agreement that allowed customers to
withdraw from the deal at a later date. Because of this side agreement, the company should not
have recorded revenue at the time the contract was signed. Comserv should have waited until
customers could no longer withdraw from the contract. The accounting department, not knowing of
the separate side agreement, recorded revenue at the time of the contract.
The Securities and Exchange Commission alleged many people at Comserv were involved in
fraudulent activities, including salespeople and accountants who unwittingly supported these
activities. In the end, several people were charged with committing fraud by the Securities and
Exchange Commission, and the company was taken over by another company in the computer
software industry.
Based on the authors' research of Securities and Exchange Commission files and court testimony.
In manufacturing companies, a product's cost is made up of three cost elements: direct material costs, direct
labor costs, and manufacturing overhead costs.
Direct materials Materials are unprocessed items used in the manufacturing process. Direct materials are
those materials used only in making the product and are clearly and easily traceable to a particular product. For
example, iron ore is a direct material to a steel company because the iron ore is clearly traceable to the finished
product, steel. In turn, steel becomes a direct material to an automobile manufacturer.
Some materials (such as glue and thread used in manufacturing furniture) may become part of the finished
product, but tracing those materials to a particular product would require more effort than is sensible. Such
materials, called indirect materials or supplies, are included in manufacturing overhead. Indirect materials are
materials used in the manufacture of a product that cannot, or will not for practical reasons, be traced directly to
the product being manufactured. Indirect materials are part of overhead, which we will discuss later.
Direct labor Direct labor costs include the labor costs of all employees actually working on materials to
convert them into finished goods. As with direct material costs, direct labor costs of a product include only those
labor costs clearly traceable to, or readily identifiable with, the finished product. The wages paid to a construction
worker, a pizza delivery driver, and an assembler in an electronics company are examples of direct labor.
Many employees receive fringe benefits—employers pay for payroll taxes, pension costs, and paid vacations.
These fringe benefit costs can significantly increase the direct labor hourly wage rate. Some companies treat fringe
benefit costs as direct labor. Other companies include fringe benefit costs in overhead if they can be traced to the
product only with great difficulty and effort.
Firms account for some labor costs (for example, wages of materials handlers, custodial workers, and
supervisors) as indirect labor because the expense of tracing these costs to products would be too great. These
indirect labor costs are part of overhead. Indirect labor consists of the cost of labor that cannot, or will not for
practical reasons, be traced to the products being manufactured.
Overhead In a manufacturing company, overhead is generally called manufacturing overhead. (You may also
see other names for manufacturing overhead, such as factory overhead, factory indirect costs, or factory burden.)
Service companies use service overhead, and construction companies use construction overhead. Any of these
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companies may just use the term overhead rather than specifying it as manufacturing overhead, service overhead,
or construction overhead. Some people confuse overhead with selling and administrative costs. Overhead is part of
making the good or providing the service, whereas selling costs result from sales activity and administrative costs
result from running the business.
In general, overhead refers to all costs of making the product or providing the service except those classified as
direct materials or direct labor. (Some service organizations have direct labor but not direct materials.) In
manufacturing companies, manufacturing overhead includes all manufacturing costs except those accounted
for as direct materials and direct labor. Manufacturing overhead costs are manufacturing costs that must be
incurred but that cannot or will not be traced directly to specific units produced. In addition to indirect materials
and indirect labor, manufacturing overhead includes depreciation and maintenance on machines and factory utility
costs. Look at Exhibit 137 for more manufacturing overhead costs.
Selling costs Selling costs are costs incurred to obtain customer orders and get the finished product in the
customers' possession. Advertising, market research, sales salaries and commissions, and delivery and storage of
finished goods are selling costs. The costs of delivery and storage of finished goods are selling costs because they are
incurred after production has been completed. Therefore, the costs of storing materials are part of manufacturing
overhead, whereas the costs of storing finished goods are a part of selling costs. Remember that retailers,
wholesalers, manufacturers, and service organizations all have selling costs.
Administrative costs Administrative costs are nonmanufacturing costs that include the costs of top
administrative functions and various staff departments such as accounting, data processing, and personnel.
Executive salaries, clerical salaries, office expenses, office rent, donations, research and development costs, and
legal costs are administrative costs. As with selling costs, all organizations have administrative costs.
Companies also classify costs as product costs and period costs. Product costs are the costs incurred in making
products. These costs include the costs of direct materials, direct labor, and manufacturing overhead.
Period costs are closely related to periods of time rather than units of products. For this reason, firms expense
(deduct from revenues) period costs in the period in which they are incurred. Accountants treat all selling and
administrative costs as period costs for external financial reporting.
Indirect labor: Repairs and maintenance on factory buildings and equipment
Janitors in factory buildings Payroll taxes and fringe benefits for manufacturing employees
Supervisors in factory buildings
Depreciation on factory buildings and equipment
Materials storeroom personnel
Insurance and taxes on factory property and inventories
Cost accountant Utilities for factory buildings Indirect materials: Oil Nails
Exhibit 137: Manufacturing overhead costs
To illustrate, assume a company pays its sales manager a fixed salary. Even though the manager may be working
on projects to benefit the company in future accounting periods, it expenses the sales manager's salary in the period
incurred because the expense cannot be traced to the production of a specific product.
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18. Managerial accounting concepts/job costing
An accounting perspective:
Business insight
Many service organizations have inventories. For example, consulting firms, public accounting
firms, and law firms have inventories of work not yet billed to clients. The inventories in service
companies are less tangible than the inventories in manufacturing companies. Inventories
represent the time and talent that have gone into the job. In service companies, this includes
working papers and documents or simply the ideas of the people doing the work.
Financial reporting by manufacturing companies
Many of you will work in manufacturing companies or provide services for them. Others will work in retail or
service organizations that do business with manufacturers. This section will help you understand how
manufacturing companies work and how to read both their internal and external financial statements.
Assume you own a bicycle store and purchase bicycles and accessories to sell to customers. To determine your
profitability, you would subtract the cost of bicycles and accessories from your gross sales as cost of goods sold.
However, if you owned the manufacturing company that made the bicycles, you would base your cost of goods sold
on the cost of manufacturing those bicycles. Accounting for manufacturing costs is more complex than accounting
for costs of merchandise purchased that is ready for sale.
Perhaps the most important accounting difference between merchandisers and manufacturers relates to the
differences in the nature of their activities. A merchandiser purchases finished goods ready to be sold. On the other
hand, a manufacturer must purchase raw materials and use production equipment and employee labor to
transform the raw materials into finished products.
Thus, while a merchandiser has only one type of inventory—merchandise available for sale—a manufacturer has
three types—unprocessed materials, partially complete work in process, and ready-for-sale finished goods. Instead
of one inventory account, three different inventory accounts are necessary to show the cost of inventory in various
stages of production. Looking at Exhibit 138, you can see how the inventory cost flows differ between
manufacturing and merchandising companies.
We compare a manufacturer's cost of goods sold section of the income statement to that same section of the
merchandiser's income statement in Exhibit 139. There are two major differences in these cost of goods sold
sections: (1) goods ready to be sold are referred to as merchandise inventory by a merchandiser and finished goods
inventory by a manufacturer, and (2) the net cost of purchases for a merchandiser is equivalent to the cost of goods
manufactured by a manufacturer.
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Exhibit 138: Comparison of inventory cost flows
Merchandiser Manufacturer Cost of goods sold: Cost of goods sold: Merchandise inventory, January 1 $ 25,000 Finished goods inventory, January
1 $ 50,000
Net cost of purchases 165,000 Cost of goods manufactured (from statement of cost of goods manufactured)
1,100,000
Cost of goods available for sale $ 190,000 Cost of goods available for sale $1,150,000 Merchandise inventory, December 31
30,000 Finished goods inventory, December 31
60,000
Cost of goods sold $ 160,000 Cost of goods sold $1,090,000
Exhibit 139: Cost of goods sold comparison
The statement of cost of goods manufactured supports the cost of goods sold figure on the income
statement. (See the USD 1,100,000 cost of goods manufactured in Exhibit 139.) The two most important numbers
on this statement are the cost to manufacture and the cost of goods manufactured. Be careful not to confuse the
terms cost to manufacture and cost of goods manufactured with each other or with the cost of goods sold. We depict
the relationship among these terms in Exhibit 140.
Cost to manufacture includes the costs of all resources put into production during the period. Cost of goods
manufactured consists of the cost of all goods completed during the period. It includes cost to manufacture plus
the beginning work in process inventory minus the ending work in process inventory. Cost of goods sold includes
the cost of goods manufactured plus the beginning finished goods inventory minus the ending finished goods
inventory.
Look at Exhibit 141, the statement of cost of goods manufactured for Farside Manufacturing Company for 2010.
Farside Manufacturing makes calendars and books.
Note how the statement shows the costs incurred for direct materials, direct labor, and manufacturing overhead.
The statement totals these three costs as cost to manufacture during the period. When adding beginning work in
process inventory and deducting ending work in process inventory from the cost to manufacture, we obtain cost of
goods manufactured or completed. Cost of goods sold does not appear on the cost of goods manufactured statement
but on the income statement.
To make the manufacturer's income statement more understandable to readers of the financial statements,
accountants do not show all of the details that appear in the cost of goods manufactured statement. In Exhibit 142
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18. Managerial accounting concepts/job costing
on the next page, we show the income statement for Farside Manufacturing Company. Notice in Exhibit 142 the
relationship of the statement of cost of goods manufactured to the income statement.
Exhibit 140: Relationship of cost to manufacture, cost of goods manufactured, and
cost of goods sold
Farside manufactured company Statement of cost of goods manufactured For the year ended 2010 December 31 Direct materials Materials inventory, January 1 $ 40,000 Materials purchases 480,000 Materials available for use $520,000 Less: Materials inventory, December 31 30,000 Materials used $490,000 Direct labor 380,000 Manufacturing overhead Indirect labor $ 120,000 Maintenance and repairs expense 60,000 Factory utilities expense 10,000 Depreciation expense – factory building 20,000 Depreciation expense – factory equipment 30,000 Other expense – factory 20,000 Total manufacturing overhead 260,000 Cost to manufacture $1,130,000 Add: Work in process inventory, January 1 30,000
$1,160,000 Less: Work in process inventory, December 31
60,000
Cost of goods manufactured $1,100,000
Exhibit 141: Statement of cost of goods manufactured
The cost of goods manufactured appears in the cost of goods sold section of the income statement. The cost of
goods manufactured is in the same place that purchases would be presented on a merchandiser's income statement.
We add cost of goods manufactured to beginning finished goods inventory to derive cost of goods available for sale.
This is similar to the merchandiser who presents purchases added to beginning merchandise to derive goods
available for sale.
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Farside manufacturing company Income statement
For the year ended 2010 December 31 Sales $1,800,000 Cost of goods sold: Finished goods inventory, January 1 $ 50,000 Cost of goods manufactured (see statement of cost of goods manufactured in Exhibit 141) 1,100,000 Cost of goods available for sale $1,150,000 Less: Finished goods inventory, December 31 60,000 Cost of goods sold 1,090,000 Gross margin $ 710,000 Operating expenses: Selling expenses $ 300,000 Administrative expenses 200,000 Total operating expenses 500,000 Income from operations $ 210,000
Note: Income statements presented in external financial statements also include nonoperating revenues and expenses and income taxes.
Exhibit 142: Income statement of a manufacturer
When financial statements are released to the public, it is common to further simplify the income statement.
These simplified statements show only the items and amounts in the right column of Exhibit 142, not the details in
the left column.
Unlike a merchandiser's balance sheet that reports a single inventory amount, the balance sheet for a
manufacturer typically shows materials, work in process, and finished goods inventories separately. A
manufacturer's balance sheet may also show greater detail in the property, plant, and equipment section because of
the significant investment in plant assets.
The general cost accumulation model
In general, companies match the flow of costs to the physical flow of products through the production process,
as shown in Exhibit 143. They place materials received from suppliers in the materials storeroom. They also record
the cost of those materials when purchasing them. As they are needed for production, the materials move from the
materials storeroom to the production departments, and their cost is assigned to those production departments, as
shown in Exhibit 143.
During production, the materials processed by workers and machines become partially manufactured products.
At any time during production, these partially manufactured products are collectively known as work in process.
For example, if accountants compute the inventory when the company has partially finished products at the end of
the year, this inventory is work in process inventory.
Completed products are finished goods. When the products are completed and transferred to the finished
goods storeroom, the company removes their costs from Work in Process Inventory and assigns them to Finished
Goods Inventory. As the goods are sold, the company transfers related costs from Finished Goods Inventory to Cost
of Goods Sold.
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18. Managerial accounting concepts/job costing
Exhibit 143: Product and cost flows
Type of production Accounting system Type of product Job shop Job costing Customized Hospital, custom home builder, consulting firm Batch production Mostly job costing Several different products Furniture manufacturer, winery Repetitive manufacturing Mostly process costing (operations) Few new products Computer manufacturer, bicycle manufacturer Continuous flow processing Process costing Standardized Oil refinery, paint manufacturer
Exhibit 144: Production activities and types of accounting systems
The accounting flow of costs follows the physical flow of the manufacturing process in most companies. Some
companies use an alternative approach that we discuss in Chapter 20. In this chapter and the next, we assume costs
follow the physical flow of products.
In discussing product costing, we described how accountants and managers assign costs to products. Recall that
products can be either goods or services, so this discussion applies to service and merchandising companies as well
as to manufacturing companies.
In Exhibit 144, we show how various companies choose different accounting systems, depending on their
products. First, companies producing individual, unique products known as jobs use job costing (also called job
order costing). Companies such as construction companies and consulting firms, produce jobs and use job costing.
Second, some companies, like furniture manufacturers, produce batches of products. They produce all of the
components of a single product (e.g. coffee tables) in one batch. They would then produce the components of
another product (e.g. dining room sets) in a new batch. (Some university food service companies prepare meals this
way.) Companies such as these use job costing methods to accumulate the cost of each batch.
The last two types of production in Exhibit 144 use process costing methods described in Chapter 19, so we give
just a brief overview here. Repetitive manufacturing lends itself to the use of automated equipment that minimizes
the amount of manual material handling. Automobile assembly plants, bicycle assembly plants, and computer
assembly plants use repetitive manufacturing.
Continuous flow processing is the opposite of job shops. Companies using this process continuously mass-
produce a single, homogeneous product. Companies use process cost systems in manufacturing paint, grinding
flour, and refining oil.
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An accounting perspective:
Business insight
Engineers for automobile companies in the United States believe that Japanese manufacturers can
build cars for considerably less than their US counterparts. Many hospitals that thrived when
health care costs were reimbursed faced troubled financial times when they had to compete with
health maintenance organizations. These organizations required a better understanding of their
costs. It is simple. Companies with competitors have to know and control their costs to be
competitive.
Job costing
A job cost system (job costing) accumulates costs incurred according to the individual jobs. Companies
generally use job cost systems when they can identify separate products or when they produce goods to meet a
customer's particular needs.
Who uses job costing? Examples include home builders who design specific houses for each customer and
accumulate the costs separately for each job, and caterers who accumulate the costs of each banquet separately.
Consulting, law, and public accounting firms use job costing to measure the costs of serving each client. Motion
pictures, printing, and other industries where unique jobs are produced use job costing. Hospitals also use job
costing to determine the cost of each patient's care.
Assume Creative Printers is a company run by a group of students who use desktop publishing to produce
specialty books and instruction manuals. Creative Printers uses job costing. Creative Printers keeps track of the
time and materials (mostly paper) used on each job.
The company compares the cost of each job with the revenue received to be sure the jobs are profitable.
Sometimes the company learns that certain jobs are too costly considering the prices they can charge. For example,
Creative Printers recently learned that cookbooks were not profitable. On the other hand, printing instruction
manuals was quite profitable, so the company has focused more on the instruction manual market. To illustrate a
job costing system, this section describes the transactions for the month of July for Creative Printers.
On July 1, Creative Printers had these beginning inventories:
Materials inventory $20,000 Work in process inventory (Job No. 106: direct materials, $4,200;direct labor, $5,000; and overhead, $4,000) 13,200 Finished goods inventory (Job No. 105) 5,500
Creative Printing had completed Job No. 105, a set of gardening books, but had not shipped them to the
customer as of June 30. They had Job No. 106, a set of instruction manuals for computer software, in process at the
beginning of July and completed it in July. They started Job No. 107, a travel guide for visitors to Southeast Asia, in
July but had not completed it.
The transactions and the journal entries to record these transactions follow. In Exhibit 145, we show the flow of
costs through accounts and the beginning balances just presented.
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18. Managerial accounting concepts/job costing
Materials Inventory Work in Inventory -
Process Job No. 106
Finished Goods Inventory
Beginning inventory (1)
20,000 25,000 (2) 24,000
Beginning inventory: Materials 4,200
Beginning inventory
5,500 Sold (6) 5,500
Ending inventory
21,000 Labor Overhead Total
5,000 4,000 13,200
Completed (5) 29,400
Current period: Mats. Labor Ovrhd. Total
(2) 9,000 (3) 4,000 (4) 3,200 16,200
Completed (5) 29,400 Ending inventory
29,400
Payroll Summary Ending inventory -0-
Cost of goods
Sold
Incurred 25,000 Distributed (3) 25,000 Sold (6) 5,500 Overhead
Indirect materials (2) 1,000
Applied to production (4) 16,000
Indirect labor
(3) 5,000
Other overhead (7) 9,800
Work in Inventory -
Process Job No. 107
Overapplied balance
200 Beginning inventory -0- Current period: Mats. Labor Ovrhd. Total
(2) 14,000 (3) 16,000 (4) 12,800 42,800
Ending inventory: Materials Labor Overhead Total
14,000 16,000 12,800 42,800
Note: Numbers in parentheses refer to journal entries in the text. We show only the entries or parts of entries that deal with cost flows.
Exhibit 145: Job cost flows-Creative Printers
• During July, Creative Printers purchased USD 25,000 of materials on account. This purchase included both
direct materials, such as paper, and indirect materials, such as printing supplies and computer supplies.
Materials inventory 25,000 Accounts payable 25,000 To record purchase of materials.
• During July, Creative Printers sent direct materials from the materials storeroom to jobs as follows: USD
9,000 to Job No. 106, and USD 14,000 to Job No. 107. The company also sent indirect materials of USD 1,000
to jobs. It charged indirect materials to overhead, not to each job, because the company does not keep track of
how much indirect materials it uses on each job. (Manufacturing companies often use Manufacturing
Overhead for the Overhead account. We generally use the Overhead account for both manufacturing and non-
manufacturing companies in this chapter.) Each job has a separate Work in Process Inventory account to keep
track of the particular job's costs.
Work in process inventory – Job No. 106 (+A) 9,000 Work in process inventory – Job No. 107 (+A) 14,000 Overhead (or manufacturing overhead) (-SE) 1,000 Materials inventory (-A) 24,000 To record direct and indirect materials sent
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from the storeroom to jobs.
See Exhibit 145, for the flow of materials from Materials Inventory to the Work in Process and Overhead
accounts.
• Production workers keep track of the time spent on each job at Creative Printers. Based on that
information, the company assigned production-related labor costs to jobs and to Overhead as follows: USD
4,000 to Job No. 106, USD 16,000 to Job No. 107, and indirect labor of USD 5,000 to Overhead.
Work in process inventory – Job No. 106 4,000 Work in process inventory – Job No. 107 16,000 Overhead 5,000 Payroll summary 25,000 To distribute labor costs to jobs and overhead
The entry to record payroll incurred during the accounting period (not shown) includes a debit to Payroll
Summary and a credit to liability accounts to show payables for fringe benefits, such as health insurance, payroll
taxes, and employee wages. In entry (3) the payroll summary is distributed to the jobs and overhead. Look at
Exhibit 145, to see the assignment of labor costs to the Work in Process and Overhead accounts.
• The company assigns overhead to each job in the following manner: Creative Printers charges indirect
materials to jobs based on each job's usage of materials; it charges indirect labor to jobs based on each job's
usage of labor; and it charges all other overhead to jobs on the basis of the machine-hours each job uses.
By definition, overhead cannot be traced directly to jobs. Instead, we use cost drivers to assign overhead to jobs.
A cost driver is a measure of activities, such as machine-hours, that is the cause of costs. To assign overhead to
jobs, the cost driver should be the cause of the overhead costs, or at least be reasonably associated with the
overhead costs. Just as automobile mileage is a good cost driver for measuring the cause of gasoline consumption,
machine-hours is a measure of what causes energy costs. By assigning energy costs to jobs based on the number of
machine-minutes or hours the job uses, we have a pretty good idea of the energy costs required to produce the job.
Creative Printers assigns overhead (such as machine maintenance) to jobs on a machine-hour basis. This makes
good sense if machine maintenance is based on hours of usage, similar to having car maintenance done every 6,000
miles.
Creative Printers also assigns overhead (such as building depreciation) to jobs on a machine-hour basis, which is
less logical. However, Creative Printers' management does not believe the time and trouble of developing a more
sophisticated method of assigning building depreciation to jobs is justified. For example, management did not
believe better overhead allocation would sufficiently improve company profits to justify hiring another accountant
to improve its overhead allocation method.
Creative Printers allocates overhead to each job as follows:
Materials basis: Overhead is assigned to a job at the rate of 5 per cent of the cost of materials used on the job.
Labor basis: Overhead is assigned at the rate of 25 per cent of the cost of labor used on the job.
Machine-hours basis: Overhead is assigned to a job at the rate of USD 2 per machine-hour used on the job.
For now, assume these overhead rates are correct. Later in the chapter we discuss how companies derive these
overhead rates. Creative Printers assigned overhead to Jobs 106 and 107 as follows:
Job 106 Overhead assigned to Job 106: Materials $9,000 5% x $9,000 $ 450 Labor cost $4,000 25% x $4,000 1,000 Machine-hours 875 hours $2 x 875 hours 1,750
Total overhead assigned to Job 106 $3,200 Job 107 Overhead assigned to Job 107:
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18. Managerial accounting concepts/job costing
Materials $14,000 5% x $14,000 $ 700 Labor cost $16,000 25% x $16,000 4,000 Machine-hours 4,050 hours $2 x 4,050 hours 8,100
Total overhead assigned to Job 107 $12,800
Here is the journal entry to assign overhead to jobs:
Work in process inventory – Job No. 106 3,200 Work in process inventory – Job No. 107 12,800 Overhead 16,000 To record application of overhead to jobs.
See Exhibit 145 for the application of overhead to jobs.
• Job No. 106 was completed. Job 106 cost USD 29,400 for the total work done on the job, including costs in
beginning Work in Process Inventory on July 1 and costs added during July. This entry records the completion
of Job 106:
Finished goods inventory (+A) 29,400 Work in process inventory – Job No. 106 (- A)
29,400
To record completed production for July.
See Exhibit 145 for the flow of costs from Work in Process Inventory to Finished Goods Inventory.
• Job No. 105 was sold on account in July for USD 9,000. These entries record the sale and the related cost of
goods sold:
Accounts receivable (+A) 9,000 Sales (+SE) 9,000 To record sales on account for July. Cost of goods sold (-SE) 5,500 Finished goods inventory (-A) 5,500 To record cost of goods sold in July (Job 105).
• The company applied overhead to the jobs in entry (4) based on a predetermined overhead rate. Many of
the actual overhead costs are not known until the end of the month or later. For example, the company would
not receive its utility bill for July until sometime in August. In addition to the indirect materials and indirect
labor recorded in entries (2) and (3), Creative Printers incurred these other overhead costs for July:
Machinery repairs and maintenance $4,500 Utilities, including energy costs to run machines 1,000 Depreciation of building and machines 2,500 Other overhead 1,800 Total overhead incurred in July other than indirect materials and indirect labor
$9,800
To prepare the journal entry, we debit the Overhead account for the actual costs. Then we credit Accounts
Payable for the machinery repairs and maintenance, utilities, and other overhead. (We assume an outside
contractor does the maintenance and repairs.) The amount is USD 7,300 (USD 4,500 + USD 1,000 + USD 1,800).
And, finally we credit Accumulated Depreciation for USD 2,500. Here is the journal entry:
Overhead 9,800 Accounts payable 7,300 Accumulated depreciation 2,500 To record actual overhead costs for July.
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Overhead Cost of goods Sold 1,000* 16,000* 5,500* 5,000* 9,800* Transfer from overhead (8)
200 Overapplied balance 200* Cost of goods
sold for July 5,300 Transfer to cost of goods sold (8) 200 -0-
*These amounts are from Exhibit 145
Exhibit 146: Transfer overapplied overhead to cost of goods sold
At this point, you may want to review the flow of costs through the inventory accounts in Exhibit 145. Note that
Exhibit 145, shows only the inventory accounts, Payroll Summary, Overhead, and Cost of Goods Sold, not all of the
accounts in the preceding entries.
• At the end of the month, the Overhead account contains overapplied overhead of USD 200 as shown in
Exhibit 145. Companies generally transfer the balance of the Overhead account to Cost of Goods Sold at the
end of the accounting period. Some companies do this monthly; others do it quarterly or annually. The journal
entry to transfer Creative Printers' overhead balance to Cost of Goods Sold for the month of July is as follows:
Overhead (-SE) 200 Cost of goods sold (+SE) 200 To transfer the overhead balance to Cost of goods sold.
See the adjusted Cost of Goods Sold and the Overhead accounts in Exhibit 146.
Why does the previous entry reduce the Cost of Goods Sold by USD 200? The overhead applied to the jobs was
too high—it was overapplied. Thus, the cost of jobs was overstated. Although those jobs are still in Work in Process
or Finished Goods Inventory, companies usually adjust the Cost of Goods Sold account instead of each inventory
account. Adjusting each inventory account for a small overhead adjustment is usually not a good use of managerial
and accounting time and effort. All jobs appear in Cost of Goods Sold sooner or later, so companies simply adjust
Cost of Goods Sold instead of the inventory accounts.
In this book, we assume companies transfer overhead balances to Cost of Goods Sold. We leave the more
complicated procedure of allocating overhead balances to inventory accounts to textbooks on cost accounting.
Although Creative Printers had overapplied overhead, it could just as easily have had underapplied
overhead. If overhead had been underapplied, the company would have debited Cost of Goods Sold and credited
Overhead to transfer the overhead balance.
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18. Managerial accounting concepts/job costing
Creative Printers Income statement
For the month ended 2010 July 31 Sales $9,000 Cost of goods sold: Finished goods inventory, July 1 $ 5,500 Cost of goods manufactured 29,400 Cost of goods available for sale $34,900 Less: Finished goods inventory, July 31 29,400 Cost of goods sold before transfer of overapplied overhead
$ 5,500
Less: Overapplied overhead 200 Cost of goods sold 5,300 Gross margin $3,700 Selling and administrative expenses 3,000 Net income $ 700
Exhibit 147: Creative Printers-Income statement
Sometime in July or August, Creative Printers would collect its receivables in cash and pay its payables. The
accounts payable for July amount to USD 32,300 (USD 25,000 for the materials purchase + USD 7,300 payables
for overhead costs). The payroll liabilities amount to USD 25,000. Here are the entries recording Creative Printers'
payment of payables and payroll liabilities, and the collection of its receivables of USD 9,000:
Accounts payable (-L) 32,300 Cash (-A) 32,300 Payroll liabilities (-L) 25,000 Cash (-A) 25,000 Cash (+A) 9,000 Accounts receivable (-A) 9,000
Note that in Exhibit 147 we present the income statement for Creative Printers. Assume the selling and
administrative expenses for July are USD 3,000.
Managers would use the preceding cost information for several purposes: First, they would compare the actual
costs of the job with expected costs, both as the work is being done and after the job has been completed. Later
chapters discuss the role of managerial accounting in performance evaluation. Second, managers would assess the
profitability of jobs. For example, Job 105 had revenue of USD 9,000 and costs of USD 5,500.
Third, managers would compare actual overhead on the left side of the Overhead account, with the overhead
applied to jobs on the right side. If the actual overhead exceeds the applied overhead, they may wish to learn why
the actual overhead is so high. Also, they may ask the accountants to increase the overhead applied to jobs to give
them a better idea of the cost of jobs. If the actual is less than the applied overhead, they may ask the accountants to
reduce the overhead applied to jobs.
Predetermined overhead rates
Creative Printers used predetermined rates to apply overhead to jobs. For example, they determined the 5 per
cent rate used to apply materials-related overhead to jobs before the month of July. Most manufacturing and
service organizations use predetermined rates.
To calculate a predetermined overhead rate, a company divides the estimated total overhead costs for a
period by an expected level of activity. This activity could be total expected machine-hours, total expected direct
labor-hours, or total expected direct labor cost for the period. Companies set predetermined overhead rates at the
beginning of the year in which they will use them. Thus, the rates for July may have been computed in November or
December of the previous year. This formula computes a predetermined rate:
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Predetermined overhead rate= Estimated overhead costs
Expected levelof activitysuch as machine−hours
To demonstrate, assume the accountants at Creative Printers estimated overhead related to machine usage to be
USD 120,000 for the year and estimated the machine usage for the year to be 60,000 machine-hours. Thus, the
predetermined overhead rate would be USD 2 per hour, calculated as follows:
Predetermined overhead rate= Estimated overhead costs
Expected machine−hours
Predetermined overhead rate= USD120,000
60,000 = USD 2 per machine-hour
Some companies compute the overhead rate after the fact; that is, after the jobs are done and the overhead costs
are known. The formula to calculate an actual overhead rate is:
Actual overhead rate= Total actualoverhead costs
Total actual manufacturingactivity
Recall that we measure manufacturing activity using machine-hours, labor-hours, labor costs, materials costs, or
some other cost driver.
Reasons for using predetermined rates Most companies use predetermined overhead rates instead of
actual overhead rates for the following reasons:
• A company usually does not incur overhead costs uniformly throughout the year. For example, heating
costs are greater during winter months. However, allocating more overhead costs to a job produced in the
winter compared to one produced in the summer may serve no useful purpose.
• Some overhead costs, like factory building depreciation, are fixed costs. If the volume of goods produced
varies from month to month, the actual rate varies from month to month, even though the total cost is
constant from month to month. The predetermined rate, on the other hand, is constant from month to month.
• Predetermined rates make it possible for companies to estimate job costs sooner. Using a predetermined
rate, companies can assign overhead costs to production when they assign direct materials and direct labor
costs. Without a predetermined rate, companies do not know the costs of production until the end of the
month or even later when bills arrive. For example, the electric bill for July will probably not arrive until
August. If Creative Printers had used actual overhead, the company would not have determined the costs of its
July work until August. It is better to have a good estimate of costs when doing the work instead of waiting a
long time for only a slightly more accurate number.
An accounting perspective:
Uses of technology
Recently, many high-tech companies have installed computer-assisted methods of manufacturing,
merchandising, or providing services. These new technologies have had a major impact on
managerial accounting. For example, where robots and computer-assisted manufacturing methods
have replaced people, labor costs have shrunk from 20 per cent to 40 per cent of product costs to
less than 5 per cent. Accounting in traditional settings required much more work to keep track of
labor costs than is necessary in current systems. On the other hand, in highly automated
Accounting Principles: A Business Perspective 744 A Global Text
18. Managerial accounting concepts/job costing
environments, accountants have had to become more sophisticated in finding the sources of
overhead costs, which have become a larger part of total product cost.
Understanding the learning objectives
• Financial accounting refers to providing financial information primarily for external use. Managerial
accounting information is intended for internal use to provide more detailed information to managers.
• In manufacturing companies, a product's cost is made up of three cost elements: direct materials costs,
direct labor costs, and manufacturing overhead costs.
• Direct materials costs are clearly and easily traceable to the product.
• Direct labor costs include only those labor costs clearly traceable to, or readily identifiable with, the finished
product.
• Overhead costs (1) include all costs of making the product except direct materials and direct labor costs; (2)
are costs that must be incurred in making the product but cannot or will not be traced directly to specific units
produced; and (3) include a number of costs related to the production process, such as depreciation and
maintenance on machines, supervisors' salaries, and utility costs for production facilities.
• Product costs are costs incurred in making products. These costs include costs of direct materials, direct
labor, and overhead.
• Period costs are not assigned to units of a product but are related more closely to periods of time. For this
reason, period costs are expensed (deducted from revenues) in the period in which they are incurred.
• The major difference between a merchandiser and a manufacturer is in the types of inventories carried.
• The statement of cost of goods manufactured supports the cost of goods sold figure on the income
statement and has two important calculations: (1) Cost to manufacture, which includes the costs of all
resources put into production during the period and (2) Cost of goods manufactured, which consists of the cost
of all goods completed during the period.
• The manufacturer's balance sheet shows materials, work in process, and finished goods inventories
separately.
• The accounting flow of costs follows the physical flow of the manufacturing process.
• Accountants record the flow of direct materials costs from Materials Inventory into Work in Process
Inventory. They add the costs of direct labor and overhead to Work in Process Inventory. When the products
are completed and transferred to the finished goods storeroom, accountants transfer their costs from Work in
Process Inventory to Finished Goods Inventory. As the goods are sold, the related costs are transferred from
Finished Goods Inventory to Cost of Goods Sold.
• Companies producing individual, unique products known as jobs use job costing (also called job order
costing).
• Companies such as furniture manufacturers produce batches of products and use job costing methods to
accumulate the cost of each batch.
• Repetitive manufacturing companies (automobile assembly plants) and companies producing in a
continuous flow (oil refineries) use process costing, discussed in the next chapter.
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• A job cost system (job costing) is a cost system that accumulates costs incurred according to the individual
jobs. Each job has its own Work in Process Inventory account.
• The formula for the predetermined overhead rate is:
Predetermined overhead rate= Estimated overhead costs
Expected levelof activitysuch as machine−hours
• Under variable costing, all the fixed manufacturing overhead costs are charged off (as period costs) during
the period rather than being deferred and carried forward (as product costs) to the next period as part of
inventory cost.
• Under absorption costing, all manufacturing costs are treated as product costs, including fixed
manufacturing overhead.
Appendix: Variable versus absorption costing
Under absorption costing, companies treat all manufacturing costs, including both fixed and variable
manufacturing costs, as product costs. Under variable costing, companies treat only variable manufacturing costs
as product costs. Total variable costs change proportionately with changes in total activity, while fixed costs do not
change as activity levels change. These variable manufacturing costs are usually made up of direct materials,
variable manufacturing overhead, and direct labor. (Direct labor can be a fixed cost if the company chooses not to
decrease or increase its direct labor force as volume changes. Unless otherwise stated, we treat direct labor as a
variable cost.)
Variable costing (also known as direct costing) treats all fixed manufacturing costs as period costs to be
charged to expense in the period received. The logic behind this expensing of fixed manufacturing costs is that the
company would incur such costs whether a plant was in production or idle. Therefore, these fixed costs do not
specifically relate to the manufacture of products.
Look at Exhibit 148, Bradley Company's income statements for May 2010 using absorption costing on top and
variable costing on the bottom. Notice that Bradley's variable costing income statement carries the goods in
inventory at USD 3.30 per unit rather than at the USD 3.90 full cost. The statement shows all variable costs as
deductions from sales to disclose the contribution margin for the month. It classifies all fixed costs as period costs
no matter what the source of the cost (manufacturing, selling, or administrative).
Income statement under Absorption costing Bradley Company Income statement
For the period ending 2010 May 31 Sales (9,000 units at $8) $72,000 Cost of goods sold: Variable costs of production (10,000 units at $3.30)
$33,000
Fixed overhead costs 6,000 Total costs of producing 10,000 units $39,000 Less: Ending inventory (1,000 units at $3.90) 3,900 35,100 Gross margin on sales $36,900 Operating expenses: Selling expenses ($15,000 fixed plus 9,000 at $0.20 each)
$16,800
Administrative expenses 12,000 28,800 Income before income taxes $ 8,100
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18. Managerial accounting concepts/job costing
Contribution margin income statement under variable costing Bradley Company Income statement
For the period ending 2010 May 31 Sales (9,000 units at $8) $72,000 Variable costs: Variable production costs incurred (10,000 units at $3.30) $33,000 Less: Ending inventory (1,000 units at $3.30) 3,300 29,700 Manufacturing margin $42,300 Variable selling expenses (9,000 units at $0.20) 1,800 Contribution margin $40,500 Fixed costs: Manufacturing overhead $ 6,000 Selling expenses 15,000 Administrative expenses 12,000 33,000 Income before income taxes $ 7,500
Exhibit 148: Comparative income statements
In comparing the two income statements in Exhibit 148, notice the USD 600 difference in net income for the
month and a USD 600 difference in ending inventory valuation, as shown in Exhibit 149, on the next page. These
differences are due to the treatment of fixed manufacturing costs. Under absorption costing, each unit in ending
inventory carries USD 0.60 of fixed overhead cost as part of product cost. At the end of the month, Bradley has
1,000 units in inventory. Therefore, ending inventory under absorption costing includes USD 600 of fixed
manufacturing overhead costs (USD 0.60 X 1,000 units) and is valued at USD 600 more than under variable
costing.
Under variable costing, companies charge off, or expense, all the fixed manufacturing costs during the period
rather than deferring their expense and carrying them forward to the next period as part of inventory cost.
Therefore, USD 6,000 of fixed manufacturing costs appear on the variable costing income statement as an expense,
rather than USD 5,400 (USD 6,000 fixed overhead costs - USD 600 fixed manufacturing included in inventory)
under absorption costing. Consequently, income before income taxes under variable costing is USD 600 less than
under absorption costing because more costs are expensed during the period.
Exhibit 149: Comparison of results under absorption and variable costing
Finally, remember that the difference between the absorption costing and variable costing methods is solely in
the treatment of fixed manufacturing overhead costs and income statement presentation. Both methods treat
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selling and administrative expenses as period costs. Regarding selling and administrative expenses, the only
difference is their placement on the income statement and the segregation of variable and fixed selling and
administrative expenses. Variable selling and administrative expenses are not part of product cost under either
method.
As a general rule, relate the difference in net income under absorption costing and variable costing to the change
in inventories. Assuming a relatively constant level of production, if inventories increase during the year,
production exceeded sales and reported income before federal income taxes is less under variable costing than
under absorption costing. Conversely, if inventories decreased, then sales exceeded production, and income before
income taxes is larger under variable costing than under absorption costing.
Variable costing is not currently acceptable for income measurement or inventory valuation in external financial
statements that must comply with generally accepted accounting principles (GAAP) in the United States. However,
managers often use variable costing for internal company reports.
Demonstration problem
Demonstration problem A Good Earth Construction Company uses a job cost system to account for the
houses it builds. Each house is a separate job. As of 2010 January 1, its records showed:
Inventories: Materials and supplies $ 48,000 Work in process (Job No. 212 and 213)
103,200
Finished goods (Job No. 211) 120,000
The work in process inventory consists of two jobs:
Job No. Direct materials
Direct Labor
Construction Overhead*
Total
212 $18,000 $24,000 $12,000 $ 54,000 213 20,400 19,200 9,600 49,200
$38,400 $43,200 $21,600 $103,200 *Construction overhead is treated just like overhead in the text examples.
Cost and sales data for 2010:
• Materials purchased on account, USD 198,000.
• Labor costs: Direct labor assigned to jobs—Job No. 212, USD 48,000; Job No. 213, USD 96,000; Job No.
214 (started in 2010), USD 144,000; supervision and other indirect labor, USD 120,000.
• Materials used: Job No. 212, USD 31,200; Job No. 213, USD 57,600; Job No. 214, USD 96,000; and
indirect materials, USD 4,800.
• Overhead is assigned to jobs at the rate of 50 per cent of the actual direct labor costs incurred on each job.
• Job No. 212 and 213 were completed.
• Jobs 211 and 212 were sold for USD 540,000.
• Construction overhead costs incurred, other than indirect materials and indirect labor: depreciation, USD
12,000; heat, light, power, and miscellaneous, USD 12,000.
Prepare journal entries to record the preceding data and close any underapplied or overapplied overhead to Cost
of Goods Sold.
Demonstration problem B Companies use different bases in computing their predetermined overhead rates.
From the following estimated data, compute the predetermined rate used by each company.
Company A B C
Machine-hours 103,000 212,000 125,000
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18. Managerial accounting concepts/job costing
Direct labor-hours 52,000 48,000 39,000 Direct labor cost $650,000$735,000 $420,000 Overhead costs $845,000$864,000 $750,000
Basis for predetermined overhead rate:
Company Basis A Direct labor cost B Direct labor-hours C Machine-hours
Solution to demonstration problem
Solution to demonstration problem A
Good Earth Construction Company General Journal
1. Materials inventory 198,000 Accounts payable 198,000 To record materials purchased on account.
2. Work in process inventory – Job No. 212 48,000 Work in process inventory – Job No. 213 96,000 Work in process inventory – Job No. 214 144,000 Construction overhead 120,000 Payroll summary 408,000 To distribute labor costs to jobs and overhead.
3. Work in process inventory – Job No. 212 31,200 Work in process inventory – Job No. 213 57,600 Work in process inventory – Job No. 214 96,000 Construction overhead 4,800 Materials inventory 189,600 To record direct and indirect materials sent from storeroom to jobs.
4. Work in process inventory – Job No. 212 24,000 Work in process inventory – Job No. 213 48,000 Work in process inventory – Job No. 214 72,000 Construction overhead 144,000 To record overhead applied to jobs using the predetermined rate 50% of direct labor cost: Job No. 212, $24,000 (50% x $48,000); Job No. 213, $48,000 (50% x $96,000); and Job No. 214, $72,000 (50% x $144,000).
5. Finished goods inventory 408,000 Work in process inventory – Job No. 212 157,200 Work in process inventory – Job No. 213 250,800 To record completion of Jobs 212 and 213.
The following amounts were computed by adding beginning Work in Process balances to the current month's
debits to Work in Process for direct materials, direct labor, and construction overhead:
Job No. 212: USD 157,200 (USD 54,000 + USD 31,200 + USD 48,000 + USD 24,000)
Job No. 213: USD 250,800 (USD 49,200 + USD 57,600 + USD 96,000 + USD 48,000)
USD 408,000
6. Accounts receivable 540,000 Sales 540,000 To record sales on account. Cost of goods sold 277,200 Finished goods inventory 277,200 To record cost of goods sold ($120,000 + $157,200 = $277,200).
7. Construction overhead 24,000 Accumulated depreciation 12,000 Various accounts (Accounts payable, accrued liabilities payable, cash, etc)
12,000
To record various construction overhead costs incurred.
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8. Cost of goods sold 4,8000 Construction overhead 4,800 To close underapplied construction overhead (actual = $148,800, applied = $144,000).
Solution to demonstration problem B Company A:
Predetermined overhead rate = USD845,000
USD650,000 =130 per cent of direct labor cost
Company B:
Predetermined overhead rate = USD864,000
48,000 hours =USD18 per direct labor−hour
Company C:
Predetermined overhead rate = USD750,000
125,000 hours =USD6 per machine−hour
Key terms Absorption costing (Appendix) A concept of costing under which all manufacturing costs, including both fixed and variable manufacturing costs, are accounted for as product costs.
Actual overhead rate Total actual manufacturing overhead divided by total actual manufacturing activity.
Administrative costs Costs of managing the organization, including the costs of top administrative functions and various staff departments such as accounting, data processing, and personnel.
Cost A financial measure of the resources used or given up to achieve a stated purpose.
Cost driver Activity or transaction that causes costs to be incurred. Machine-hours can be a cost driver for costs of energy to run machines, for example.
Cost of goods manufactured Consists of the total costs of all goods completed during the period; includes cost to manufacture plus beginning work in process inventory minus ending work in process inventory
Cost of goods sold Cost of goods manufactured plus the beginning finished goods inventory minus the ending finished goods inventory.
Cost to manufacture Includes the direct materials, direct labor, and manufacturing overhead incurred during the period.
Direct labor Labor costs of all employees actually working on materials to convert them to finished goods. Direct labor costs are directly traced to particular products in contrast to indirect labor costs.
Direct materials Materials that are used only in making the product and are clearly and easily traceable to a particular product.
Finished goods Completed manufactured products ready to be sold. Finished Goods Inventory is the title of an inventory account maintained for such products.
Indirect labor The cost of labor that cannot, or will not for practical reasons, be traced to the goods being produced or the services being provided.
Indirect materials Materials used in making a product that cannot, or will not for practical reasons, be traced directly to particular products.
Job cost system (job costing) A manufacturing cost system that accumulates costs incurred to produce a product according to individual jobs, such as a building, a consulting job, or a batch of 100 computer desks.
Managerial accounting Managerial accounting information is intended for internal use. The purpose is to generate information managers can use to make good decisions.
Manufacturing overhead All manufacturing costs except for those costs accounted for as direct materials and direct labor.
Materials Unprocessed items used in the manufacturing process.
Overapplied (overabsorbed) overhead The amount by which the overhead applied to production exceeds the actual overhead costs incurred in that same period.
Overhead All costs of making goods or providing services except for those costs classified as direct materials and direct labor. See manufacturing overhead for overhead in manufacturing companies.
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18. Managerial accounting concepts/job costing
Period costs Costs related more closely to periods of time than to products produced. Period costs cannot be traced directly to the manufacture of a specific product; they are expensed in the period in which they are incurred.
Predetermined overhead rate Calculated by dividing estimated total overhead costs for a period by the expected level of activity, such as total expected machine-hours or total expected direct labor-hours for the period.
Product costs Costs a company assigns to units produced. In manufacturing companies, these costs are direct materials, direct labor, and manufacturing overhead. In service companies that have no materials, these costs are direct labor and overhead.
Selling costs Costs incurred to obtain customer orders and distribute the finished product to the customer.
Statement of cost of goods manufactured An accounting report showing the cost to manufacture and the cost of goods manufactured.
Underapplied (underabsorbed) overhead The amount by which actual overhead costs incurred in a period exceed the overhead applied to production in that period.
Variable costing (also called direct costing) (Appendix) A concept of costing under which only variable manufacturing costs are accounted for as product costs and charged to the units produced during a period. All fixed manufacturing costs are charged to expense in the period in which they are incurred.
Work in process Partially manufactured products; a Work in Process Inventory account is maintained for such products.
Self-test
True-false
Indicate whether each of the following statements is true or false.
Managerial accounting is for external use and gives less detailed information than financial accounting.
A manufacturer produces speedboats, and each one requires a motor. The motors are considered direct
materials and are product costs.
A Pepsi-Cola bottling plant is an example of a company that would use a job cost system.
A predetermined overhead rate is calculated by dividing the expected level of activity by the estimated total
overhead cost.
Overhead cannot be entered in Work in Process Inventory when using a predetermined overhead rate. Only
when the actual overhead costs are determined is the overhead entered.
Selling and administrative expenses are part of period costs under both absorption and variable costing
methods.
Multiple-choice
Select the best answer for each of the following questions.
Under which cost category are indirect material costs included?
a. Direct materials.
b. Overhead.
c. Direct labor.
d. None of the above.
For financial accounting and external reporting purposes, all selling and administrative expenses are treated as:
a. Period costs.
b. Selling costs.
c. Manufacturing overhead costs.
d. Product costs.
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What are the differences between the cost of goods sold sections in a manufacturer's and a merchandiser's
income statements?
a. A merchandiser uses Merchandise Inventory and Direct Labor, whereas a manufacturer uses Finished Goods
Inventory and Cost of Goods Manufactured.
b. A merchandiser uses Merchandise Inventory and Cost of Goods Available for Sale, whereas a manufacturer
uses Finished Goods Inventory and Cost of Goods Available for Sale.
c. A merchandiser uses Work in Process Inventory and Cost of Goods Sold, whereas a manufacturer uses
Finished Goods Inventory and Cost of Goods Sold.
d. None of the above.
A job cost system is used:
a. When there are dissimilar products.
b. By manufacturers and service companies.
c. When goods are produced to meet a customer's particular needs.
d. All of the above.
Which of the following best describes the advantages of using a predetermined overhead rate?.
a. Overhead costs are applied evenly throughout the year rather than fluctuating from month to month.
b. Predetermined rates require managers to wait until long after the accounting period to get an estimate of
product costs.
c. Total unit costs of production are known sooner than using actual overhead rates, and overhead costs are
evenly distributed throughout the year.
d. Both (a) and (c) above.
The expected level of activity in a production center is 30,000 machine-hours. Estimated overhead costs are
indirect materials and indirect labor, USD 360,000; other overhead, USD 90,000. Which of the following is the
predetermined overhead rate per machine-hour?
a. USD 3.
b. USD 12.
c. USD 15.
d. USD 20.
You are given the following data relating to a company:
Estimated manufacturing overhead per year
USD 24,000
Expected level of activity per year 40,000 machine-hours Predetermined overhead rate USD 0.60 per machine-hour Actual overhead costs incurred during year
USD 22,500
Actual machine-hours 35,000
Which of the following are the correct journal entries for the preceding data?
a. Manufacturing overhead 22,500 Various accounts 22,500 Work in process inventory 21,000 Manufacturing overhead 21,000
b. Manufacturing overhead 22,500 Various accounts 22,500 Work in process inventory 15,428 Manufacturing overhead 15,428
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18. Managerial accounting concepts/job costing
c. Manufacturing overhead 24,000 Various accounts 24,000 Work in process inventory 15,428 Manufacturing overhead 15,428
d. Various accounts 22,500 Manufacturing overhead 22,500 Manufacturing overhead 15,428 Work in process inventory 15,428
Now turn to “Answers to self-test” at the end of the chapter to check your answers.
Questions
➢ What are the major differences between managerial and financial accounting?
➢ Identify the three elements of cost incurred in manufacturing a product and indicate the
distinguishing characteristics of each.
➢ Why might a company claim that the total cost of employing a person is USD 15.30 per hour when
the employee's wage rate is USD 10.50 per hour? How should this difference be classified and why?
➢ Why are certain costs referred to as period costs? What are the major types of period costs incurred
by a manufacturer?
➢ Explain why the income statement of a manufacturing company differs from the income statement of
a merchandising company.
➢ What is the general content of a statement of cost of goods manufactured? What is its relationship to
the income statement?
➢ What is the relationship between cost flows in the accounts and the flow of physical products through
a factory?
➢ Define a job cost system and give an example of a situation in which it can be used.
➢ What are the major reasons for using predetermined manufacturing overhead rates?
➢ What is the formula for computing a predetermined overhead rate? If the expected level of activity in
a production center is 50,000 machine-hours and the estimated overhead costs are USD 750,000,
what is the predetermined overhead rate? Show the calculation.
➢ What is underapplied and overapplied overhead? What type of balance does each have in the
Overhead account?
➢ Direct materials were issued to the following jobs: Material A was issued to Job No. 101, USD 2,000;
Job No. 102, USD 1,000; and Job No. 103, USD 5,000. Material B was issued to Job No. 101, USD
5,000; Job No. 102, USD 2,000; and Job No. 103, USD 3,000. A total of USD 3,000 in indirect
materials was issued to all jobs.
➢ Record the direct and indirect materials issued in journal entry form.
➢ Real world question Assume Domino's Pizza is considering offering a new product—a 6-inch
(15.24 cm) pizza. Why would it matter if Domino's Pizza knows how much it costs to produce and
deliver this 6-inch (15.24 cm) pizza?
➢ Real world question Why is it becoming more important that the managers of hospitals
understand their product costs?
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➢ Real world question Besides law firms and public accounting firms, name three service
organizations that produce individual jobs and would use job costing.
➢ (Appendix) Under what specific circumstances would you expect net income to be larger under
variable costing than under absorption costing? What is the reason for this difference?
Exercises
Exercise A The following costs are incurred by an electrical appliance manufacturer. Classify these costs as
direct materials, direct labor, manufacturing overhead, selling, or administrative.
a. President's salary.
b. Cost of electrical wire used in making appliances.
c. Cost of janitorial supplies (the janitors work in the factory).
d. Wages of assembly-line workers.
e. Cost of promotional displays.
f. Assembly-line supervisor's salary.
g. Cost accountant's salary (the accountant works in the factory).
h. Cost of cleaner used to clean appliances when they are completed.
i. Cost of aluminum used for toasters.
j. Cost of market research survey.
Exercise B Classify the costs listed in the previous exercise as either product costs or period costs.
Exercise C Gore Company makes products for sporting events. The following data are for the year ended 2010
December 31:
Materials inventory, 2010 January 1 $ 45,000 Materials inventory, 2010 December 31 65,000 Materials purchases 175,000 Direct labor 225,000 Work in process inventory, 2010 January 1 30,000 Work in process inventory, 2010 December 31 40,000 Manufacturing overhead 130,000 Finished goods inventory, 2010 January 1 80,000 Finished goods inventory, 2010 December 31 140,000
Prepare a Cost of Goods Manufactured Statement and compute the cost of goods sold.
Exercise D In June, Sierra Company worked only on Job No. 100 and completed it on June 30. There were no
prior costs accumulated on Job No. 100 before June 1. During the month, the company purchased and used USD
10,800 of direct materials, used 2,000 machine-hours, and incurred USD 19,200 of direct labor costs. Assuming
manufacturing overhead is applied at the rate of USD 12 per machine-hour, what is the total cost of Job No. 100?
Prepare journal entries to assign the materials, labor, and manufacturing overhead costs to production and to
record the transfer of Job No. 100 to Finished Goods Inventory.
Exercise E At the end of the second week in March, Job No. 710 has an accumulated total cost of USD 37,800.
In the third week, USD 9,000 of direct materials were used on Job 710, 300 hours of direct labor were charged to
the job at USD 40 per hour, and manufacturing overhead was applied on the basis of USD 40 per machine-hour for
overhead. Job No. 710 was the only job worked on in the third week. It was also completed in the third week. Job
No. 710 used 160 machine-hours during the third week in March. Compute the cost of Job No. 710, and give the
journal entry required to record its completion and transfer to Finished Goods Inventory.
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18. Managerial accounting concepts/job costing
Exercise F Different companies use different bases in computing their predetermined overhead rates. From
the following estimated data, compute the predetermined rate to be used by each company:
Company Paper Rock Scissors
Machine-hours 100,000 210,000 125,000 Direct labor-hours 50,000 48,000 39,000 Direct labor cost $800,000 $735,000 $410,000 Manufacturing overhead cost $400,000 $432,000 $375,000
Basis for determining predetermined overhead rate:
Company Basis Paper Direct labor cost Rock Direct labor-hours Scissors Machine-hours
Exercise G Refer to the previous exercise. Assume the actual hours and cost data were:
Actual Paper Rock Scissors Manufacturing overhead $450,000 $400,000 $375,000 Direct labor cost $850,000 $700,000 $400,000 Direct labor-hours 45,000 46,000 38,000 Machine-hours 105,000 200,000 130,000
a. Compute overapplied or underapplied overhead for each company.
b. Prepare journal entries to transfer overapplied or underapplied overhead to Cost of Goods Sold for each
company.
Exercise H Ernest Peat Consultants uses a job cost system and had the following activity during December:
There were no jobs in beginning Work in Process or Finished Goods Inventory.
Three jobs were started: No. 222, 223, and 224. Job No. 222 was completed and the customer was billed for
USD 10,000 on account. Job No. 223 was completed and in Finished Goods Inventory awaiting billing to the client
at the end of the month. Job No. 224 was still in process at month-end.
Direct labor costs incurred for:
Job No. 222 200 hours @ $21/hour Job No. 223 300 hours @ $18/hour Job No. 224 120 hours @ $17/hour
Assume overhead is applied at the rate of USD 10 per labor-hour.
Actual overhead was USD 6,400. (The credit part of the journal entry is to Accounts Payable.
Prepare journal entries to record the preceding data, as well as the transfer of underapplied or overapplied
overhead to Cost of Goods Sold.
Exercise I The following data relate to Socks Company for the year ended 2010 December 31:
Cost of production: Direct materials (variable) $360,000 Direct labor (variable) 504,000 Manufacturing overhead: Variable 180,000 Fixed 360,000 Sales commissions (variable) 108,000 Sales salaries (fixed) 72,000 Administrative expenses (fixed) 144,000 Units produced 150,000 Units sold (at $18 each) 120,000 Beginning inventory, 2010 January 1 -0-
There were no beginning inventories. Assume direct materials and direct labor are variable costs. Prepare two
income statements—a variable costing income statement and an absorption costing income statement.
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Problems
Problem A Total Block, Inc., is considering a new sunscreen packet that contains a skin wipe with sunscreen
on it. These would be particularly useful for people who do not want to carry a bottle of sunscreen, according to
Sunspot's marketing manager. Classify the following costs of this new product as direct materials, direct labor,
manufacturing overhead, selling, or administrative.
a. President's salary.
b. Packages used to hold the skin wipes.
c. Cleaning materials used to clean the skin wipe packages.
d. Wages of workers who package the product.
e. Cost of advertising the product.
f. The salary of the supervisor of the workers who package the product.
g. Cost accountant's salary (the accountant works in the factory).
h. Cost of a market research survey.
i. Sales commissions paid as a percent of sales.
j. Depreciation of administrative office building.
Problem B Classify the costs listed in the previous problem as either product costs or period costs.
Problem C Good Vibrations, Inc., produces videotapes of musical performances. A newly hired executive of the
company has asked you to sort through the records and prepare a statement of the company's cost of goods
manufactured. You find the following data from records prepared by Good Vibrations, Inc., for the year ended 2009
December 31:
Inventories: Beginning direct materials inventory, 2009 January 1
$ 6,000
Ending direct materials inventory, 2009 December 31
10,500
Beginning work in process inventory, 2009 January 1
10,000
Ending work in process inventory, 2009 December 31
9,500
Materials purchases 50,000 Direct labor 40,000 Indirect labor 15,000 Factory utilities expense 7,000 Factory supplies expense 5,000 Depreciation expense – factory building 14,000 Depreciation expense – Factory Equipment 10,500 Other manufacturing overhead 25,000
You also learn that beginning Finished Goods Inventory on 2009 January 1, was USD 20,000 and ending
Finished Goods Inventory on 2009 December 31, was USD 5,000. Sales for the year were USD 400,000. Selling
expenses were USD 50,000 and administrative expenses were USD 75,000.
a. Prepare a statement of cost of goods manufactured for Good Vibrations, Inc., for the year ended 2009
December 31.
b. Prepare an income statement for Good Vibrations, Inc., for the year ended 2009 December 31.
Problem D Log Cabin Homes, Inc., uses a job cost system to account for its jobs, which are prefabricated
houses. As of 2010 January 1, its records showed inventories as follows:
Materials and supplies $100,000 Work in process (Job Nos. 22 and 23)
180,000
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18. Managerial accounting concepts/job costing
Finished goods (Job No. 21) 140,000
The work in process inventory consisted of two jobs:
Job No. Direct materials
Direct labor
Manufacturing overhead
Total
22 $36,000 $40,000 $20,000 $ 96,000 23 40,000 28,000 16,000 84,000
$76,000 $68,000 $180,000
Cost and sales data for 2010:
Materials purchased on account, USD 400,000.
Direct materials used: Job No. 22, USD 60,000; Job No. 23, USD 120,000; Job No. 24, USD 180,000.
Indirect materials used, USD 10,000.
Direct labor costs: Job No. 22, USD 100,000; Job No. 23, USD 200,000; and Job No. 24, USD 80,000.
Indirect labor costs, USD 80,000.
Overhead is assigned to jobs at USD 100 per machine-hour. Job No. 22 used 500 machine-hours, Job No. 23
used 1,000 machine-hours, and Job No. 24 used 300 machine-hours in January.
Job No. 22 and 23 were completed and transferred to Finished Goods Inventory.
Job No. 21 and 22 were sold on account for USD 1,200,000, total.
Manufacturing overhead costs incurred, other than indirect materials and indirect labor, were depreciation,
USD 80,000, and heat, light, power, miscellaneous, USD 40,000.
a. Prepare journal entries to assign the preceding costs to jobs. Show the appropriate entries debiting Finished
Goods Inventory and Cost of Goods Sold. Transfer overapplied or underapplied overhead to Cost of Goods Sold.
b. Assuming selling and administrative expenses were USD 100,000, prepare an income statement for 2010.
Problem E Green Thumb Landscaping Company uses a job cost system. As of 2010 January 1, its records
showed the following inventory balances:
Materials (shrubs, trees, etc.)
$ 13,500
Work in process 25,800 Finished goods (Job No. 211)
30,000
The work in process inventory consisted of two jobs:
Job No. Direct Materials
Direct Labor
Manufacturing Overhead
Total
212 10 Downing St. $4,500 $ 6,000 $2,400 $12,900 213 1010 Wilshire Blvd. 5,100 4,800 3,000 12,900
$9,600 $10,800 $5,400 $25,800
Here are data for the company for January:
Materials purchased, USD 48,000.
Landscaping direct labor costs: direct labor to Job No. 212, USD 12,000; to Job No. 213, USD 24,000; and to
Job No. 214, USD 36,000. Indirect labor, USD 30,000.
Direct materials used: direct materials for Job No. 212, USD 7,800; for Job No. 213, USD 14,400; and for Job
No. 214, USD 24,000. Supplies (indirect materials) used amounted to USD 1,200.
Overhead is assigned to jobs at USD 3 per labor-hour, with 8,000 labor-hours to Job 212 and 2,000 labor-hours
each to Jobs 213 and 214.
Jobs 212 and 213 were completed and in Finished Goods Inventory at the end of January.
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Sales revenues for January were USD 45,000; cost of goods sold was USD 30,000 for Job No. 211 that was in
Finished Goods Inventory on 2010 January 1.
Overhead costs incurred other than indirect labor and indirect materials were depreciation, USD 3,000, and
utilities, fuel, and miscellaneous, USD 3,000.
a. Prepare journal entries to record the preceding transactions, including the transfer of underapplied or
overapplied overhead to Cost of Goods Sold.
b. Assuming selling and administrative expenses were USD 10,000, prepare an income statement for January.
Problem F Speedy Delivery, Inc., transports computer equipment for various computer manufacturers. Speedy
applies overhead to jobs using a predetermined overhead rate based on truck miles. Estimated data for 2010 are:
Estimated truck miles 20 million Estimated overhead for hauling operations (equivalent to manufacturing overhead)
$12 million
a. Compute the predetermined overhead rate per mile.
b. Assume that in 2010, actual manufacturing overhead for hauling operations amounted to USD 15 million, and
24 million truck miles were driven. Compute the amount of underapplied or overapplied manufacturing overhead
for 2010.
c. Prepare the journal entry to transfer underapplied or overapplied overhead to Cost of Goods Sold.
Problem G Costner Company uses an absorption costing system in accounting for the single product it
manufactures. The following selected data are for the year 2009:
Sales (10,000 units) $360,000 Direct materials used (variable cost) 129,600 Direct labor costs (variable cost) 43,200 Variable manufacturing overhead 12,960 Fixed manufacturing overhead 17,280 Variable selling and administrative expenses
21,600
Fixed selling and administrative expenses
72,000
The company produced 12,000 units and sold 10,000 units. Direct materials and direct labor are variable costs.
One unit of direct material goes into each unit of finished goods. Overhead rates are based on a volume of 12,000
units and are USD 1.08 and USD 1.44 per unit for variable and fixed overhead, respectively. The ending inventory is
the 2,000 units of finished goods on hand at the end of 2009. There was no inventory at the beginning of 2009.
a. Prepare an income statement for 2009 under variable costing.
b. Prepare an income statement for 2009 under absorption costing.
c. Explain the reason for the difference in net income between a and b.
Alternate problems
Alternate problem A Pocket Umbrella, Inc., is considering producing a new type of umbrella. This new
pocket-sized umbrella would fit into a coat pocket or purse. Classify the following costs of this new product as direct
materials, direct labor, manufacturing overhead, selling, or administrative.
a. Cost of advertising the product.
b. Fabric used to make the umbrellas.
c. Maintenance of cutting machines used to cut the umbrella fabric so it will fit the umbrella frame.
d. Wages of workers who assemble the product.
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18. Managerial accounting concepts/job costing
e. President's salary.
f. The salary of the supervisor of the people who assemble the product.
g. Wages of the product tester who stands in a shower to make sure the umbrellas do not leak.
h. Cost of market research survey.
i. Salary of the company's sales managers.
j. Depreciation of administrative office building.
Alternate problem B Classify the costs listed in Alternate problem A as either product costs or period costs.
Alternate problem C Presley Manufacturing Company is a producer of music compact discs (CDs) and tapes.
The following account balances are for the year ended 2009 December 31
Administrative expenses $ 60,000 Depreciation expense – Manufacturing equipment 50,000 Direct labor 468,000 Manufacturing supplies expense 40,000 Indirect labor 36,000 Beginning inventories, 2009 January 1: Direct materials 14,000 Work in process 20,000 Finished goods 128,000 Ending inventories, 2009 December 31 Direct materials 44,000 Work in process 56,000 Finished goods 92,000 Direct materials purchases 216,000 Rent expense – Factory 28,000 Sales 1,400,000 Selling expense 72,000 Other manufacturing overhead 126,000
a. Prepare a statement of cost of goods manufactured for Presley Manufacturing Company for 2009.
b. Prepare an income statement for the year ended 2009 December 31.
Alternate problem D Cathy's Catering Company uses a job cost system. Its activities in November 2010, the
first month of operations, were as follows:
Job First-rate University
Active life home
Precocious School
Direct materials cost (food) $54,000 $36,000 $81,000 Direct labor cost $45,000 $40,500 $54,000 Labor-hours 2,900 3,500 3,800
The company applies overhead at a rate of USD 16 per labor-hour. It completed all jobs in November. The total
revenue for the three jobs was USD 400,000. The actual overhead for the month was USD 160,000, of which USD
120,000 should be credited to Accounts Payable and USD 40,000 should be credited to Accumulated Depreciation.
Prepare journal entries to record the costs of jobs and to record the transfer of completed jobs to Finished Goods
Inventory and to Cost of Goods Sold. Transfer any underapplied or overapplied overhead to Cost of Goods Sold.
The company had no beginning or ending inventories.
Alternate problem E Sullivan Company applied overhead to production using a predetermined overhead rate
based on machine-hours. Budgeted data for 2010 are:
Budgeted machine-hours 75,000 Budgeted manufacturing overhead $870,000
a. Compute the predetermined overhead rate.
b. Assume that in 2010, actual manufacturing overhead amounted to USD 997,500, and 86,000 machine-hours
were used. Compute the amount of underapplied or overapplied manufacturing overhead for 2010.
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c. Prepare the journal entry to transfer underapplied or overapplied overhead to Cost of Goods Sold.
Beyond the numbers—Critical thinking
Business decision case A Companies often do work on a cost-reimbursement basis. That is, Company B
reimburses Company A for the cost of doing work for Company B. Suppose your company has a contract that calls
for reimbursement of direct materials and direct labor, but not overhead. Following are costs that various
organizations incur; they fall into three categories: direct materials (DM), direct labor (DL), or overhead (OH).
Glue used to attach labels to bottles containing a patented medicine.
Compressed air used in operating paint sprayers for Student Painters, a company that paints houses and
apartments.
Insurance on a factory building and equipment.
A production department supervisor's salary.
Rent on factory machinery.
Iron ore in a steel mill.
Oil, gasoline, and grease for forklift trucks in a manufacturing company's warehouse.
Services of painters in building construction.
Cutting oils used in machining operations.
Cost of paper towels in a factory employees' washroom.
Payroll taxes and fringe benefits related to direct labor.
The plant electricians' salaries.
Crude oil to an oil refinery.
Copy editor's salary in a book publishing company.
a. Classify each of these items as direct materials, direct labor, or overhead.
b. Assume your classifications could be challenged in a court case. Indicate to your attorneys which of your
answers for part a might be successfully disputed by the opposing attorneys. In which answers are you completely
confident?
Business decision case B Quality Painters, Inc., uses a job cost system. As of 2010 January 1, its records
showed the following inventory balances:
Materials $ 7,000 Work in process 50,000 Finished goods 0
The work in process inventory consisted of two jobs:
Job No. Direct Materials
Direct Labor
OverheadTotal
100 Community housing
$ 9,000 $12,000 $ 4,000 $25,000
101 Regal apartments 10,000 9,000 6,000 25,000 $19,000 $21,000 $10,00 $50,000
Here are data for the company for January:
Materials purchased, USD 90,000.
Direct labor costs: direct labor to Job No. 100, USD 20,000; to Job No. 101, USD 48,000; and to Job No. 102 (a
new job), USD 50,000. Indirect labor, USD 10,000.
Direct materials used: direct materials for Job No. 100, USD 15,600; for Job No. 101, USD 28,800; and for Job
No. 102, USD 48,000. Supplies (indirect materials) used amounted to USD 4,000.
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18. Managerial accounting concepts/job costing
Overhead is assigned to jobs at USD 5 per labor-hour, with 1,000 labor-hours to Job 100 and 2,000 labor-hours
each to Jobs 101 and 102.
All three jobs were completed in January.
Sales revenues for January were USD 350,000 for the three jobs.
Overhead costs incurred other than indirect labor and indirect materials were depreciation, USD 6,000, and
utilities, fuel, and miscellaneous, USD 6,000.
Management is concerned about the relationship between costs incurred on jobs and the costs expected to be
incurred, and has asked for your help. Here are the expected total costs (direct materials, direct labor, and
overhead) for the three jobs:
Job 100 $ 60,000 Job 101 120,000 Job 102 130,000
These cost estimates cover the entire job, including both costs in beginning Work in Process Inventory and costs
incurred during January.
a. Compare the costs incurred on each job, including the costs in beginning Work in Process Inventory and costs
incurred during January with the expected costs. Is the company keeping its costs below the expected costs for each
job?
b. Prepare an income statement for January 2010 assuming selling and administrative expenses for January
were USD 50,000. Don't forget to transfer any underapplied or overapplied overhead balance to Cost of Goods
Sold.
c. Is the company profitable (that is, showing net income greater than zero)? What suggestions can you make for
management to help increase the company's net income?
Writing assignment C Refer to Presley Manufacturing company, Problem C. Assume the newly hired
executive is a whiz at marketing, but a person whose eyes glaze over at the sight of a number. The executive wants
you to explain the financial results for the year in words. Essentially, assume the executive has not seen the
financial statements prepared. What would you say to convey the message in the financial statements? Keep it short
—less than 100 words.
Ethics case – Writing experience D Refer to the Ethical Perspective discussion of Comserv's activities
entitled “High pressure sales tactics and creative accounting”. As a salesperson, how would you respond if your boss
asked you to backdate contracts from 2010 January 3, to 2009 December 28? What if you were asked to backdate
the contracts from 2010 February 1, to 2009 December 28? Assume December 31 is the company's fiscal year-end.
Ethics case E Suzie Garcia, an accountant for a consulting firm, had just received the monthly cost reports for
the two jobs she supervises: one for Arrow Space, Inc., and one for the US government. She immediately called her
boss after reading the figures for the Arrow Space job.
"We are going to be way over budget on the Arrow Space contract," she informed her boss. "The job is only about
three-fourths complete, but we have spent all the money that we had budgeted for the entire job."
"You had better watch these job costs more carefully in the future," her boss advised. "Meanwhile, charge the
rest of the costs needed to complete the Arrow Space job to your US government job. The government will not
notice the extra costs. Besides, we get reimbursed for costs on the government job, so we will not lose any money on
this problem you have with the Arrow Space contract."
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What should Suzie do? Does it matter that Suzie's company is reimbursed for costs on the US government
contract? Explain.
Group project – Ethical perspective F Refer to the “An ethical perspective” discussion of Comserv's
activities. As a salesperson, suppose your boss asked you to write a side agreement that allowed a customer to back
out of a contract, and insisted that you not reveal the side contract to anyone else in your organization. You like
your job a lot, and you will probably lose it if you do not comply with your boss's wish. In groups of three, discuss
how you would respond to your boss. Try to develop a creative way to handle this situation. Choose a group
spokesperson to report to the class.
Group project G In teams of two or three students, interview in person or by speakerphone, a businessperson
in your community who uses job costing (for example, businesses that produce custom products such as homes,
signs, or landscape design, or business consultants). Ask how this person assigns costs to products and how this
information affects business decisions. Keep in mind that many businesspeople use terms other than job costing
and manufacturing overhead. Be flexible with your use of accounting terminology in this interview. Each team
should write a memorandum to the instructor summarizing the results of the interview. Information contained in
the memo should include:
Date:
To:
From:
Subject:
Content of the memo must include the name and title of the person interviewed, name of the company, date of
the interview, examples of the use of accounting information for decision making, and any other pertinent
information.
Group project H In teams of two or three students, interview the manager of a campus print shop or a print
shop in the area about how the company bids on prospective jobs. Does it use cost information from former jobs
that are similar to prospective ones, for example? Does it have a specialist in cost estimation who estimates the
costs of prospective jobs? Each team should write a memorandum to the instructor summarizing the results of the
interview. Information contained in the memo should include:
Date:
To:
From:
Subject:
Content of the memo must include the name and title of the person interviewed, name of the company, date of
the interview, and information responding to the questions above.
Using the Internet—A view of the real world
Visit the website for a high technology company, such as HP, Intel Corporation, or IBM, and locate its annual
report. Review the annual report to gain a general understanding of the company's primary business segments and
products. Write a report addressing the following questions based on your research. What products or services are
provided by the company? How does the financial information provided in the annual report (focus on the income
statement) differ from financial information used for managerial accounting purposes? As a manager making
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18. Managerial accounting concepts/job costing
business decisions within the company, what additional information would you need? (Remember that the income
statement may be referred to using different terminology such as statement of earnings or statement of operations.)
Company Website
Hewlett Packard Http://www.hp.com
Intel Corporation Http://www.intel.com
IBM Http://www.ibm.com
Visit the following website for Wells Fargo (a financial institution) and locate its annual report:
http://www.wellsfargo.com
Review the annual report to gain a general understanding of the company's primary business segments and
products. Write a report addressing the following questions based on your research. What products or services are
provided by the company? How does the financial information provided in the annual report (focus on the income
statement) differ from financial information used for managerial accounting purposes? As a manager making
business decisions within the company, what additional information would you need? (Remember that the income
statement may be referred to using different terminology such as statement of earnings or statement of operations.)
Visit the following website for Home Depot (a retail organization) and locate its annual report:
http://www.homedepot.com
Review the annual report to gain a general understanding of the company's primary business segments and
products. Write a report addressing the following questions based on your research. What products or services are
provided by the company? How does the financial information provided in the annual report (focus on the income
statement) differ from financial information used for managerial accounting purposes? As a manager making
business decisions within the company, what additional information would you need? (Remember that the income
statement may be referred to using different terminology such as statement of earnings or statement of operations.)
Answers to self-test
True-false
False. Managerial accounting is for internal use by managers, not external use, and gives more detailed
information than financial accounting.
True. The motors are direct materials, and they are product costs.
False. Because bottling soft drinks is a process, the plant would not use job costing.
False. The answer is the opposite. The estimated total overhead is the numerator, and the expected level of
activity is the denominator.
False. Overhead can be applied to jobs during the period.
True. Selling and administrative expenses are part of period costs under both absorption and variable costing
methods.
Multiple-choice
b. Indirect materials are included under overhead.
a. Selling and administrative expenses are period costs for financial accounting purposes.
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b. A merchandiser uses Merchandise Inventory and Cost of Goods Available for Sale, whereas a manufacturer
uses Finished Goods Inventory and Cost of Goods Available for Sale.
d. All of the answers are true.
d. Both (a) and (c) are advantages of using a predetermined overhead rate.
c. USD15= USD360,000USD90,000
30,000 machine−hours .
a.
Manufacturing overhead 22,500 Various accounts 22,500 Work in process inventory 21,000 Manufacturing overhead 21,000
Note the predetermined overhead rate times the actual activity is USD 0.60 X 35,000 machine-hours = USD
21,000.
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19. Process: Cost systems Learning objectives
After studying this chapter, you should be able to:
• Describe the types of operations that require a process cost system.
• Distinguish between process and job costing systems.
• Discuss the concept of equivalent units in a process cost system.
• Compute equivalent units of production and unit costs under the average cost procedure.
• Prepare a production cost report for a process cost system and discuss its relationship to the Work in Process
Inventory account.
• Distinguish between normal and abnormal spoilage.
• Compute equivalent units of production and unit costs under the first-in first-out (FIFO) system (Appendix
19-A).
• Discuss how joint costs are allocated to joint products (Appendix 19-B).
This chapter continues the discussion of cost accumulation systems. In Chapter 18, we explained and illustrated
job costing. The job cost system (job costing) accumulates costs incurred to produce a product according to
individual jobs. For example, construction companies use job costing to keep track of the costs of each construction
job.
This chapter discusses another cost accumulation system, process costing. The chapter begins with a discussion
of the nature of a process cost system. We review the similarities and differences between job costing and process
costing. We also present an extended illustration of process costing that includes a discussion of equivalent units of
production and the production cost report. In the chapter appendixes, we discuss and illustrate FIFO process
costing and the allocation of joint product costs.
Nature of a process cost system
Many businesses produce large quantities of a single product or similar products. Pepsi-Cola makes soft drinks,
Exxon Mobil produces oil, and Kellogg Company produces breakfast cereals on a continuous basis over long
periods. For these kinds of products, companies do not have separate jobs. Instead, production is an ongoing
process.
A process cost system (process costing) accumulates costs incurred to produce a product according to the
processes or departments a product goes through on its way to completion. Companies making paint, gasoline,
steel, rubber, plastic, and similar products using process costing. In these types of operations, accountants must
accumulate costs for each process or department involved in making the product. Accountants compute the cost per
unit by first accumulating costs for the entire period (usually a month) for each process or department. Second,
they divide the accumulated costs by the number of units produced (tons, pounds, gallons, or feet) in that process
or department.
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19. Process: Cost systems
In "A broader perspective: Producing cans of Coca-Cola", we describe production in bottling and canning plants
that use a process cost system. Job costing and process costing have important similarities:
• Both job and process cost systems have the same goal: to determine the cost of products.
• Both job and process cost systems have the same cost flows. Accountants record production in separate
accounts for materials inventory, labor, and overhead. Then, they transfer the costs to a Work in Process
Inventory account.
• Both job and process cost systems use predetermined overhead rates (defined in Chapter 18) to apply
overhead.
Job costing and process costing systems also have their significant differences:
• Types of products produced. Companies that use job costing work on many different jobs with different
production requirements during each period. Companies that use process costing produce a single product,
either on a continuous basis or for long periods. All the products that the company produces under process
costing are the same.
• Cost accumulation procedures. Job costing accumulates costs by individual jobs. Process costing
accumulates costs by process or department.
• Work in Process Inventory accounts. Job cost systems have one Work in Process Inventory account for each
job. Process cost systems have a Work in Process Inventory account for each department or process.
Exhibit 150 shows the cost flows in a process cost system that processes the products in a specified sequential
order. That is, the production and processing of products begin in Department A. From Department A, products go
to Department B. Department B inputs direct materials and further processes the products. Then Department B
transfers the products to Finished Goods Inventory. For illustration purposes, we assume that all the process cost
systems in this chapter are sequential. There are many production flow combinations; Exhibit 151 presents three
possible production flow combinations.
Process costing illustration
Assume that Jax Company manufactures and sells a chemical product used to clean kitchen counters and sinks.
The company processes the product in two departments. Department A crushes powders and blends the basic
materials. Department B packages the product and transfers it to finished goods. Exhibit 151 shows this
manufacturing process.
The June production and cost data for Jax Company are:
Department A Department B Beginning inventory -0- -0- Units started, completed, and transferred 11,000 9,000 Units on hand June 30, partially completed -0- 2,000 Direct materials $16,500 $1,100 Direct labor 2,500 2,880 Actual overhead 7,500 8,600 Applied overhead 7,400 8,880
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Exhibit 150: Cost flows in a process cost system
(Jax's accountant applies manufacturing overhead in Departments A and B based on the machine-hours used in
production.) From these data, we can construct and summarize the Work in Process Inventory—Department A
account below.
Work in process inventory – Department
A
Direct materials 16,500 Transferred to department B: 11,000 unites @ $2.40
26,400
Direct labor 2,500 Applied overhead 7,400 Balance -0-
Department A completed all the units it started in June and transferred them to Department B. So all the costs
assigned to these units were transferred to Department B. Jax's accountant computed the unit costs in Department
A by dividing the USD 26,400 total costs by the 11,000 units completed and transferred. The result is USD 2.40, the
average unit cost of 11,000 units.
Computations are seldom this simple; one complication is partially completed inventories. Consider Department
B, for example. Before Department B transfers the cost of completed units, its Work in Process Inventory account
for June is as follows:
Work in process inventory – Department B Transferred in from department A 26,400 Costs added in Dept. B: Direct materials 1,100 Direct labor 2,880 Applied overhead 8,880 Balance 39,260
Accounting Principles: A Business Perspective 767 A Global Text
19. Process: Cost systems
Exhibit 151: Possible production flow combinations
A broader perspective:
Producing cans of Coca-Cola®
How was the Diet Coke® I just finished drinking produced? A Coca-Cola bottling plant purchased
cola syrup or a concentrate from The Coca-Cola Company, combined it with carbonated water, put
it in cans, and sealed the cans. (Although these plants are usually called bottling plants, they also
produce cans of Coke®.)
In a bottling plant, the first process combines the syrup or concentrate with carbonated water to
make cola. In a second process, empty cans are rinsed and inspected. A third process combines
these two materials by pouring the cola into the cans. Next, tops are placed on the cans. Finally, the
cans are combined into packages. This completes the work in process stage.
The product enters finished goods inventory when it is sent to the warehouse. The product
becomes cost of goods sold to the bottling plants when it is shipped to distributors or retail outlets.
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Source: Based on the authors' research and documents provided by The Coca-Cola Company. Coca-
Cola, Diet Coke, and Coke are registered trademarks of The Coca-Cola Company.
Recall that direct materials, direct labor, and applied overhead are product costs; that is, the costs attach to the
product. Thus, Transferred in from Department A in the T-account represents the direct materials, direct labor, and
applied overhead costs assigned to products in Department A. These costs have followed the physical units to
Department B.
Now, Jax's accountant must divide the USD 39,260 total costs charged to Department B in June between the
units transferred out and those remaining on hand in the department. The accountant cannot divide USD 39,260
by 11,000 units to get an average unit cost because the 11,000 units are not alike. Department B has 9,000 finished
units and has 2,000 partially finished units. To solve this problem, the accountant uses the concept of equivalent
units of production, which we discuss next.
Essentially, the concept of equivalent units involves expressing a given number of partially completed units as
a smaller number of fully completed units. For example, if we bring 1,000 units to a 40 per cent state of completion,
this is equivalent to 400 units that are 100 per cent complete. Accountants base this concept on the supposition
that a company must incur approximately the same amount of costs to bring 1,000 units to a 40 per cent level of
completion as it would to complete 400 units.
On the next page look at Exhibit 152, a diagram of the concept of equivalent units. As you examine the diagram,
think of the amount of water in the glasses as costs that the company has already incurred.
The beginning step in computing Department B's equivalent units for Jax Company is determining the stage of
completion of the 2,000 unfinished units. These units are 100 per cent complete as to transferred-in costs; if
they were not, Department A would not have transferred them to Department B. In Department B, however, the
units may be in different stages of completion regarding the materials, labor, and overhead costs. Assume that
Department B adds all materials at the beginning of the production process. Then both ending inventory and units
transferred out would be 100 per cent complete as to materials. Therefore, equivalent production for materials
would be 11,000 units.
Accountants often assume that units are at the same stage of completion for both labor and overhead.
Accountants call the combined labor and overhead costs conversion costs. Conversion costs are those costs
incurred to convert raw materials into the final product.
Let us assume that, on average, the 2,000 units in ending inventory are 40 per cent complete as to conversion
costs. This means that Department B transferred out 9,000 units fully completed and brought 2,000 units to a 40
per cent completion state. Department B now has an equivalent of 800 fully completed units remaining in
inventory (800 = 2,000 X 40 per cent). The equivalent units for labor and overhead would therefore be 9,800
units.
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19. Process: Cost systems
Exhibit 152: The concept of equivalent units
The formula for equivalent units for each cost element (transferred-in, materials, and conversion) is:
Equivalent units = Units completed + (Units in ending inventory Xper cent complete)
When we know the equivalent units of production, we can compute unit costs for transferred-in, materials, and
conversion elements. The average unit cost formulas for each cost element are:
Unit cost for transferred= Total transferred costs
Equivalent unitsfor transferred costs
Unit cost for materials= Total materials costs
Equivalent unitsfor conversion costs
Unit cost for conversion= Total conversion costs
Equivalent units for conversion costs
Know we can compute unit costs for each element in Department B as follows:
Transferred-in Materials ConversionTotal Costs to be accounted for: Charged to Department B $26,000 $1,100 $11,760* $39,260 Equivalent units 11,000 11,000 9,800† Unit costs $ 2.40 $ 0.10 $ 1.20 $ 4.70 *Conversion costs consist of direct labor + overhead ($2,880 + $8,880). †Units transferred out (9,000) + equivalent units in ending inventory (800).
We can use the USD 3.70 computed unit costs to divide Department B's USD 39,260 June costs between the
units completed and transferred out and the units remaining in the department's ending inventory. We do this in
the following table:
Transferred-in Materials Conversion Total (@ $2.40) (@ $0.10) (@ $1.20)
Costs accounted for: Units completed and transferred out (9,000 units)
$21,600 $900 $10,800 $33,300
Units remaining in ending inventory (2,000 units)
4,800 200 960* 5,960
Costs accounted for $26,400 $1,100 $11,760 $39,260
*Equivalent units = 800 units
The USD 33,300 total costs transferred out of Department B consist of USD 21,600 transferred in from
Department A (9,000 X USD 2.40), USD 900 of materials costs (9,000 X USD 0.10), and USD 10,800 of
conversion costs (9,000 X USD 1.20), or a total cost of USD 3.70 per unit. The 2,000 units of ending inventory in
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Department B are fully complete as to costs transferred in from Department A and materials and 40 per cent
complete as to conversion. We calculate the ending inventory cost as follows:
Costs from Department A (2,000 x $2.40) $4,500 Costs added by Department B: Materials (2,000 x $0.10) $200 Conversion (800 equivalent units x $1.20) 960 1160 Total cost of ending inventory $5,960
Jax carries units transferred out of Department B in finished goods inventory at a cost of USD 3.70 each until
they are sold. Then, Jax charges the cost of units sold to Cost of Goods Sold.
An ethical perspective:
Rynco Scientific Corporation
Rynco Scientific Corporation was a manufacturer of contact lenses that the Securities and Exchange
Commission (SEC) investigated concerning the way it computed equivalent units of production.
According to the SEC, Rynco made errors in calculating the equivalent units of production that
materially overstated its ending inventory, and understated its losses. As a result of the SEC's
investigation, Rynco agreed to hire an accounting firm to conduct a thorough study of its financial
statements for a five-year period, and it agreed to restate its financial statements to conform to
generally accepted accounting principles.
We have discussed how to determine the costs of each cost element placed in production, transferred to finished
goods inventory, and charged to cost of goods sold. Now let us look at the summary of the journal entries for these
activities for the month of June.
1. Work in process inventory – Department A (+A) 16,500 Work in process inventory – Department B (+A) 1,100 Materials inventory (-A) 17,600 To record materials placed in production in June.
2. Work in process inventory – Department A (+A) 2,500 Work in process inventory – Department B (+A) 2,880 Payroll summary (+L) 5,380 To assign labor costs to departments.
3. Work in process inventory – Department A (+A) 7,400 Work in process inventory – Department B (+A) 8,880 Overhead (or manufacturing overhead) (+SE) 16,280 To apply overhead to production.
4. Work in process inventory – Department B (+A) 26,400 Work in process inventory – Department A (-A) 26,400 To record transfer of goods from Department A to Department B.
5. Overhead (of Manufacturing Overhead) (-SE) 16,100 Various accounts – Cash, Accounts payable, accruals, and accumulated depreciation (varies) 16,100 To record actual overhead costs incurred in June.
6. Finished goods inventory (+A) 33,300 Work in process inventory – Department B (-A) 33,300 To record transfer of completed goods from Department B to finished goods.
If Jax Company sold 6,000 of these completed units in June at USD 10 per unit on account, it would make the
following entries:
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19. Process: Cost systems
7. Accounts receivable (+A) 60,000 Sales (+SE) 60,000 To record sales on account.
8. Cost of goods sold (-SE) 22,200 Finished goods inventory (-A) 22,200 To record cost of goods sold in June, 6,000 units @$3.70.
The key document in a process costing system is the production cost report. A production cost report shows
both the flow of units and the flow of costs through a processing center. It also shows how accountants divide these
costs between the cost of units completed and transferred out and the cost of units still in the processing center's
ending inventory. This report makes the equivalent unit and unit cost computations easier.
To illustrate the preparation of a production cost report with partially completed beginning and ending
inventories, assume the following June 2011 data for Department 3 of a different company, Storey Company:
Units Units in beginning inventory, complete as to materials, 60% complete as to conversion costs
6,000
Units transferred in from Department 2
18,000
Units completed and transferred out 16,000 Units in ending inventory, completed as to materials, 50% complete as to conversion costs
8,000
Costs Cost of beginning inventory: Costs transferred in from Department 2 in May
$12,000
Materials added in May in Department 3
6,000
Conversion costs (labor and overhead)
3,000 $21,000
Costs transferred in from Department 2 in June
37,200
Costs added in Department 3 in June: Materials $18,480 Conversion (equal amounts of labor and overhead) 18,000
36,480
Total costs in beginning inventory and placed in production in Department 3 in June
$94,680
The preparation of the production cost report includes the following four steps:
• Trace the physical flow of the units through the production department.
• Convert actual units to equivalent units.
• Compute unit costs for each cost element.
• Distribute the total cost between the units completed and transferred out and the units remaining in the
ending inventory.
Using the June data, Storey developed the production cost report for Department 3 shown in Exhibit 154.
The first step in the preparation of a production cost report is to trace the physical flow of actual units in and out
of Department 3. The units section in Exhibit 154 shows that Department 3 had 6,000 units in the June beginning
inventory. Department 3 also had 18,000 units transferred in from Department 2. This makes a total of 24,000
units for which Department 3 must account.
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Of these 24,000 units, Department 3 completed and transferred out 16,000 units (either to the next processing
department or to finished goods). At the end of the month, Department 3 had 8,000 partially completed units.
These 8,000 units are the June ending inventory. Now we are ready for the second step in the preparation of the
production cost report—to convert actual units to equivalent units.
Storey Company's cost of production report uses the average cost procedure. Under the average cost
procedure, the number of equivalent units for each cost element equals the number of units transferred out plus
the number of equivalent units of that cost element in the ending inventory. The average cost procedure does not
consider the number of units in the beginning inventory and the degree of completion of the beginning inventory.
Alternatively, Storey could use First-in, First-out (FIFO) or Last-in, First-out (LIFO). We use the average cost
procedure in this chapter because it is simpler and commonly used in practice.
Storey Company Production Cost Report -
Department 3
For the month of June 2011
Equivalent units
Units Actual units Transferred- in
Materials Conversion
Units in beginning inventory
6,000
Units transferred in from Department 2
18,000
Units to be accounted for
24,000
Units completed and transferred out
16,000 16,000 16,000 16,000
Units in ending inventory*
8,000 8,000 8,000 4,000
Units accounted for 24,000 24,000 24,000 20,000
Costs Transferred- in
Materials Conversion Total
Costs to be accounted for: Costs in beginning inventory
$12,000 $6,000 $3,000 $21,000
Costs transferred in from Department 2 in June
37,200 37,200
Costs added in Department 3
18,480 18,000 36,480
Costs to be accounted for
$49,200 $24,480 $21,000 $94,680
Equivalent units (from above)
24,000 24,000 20,000
Unit cost (per equivalent unit)†
$2.05 $1.02 $1.05 $4.12
Costs accounted for: Units completed and transferred out (16,000 units)
$32,800 $16,320 $16,800 $65,920
Units remaining in ending inventory (8,000 units)*
16,400 8,160 4,200 28,760
Costs accounted for $49,200 $24,480 $21,000 $94,680 *Inventory is complete as to materials added, 50% complete as to conversion. † Unit cost equals costs to be accounted to divided for divided by equivalent units.
Exhibit 153: Production cost report
Storey's units in the ending inventory are fully complete as to costs transferred in and materials cost. Therefore,
the number of equivalent units for each of these cost elements is 24,000 (16,000 units completed and transferred
Accounting Principles: A Business Perspective 773 A Global Text
19. Process: Cost systems
out + [8,000 units in the ending inventory X 100 per cent complete for transferred-in costs and materials costs]).
The 8,000 units remaining in ending inventory are 50 per cent complete as to conversion. Therefore, there are
20,000 equivalent units with regards to conversion—16,000 units transferred out plus 8,000 units in ending
inventory that were 50 per cent complete.
Once a company has computed its equivalent units, it must calculate the unit costs. This is the third step in
preparing the production cost report. Each cost element of production—costs transferred in, materials, and
conversion—has accumulated costs. Notice in Exhibit 153 that for each cost element, we total the costs of beginning
inventory and costs of the current month. We refer to the total costs charged to a department as costs to be
accounted for. These costs must either be transferred out or appear in the ending inventory of Department 3.
To determine the cost per equivalent unit for each cost element, divide the total cost for each cost element by the
equivalent units of production related to that cost element. (Since we totaled all costs for each cost element before
the division, we can average the computed unit costs across the current and prior period.) Exhibit 153 shows the
average per unit costs for June as transferred-in costs, USD 2.05; materials costs, USD 1.02; and conversion costs,
USD 1.05. In monitoring these costs closely for cost control purposes, management watches for extreme
fluctuations from one month to the next.
The last step in preparing the production cost report is to allocate costs between the units completed and
transferred out and the units remaining in ending inventory. The units transferred out were fully complete as to all
elements of production. Therefore, we can multiply the 16,000 units by USD 4.12, the total cost per unit. The result,
USD 65,920, is the amount Storey assigns to the next department as cost transferred in or to finished goods as the
cost of completed current period production. We now compute the cost of ending inventory as follows:
8,000 equivalent units transferred in @ $2.05 8,000 equivalent units of materials costs @ $1.02 4,000 equivalent units of conversion costs @ $1.05 Total cost of ending inventory
The sum of the ending inventory cost and the cost of the units transferred out must equal the total costs to be
accounted for. This built-in check determines whether the company has properly followed the procedures of cost
allocation. As shown in the production cost report, Department 3 adds the USD 65,920 costs transferred out to the
USD 28,760 ending inventory cost. The total equals the USD 94,680 for which Department 3 must account.
Some companies replace the production cost report with three schedules. The first schedule is the schedule of
equivalent production. This schedule computes the equivalent units of production for the period for transferred-in,
materials, and conversion costs. The second schedule is the unit cost analysis schedule. This schedule sums all the
costs charged to the Work in Process Inventory account of each production process department. Then it calculates
the cost per equivalent unit for transferred-in, materials, and conversion costs. The third schedule is the cost
summary schedule. This schedule uses the results of the preceding two schedules to distribute the total costs
accumulated during the period among all the units of output. Companies generally show these three schedules in a
process cost analysis report.
Companies that use a process cost system may use the first-in, first-out (FIFO) method instead of the
average cost procedure. Generally, under FIFO, the equivalent number of units for each cost element consists of:
• Work needed to complete the units in beginning inventory.
• Work done on units started and completed during the period.
• Work done on partially completed units in ending inventory.
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Appendix 19-A, at the end of this chapter, illustrates this method.
Now that you have studied both job costing in Chapter 18 and process costing in this chapter, you can appreciate
why manufacturing companies must accurately account for product unit costs. Without accurate cost accounting
information, a manufacturing company cannot determine the cost of its products for managerial decision making
or prepare accurate financial statements.
Process costing in service organizations
Service organizations that provide similar services to a variety of customers are potential users of process
costing. For example, a clinic dispensing flu shots, a delicatessen selling only pastrami sandwiches, and a photo
shop that processes pictures could use process costing. In manufacturing, the difficult task is to match period costs
with the units produced that period, which is why companies compute equivalent units of production. (And that is
what most people find difficult about process costing.)
Generally, service companies complete the service by the end of the period and have no work in process at the
end of the period. Nurses do not leave for home halfway through giving a flu shot, and the delicatessen does not
partially serve a sandwich one month and complete it the next. Consequently, there is no need to compute
equivalent units, which simplifies process costing.
Note that some service companies do have partially completed work at the end of the period. Certain types of dry
cleaning and photo processing may still be in process at the end of a period. You could apply the methods described
in this chapter for manufacturing to those service companies. For materials, you could substitute any significant
supplies, and for conversion costs, service labor and overhead.
Spoilage
If you have ever tried to make something that did not work out, you know the concept of spoilage. Spoilage
refers to the loss of goods during production. For example, suppose some of the cans are dented during the canning
of tuna fish. Accountants would treat the cost of the dented cans of tuna fish as spoilage.
Accountants treat spoilage either as normal spoilage or abnormal spoilage. Normal spoilage occurs in the
normal production process. Accountants generally assign normal spoilage costs to the good units produced.
According to one method found in practice, accountants divide the total cost of production by the good units
produced.
For example, suppose the total cost of producing tuna fish for one day is USD 100,000. The company produced
220,000 cans of tuna fish, but 20,000 cans of tuna fish did not meet quality inspection requirements.
Consequently, these 20,000 units were considered to be spoiled in the normal production process. One way
accountants deal with the cost of such normal spoilage is to compute the cost per good unit by dividing total
production costs by the number of good cans of tuna fish produced. That is:
Cost per good unit= USD100,000
200,000 good units producted
= USD 0.50 per good unit produced
Abnormal spoilage refers to spoilage that exceeds the amount expected under normal operating conditions.
For example, if denting the tuna fish cans is unusual, accountants would treat the cost of those dented cans of tuna
fish as abnormal spoilage. Whereas normal spoilage costs are assigned to good products, abnormal spoilage costs
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19. Process: Cost systems
are typically expensed. Thus, accountants treat normal spoilage as a product cost and abnormal spoilage as a period
cost.
Advocates of total quality management may prefer to classify all spoilage as abnormal. Normal spoilage costs are
buried in the costs of the good products. Unless management personnel ask for a special analysis of spoilage costs,
they will not know whether the spoilage costs are a small per cent or a large per cent of product costs. For example,
management could see a report on tuna fish production costs stating the cost is USD 0.50 per can, but they do not
know how much of the USD 0.50 was the cost of spoilage.
We recommend that accountants report spoilage costs to management, whether normal spoilage or abnormal
spoilage, so management can make informed decisions to reduce spoilage.
Understanding the learning objectives
• Process cost systems are used for businesses that produce products on a continuous basis over long periods.
• Paint, paper, chemicals, gasoline, beverages, and food products should be accounted for under a process
cost system.
• Types of products produced under each system: Companies that use job costing work on many different
jobs with different production requirements during each period. Companies that use process costing produce a
single product, either on a continuous basis or for long periods.
• Cost accumulation procedures used under each system: Job costing accumulates costs by individual jobs.
Process costing accumulates costs by process or department.
• Work in Process accounts: Job cost systems have a Work in Process Inventory account for each job. Process
cost systems have a Work in Process Inventory account for each department or process.
• Whenever partially completed inventories are present, the number of equivalent units of production must
be computed. Basically, the concept of equivalent units involves expressing a given number of partially
completed units as a smaller number of fully completed units.
• As a simple example of equivalent units, two apples that are half eaten are equivalent to one whole apple
eaten. In manufacturing, we estimate the degree of completion for a group of products with respect to
transferred-in, materials, and conversion (direct labor and overhead). Accountants base the concept of
equivalent units on the supposition that a company must incur approximately the same costs to partially
complete a large number of units as to totally complete a smaller number of units.
• Accountants compute equivalent units of production for transferred-in units, materials, and conversion.
For each of these categories, the number of units transferred out is added to the equivalent units remaining in
ending work in process in the department.
• Unit costs for the three categories—transferred-in units, materials, and conversion—are determined by
dividing the equivalent units into the cost in beginning inventory plus the costs transferred in or added in the
department during this period.
• A production cost report shows both the flow of units and the flow of costs through a processing center. The
report is divided into two parts. The first part traces the physical flow of the units through the production
department and converts actual units to equivalent units. The second part shows the costs to be accounted for,
computes unit costs based on equivalent units as determined in the first part, and shows how the costs were
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accounted for by adding the costs completed and transferred out with the costs remaining in ending inventory.
The costs to be accounted for and the costs accounted for must balance.
• The production cost report provides a check on the Work in Process Inventory account. Each processing
department normally has its own Work in Process Inventory account and related production cost report. The
separate items that make up work in process inventory—direct labor, direct materials, applied overhead, and
cost of units transferred in and out—can be traced from the production cost report to the Work in Process
Inventory account (and vice versa) during a given period.
• Normal spoilage occurs in the normal course of production and is treated as a product cost. Abnormal
spoilage exceeds the spoilage that occurs in the normal course of production and is treated as a period cost.
• Under FIFO equivalent units of production are computed by taking the equivalent units of work done to
complete the beginning inventory, plus units started and completed during the current period, plus equivalent
units of work done on the ending inventory. As is true under the average cost method, the equivalent units
usually differ between materials and conversion.
• Unit costs for the three categories—transferred-in units, materials, and conversion—are determined by
dividing cost to be accounted for during the period by units produced during the period.
• The physical measures method allocates joint product costs based on physical measures, such as units,
pounds, or liters.
• The relative sales value method is the most commonly used method to allocate joint product costs. It is
based on the relative sales values of the products at the split-off point.
Appendix 19A: The FIFO process cost method
In this chapter, the discussion assumed the use of the average cost method for determining unit costs under
process costing. Another acceptable method for determining unit cost under process costing is the first-in, first-out
(FIFO) cost method. This appendix presents a detailed illustration of the FIFO process costing system.
The following table shows how the computation of equivalent units differs between the average cost method and
the FIFO cost method:
Average cost method FIFO cost method Equivalent units of production = Units completed this period + Equivalent units of work done on the ending inventory
Equivalent units of production = equivalent units of work done to complete the beginning inventory + units started and completed this period + Equivalent units of work done on the ending inventory
To illustrate the computation of equivalent units under the FIFO method, assume the following facts:
Beginning inventory, 3,000 units, 40% complete Units started this period, 10,000 units
Ending inventory, 5,000 units, 20% complete
The equivalent production for the period would be:
Equivalent units of work done to complete the beginning inventory (3,000 x 0.60)
1,800
Units started and completed this period (10,000 – 5,000 in ending inventory)
5,000
Equivalent units of work done to partially complete the ending inventory (5,000 x 0.20)
1,000
Equivalent units of production 7,800
As is true under the average cost method, the number of equivalent units usually differs between materials and
conversion.
Accounting Principles: A Business Perspective 777 A Global Text
19. Process: Cost systems
FIFO process costing—An illustration
To illustrate more completely the operation of the FIFO process cost method, we use an example of the month of
June production costs for a company having Departments A and B. Both departments add materials only at the
beginning of processing. Department A has no May 31 inventory. The May 31 inventory in Department B consists of
2,000 units that are fully complete as to materials and 50 per cent complete as to conversion. This inventory has
accumulated costs of USD 6,180.
The following transactions and additional data summarize manufacturing operations in both departments for
June:
Raw materials purchased on account, USD 25,000.
Direct materials issued: Department A (14,000 units at USD 1.50), USD 21,000; and Department B (10,000
units at USD 0.13), USD 1,300.
Indirect materials issued: Department A, USD 400; and Department B, USD 200.
Labor costs: direct labor, Department A, USD 6,600, Department B, USD 5,400; and indirect labor, USD 3,000.
Manufacturing overhead is applied as follows: USD 5,280 in Department A and USD 5,400 in Department B.
Other manufacturing overhead incurred:
Repairs (on account)
$2,100
Depreciation 3,000 Utilities (on account)
3,000
$8,100
• Production reports show the following for June:
Department ADepartment B Beginning inventory -0- 2,000 Units started 14,000 10,000 Units completed and transferred out 10,000 9,000 Units in inventory, June 30 4,000 3,000 Estimated percentage 50 33 1/3
• Sales for the month on account, 15,000 units at USD 6 per unit.
• The company computed cost of goods sold at USD 55,866 on a FIFO basis.
The general journal entries and their explanation follow:
1. Materials inventory (+A) 25,000 Accounts payable (+L) 25,000 To record materials purchased on account.
2. Work in process – Department A (+A) 21,000 Work in process – Department B (+A) 1,300 Manufacturing overhead (-SE) 600 Materials inventory (+L) 22,900 To record direct and indirect materials used.
3. Work in process – Department A (+A) 6,600 Work in process – Department B (+A) 5,400 Manufacturing overhead (+SE) 3,000 Payroll summary (-SE) 15,000 To distribute labor.
4. Work in process – Department A (+L) 5,280 Work in process – Department B (-A) 5,400 Manufacturing overhead (+A) 10,680 To record assignment of overhead to production.
5. Manufacturing overhead (-A) 8,100
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Accounts payable (+A) 5,100 Accumulated depreciation – Plant and equipment (-A)
3,000
To record various overhead costs incurred.
6. Work in process – Department B (+A) 24,900 Work in process – Department A (+SE) 24,900 To record transfer of completed production from Department A to Department B. (For details of computation, see production cost report of Department A in Exhibit 155).
7. Accounts receivable (-SE) 90,000 Sales (-A) 90,000 To record sales for the month.
8. Cost of goods sold 55,866 Finished goods 55,866 To record cost of goods sold.
As noted in the journal entries for June's manufacturing operations, the production cost report provided the
dollar amounts of certain entries. For product costing purposes, the production cost report is the primary report in
a process cost system. The chapter illustration of the production cost report shows the units and costs charged to a
department, the disposition of these units and costs, and, typically, some of the supporting details and
computations.
Production cost report—Department A To illustrate flexibility in format, Exhibit 154 shows the production
cost report for Department A in a format different from the one in the chapter. Note that Department A placed
14,000 units into production. Then, Department A completed and transferred out 10,000 units. Department A
retained the remaining 4,000 partially completed units in the department. The footnote in the illustration shows
the computation of equivalent units.
Department A Production cost report
For the month ended 2011 June 30 Units in beginning inventory -0- Units started during period 14,000 Units to be accounted for 14,000 Units completed and transferred out 10,000 Units in ending inventory 4,000 Units accounted for 14,000 Costs Equivalent
units Total cost
Current unit cost
Costs to be accounted for: Costs added during the month: Direct materials 14,000* $21,000 $1.50 Conversion 12,000* 11,880 0.99 Costs added in month and costs to be accounted for
$32,880 $2.49
Costs accounted for: Cost of ending inventory: Direct materials (4,000 x 100% x $1.50)
$6,000
Conversion (4,000 x 50% x $0.99)
1,980
Total cost of ending inventory $7,980 Cost of 10,000 units transferred out
24,900 $2.49
Costs accounted for $32,880 *Supporting computations and data:
Materials Conversion Computations of equivalent units: Equivalent units to complete beginning inventory
-0- -0-
Units started and completed 10,000 10,000
Accounting Principles: A Business Perspective 779 A Global Text
19. Process: Cost systems
Equivalent units in partially completed ending inventory
4,000 2,000
Equivalent units of production for month 14,000 12,000
Materials Conversion Computations of equivalent units: Equivalent units to complete beginning inventory
-0- -0-
Units started and completed 10,000 10,000 Equivalent units in partially completed ending inventory
4,000 2,000
Equivalent units of production for month 14,000 12,000
Exhibit 154: Production cost report—Department A
The costs section of the report shows that the only costs to be accounted for were those added in the department
in June. These costs include USD 21,000 for materials and USD 11,880 for conversion, totaling USD 32,880.
Department A had no beginning inventory and no transfers in. Note how Department A determines its unit costs
for each of the two elements of manufacturing costs (USD 1.50 for materials and USD 0.99 for conversion). The
total current unit cost is USD 2.49. The report shows the disposition of the costs—the cost of the units transferred
to Department B (USD 24,900) and the amount of ending inventory remaining in Department A (USD 7,980 based
on current unit costs). The units transferred to Department B have the same unit cost as the unit cost in
Department A for the month. The current unit cost and the cost of the transferred units is not always the same, as
we will show for Department B in Exhibit 155.
Department B Production cost report
For the month ended 2011 June 30 Units Units in beginning inventory 2,000 Units started during period 10,000 Units to be accounted for 12,000 Units completed and transferred out 9,000 Units in ending inventory 3,000 Units accounted for 12,000 Costs Equivalent
units Total cost Current unit
cost Costs to be accounted for: Costs added during the month: Direct materials 10,000* $ 1,300 $ 0.13 Conversion 9,000* 10,800 1.20 Costs added during the month $12,100 $ 1.33 Costs in beginning inventory 6,180 Costs transferred in from Department A
24,900
Total costs to be accounted for $43,180 Costs accounted for: Cost of ending inventory: Transferred in from Department A (3,000 units at $2.49)
$ 7,340
Direct materials (3,000 x 100% x $0.13)
390
Conversion (3,000 x 1/3 x $1.20)
1,200
Total cost of ending inventory $ 9,060 Cost of 9,000 units transferred out
34,120 $3.791
Costs accounted for $43,180 *Supporting computations and data:
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Materials Conversion Computations of equivalent units: Equivalent units to complete beginning inventory
-0- 1,000
Units started and completed 7,000 7,000 Equivalent units in partially completed ending inventory
3,000 1,000
Equivalent units of production for the month 10,000 9,000
Beginning and ending inventories are complete as to materials. Beginning inventory is 50% complete and ending inventory 33 1/2% complete as to processing.
Exhibit 155: Production cost report—Department B
Production cost report—Department B The production cost report for Department B (Exhibit 155) is
similar to that of Department A. Note how the report highlights the current unit cost of the operations performed in
the department. Note also that Department B must account for the costs in the beginning inventory and the cost of
the units transferred in from Department A. Department B determines the cost of the ending inventory through the
use of the current month's unit cost (USD 1.33). All of Department B's other costs are included in the costs of the
9,000 units transferred to Finished Goods.
In the production cost report in Exhibit 155, we determine the cost of units transferred out by subtracting the
cost of the ending inventory from the total costs to be accounted for (USD 43,180 - USD 9,060 = USD 34,120). We
can compute average unit cost of USD 3.791 by dividing USD 34,120 by the 9,000 units transferred out.
Appendix 19B: Allocation of joint costs
A company incurs joint costs when it produces two or more products through the same production process or
from a common raw material. The company produces these products simultaneously. The products are not
identifiable as different individual products until a particular point in the manufacturing process known as the
split-off point.
The split-off point is a certain stage of production at which the separate products become identifiable from a
common processing unit. We refer to any costs beyond the split-off point as separable costs because they can be
directly traced to individual products. Examples of joint products are petroleum products, lumber, flour milling,
dairy products, and chemicals. In Exhibit 156, we show the joint production process.
By definition, joint costs are not identified with individual products. Any allocation of joint costs to one of the
products is inherently arbitrary. Many companies do not allocate joint costs to particular products for managerial
decision making because the allocated numbers could be misleading to decision makers. 57 The accounting problem
we face is how to allocate the joint costs that a company incurred before the products become separately identified.
Commonly used methods to allocate joint costs are the physical measures method and the relative sales value
method.
The physical measures method allocates joint costs on the basis of physical measures such as units, pounds,
or liters.
To illustrate, assume that Roy Company produces two grades of oil, product A and product B, through a joint
process. The cost and production data of Roy Company for July are:
Product AProduct B Total
57 For example, a survey of oil refineries indicated that seven of the nine companies did not allocate joint costs. See
K. Slater and C. Wooton, A Study of Joint and By-Product Costing in the U.K. (Reprint, London: Chartered
Institute of Management Accountants, 1988), p. 110.
Accounting Principles: A Business Perspective 781 A Global Text
19. Process: Cost systems
Units (barrels) produced 15,000 25,000 40,000 Unit selling price at split-off $ 15 $ 6 Revenue at split-off $225,000 $150,000 Joint product costs: Direct materials $125,000 Direct labor 105,000 Manufacturing overhead 70,000
$300,000
Exhibit 156: Production cost report-Department B
The physical measures method uses a ratio of the physical volume of each product to total volume as a basis for
allocation of joint costs. We compute the allocation of joint costs to each product as follows:
Total barrels
Ratio Joint costs
Allocated joint costs
Product A 15,000 15,000 40,000
X $300,000 $112,500
Product B 25,000 25,000 40,000
X $300,000 187,500
40,000 $300,000
If Roy Company sells both products without further processing, the gross margin for product A is USD 112,500,
or USD 225,000 less USD 112,500. Product B incurs a loss of USD 37,500, or USD 150,000 less USD 187,500. Even
though the physical measures method is easy to use, it often has no relationship to the revenue-generating power of
each product. In this instance, product B suffers a loss of USD 37,500 because the company allocated a high portion
of joint costs based on product B's high volume of physical units even though its selling price is less than that of
product A.
Keep in mind that the joint costs cannot be directly assigned to one product because joint costs are inseparable
between the products. Thus, because any allocation of joint costs to one product is arbitrary, the resulting measures
of each product's income are arbitrary.
The relative sales value method is a commonly used basis to allocate joint costs at the split-off point.
Accountants use the relative sales value method because it matches joint costs with revenue much like the matching
concept.
Using the relative sales value method, Roy Company would allocate the joint costs as follows:
Sales value at split-off
Ratio Joint costs
Allocated joint costs
Product A: ($15 x 15,000)
$225,000 $225,500 $375,000
X $300,000 $180,000
Product B: ($6 x 25,000)
150,000 $150,000 $375,000
X $300,000 120,000
$375,000 $300,000
The allocation ratios of 60 per cent and 40 per cent, respectively, for product A and product B result in allocated
joint costs of USD 180,000 to product A, and USD 120,000 to product B.
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To compare the physical measures method and the relative sales value method, assume Roy Company has no
inventory at the end of July. A partial July income statement would appear as shown:
Product A Product B Physical Measures Method
Relative Sales Value Method
Physical Measures Method
Relative Sales Value Method
Sales $225,000 $225,000 $150,000 $150,000 Cost of goods sold 112,500 180,000 187,500 120,000 Gross margin $112,500 $ 45,000 $(37,500) $ 30,000
Demonstration problem
Zarro, Inc., uses a process cost system to accumulate the costs it incurs to produce aluminum awning stabilizers
from recycled aluminum cans. The May 1 inventory in the finishing department consisted of 36,000 units, fully
complete as to materials and 80 per cent complete as to conversion. The beginning inventory cost of USD 288,000
consisted of USD 216,000 of costs transferred in from the molding department, USD 30,000 of finishing
department materials costs, and USD 42,000 of finishing department conversion costs (conversion costs are direct
labor and overhead). The costs incurred in the finishing department for May appear as follows:
Costs transferred in from molding department (excluding costs in beginning inventory)
$720,000
Costs added in finishing department in May (excluding costs in beginning inventory): $63,600 Materials 131,376 194,976 Conversion costs $914,976
The finishing department received 120,000 units from the molding department in May. During May, 127,200
units were completed by the finishing department and transferred out. As of May 31, 28,800 units, complete as to
materials and 60 per cent complete as to conversion, were left in inventory of the finishing department.
a. Using the average cost procedure, prepare a production cost report for the finishing department for May.
b. Compute the average unit cost for conversion in the finishing department in April.
Solution to demonstration problem
a.
Zarbo, Inc. Finishing department Production cost report For the month ending May 31
Equivalent units
Units Actual units Transferred -in
Materials Conversion
Units in May 1 inventory 36,000 Units transferred in 120,000 Units to be accounted for 156,000 Units completed and transferred out
127,000 127,200 127,200 127,200*
Units in May 31 inventory* 28,800 28,800 28,800 17,280† Units accounted for 156,000 156,000 156,000 144,480 *Inventory is complete as to materials, 60% complete as to conversion.
†(28,800 x 60% = 17,280).
Costs Transferred -in
Materials Conversion Total
Costs to be accounted for: Costs in May 1 inventory $216,000 $30,000 $42,000* $288,000 Costs transferred in 720,000 720,000 Costs added in department
63,600 131,376 194,976
Costs to be accounted for $936,000 $93,600 $ 173,376 $1,202,976 Equivalent units (from above)
156,000 156,000 144,480
Accounting Principles: A Business Perspective 783 A Global Text
19. Process: Cost systems
Unit costs $ 6.00 $ 0.60 $ 1.20 $7.80 Costs accounted for: Units completed and transferred out (127,200 units)
$763,200 $76,320 $ 152,640* $992,160
Units remaining in May 31 inventory (28,800 units)
172,800 17,280 20,736* 210,816
Costs accounted for $936,000 $93,600 $173,376 $1,202,976
*17,280 equivalent units x $1.20 = $20,736.
b. The average unit cost for conversion in the finishing department in April was USD 1.46, calculated as
USD42,000
0.8×36,000 .
Key terms Abnormal spoilage Spoilage that exceeds the amount expected under normal operating conditions.
Average cost procedure A method of computing equivalent units where the number of equivalent units for each cost element equals the number of units transferred out plus the number of equivalent units of that cost element in the ending inventory.
Conversion costs Costs of converting raw materials into the final product. Direct labor plus overhead.
Equivalent units A method of expressing a given number of partially completed units as a smaller number of fully completed units; for example, bringing 1,000 units to a 75 per cent level of completion is the equivalent of bringing 750 units to a 100 per cent level of completion.
First-in, first-out (FIFO) method A method of determining unit cost. This method computes equivalent units by adding equivalent units of work needed to complete the units in beginning inventory, work done on units started and completed during the period, and work done on partially completed units in ending inventory.
Job cost system (job costing) A manufacturing cost system that accumulates costs incurred to produce a product according to individual jobs.
Joint costs Those production costs incurred up to the point where the joint products split off from each other.
Normal spoilage Spoilage that occurs in the normal production process.
Physical measures method A method of allocating joint product costs on the basis of physical measures such as units, pounds, or liters.
Process cost system (process costing) A manufacturing cost system that accumulates costs incurred to produce a product according to the processes or departments a product goes through on its way to completion.
Production cost report A report that shows both the flow of units and the flow of costs through a processing center. It also shows how accountants divide these costs between the cost of units completed and transferred out and the cost of units still in the processing center's ending inventory.
Relative sales value method A method of allocating joint product costs on the basis of the relative market value at the split-off point.
Split-off point A certain stage of production at which the separate products become identifiable from a common processing unit.
Spoilage The loss of goods during production.
Transferred-in costs Costs associated with physical units that were accumulated in previous processing centers.
Self-test
True-false
Indicate whether each of the following statements is true or false.
In process costing, costs are accumulated by process or department.
Both job and process cost systems can only have one Work in Process Inventory account.
The first step in computing equivalent units is to determine the amount of materials being used.
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Abnormal spoilage is treated as a product cost.
(Based on Appendix 19-B.) A commonly used basis to allocate joint costs is the relative sales value of the
products at the split-off point.
Multiple choice
Select the best answer for each of the following questions.
Which of the following does not apply to process costing?
a. Uses the equivalent unit concept.
b. Includes overhead in product costs.
c. Costs of production are first recorded in Work in Process Inventory accounts then transferred to Finished
Goods Inventory and Cost of Goods Sold.
d. Keeps track of the actual cost of each individual unit produced.
Which of the following formulas is the correct formula for equivalent units of production under the average cost
procedure?
a. Units completed - [Units in ending inventory X Percentage complete] = Equivalent production
b. Units completed - [Units in beginning inventory X Percentage complete] = Equivalent production
c. Units completed + [Units in ending inventory X Percentage complete] = Equivalent production
d. None of the above.
Using the following data, compute the ending inventory cost:
1,000 units are in ending inventory in Department B. The 1,000 units are fully complete as to materials and 20
per cent complete as to conversion. The unit cost for materials is USD 0.05, and conversion unit cost equals USD
0.60. The unit cost of goods transferred in from Department A is USD 1.20.
a. USD 1,370.
b. USD 1,170.
c. USD 1,320.
d. USD 1,250.
A production cost report reports which of the following:
a. Units in a production department.
b. Costs related to production.
c. Unit costs.
d. Equivalent units.
e. All of the above are included in the production cost report.
(Based on Appendix 19-A) Compute the equivalent units of production under the FIFO method using this data:
Beginning inventory, 1,500 units—40 per cent complete
Units started this period, 5,000 units
Ending inventory, 2,500 units—20 per cent complete
a. 3,000.
b. 3,900.
c. 3,400.
d. 3,600.
Now refer to “Answers to self-test” at the end of the chapter to check your answers.
Accounting Principles: A Business Perspective 785 A Global Text
19. Process: Cost systems
Questions
➢ Define process costing and describe the types of companies that use process costing.
➢ How does a process cost system differ from a job costing system?
➢ Would a lumber mill use process or job costing?
➢ What is meant by the term equivalent units? Of what use is the computation of the numbers of
equivalent units of production?
➢ Distinguish between the number of units completed and transferred during a period and the
equivalent units for the same period.
➢ Under what circumstances would the number of equivalent units of materials differ from the number
of equivalent units of labor and overhead in the same department in the same period? Under what
circumstances would they be the same?
➢ When transferring goods from one department to another, which accounts require journal entries?
➢ Units are usually assumed to be at the same stage of completion for both labor and overhead. What is
the reason for this assumption?
➢ What is the basic information conveyed by a production cost report?
➢ What are the four steps in preparing a production cost report?
➢ What is meant by average cost procedure? What other two cost flow assumptions could be used?
➢ Would an automobile plant that makes specialty race cars use job costing or process costing? Would
an automobile plant that makes all terrain vehicles use job costing or process costing? Explain your
answer.
➢ What is the difference between normal and abnormal spoilage?
➢ Why might an advocate of total quality management prefer to see all spoilage labeled as abnormal?
➢ Show the differences between computing equivalent units of production using the average cost
method and FIFO cost method (Appendix 19A).
➢ Describe the relative sales value method and show how it is used (Appendix 19B).
➢ Real world question Refer to "A broader perspective: Producing cans of Coca-Cola". Describe the
different processes used in a cola bottling plant.
➢ Real world question Does The Coca-Cola Company use a process cost system or a job costing
system in its bottling plants? Why?
➢ Real world question Name five companies that probably use process costing.
Exercises
Exercise A Using the average cost method, compute the equivalent units of production in each of the following
cases:
a. Units started in production during the month, 72,000; units completed and transferred, 52,800; and units in
process at the end of the month (100 per cent complete as to materials; 60 per cent complete as to conversion),
19,200. (There was no beginning inventory.)
b. Units in process at the beginning of the month (100 per cent complete as to materials; 30 per cent complete as
to conversion), 12,000; units started during the month, 48,000; and units in process at the end of the month (100
per cent complete as to materials; 40 per cent complete as to conversion), 24,000.
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Exercise B In Department C, materials are added at the beginning of the process. There were 1,000 units in
beginning inventory, 10,000 units were started during the month, and 7,000 units were completed and transferred
to finished goods inventory. The ending inventory in Department C in June was 40 per cent complete as to
conversion costs. Under the average cost method, what are the equivalent units of production for materials and
conversion?
Exercise C In Department D, materials are added uniformly throughout processing. The beginning inventory
was considered 80 per cent complete, as was the ending inventory. Assume that there were 6,000 units in the
beginning inventory and 20,000 in the ending inventory, and that 80,000 units were completed and transferred
out of Department D. What are the equivalent units for the period using the average cost method?
Exercise D If in the previous exercise the total costs charged to the department amounted to USD 960,000,
including the USD 48,000 cost of the beginning inventory, what is the cost of the units completed and transferred
out?
Exercise E The following data relate to Work in Process—Department C, in which all materials are added at the
start of processing:
Work in process – Department C: Inventory, March 1: Materials cost (1,200 pounds; 100% complete)
$7,020
Conversion cost (20% complete) 1,804 Costs incurred this period: Direct materials used (9,000 pounds) $36,330 Direct labor 10,880 Overhead 17,820 Inventory, March 31 Materials cost (1,800 pounds, 100% complete)
?
Conversion cost (1,800 pounds, 80% complete)
?
Pounds of product transferred out: 8,400
Using these data, compute:
a. The unit cost per equivalent unit for materials and conversion (use the average cost method).
b. The cost of the product transferred out.
Problems
Problem A The following data refer to a production center of Sipp-Fizz, a soft drink bottler:
Work in process inventory, August 1, 4,000 units (units equal 12-bottle cases): Direct materials $12,000 Direct labor 6,120 Manufacturing overhead applied 8,000
$26,120 Units started in August 12,000 Costs incurred in August: Direct materials $36,000 Direct labor 48,000 Manufacturing overhead applied 60,000
The beginning inventory was 100 per cent complete for materials and 50 per cent complete for conversion costs.
The ending inventory on August 31 consisted of 6,000 units (100 per cent complete for materials, 70 per cent
complete for conversion costs).
Compute the following:
a. Number of units completed and transferred to finished goods inventory.
Accounting Principles: A Business Perspective 787 A Global Text
19. Process: Cost systems
b. The equivalent units of production for materials and conversion costs using the average cost method.
c. Cost per equivalent unit for materials and conversion costs.
d. Cost of units completed and transferred.
e. Cost of ending inventory.
Problem B The following information relates to Aromatic Company for its line of perfume products for the
month ended March 31:
Units in beginning inventory (units equal cases of product)
2,7000
Cost of units in beginning inventory: Materials $40,500 Conversion $ 18,900 Units placed in production 54,000 Cost incurred during current period: Materials $239,598 Conversion $215,310 Units remaining in ending inventory (100% complete as to materials, 60% complete as to conversion)
3,000
Prepare a production cost report for the month ended March 31, using the average cost method.
Problem C Shine Company uses a process cost system to account for the costs incurred in making its single
product, a hair conditioner. This product is processed in Department A and then in Department B. Materials are
added in both departments. Production for May was as follows:
Department A Department B Units started or transferred in 200,000 160,000 Units completed and transferred out 160,000 120,000 Stage of completion of May 31 inventory: Materials 100% 80% Conversion 50% 40% Costs incurred this month: Direct materials costs $200,000 $304,000 Conversion costs $540,000 $272,000
There was no May 1 inventory in either department.
a. Prepare a production cost report for Department A in May.
b. Prepare a production cost report for Department B in May.
Problem D A bottling company bottles soft drinks using a process cost system. Following are cost and
production data for the mixing department for June:
Units Materials costs
Conversion costs
Inventory, June 1 56,000 $11,620 $16,240 Placed in production in June 133,000 29,960 41,720 Inventory, June 30 63,000 ? ?
The June 30 inventory was 100 per cent complete as to materials and 30 per cent complete as to conversion.
Prepare a production cost report for the month ended June 30 using the average cost method.
Problem E Refer to the facts given in the previous problem. Assume the beginning inventory on June 1 was 100
per cent complete as to materials and 25 per cent complete as to conversion.
a. Prepare a production cost report for the month ended June 30, using FIFO. Round unit costs to the nearest
cent.
b. Why are ending inventory amounts different than those for the previous problem?
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Problem F Quality Lumber Company produces two products from logs, Grade A lumber and Grade B lumber.
The following events took place in June:
Grade A Grade B Total Units produced 80,000 120,000 200,000 Unit selling price at split-off $4.00 $2.00 Joint costs ? ? $120,000
a. Allocate the joint costs to the two products using the physical measures method.
b. Allocate the joint costs to the two products using the relative sales value method.
c. Explain the difference in unit costs using the two methods.
d. What are advantages of the relative sales value method if all of Grade A lumber has been sold and none of
Grade B lumber has been sold at the end of a month?
Alternate problems
Alternate problem A Pure Aqua Company is a producer of flavored mineral water. These data are for its
March production:
Work in process inventory, March 1, 3,000 (units equal cases): Direct materials $12,600 Direct labor 6,000 Manufacturing overhead (1,500 machine-hours at $6 per machine-hours)
9,000
$27,600 Units started in March 9,000 Costs incurred in March: Direct materials $36,360 Direct labor 55,200 Manufacturing overhead applied (13,800 machine-hours) ?
The ending inventory consisted of 4,500 units (100 per cent complete as to materials, 60 per cent complete as to
conversion).
Compute the following:
a. Number of units completed and transferred to finished goods inventory.
b. The equivalent units of production for materials and conversion costs using the average cost method.
c. Cost per equivalent unit for materials and conversion costs.
d. Cost of units completed and transferred.
e. Cost of ending inventory.
Alternate problem B The following data pertain to a production center of Sunbelt Company, a maker of
sunscreen products:
Units Materials costs
Conversion costs
Inventory, October 1 70,000 $12,000 $16,000 Placed in production in October 200,000 20,400 18,200 Inventory, October 31 100,000 ? ?
The October 31 inventory was 100 per cent complete as to materials and 20 per cent complete as to conversion
costs.
Prepare a production cost report for the month ended October 31, using the average cost method.
Alternate problem C Healthbar Company produces a health food and determines product costs using a
process cost system. The product is moved through two departments, mixing and bottling. Production and cost data
for the bottling department in August follow.
Work in process, August 1 (30,000 pints):
Accounting Principles: A Business Perspective 789 A Global Text
19. Process: Cost systems
Costs transferred in $30,000 Materials costs 15,000 Conversion costs 9,000 Costs incurred in August: Transferred in (100,000 pints) $100,00
0 Materials costs 50,000 Conversion costs 39,300
All materials are added at the beginning of the bottling process. Ending inventory consists of 25,000 pints, 100
per cent complete as to materials and 40 per cent complete as to conversion.
Prepare a production cost report for August using the average cost method.
Beyond the numbers—Critical thinking
Business decision case A Bicycles Plus, Inc., produces bicycles. While the company has developed a per unit
cost, it has not been able to break down its costs in each of its three departments: frames, assembling, and finishing.
Karol Ring, the production manager, has been concerned with cost overruns during July in the frames department,
which produces the bicycle frames.
On July 1, the frames department had 6,000 units in its work in process inventory. These units were 100 per
cent complete as to materials and 40 per cent complete as to conversion. The department had incurred USD 12,000
in materials costs and USD 90,000 in conversion costs in processing these 6,000 units.
The department handled 30,000 units during the month, including the 6,000 units in beginning inventory on
July 1. At the end of the month, the department's work in process included 3,600 units that were 100 per cent
complete as to materials and 30 per cent complete as to conversion. The month's costs were allocated on the
number of units processed during the month as follows:
Materials Conversion Costs $60,000 $300,216 Units handled during month 30,000 30,000 Cost per unit $ 2 $ 10
The USD 12 per unit cost was assigned in a way that resulted in the following costs:
Beginning work in process
Work started and completed
Ending work in process
Cost per unit incurred during the month: Units 6,000 20,400 3,600 Cost per unit $12 $12 $12
Ring realized that this per unit cost is incorrect and asks you to develop a better method of computing these
costs for the month ended July 31.
a. How would you recommend that July's costs be assigned to the units produced? How would this differ from
the present method?
b. To justify your recommendation, recalculate July's costs using your recommendation. Present your analysis in
a production cost report.
Ethics case – Writing experience B Steve Yung works in the inventory control group at a company that
produces stone-washed jeans. A good friend manages the Stitching Department at the same company. At the end of
a recent month, Yung reviewed the Stitching Department's production cost report and found the department had
no beginning Work in Process Inventory, had started 27,000 pairs of jeans, and had produced only 24,000 pairs.
That leaves 3,000 pairs in ending inventory, Yung thought, that is a lot of jeans they did not finish.
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Later, Yung visited his friend who managed the Stitching Department. "Why all the ending inventory?" he asked.
"One of the new workers set several machines wrong, and the stitching was bad on 2,400 pairs," the manager
replied. "We set those aside, and we will fix them when we have some free time. The other 600 pairs are complete
now, and have been transferred out. Our entire operation was slower because of the machine problem."
"Company policy is to send all defective products to the Rework Department. They can fix the jeans. That is their
job," Yung said.
“No way!" exclaimed the Stitching Department manager. "We would all be in trouble if plant management finds
out. The worker who messed up would probably be fired. I do not want that. This is our little problem, and we will
take care of it."
a. What should Yung do?
b. Would your answer change if Yung learned that the Stitching Department had fixed the jeans and sent them
on to the next department?
Financial analysis C Suppose a bottling company made an error in estimating the stage of completion of its
work in process inventory. Suppose the costs in beginning inventory and the costs transferred in were correct, but
the company overstated the stage of completion for both materials and conversion costs in ending Work in Process
Inventory causing ending Work in Process Inventory to be USD 100,000 too high. The beginning and ending
Finished Goods Inventory amounts are correct. What effect would this error have on the company's last year's
financial statements?
Group project D In groups of 3 or 4 students, write a paper on the topic, "How scientific is the allocation of
joint costs to products?" Prepare the paper on a computer and prepare and edit several drafts before turning in the
final paper. Use examples to demonstrate your points.
Group project E In teams of two or three students, interview the manager of a grocery store. What is the cost
of spoilage in the vegetable and fruit section as a percentage of the total cost of goods sold? Does the manager
differentiate between normal and abnormal spoilage? If so, provide some examples. Each team should write a
memorandum to the instructor summarizing the results of the interview. Information contained in the memo
should include:
Date:
To:
From:
Subject:
Content of the memo must include the name and title of the person interviewed, name of the company, and
information responding to the questions above.
Group project F In teams of two or three students, interview the manager of a fast food restaurant such as
McDonald's. What is the cost of spoilage as a percentage of the total cost of goods sold? Does the manager
differentiate between normal and abnormal spoilage? If so, provide some examples. Each team should write a
memorandum to the instructor summarizing the results of the interview. Information contained in the memo
should include:
Date:
To:
From:
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19. Process: Cost systems
Subject:
Content of the memo must include the name and title of the person interviewed, name of the company, and
information responding to the questions above.
Using the Internet—A view of the real world
Using the Internet as a research tool, describe the conversion activities (or processes) involved in producing oil
or oil-related products. Your description should include examples of raw materials used as inputs, production
activities required to convert inputs into products, and resulting outputs (finished goods). Write your report in the
form of a memorandum. The heading of the memorandum should contain the date, to whom it is written, from
whom, and the subject matter. Be sure to attach your research materials obtained from the Internet to the
memorandum.
Using the Internet as a research tool, describe the conversion activities (or processes) involved in producing
milk or milk-related products. Your description should include examples of raw materials used as inputs,
production activities required to convert inputs into products, and resulting outputs (finished goods). Write your
report in the form of a memorandum. The heading of the memorandum should contain the date, to whom it is
written, from whom, and the subject matter. Be sure to attach your research materials obtained from the Internet to
the memorandum.
Answers to self-test
True-false
True. In process costing, costs are accumulated by process or department.
False. Job cost systems have one Work in Process Inventory account for each job, and process cost systems
have a Work in Process Inventory account for each process or department.
False. The initial step in computing equivalent units is to determine either the stage of completion or the
number of partially complete units.
False. Abnormal spoilage is treated as a period cost.
True. The relative sales value of the products at the split-off point is a commonly used basis to allocate joint
costs.
Multiple-choice
d. Process costing does not keep track of the actual cost of each individual unit produced.
c. Units completed + [Units in ending inventory X Percentage complete] = Equivalent production
a. USD 1,370 [USD 1,200 + (1,000 X USD .05) + (200 X USD .60)]
e. Items a through d are included in the production cost report.
b. The equivalent production for the period would be:
Equivalent units of work done to complete the beginning inventory (1,500 x 0.60)
900
Units started and completed this period (5,000 – 2,500)
2,500
Equivalent units of work done to partially complete the ending inventory (2,500 x 0.20)
500
Equivalent units of production 3,900
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Comprehensive review problem
The Compack Company assembles personal computers. Personal computers go through several departments
where sub assemblies are unpacked and checked, the circuit board is attached, the product is tested and repaired if
defective, and the computers are packed carefully for shipping. Each order is treated as a job, and the entire job is
shipped at once. The company keeps track of costs by job and calculates the equivalent stage of completion for each
job based on machine-hours.
Although the company has grown rapidly, it has yet to show a profit. You have been called in as a consultant.
Management believes some jobs are profitable and others are not, but it is not clear which are profitable. The
accounting system is almost nonexistent; however, you piece together the following information for April:
• Production:
a. Completed Job No. 101.
b. Started and completed Job No. 102.
c. Started Job No. 103.
• Inventory values:
a. Work in process inventory:
March 31: Job No. 101 Direct materials $60,000 Direct labor 9,600 Overhead 14,400 April 30: Job No. 103 Direct materials $45,000 Direct labor 10,400 Overhead 15,600
b. Job No. 101 was exactly one-half finished in direct labor-hours and machine-hours at the beginning of April,
and Job No. 103 was exactly one-half complete in direct labor-hours and machine-hours at the end of April.
However, all of the direct materials necessary to do the entire job were charged to each job as soon as the job was
started.
c. There were no direct materials inventories or finished goods inventories at either March 31 or April 30.
• Manufacturing overhead is applied at USD 30 per machine-hour. The company used 1,600 machine-hours
during April, 480 machine-hours on Job 101 and 600 machine-hours on Job 102. The actual overhead for the
month of April was USD 50,000.
• Cost of goods sold (before adjustment for over applied or under applied overhead):
Job No. 101: Materials $60,000 Labor ? Overhead ? Total ? Job No. 102: Materials ? Labor ? Overhead ? Total ?
• Overhead was applied to jobs using the predetermined rate of USD 30 per machine-hour. The same rate
had been used since the company began operations. Over- or under applied overhead is debited or credited to
Cost of Goods Sold.
• All direct materials were purchased on account. Direct materials purchased in April amounted to USD
150,000.
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19. Process: Cost systems
• Direct labor costs charged to jobs in April were USD 32,000. All labor costs were the same rate per hour for
April for all laborers.
a. Compute the cost of each job, whether in inventory or sold.
b. Show the transactions in journal entry form. Use a separate Work in Process Inventory account for each job.
c. Prepare an income statement for April assuming revenue was USD 250,000 and selling and administrative
expenses were USD 60,000.
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20. Using accounting for quality and cost management
Learning objectives
After studying this chapter, you should be able to:
• Describe why managers need good accounting information to be competitive in the new production
environment.
• Identify ways to improve quality.
• Develop measures of performance that help achieve high quality.
• Understand how the balanced scorecard helps organizations recognize and deal with opposing
responsibilities.
• Explain how just-in-time purchasing and production can reduce costs and improve quality.
• Compare and contrast accounting in just-in-time settings with accounting in traditional settings.
• Define activity-based costing and explain its benefit to companies.
• List the four steps in activity-based costing.
• Compare product costs using activity-based costing with product costs using traditional costing methods.
• Describe the strategic and behavioral advantages of activity-based management.
Importance of good accounting information
Have you ever purchased a product and found it to be defective? If so, you may have sworn to yourself that you
would never buy one of those again. By doing so, you have demonstrated why high-quality products are essential for
business success. Successful companies remain in business by seeking continual improvement in the quality of their
products. For example, Territory Ahead, a merchandising company tells its customers to please hassle them if not
completely satisfied. Nordstrom's department stores, Southwest Airlines Company, and Apple . are companies that
have built reputations based on the notion of hassle us if you are not completely satisfied.
In its plant near Nashville, Tennessee, USA, Nissan Motor Corporation places some of the previous day's
production of cars and trucks in the lobby with charts showing the number of production defects for that day.
Displaying products and reporting on performance gives workers a sense of pride in their work and an incentive to
reduce defects.
Quality and the new production environment
Attention to quality is an important feature of the new production environment. The phrase, new production
environment, refers to an environment in which company managers are concerned with (1) improving customer
service and product quality and (2) reducing costs. Both actions are necessary to stay competitive.
In the new production environment, new technology is helping managers improve quality and reduce costs.
Computer-assisted manufacturing enables managers to reduce inventories, yet respond quickly to customers'
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20. Using accounting for quality and cost management
needs. For example, robots perform certain repetitive functions more reliably than humans. Computerized airline
reservations systems also provide better customer service at a lower cost to airlines.
The new production environment is rooted in the new management philosophies that we discuss in this chapter.
For example, managers now use nonfinancial as well as financial measures of quality performance. Many
companies have adopted a just-in-time philosophy for managing purchasing and production. Managerial
accountants are restructuring costing systems to provide activity-based costs resulting in better managerial
decision making. Many observers believe that United States industry has fallen behind foreign competitors because
managers and accountants have not worked together to produce the information management needs to make good
decisions.
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Improving quality
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20. Using accounting for quality and cost management
To make decisions about the costs and benefits of quality, we need to know what those costs and benefits of
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quality are. Managers at Texas Instruments have placed the costs of quality in these four categories:55
• Prevention costs. Prevention costs cover the cost of preventing poor-quality products from being produced.
Prevention costs include training employees to do quality work.
• Appraisal costs. Appraisal costs are the costs of detecting poor-quality products. Appraisal costs include the
costs of inspecting materials when purchased and product testing during production.
• Internal failure costs. Internal failure costs are the costs of producing poor-quality products detected before
products are shipped to customers. Internal failure costs include the costs of reworking poor-quality products
to bring their quality up to specifications.
• External failure costs. External failure costs are the costs incurred because customers purchased poor-
quality products. External failure costs include the costs of dealing with returned products and future lost
profits because customers are dissatisfied.
The manager's task is to minimize the sum of these costs. By incurring substantial costs of prevention, for
example, a company might reduce costs of appraisal, internal failure, and external failure costs. This idea is a
modern adaptation of the old saying, "An ounce of prevention is worth a pound of cure". Small prevention costs
may even result in large cost savings in the other three categories.
Assume Diana's Secret is a company that sells clothing through catalogs. A marketing manager concerned about
customer satisfaction noticed a substantial amount of returned merchandise. Upon investigating, the manager
discovered that most returns were due to an incorrect color or size; most of these errors could be traced to mistakes
made by order takers who had not been adequately trained.
The company decided to invest USD 5,000 per month in a training program for order takers. After the training
program started, the amount of returned merchandise dropped dramatically. Working with people in the marketing
department, accountants estimated the company saved USD 4,000 per month by having less returned merchandise
and fewer refilled orders. In addition, marketing managers believed Diana's Secret's profits increased by USD
2,000 to USD 10,000 per month because of increased customer satisfaction. Management considered the USD
5,000 cost of prevention to be justified by the benefits of reduced returned merchandise and increased customer
satisfaction.
As you already may have figured out, measuring the cost of quality has a major disadvantage. It is difficult to
measure increased customer satisfaction (reflected in sales) resulting from additional spending on prevention costs
(or any of the four categories), and it is difficult to measure decreased customer satisfaction resulting from a
reduction in prevention costs. For example, if prevention costs are reduced, how do we measure lost sales as a
result of this reduction? Conversely, how do we measure the increase in sales directly associated with an increase in
prevention costs? It is difficult to accurately measure the change in sales specifically resulting from either scenario.
A current theme in business today is that "quality is free". The belief is that if quality is built into the product,
the resulting benefits in customer satisfaction, reduced rework and warranty costs, and other important factors far
outweigh the costs of improving quality. Cost-benefit analyses are no longer the primary focus in improving quality.
Instead, the emphasis is on improving quality with the understanding that quality is free in the long run.
Those who subscribe to the quality is free concept believe that zero defects is the only acceptable goal. The
production process should be continuously improved. The result? Quality will improve, customers will be
increasingly satisfied, and the cost of improving quality will pay for itself through increased sales and lower costs
(providing for increased profit margins).
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20. Using accounting for quality and cost management
Although both cost of quality and quality is free concepts strive for improved quality, the cost of quality
approach assumes a cost-benefit trade-off when spending money on quality improvement. The quality is free
approach assumes that the long-run benefits will always outweigh the costs of improving quality. One thing is for
certain: quality is important to the success of any company!
The key quality concept in the new production environment is total quality management. Total quality
management (TQM) is defined as managing the entire organization so it excels in its goods and services that are
important to the customer. The key ideas are that the organization strives for excellence and that quality is
ultimately defined by the customer.
Customer-driven quality standards Total quality management means that your goods and services are not
excellent until the customer says they are excellent. It is not enough for production managers or engineers to say an
automobile is well-designed and produced; customers must say they like it—a lot. TQM means translating customer
needs and wants into specifications for product design. Southwest Airlines learned that customers want flights to
leave and arrive on time. No amount of free food and beverages served to placate customers made up for late
arrivals, missed connections, missed meetings, and missed birthday parties. So Southwest Airlines went to work to
improve those things its customers wanted most; namely, on-time departures and arrivals. (Actually, the customers
wanted on-time arrivals more than on-time departures, but on-time departures help you on-time arrivals.)
How do companies identify quality problems? Three methods managers use to identify quality problems are the
following:
• Control charts.
• Pareto diagrams.
• Cause and effect analyses.
Control charts Control charts help managers distinguish between random or routine variations in quality
and variations that should be investigated. For example, the managers of CD, Inc., expect some returned
merchandise and do not panic because a customer returns merchandise. They use a control chart to plot data that
shows trends or unusually high rates of returned merchandise.
Look at Exhibit 157, a control chart for product defects in producing compact disc players at CD, Inc. Every
compact disc player is tested to ensure it works. Those products failing the test are reworked or scrapped, an
example of internal failure cost. Management expects an average failure rate of 2 per cent of the daily production.
Management has set an upper limit for failure at 4 per cent of daily production. If the failure rate exceeds 4 per
cent, management investigates to find out what is causing such a high rate.
Quality testers continuously record failure rates at CD, Inc. Managers can call up the results on their computers
at any time. Note in Exhibit 157 that Wednesday's results exceeded the 4 per cent limit. Management investigated
the problem Wednesday afternoon and found a machine improperly installing a switch. The machine was fixed
Wednesday night and production returned to normal on Thursday.
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Exhibit 157: Control chart for defective products
Pareto diagrams Pareto diagrams indicate how frequently each type of failure occurs. Note the Pareto
diagram for compact disc player production at CD, Inc., in Exhibit 158. Pareto diagrams have more information
than simple control charts, but they require quality testers to classify and report defects. Managers learn more
about the causes of problems from Pareto diagrams than they do from control charts.
Exhibit 158: Pareto diagram for production at CD, Inc.
Cause-and-effect analysis Cause-and-effect analysis identifies potential causes of defects. Consider the
problem of cracked compact disc player cases, for example. Cracked cases could be due to breakage during
production, faulty materials, or other handling problems. Managers must know the cause of problems to solve
them. It makes no sense to focus on product handling, for example, if the problem is purchasing poor-quality
materials.
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20. Using accounting for quality and cost management
Quality and customer satisfaction measures
Quality-oriented organizations continually monitor the quality of their products and solicit feedback from
customers to assess their satisfaction with goods and services. For instance, in Exhibit 159 the second nonfinancial
measure deals with delivery performance. Delivery performance is critical to success for companies such as FedEx,
UPS, the US Postal Service, and other delivery services.
Performance measure Objective 1. Quality control Number of customer complaints Create customer satisfaction Number of defects Make a high-quality product 2. Delivery performance Percentage of on-time deliveries Increase on-time deliveries 3. Materials waste Scrap and waste as a percentage of total materials used
Decrease scrap and waste; improve the quality of products
4. Machine downtime Percentage of time machines are not working
Decrease machine downtime; increase on-time delivery to customers
Exhibit 159: Nonfinancial performance measures
The success of Lands' End, L. L. Bean, The Territory Ahead, and other companies that sell through catalogs
depends on quick delivery of their merchandise. Bottlers of soft drinks such as PepsiCola and canneries like
Campbell Soup require precisely timed deliveries of cans and bottles. Ideally, the truck or railroad car unloads
containers right onto the production line.
Nonfinancial performance measures are particularly important to motivate people to provide high-quality
products and excellent customer service. For example, Exhibit 159 presents four nonfinancial performance
measures used by managers to evaluate performance in providing quality products and service at a reasonable cost.
Quality control The first set of measures in Exhibit 159 reflect quality control. Firms measure their product
quality by the number and type of customer complaints or by the number of product defects. By reducing the
number of product defects, companies reduce the number of customer complaints. The objective is to increase
customer satisfaction with the product, reduce the costs of dealing with customer complaints, and reduce the costs
of repairing products or providing a new service.
Delivery performance The second type of nonfinancial measure in Exhibit 159 deals with delivery
performance. As we noted earlier, delivery performance is critical for many companies. Domino's Pizza bases its
success on delivery service. The objective is to deliver goods and services when promised. To achieve this objective,
companies keep track of the percentage of total deliveries that are on time.
Materials waste Companies can take several steps to reduce materials waste, the third type of nonfinancial
measure. They can purchase a higher quality of raw materials so there is less waste from defective materials,
increase employee training so workers make fewer mistakes, and improve the production process. Reducing waste
can improve quality. The causes of waste are often the causes of poor quality. For example, waste may reflect poor
training of employees. Improving training could improve the quality of their work on all products, not just those
that result in waste. Generally, workers are motivated to find ways to reduce waste when companies keep track of
the quantity of materials wasted every day. Companies sometimes provide immediate feedback to workers the next
day, often in the form of large charts showing the previous day's waste.
Machine downtime The fourth type of nonfinancial measure, machine downtime, is very important in all
companies. At some automobile assembly plants, workers have the authority to stop the assembly line when they
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see something wrong. It should come as no surprise that such an action brings a lot of attention to the problem
from many people in the plant. Stopping production causes a loss of output while people wait for the machinery to
start up again. Machine downtime also can cause customer dissatisfaction and loss of sales. You may have
experienced this dissatisfaction at a bank when you could not be served because the computer was down, or when
your airline flight was canceled because of an airplane's maintenance problems.
People like to take pride in their work. Surveys indicate that workers prefer to do high-quality work rather than
low-quality work. Companies generally find that workers respond favorably to performance measures and
incentives measuring and rewarding high-quality work.
Many companies use high quality as their strategic advantage. For example, FedEx entered the air courier
business with a promise that it would guarantee delivery the next day by mid-morning. By continually delivering on
this promise, the company built up trust in its customers. Canon and Honda are other well-known companies that
have used product quality to compete effectively.
Benchmarking is the continuous process of measuring how well one is doing against performance levels either
inside or outside of the organization. For instance, students often benchmark by comparing their performance
against the professor's standards or other students' performance. Students often are interested in how well
graduates of their school compare to graduates of other schools on CPA exams, bar exams, or other standardized
exams.
Companies are benchmarking in a similar way. American Airlines looks at its own on-time arrival performance
by computing the percentage of its flights that land within 15 minutes of their scheduled arrival time. The company
compares the results with its own past experience and with its competitors' performance. American Airlines also
compares its own per cent of lost luggage to its own past experience and the performance of major competitors such
as United Airlines and Delta Air Lines.
Benchmarking transforms the theory of quality products or service into practice. Benchmarking focuses
attention on the objective. When American Airlines benchmarks on-time arrivals, it focuses the attention of its
pilots, ground crews, mechanics, and everyone else on ways to improve on-time arrival performance.
An accounting perspective:
Managers executed for poor quality
Business insight
Eighteen managers were executed for poor product quality in a refrigerator plant on the outskirts
of Beijing, China. The managers—12 men and 6 women-were taken to a rice paddy outside of the
factory and shot while plant workers watched.
A government official stated the action was required for committing unpardonable sins against the
people of China. Apparently, workers complained the managers were forcing the production of
poor quality products. When workers complained that components did not meet specifications and
the refrigerators did not function as required, the managers told them to ship the products.
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20. Using accounting for quality and cost management
Customers also had complained. This factory had a reputation for turning out poor quality
products.
Source: Authors' research.
The balanced scorecard is a set of performance targets and results that show an organization's performance
in meeting its objectives to its stakeholders. It is a management tool that recognizes organizational responsibility to
different stakeholder groups, such as employees, suppliers, customers, business partners, the community, and
shareholders. Often different stakeholders have different needs or desires that the managers of the organization
must balance. The concept of a balanced scorecard is to measure how well the organization is doing in view of those
competing stakeholder concerns.
An example of a balanced scorecard is shown in Exhibit 160. As you can see, the focus is to balance the efforts of
the organization between the financial, customer, process, and innovative responsibilities. Traditionally, business
organizations have focused on financial results, which mainly have reflected the shareholders' interests. In recent
years, organizations have shifted attention to customer issues, such as quality and service, to employees, and to the
community. For example, Ben & Jerry's Ice Cream measures its social performance along with financial
performance and presents a social audit in its annual report next to its financial audit. Johnson & Johnson's code of
conduct makes it clear that the company has a responsibility to several competing stakeholders.
Exhibit 160: Balanced scorecard
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The balanced scorecard has been developed and used in many companies. It primarily has been used at the top
management level to support the organization's development of strategies. For example, Kaplan and Norton
describe the development of the balanced scorecard at an insurance company as follows:56
Step 1: Ten of the company's top executives formed a team to clarify the company's strategy and objectives to
meet responsibilities.
Step 2: The top three layers of the company's management (100 people) were brought together to discuss the
new strategy and to develop performance measures for each part of the company. These performance measures
became the scorecards for each part of the business and reflected the company's desired balance in satisfying
different stakeholders.
Step 3: Managers began eliminating programs that were not contributing to the company's objectives.
Step 4: Top management reviewed the scorecards for each part of the organization.
Step 5: Based on its reviews in step 4, top management went back to step 1 to refine and further clarify the
company's strategy and objectives.
Organizations using the balanced scorecard generally have found it to be helpful for top and middle
management to shape and clarify organization goals and strategy in the face of competing stakeholder wants.
Just-in-time method
Innovations in purchasing, production, and inventory management have the potential to revolutionize
companies. One of these innovations is the just-in-time (JIT) method. Companies that use just-in-time methods
purchase materials just in time for production, produce parts just when needed in the production process, and
complete finished goods just in time for sale.
The principal feature of the just-in-time system is that production does not begin on an item until an order is
received. When a company receives an order it buys the raw materials, and the production cycle begins. As soon as
the order is filled, production ends. Consequently, just-in-time requires immediate correction of processes or
people making defective products because there is no inventory where defective products can await reworking or
scrapping.
In theory, a JIT system eliminates the need for inventories because no production takes place until the company
knows its products will be sold. As a practical matter, companies using this system normally have a backlog of
orders so they can keep their production operations going. The benefits of the JIT system would be lost if a
company had to shut down its operations for lengthy periods while waiting for new orders.
Just-in-time helps assure quality. If a unit is defective, employees cannot simply put it aside in inventory.
Production workers and machines must do it right the first time.
To achieve just-in-time production, many companies install a system of flexible manufacturing. A flexible
manufacturing system is computer-based; it enables companies to make a variety of products with a minimum of
setup time. The system does what its name implies: it enables companies to be flexible in making products just-in-
time to fill customers' orders.
For example, consider a company that makes after-market running boards for trucks. Customers install these
running boards on trucks after they purchase them. By using flexible manufacturing, the company that makes these
56 Based on R. S. Kaplan and D. P. Norton, "Using the Balanced Scorecard as a Strategic Management System,"
Harvard Business Review, January-February 1996.
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20. Using accounting for quality and cost management
running boards produces one set of running boards for a particular model of Dodge then one set for a particular
GMC model, and so forth to fill customer orders. A traditional production system, by contrast, would produce
numerous sets of running boards for the Dodge which would remain in inventory until needed to fill customer
orders. The traditional company would then produce numerous sets of running boards for the GMC and place them
in inventory until needed to fill customer orders.
Just-in-time is part of a lean production philosophy that has helped many companies successfully reduce costs
and increase quality. One feature of lean production is the absence of shelves, floor space, and other places used to
store partially finished products. For an example of lean production, imagine you are building a house and you have
just enough materials arriving just when you need them. You do not have extra lumber lying about in case you make
a mistake cutting the boards the first time. If your supplier of plumbing products does not deliver in time for your
needs, you have to shut down production until the plumbing products arrive. As you can see, lean production
requires high levels of efficiency and quality.
Accounting perspective:
Business insight
A labor strike at General Motors' Dayton, Ohio, USA, plant, which produces brake parts,
demonstrated the far-reaching effects of just-in-time when companies face plant shutdowns. When
the United Auto Workers (UAW) struck the Dayton plant, they forced 30,000 non-UAW workers
off their jobs. As General Motors has moved toward just-in-time production methods, its
inventories of brakes and other parts have decreased. Because of the strike at the Dayton plant, US
and Canadian plants using the brakes shut down quickly. Mexican plants were slower to shut down
because inventory in transit kept the Mexican plants going for about a week longer than their US
and Canadian counterparts.
Source: Authors' research.
Accountants using traditional costing methods assign costs to products as they go through the production steps.
Assigning costs to products is time-consuming and expensive, not only for accountants, but also for workers and
managers. One of the reasons for assigning costs as products proceed through production steps is to know the value
of work-in-process inventory at the end of an accounting period. Suppose a product has completed the first three
steps in a six-step production process at the end of the month. By assigning costs at each step along the way,
accountants know the cost of the product at the end of the third step.
Accountants in JIT production facilities do not have to compute the cost of work-in-process inventories. There
are no such inventories. Instead, accountants assign costs directly to the Cost of Goods Sold account. Companies
have been known to save the time of two or three full-time accountants by assigning costs directly to Cost of Goods
Sold. Since JIT production responds to the receipt of an order for goods, a JIT accounting system normally debits
all costs directly to cost of goods sold and bypasses the usual inventory accounts. When it is necessary to report
inventory amounts in the financial statements, accountants back the inventory amounts out of the Cost of Goods
Sold account using a method called backflush costing. Backflush costing is a method of assigning costs to
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inventories backwards from Cost of Goods Sold to Finished Goods Inventory and/or Work in Process Inventory
accounts.
For example, say Arizona Sunscreen Company uses the JIT method. Direct materials costs are USD 3.00 per
bottle and other manufacturing costs are USD 1.50 per bottle. The company received an order for 10,000 bottles of
sunscreen. Materials costs were USD 30,000 and other manufacturing costs were USD 15,000. Assume that USD
6,000 of these other costs are wages and the remaining USD 9,000 were applied to production from overhead.
Assume also the company had an inventory of USD 4,500 left in work in process as of the date financial statements
were prepared.
Traditional methods Using traditional methods of recording costs, the costs would flow through the
inventory accounts to Cost of Goods Sold as shown by the following journal entries:
(1) Materials inventory (+A) 30,000 Accounts payable (+L) 30,000 To record the purchase of materials.
(2) Work in process inventory (+A) 45,000 Materials inventory (-A) 30,000 Payroll summary (+L) 6,000 Overhead (applied) (+SE) 9,000 To record production costs in the work in process account.
(3) Finished goods inventory (+A) 40,500 Work in process inventory (-A) 40,500 To transfer product from work in process to finished goods.
(4) Cost of goods sold (-SE) 40,500 Finished goods inventory (-A) 40,500
To record the cost of the goods sold.
Just-in-time and backflush costing Using a just-in-time accounting system, the accountants would initially
assume the company has no inventories. Therefore, they would debit all costs directly to Cost of Goods Sold, as
follows:
(1) Cost of goods sold (-SE) 30,000 Accounts payable (+L) 30,000 To record the use of materials.
(2) Cost of goods sold (-SE) 15,000 Payroll summary (+L) 6,000 Overhead (applied) (+SE) 9,000 To record other manufacturing costs.
Upon learning the company has USD 4,500 of inventory in work in process, the accountants would back out
USD 4,500 from Cost of Goods Sold, as follows:
(3) Work in process inventory (+A) 4,500 Cost of goods sold (+SE) 4,500 To record inventory.
This last entry is the backflush costing step. These entries appear in T-accounts in Exhibit 161.
Just-in-time production simplifies accounting procedures. If the costs of these sunscreen bottles were charged
into production using traditional costing methods, it would be necessary to debit the materials costs to a Materials
Inventory account. As the materials were used, their costs would be transferred to Work in Process Inventory and
other manufacturing costs would be charged to Work in Process Inventory. As goods were completed, costs would
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20. Using accounting for quality and cost management
be transferred out of Work in Process Inventory, into Finished Goods Inventory, and finally, into Cost of Goods
Sold. Exhibit 161 contrasts traditional versus just-in-time cost flows.
Exhibit 161: Traditional versus just-in-time cost flows
By reducing inventories, a just-in-time system offers potentially great cost savings. As noted earlier, it simplifies
the accounting system. By reducing inventories, it releases investment dollars for use elsewhere and frees space that
the inventory previously occupied. Companies also have found that reducing inventories where defective products
could be hidden helps management detect production problems more quickly. By tying JIT to quality improvement
programs, companies move toward zero defect production.
Activity-based costing and management
Suppose you go to a movie theater that has five screens showing five different movies. Jerome Justin works for
the movie theater selling tickets for all five movies. Suppose management wants to know the cost of selling tickets
per movie and asks you to assign Justin's wages to each of the five movies. How would you assign his wages?
You could simply divide Justin's wages by the number of movies and allocate 20 per cent of his salary to each
movie. Or you could figure out how many tickets he sold to each movie, and allocate his wages on the basis of ticket
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sales. For example, if 50 per cent of the ticket sales were for Avatar, you might allocate 50 per cent of Justin's
wages to Avatar. You probably also could think of additional ways to allocate Justin's wages. No matter how we
allocate Justin's wages, his wages would not be directly traceable to one of the movies if he sold tickets for all five
movies. In short, the allocation of Justin's wages to a particular movie is at least somewhat arbitrary because
alternative methods could allocate different amounts of Justin's wages to each movie. Justin's wages would be
indirect costs to the different movies because his wages could not be directly assigned to any one of the movies.
By definition, the allocation of indirect costs is at least somewhat arbitrary. Nevertheless, accountants have
discovered that they can improve the ways costs are assigned, such as to movies in this case, by using activity-based
costing.
Activity-based costing is a costing method that assigns indirect costs to activities and to the products based
on each product's use of activities. Activity-based costing is based on the premise: Products consume activities;
activities consume resources.
Numerous companies, such as HP, Caterpillar, and IBM, have implemented activity-based costing. Activity-
based costing (ABC) has revealed startling information in these companies. For example, after installing new
costing methods, one well-known company found that one of its products, a printed circuit board, was generating
negative margins of 46 per cent.
Activity-based costing identifies the activities generating costs and assigns costs to those activities. Take the
earlier Justin example. By focusing on Justin's activities, management could learn what caused costs and find ways
to improve Justin's efficiency. Suppose that by studying Justin's activities, management learns he spends 40 per
cent of his time answering questions about movies, 40 per cent of his time selling tickets, and 20 per cent doing
nothing. Based on this information, management could think about better ways to use Justin's time. By improving
their signs and posting information about the movies, management could reassign Justin to other tasks.
Closely related to activity-based costing is the notion of activity-based management (ABM). Using activity-based
management, managers identify which activities consume resources. The focus is then to effectively manage costly
activities with the goal of reducing costs and improving quality. Consider Justin and the movie theater again. Using
activity-based management, managers would identify what Justin did with his time and perhaps find ways to help
him become more efficient.
The following discussion at a textile company that makes jeans demonstrates important issues about the
difficulty with traditional cost allocation methods and the advantages of activity-based costing. The participants are
concerned about their company's ability to compete with foreign manufacturers that have lower labor costs. Many
people in the company believe the company's managerial accounting system provides inadequate information. In
this discussion, George, a managerial accountant, reports on his recent study of activity-based costing.
A broader perspective:
HP
When a division of Hewlett-Packard Company introduced the just-in-time production method, the
accountants found their traditional methods of cost accounting were no longer applicable. Reducing
the work in process and finished goods inventories meant the accountants no longer needed to keep
detailed records for inventory valuation.
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20. Using accounting for quality and cost management
Lowering inventories to immaterial levels for financial reporting purposes reduces the amount of
accounting time required to make journal entries to transfer costs between inventory accounts. This
Hewlett-Packard plant saved an estimated 100,000 journal entries per month by simplifying the
accounting for work in process inventories.
JIT did not eliminate the need for product costing. Managers needed to know how much products
cost so they could make decisions, plan, and evaluate performance. After simplifying inventory
accounting at the Hewlett-Packard plant, the accountants turned their attention to providing better
information in a form managers could understand and use. The accountants found their new role in
helping managers plan and control production exciting and challenging.
Source: Authors' research.
George (managerial accountant): I have been reading a lot of articles about companies like Ford and HP
that have discovered major problems with their cost systems. Their symptoms are similar to ours. Namely, they
cannot lower prices to be competitive on high-volume products, and their profits are shrinking.
Pam (company president): That sounds like us! What are they doing about it?
George: Well, they are putting in a new type of cost system called activity-based costing, or ABC for short. This
system gives more detailed and better estimates of product costs, which helps their friends in marketing set prices.
Applying this to ourselves, we may find, for example, that activity-based costing could reveal that the cost of skirts
is lower than we thought, meaning we could lower our prices.
Lynn (vice president of marketing): That would be good news, but I thought costs were pretty cut-and-
dried. How can a product cost less under one cost system than under another?
George: Actually, Lynn, the product does not cost less under one system or another. Our problem is that no
cost system measures costs perfectly. We are able to trace some costs directly to the product. For example, we are
pretty accurate in measuring the cost of denim, which is a direct material, in each of our shirts, pants, jackets, and
so forth.
Overhead costs are another matter. Overhead includes costs like electricity to run machines and salaries of
product designers and inspectors. All these costs are allocated to products. We know quality control inspectors cost
money, but we do not know how much of that cost is caused by a particular jacket or pair of pants. So we make
some assumptions about the relation between products and overhead costs. For example, we typically allocate
overhead based on machine-hours required to stitch and fasten snaps. While that is probably a reasonable way to
allocate the costs of electricity to run machines, its not a desirable way to allocate the cost of quality control
inspectors.
Pam: As I understand it, overhead allocation is somewhat arbitrary. How will activity-based costing help?
George: Activity-based costing provides more accurate information because we can identify which activities
cause costs, and we can determine the cost of the activity. Activity-based costing identifies and measures the costs
of performing the activities that go into a product much better than traditional cost methods. For example, if a
particular jacket requires 10 inspections for a production run of 1,000 jackets, we figure out the cost of those
inspections and assign that cost to the production run for this particular jacket.
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Martha (vice president of production): That makes sense to me. But exactly how would activity-based
costing help us cut production costs?
George: Once we identify activities that cause costs, we can eliminate or modify costly activities. For example, if
we find that a jacket requires too many costly inspections, we could redesign the jacket to reduce the need for
inspections. Our current cost system allocates all overhead costs, including inspection costs, to products based on
machine-hours. We really do not know how much it costs to make an inspection and how much inspection cost is
required by each product.
Pam: George, why have you not used activity-based costing before?
George (feeling somewhat defensive): Because activity-based costing provides more information, it takes
more time than traditional cost systems. New accounting methods sound great in theory, but there must be enough
benefit from improved management decisions to justify the additional work required to provide numbers. Until
now, I did not think activity-based costing would pass a cost-benefit test.
Pam: I see many benefits in better pricing, reducing the costs of high-cost activities, and possibly dropping
some products if we learn that their costs are too high. Our long-term strategy calls for new product lines in new
markets where we are low-cost, low-price producers. We need the best cost information we can get to succeed in
those markets. George, what do you need to get started developing an activity-based costing system for us?
George: I need a lot of support. Installing a new cost system requires teamwork between management,
accounting, marketing, engineering, production, purchasing, and everybody else. This is not something to be done
in an ivory tower.
Remember these important points about activity-based costing:
• The allocation of indirect costs is at least somewhat arbitrary, even using sophisticated accounting
methods.
• Activity-based costing provides more detailed measures of costs than traditional allocation methods.
• Activity-based costing can help marketing people by providing more accurate product cost numbers for
decisions about pricing and which unprofitable products the company should eliminate.
• Production also benefits because activity-based costing provides better information about the cost of each
activity. In practice, ABC helps managers identify cost-causing activities. To manage costs, production
managers learn to manage the activities that cause costs.
• Activity-based costing provides more information about product costs than traditional methods but
requires more record-keeping. Managers must decide whether the benefits or improved decisions justify the
additional record-keeping cost.
• Installing activity-based costing requires teamwork among accountants, production managers, marketing
managers, and other nonaccounting people.
Next, we discuss the methods used for activity-based costing and illustrate them with an example.
Methods used for activity-based costing
Activity-based costing requires accountants to use the following four steps:
• Identify the activities that consume resources and assign costs to those activities. Purchasing materials
would be an activity, for example.
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20. Using accounting for quality and cost management
• Identify the cost drivers associated with each activity. A cost driver is an activity or transaction that
causes costs to be incurred. For the purchasing materials activity, the cost drivers could be the number of
orders placed or the number of items ordered. Each activity could have multiple cost drivers.
• Compute a cost rate per cost driver unit. The cost driver rate could be the cost per purchase order, for
example.
• Assign costs to products by multiplying the cost driver rate times the volume of cost driver units consumed
by the product. For example, the cost per purchase order times the number of orders required for Product A
for the month of December would measure the cost of the purchasing activity for Product A for December.
The next section describes these four steps.
Step one is often the most interesting and challenging part of the exercise. This step requires people to
understand all of the activities required to make the product. Imagine the activities involved in making a simple
product like a pizza—ordering, receiving and inspecting materials, making the dough, putting on the ingredients,
baking, and so forth. Or imagine the activities involved in making a complex product such as an automobile or
computer.
Complexity as an activity that consumes resources One of the lessons of activity-based costing has been
that the more complex the business, the higher the indirect costs. Imagine that each month you produce 100,000
gallons of vanilla ice cream and your friend produces 100,000 gallons of 39 different flavors of ice cream. Further,
assume your ice cream is sold only in one liter containers, while your friend sells ice cream in various containers.
Your friend has more complicated ordering, storage, product testing (one of the more desirable jobs, nevertheless),
and packing in containers. Your friend has more machine setups, too. Presumably, you can set the machinery to one
setting to obtain the desired product quality and taste. Your friend has to set the machines each time a new flavor is
produced. Although both of you produce the same total volume of ice cream, it is not hard to imagine that your
friend's overhead costs would be considerably higher.
In Exhibit 162, we present several examples of the cost drivers companies use. Most cost drivers are related to
either the volume of production or to the complexity of the production or marketing process. In deciding which cost
drivers to use, managers consider these three factors:
Cost driver Cost of assigned cost driver Miles driven Automobile costs Machine-hours Electricity to run machines Customers served Overhead in a bank Flight hours Airplane maintenance costs Number of customers Selling costs
Exhibit 162: Cost drivers
• Causal relation. Choosing a cost driver that causes the cost is ideal. For example, suppose students in
biology classes are messier than students in history classes. As a result, the university does more maintenance
per square foot in biology classrooms and labs than in history classrooms. Further, it is possible to keep track
of the time maintenance people spend cleaning classrooms and labs. The university could assign maintenance
costs based on the time spent in history classrooms and in biology classrooms and labs, respectively, to the
history and biology departments.
• Benefits received. Choose a cost driver so costs are assigned in proportion to benefits received. For
example, if the physics department in a university benefits more from the university's supercomputer than the
German department does, the university should select a cost driver that recognizes such differences in
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benefits. The cost driver could be the number of faculty and/or students in each department who use the
computer.
• Reasonableness. Some costs that cannot be linked to products based on causality or benefits received are
assigned on the basis of reasonableness.
In general, predetermined rates for allocating indirect costs to products are computed as follows:
Predetermined indirect cost rate= Estimated indirect cost
Estimated volume of the allocation base
This formula applies to all indirect costs, whether manufacturing overhead, administrative costs, distribution
costs, selling costs, or any other indirect cost.
Using activity-based costing, we first define the notion of an activity center. An activity center is a unit of the
organization that performs some activity. For example, the costs of setting up machines would be assigned to the
activity center that sets up machines. This means that each activity has associated costs. When the cost driver is the
number of inspections, for example, the company must keep track of the cost of inspections.
Workers and machines perform activities on each product as it is produced. Accountants allocate costs to
products by multiplying each activity's indirect cost rate by the volume of activity used in making the product.
The following example illustrates how unit costs are computed when companies use activity-based costing. We
contrast the results using activity-based costing to those using a departmental rate.
Assume High Challenge Company makes two products, touring bicycles and mountain bicycles. The touring
bicycles product line is a high-volume line, while the mountain bicycle is a low-volume, specialized product.
Traditional costing method Using a traditional costing method, assume that High Challenge Company
followed this procedure to allocate manufacturing overhead costs to the two products for the month of January
2011.
• Managers and accountants developed an overhead rate based on the following data for 2011:
Overhead for department A for 2011 $2,000,000 Machine-hours worked during 2011 in department A
20,000 hours
Department A overhead rate ($2,000,000/20,000 hours)
$100 per machine- hour
• To compare activity-based costing with the company's traditional method, the accountants selected the
month of January to study. At the end of January 2011 the following information was available for the month:
Actual machine-hours used in January 2011: Touring bicycle products 1,500 Mountain bicycle products 500 Total 2,000
• Using a traditional costing method, accountants then allocated overhead to the products worked on in
January using the overhead rate of USD 100 per machine-hour times the machine-hours worked on each
product in Department A during January:
Overhead allocated to products worked on in January: Touring bicycles ($100 x 1,500 hours) $150,000 Mountain bicycles ($100 x 500 hours) 50,000 Total overhead $200,000
In using activity-based costing, the company identified four activities that were important cost drivers and a cost
driver used to allocate overhead. These activities were (1) purchasing materials, (2) setting up machines when a new
product was started, (3) inspecting products, and (4) operating machines.
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20. Using accounting for quality and cost management
Accountants estimated the overhead and the volume of events for each activity. For example, management
estimated the company would purchase 100,000 pieces of materials that would require overhead costs of USD
200,000 for the year. These overhead costs included salaries of people to purchase, inspect, and store materials.
Consequently, each piece of material used to make a product would be assigned an overhead cost of USD 2.00 (USD
200,000/100,000 pieces).
These estimates made in 2010 were used during all of 2011. In practice, companies most frequently set rates for
the entire year, although some set rates for shorter periods, such as a quarter. Look at the overhead rates computed
for the four activities in Exhibit 163. Note that the total overhead for 2011 is USD 2,000,000 using activity-based
costing, just as it was using a traditional costing method. The total amount of overhead should be the same whether
using activity-based costing or traditional methods of cost allocation to products. The primary difference between
activity-based costing and the traditional allocation methods is the amount of detail; particularly, the number of
activities used to assign overhead costs to products. Traditional allocation uses just one activity, such as machine-
hours. Activity-based costing used four activities in this case. In practice, companies using activity-based costing
generally use more than four activities because more than four activities are important. We used four to keep the
illustration as simple as possible. (Many companies that use traditional allocation methods use just one activity, as
we have in this example.)
(1) (2) (3) (4) (5) Activity Cost driver used to
allocate overhead cost driver
Overhead cost for the activity
Cost driver units for 2011
Rate: column (3)/column (4)
1. Purchasing materials
Pieces of materials in each unit
$ 200,000 100,000 pieces $2/piece
2. Machine setups Machine setups 800,000 400 setups $2,000/setup 3. Inspections Inspection hours 400,000 4,000 hours $100/hour 4. Running machines
Machine-hours 600,000 20,000 $30/hour
Total overhead $ 2,000,000
Exhibit 163: Overhead rates for activity-based costing
For January 2011, the High Challenge Company has the following information about the actual number of cost
driver units for each of the two products:
Touring bicycles
Mountain bicycles
1. Purchasing materials 6,000 pieces
4,000 pieces
2. Machine setups 10 setups 30 setups 3. Inspections 200 hours 200 hours 4. Running machines 1,500
hours 500 hours
Multiplying the actual activity events for each product times the predetermined rates computed earlier resulted
in the overhead allocated to the two products shown in Exhibit 164.
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Touring Bicycles Mountain Bicycles Activity Rate Actual
cost driver units
Cost allocated to Product
Actual cost driver units
Cost allocated to product
1. Purchasing materials$2/piece 6,000 pieces
$12,000 4,000 pieces
$ 8,000
2. Machine setups $2,000/setup10 setups 20,000 30 setups 60,000 3. Inspections $100/hour 200 hours 20,000 200 hours 20,000 4. Running machines $30/hour 1,500
hours 45,000 500 hours 15,000
Total cost allocated to each product
$97,000 $ 103,000
Exhibit 164: Overhead costs assigned to products using activity-based costing
Now we can compare the overhead allocated to the two product lines using the traditional method and activity-
based costing, as follows:
Touring bicycles
Mountain bicycles
Traditional method $150,000 $50,000 Activity-based costing 97,000 103,000
Unit costs Assume High Challenge Company produced 1,000 units of touring bicycles and 200 units of
mountain bicycles in January. The direct materials cost is USD 100 per unit for touring bicycles and USD 200 per
unit for mountain bicycles. Direct labor cost is USD 20 per unit for touring bicycles and USD 30 per unit for
mountain bicycles. Comparing the overhead allocations using the department allocation and the activity-based
costing allocation reveals the differences in unit costs, as we show in Exhibit 165.
Traditional Costing Activity-based Costing Touring bicycles
Mountain bicycles
Touring bicycles
Mountain bicycles
Direct materials $ 100 $200 $100 $200 Direct labor 20 30 20 30 Overhead 150a 250b 97 515d
Total $270 $480 $217 $745 A $150 = overhead cost allocation to products using departmental rate divided by number of units produced = $150,000/1,000 units. B $250 = overhead cost allocation to products using departmental rate divided by number of units produced = $50,000/200 units. C $97 = overhead cost allocation to products using activity-based costing divided by number of units produced = $97,000/1,000 units. D $515 = overhead cost allocation to products using activity-based costing divided by number of units produced = $103,000/200 units.
Exhibit 165: Comparison of product costs using traditional costing and activity-based costing
Analysis More overhead is allocated to the lower volume mountain bicycles using activity-based costing. The
mountain bicycles are allocated more overhead per unit primarily because activity-based costing recognizes the
need for more setups for mountain bicycles and for as many inspection hours for the more specialized mountain
bicycles as for the higher volume touring bicycles. By failing to assign costs to all of the activities, touring bicycles
were subsidizing mountain bicycles. Many companies have found themselves in similar situations. Activity-based
costing has revealed that low-volume, specialized products have been the cause of greater costs than managers had
realized.
Impact of new production environment on cost drivers
When cost systems were first developed in industry, companies were far more labor intensive than they are
today. The majority of the overhead cost was related to the support of labor, so it made sense to allocate overhead to
products based on the amount of labor in the products. Labor is still a major product cost in many companies,
especially service organizations such as public accounting firms. Often they allocate overhead to products (which
are called jobs) on the basis of the amount of labor in the product.
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20. Using accounting for quality and cost management
As manufacturers and service companies have become more automated, direct labor has become less
appropriate as a basis for allocating overhead. Direct labor has shrunk to less than 5 per cent of product costs in
many companies and overhead has increased. Thus, companies that continue to allocate overhead to products
based on direct labor are seeing rates increase as high as 500 per cent or more. (Some overhead rates are more than
1,000 per cent of direct labor costs.)
When labor is such a small part of product costs, there is little—if any—relationship between labor and
overhead. Further, small errors in assigning labor to products are magnified many times when overhead rates are
several hundred per cent of labor costs, or more.
Finally, allocating overhead on the basis of direct labor sends signals that direct labor is more expensive than it
really is. This also creates tremendous incentives to reduce the labor content of products. While this may be
desirable in particular circumstances, such decisions should be based on accurate cost numbers, not numbers
heavily biased because of an arbitrary cost allocation method.
Activity-based costing in marketing
Activity-based costing is not limited to the cost of producing goods and services; companies also apply it to
marketing or administrative activities. The principles and methods are the same as discussed earlier: (1) identify
activities or cost drivers, (2) compute an indirect cost rate for each activity, and (3) allocate indirect costs by
multiplying the indirect cost rate for each activity by the volume of activities.
Instead of computing a cost of production, however, accountants compute a cost of performing an
administrative or marketing service. Tissue products, for example, can be sold to grocery stores, convenience
stores, the industrial market, and other channels of distribution. Each channel has different activities:
• Convenience stores would require many shipments in small orders and considerable marketing support.
• Grocery stores would require relatively large shipments, a variety of products, and considerable marketing
support.
• Industrial users would involve brokers, minimum marketing support, and large orders.
Information on the cost of alternative channels of distribution is useful to marketing managers who make
decisions about which channel to use. In this case, obvious cost drivers would include the number of shipments per
period, size of shipment, number of products in a shipment, and measures of merchandising support.
Strategic use of activity-based management
Many believe activity-based costing offers strategic opportunities for companies. One of the key ways companies
develop a competitive advantage is by becoming low-cost producers or sellers. Companies such as Wal-Mart Stores
in retailing, UPS in delivery services, and Southwest Airlines in the airline industry have created competitive
advantages by reducing costs. Professor Michael Porter of the Harvard Business School, among others, has pointed
out that certain companies have learned to use the information they have gained from their cost systems to make
substantial price cuts to increase market share.
Activity-based costing plays an important role in companies' strategies and long-range plans to develop a
competitive cost advantage. Activity-based costing focuses attention on activities. Cost reduction generally requires
a change in activities. Although top management can send notices asking company employees to reduce costs, the
implementation requires a change in activities. If you have been in school during a period when education costs
were cut, you know that achieving the cut required a change in activities such as canceled classes, larger class sizes,
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and reduced services. It is impossible to know the effect of a change in activities on costs without the cost
information provided by activity-based costing.
Behavioral and implementation issues
Accountants cannot implement activity-based costing without becoming familiar with the operations of the
company. In identifying activities, accountants team up with management and people from production,
engineering, marketing, and other departments in identifying the activities that drive the company's costs. This
often creates discomfort at first as accountants are forced to deal with unfamiliar areas; in the long run their
familiarity with the company's operating activities can improve their contribution to the company. Nonaccounting
personnel also feel a greater sense of ownership of the numbers reported by the accounting system so accounting
improves its credibility among nonaccountants.
One of the problems encountered when implementing activity-based costing is the failure to get influential
people in the organization to buy into the process. Accounting methods in companies are like rules in sports; people
become accustomed to playing by the rules and oppose changing to something unknown.
For example, two analysts at one company spent several months of their time and hundreds of hours of
computer time to develop an activity-based costing system. Their analysis revealed several hundred products that
were clearly unprofitable and should be eliminated. However, the key managers who made product elimination
decisions agreed to drop only about 20 products. Why? The analysts had failed to talk to these key managers early
in the process. When presented with the final results, these managers raised numerous objections that the analysts
had not anticipated. Moral: If you are involved in trying to make a change, get all of the people who are important
to that change to buy into the process early.
Opportunities to improve activity-based costing in practice
The use of activity-based costing in industry is relatively new. Companies are continually encountering
limitations and finding ways to improve activity-based costing. A philosopher once said that our knowledge is like a
circle; the more we know, the larger the circle. But the larger the circle, the greater its boundary and the more we
realize the limits of our knowledge. Activity-based costing has shown managers they have much to learn about the
cost of the activities required to make their products.
Understanding the learning objectives
• The new production environment refers to an environment in which company managers are concerned
with (1) improving quality and (2) reducing costs. Accounting information can help managers assess the costs
of quality and reduce the costs of making products.
• Three methods managers use to identify quality problems are control charts, Pareto diagrams, and cause
and effect analyses.
• Knowing the four costs of quality—prevention, appraisal, internal failure, and external failure—can help
managers minimize the cost of quality while providing high-quality products to customers.
• Four such measures are quality control, delivery performance, materials waste, and machine downtime.
• Managers can use benchmarking to focus attention on measuring how well one is doing against levels of
performance either inside or outside of the organization.
• The balanced scorecard is a set of performance targets and results that show an organization's performance
in meeting its stakeholder objectives.
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20. Using accounting for quality and cost management
• JIT substantially reduces or eliminates the need for inventories and improves quality by eliminating the
flexibility provided by inventories. Products must be produced properly the first time.
• Just-in-time accounting procedures normally debit all costs directly to cost of goods sold and bypass the
usual inventory accounts. When it is necessary to report inventories in financial statements, the inventory
amounts are backed out of the Cost of Goods Sold account.
• Activity-based costing is a costing method that assigns costs to activities and then to the products based on
each product's use of activities. Activity-based costing is based on the premise that products consume
activities; activities consume resources.
• Companies benefit from activity-based costing because managers have more detailed information about the
cost of activities and better product cost information.
• First, identify the activities that consume resources and assign costs to those activities. Second, identify the
cost drivers associated with each activity. Third, compute a cost rate per cost driver unit. Fourth, assign costs
to products by multiplying the cost driver rate times the volume of cost driver units consumed by the product.
• In many companies, activity-based costing has revealed that low-volume, specialized products have been
more costly than managers had realized.
• By focusing attention on activities that cause costs, activity-based management helps managers eliminate
activities that consume resources, thereby becoming more efficient and competitive.
Demonstration problem
To continue the text example, consider December 2011 for High Challenge Company. Recall that the
departmental overhead rate for 2011 was USD 100 per machine-hour. The following information for December is
available:
Touring bicycles
Mountain bicycles
Machine-hours 2,000 1,000 Units 1,300 400 Activities 1. Purchasing materials 10,000
pieces 10,000 pieces
2. Machine setups 15 setups 40 setups 3. Inspections 200 hours 400 hours 4. Running machines 2,000
hours 1,000 hours
Compute the costs in total and per unit for touring bicycle and mountain bicycle products using both the
traditional method based on machine-hours to allocate overhead and the activity-based costing rates. The actual
activity levels for December are given in this problem; however, you should use the rates presented earlier in the
text. Do not assume that the total overhead assigned to products for December using activity-based costing
necessarily equals the total overhead allocated using the departmental allocation rate. Assume the direct materials
costs are USD 100 and USD 200 per unit for touring bicycles and mountain bicycles, respectively; and direct labor
costs are USD 20 and USD 30 per unit, respectively. Production was 1,300 touring bicycles and 400 mountain
bicycles. Round unit costs to the nearest dollar.
Solution to demonstration problem
Overhead costs allocated to products using the traditional method:
Touring bicycles ($100 x 2,000 machine- hours)
$200,000
Mountain bicycles ($100 x 1,000 machine- 100,000
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hours) Total $300,000
Overhead costs assigned to products using activity-based costing:
Touring Bicycles Mountain Bicycles Activity Rate Actual cost
driver units Cost allocated to product
Actual cost driver units
Cost allocated to product
1. Purchasing materials$2/piece 10,000 pieces $ 20,000 10,000 pieces $ 20,000 2. Machine setups $2,000/setup 15 setups 30,000 40 setups 80,000 3. Inspections $100/hour 200 hours 20,000 400 hours 40,000 4. Running machines $30/hour 2,000 hours 60,000 1,000 30,000 Total cost allocated to each product
$ 130,000 $ 170,000
Comparison of product costs using traditional costing and activity-based costing:
Traditional Costing Activity-based Costing Touring bicycles
Mountain bicycles
Touring bicycles
Mountain bicycles
Direct materials $100 $200 $100 $200 Direct labor 20 30 20 30 Overhead 154a 250b 100c 425d
Total $274 $480 $220 $655 A $154 = overhead cost allocation to products using departmental rate divided by number of units produced = $200,000/1,300 units. B$250 = overhead cost allocation to products using departmental rate divided by number of units produced = $100,000/400 units. C $100 = overhead cost allocation to products using activity-based costing divided by number of units produced = $130,000/1,300 units. D $425 overhead cost allocation to products using activity-based costing divided by number of units produced = $170,000/400 units.
Key terms Activity-based costing A costing method that first assigns costs to activities, then assigns costs to products based on their consumption of activities.
Activity center An activity center is a unit of the organization that performs some activity.
Backflush costing Backflush costing is a method of assigning costs to inventories backwards from Cost of Goods Sold to Work in Process or Finished Goods Inventory accounts.
Balanced scorecard A set of performance targets and results that show an organization's performance in meeting its responsibilities to various stakeholders.
Benchmarking Benchmarking is the continuous process of measuring how well one is doing against performance levels either inside or outside of the organization.
Cause-and-effect analysis Cause-and-effect analysis identifies potential causes of defects.
Control charts Control charts help managers distinguish between random or routine variations in quality and variations that they should investigate.
Cost driver A cost driver is an activity or transaction that causes costs to be incurred.
Just-in-time (JIT) method The just-in-time method manages purchasing and production so that materials are purchased just in time for production, parts are produced just when needed for the next step in the production process, and finished goods are completed just in time for sale.
Pareto diagrams Pareto diagrams indicate how frequently each type of failure occurs.
Total quality management (TQM) Defined as managing the entire organization so it excels in its goods and services that are important to the customer.
Self-test
True-false
Indicate whether each of the following statements is true or false.
In Texas Instruments' cost of quality program, the managers' task was to maximize the sum of prevention,
appraisal, internal failure, and external failure costs.
Control charts are a means of distinguishing between random or routine variation in product quality and
variations that managers should investigate.
The allocation of indirect costs is never arbitrary.
A cost driver is an activity or transaction that causes costs to be incurred.
Accounting Principles: A Business Perspective 819 A Global Text
20. Using accounting for quality and cost management
The formula for computing an indirect cost rate has the cost in the numerator and the volume of the cost driver
or allocation base in the denominator.
Multiple-choice
Select the best answer for each of the following questions.
The new production environment refers to an environment in which company managers are concerned with:
a. Improving customer service and product quality.
b. Reducing costs.
c. Increasing government regulation.
d. a and b above.
e. All of the above.
Just-in-time production and purchasing methods:
a. Must be used in conjunction with activity- based costing.
b. Require government regulation.
c. Eliminate the need for inventories in theory because production does not take place until it is known the item
will be sold.
d. Require the use of Pareto charts.
e. All of the above.
UR Company has two products, U and R. Overhead costs are presently allocated to the two products based on
the labor-hours used to produce each product. It takes one labor-hour to make one unit of each product. The chief
financial officer has suggested converting to activity-based costing. She collected the data shown below for three
cost drivers and activities to be used under activity-based costing:
Cost driver
Volume
Activity Cost driver Amount U R Production Number of setups $82,000 8 12 Quality control Number of inspections 48,000 56 24 Packaging costs Number of units
produced 130,000 80,000 50,000
Total overhead $260,000
What is the total overhead allocated to Product U using the current method of allocating overhead based on
labor-hours (80,000 labor-hours for U and 50,000 labor-hours for R)?
a. USD 113,600.
b. USD 130,000.
c. USD 146,400.
d. USD 160,000.
e. None of the above.
Refer to the facts for in the above question. What is the overhead per unit assigned to Product R using activity-
based costing? (Round to the nearest cent.)
a. USD 2.60.
b. USD 2.27.
c. USD 2.00.
d. USD 1.83.
e. None of the above.
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Now turn to “Answers to self-test” at the end of the chapter to check your answers.
Questions
➢ To what does the phrase new production environment refer?
➢ Explain the purpose of using control charts, Pareto diagrams, and cause and effect analyses. You may
find it useful to use examples.
➢ Audio Company makes compact disc players. After producing a compact disc player, the company
tests it, then scraps it because it does not work. Is this an example of an internal failure cost, an
appraisal cost, or a prevention cost?
➢ A company's performance measure is the number of customer complaints. Why would the company
measure the number of customer complaints?
➢ A company's performance measure is the percentage of time that machines are not working. Why
would the company measure the percentage of time that the machines are not working?
➢ How could reducing materials waste during production improve the quality of products?
➢ What is benchmarking? Give an example of benchmarking that you might use.
➢ What is the benefit to American Airlines of benchmarking on-time airplane arrivals?
➢ How does just-in-time help assure quality of production?
➢ Elimination of inventories through a just-in-time (JIT) method is believed to result in different types
of cost savings. Give an example of a type of savings from JIT.
➢ What is the difference between accounting for costs using a JIT method and using traditional cost
flows through inventory accounts?
➢ What operating conditions are necessary for a company to make use of a JIT method?
➢ What is the difference between activity-based costing and activity-based management?
➢ Activity-based costing methods use four steps in computing a product's cost. What are these steps?
➢ "Activity-based costing is great for manufacturing plants, but does not really address the needs of the
service sector." Do you agree with this statement? Explain.
➢ What is a cost driver? Give three examples.
➢ The vice president of marketing wonders how products can cost less under one cost system than
under another. How would you respond to her question "Are not costs cut-and-dried?"
➢ A drawback to activity-based costing is that it requires more record-keeping and extensive teamwork
between all departments. What are the potential benefits of a more detailed product cost system?
➢ Give three criteria for choosing cost drivers for allocating costs to products.
➢ "Activity-based costing is for accountants and production managers. I plan to be a marketing
specialist so ABC will not help me." Do you agree with this statement? Explain.
➢ Observe the workings of a food service or coffee house. What activities are being performed? Give
examples of some cost drivers that cause the cost of those activities. (For example, cooking food is an
activity; the number of meals could be a cost driver for the cooking activity.)
➢ Observe the workings of a bank, credit union, or savings and loan institution. What activities are
being performed? Give examples of some cost drivers that cause the cost of those activities. (For
Accounting Principles: A Business Perspective 821 A Global Text
20. Using accounting for quality and cost management
example, opening checking accounts is an activity; the number of accounts opened could be a cost
driver for the opening accounts activity.)
➢ Activity-based costing assigns costs to activities that consume resources and to the products based on
each product's use of activities. What is a benefit of this approach compared to a traditional approach
that allocates costs to products based on the machine-hours used to produce the product?
➢ What is a balanced scorecard?
➢ Real world question Refer to the discussion “A broader perspective: HP” of the impact of just-in-
time on accounting methods at HP. What effect did the implementation have on the HP plant's
accounting methods?
➢ Real world question Why might Domino's Pizza make such a big deal out of delivering pizzas
within 30 minutes?
Exercises
Exercise A Classify Curly Company's costs for a typical month into prevention costs, appraisal costs, internal
failure costs, and external failure costs:
Inspection at the end of the production process
$10,000
Scrap 9,000 Design work to improve the way products are made
12,000
Cost of customer complaints 20,000 Employee training 6,000 Incoming materials inspection 5,000
Suppose Curly Company could increase employee training by USD 7,500 per month, and thereby reduce
internal failure and external failure costs by 20 per cent each per month. (Appraisal costs would not be affected.)
Would this be a wise thing for Curly Company to do?
Exercise B You have been hired by a food service organization on campus to help assess the quality of food
services in the student union building. The following food service information is for the month of February:
Customer complaints 60 Waste as a percentage of total food prepared
10%
Cases of food poisoning 2
What additional information would you like to have to assess the quality of the food service organization's
performance?
Exercise C Network, Inc., manufactures networking devices for personal computer systems, using just-in-time
methods. After receiving an order for 300 devices, the company bought materials (for cash) costing USD 14,000 to
fill this order. It incurred labor and overhead costs of USD 48,000, of which USD 10,000 was for wages and the rest
overhead.
After the production was finished, but before all goods were sold, the company needed to compute an inventory
cost for financial statement purposes. The cost of finished goods inventory was USD 2,480.
a. Use T-accounts to show the flow of costs under a traditional costing system.
b. Prepare journal entries for these transactions using backflush costing.
c. Use T-accounts to show the flow of costs using a JIT system with backflush costing.
Exercise D Quality Sound Corporation produces two types of compact discs (CDs), one is to install on touring
bicycles and the other is a high-grade product for home and car use. The touring bicycles' CDs are designed for
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durability rather than accurate sound reproduction. The company only recently began producing the high-grade
disc. Management believes the accounting system may not be accurately allocating costs to products.
Management asked you to investigate the cost allocation problem. You found that manufacturing overhead is
currently assigned based on the direct labor costs in the products. For your investigation, you are using data from
last year. Last year's manufacturing overhead was USD 440,000 based on production of 320,000 touring bicycle
CDs and 100,000 high-grade CDs. Direct labor and direct materials costs were as follows:
Touring bicycle
High grade
Total
Direct labor $180,000 $60,000 $240,000 Materials 120,000 112,000 232,000
Management believes three activities cause overhead costs. The cost drivers and related costs for your analysis
are as follows:
Activity Level Cost drivers Cost assigned Touring
bicycle High grade
Total
Number of production runs $200,000 40 10 50 Quality tests performed 180,000 12 18 30 Shipping orders processed 60,000 100 50 150 Total overhead $440,000
a. How much of the overhead would be assigned to each product if the three cost drivers are used to allocate
overhead? What would be the cost per unit (including materials, labor, and overhead) for each product if overhead
is assigned to products using the three cost drivers?
b. How much of the overhead would be assigned to each product if direct labor costs had been used as the basis
for allocating overhead to each product? What would be the cost per unit (including materials, labor, and overhead)
for each product if overhead is allocated to products using direct labor cost as the allocation base?
Exercise E Landscape, Inc., is a lawn and garden service. The company originally specialized in serving small
residential clients; recently it has started contracting for work on larger office building grounds.
Employees worked a total of 10,000 hours last year, 6,500 on residential jobs and 3,500 on commercial jobs.
Wages amounted to USD 10 per hour for all work done. Materials used are included in overhead and called
supplies. All overhead is allocated on the basis of labor-hours worked, which is also the basis for customer charges.
Landscape, Inc., can charge USD 30 per hour for residential work but, because of greater competition for
commercial accounts, only USD 20 per hour for commercial work.
a. Using labor-hours as the basis for allocating overhead, what was the gross margin (revenues minus labor and
overhead expense) for (1) commercial and (2) residential service? Assume overhead was USD 50,000.
b. Overhead consists of transportation, lawn mowing and landscaping equipment costs, depreciation on
equipment, supplies, fuels, and maintenance. These costs can be traced to the following activities:
Activity Level Activity Cost driver Cost Commercial Residential Transportation Clients served $10,000 15 45 Equipment costs: Fuel, maintenance, depreciation
Equipment hours
25,000 3,000 2,000
Supplies Square yards serviced per year
15,000 100,000 50,000
Total overhead $50,000
Recalculate gross margin for commercial and residential services based on these cost driver bases.
Accounting Principles: A Business Perspective 823 A Global Text
20. Using accounting for quality and cost management
c. Would you advise Landscape, Inc., to drop either the residential or commercial service based on your
analysis? Explain.
Problems
Problem A Here are cost items from Huskie Company's accounts for a typical month:
Inspection at the end of the production process $80,000 Cost of returned goods 36,000 Design work to improve the way products are made
48,000
Repairs to satisfy customer complaints 20,000 Employee training 24,000 Incoming materials inspection 20,000 Scrap 36,000
a. Classify these items into prevention costs, appraisal costs, internal failure costs, and external failure costs.
b. Suppose Huskie Company could spend an additional USD 40,000 per month on design work to improve the
way products are made, and thereby reduce internal failure and external failure costs by 30 per cent each per
month. (Appraisal costs would not be affected.) Would this be a wise thing for Huskie Company to do?
c. Give two examples of additional nonfinancial quality measures that Huskie Company could use to help
improve quality. (Hint: See Exhibit 159.)
Problem B You have been hired by Bucks 'R' Us Bank to help assess the quality of their services. This
information is for the month of March:
Customer complaints 60 Average customer waiting time 22 minutes Number of lost files 2 Lawsuits filed against the bank 1
What additional information would you like to have to assess the quality of the bank's performance?
Problem C Heatseek Precision Instruments produces sensitive heat measurement meters. The company has a
large backlog of orders and no beginning inventories because all units in production last year were sold by the end
of the year. At the start of this year, an order was received for 2,000 meters.
The company purchased and used USD 105,000 of materials in production for this order. Direct labor costs of
USD 320,000 were incurred, and overhead costs of USD 520,000 were applied. Goods representing 10 per cent of
these costs were still in finished goods inventory at the end of the period.
a. Use T-accounts to show the flow of costs under a traditional costing system.
b. Prepare journal entries for these transactions using backflush costing.
c. Use T-accounts to show the flow of costs using a JIT system with backflush costing.
Problem D C & W Corporation manufactures travel clocks and watches. Overhead costs are currently allocated
using direct labor-hours, but the controller has recommended using an activity-based costing system based on the
following data:
Activity Level Activity Cost driver Cost Travel
clocks Watches
Production setup Setups $100,000 20 30 Material handling and requisition
Parts 30,000 24 36
Packaging and shipping Units shipped 60,000 80,000 120,000 Total overhead $190,000
a. Compute the amount of total overhead allocated to each of the products under activity-based costing.
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b. Compute the amount of total overhead allocated to each product using labor-hours as the allocation base.
Assume labor-hours required to assemble each unit are .5 per travel clock and 1.0 per watch, and that 80,000 travel
clocks and 120,000 watches were produced.
c. Should the company follow the controller's recommendations?
Problem E Sunshield Company makes three types of sunglasses: Nerds, Stars, and Fashions. Sunshield
presently allocates overhead to products using a rate based on direct labor-hours. A consultant recommended that
Sunshield switch to activity-based costing. Management decided to give ABC a try and identified the following
activities, cost drivers, and costs for a typical year for each activity center. Use this information to compute the
overhead rates for each cost driver.
Activity Recommended cost driver
Costs Cost driver units
Production setup Production runs $ 30,000 100 Order processing Orders 50,000 200 Materials handling Pounds of
materials used 20,000 8,000
Equipment depreciation and maintenance
Machine-hours 60,000 10,000
Quality management Inspections 50,000 40 Packing and shipping Units shipped 40,000 20,000 Total overhead $250,000
In addition, there are 2,500 direct labor-hours in a typical year.
Assume the following activities occurred in February of 2011:
Nerds Stars Fashions Units produced 1,000 500 400 Direct materials costs $4,000 $2,500 $2,000 Direct labor-hours 100 100 89 Orders 8 8 4 Production runs 2 4 8 Pounds of material 400 200 200 Machine-hours 500 300 300 Inspections 2 2 2 Units shipped 1,000 500 300
Direct labor costs are USD 15 per hour.
a. Compute an overhead allocation rate (1) for each of the cost drivers recommended by the consultant and (2)
for direct labor.
b. Management wants to compare the product costs using ABC and the traditional method for the month of
February. Compute the production costs for each product for February using direct labor-hours as the allocation
base. (Note: Production costs are direct materials, direct labor, and overhead.)
c. To derive product costs under ABC, compute the production costs for each product for February using the cost
drivers recommended by the consultant.
d. Management has seen your numbers and wants to know how you account for the discrepancy between the
product costs using direct labor-hours as the allocation base and using activity-based costing. Write a brief
response to management.
Problem F Filmworks Photography offers two types of services, student portraits and family portraits. Last
year, Filmworks had the following costs and revenues:
Filmworks Photography
Income statement Deluxe Family Total
Accounting Principles: A Business Perspective 825 A Global Text
20. Using accounting for quality and cost management
Revenue $180,000 $200,000 $380,000 Direct materials 25,000 25,000 50,000 Direct labor 90,000 60,000 150,000 Indirect costs: Administration ------- ---------- 25,000 Production setup ------- ---------- 50,000 Quality control ------- ---------- 25,000 Marketing ------- ---------- 20,000 Operating profit $60,000
Filmworks Photography currently uses labor costs to allocate all overhead, but management is considering
implementing an activity-based costing system. After interviewing the sales and production staff, management
decides to allocate administrative costs on the basis of direct labor costs and to use the following bases to allocate
the remaining overhead:
Cost driver Units Activity Cost driver Student Family Production setup Photo sessions 150 250 Quality control Customer inspections 300 200 Marketing Advertisements 60 40
a. Complete the income statement using these activity bases.
b. Write a report describing how management might use activity-based costing to reduce costs.
c. Restate the income statement for Filmworks Photography using direct labor costs as the only overhead
allocation base.
d. Write a report to management stating why product line profits differ using activity-based costing compared to
the traditional approach. Indicate whether the activity-based costing method provides more accurate information
and why (if you believe it does provide more accurate information). Indicate in your report how the use of labor-
based overhead allocation could result in Filmworks Photography management making suboptimal decisions.
Alternate problems
Alternate problem A These cost items are from Rocket Company's accounts for a typical month:
Design work to improve the way products are made
$48,000
Warranty work to satisfy customer complaints 24,000 Employee training 36,000 Incoming materials inspection 40,000 Scrap 36,000 Cost of returned goods 48,000 Inspection at the end of the production process 60,000
a. Classify these items into prevention costs, appraisal costs, internal failure costs, and external failure costs.
b. Suppose Rocket Company could spend an additional USD 40,000 per month on incoming materials
inspection, and thereby reduce internal failure and external failure costs by 20 per cent each per month. Would this
be a wise thing for Rocket Company to do?
c. Give two examples of additional nonfinancial quality measures that Rocket Company could use to help
improve quality. (Hint: See Exhibit 159.)
Alternate problem B You have been hired by Student Health Services to help assess the quality of their
services. You have been looking over the following information for the month of May:
Number of patient complaints 120 Minutes the average patient waits 3.8 Cases of missed diagnosis 4
What additional information would you like to have to assess the quality of the organization's performance?
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Alternate problem C Precision Instruments produces high-tech devices. The company has a large backlog of
orders and had no beginning inventories because all units in production last year were sold by the end of the year.
At the start of this year, the firm received an order for 6,000 items.
The company purchased and used USD 200,000 of materials in production for this order. Direct labor costs of
USD 150,000 and overhead costs of USD 400,000 were incurred. Goods representing 10 per cent of these costs
were still in finished goods inventory at the end of the period.
a. Use T-accounts to show the flow of costs under a traditional costing system.
b. Prepare journal entries for these transactions using backflush costing.
c. Use T-accounts to show the flow of costs using a JIT system with backflush costing.
Alternate problem D The manager of Rafting Excursions uses activity-based costing to compute the costs of
her raft trips. Each raft holds six paying customers and a guide. She offers two types of raft trips, a three-day float
trip for beginners, and a three-day white-water trip for seasoned rafters. The breakdown of costs is as follows:
Activities (with cost drivers) Costs per float trip Costs per white-water trip Advertising (trips) $430 $430 Permit to use the river (trips) 60 100 Equipment use (trips, people) 40 + 10 per person 80 + $16 per person Insurance (trips) 150 300 Paying guide (trips, guides) 600 per guide 800 per guide Food (people) 120 per person 120 per person
a. Compute the cost of a 28-person (including guides) float trip with four rafts and four guides.
b. Compute the cost of a 28-person (including guides) white-water trip with four rafts and four guides.
c. How much should the manager charge each customer if she wants to cover her costs?
Alternate problem E Shoe Express, Inc., manufactures two types of shoes, B-Ball and Marathon. The B-Ball
shoe has a complex design that uses gel-filled compartments to provide support. The Marathon shoe is simpler to
manufacture and uses conventional foam padding. Last year, Shoe Express had the following revenues and costs:
Shoe Express, Inc. Income Statement
B-Ball Marathon Total Revenue $390,000 $368,000 $758,000 Direct materials 110,000 100,000 210,000 Direct labor 80,000 40,000 120,000 Indirect costs: Administration -------- --------- 40,000 Production setup --------- --------- 90,000
--------- --------- Quality control --------- --------- 60,000 Advertising ---------- --------- 120,000 Net income before taxes
$118,000
Shoe Express currently uses labor costs to allocate all overhead, but management is considering implementing
an activity-based costing system. After interviewing the sales and production staff, management decides to allocate
administrative costs on the basis of direct labor costs, but to use the following bases to allocate the remaining
overhead:
Activity Level Activity Cost drivers B-ball Marathon Production setup Production runs 20 20 Quality control Inspections 40 20 Advertising Advertisements 12 48
a. Complete the income statement using these activity bases.
b. Write a brief report indicating how management could use activity-based costing to reduce costs.
Accounting Principles: A Business Perspective 827 A Global Text
20. Using accounting for quality and cost management
c. Restate the income statement for Shoe Express, Inc., using direct labor costs as the only overhead allocation
base.
d. Write a report to management stating why product line profits differ using activity-based costing compared to
the traditional approach. Indicate whether the activity-based costing method provides more accurate information
and why (if you believe it does provide more accurate information). Indicate in your report how the use of labor-
based overhead allocation could result in Shoe Express management making suboptimal decisions.
Beyond the numbers—Critical thinking
Business decision case A Many companies recognize that their cost systems are inadequate for today's global
market. Managers in companies selling multiple products are making important product decisions based on
distorted cost information.
Write a short paper describing the benefits management should expect from implementing activity-based
costing.
Business decision case B A company that makes Halloween costumes is considering using just-in-time
purchasing and production methods. Write a short paper describing the problems this company might face in using
just-in-time.
Business decision case C Managers at Texas Instruments developed these four cost-of-quality categories:
prevention costs, appraisal costs, internal failure costs, and external failure costs. Give an example of a cost for each
of these four categories. Would minimizing the sum of these four costs assure high-quality products? Why or why
not? Write a short paper summarizing your analysis.
Group project D The chapter listed the following six important points to remember about activity-based
costing. Following each point are the comments of a cynic in italics. After forming six groups, discuss one of these
points in each group. How would you respond to the cynic's comments? (It is okay to agree; even cynics have good
points to make.) Choose one group member to report your group's response to the class.
• The allocation of indirect costs is at least somewhat arbitrary, even using sophisticated accounting
methods. ("This means no method gives you a true cost; all are arbitrary. So why go to the trouble of
implementing ABC?")
• Activity-based costing provides more detailed measures of costs than traditional allocation methods. ("Who
needs more detail? Life is already too complicated".)
• Activity-based costing can help marketing people by providing more accurate product cost numbers for
decisions about pricing and which unprofitable products the company should eliminate. ("Why should
accountants want to help marketing people?")
• Production also benefits because activity-based costing provides better information about the cost of each
activity. In practice, ABC helps managers identify cost causing activities. To manage costs, production
managers learn to manage the activities that cause costs. ("If production people know their jobs, they do not
need help from accountants".)
• Activity-based costing provides more information about product costs than traditional methods but
requires more record-keeping. Managers must decide whether the benefits of improved decisions justify the
additional record-keeping cost. ("ABC sounds like a lot of work. Why bother?")
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• Installing activity-based costing requires teamwork among accountants, production managers, marketing
managers, and other nonaccounting people. ("You will never get these people to work together. Accountants
and marketing people? You have got to be kidding!")
Group project E Form a group of three or four students and assume you are hired as business consultants for
each of the cases below. Respond to each of the comments made in case 1 and case 2. Your response should assume
you are talking directly to the CEO. State whether you agree or disagree with the statement and justify your
response. (Hint: Consider the potential costs and benefits associated with each case.)
Case 1 Your group is meeting with the CEO of a relatively small company that produces one model of bicycles.
After lengthy discussion regarding the company's costing system, the CEO makes the following statement: "From
what I have seen at other companies lately, activity-based costing is the wave of the future. Everyone, including us,
should drop existing cost systems and adopt ABC!"
Case 2 Your group is meeting with the CEO of a relatively large company that produces hundreds of expensive
custom computers. After lengthy discussion regarding the company's costing system, the CEO makes the following
statement: "From what I have seen at other companies lately, activity-based costing is the wave of the future.
Everyone, including us, should drop existing cost systems and adopt ABC!"
Group project F In teams of two or three, interview the manager of a retail (or wholesale) store such as a
music store, an automobile parts store, or the parts department of an appliance dealership. Ask the manager how
items are ordered to replace those sold. For example, does he or she order based on observing inventory levels or
place an order each time a customer buys an item? Does he or she appear to use just-in-time inventory? Write a
memorandum to the instructor summarizing the results of the interview. Information contained in the memo
should include:
Date:
To:
From:
Subject:
Content of the memo must include the name and title of the person interviewed, name of the company, date of
the interview, and the results of the interview.
Group project G In teams of two or three, observe an organization of your choice—wholesale, retail, or service.
Give examples of warning and diagnostic signals the organization uses. How could it use control charts, Pareto
charts, and cause-and-effect analysis?
Using the Internet—A view of the real world
The Malcolm Baldrige National Quality Award is awarded to companies meeting certain quality standards and
criteria. This award is issued annually by the National Institute of Standards and Technology (NIST). Visit the
following website:
http://www.baldrige.nist.gov
Click on "Criteria and their Impact". What criteria are used as a basis for making awards to applicants? Click on
"Winners Showcase". Who were the most recent winners of the Baldrige Award? What products or services do these
companies provide?
Based on the results of the previous Internet project, perform an Internet search to find at least one recent
Baldrige Award winning company. Does the company provide information on the Internet about being the recipient
Accounting Principles: A Business Perspective 829 A Global Text
20. Using accounting for quality and cost management
of the award? If so, write a report summarizing this information. If not, search for a recent award winner that does
provide this information, and write a report summarizing the information provided.
Answers to self-test
True-false
False. The managers' task is to minimize these costs, not maximize them.
True. Control charts are a means of distinguishing between random or routine variations in product quality and
variations that managers should investigate.
False. To the contrary, the allocation of indirect costs is, by definition, at least somewhat arbitrary.
True. A cost driver is an activity or transaction that causes costs to be incurred.
True. The formula for computing an indirect cost rate has the cost in the numerator and the volume of the cost
driver or allocation base in the denominator.
Multiple-choice
d. The new production environment refers to an environment in which company managers are concerned with
improving customer service and product quality, and reducing costs.
c. Production does not begin on an item until an order is received.
d. USD 160,000
USD 260,000/(80,000 hours + 50,000 hours) = USD 2. USD 2 X 80,000 hours = USD 160,000.
b. USD 2.27
First find the rates:
USD82,000
812 =USD 4,100.
USD48,000
5624 =USD600.
USD 130,000
80,00050,000 =USD1.
Next assign overhead to Product R:
(USD 4,100 X 12) + (USD 600 X 24) + (USD 1 X 50,000) = USD 49,200 + USD 14,400 + USD 50,000 = USD
113,600.
Now find the unit cost:
USD113,600
50,000 units =USD2.27 .
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21. Cost-volume-profit analysis
Learning objectives
After studying this chapter, you should be able to:
• Explain and describe cost behavior patterns.
• Separate mixed costs into fixed and variable components using the scatter diagram and high-low method.
• Explain the relationship among costs, volume, revenue, and profits.
• Find the break-even point.
• Compute the margin of safety.
• Demonstrate applications of cost-volume-profit analysis.
• List the assumptions underlying cost-volume-profit analysis.
• Describe how computer spreadsheets expand your capability to use cost-volume-profit analysis.
• Describe the impact of automation on fixed-variable cost relationships.
A manager's perspective
Renee Vaughn
Manager, Administration and Special Projects
Public and Media Relations
The Coca-Cola Company
I am responsible for providing scheduling and assisting with staffing with the Public and Media Relations group.
This requires anticipating needs for the group and planning accordingly. I also administer budgets for three
departments (about 35 employees).
I began my professional career in an elementary school district administration office, serving as an
administrative assistant for the superintendent of schools. I learned to plan and manage budgets in that capacity. At
The Coca-Cola Company, once a budget is created at the departmental level, it is tracked on a monthly basis by
reviewing all spending by account and in total. We also review a rolling estimate of annual expenses and adjust the
budget accordingly.
We plan for non-project capital budgeting a year in advance, which enables us to order computer, fax, and other
office equipment as well as make other necessary major purchases. If an unforeseen need develops, we will review
our plan and make revisions as necessary on a case-by-case basis.
Assume that a student organization wants to show movies on campus. The organization can rent a particular
movie for one weekend for USD 1,000. Rent for an auditorium, salaries for ticket takers and other personnel, and
other fixed costs would amount to USD 800 for the weekend. The organization would sell tickets for USD 4 per
person. In addition, profits from the sale of soft drinks, popcorn, and candy are estimated to be USD 1 per ticket
Accounting Principles: A Business Perspective 831 A Global Text
21. Cost-volume-profit analysis
holder. How many people would have to buy tickets to justify renting the movie? (The answer is 360 ticket-buyers
as shown in the solution to Demonstration problem at the end of this chapter.)
Solving problems like this requires an understanding of the relationship between costs, revenue, and volume.
This chapter discusses the use of cost-volume-profit analysis for decision making and planning. (Although
accountants call this topic cost-volume-profit analysis, it could just as easily have been called cost-volume- revenue
analysis.) All of the analysis in this chapter is on a before-tax basis.
In this chapter we will focus on short-run decisions. The term short run describes a time frame during which a
company's management cannot change the effects of certain past decisions. The short run is one year or less for
practical purposes. For example, GM's decision to offer a special rebate starting January 5 and expiring on January
31 would be a short-run decision. In contrast, GM's decision to begin producing cars in China .
In the short run, we assume many costs are fixed and unchangeable, such as building rental expense. However,
all costs are subject to change in the long run. Although we identify particular costs as fixed in this chapter, you
should realize that costs fixed in the short run may change in the long run. Someday the building rental agreement
will change, so the building rental expense will change.
Cost behavior patterns
Exhibit 166 shows four basic cost behavior patterns: fixed, variable, mixed (semivariable), and step. As
discussed in earlier chapters, fixed costs remain constant (in total) over some relevant range of output. Often, we
describe them as time-related costs. Depreciation, insurance, property taxes, and administrative salaries are
examples of fixed costs. Recall that so-called fixed costs are fixed in the short run but not necessarily in the long
run.
For example, a local high-tech company did not lay off employees during a recent decrease in business volume
because the management did not want to hire and train new people when business picked up again. Management
treated direct labor as a fixed cost in this situation. Although volume decreased, direct labor costs remained fixed.
Exhibit 166: Four cost patterns
In contrast to fixed costs, variable costs vary (in total) directly with changes in volume of production or sales.
In particular, total variable costs change as total volume changes. If pizza production increases from 100 10-inch
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pizzas to 200 10-inch pizzas per day, the amount of dough required per day to make 10-inch pizzas would double.
The dough is a variable cost of pizza production. Direct materials and sales commissions are variable costs.
Direct labor is a variable cost in many cases. If the total direct labor cost increases as the volume of output
increases and decreases as volume decreases, direct labor is a variable cost. Piecework pay is an excellent example
of direct labor as a variable cost. In addition, direct labor is frequently a variable cost for workers paid on an hourly
basis, as the volume of output increases, more workers are hired. However, sometimes the nature of the work or
management policy does not allow direct labor to change as volume changes and direct labor can be a fixed cost.
Mixed costs have both fixed and variable characteristics. A mixed cost contains a fixed portion of cost incurred
even when the facility is idle, and a variable portion that increases directly with volume. Electricity is an example of
a mixed cost. A company must incur a certain cost for basic electrical service. As the company increases its volume
of activity, it runs more machines and runs them longer. The firm also may extend its hours of operation. As activity
increases, so does the cost of electricity.
Managers usually separate mixed costs into their fixed and variable components for decision-making purposes.
They include the fixed portion of mixed costs with other fixed costs, while assuming the variable part changes with
volume. Look at Exhibit 167 to see how to separate the fixed and variable portions of a mixed cost such as
electricity.
Exhibit 167: Separation of mixed costs into fixed and variable parts
A step cost remains constant at a certain fixed amount over a range of output (or sales). Then, at certain points,
the step costs increase to higher amounts. Visually, step costs appear like stair steps, as shown in Exhibit 166.
Supervisors' salaries are an example of a step cost when companies hire additional supervisors as production
increases. For instance, the local McDonald's restaurant has one supervisor until sales exceed 100 meals during the
lunch hour. If sales regularly exceed 100 meals during that hour, the company adds a second supervisor. In Exhibit
168, we show a step cost for supervisors' salaries, assuming each supervisor is paid USD 2,000 per month. Step
costs are sometimes labeled as step variable costs (many small steps) or step fixed costs (only a few large steps).
Accounting Principles: A Business Perspective 833 A Global Text
21. Cost-volume-profit analysis
Exhibit 168: A step cost
Although we have described four different cost patterns (fixed, variable, mixed, and step), we simplify our
discussions in this chapter by assuming managers can separate mixed and step costs into fixed and variable
components.
Many costs do not vary in a strictly linear relationship with volume. Rather, costs may vary in a curvilinear
pattern—a 10 per cent increase in volume may yield an 8 per cent change in total variable costs at lower output
levels and an 11 per cent change in total variable costs at higher output levels. We show a curvilinear cost pattern in
Exhibit 169.
Exhibit 169: Curvilinear cost pattern
One way to deal with a curvilinear cost pattern is to assume a linear relationship between costs and volume
within some relevant range. The relevant range is the range of production or sales volume over which the
assumptions about cost behavior are valid. Look at Exhibit 170 to see how to apply the relevant range to a portion of
the curvilinear cost curve. Within that relevant range, the total cost varies linearly with volume, at least
approximately. Outside of the relevant range, we presume the assumptions about cost behavior may be invalid.
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Exhibit 170: Relevant range
Costs rarely behave in the simple way that would make life easy for decision makers. Even within the relevant
range, the assumed cost behavior is usually only approximately linear. As decision makers, we have to live with the
fact that cost estimates are not as precise as physical or engineering measurements.
Methods for analyzing costs
You can use several methods to break down a mixed cost into its fixed and variable cost components. We present
two of these methods—the scatter diagram and the high-low method.
A scatter diagram shows plots of actual costs incurred for various levels of activity. Assume the dots on the
scatter diagram in Exhibit 171 represent total actual maintenance costs per month for a Federal Express fleet of
delivery trucks. Each dot represents one month's activity for one city. For example, the left point represents a USD
38,000 cost for approximately 30,000 miles a month. The next point to the right represents USD 42,000 for
approximately 40,000 miles for another month. We drew a line that appears to best fit the pattern of dots. The line
we drew is subjective. If you were to draw such a line, your line would probably differ from ours.
Estimating fixed and variable costs using a scatter diagram is subjective. If your line through the dots in Exhibit
171 differs from ours, you would estimate different fixed and variable costs. Your line and cost estimates would not
necessarily be right or wrong compared to ours, just different.
Accounting Principles: A Business Perspective 835 A Global Text
21. Cost-volume-profit analysis
Exhibit 171: Scatter diagram
In Exhibit 171, our line intersects the vertical axis at USD 25,000, which we estimate to be the fixed portion of
the mixed cost. We estimate the line would pass through a point representing a cost of USD 57,000 at a volume of
80,000 miles. Thus, our line rises from USD 25,000, representing 0 (zero) miles, to USD 57,000 over a volume of
80,000 miles on the horizontal axis. Based on that information, we can now compute the variable cost portion of
the mixed cost as follows:
USD57,000 – USD25,000
80,000 miles –0 miles =USD0.40 per mile
Using this result, we estimate the company's truck maintenance costs are USD 25,000 per month plus 40 cents
for every mile driven.
You can also use the high-low method to identify the elements of mixed costs. This method uses only the
highest and lowest points (levels of operation) on a scatter diagram to fit a line to the data.
To illustrate, the lowest point in Exhibit 171, is USD 38,000 of expense at 30,000 miles driven, and the highest
point is USD 60,000 at 80,000 miles. Calculate the amount of variable cost per mile as follows:
Changefor cost
Change for units =
USD60,000 – USD 38,000
80,000 miles – 30,000 miles =
USD22,000
50,000 miles = USD 0.44 per mile
To compute the fixed portion:
Total cost at 80,000 miles $60,000 Less: Variance cost at that level of output (80,000 x $0.44)
35,200
Fixed cost at all levels of mileage within the relevant range
$24,800
The high-low method is less precise than the scatter diagram because it uses only two data points in the
computation. Either or both points may not be representative of the data as a whole.
Many people use more sophisticated statistical techniques to divide mixed costs into fixed and variable portions.
Statistics and cost accounting texts discuss these techniques.
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Now that you understand cost patterns and how to analyze costs, we will apply these concepts to the specific
tools that managers use in short-term decision making. The first of these tools is cost-volume-profit (CVP) analysis.
Cost-volume-profit (CVP) analysis
Companies use cost-volume-profit (CVP) analysis (also called break-even analysis) to determine what
affects changes in their selling prices, costs, and/or volume will have on profits in the short run. A careful and
accurate cost-volume-profit (CVP) analysis requires knowledge of costs and their fixed or variable behavior as
volume changes.
A cost-volume-profit chart is a graph that shows the relationships among sales, costs, volume, and profit.
Look at Exhibit 172, a cost-volume-profit chart for Video Productions, a company that produces videotapes. Each
tape sells for USD 20. The variable cost per tape is USD 12, and the fixed costs per month are USD 40,000.
The total cost line in Exhibit 172 represents the fixed costs of USD 40,000 plus USD 12 per unit. Thus, if Video
Productions produces and sells 6,000 tapes, the company's total costs are USD 112,000, made up of USD 40,000
fixed costs and USD 72,000 total variable costs (USD 72,000 = USD 12 per unit X 6,000 units produced and sold).
The total revenue line in Exhibit 172 shows how revenue increases as volume increases. Total revenue is USD
120,000 for sales of 6,000 tapes (USD 120,000 = USD 20 per unit X 6,000 units sold). In Exhibit 172, we
demonstrate the effect of volume on revenue, costs, and net income, for a particular price, variable cost per unit,
and fixed cost per period.
Exhibit 172: The cost-volume-profit chart
At each volume, one can estimate the company's profit or loss. For example, at a volume of 6,000 units, the
profit is USD 8,000. We can find the net income either by constructing an income statement or using the profit
equation. The income statement gives the following results for a volume of 6,000 units:
Revenue $120,000
Accounting Principles: A Business Perspective 837 A Global Text
21. Cost-volume-profit analysis
Less: variable costs 72,000 Contribution margin $ 48,000 Less: Fixed costs 40,000 Net income $ 8,000
We have introduced a new term in this income statement—the contribution margin. The contribution margin
is the amount by which revenue exceeds the variable costs of producing that revenue. We can calculate it on a per
unit or total sales volume basis. On a per unit basis, the contribution margin for Video Productions is USD 8 (the
selling price of USD 20 minus the variable cost per unit of USD 12).
The contribution margin indicates the amount of money remaining after the company covers its variable costs.
This remainder contributes to the coverage of fixed costs and to net income. In Video Production's income
statement, the USD 48,000 contribution margin covers the USD 40,000 fixed costs and leaves USD 8,000 in net
income.
Profit equation The profit equation is just like the income statement, except it presents the analysis in a
slightly different form. According to the profit equation:
Net income = Revenue - Total variable costs - Fixed costs
For Video Productions, the profit equation looks like this:
Net income=USD120,000−USD72,000−USD40,000
Net income=USD8,000
Exhibit 172 shows cost data for Video Productions in a relevant range of output from 500 to 10,000 units. Recall
the relevant range is the range of production or sales volume over which the basic cost behavior assumptions hold
true. For volumes outside these ranges, costs behave differently and alter the assumed relationships. For example,
if Video Productions produced and sold more than 10,000 units per month, it might be necessary to increase plant
capacity (thus incurring additional fixed costs) or to work extra shifts (thus incurring overtime charges and other
inefficiencies). In either case, the assumed cost relationships would no longer be valid.
Finding the break-even point
A company breaks even for a given period when sales revenue and costs charged to that period are equal. Thus,
the break-even point is that level of operations at which a company realizes no net income or loss.
A company may express a break-even point in dollars of sales revenue or number of units produced or sold. No
matter how a company expresses its break-even point, it is still the point of zero income or loss. To illustrate the
calculation of a break-even point, recall that Video Productions produces videotapes selling for USD 20 per unit.
Fixed costs per period total USD 40,000, while variable cost is USD 12 per unit.
Break-even in units We compute the break-even point in units by dividing total fixed costs by the
contribution margin per unit. The contribution margin per unit is USD 8 (USD 20 selling price per unit - USD 12
variable cost per unit). In the following break-even equation, BE refers to the break-even point:
BE units= Fix costs
Contribution margin per unit
BE units= USD40,000
USD8per unit
BE units=5,000 units
The result tells us that Video Productions breaks even at a volume of 5,000 units per month. We can prove that
to be true by computing the revenue and total costs at a volume of 5,000 units. Revenue = 5,000 units X USD 20
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sales price per unit = USD 100,000. Total costs = USD 100,000 = USD 40,000 fixed costs + USD 60,000 variable
costs (USD 60,000 = USD 12 per unit X 5,000 units).
Look at Exhibit 172 and note that the revenue and total cost lines cross at 5,000 units—the break-even point.
Video Productions has net income at volumes greater than 5,000, but it has losses at volumes less than 5,000 units.
Break-even in sales dollars Companies frequently think of volume in sales dollars instead of units. For a
company such as GM that makes Cadillacs and certain small components, it makes no sense to think of a break-
even point in units. GM breaks even in sales dollars.
The formula to compute the break-even point in sales dollars looks a lot like the formula to compute the break-
even in units, except we divide fixed costs by the contribution margin ratio instead of the contribution margin per
unit.
BE dollars= Fix costs
Contribution margin ratio
A broader perspective:
Even colleges use CVP
The dean of the Business School at a particular university was considering whether to offer a
seminar for executives. The tuition would be USD 650 per person. Variable costs, including meals,
parking, and materials, would be USD 80 per person. Certain costs of offering the seminar,
including advertising, instructors' fees, room rent, and audiovisual equipment rent, would not be
affected by the number of people attending (within a "relevant range”). Such costs, which could be
thought of as fixed costs, amounted to USD 8,000 for the seminar.
In addition to these costs, a number of staff, including the dean, would work on the program.
Although the salaries paid to these staff were not affected by offering the seminar, working on it
took these people away from other duties, thus creating an opportunity cost, estimated to be USD
7,000 for this seminar.
Given this information, the school estimated the break-even point to be (USD 8,000 + USD 7,000)/
(USD 650 - USD 80) = 26.3 students. If the school wanted at least to break even on this program, it
should offer the program only if it expected at least 27 students to attend.
Based on the authors' research.
The contribution margin ratio expresses the contribution margin as a percentage of sales. To calculate this
ratio, divide the contribution margin per unit by the selling price per unit, or total contribution margin by total
revenues. Video Production's contribution margin ratio is:
Contribution margin ratio= Contribution margin per unit
Selling price per unit
USD20 – USD12
USD 20 –
USD8
USD20
= 0.40
Or, referring to the income statement in which Video Productions had a total contribution margin of USD
48,000 on revenues of USD 120,000, we compute the contribution margin ratio as follows:
Accounting Principles: A Business Perspective 839 A Global Text
21. Cost-volume-profit analysis
Contribution margin ratio= Totalcontribution margin
Total revenues
= USD48,000
USD120,000
= 0.40
That is, for each dollar of sales, there is a USD 0.40 contribution to covering fixed costs and generating net
income.
Using this ratio, we calculate Video Production's break-even point in sales dollars as:
BE dollars= Fix costs
Contribution margin rate
BE dollars= USD 40,000
0.40
= USD 100,000
The break-even volume of sales is USD 100,000 (5,000 units at USD 20 per unit). At this level of sales, fixed
costs plus variable costs equal sales revenue, as shown here:
Revenue $120,000 Less: variable costs 72,000 Contribution margin $ 48,000 Less: Fixed costs 40,000 Net income $ 8,000
The cost-volume-profit chart in Exhibit 172 shows that in a period of complete idleness, Video Productions
would lose USD 40,000 (the amount of fixed costs). However, when Video Productions has an output of 10,000
units, the company has net income of USD 40,000. Other points on the graph show that sales of 7,500 units results
in USD 150,000 of revenue. At that point, Video Production's total costs amount to USD 130,000, leaving net
income of USD 20,000.
Although you are likely to use cost-volume-profit analysis for a single product, you will more frequently use it in
multi-product situations. The easiest way to use cost-volume-profit analysis for a multi-product company is to use
dollars of sales as the volume measure. For CVP purposes, a multi-product company must assume a given product
mix. Product mix refers to the proportion of the company's total sales attributable to each type of product sold.
To illustrate the computation of the break-even point for Wonderfood, a multi-product company that makes
three types of cereal, assume the following historical data:
Product 1 2 3 Total AmountPer cent AmountPer cent Amount Per cent Amount Per cent
Sales $60,000 100% $30,000 100% $10,000 100% $100,000100% Less: Variable costs 40,000 67% 16,000 53% 4,000 40% 60,000 60% Contribution margin $20,000 33% $14,000 47% $ 6,000 60% $ 40,000 40%
We use the data in the total columns to compute the break-even point. The contribution margin ratio is 40 per
cent or (USD 40,000/USD 100,000). Assuming the product mix remains constant and fixed costs for the company
are USD 50,000, break-even sales are USD 125,000, computed as follows:
BE dollars= Fix costs
Contribution margin ratio
BE dollars= USD50,000
0.40
= USD 125,000
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[To check our answer: (USD 125,000 X 0.40) - USD 50,000 = USD 0.]
To find the three product sales totals, we multiply total sales dollars by the per cent of product mix for each of
the three products. The product mix for products 1, 2, and 3 is 60:30:10, respectively. That is, out of the USD
100,000 total sales, there were sales of USD 60,000 for product 1, USD 30,000 for product 2, and USD 10,000 for
product 3. Therefore, the company has to sell USD 75,000 of product 1 (0.6 X USD 125,000), USD 37,500 of
product 2 (0.3 X USD 125,000), and USD 12,500 of product 3 (0.1 X USD 125,000) to break even.
An accounting perspective:
Business insight
The founder of Domino's Pizza, Inc. nearly went bankrupt several times before he finally made
Domino's a financial success. One early problem was that the company was providing small pizzas
that cost almost as much to make and just as much to deliver as larger pizzas. Because they were
small, the company could not charge enough to cover its costs. At one point, the company's founder
was so busy producing small pizzas that he did not have time to determine that the company was
losing money on them.
If a company's current sales are more than its break-even point, it has a margin of safety equal to current sales
minus break-even sales. The margin of safety is the amount by which sales can decrease before the company
incurs a loss. For example, assume Video Productions currently has sales of USD 120,000 and its break-even sales
are USD 100,000. The margin of safety is USD 20,000, computed as follows:
Margin safety = Current sales – Break-even sales
= USD 120,000 - USD 100,000
= USD 20,000
Sometimes people express the margin of safety as a percentage, called the margin of safety rate. The margin of
safety rate is equal to Current sales – Break−even sales
Current sales . Using the data just presented, we compute the margin
of safety rate as follows:
Margin of safety rate= Current sales – Break−even sales
Current sales
= USD120,000−USD100,000
USD120,000
= 16.67 per cent
This means that sales volume could drop by 16.67 per cent before the company would incur a loss.
Cost-volume-profit analysis illustrated
CVP analysis has many applications. This section illustrates several applications using airline data.
The management of a major airline wishes to know how many seats must be sold on Flight 529 to break even. To
solve this problem, management must identify and separate costs into fixed and variable categories.
Accounting Principles: A Business Perspective 841 A Global Text
21. Cost-volume-profit analysis
The fixed costs of Flight 529 are the same regardless of the number of seats filled. Fixed costs include the fuel
required to fly the plane and crew (with no passengers) to its destination; depreciation on the plane used on the
flight; and salaries of required crew members, gate attendants, and maintenance and refueling personnel.
The variable costs vary directly with the number of passengers. Variable costs include snacks and beverages
provided to passengers, baggage handling costs, and the cost of the additional fuel required to fly the plane with
passengers to its destination. Management would express each variable cost on a per passenger basis.
Assume that after analyzing the various costs and separating them into fixed or variable categories, management
finds the fixed costs for Flight 529 are USD 12,000 and variable costs are USD 25 per passenger. Tickets cost USD
125. Thus, the contribution margin ratio is 80 per cent or [(USD 125 - USD 25)/USD 125].
We can express the break-even point either in sales dollars or in the number of passengers. The break-even
point in sales dollars is:
BE dollars= Fix costs
Contribution margin ratio
= USD12,000
0.80
= USD 15,000
We can find the break-even point in number of passengers (units) by dividing fixed costs by the contribution
margin per unit:
BE units= Fix costs
Contribution margin per unit passenger
= USD 12,000
USD125−USD25
= 120 passengers
To check our answers: 120 passengers X USD 125 ticket price = USD 15,000.
With a simple adjustment in the break-even formulas, CVP analysis can also show the sales volume needed to
generate some desired level of net income (ignore taxes). To make this adjustment, management adds the desired
net income amount to the fixed costs that must be covered. From this, management can determine the necessary
sales volume in dollars or units to provide the desired net income. For example, assume management wishes to
earn USD 8,000 of net income on Flight 529.
How many passenger tickets must the airline sell to earn USD 8,000? Remember, the contribution margin per
ticket is USD 100. We compute the number of tickets to be sold to earn USD 8,000 on a flight as follows:
Numberof units= Fix costsDesired net income Contribution margin per unit
= USD12,000USD8,000
USD100
= USD20,000
USD100
= 200 tickets
The airline must sell 200 tickets to earn net income of USD 8,000. To check our answer: (200 tickets X USD 125
sales price per ticket) - (200 tickets X USD 25 variable cost per ticket) - USD 12,000 fixed costs = USD 25,000 -
USD 5,000 - USD 12,000 = USD 8,000.
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The airline management can also use cost-volume-profit analysis to determine the effect of changing the sales
price. To illustrate, assume that Flight 529 normally carries 150 passengers (sales of USD 18,750 and net income of
USD 3,000), and the airline decides to increase ticket prices by 5 per cent. If variable and fixed costs remain
constant and passenger load does not change, net income increases from USD 3,000 to USD 3,937.50 as follows:
Revenue – Total variable costs – Fixed costs = Net income
[USD 125[1.05) x 150 passengers] – (USD 25 x 150 passengers) – USD 12,000 = NI
USD 19,687.50 – USD 3,750 – USD 12,000 = NI
USD 3,937.50 = NI
Net income would rise by the entire amount of the price increase (USD 19,687.50 - USD 18,750 = USD 937.50).
Management can use cost-volume-profit analysis to calculate the sales needed to maintain net income when
costs change. For example, assume both fixed and variable costs would increase for the airline if the price of fuel
rises. Assume that fixed costs increase by USD 4,000 and variable costs increase by USD 6.25 per passenger.
Variable costs are now 25 per cent, or (USD 31.25/USD 125), of the sales price. The contribution margin is now
USD 93.75, or (USD 125 - USD 31.25), per passenger. The contribution margin ratio is now 75 per cent, or (USD
93.75/USD 125).
To maintain the current net income of USD 3,000, the airline needs to increase sales revenue to USD 25,333:
Revenue required= Fix costsDesired net income
Contribution margin ratio
= USD16,000USD3,000
0.75
= USD 25,333
Management can also use its knowledge of cost-volume-profit relationships to determine whether to increase
sales promotion costs in an effort to increase sales volume or to accept an order at a lower-than-usual price. In
general, the careful study of cost behavior helps management plan future courses of action.
A broader perspective:
Major television networks are finding it harder to break even
With increasing competition from cable and satellite television, prerecorded videos, and
independent stations, the three major television networks are facing smaller and smaller margins of
safety. Most new shows do not break even. Many do not even cover their variable costs and are
dropped during the first season.
As the networks find it more and more difficult to break even on their regular shows, they are
expanding into cable, satellite, and pay-per-view television. For example, the National Broadcasting
Company (NBC), a major television network owned by General Electric Company, is part owner of a
national cable channel and a sports channel. The company has also invested in CNBC, a cable
network that specializes in consumer and business issues.
Based on the authors' research.
Assumptions made in cost-volume-profit analysis
To summarize, the most important assumptions underlying CVP analysis are:
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21. Cost-volume-profit analysis
• Selling price, variable cost per unit, and total fixed costs remain constant through the relevant range. This
means that a company can sell more or fewer units at the same price and that the company has no change in
technical efficiency as volume changes.
• In multi-product situations, the product mix is known in advance.
• Costs can be accurately classified into their fixed and variable portions.
Critics may call these assumptions unrealistic in many situations, but they greatly simplify the analysis.
Using computer spreadsheets for CVP analysis
Computer spreadsheet packages are well suited for CVP analysis because they enable managers to answer what-
if questions. The cost and revenue items in CVP analysis are estimates, not actual results. Since they are used in
planning and decision making, it is reasonable to ask whether plans or decisions would change if the estimates
changed. The most important issue is whether the information is correct. The output is only as good as the
information that goes in.
Consider the following example: The management of Prince Cruises wants to know what the income before taxes
would be for a proposed product, a Caribbean cruise. The analyst prepared the following formulas for the
spreadsheet:
• Revenue equals ticket price times number of passengers (amounts to be inserted for ticket price and
number of passengers).
• Contribution margin equals (amount to be inserted) per cent of revenue.
• Fixed costs equal USD 200,000.
• Income equals revenue minus variable costs minus fixed costs.
Management then inserted various values for ticket price, number of passengers, the per cent of variable cost to
revenue, and fixed costs, all per cruise. Exhibit 173 shows the results. Based on these results, management sees
what combinations of ticket price, number of passengers, and contribution ratio are required for the cruise to be
profitable.
We show only a few of the possible combinations in Exhibit 173 to save space. Spreadsheets provide the
advantage of a large number of possible combinations with minimal data entry.
Fixed cost Ticket priceNumber of passengers
Per cent contribution margin to revenue
Income
$200,000 $3,000 100 70% $10,000 200,000 3,000 80 70% (32,000) 200,000 3,000 100 75% 25,000 200,000 3,000 80 75% (20,000) 200,000 4,000 70 70% (4,000) 200,000 4,000 50 70% (60,000) 200,000 4,000 70 75% 10,000 200,000 4,000 50 75% (50,000)
Exhibit 173: Spreadsheet analysis of CVP relationships
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An accounting perspective:
Uses of technology
Cost-volume-profit analysis using a computer spreadsheet is becoming routine. In many business
meetings, we find one or more people crunching cost-volume-profit numbers on their notebook or
laptop computers.
Effect of automation on cost-volume-profit analysis
Increasing automation does not affect the fundamental CVP model or the types of analysis we have discussed.
However, it does affect the relative size of fixed and variable costs. As companies become more automated, they
substitute machinery for labor. Companies that make this substitution often increase fixed costs and decrease
variable costs. For example, when banks installed automated teller machines, their labor costs decreased but their
fixed costs, including machine depreciation, increased.
When a company substitutes fixed costs for variable costs, the total cost line shifts up as shown in Exhibit 174. At
low levels of volume, becoming more automated increases total costs, but at high levels of volume it decreases
them. What does this do to the company's break-even point? It depends on where the revenue line crosses the total
cost line.
Exhibit 174: Effects of automation
If it crosses at low volumes, to the left of point A in Exhibit 174, then increasing automation increases the
company's break-even point. At high volumes, however, if increasing automation lowers total costs, it lowers the
company's break-even point.
In this chapter we began studying short-run decisions based on cost-volume-profit analysis. In Chapter 22 we
will apply differential analysis to short-term decisions.
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21. Cost-volume-profit analysis
Understanding the learning objectives
• Fixed costs. These costs remain constant in total over some relevant range of output and are often
described as time-related costs. Depreciation and insurance are examples.
• Variable costs. These costs vary in total directly with changes in the volume of production or sales. Direct
materials and sales commissions are examples.
• Mixed costs. These costs contain a fixed portion of cost incurred even when the plant is completely idle
and a variable portion that increases directly with production volume. Electricity is an example of a mixed cost.
• Step costs. These costs remain constant at a certain fixed amount over a short range of output (or sales)
but increase to higher amounts at certain points. The cost of supervisors' salaries is an example.
• The scatter diagram shows plots of actual costs incurred for various levels of activity.
• The high-low method uses the highest and lowest points on a scatter diagram to fit a line to the data.
• Cost-volume-profit analysis (sometimes called break-even analysis) can determine what effects any changes
in a company's selling prices, costs, and/or volume will have on net income in the short run.
• The break-even point is that level of operations at which a company realizes no income or loss.
• To compute the break-even point in sales dollars:
BE dollars= Fix costs
Contribution margin ratio
Or, to express the break-even point in units:
BE units= Fix costs
Contribution margin per unit
• To compute the margin of safety:
Margin of safety = Current sales – Break-even sales
• Applications include calculation of the break-even point, calculation of the sales volume needed for a
desired net income, calculation of the effect of changing price on net income, and calculation of the sales
needed to maintain net income when costs change.
• Selling price, variable cost per unit, and total fixed costs remain constant through the relevant range.
• In multi-product situations, the product mix is known in advance.
• Costs can be accurately classified into their fixed and variable portions.
• Computer spreadsheet packages are well suited for CVP analysis because they enable managers to answer
what-if questions.
• As companies become more automated, they substitute machinery for labor, which generally increases
fixed costs and decreases variable costs.
Demonstration problem
Demonstration problem A Davis Company has fixed costs of USD 625,000 per year and variable costs of
USD 7.50 per unit. Its product sells for USD 12.50 per unit. Full capacity is 200,000 units. The contribution margin
is USD 5 per unit (USD 12.50 - USD 7.50).
a. Compute the break-even point in (1) sales dollars and (2) units.
b. Compute the number of units the company must sell if it wishes to have net income of USD 300,000.
Demonstration problem B At the beginning of this chapter, we presented a problem: A campus organization
wants to show movies. Recall that the movie rental would be USD 1,000. Rent for an auditorium, salaries to the
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ticket takers and other personnel, and other fixed costs would be USD 800 for the weekend. The organization
would sell tickets for USD 4 per person. In addition, profits from the sale of soft drinks, popcorn, and candy are
estimated to be USD 1 per ticket holder. How many people have to buy tickets for the organization to break even?
Solution to demonstration problem
Solution to demonstration problem A
a. (1) The contribution margin ratio is 0.40.
BE dollars= Fix costs
Contribution margin ratio
BE dollars= USD625,000
0.40
= USD 1,562,500
(2) BE units= Fix costs
Contribution margin per unit
BE units= USD625,000
USD 5
= 125,000 units
b. Number of units= Fix costDesired net income
Contribution margin per unit
= USD625,000USD 300,000
USD5
= USD925,000
USD5
= 185,000 units
Solution to demonstration problem B
Number of ticket buyersso they break even= USD 1,000USD800
USD4USD1
= USD1,800
USD5
= 360 ticket buyers
Key terms* Break-even point That level of operations at which revenues for a period are equal to the costs assigned to that period so there is no net income or loss.
Contribution margin The amount by which revenue exceeds the variable costs of producing that revenue. The contribution margin per unit is the selling price minus the variable cost per unit.
Contribution margin ratio Contribution margin per unit divided by selling price per unit, or total contribution margin divided by total revenues.
Cost-volume-profit (CVP) analysis An analysis of the effect that any changes in a company's selling prices, costs, and/or volume will have on income (profits) in the short run. Also called break-even analysis.
Cost-volume-profit (CVP) chart A graph that shows the relationships among sales, volume, costs, and net income or loss.
Fixed costs Costs that remain constant (in total) over some relevant range of output.
High-low method A method used in dividing mixed costs into their fixed and variable portions. The high plot and low plot of actual costs are used to draw a line representing a total mixed cost.
Margin of safety Amount by which sales can decrease before a loss is incurred.
Margin of safety rate Margin of safety expressed as a percentage, which equals (Current sales – Break- even sales)/Current sales.
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21. Cost-volume-profit analysis
Mixed cost Contains a fixed portion of cost incurred even when the plant is completely idle and a variable portion that increases directly with production volume.
Product mix The proportion of the company's total sales attributable to each type of product sold.
Profit equation The equation is Net income = Revenue - Total variable costs - Fixed costs.
Relevant range The range of production or sales volume over which the assumptions about cost behavior are valid.
Scatter diagram A diagram that shows plots of actual costs incurred for various levels of activity; it is used in dividing mixed costs into their fixed and variable portions.
Short run The time during which a company's management cannot change the effects of certain past decisions; often determined to be one year or less. In the short run, many costs are assumed to be fixed and unchangeable.
Step cost A cost that remains constant at a certain fixed amount over a range of output (or sales) but then keeps increasing to a higher amount at certain points.
Variable costs Costs that vary (in total) directly with changes in the volume of production or sales.
*Some terms listed in earlier chapters are repeated here for your convenience.
Self-test
True-false
Indicate whether each of the following statements is true or false.
The scatter diagram method is less precise than the high-low method for evaluating costs.
A break-even point is expressed only in dollars of sales revenues.
Total contribution margin indicates the amount of money remaining after variable and fixed costs are covered.
The margin of safety is calculated using the following formula:
Margin of safety = Break-even sales - Current sales
Dollars of sales are used when computing the break-even point for a multi-product company.
Multiple-choice
Select the best answer for each of the following questions.
Under which of the following cost behavior patterns would electricity be categorized?
a. Variable cost.
b. Fixed cost.
c. Mixed cost.
d. Step cost.
Which of the following are characteristics of step costs?
a. A fixed component.
b. Costs increase in steps as production volume increases.
c. Can remain constant over some relevant range of output.
d. All of the above.
Using the following data, calculate the sales revenue needed to break even:
Selling price per unit USD 10
Fixed costs 20,000
Variable cost per unit 6
a. USD 40,000.
b. USD 33,333.
c. USD 50,000.
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d. USD 60,000.
Using the following data, calculate the contribution margin:
Selling price USD 20
Fixed costs 4
Variable cost 6
a. USD 14.
b. USD 10.
c. USD 16.
d. USD 18.
Using the following data, calculate the break-even point in units:
Selling price per unit USD 20
Fixed costs 28,000
Variable cost per unit 6
a. 1,400 units.
b. 2,800 units.
c. 2,275 units.
d. 2,000 units.
Which of the following describe(s) the underlying assumptions of cost-volume-profit analysis?
a. Selling price, variable cost per unit, and total fixed costs remain constant through the relevant range.
b. In multi-product situations, the product mix is known in advance.
c. Costs can be accurately classified into their fixed and variable portions.
d. All of the above.
Now turn to “Answers to self-test” at the end of the book to check your answers.
Questions
➢ Name and describe four cost behavior patterns.
➢ Describe two methods of determining the fixed and variable components of mixed costs.
➢ What is meant by the term break-even point?
➢ What are two ways in which the break-even point can be expressed?
➢ What is the relevant range?
➢ What is the formula for calculating the break-even point in sales revenue?
➢ What formula is used to solve for the break-even point in units?
➢ How can the break-even formula be altered to calculate the number of units that must be sold to
achieve a desired level of income?
➢ Why might a business wish to lower its break-even point? How would it go about lowering the break-
even point?
➢ What effect would you expect the mechanization and automation of production processes to have on
the break-even point?
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21. Cost-volume-profit analysis
➢ Real world question Assume your college is considering hiring a lecturer to teach a special class in
communication skills. Identify at least two costs that college administrators might consider in
deciding whether to hire the lecturer and add the class.
➢ Real world question Two enterprising students are considering renting space and opening a class
video recording service. They would hire camera operators to record large introductory classes. The
students taking the classes would be charged a fee to rent and view the video on their laptops or
smart phones. Identify as many costs of this business as you can and indicate which would be
variable and which would be fixed.
Exercises
Exercise A Name and match the types of cost behavior with the appropriate diagram below:
Exercise B Research Inc., performs laboratory tests. Use the high-low method to determine the fixed and
variable components of a mixed cost, given the following observations:
Volume (number of tests) Total cost 4,800 $6,000 19,200 9,600
Exercise C Compute the break-even point in sales dollars if fixed costs are USD 200,000 and the total
contribution margin is 20 per cent of revenue.
Exercise D Barney Company makes and sells stuffed animals. One product, Michael Bears, sells for USD 28
per bear. Michael Bears have fixed costs of USD 100,000 per month and a variable cost of USD 12 per bear. How
many Michael Bears must be produced and sold each month to break even?
Exercise E Peter Garcia Meza is considering buying a company if it will break even or earn net income on
revenues of USD 80,000 per month. The company that Peter is considering sells each unit it produces for USD 5.
Use the following cost data to compute the variable cost per unit and the fixed cost for the period. Calculate the
break-even point in sales dollars. Should Peter buy this company?
Volume (units) Cost 8,000 $70,000 68,000 190,000
Exercise F Never Late Delivery currently delivers packages for USD 9 each. The variable cost is USD 3 per
package, and fixed costs are USD 60,000 per month. Compute the break-even point in both sales dollars and units
under each of the following independent assumptions. Comment on why the break-even points are different.
a. The costs and selling price are as just given.
b. Fixed costs are increased to USD 75,000.
c. Selling price is increased by 10 per cent. (Fixed costs are USD 60,000.)
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d. Variable cost is increased to USD 4.50 per unit. (Fixed costs are USD 60,000 and selling price is USD 9.)
Exercise G Best Eastern Motel is a regional motel chain. Its rooms rent for USD 100 per night, on average. The
variable cost is USD 40 a room per night. Fixed costs are USD 5,000,000 per year. The company currently rents
200,000 units per year, with each unit defined as one room for one night. Should this company undertake an
advertising campaign resulting in a USD 500,000 increase in fixed costs per year, no change in variable cost per
unit, and a 10 per cent increase in revenue (resulting from an increase in the number of rooms rented)? What is the
margin of safety before and after the campaign?
Exercise H Fall-For-Fun Company sells three products. Last year's sales were USD 600,000 for parachutes,
USD 800,000 for hang gliders, and USD 200,000 for bungee jumping harnesses. Variable costs were: parachutes,
USD 400,000; hang gliders, USD 700,000; and bungee jumping harnesses, USD 100,000. Fixed costs were USD
240,000. Find (a) the break-even point in sales dollars and (b) the margin of safety.
Exercise I Early Horizons Day Care Center has fixed costs of USD 300,000 per year and variable costs of USD
10 per child per day. If it charges USD 25 a child per day, what will be its break-even point expressed in dollars of
revenue? How much revenue would be required for Early Horizons Day Care to earn USD 100,000 net income per
year?
Problems
Problem A Assume the local franchise of Togorio Sandwich Company assigns you the task of estimating total
maintenance cost on its delivery vehicles. This cost is a mixed cost. You receive the following data from past
months:
Month Units Costs March 8,000 $14,000 April 10,000 14,960 May 9,000 15,200 June 11,000 15,920 July 10,000 15,920 August 13,000 16,880 September 14,000 18,080 October 18,000 19,280 November 20,000 21,200
a. Using the high-low method, determine the total amount of fixed costs and the amount of variable cost per
unit. Draw the cost line.
b. Prepare a scatter diagram, plot the actual costs, and visually fit a linear cost line to the points. Estimate the
amount of total fixed costs and the amount of variable cost per unit.
Problem B
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21. Cost-volume-profit analysis
a. Using the preceding graph, label the relevant range, total costs, fixed costs, break-even point, and profit and
loss areas.
b. At 8,000 units, what are the variable costs, fixed costs, sales, and contribution margin amounts in dollars?
c. At 8,000 units, is there net income or loss? How much?
Problem C The management of Bootleg Company wants to know the break-even point for its new line hiking
boots under each of the following independent assumptions. The selling price is USD 50 pair of boots unless
otherwise stated. (Each pair of boots is one unit.)
a. Fixed costs are USD 300,000; variable cost is USD 30 per unit.
b. Fixed costs are USD 300,000; variable cost is USD 20 per unit.
c. Fixed costs are USD 250,000; variable cost is USD 20 per unit.
d. Fixed costs are USD 250,000; selling price is USD 40; and variable cost is USD 30 per unit.
Compute the break-even point in units and sales dollars for each of the four independent case.
Problem D Refer to the previous problem. Bootleg Company's sales are USD 1,100,000. Determine the margin
(safety in dollars for cases (a) through (d).
Problem E Using the data in the Bootleg Company problem (a through d), determine the level of sales dollars
required achieve a net income of USD 125,000.
Problem F Bikes Unlimited, Inc., sells three types of bicycles. It has fixed costs of USD 258,000 per month.
The sales and variable costs of these products for April follow:
Bikes Racing Mountain Touring
Sales $1,00,00 0
$1,500,000 $2,500,000
Variable costs 700,000 900,000 1,250,000
Compute the break-even point in sales dollars.
Problem G a. Assume that fixed costs of Celtics Company are USD 180,000 per year, variable cost is USD 12
per unit, and selling price is USD 30 per unit. Determine the break-even point in sales dollars.
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b. Hawks Corporation breaks even when its sales amount to USD 89,600,000. In 2010, its sales were USD
14,400,000, and its variable costs amounted to USD 5,760,000. Determine the amount of its fixed costs.
c. The sales of Niners Corporation last year amounted to USD 20,000,000, its variable costs were USD
6,000,000, and its fixed costs were USD 4,000,000. At what level of sales dollars would the Niners Corporation
break even?
d. What would have been the net income of the Niners Corporation in part (c), if sales volume had been 10 per
cent higher but selling prices had remained unchanged?
e. What would have been the net income of the Niners Corporation in part (c), if variable costs had been 10 per
cent lower?
f. What would have been the net income of the Niners Corporation in part (c), if fixed costs had been 10 per cent
lower?
g. Determine the break-even point in sales dollars for the Niners Corporation on the basis of the data given in (e)
and then in (f).
Answer each of the preceding questions.
Problem H After graduating from college, M. J. Orth started a company that produced cookbooks. After three
years, Orth decided to analyze how well the company was doing. He discovered the company has fixed costs of USD
1,200,000 per year, variable cost of USD 14.40 per cookbook (on average), and a selling price of USD 26.90 per
cookbook (on average).
How many units (that is, cookbooks) must be sold to break even? How many units will the company have to sell
to earn USD 48,000?
Problem I The operating results for two companies follow:
Sierra Olympias Sales (20,000) units $1,920,000 $1,920,000 Variable costs 480,000 1,056,000 Contribution margin 1,440,000 864,000 Fixed costs 960,000 384,00 Net income 480,000 480,000
a. Prepare a cost-volume-profit chart for Sierra Company, indicating the break-even point, the contribution
margin, and the areas of income and losses.
b. Compute the break-even point of both companies in sales dollars and units.
c. Assume that without changes in selling price, the sales of each company decline by 10 per cent. Prepare
income statements similar to the preceding statements for both companies.
Problem J Soundoff, Inc., a leading manufacturer of electronic equipment, decided to analyze the profitability
of its new portable compact disc (CD) players. On the CD player line, the company incurred USD 2,520,000 of fixed
costs per month while selling 20,000 units at USD 600 each. Variable cost was USD 240 per unit.
Recently, a new machine used in the production of CD players has become available; it is more efficient than the
machine currently being used. The new machine would reduce the company's variable costs by 20 per cent, and
leasing it would increase fixed costs by USD 96,000 per year.
a. Compute the break-even point in units assuming use of the old machine.
b. Compute the break-even point in units assuming use of the new machine.
c. Assuming that total sales remain at USD 12,000,000 and that the new machine is leased, compute the
expected net income.
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21. Cost-volume-profit analysis
d. Should the new machine be leased? Why?
Problem K Surething CD Company reports sales of USD 720,000, variable costs of USD 432,000, and fixed
costs of USD 108,000. If the company spends USD 72,000 on a sales promotion campaign, it estimates that sales
will be increased by USD 270,000.
Determine whether the sales promotion campaign should be undertaken. Provide calculations.
Alternate problems
Alternate problem A Hear Right Company has identified certain variable and fixed costs in its production of
hearing aids. Management wants you to divide one of its mixed costs into its fixed and variable portions. Here are
the data for this cost:
Month Units Costs January 20,800 $57,600 February 20,000 54,000 March 22,000 58,500 April 25,600 57,600 May 28,400 58,500 June 30,000 62,100 July 32,800 63,900 August 35,600 68,400 September 37,600 72,000 October 40,000 77,400
a. Using the high-low method, determine the total amount of fixed costs and the amount of variable cost per
unit. Draw the cost line.
b. Prepare a scatter diagram, plot the actual costs, and visually fit a linear cost line to the points. Estimate the
amount of total fixed costs and the variable cost per unit.
Alternate problem B
a. Using the preceding graph, label the relevant range, total costs, fixed costs, break-even point, and profit and
loss areas.
b. At 18,000 units, what would sales revenue, total costs, fixed and variable costs be?
c. At 18,000 units, would there be a profit or loss? How much?
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Alternate problem C Jefferson Company has a plant capacity of 100,000 units, at which level variable costs
are USD 720,000. Fixed costs are expected to be USD 432,000. Each unit of product sells for USD 12.
a. Determine the company's break-even point in sales dollars and units.
b. At what level of sales dollars would the company earn net income of USD 144,000?
c. If the selling price were raised to USD 14.40 per unit, at what level of sales dollars would the company earn
USD 144,000?
Alternate problem D a. Determine the break-even point in sales dollars and units for Cowboys Company that
has fixed costs of USD 63,000, variable cost of USD 24.50 per unit, and a selling price of USD 35.00 per unit.
b. Wildcats Company breaks even when sales are USD 280,000. In March, sales were USD 670,000, and
variable costs were USD 536,000. Compute the amount of fixed costs.
c. Hoosiers Company had sales in June of USD 84,000; variable costs of USD 46,200; and fixed costs of USD
50,400. At what level of sales, in dollars, would the company break even?
d. What would the break-even point in sales dollars have been in (c) if variable costs had been 10 per cent
higher?
e. What would the break-even point in sales dollars have been in (c) if fixed costs had been 10 per cent higher?
f. Compute the break-even point in sales dollars for Hoosiers Company in (c) under the assumptions of (d) and
(e) together.
Answer each of the preceding questions.
Alternate problem E See Right Company makes contact lenses. The company has a plant capacity of 200,000
units. Variable costs are USD 4,000,000 at 100 per cent capacity. Fixed costs are USD 2,000,000 per year, but this
is true only between 50,000 and 200,000 units.
a. Prepare a cost-volume-profit chart for See Right Company assuming it sells its product for USD 40 each.
Indicate on the chart the relevant range, break-even point, and the areas of net income and losses.
b. Compute the break-even point in units.
c. How many units would have to be sold to earn USD 200,000 per year?
Alternate problem F Mr Feelds Cookies has fixed costs of USD 360,000 per year. It sells three types of
cookies. The cost and revenue data for these products follow:
Cookies Cream cake Goo fill Sweet tooth
Sales $64,000 $95,0000 $131,000 Variable costs 38,400 55,100 66,000
Compute the break-even point in sales dollars.
Beyond the numbers—Critical thinking
Business decision case A Quality Furniture Company is operating at almost 100 per cent of capacity. The
company expects sales to increase by 25 per cent in 2011. To satisfy the demand for its product, the company is
considering two alternatives: The first alternative would increase fixed costs by 15 per cent but not affect variable
costs. The second alternative would not affect fixed costs but increase variable costs to 60 per cent of the selling
price of the company's product.
This is Quality Furniture Company's condensed income statement for 2010:
Sales $3,600,000 Costs: Variable $1,620,000
Accounting Principles: A Business Perspective 855 A Global Text
21. Cost-volume-profit analysis
Fixed 330,000 1,950,000 Income before taxes $1,650,000
a. Determine the break-even point in sales dollars for 2011 under each of the alternatives.
b. Determine projected income for 2011 under each of the alternatives.
c. Which alternative would you recommend? Why?
Business decision case B When the Weidkamp Company's plant is completely idle, fixed costs amount to
USD 720,000. When the plant operates at levels of 50 per cent of capacity or less, its fixed costs are USD 840,000;
at levels more than 50 per cent of capacity, its fixed costs are USD 1,200,000. The company's variable costs at full
capacity (100,000 units) amount to USD 1,800,000.
a. Assuming that the company's product sells for USD 60 per unit, what is the company's break-even point in
sales dollars?
b. Using only the data given, at what level of sales would it be more economical to close the factory than to
operate it? In other words, at what level would operating losses approximate the losses incurred if the factory closed
down completely?
c. Assume that Weidkamp Company is operating at 50 per cent of its capacity and decides to reduce the selling
price from USD 60 per unit to USD 36 per unit to increase sales. At what percentage of capacity must the company
operate to break even at the reduced sales price?
Business decision case C Monroe Company has recently been awarded a contract to sell 25,000 units of its
product to the federal government. Monroe manufactures the components of the product rather than purchasing
them. When the news of the contract was released to the public, President Mary Monroe, received a call from the
president of the McLean Corporation, Carl Cahn. Cahn offered to sell Monroe 25,000 units of a needed component,
Part J, for USD 15.00 each. After receiving the offer, Monroe calls you into her office and asks you to recommend
whether to accept or reject Cahn's offer.
You go to the company's records and obtain the following information concerning the production of Part J.
Costs at current production level (200,000 units)
Direct labor $1,248,000 Direct materials 576,000 Manufacturing overhead 600,000 Total cost $2,424,000
You calculate the unit cost of Part J to be USD 12.12 or (USD 2,424,000/200,000). But you suspect that this
unit cost may not hold true at all production levels. To find out, you consult the production manager. She tells you
that to meet the increased production needs, equipment would have to be rented and the production workers would
work some overtime. She estimates the machine rental to be USD 60,000 and the total overtime premiums to be
USD 108,000. She provides you with the following information:
Costs at current production level (225,000 units)
Direct labor $1,404,000 Direct materials 648,000 Manufacturing overhead (including equipmental rental and overtime premiums)
828,000
Total cost $2,880,000
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The production manager advises you to reject Cahn's offer, since the unit cost of Part J would be only USD 12.80
or (USD 2,880,000/225,000 units) with the additional costs of equipment rental and overtime premiums. This
amount still is less than the USD 15.00 that Cahn would charge. Undecided, you return to your office to consider
the matter further.
a. Using the high-low method, compute the variable cost portion of manufacturing overhead. (Remember that
the costs of equipment rental and overtime premiums are included in manufacturing overhead. Subtract these
amounts before performing the calculation).
b. Compute the total costs to manufacture the additional units of Part J. (Note: include overtime premiums as a
part of direct labor.)
c. Compute the unit cost to manufacture the additional units of Part J.
d. Write a report recommending that Monroe accept or reject Cahn's offer.
Business decision case D Refer to the "A broader perspective: Major television networks are finding it harder
to break even" discussion of cost-volume-profit analysis for television networks. Write a memo to your instructor
describing how the networks can reduce their break-even points.
Group project E In teams of two or three students, develop a cost-volume-profit equation for a new business
that you might start. Examples of such businesses are a portable espresso bar, a pizza stand, a campus movie
theater, a package delivery service, a campus-to-airport limousine service, and a T-shirt printing business.
Your equation should be in the form: Profits = (Price per unit X Volume) – (Variable cost per unit X Volume) -
Fixed costs per period. Pick a period of time, say one month, and project the unit price, volume, unit variable cost,
and fixed costs for the period. From this information, you will be able to estimate the profits—or losses—for the
period. Select one spokesperson for your team to tell the class about your proposed business and its profits or
losses. Good luck, and have fun.
Group project F Refer to "A broader perspective: Even colleges use CVP" discussion of how cost-volume-profit
analysis is used by colleges. In teams of two or three students, write a memo to your instructor defining step costs
and explain why the step costs identified in the case are classified as such. Also include in your memo how the
school might lower its break-even point.
Group project G In teams of two or three students, address the following questions:
• Why would a company consider increasing automation and decreasing the use of labor if the result would
be an increase in the break-even point?
• Would an increase in automation increase fixed costs over the short-run, long-run, or both?
Write a memo to your instructor that addresses both questions. Be sure to explain your answers.
Using the Internet—A view of the real world
Visit the website for Intel Corporation, a high technology manufacturing company.
http://www.intel.com
Go to the company's most recent financial statements and review the consolidated statement of income. What
additional information, if any, would you need to perform cost-volume-profit analysis? Why is this information
excluded from Intel's income statement?
Visit the website for Wal-Mart Corporation, a retail company.
http://www.walmart.com
Accounting Principles: A Business Perspective 857 A Global Text
21. Cost-volume-profit analysis
Go to the company's most recent financial statements and review the statement of income. What additional
information, if any, would you need to perform cost-volume-profit analysis? Why is this information excluded from
Wal-Mart Corporation's income statement?
Answers to self-test
True-false
False. The high-low method is less precise than the scatter diagram because it requires only two data points in
the computation.
False. The break-even point can also be expressed in units produced or sold.
False. Total contribution margin is the amount by which revenue exceeds variable costs of producing that
revenue.
False. Margin of safety = Current sales - Break-even sales.
True. Dollars of sales are used as the measure of volume when a company has many different products.
Multiple-choice
c. Electricity is a mixed cost.
d. Step costs have all of these characteristics—a fixed component, costs increase, and constancy over a relevant
range for a step.
c. BE dollars= Fix costs
Contribution margin ratio
Contribution margin ratio = USD 10– USD 6
USD10 =0.40
BE dollars = USD20,000
0.40 =USD50,000
a. Contribution margin = Selling price – Variable costs
= USD 20 – USD 6 = USD 14
d. BE units= Fix costs
Contribution margin per unit
BE units= USD28,000
USD14 per unit
= 2,000
d. All of these are assumptions—prices and costs remain constant through the relevant range, product mix is
known, and costs can be accurately classified into fixed and variable components.
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22. Short-term decision making: Differential analysis
Learning objectives
After studying this chapter, you should be able to:
• Compare and contrast contribution margin income statements to traditional income statements.
• Explain differential analysis and describe its components.
• Make pricing decisions using differential analysis.
• Use differential analysis to decide whether to accept or reject special orders.
• Decide whether to eliminate or add product lines or segments of the business using differential analysis.
• Use differential analysis to decide whether to sell joint products at the split-off point or process them further.
• Decide whether to make or buy products using differential analysis.
• Use differential analysis to decide whether to improve product quality.
In this chapter, we will discuss how companies use financial information in making decisions. The framework
for our discussion is differential analysis. We begin by presenting an alternative to the traditional income statement
format. This alternative, the contribution margin income statement, generally is more useful for the managerial
decisions we discuss in this chapter. Then we discuss differential analysis as a method of choosing the best solution
to decision problems. We also present several applications of differential analysis to managerial problems that you
will likely encounter.
Contribution margin income statements
Both this and the previous chapter discuss the use of accounting for managerial decision making. We have
introduced the concepts of fixed and variable costs, and shown how you can use these concepts in making decisions.
However, income statements published for external use do not break costs down into fixed and variable
components. We now present another income statement that not only breaks down costs into their fixed and
variable components but also presents the total contribution margin. The contribution margin income statement
subtracts variable costs from revenues to show the contribution margin, and then subtracts fixed costs to derive net
income.
You can see the differences between the traditional and contribution margin income statements by contrasting
two income statements based on the same data. Assume Bart Company had the following data relating to
manufacturing and sales activities for May 2011:
Bart Company May 2011
Variable manufacturing costs (per unit): Direct materials $ 1 Direct labor 1 Overhead 1 Total 3 Variable selling expenses (per unit) $0.50 Fixed costs:
Accounting Principles: A Business Perspective 859 A Global Text
22. Short-term decision making: Differential analysis
Manufacturing overhead ($1.00 per unit for 9,000 units)
$ 9,000
Selling expenses 15,000 Administrative expenses 18,000 Selling price (per unit) $ 9
Look at Exhibit 175, where we compare the traditional and contribution margin methods.
A. Traditional method Bart company
Income statement For the month ending 2011 May 31
Revenue (9,000 units at $9 per unit) $81,000 Less: Cost of goods sold (9,000 units at $4 manufacturing cost per unit: Less: $3 variable + $1 fixed)
36,000
Gross margin $45,000 Less: Selling and administrative expenses (9,000 units at $0.50 variable selling cost per unit, plus fixed costs of $15,000 for selling and $18,000 for administrative)
37,500
Net income tax $7,500 B. Contribution margin method
Bart company Income statement
For the month ending 2011 May 31 Revenue (9,000 units at $9 per unit) $81,000 Less: Variable cost of goods sold (9,000 units at $3 variable manufacturing cost per unit)
$27,000
Variable selling expenses (9,000 units at $0.50 per unit)
4,500 31,500
Total contribution margin $ 49,500 Less: Fixed manufacturing costs $ 9,000 Less: Fixed selling expenses 15,000 Less: Fixed administrative expenses 18,000 42,000 Net income before tax $ 7,500
Exhibit 175: Comparative income statements
The contribution margin method shows managers the amount of variable costs, the amount of fixed costs, and
the contribution the company is making toward covering fixed costs and earning net income. For example, suppose
the managers of Bart Company asked, "What would be the impact on net income if we increase sales units by 10 per
cent without changing unit price or variable cost per unit or total fixed costs?" Looking at the contribution margin
statement, we predict the following increases:
Revenue increase (10% of $81,000) $8,100 Variable cost of goods sold increase (10% of $27,000)
$2,700
Increase in total variable selling expense (10% of $4,500)
450 3,150
Increase in total contribution margin $4,950
If we assume no increase in fixed costs, we expect Bart's net income to increase by USD 4,950.
The traditional statement does not break down costs into fixed and variable components, so we cannot easily
answer the question posed by Bart's management. Most companies use the traditional approach for external
financial statements, but they use the contribution margin format for internal purposes because it is more
informative. Management often needs information on the contribution margin rather than the gross margin to
calculate break-even points and make decisions regarding special-order pricing.
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An accounting perspective:
Uses of technology
Generating multiple financial reports in different formats does not mean companies must keep
several sets of books. After data are entered into a database, it is relatively simple for computer
software to generate several sets of financial statements—a contribution margin income statement
for managers, a traditional income statement for external financial reporting, and yet another
report for tax purposes. Two problems remain: First, the reports are only as good as the quality of
the data in the database. Second, people who read the financial statements must be sufficiently
informed to understand the differences in the way the information is presented.
Differential analysis
Differential analysis involves analyzing the different costs and benefits that would arise from alternative
solutions to a particular problem. Relevant revenues or costs in a given situation are future revenues or costs
that differ depending on the alternative course of action selected. Differential revenue is the difference in
revenues between two alternatives. Differential cost or expense is the difference between the amounts of
relevant costs for two alternatives.53
Future costs that do not differ between alternatives are irrelevant and may be ignored since they affect both
alternatives similarly. Past costs, also known as sunk costs, are not relevant in decision making because they have
already been incurred; therefore, these costs cannot be changed no matter which alternative is selected.
For certain decisions, revenues do not differ between alternatives. Under those circumstances, management
should select the alternative with the least cost. In other situations, costs do not differ between alternatives.
Accordingly, management should select the alternative that results in the largest revenue. Many times both future
costs and revenues differ between alternatives. In these situations, the management should select the alternative
that results in the greatest positive difference between future revenues and expenses (costs).
To illustrate relevant, differential, and sunk costs, assume that Joanna Bennett invested USD 400 in a tiller so
she could till gardens to earn USD 1,500 during the summer. Not long afterward, Bennett was offered a job at a
horse stable feeding horses and cleaning stalls for USD 1,200 for the summer. The costs that she would incur in
tilling are USD 100 for transportation and USD 150 for supplies. The costs she would incur at the horse stable are
USD 100 for transportation and USD 50 for supplies. If Bennett works at the stable, she would still have the tiller,
which she could loan to her parents and friends at no charge.
The tiller cost of USD 400 is not relevant to the decision because it is a sunk cost. The transportation cost of
USD 100 is also not relevant because it is the same for both alternatives. These costs and revenues are relevant:
Performing tilling service
Working at horse stable
Differential
Revenues $1,500 $1,200 $300 Costs 150 50 100 Net benefit in favor of tilling $200
53 Some authors equate relevant cost and differential cost. This text uses the term relevant to identify which costs
should be considered in a situation and the term differential to identify the amount by which these costs differ.
Accounting Principles: A Business Perspective 861 A Global Text
22. Short-term decision making: Differential analysis
service
Based on this differential analysis, Joanna Bennett should perform her tilling service rather than work at the
stable. Of course, this analysis considers only cash flows; nonmonetary considerations, such as her love for horses,
could sway the decision.
In many situations, total variable costs differ between alternatives while total fixed costs do not. For example,
suppose you are deciding between taking the bus to work or driving your car on a particular day. The differential
costs of driving a car to work or taking the bus would involve only the variable costs of driving the car versus the
variable costs of taking the bus.
Suppose the decision is whether to drive your car to work every day for a year versus taking the bus for a year. If
you bought a second car for commuting, certain costs such as insurance and an auto license that are fixed costs of
owning a car would be differential costs for this particular decision.
Before studying the applications of differential analysis, you must realize that (1) two types of fixed costs exist
and (2) opportunity costs are also relevant in choosing between alternatives. For this reason, we discuss committed
fixed costs, discretionary fixed costs, and opportunity costs before concentrating on the applications of differential
analysis.
Up to this point, we have treated fixed costs as if they were all alike. Now we describe two types of fixed costs—
committed fixed costs and discretionary fixed costs.
Committed fixed costs Committed fixed costs relate to the basic facilities and organizational structure
that a company must have to continue operations. These costs cannot be changed in the short run without seriously
disrupting operations. Examples of committed fixed costs are leases on buildings and equipment and salaries of key
executives. In the short run, these costs are not subject to the discretion or control of management. These costs
result from past decisions that committed the company for several years. For instance, once a company constructs a
building to house production operations, it is committed to use the building for many years. Thus, unlike some
other types of fixed costs, the depreciation on that building is not as subject to management's control.
Discretionary fixed costs In contrast to committed fixed costs, management controls discretionary fixed
costs from year to year. Each year management decides how much to spend on advertising, research and
development, and employee training or development programs. Because it makes such decisions each year, these
costs are under management's discretion. Management is not locked in or committed to a certain level of expense
for longer than one budget period. In the next period, management may change the level of expense or eliminate
the expense completely.
To some extent, management's philosophy can affect which fixed costs are committed and which are
discretionary. For instance, some companies terminate people in the upper levels of management when they
downsize, while other companies keep their management team intact. Thus, in some companies the salaries of top-
level managers are discretionary while in other companies they are committed.
The discussion of committed fixed costs and discretionary fixed costs is relevant to CVP analysis. When almost
all of a company's fixed costs are committed fixed costs, it has more difficulty reducing its break-even point for the
next budget period than if most of its fixed costs are discretionary. A company with a large proportion of
discretionary fixed costs may be able to reduce fixed costs dramatically in recessionary periods. By running lean,
the company may show some income even when economic conditions are difficult. As a result, the company may
enhance its chances of long-run survival.
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Another cost concept relevant to decision making is opportunity cost. An opportunity cost is the potential
benefit that is forgone by not following the next best alternative course of action. For example, assume that the two
best uses of a plot of land are as a mobile home park (annual income of USD 100,000) and as a golf driving range
(annual income of USD 60,000). The opportunity cost of using the land as a mobile home park is USD 60,000,
while the opportunity cost of using the land as a driving range is USD 100,000.
Companies do not record opportunity costs in the accounting records because they are the costs of not following
a certain alternative. Thus, opportunity costs are not transactions that occurred but that did not occur. However,
opportunity cost is a relevant cost in many decisions because it represents a real sacrifice when one alternative is
chosen instead of another.
Applications of differential analysis
To illustrate the application of differential analysis to specific decision problems, we consider five decisions: (1)
setting prices of products; (2) accepting or rejecting special orders; (3) adding or eliminating products, segments, or
customers; (4) processing or selling joint products; and (5) deciding whether to make products or buy them.
Although these five decisions are not the only applications of differential analysis, they represent typical short-term
business decisions using differential analysis. Our discussion ignores income taxes.
When applying differential analysis to pricing decisions, each possible price for a given product represents an
alternative course of action. The sales revenues for each alternative and the costs that differ between alternatives
are the relevant amounts in these decisions. Total fixed costs often remain the same between pricing alternatives
and, if so, may be ignored. In selecting a price for a product, the goal is to select the price at which total future
revenues exceed total future costs by the greatest amount, thus maximizing income.
A high price is not necessarily the price that maximizes income. The product may have many substitutes. If a
company sets a high price, the number of units sold may decline substantially as customers switch to lower-priced
competitive products. Thus, in the maximization of income, the expected volume of sales at each price is as
important as the contribution margin per unit of product sold. In making any pricing decision, management should
seek the combination of price and volume that produces the largest total contribution margin. This combination is
often difficult to identify in an actual situation because management may have to estimate the number of units that
can be sold at each price.
For example, assume that a company selling fried chicken in the New York market estimates product demand
for its large bucket of chicken for a particular period to be:
Choice Demand 1 15,000 units at $6 per unit 2 12,000 units at $7 per unit 3 10,000 units at $8 per unit 4 7,000 units at $9 per unit
The company's fixed costs of USD 20,000 per year are not affected by the different volume alternatives. Variable
costs are USD 5 per unit. What price should be set for the product? Based on the calculations shown in the table
below, the company should select a price of USD 8 per unit because choice (3) results in the greatest total
contribution margin. In the short run, maximizing total contribution margin maximizes profits.
Choice Contribution margin per unit* x
Number of units =
Total margin
Fixed costs
Net income (loss)
1 $1 15,000 $15,000 $20,000 $(5,000) 2 2 12,000 24,000 20,000 4,000
Accounting Principles: A Business Perspective 863 A Global Text
22. Short-term decision making: Differential analysis
3 3 10,000 30,000 20,000 10,000 4 4 7,000 28,000 20,000 8,000 *Sales price – Variable cost.
Sometimes management has an opportunity to sell its product in two or more markets at two or more different
prices. Movie theaters, for example, sell tickets at discount prices to particular groups of people—children, students,
and senior citizens. Differential analysis can determine whether companies should sell their products at prices
below regular levels.
Good business management requires keeping the cost of idleness at a minimum. When operating at less than
full capacity, management should seek additional business. Management may decide to accept such additional
business at prices lower than average unit costs if the differential revenues from the additional business exceed the
differential costs. By accepting special orders at a discount, businesses can keep people employed that they would
otherwise lay off.
To illustrate, assume Rios Company produces and sells a single product with a variable cost of USD 8 per unit.
(See Exhibit 176 for details.) Annual capacity is 10,000 units, and annual fixed costs total USD 48,000. The selling
price is USD 20 per unit and production and sales are budgeted at 5,000 units. Thus, budgeted income before
income taxes is USD 12,000, as shown in Exhibit 176.
Rios company Income statement
For the period ending 2011 May 31
Revenue (5,000 units at $20) $100,000 Variable costs: Direct materials cost $20,000 Labor 5,000 Overhead 10,000 Marketing and administrative costs
5,000
Total variable costs ($8 per unit) $40,000 Fixed costs: Overhead $28,000 Marketing and administrative costs
20,000
Total fixed costs 48,000 Total costs ($17.60 per unit) 88,000 Net income $12,000
Exhibit 176: Rios company before special order
Assume the company receives an order from a foreign distributor for 3,000 units at USD 10 per unit. This USD
10 price is not only half of the regular selling price per unit, but also less than the USD 17.60 average cost per unit
(USD 88,000/5,000 units). However, the USD 10 price offered exceeds the variable cost per unit by USD 2. If the
company accepts the order, net income increases to USD 18,000.
As shown in the income statement in Exhibit 177, revenue increases to USD 130,000 with the special order.
Each of the variable costs increases in total by 60 per cent because total volume increases by 60 per cent (3,000
units in the special order/5,000 units regularly produced).
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Rios company Income statement
For the period ending 2011 May 31
Revenue (5,000 units at $20, 3,000 units at $10)
$130,000
Variable costs: Direct materials cost $32,000 Labor 8,000 Overhead 16,000 Marketing and administrative costs 8,000 Total variable costs ($8 per unit) $64,000 Fixed costs: Manufacturing overhead $28,000 Marketing and administrative costs 20,000 Total fixed costs 48,000 Total costs ($14 per unit) 112,000 Net income $18,000
Exhibit 177: Rios company if special order is accepted
Note that the fixed costs do not increase with the special order. Because the special order does not increase the
fixed costs, the special order's revenues need only cover its variable costs.
If Rios Company continues to operate at 50 per cent capacity (producing 5,000 units) it would generate income
of only USD 12,000. By accepting the special order, net income increases by USD 6,000.
Differential analysis would provide the following calculations:
Accept order
Reject order
Differential
Revenues $130,000 $100,000 $30,000 Costs 112,000 88,000 24,000 Net benefit of accepting order $6,000
Variable costs set a floor for the selling price in special-order situations. Even if the price exceeds variable costs
only slightly, the additional business increases net income, assuming fixed costs do not change. However, pricing
just above variable costs of special-order business often brings only short-term increases in net income. In the long
run, companies must cover all of their costs, not just the variable costs.
Periodically, management has to decide whether to add or eliminate certain products, segments, or customers. If
you have watched a store or a plant open or close in your area, you have seen the results of these decisions.
Differential analysis is useful in this decision making because a company's income statement does not automatically
associate costs with certain products, segments, or customers. Thus, companies must reclassify costs as those that
the action would change and those that it would not change.
If companies add or eliminate products, they usually increase or decrease variable costs. The fixed costs may
change, but not in many cases. Management bases decisions to add or eliminate products only on the differential
items; that is, the costs and revenues that change.
To illustrate, assume that the Campus Bookstore is considering eliminating its art supplies department. If the
bookstore dropped the art supplies department, it would lose revenues of USD 100,000 annually. The bookstore's
management assigns costs of USD 110,000 (USD 80,000 variable and USD 30,000 fixed) to the art supplies
department. Therefore, art supplies has an apparent annual loss of USD 10,000 (USD 100,000 revenue minus USD
110,000 costs). But careful cost analysis reveals that if the art supplies department were dropped, the reduction in
costs would be only USD 80,000. The USD 30,000 fixed costs were general bookstore fixed costs allocated to the
art supplies department. These fixed costs would continue to be incurred and would not be saved by closing the art
supplies department. Look at the differential analysis in Exhibit 178. Note that the art supplies department has
Accounting Principles: A Business Perspective 865 A Global Text
22. Short-term decision making: Differential analysis
been contributing USD 20,000 (USD 100,000 revenues - USD 80,000 variable costs) annually toward covering the
fixed costs of the business. Consequently, its elimination could be a costly mistake unless there is a more profitable
use for the vacated facilities.
Art Supplies Department Keep Close Differential
Revenues $100,000 $-0- $100,000 Variable costs 80,000 -0- 80,000 Fixed costs 30,000 30,000 -0- Net benefit of keeping art supplies department
$ 20,000
Exhibit 178: Differential analysis: Decision whether to close a department
If the company has a profitable alternative use for the vacated facilities, the potential income from that
alternative represents an opportunity cost of retaining the product, segment, or customer. Assume, for example,
that the bookstore could use the facilities currently occupied by the art supplies department to open a new
department to display and sell personal computers, printers, and software. This new department would contribute
USD 35,000 to the bookstore's income.
The relevant costs in the decision to retain the art supplies department are USD 115,000 (USD 80,000 of
variable manufacturing costs and USD 35,000 of opportunity cost), while the relevant revenues are still USD
100,000. Therefore, the bookstore has a net disadvantage in keeping the art supplies department because it loses
USD 15,000 compared to the computer department.
Sometimes two or more products result from a common raw material or production process; these products are
called joint products. Companies can process these products further or sell them in their current condition. For
instance, when Chevron refines crude oil, it produces a wide variety of fuels, solvents, lubricants, and residual
petrochemicals.
Management can use differential analysis to decide whether to process a joint product further or to sell it in its
present condition. Joint costs are those costs incurred up to the point where the joint products split off from each
other. These costs are sunk costs and are not considered when deciding whether to process a joint product further
before selling it or to sell it in its condition at the split-off point.
The following example illustrates the issue of whether to process or sell joint products. Assume that Pacific
Paper, Inc., produces two paper products, A and B, from a common manufacturing process. Each of the products
could either be sold in its present form or processed further and sold at a higher price. Data for both products
follow:
Product Selling price per unit at split-off point
Cost per unit of further processing
Selling price per unit after further processing
A $10 $6 $21 B 12 7 18
The differential revenues and costs of further processing of the two products are as follows:
Product Different revenue of further processing
Differential cost of further processing
Net advantage (disadvantage) of further processing
A $11 $6 $5 B 6 7 (1)
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Based on this analysis, Pacific Paper should process product A further to increase income by USD 5 per unit
sold. The company should not process product B further because that would decrease income by USD 1 per unit
sold.
Companies use this same form of differential analysis to decide whether they should discard their by-products or
process them further. By-products are additional products resulting from the production of a main product and
generally have a small market value compared to the main product. Sometimes companies consider by-products to
be waste materials. For example, the bark from trees cut into lumber is a by-product of lumber production.
Although a by-product, companies convert this bark into fuel or landscaping material. When the differential
revenue of further processing exceeds the differential cost, firms should do further processing. As concerns increase
about the effects of waste on the environment, companies find more and more waste materials that can be
converted into by-products.
Managers also apply differential analysis to make-or-buy decisions. A make-or-buy decision occurs when
management must decide whether to make or purchase a part or material used in manufacturing another product.
Management must compare the price paid for a part with the additional costs incurred to manufacture the part.
When most of the manufacturing costs are fixed and would exist in any case, it is likely to be more economical to
make the part rather than buy it.
To illustrate the application of differential analysis to make-or-buy decisions, assume that Small Motor
Company manufactures a part costing USD 6 for use in its toy automobile engines. Cost components are: materials,
USD 3.00; labor, USD 1.50; fixed overhead costs, USD 1.05; and variable overhead costs, USD 0.45. Small could
purchase the part for USD 5.25. Fixed overhead would presumably continue even if the part were purchased. The
added costs of manufacturing amount to only USD 4.95 (USD 3.00 + USD 1.50 + USD 0.45). This amount is 30
cents per unit less than the purchase price of the part. Therefore, manufacturing the part should be continued as
shown in the following analysis:
Make Buy Differential Costs $4,95 $5.25 $0.30 Net advantage of making $0.30
In make-or-buy decisions, management also should consider the opportunity cost of not utilizing the space for
some other purpose. In the previous example, if the opportunity costs of not using this space in its best alternative
use is more than 30 cents per unit times the number of units produced, the part should be purchased.
In some manufacturing situations, firms avoid a portion of fixed costs by buying from an outside source. For
example, suppose eliminating a part would reduce production so that a supervisor's salary could be saved. In such a
situation, firms should treat these fixed costs the same as variable costs in the analysis because they would be
relevant costs.
Sometimes the cost to manufacture may be only slightly less than the cost of purchasing the part or material.
Then management should place considerable weight on other factors such as the competency of existing personnel
to undertake manufacturing the part or material, the availability of working capital, and the cost of any loans that
may be necessary.
Applying differential analysis to quality
High quality is essential to success in a competitive environment. Therefore, companies use differential analysis
to make decisions about the quality of their products.
Accounting Principles: A Business Perspective 867 A Global Text
22. Short-term decision making: Differential analysis
Assume Erie Waters produces bottled water. The variable cost of a case (12 one-liter bottles) is as follows:
Water and bottles $2.00 Inspection and rework costs 1.00 All other variable costs 3.00 Total variable cost per case $6.00
In addition, the company has USD 150,000 of fixed costs per year.
The company inspects the product at various stages. When inspectors find the water is below standard or the
bottles have defects, production workers replace the water and/or the bottles. The cost of inspecting the product
and replacing water and/or bottles averages USD 1.00 per case, and is shown as inspection and rework costs.
Management of Erie Waters is concerned about product quality. Despite the inspection just noted, management
has learned that dissatisfied customers are switching to competitive products. Management is considering
purchasing a high-quality water product. This product would increase water and bottle costs to USD 2.50 per case
while decreasing inspection and rework costs to USD .40 per case. All other variable costs would remain at USD
3.00 per case. Erie Waters would sell this water for USD 8.00 per case. If the high-quality water is purchased, Erie
Waters expects to sell 100,000 cases of water this year at USD 8.00 per case. If Erie continues to use the current
low-quality water, the company expects to sell 90,000 cases of water this year at USD 8.00 per case. Fixed costs are
USD 150,000 per year whether the company buys high-quality water or low-quality water. Should Erie Waters buy
the high-quality water? We compare the two alternatives in Exhibit 179.
An accounting perspective:
Business insight
The 1950s through 1970s were boom periods for manufacturing companies in the United States. As
one of the few industrial countries left intact after World War II, the United States had little
competition from manufacturers in other countries. But, countries such as Japan, Taiwan and
Korea made a comeback and dominated in steel, automobiles, and electronics.
By the end of the 20th century, US industry realized that without a substantial improvement in
quality, it could not compete in worldwide markets.
Low-quality water (90,000 cases)
High-quality water (100,000 cases)
Revenue at $8.00 per case $ 720,000 $ 800,000 Water and bottles at $2.00 per case for low quality and $2.50 per case for high quality
(180,000) (250,000)
Inspection and rework at $1.00 per case for low quality and $0.40 per case for high quality
(90,000) (40,000)
All other variable costs at $3.00 per case
(270,000) (300,000)
Fixed costs (150,000) (150,000) Net income $ 30,000 $ 60,000
Exhibit 179: Decision whether to improve quality
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Erie Waters should purchase the high-quality water because it increases net income from USD 30,000 to USD
60,000 per year. In addition, a high-quality product improves the company's prospects for maintaining or even
increasing its market share in years to come. Many companies have learned the hard way that letting quality slip
creates a bad reputation that is hard to overcome.
The focus of this chapter has been short-term decision making. Part of decision making involves planning
through the use of budgets. The topic of Chapter 23 is budgeting—an important tool for company management.
Understanding the learning objectives
• The contribution margin format separates fixed costs from variable costs; the traditional method does not.
• The contribution margin format reports contribution margin; the traditional method reports gross margin.
In a manufacturing company:
(a) Contribution margin = Revenue - Variable manufacturing costs - Variable nonmanufacturing costs
(b)Gross margin = Revenue - Cost of goods sold (where cost of goods sold equals Variable
manufacturing cost of goods sold + Fixed manufacturing cost of goods sold)
• Differential analysis involves analyzing the different costs and benefits that would arise from alternative
solutions to a particular situation.
• The components are: (1) differential revenue, the difference in revenue between two alternatives; and (2)
differential cost or expense, the difference between relevant costs for two alternatives.
• In selecting a price for a product, the goal is to select the price at which total future revenues exceed total
future variable costs by the greatest amount or, in other words, the price that results in the greatest total
contribution margin.
A broader perspective:
Differential analysis in sports
When the major sports teams acquire stars, many observers think the price is too high. By using
differential analysis, the teams figure that the acquisition will be profitable for the club based on the
increased ticket sales and other revenues that would follow the acquisition.
When the a major league baseball team acquires an expensive super-star many people in the
baseball world wonder if it is a wise financial decision. In many cases, the team becomes a pennant
contender after the acquisition, and attendance at their games increases dramatically compared to
the previous year. The differential costs of acquiring the super-star appears to have been justified.
Sports teams routinely face make-or-buy decisions concerning their players. Some teams, such as
the New York Yankees, have extensive farm systems. They usually develop players by bringing them
up through the system. Teams also buy players by waiting until young players have proven
themselves with other teams, then acquiring them. Variable costs set a floor for the selling price in
cost analyses. Such pricing should be appraised concerning their long-range effects on company
and industry price structures. In the long run, full costs must be covered.
• Costs must be reclassified as those that would be changed by the elimination and those that would not. In
effect, one must simply assume elimination and compare the reduction in revenues with the eliminated costs.
Accounting Principles: A Business Perspective 869 A Global Text
22. Short-term decision making: Differential analysis
• Joint costs are those costs incurred up to the point where the joint products split off from each other. These
costs are sunk costs in deciding whether to process a joint product further before selling it or to sell it in its
condition at the split-off point.
• A make-or-buy decision concerns whether to manufacture or purchase a part or material used in
manufacturing of another product. The price that would be paid for the part if it were purchased is compared
with the additional costs that would be incurred if the part were manufactured.
• High quality is essential to success in a competitive environment. Therefore, companies use differential
analysis to make decisions about the quality of their products.
Demonstration problem
National Express, an international delivery service, is considering eliminating operations in Eastern Europe. If
the company dropped the East European market, it would lose revenues of USD 1,000,000 annually. Management
assigns costs of USD 1,200,000 (USD 800,000 variable and USD 400,000 fixed) to the East European market.
Therefore, the East European market has an apparent annual loss of USD 200,000 per year (USD 1,000,000
revenue minus USD 1,200,000 costs). Careful cost analysis reveals that if East European operations were dropped,
the reduction in costs would be only USD 800,000 of variable and USD 250,000 of fixed costs. The remaining USD
150,000 of fixed costs were general fixed costs the company allocated to the East European market. These costs
would continue to be incurred and would not be saved by shutting down the East European market.
Solution to demonstration problem
The differential analysis for National Express's analysis of its East European operations is as follows:
East European Operations Keep Eliminate Differential
Revenues $1,000,000 $ -0- $1,000,000 Variable costs 800,000 -0- 800,000 Fixed costs 400,000 150,000 250,000 Net advantage of keeping East European operations open
$ (50,000)
Elimination of the East European market is justified according to this analysis. By eliminating this market,
National Express would reduce revenues by USD 1,000,000 and would reduce costs by USD 1,500,000 (USD
800,000 + USD 250,000), resulting in a USD 50,000 benefit of closing the operations (or a USD 50,000
differential loss by keeping the operations open).
Key terms* By-products Additional products resulting from the production of a main product. By-products generally have a small market value compared to the main product.
Committed fixed costs Costs relating to the basic facilities and organizational structure that a company must have to continue operations.
Differential analysis An analysis of the different costs and benefits that would arise from alternative solutions to a particular problem.
Differential cost or expense The difference between the amounts of relevant costs for two alternatives.
Differential revenue The difference between the amounts of relevant revenues for two alternatives.
Discretionary fixed costs Fixed costs subject to management control from year to year; an example is advertising expense.
Joint costs Those production costs incurred up to the point where the joint products split off from each other.
Joint products Two or more products resulting from a common raw material or production process.
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Make-or-buy decision A decision concerning whether to manufacture or purchase a part or material used in manufacturing another product.
Opportunity cost The potential benefit that is forgone from not following the next best alternative course of action.
Relevant revenues or costs Revenues or costs that will differ in the future depending on which alternative course of action is selected.
Sunk costs Past costs that are not relevant in decision making because they have already been incurred.
*Some terms listed in earlier chapters are repeated here for your convenience.
Self-test
True-false
Indicate whether each of the following statements is true or false.
Opportunity costs are recorded in the accounting records because they are the costs of not following a certain
alternative.
Only variable costs can be differential costs.
Contribution margin is often more valuable to management than gross margin when making decisions.
It is important to estimate sunk costs for decision making.
The decision whether to sell at the split-off point or process further is one that a petroleum company might
make.
A restaurant's chef must decide whether to make soup from dry soup mix purchased at a store or to make the
soup from scratch using vegetables, meats, and pasta. This decision is an example of a make-or-buy decision.
Multiple choice
Select the best answer for each of the following questions.
Differential analysis is best described by which of the following statements:
a. Determines only the difference in revenues between two alternatives.
b. Analyzes opportunity costs.
c. Determines only the difference between relevant costs for two alternatives.
d. Analyzes future revenues and costs that differ depending on the course of action selected.
In selecting a price for a product using differential analysis, which of the following decisions should be made?
a. The highest price should always be selected.
b. The price that will result in the greatest total contribution margin, assuming fixed costs are the same for each
price-quantity combination, should be selected.
c. Total future revenues should exceed total future variable and fixed costs.
d. All of the above.
Which of the following decisions involve differential analysis?
a. The decision to close a segment of a business.
b. The decision by a record store to add videotapes to its product line.
c. The decision by a university to drop its intercollegiate football program.
d. All of the above.
Assume Mikey Shoe Company is considering making special shoes just for Olympic athletes. In making this
decision, how would you categorize the salary of the president of Mikey?
a. Differential variable cost.
Accounting Principles: A Business Perspective 871 A Global Text
22. Short-term decision making: Differential analysis
b. Differential revenue.
c. Discretionary fixed cost.
d. Committed fixed cost.
Now turn to “Answer to self-test” at the end of the chapter to check your answers.
Questions
➢ Identify types of decisions that can be made using differential analysis.
➢ What is a committed fixed cost? Give some examples.
➢ What is a discretionary fixed cost? Give some examples.
➢ Give an example of a fixed cost that might be considered committed for one company and
discretionary for another.
➢ What is the disadvantage of a company having all committed fixed costs? Explain.
➢ What is an opportunity cost? Give some examples.
➢ What essential feature distinguishes the contribution margin income statement from the traditional
income statement?
➢ Real world question Give an example of a make-or-buy decision that you have made or someone
you know has made.
➢ Real world question Give an example in which your campus bookstore replaces one of its
departments with another it currently does not have. (For example, it stops selling magazines and
starts selling cameras.) What revenues and costs would be differential?
➢ Real world question Assume that McDonald's, of McDonald's fast-food restaurants, currently
buys its french fries from agricultural growers and food processors. In doing so, McDonald's has
decided to buy the materials for its french fries instead of "make" them. (Assume that making french
fries includes growing the potatoes.) What factors would go into McDonald's decision to buy instead
of make french fries?
➢ Real world question Suppose that Wal-Mart, one of the fastest growing companies in the world,
were to close one of its stores. Which differential revenues and costs would be affected by that
decision?
Exercises
Exercise A The following data are for Paso Robles Company for the year ended 2009 December 31:
Costs: Direct material $ 90,000 Direct labor 130,000 Manufacturing overhead: Variable 45,000 Fixed 90,000 Sales commissions (variable) 25,000 Sales salaries (fixed) 20,000 Administrative expenses (fixed) 35,000 Selling price per unit $ 10 Units produced and sold 60,000
Assume direct materials and direct labor are variable costs. Prepare a contribution margin income statement
and a traditional income statement.
Exercise B Assume you had invested USD 1,000 in a lawn mower to set up a lawn mowing business for the
summer. During the first week, you could choose either to mow the grounds at a housing development for USD
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1,400 or to help paint a garage for USD 1,360. Each job would take one week. You cannot do both. You would incur
additional costs of USD 160 for lawn mowing and USD 80 for garage painting. These costs include USD 60 under
each alternative for transportation to the job. Prepare a schedule showing the net benefit or advantage of selecting
one alternative over the other.
Exercise C The marketing department of Specialty Coffees estimates the following monthly demand for
espresso in these four price-quantity relationships:
Demand 1 9,000 cups at $1.00 per cup 2 8,000 cups at $1.25 per cup 3 6,000 cups at $1.50 per cup 4 4,000 cups at $1.75 per cup
The fixed costs of USD 3,000 per month are not affected by the different price-volume alternatives. Variable
costs are USD 0.25 per cup. What price should Specialty Coffees set for espresso?
Exercise D Viking Corporation is operating at 80 per cent of capacity, which means it produces 8,000 units.
Variable cost is USD 100 per unit. Wholesaler Y offers to buy 2,000 additional units at USD 120 per unit.
Wholesaler Z proposes to buy 1,500 additional units at USD 140 per unit. Which offer, if either, should Viking
Corporation accept? Fixed costs are not affected by accepting either offer.
Exercise E Analysis of Hair Care Company's citrus hair conditioner reveals that it is losing USD 5,000
annually. The company sells 5,000 units of citrus hair conditioner each year at USD 10 per unit. Variable costs are
USD 6 per unit. None of the company's fixed costs would be saved if the citrus hair conditioner were eliminated.
What would be the increase or decrease in company net income if citrus hair condition were eliminated?
Exercise F The luggage department of Sampson Company has revenues of USD 1,000,000; variable expenses
of USD 250,000; direct fixed costs of USD 500,000; and allocated, indirect fixed costs of USD 300,000 in an
average year. If the company eliminates this department, what would be the effect on net income?
Exercise G Raiders Company manufactures two joint products. At the split-off point, they have sales values of:
Product 1 $18 per unit Product 2 12 per unit
After further processing, the company can sell them for USD 36 and USD 16, respectively. Product 1 costs USD
12 per unit to process further and Product 2 costs USD 8 to process further. Should further processing be done on
either or both of these products? Why or why not?
Exercise H Gopherit Corporation currently is manufacturing 40,000 units per year of a part used in its final
product. The cost of producing this part is USD 50 per unit. The variable portion of this cost consists of direct
materials of USD 25, direct labor of USD 15, and variable manufacturing overhead of USD 3. The company could
earn USD 100,000 per year from the space now used to manufacture this part. Assuming equal quality and
availability, what is the maximum price per unit that Gopherit Corporation should pay to buy the part rather than
make it? (The total fixed costs would not be affected by this decision.)
Exercise I Ortez Company buys strawberries and produces strawberry jam. The variable cost of a case of
strawberry jam is as follows:
Materials (strawberries and jars) $10.00 Inspection and rework costs 4.00 All other variable costs 8.00 Total variable cost per case $22.00
In addition, the company has USD 1,000,000 of fixed costs per year.
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22. Short-term decision making: Differential analysis
The company inspects the product at various stages. The cost of inspecting the product and replacing jam
and/or jars averages USD 4.00 per case, shown as in the inspection and rework costs.
Management is considering purchasing high-quality strawberries. This would increase materials costs to USD
12.00 per case, while decreasing inspection and rework costs to USD 2.00 per case. All other costs would remain at
USD 8.00 per case for variable costs and USD 1,000,000 for fixed costs whether or not the high-quality
strawberries were purchased. Ortez's jam sells for USD 40 per case. If the high-quality strawberries were
purchased, the company could sell 100,000 cases of jam this year at USD 40 per case. If the company continued to
use the current low-quality berries, it could sell 80,000 cases of jam this year at USD 40 per case.
Should Ortez purchase the high-quality strawberries?
Problems
Problem A Montonya Company has the following selected data for the current year:
Sales (10,000 units) $90,000 Direct materials 30,000 Direct labor costs 10,000 Variable manufacturing overhead 3,500 Fixed manufacturing overhead 7,500 Variable selling and administrative expenses
2,500
Fixed selling and administrative expenses
15,000
The company produced and sold 10,000 units. Direct materials and direct labor are variable costs.
a. Prepare an income statement for the current year using the contribution margin format.
b. Prepare an income statement for the current year using the traditional format.
c. What additional information do you learn from the contribution margin format?
Problem B Pick-Me-Up Company is introducing a new coffee in its stores and must decide what price to set for
the coffee beans. An estimated demand schedule for the product follows:
Price One-pound units demanded $ 5 80,000 6 72,000 7 56,000 8 48,000 9 36,000 10 30,000
Estimated costs follow:
Variable manufacturing costs $2 per unit Fixed manufacturing costs $40,000 per year Variable selling and administrative costs
$1 per unit
Fixed selling and administrative costs
$20,000 per year
a. Prepare a schedule showing management the total revenue, total cost, and total profit or loss for each selling
price.
b. Which price do you recommend to the management of Pick-Me-Up? Explain your answer.
Problem C Ocean View Company operates tour boats. Its predicted operations for the year are as follows:
Sales (1,000 tours per year) $400,000 Costs: Variable $250 per tour Fixed $100,000 per year
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The company has received a request to offer 100 tours for USD 300 each. Ocean View has plenty of capacity to
do these tours in addition to its regular business. Doing these tours would not affect the company's regular sales or
its fixed costs.
a. Should the company do the special tours for USD 300 per tour?
b. What is the effect of the decision on the company's operating profit?
Problem D Following are sales and other operating data for the three products made and sold by Ranger
Company:
Product A B C Total
Sales $ 600,000 $ 300,000 $ 200,000 $ 1,100,000
Manufacturing costs: Fixed $ 60,000 $ 20,000 $ 60,000 $ 140,000 Variable 280,000 220,000 100,000 600,000 Selling and administrative expenses: Fixed 20,000 20,000 12,000 52,000 Variable 40,000 20,000 30,000 90,000 Total costs $ 400,000 $ 280,000 $ 202,000 $ 882,000 Net income $ 200,000 $ 20,000 $ (2,000) $ 218,000
In view of the net loss for Product C, Ranger's management is considering dropping that product. All variable
costs are direct costs and would be eliminated if Product C were dropped. Fixed costs are indirect costs; no fixed
costs would be eliminated. Assume that the space used to produce Product C would be left idle.
Would you recommend the elimination of Product C? Give supporting computations.
Problem E Sierra Lumber Company produces lumber. The company has two grades of lumber at the split-off
point, A and B. Grade A sells for USD 4 per board foot and Grade B sells for USD 2 per board foot. This lumber is
suitable for framing and most exterior work but not for the interior of buildings. Either grade can be further
processed to make it suitable for interior work at a cost of USD 1.20 per board foot. After this further processing,
the firm can sell Grade A lumber for USD 5.50 per board foot and Grade B for USD 3.00 per board foot.
Would you recommend the company sell the lumber at the split-off point or process it further to make it suitable
for interior work? Explain and give supporting computations.
Problem F Skate-Right Company, a skateboard manufacturer, is currently operating at 60 per cent capacity
and producing about 8,000 units a year. To use more capacity, the manager has been considering the research and
development department's suggestion that the company manufacture its own wheels.
Currently the company purchases wheels from a supplier at a unit price of USD 20. (Each unit is a set of wheels
for a skateboard.) Estimates show the company can manufacture its own wheels at USD 10 for direct materials costs
and USD 4 for direct labor cost per unit. The variable factory overhead is USD 1 per unit. The company's
accountants would probably allocate another USD 6 per unit to the wheels.
a. Should Skate-Right make or buy the wheels?
b. Suppose Skate-Right could rent out the factory space needed to make the wheels for USD 30,000 a month.
How would this affect your decision in (a), if at all?
Problem G Quality Calc, Inc., purchases calculator components and assembles them into handheld calculators.
The variable cost of one Model A-25 is as follows:
Materials $10 Inspection and rework costs 2 All other variable costs 5
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22. Short-term decision making: Differential analysis
Total variable cost per case $17
In addition, this product incurs USD 5,000,000 of fixed costs per year.
The company inspects the product at various stages. The cost of inspecting the product and replacing
components averages USD 2 per calculator, shown as the inspection and rework costs.
Management is considering purchasing better components that would both increase quality and expand the
calculator's capacity. These new components would increase materials costs to USD 12.50 per calculator, but would
decrease inspection and rework costs to USD 1.50 per calculator. All other variables cost would remain at USD 5 per
calculator. Fixed costs would remain at USD 5,000,000 per year.
Quality Calc currently sells each A-25 calculator for USD 25 at a volume of 1 million calculators per year.
Management believes it can increase the price of the calculator (which would now be called the A-25 STAR) to USD
30 per calculator because of its increased capability. Sales volume would remain at 1 million calculators per year for
the improved A-25 STAR. Should Quality Calc purchase the better components?
Alternate problems
Alternate problem A The following data are for Nets Company for the current year:
Sales (20,000 units) $750,000 Direct materials 270,000 Direct labor cost 90,000 Variable manufacturing overhead 27,000 Fixed manufacturing overhead 36,000 Variable selling and administrative expenses
45,000
Fixed selling and administrative expenses
150,000
The company produced and sold 20,000 units.
a. Prepare an income statement for the current year using the contribution margin format.
b. Prepare an income statement for the current year using the traditional format.
c. What additional information does the contribution margin format provide compared to the traditional
format?
Alternate problem B The Havana Company is introducing a new product and must decide its price. An
estimated demand schedule for the product is as follows:
Price Units demanded $ 5 20,000 6 18,000 7 14,000 8 12,000 9 9,000 10 8,000
Estimated costs are as follows:
Variable manufacturing costs $2.20 per unit Fixed manufacturing costs $20,000 per year Variable selling and administrative costs
$1.00 per unit
Fixed selling and administrative costs $5,000 per year
a. Prepare a schedule showing the total revenue, total cost, and total profit or loss for each selling price.
b. Which price should Havana select? Explain.
Alternate problem C Following are sales and other operating data for the three products made and sold by
Marine Enterprises:
Product
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A B C Total Sales $150,000$90,000 $240,000 $480,000 Manufacturing costs: Fixed $ 15,000 $25,000 $ 30,000 $ 70,000 Variable 120,000 35,000 134,000 289,000 Selling and administrative expenses: Fixed 5,000 30,000 10,000 45,000 Variable 2,500 5,000 6,000 13,500 Total costs $142,500$95,000 $180,000 $417,500 Net income (loss) $ 7,500 $(5,000) $ 60,000 $ 62,500
In view of the net loss shown for Product B, company management is considering dropping that product. All
variable costs are direct costs and would be eliminated if Product B were dropped; all fixed costs are indirect costs
and would not be eliminated. Assume that the space used to produce Product B would be left idle.
Would you recommend the elimination of Product B? Give supporting computations.
Alternate problem D Sailboard Enterprises, a wind sailing board manufacturer, is currently operating at 70
per cent capacity and producing about 20,000 units a year. To use more capacity, the manager has been
considering the research and development department's suggestion that Sailboard manufacture its own sails.
Currently Sailboard purchases sails from a supplier at a unit price of USD 100. Estimates show that Sailboard can
manufacture its own sails for a USD 40 direct materials cost and a USD 32 direct labor cost per unit. The variable
factory overhead is USD 8 per sail. The company's accountants would allocate fixed manufacturing overhead of
USD 30 per sail to the sail production.
a. Should Sailboard Enterprises make or buy the sails?
b. Suppose that Sailboard Enterprises could rent out the part of the factory that would otherwise be used for sail
manufacturing for USD 8,000 a month. How would this affect the decision in (a)?
Alternate problem E Cool-Snacks Company produces and sells ice cream for ice cream shops. Management is
considering purchasing better ingredients. The variable cost of producing a gallon of ice cream is as follows:
Materials (cream, containers, etc.) $1.40 Inspection and replacement costs .40 All other variable costs .70 Total variable cost per gallon $2.50
In addition, the company has USD 1,000,000 of fixed costs per year.
The company inspects the product at various stages. The cost of inspecting the product and replacing ice cream
averages USD 0.40 per gallon, shown as the inspection and replacement costs.
Management is considering purchasing high-quality ingredients, in particular, high-quality dairy products.
These high-quality ingredients would increase materials costs to USD 1.80 per gallon, but would decrease
inspection and replacement costs to USD 0.30 per gallon. All other costs would remain at USD 0.70 per gallon for
variable costs and USD 1,000,000 for fixed costs whether or not the high-quality ingredients are purchased. If the
high-quality ingredients are purchased, the company expects to sell 1,200,000 gallons of ice cream this year at USD
4 per gallon. If the company continues to use the current low-quality ingredients, the company expects to sell
1,000,000 gallons of ice cream at USD 3.50 per gallon. Should Cool-Snacks Company buy the high-quality
ingredients for its ice cream?
Beyond the numbers—Critical thinking
Business decision case A Prior to 2011, Starks Wholesalers Company had not kept department income
statements. To achieve better management control, the company decided to install department-by-department
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22. Short-term decision making: Differential analysis
accounts. At the end of 2011, the new accounts showed that although as a whole the business was profitable, the dry
goods department had a substantial loss. The following income statement for the dry goods department reports on
operations for 2011:
Starks wholesalers company Dry goods department
Partial income statement for 2011 Sales $1,200,000 Cost of goods sold 800,000 Gross margin $ 400,000 Costs: Payroll, direct labor, and supervision $120,000 Commissions of sales staff a 60,000 Rent b 40,000 Insurance on inventory 20,000 Depreciation c 80,000 Administration and general office d 80,000 Interest for inventory carrying costs e 10,000 Total costs 410,000 Net income (loss) $ (10,000) A All sales staff are compensated on straight commission on sales. B Rent charged to departments on a square-foot basis. The company rents an entire building, and the dry goods department occupies 15% of the building. C Depreciation is 8.5% of the cost of the departmental equipment. D Allocated on basis of departmental sales as a fraction of total company sales.
D Based on average inventory quantity multiplied by the company's borrowing rate for three-month loans.
Analysis of these results has led management to suggest closing the dry goods department. Members of the
management team agree that keeping the dry goods department is not essential to maintaining good customer
relations and supporting the rest of the company's business. In other words, eliminating the dry goods department
is expected to have no effect on the amount of business done by the other departments.
Prepare a written report recommending whether or not Starks should close the dry goods department. Explain
why. State your assumptions.
Business decision case B After working for a software company for several years, Chris and Terry quit their
jobs and set up their own consulting firm called C & T Software, Inc. Major customers include corporate,
professional, and government organizations that are setting up information networks.
The cost per billable hour of service at the company's normal volume of 3,000 billable hours per month follows.
(A billable hour is one hour billed to a client.)
Average cost per hour billed to client: Variable labor – consultants $50 Variable overhead, including supplies and clerical support
20
Fixed overhead, including allowance for unbilled hours
80
$150 Marketing and administrative costs per billable hour (all fixed)
40
Total hourly cost $190
Treat each of the following questions independently. Unless given otherwise, the regular fee per hour is USD
200.
a. How many hours must the firm bill per month to break even? (You may need to refer to Chapter 21 to answer
this question.)
b. Market research estimates that a fee increase to USD 250 per hour would decrease monthly volume to 2,000
hours. The accounting department estimates that fixed overhead costs would be USD 120 per hour, while variable
cost per hour would remain unchanged. What effect would a fee increase have on profits?
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c. Assume C & T Software is operating at its normal volume of 3,000 hours per month. It has received a special
request from one of its long-time customers to provide services on a special-order basis. Because of the long-term
nature of the contract (four months) and the magnitude (1,000 hours per month), the customer believes a fee
reduction is in order. C & T Software has a capacity limitation of 4,000 hours per month. Fixed costs would not
change if the firm accepts the special order. What is the lowest fee C & T Software would be willing to charge?
Business decision case C Refer to "A broader perspective: Differential analysis in sports". In a memorandum
to your instructor identify which costs and revenues you think would be differential for a sports team acquiring a
major star like Bonds. The heading of the memorandum should contain the date, to whom it is written, from whom,
and the subject matter.
Group project D In teams of two or three students, visit a local department store and imagine the types of
costs that it would save if it closed a significant department (for example, the housewares department). List the
types of costs that would be saved, but do not attempt to assign numbers to those costs. For example, would rent be
saved? Would security be saved? What about taxes on inventories? Consider the effects of closing the department
on the people who work there. As a team, write a memorandum describing the costs saved and the effects of closing
a department in a local department store. The heading of the memorandum should contain the date, to whom it is
written, from whom, and the subject matter.
Group project E A manager in your organization just received a special order at a price that is "below cost".
The manager points to the document and says, "These are the kinds of orders that will get you in trouble. Every sale
must bear its share of the full costs of running the business. If we sell below our full cost, we will be out of business
in no time." In groups of two or three students, write a memorandum to your instructor stating whether you agree
with this comment or not and explain why. The heading of the memorandum should contain the date, to whom it is
written, from whom, and the subject matter.
Group project F Form a group of two or three students. Assume you are considering driving to a weekend
resort for a quick break from school. What are the differential costs of operating your car for the drive? Write a
memorandum to your instructor addressing this question. The heading of the memorandum should contain the
date, to whom it is written, from whom, and the subject matter.
Using the Internet—A view of the real world
Visit the website for Intel Corporation, a high technology manufacturing company.
http:/www.intel.com
Go to the company's most recent financial statements and review the consolidated statement of income. Looking
at the most recent year on the statement of income, assume 70 per cent of the cost of sales are variable costs and the
remaining 30 per cent are fixed costs. Furthermore, assume all other costs and expenses (research and
development, marketing, general and administrative, interest, taxes, etc.) are 60 per cent variable and 40 per cent
fixed. Prepare an income statement using the contribution margin format. Be sure to submit a copy of Intel's
consolidated statement of income with the contribution margin income statement.
Visit the following website for Wal-Mart, a retail company.
http:/www.walmart.com
Go to the company's most recent financial statements and review the statement of income. Looking at the most
recent year on the statement of income, assume 45 per cent of the cost of sales are variable costs and the remaining
55 per cent are fixed costs. Furthermore, assume all other costs and expenses (research and development,
Accounting Principles: A Business Perspective 879 A Global Text
22. Short-term decision making: Differential analysis
marketing, general and administrative, interest, taxes, etc.) are 30 per cent variable and 70 per cent fixed. Prepare
an income statement using the contribution margin format. Be sure to submit a copy of Wal-Mart's income
statement with the contribution margin income statement.
Answers to self-test
True-false
False. Opportunity costs are not recorded in the accounting records. However, opportunity costs are relevant
costs in many decisions because they represent real sacrifices that come about because one alternative is chosen
instead of another.
False. Fixed costs also can be differential costs. For example, the differential cost between operating at a
production level of 40,000 units compared to 60,000 units might include increases in both variable and fixed costs.
True. The contribution margin is often more important to management because it is needed to calculate break-
even points and make decisions.
False. Sunk costs are not relevant for decision making.
True. Petroleum companies make this decision; for example, they might decide whether to sell crude oil or
refine it further into gasoline or other petroleum products.
True. A decision to make the soup from scratch is a make decision; deciding to make the soup from purchased
mix is a buy decision.
Multiple-choice
d. Differential analysis estimates future revenues and costs that differ depending on the course of action.
b. This is the best answer. Assuming fixed costs remain the same for each price-quantity combination,
maximizing the total contribution margin maximizes net income. We did not choose (c) because it does not result in
net income maximization, merely that net income be greater than zero.
d. All of these decisions involve differential analysis.
d. The president's salary would be a committed fixed cost. (Those who believe the salary should be a
discretionary fixed cost have a good point.)
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23. Budgeting for planning and control
A manager's perspective
Jim Wardlaw
Regional Vice President and General Manager
Atlanta Region
The Coca-Cola Company
I began my career with The Coca-Cola Company as an account manager supplying product to local stores and
restaurants in my territory. I then spent some time as Area Marketing Manager and Area Sales Development
Manager before reaching my current position.
As Regional Vice President and General Manager, I oversee the administration and operations of a region
spanning 150,000 square miles, and one of my primary objectives is to maintain a successful return on investment.
I manage three division vice presidents and four regional vice presidents, and I try to spend about 60 percent of my
time working with account managers who call on retail trade accounts.
In fact, a lot of my job is providing training and inspiration. We hold monthly meetings with each division to
assess sales and provide motivation for the account managers. I also monitor daily key indicator reports to track
sales performance in the region.
Behind increasing sales, a strong emphasis on training is one of my most important objectives. For example,
Coca-Cola recently instituted a six-week training program for new account managers. The program brings new
members of the sales team up to speed on the company and sales techniques, then puts them out in the field. Our
sales base is constantly expanding, and we are starting to call on different buyers, so we need ongoing training to
stay competitive.
All of this training helps the region achieve its number one objective—increasing sales and making the "bottom
line". Sales for each division are closely monitored, and we measure employees' performances against the sales
budget established for the region.
In managing your personal finances, you may prepare a written plan of your anticipated cash inflows and
outflows. In fact, financial advisors often recommend that we prepare a written plan of cash inflows and outflows,
then—here is the hard part—follow it. Such a written plan is a budget.
Companies prepare budgets to plan for and then control their revenues (inflows) and expenses (outflows).
Failure to prepare a budget could lead to significant cash flow problems or even financial disaster for a company. In
fact, one of the leading causes of failure in small businesses is failing to plan and control operations through the use
of budgets.
This chapter first provides a conceptual foundation for budgeting. Then we describe and illustrate a master
budget. The chapter concludes with special topics relating to budgeting.
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23. Budgeting for planning and control
The budget—For planning and control
Time and money are scarce resources to all individuals and organizations; the efficient and effective use of these
resources requires planning. Planning alone, however, is insufficient. Control is also necessary to ensure that plans
actually are carried out. A budget is a tool that managers use to plan and control the use of scarce resources. A
budget is a plan showing the company's objectives and how management intends to acquire and use resources to
attain those objectives.
Companies, nonprofit organizations, and governmental units use many different types of budgets.
Responsibility budgets, discussed in Chapter 25, are designed to judge the performance of an individual segment or
manager. Capital budgets, discussed in Chapter 26, evaluate long-term capital projects such as the addition of
equipment or the relocation of a plant. This chapter examines the master budget, which consists of a planned
operating budget and a financial budget. The planned operating budget helps to plan future earnings and
results in a projected income statement. The financial budget helps management plan the financing of assets and
results in a projected balance sheet.
The budgeting process involves planning for future profitability because earning a reasonable return on
resources used is a primary company objective. A company must devise some method to deal with the uncertainty
of the future. A company that does no planning whatsoever chooses to deal with the future by default and can react
to events only as they occur. Most businesses, however, devise a blueprint for the actions they will take given the
foreseeable events that may occur.
A budget: (1) shows management's operating plans for the coming periods; (2) formalizes management's plans
in quantitative terms; (3) forces all levels of management to think ahead, anticipate results, and take action to
remedy possible poor results; and (4) may motivate individuals to strive to achieve stated goals.
Companies can use budget-to-actual comparisons to evaluate individual performance. For instance, the
standard variable cost of producing a personal computer at IBM is a budget figure. This figure can be compared
with the actual cost of producing personal computers to help evaluate the performance of the personal computer
production managers and employees who produce personal computers. Chapter 24 illustrates this type of
comparison.
Many other benefits result from the preparation and use of budgets. For example: (1) businesses can better
coordinate their activities; (2) managers become aware of other managers' plans; (3) employees become more cost
conscious and try to conserve resources; (4) the company reviews its organization plan and changes it when
necessary; and (5) managers foster a vision that otherwise might not be developed.
The planning process that results in a formal budget provides an opportunity for various levels of management
to think through and commit future plans to writing. In addition, a properly prepared budget allows management
to follow the management-by-exception principle by devoting attention to results that deviate significantly from
planned levels. For all these reasons, a budget must clearly reflect the expected results.
Failing to budget because of the uncertainty of the future is a poor excuse for not budgeting. In fact, the less
stable the conditions, the more necessary and desirable is budgeting, although the process becomes more difficult.
Obviously, stable operating conditions permit greater reliance on past experience as a basis for budgeting.
Remember, however, that budgets involve more than a company's past results. Budgets also consider a company's
future plans and express expected activities. As a result, budgeted performance is more useful than past
performance as a basis for judging actual results.
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A budget should describe management's assumptions relating to: (1) the state of the economy over the planning
horizon; (2) plans for adding, deleting, or changing product lines; (3) the nature of the industry's competition; and
(4) the effects of existing or possible government regulations. If these assumptions change during the budget
period, management should analyze the effects of the changes and include this in an evaluation of performance
based on actual results.
Budgets are quantitative plans for the future. However, they are based mainly on past experience adjusted for
future expectations. Thus, accounting data related to the past play an important part in budget preparation. The
accounting system and the budget are closely related. The details of the budget must agree with the company's
ledger accounts. In turn, the accounts must be designed to provide the appropriate information for preparing the
budget, financial statements, and interim financial reports to facilitate operational control.
Management should frequently compare accounting data with budgeted projections during the budget period
and investigate any differences. Budgeting, however, is not a substitute for good management. Instead, the budget
is an important tool of managerial control. Managers make decisions in budget preparation that serve as a plan of
action.
The period covered by a budget varies according to the nature of the specific activity involved. Cash budgets may
cover a week or a month; sales and production budgets may cover a month, a quarter, or a year; and the general
operating budget may cover a quarter or a year.
Budgeting involves the coordination of financial and nonfinancial planning to satisfy organizational goals and
objectives. No foolproof method exists for preparing an effective budget. However, budget makers should carefully
consider the conditions that follow:
Top management support All management levels must be aware of the budget's importance to the company
and must know that the budget has top management's support. Top management, then, must clearly state long-
range goals and broad objectives. These goals and objectives must be communicated throughout the organization.
Long-range goals include the expected quality of products or services, growth rates in sales and earnings, and
percentage-of-market targets. Overemphasis on the mechanics of the budgeting process should be avoided.
Participation in goal setting Management uses budgets to show how it intends to acquire and use resources
to achieve the company's long-range goals. Employees are more likely to strive toward organizational goals if they
participate in setting them and in preparing budgets. Often, employees have significant information that could help
in preparing a meaningful budget. Also, employees may be motivated to perform their own functions within budget
constraints if they are committed to achieving organizational goals.
Communicating results People should be promptly and clearly informed of their progress. Effective
communication implies (1) timeliness, (2) reasonable accuracy, and (3) improved understanding. Managers should
effectively communicate results so employees can make any necessary adjustments in their performance.
Flexibility If significant basic assumptions underlying the budget change during the year, the planned
operating budget should be restated. For control purposes, after the actual level of operations is known, the actual
revenues and expenses can be compared to expected performance at that level of operations.
Follow-up Budget follow-up and data feedback are part of the control aspect of budgetary control. Since the
budgets are dealing with projections and estimates for future operating results and financial positions, managers
must continuously check their budgets and correct them if necessary. Often management uses performance reports
as a follow-up tool to compare actual results with budgeted results.
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23. Budgeting for planning and control
The term budget has negative connotations for many employees. Often in the past, management has imposed a
budget from the top without considering the opinions and feelings of the personnel affected. Such a dictatorial
process may result in resistance to the budget. A number of reasons may underlie such resistance, including lack of
understanding of the process, concern for status, and an expectation of increased pressure to perform. Employees
may believe that the performance evaluation method is unfair or that the goals are unrealistic and unattainable.
They may lack confidence in the way accounting figures are generated or may prefer a less formal communication
and evaluation system. Often these fears are completely unfounded, but if employees believe these problems exist,
it is difficult to accomplish the objectives of budgeting.
Problems encountered with such imposed budgets have led accountants and management to adopt participatory
budgeting. Participatory budgeting means that all levels of management responsible for actual performance
actively participate in setting operating goals for the coming period. Managers and other employees are more likely
to understand, accept, and pursue goals when they are involved in formulating them.
Within a participatory budgeting process, accountants should be compilers or coordinators of the budget, not
preparers. They should be on hand during the preparation process to present and explain significant financial data.
Accountants must identify the relevant cost data that enables management's objectives to be quantified in dollars.
Accountants are responsible for designing meaningful budget reports. Also, accountants must continually strive to
make the accounting system more responsive to managerial needs. That responsiveness, in turn, increases
confidence in the accounting system.
Although many companies have used participatory budgeting successfully, it does not always work. Studies have
shown that in many organizations, participation in the budget formulation failed to make employees more
motivated to achieve budgeted goals. Whether or not participation works depends on management's leadership
style, the attitudes of employees, and the organization's size and structure. Participation is not the answer to all the
problems of budget preparation. However, it is one way to achieve better results in organizations that are receptive
to the philosophy of participation.
A master budget consists of a projected income statement (planned operating budget) and a projected balance
sheet (financial budget) showing the organization's objectives and proposed ways of attaining them. In Exhibit 180,
we depict a flowchart of the financial planning process that you can use as an overview of the elements in a master
budget. The remainder of this chapter describes how a company prepares a master budget. We emphasize the
master budget because of its prime importance to financial planning and control in a business entity.
Exhibit 180: Flowchart of the financial planning process
The budgeting process starts with management's plans and objectives for the next period. These plans take into
consideration various policy decisions concerning selling price, distribution network, advertising expenditures, and
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environmental influences from which the company forecasts its sales for the period (in units by product or product
line). Managers arrive at the sales budget in dollars by multiplying sales units times sales price per unit. They use
expected production, sales volume, and inventory policy to project cost of goods sold. Next, managers project
operating expenses such as selling and administrative expenses.
This chapter cannot cover all areas of budgeting in detail—entire books have been written on budgeting.
However, the following presentation provides an overview of a budgeting procedure that many successful
companies have used. We begin by discussing the planned operating budget or projected income statement.
The projected balance sheet, or financial budget, depends on many items in the projected income statement.
Thus, the logical starting point in preparing a master budget is the projected income statement, or planned
operating budget. However, since the planned operating budget shows the net effect of many interrelated activities,
management must prepare several supporting budgets (sales, production, and purchases, to name a few) before
preparing the planned operating budget. The process begins with the sales budget.
Sales budget The cornerstone of the budgeting process is the sales budget because the usefulness of the entire
operating budget depends on it. The sales budget involves estimating or forecasting how much demand exists for a
company's goods and then determining if a realistic, attainable profit can be achieved based on this demand. Sales
forecasting can involve either formal or informal techniques, or both.
Formal sales forecasting techniques often involve the use of statistical tools. For example, to predict sales for the
coming period, management may use economic indicators (or variables) such as the gross national product or gross
national personal income, and other variables such as population growth, per capita income, new construction, and
population migration.
To use economic indicators to forecast sales, a relationship must exist between the indicators (called
independent variables) and the sales that are being forecast (called the dependent variable). Then management can
use statistical techniques to predict sales based on the economic indicators.
Management often supplements formal techniques with informal sales forecasting techniques such as intuition
or judgment. In some instances, management modifies sales projections using formal techniques based on other
changes in the environment. Examples include the effect on sales of any changes in the expected level of advertising
expenditures, the entry of new competitors, and/or the addition or elimination of products or sales territories. In
other instances, companies do not use any formal techniques. Instead, sales managers and salespersons estimate
how much they can sell. Managers then add up the estimates to arrive at total estimated sales for the period.
Usually, the sales manager is responsible for the sales budget and prepares it in units and then in dollars by
multiplying the units by their selling price. The sales budget in units is the basis of the remaining budgets that
support the operating budget.
Production budget The production budget considers the units in the sales budget and the company's
inventory policy. Managers develop the production budget in units and then in dollars. Determining production
volume is an important task. Companies should schedule production carefully to maintain certain minimum
quantities of inventory while avoiding excessive inventory accumulation. The principal objective of the production
budget is to coordinate the production and sale of goods in terms of time and quantity.
Companies using a just-in-time inventory system, which we discussed in Chapter 20, need to closely coordinate
purchasing, sales, and production. In general, maintaining high inventory levels allows for more flexibility in
coordinating purchases, sales, and production. However, businesses must compare the convenience of carrying
Accounting Principles: A Business Perspective 885 A Global Text
23. Budgeting for planning and control
inventory with the cost of carrying inventory; for example, they must consider storage costs and the opportunity
cost of funds tied up in inventory.
Firms often subdivide the production budget into budgets for materials, labor, and manufacturing overhead.
Usually materials, labor, and some elements of manufacturing overhead vary directly with production within a
given relevant range of production. Fixed manufacturing overhead costs do not vary directly with production but
are constant in total within a relevant range of production. For example, fixed manufacturing overhead costs may
be USD 150,000 when production ranges from 60,000 to 80,000 units. However, when production is 80,001 to
95,000 units, the fixed manufacturing overhead costs might be USD 250,000. To determine fixed manufacturing
overhead costs accurately, management must determine the relevant range for the expected level of operations.
Selling, administrative, and other expense budgets (schedules) The costs of selling a product are
closely related to the sales forecast. Generally, the higher the forecast, the higher the selling expenses.
Administrative expenses are likely to be less dependent on the sales forecast because many of the items are fixed
costs (e.g. salaries of administrative personnel and depreciation of administrative buildings and office equipment).
Managers must also estimate other expenses such as interest expense, income tax expense, and research and
development expenses. Once management has prepared the planned operating budget, the next task is to prepare
the financial budget (or projected balance sheet).
Preparing a projected balance sheet, or financial budget, involves analyzing every balance sheet account. The
beginning balance for each account is the amount on the balance sheet prepared at the end of the preceding period.
Then, managers consider the effects of any planned activities on each account. Many accounts are affected by items
appearing in the operating budget and by either cash inflows or outflows. Cash inflows and outflows usually appear
in a cash budget discussed later in the chapter.
The complexities encountered in preparing the financial budget often require the preparation of detailed
schedules. These schedules analyze such things as planned accounts receivable collections and balances, planned
material purchases, planned inventories, changes in all accounts affected by operating costs, and the amount of
federal income taxes payable. Dividend policy, inventory policy, financing policy and constraints, credit policy, and
planned capital expenditures also affect the amounts in the financial budget.
An accounting perspective:
Business insight
To a manager, a budget is like an architect's blueprints or a house builder's plans. Like the
blueprints, a budget shows the details of each part of the plan and how the various parts fit
together into the overall plan. Production people focus on production plans, salespeople focus on
sales plans, and financial people focus on projected cash receipts and disbursements. The general
manager, like the house builder, must be able to see the big picture and tie all of the pieces
together.
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The master budget illustrated
Earlier this chapter discussed general concepts relating to the preparation of a master budget. This section
illustrates the step-by-step preparation of a master budget for 2010 for Leed Company, which manufactures low-
priced running shoes.
A company develops its planned operating budget in units rather than dollars. Because revenues and many
expenses vary with volume, they can be forecasted more easily after the company estimates sales and production
quantities.
To illustrate this step, assume that Leed's management forecasts sales for the year 2010 at 100,000 units (each
pair of shoes is one unit). Quarterly sales are expected to be 20,000, 35,000, 20,000, and 25,000 units, reflecting
higher demand for shoes in the late spring and again around Christmas.
Assuming the company's policy is to stabilize production, it would produce 100,000 units uniformly throughout
the year. Therefore, production would be 25,000 units per quarter (100,000 units/four quarters). To simplify our
example, assume the company has no beginning or ending work in process inventories (although it would be
equivalent to assume that work in process inventories would remain at a constant amount throughout the year).
Finished goods inventory on 2010 January 1, is 10,000 units. From these data, we can prepare the schedule of
planned production and sales. Exhibit 181 shows the first two quarters.
Leed Company Planned production and Sales (in units)
Quarter Ending 2010 March 31 2010 June 30
Beginning finished goods inventory 10,000* 15,000 Add: Planned production 25,000 25,000 Units available for sale 35,000 40,000 Less: sales forecast 20,000 35,000 Ending finished goods inventory 15,000 5,000 * Actual on January 1
Exhibit 181: Leed Company: Planned production and sales (in units) for the first two quarters of 2010
Notice that if Leed wants to maintain a stable production of running shoes, it must allow the ending inventory to
fluctuate if sales vary. Thus, the finished goods inventory is affected by the difference between production and sales.
When establishing inventory policy, Leed's management has decided that it is less costly to deal with fluctuating
inventories than with fluctuating production.
Sometimes we receive sales and ending inventory data described as a certain percentage of the next period's
sales, and we must calculate the required level of production. Assume Leed Company wishes to have ending
inventory of 15,000 units. We could use the following format to calculate planned production:
Sales forecast (units) – current quarter 20,000 Add: Planned ending finished goods inventory 15,000 Total units required for the period 35,000 Deduct: Beginning finished goods inventory 10,000 Planned production (units) 25,000
Next, Leed's management must introduce dollars into the analysis. To do this, management forecasts the
expected selling price and costs. Exhibit 182, shows Leed's forecasted selling price and costs. Note that Leed's
management classifies costs into variable or fixed categories and budgets accordingly. As noted earlier, variable
costs vary in total directly with production or sales. Fixed costs are unaffected in total by the relative level of
production or sales.
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23. Budgeting for planning and control
Leed Company Budget Estimates of selling price and costs For quarters ending March 31 and 2010 June 30 Forecasted selling price $ 20 Manufacturing costs: Variable (per unit manufactured): Direct materials 2 Direct labor 6 Manufacturing overhead 1 Fixed overhead (total each quarter) 75,000 Selling and administrative expenses: Variable (per unit sold) 2 Fixed (total each quarter) 100,000
Exhibit 182: Leed Company: Budget estimate of selling price and costs
Management must now prepare a schedule to forecast cost of goods sold, the next major amount in the planned
operating budget. Exhibit 183, shows this schedule. Notice that the beginning finished goods inventory amount for
the quarter ending March 31 is the amount shown on the 2009 December 31, year-end balance sheet (see Exhibit
188). From the data in Exhibit 182, management calculates the cost of goods manufactured using the variable costs
of production plus an allocated amount of fixed manufacturing overhead (USD 75,000/25,000 units). The amount
of ending finished goods inventory is the number of units determined to be in ending inventory (from Exhibit 181)
times the cost per unit manufactured during the period.
Leed Company Planned cost of goods sold
Quarter Ending 2010 March 31 2010 June 30
Beginning finished goods inventory $130,000* $180,000 Cost of goods manufactured: Direct materials (25,000 x $2) $ 50,000 $ 50,000 Direct labor (25,000 x $6) 150,000 150,000 Variable manufacturing overhead (25,000 x $1)
25,000 25,000
Fixed manufacturing overhead (per Exhibit 182)
75,000 75,000
Cost of goods manufactured (25,000 units at $12)
$300,000 $300,000
Cost of goods available for sale $430,000 $480,000 Ending finished goods inventory: (15,000 at $12)† 180,000 (5,000 at 12) 60,000 Cost of goods sold $250,000 $420,000 * Actual on January 1 (10,000 at $13); see balance sheet Exhibit 188. † First in, first-out procedure assumed.
Exhibit 183: Leed Company: Planned cost of goods sold
After managers forecast cost of goods sold, they prepare a separate budget for all selling and administrative
expenses. Several supporting schedules may be prepared for items such as advertising expense, office expense, and
payroll department expense. Although we do not show the schedules to support budgeted selling and
administrative expenses here, note the total selling and administrative expenses for each of the first two quarters in
the planned operating budget in Exhibit 184.
Exhibit 184 shows the operating budget for Leed Company. We have discussed and explained all of the items
appearing in the planned operating budget except the income tax accrual. State and federal income taxes are
budgeted for Leed Company at an assumed rate of 40 per cent of income before income taxes.
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If the planned operating budget does not show the desired net income, managers must formulate new operating
plans and develop a new budget. The purpose of preparing a planned operating budget is to gain some knowledge of
the results of a period's activities before they actually occur.
A company seldom operates at the level of operations assumed in preparing the planned operating budget. After
the company knows the results of actual operations, management compares actual expenses with budgeted
expenses at the actual level of operations. To facilitate adjusting the budgeted items to the actual level of operations,
management sometimes prepares in advance flexible budgets for the entire operating budget or for certain
expenses. The next section discusses these flexible operating budgets and shows how companies prepare budget
variances.
Early in the chapter, you learned that a budget should be adjusted for changes in assumptions or variations in
the level of operations. Managers use a technique known as flexible budgeting to deal with budgetary adjustments.
A flexible operating budget is a special kind of budget that provides detailed information about budgeted
expenses (and revenues) at various levels of output.
A broader perspective:
Planning in a changing environment
Few industries have changed as much in the past decade as the telephone industry. The old-
fashioned phone company monopoly is over; it now faces intense competition from new
technologies ranging from wireless telephones to free audio and video calls over the Internet. Many
people no longer have land line phones and only use wireless phones. Indeed, the industry has been
transformed by rapidly changing technology and accompanying changes in consumer behavior.
Verizon Communications, Inc. provides telecommunications services. Its old approach to planning
and budgeting was not dynamic and creative enough to deal with the new competitive environment.
To start thinking about planning in the new environment, the company's managers met to discuss
the company's basic values. These managers developed such values as respect and trust in each
other, excellence, profitable growth, individual fulfillment, and integrity as the foundation for the
company's goals and plans. Management then established corporate goals along the lines of these
values, such as profit growth goals, and goals for achieving excellence in customer service, taking
the changing competitive environment into account.
Employee participation in setting goals, planning, and budgeting has been key to Verizon
Communications, Inc. in communicating corporate values and goals. To communicate the
company's goals, top management wrote down the company's basic business problems and the
steps they wanted to take to solve these problems. This action put Verizon's goals in terms that
employees could understand. After this communication step, employees knew better how to relate
their day-to-day work activities to the big picture, namely, ultimate corporate objectives.
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23. Budgeting for planning and control
Leed Company Planned operating budgets
Quarter Ending 2010 March 31
2010 June 30
Forecasted sales (20,000 and 35,000 at $20, per Exhibit 181 and Exhibit 182)
$400,000 $700,000
Cost of goods sold (per Exhibit 183) 250,000 420,000 Gross margin $150,000 $280,000 Selling and administrative expenses: Variable (20,000 and 35,000 at $2,, per Exhibit 182)
$ 40,000 $ 70,000
Fixed (per Exhibit 182) 100,000 100,000 Total selling and administrative expenses $140,000 $170,000 Income before income taxes $ 10,000 $110,000 Deduct: Estimated income taxes (assumed to be 40%)
4,000 44,000
Net income $ 6,000 $ 66,000
Exhibit 184: Leed Company: Planned operating budgets
Exhibit 185 shows a flexible budget for Leed Company's manufacturing overhead costs at various levels of
output. To keep the example simple, we assume that the first four costs are strictly variable, starting at zero. On the
other hand, the last two costs, depreciation and supervision, are fixed costs in this example because they are
assumed to be constant over the entire relevant range of activity.
Leed Company Flexible budget for
manufacturing overhead Element of manufacturing overhead
Volume (per cent Of Capacity)*
70% 80% 90% 100% Units 17,500 20,000 22,500 25,000 Supplies $ 1,400 $ 1,600 $ 1,800 $ 2,000 Power 7,000 8000 9,000 10,000 <---Variable portion is $25,000 Insurance 4,200 4,800 5,400 6,000 Maintenance 4,900 5,600 6,300 7,000 Depreciation 18,000 18,000 18,000 18,000 <--- Fixed portion is $75,000 Supervision 57,000 57,000 57,000 57,000
$ 92,500 $ 95,000 $ 97,500 $ 100,000 *Capacity is 25,000 units per three-month period.
Exhibit 185: Leed Company: Flexible budget for manufacturing overhead
Leed's management could prepare a similar flexible budget for selling and administrative expenses with
supporting schedules for each expense item. Using flexible budgeting, a company calculates variable expenses for
various levels of sales volume, while fixed costs remain constant within the relevant range.
Budget variances When management uses a flexible budget to appraise a department's performance, it bases
the evaluation on the amounts budgeted for the level of activity actually experienced. The difference between actual
costs incurred and the flexible budget amount for that same level of operations is called a budget variance.
Budget variances can indicate a department's or company's degree of efficiency, since they emerge from a
comparison of what was with what should have been.
To illustrate the computation of budget variances, assume that Leed's management prepared an overhead
budget based on an expected volume of 100 per cent, or 25,000 units. At this level of production, the budgeted
amount for supplies is USD 2,000. By the end of the period, Leed has used USD 1,900 of supplies. Our first
impression is that a favorable variance of USD 100 exists.
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However, if Leed's actual production for the period was only 22,500 units (90 per cent of capacity), the company
actually has an unfavorable variance of USD 100. Why? Because at 90 per cent of capacity, according to the flexible
operating budget, only USD 1,800 of supplies should have been used. Consequently, it appears that Leed used
supplies inefficiently.
To give another example using the data in Exhibit 185, Leed's management may have budgeted maintenance at
USD 5,600 for a given period assuming the company planned to produce 20,000 units (80 per cent of operating
capacity). However, Leed's actual maintenance costs may have been USD 6,200 for the period. This result does not
necessarily mean that Leed had an unfavorable variance of USD 600. The variance depends on actual production
volume.
Assume once again that Leed actually produced 22,500 units during the period. The company had budgeted
maintenance costs at USD 6,300 for that level of production. Therefore, there would actually be a favorable
variance of USD 100 (USD 6,300 - USD 6,200).
Flexible budgets often show budgeted amounts for every 10 per cent change in the level of operations, such as at
the 70 per cent, 80 per cent, 90 per cent, and 100 per cent levels of capacity. However, actual production may fall
between the levels shown in the flexible budget. If so, the company can find the budgeted amounts at that level of
operations using the following formula:
Budgeted amount = Budgeted fixed portion of costs + [Budgeted variable portion of cost per unit X Actual units
of output]
Flexible operating budget and budget variances illustrated As stated earlier, a flexible operating budget
provides detailed information about budgeted expenses at various levels of activity. The main advantage of using a
flexible operating budget along with a planned operating budget is that management can appraise performance on
two levels. First, management can compare the actual results with the planned operating budget, which enables
management to analyze the deviation of actual output from expected output. Second, given the actual level of
operations, management can compare actual costs at actual volume with budgeted costs at actual volume. The use
of flexible operating budgets gives a valid basis for comparison when actual production or sales volume differs from
expectations.
Using the data from Exhibit 182, Exhibit 186 and Exhibit 187, present Leed's detailed planned operating budget
and flexible operating budget for the quarter ended 2010 March 31. The planned operating budget was based on a
sales forecast of 20,000 units and a production forecast of 25,000 units. Exhibit 186 and Exhibit 187 show actual
sales of 19,000 units and actual production of 25,000 units. (As is typically the case, the budgeted and actual
amounts are not equal.) The actual selling price was USD 20 per unit, the same price that management had
forecasted.
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23. Budgeting for planning and control
Leed Company Comparison of planned operating budget and actual results For quarter ended 2010 March 31
Planned budget Actual Sales (budgeted 20,000 units, actual 19,000 units)
$400,000 $380,000
Cost of goods sold: Beginning finished goods inventory $130,000 $130,000 Cost of goods manufactured (25,000 units): Direct materials $ 50,000 $ 62,500 Direct labor 150,000 143,750 Variable manufacturing overhead 25,000 31,250 Fixed manufacturing overhead 75,000 75,000 Cost of goods manufactured $300,000 $312,500 Cost of goods available for sale $430,000 $442,500 Ending finished goods inventory 180,000 200,000 Cost of goods sold $250,000 $242,500 Gross margin $150,000 $137,500 Selling and administrative expenses: Variable $ 40,000 $ 28,500 Fixed 100,000 95,000 Total selling and administrative expenses $ 140,000 $123,500 Income before income taxes $ 10,000 $ 14,000 Deduct: Estimated income taxes (40%) 4,000 5,600 Net income $ 6,000 $ 8,400
Exhibit 186: Leed Company: Comparison of planned operating budget and actual results
In Exhibit 186 we compare the actual results with the planned operating budget. Comparison of actual results
with the planned operating budget yields some useful information because it shows where actual performance
deviated from planned performance. For example, sales were 1,000 units lower than expected, sales revenue was
USD 20,000 less than expected, gross margin was USD 12,500 less than expected, and net income was USD 2,400
more than expected.
The comparison of actual results with the planned operating budget does not provide a basis for evaluating
whether or not management performed efficiently at the actual level of operations. For example, in Exhibit 186, the
cost of goods sold was USD 7,500 less than expected. The meaning of this difference is not clear, however, because
the actual cost of goods sold relates to the 19,000 units actually sold, while the planned cost of goods sold relates to
the 20,000 units expected.
A company makes a valid analysis of expense controls by comparing actual results with a flexible operating
budget based on the levels of sales and production that actually occurred. Exhibit 187 shows the comparison of
Leed's flexible operating budget with the actual results. Note that the flexible budget in Exhibit 187 is made up of
several pieces. The flexible budget amounts for sales revenue and selling and administrative expenses come from a
flexible sales budget (not shown) for 19,000 units of sales.
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Leed Company Comparison of flexible operating
budget and actual results For quarter ended 2010 March 31
Flexible budget
Actual Budget variance over (under)
Sales (19,000 units) $ 380,000 $ 380,000 $ -0- Cost of goods sold: Beginning finished goods inventory $ 130,000 $ 130,000 $ -0- Cost of goods manufactured (25,000 units): Direct materials $ 50,000 $ 62,500 $ (12,500) Direct labor 150,000 143,750 (6,250) Variable manufacturing overhead 25,000 31,250 6,250 Fixed manufacturing overhead 75,000 75,000 -0- Cost of goods manufactured) $300,000 $312,500 $ 12,500 Cost of goods available for sale $430,000 $442,500 $ 12,500 Ending finished goods inventory 192,000 200,000 8,000 Cost of goods sold (19,000 units) $238,000 $242,500 $ 4,500 Gross margin $ 142,000 $ 137,500 $ (4,500) Selling and administrative expenses: Variable $ 38,000 $ 28,500 $ (9,500) Fixed 100,000 95,000 (5,000) Total selling and administrative expenses
$138,000 $123,500 $ (14,500)
Income before income taxes $ 4,000 $ 14,000 $ 10,000 Deduct: estimated taxes (40%) 1,600 5,600 4,000 Net income $ 2,400 $ 8,400 $ 6,000
Exhibit 187: Leed Company: Comparison of flexible operating budget and actual results
In comparisons such as these, if the number of units produced is equal to the number sold, many companies do
not show their beginning and ending inventories in their flexible operating budgets. Instead, the flexible operating
budget may show the number of units actually sold multiplied by the budgeted unit cost of direct materials, direct
labor, and manufacturing overhead. This budget also shows actual costs for direct materials, direct labor, and
manufacturing overhead for the number of units sold.
The comparison of the actual results with the flexible operating budget (Exhibit 187) reveals some inefficiencies
for items in the cost of goods manufactured section. For instance, direct materials and variable overhead costs were
considerably higher than expected. Direct labor costs, on the other hand, were somewhat lower than expected. Both
variable and fixed selling and administrative expenses were lower than expected. Net income was USD 6,000 more
than expected at a sales level of 19,000 units.
Now that Leed's management has prepared the operating budget (or projected income statement), it can
prepare its financial budget. Remember that the financial budget is a projected balance sheet.
To prepare a projected balance sheet, Leed's management must analyze each balance sheet account. Managers
take the beginning balance from the balance sheet at the end of the preceding period. Look at Exhibit 188, Leed
Company's balance sheet as of 2009 December 31. Management must consider the effects of planned activities on
these balances. Many accounts are affected by items in the planned operating budget, by cash inflows and outflows,
and by policy decisions. Management uses the planned operating budget in Exhibit 184 and the other illustrations
previously given to prepare Leed Company's financial budget for the first two quarters of 2010.
Leed Company Balance sheet
2009 December 31 Assets Current assets: Cash $ 130,000 Accounts receivable 200,000
Accounting Principles: A Business Perspective 893 A Global Text
23. Budgeting for planning and control
Inventories: Materials $ 40,000 Finished goods 130,000 170,000 Prepaid expenses 20,000 Total current assets $ 520,000 Property, plant, and equipment: Land $ 60,000 Buildings $1,000,000 Less: accumulated depreciation 400,000 600,000 Equipment $ 600,000 Less: accumulated depreciation 180,000 420,000 Total property, plant, and equipment $ 1,080,000 Total assets $ 1,600,000
Liabilities and stockholders' equity Current liabilities: Accounts payable $ 80,000 Accrued liabilities payable 160,000 Income taxes payable 100,000 Total current liabilities $ 340,000 Stockholders' equity: Capital stock 100,000 shares of $10 par value) $ 1,000,000 Retained earnings 260,000 Total stockholders' equity $ 1,260,000 Total liabilities and stockholders' equity $ 1,600,000
Exhibit 188: Leed Company: Balance sheet at beginning of period
Accounts receivable Leed must prepare several new schedules to prepare a financial budget. The first of these
schedules is the accounts receivable schedule in Exhibit 189. Assume that Leed will collect 60 per cent of the
current quarter's sales in that quarter, and the remaining 40 per cent will be collected in the following quarter.
Thus, collections for the first quarter will be USD 440,000. The USD 440,000 equals 60 per cent of budgeted sales
of USD 400,000 for the first quarter plus the uncollected sales of the previous quarter [(0.6 X USD 400,000) +
USD 200,000]. Second quarter collections would be USD 580,000 [(0.6 X USD 700,000) + USD 160,000]. We
have simplified the illustration by assuming all sales are on credit, and that there are no sales returns or allowances,
no discounts, and no uncollectible accounts.
Leed company Planned accounts receivable collections and balances
Quarter Ending 2010 March 31 2010 June 30
Planned balance at beginning of quarter
$200,000* $160,000
Planned sales for period (per Exhibit 184)
400,000 700,000
Total $600,000 $860,000 Projected collections during quarter (per discussion in text)
440,000 580,000
Planned balance at end of quarter $160,000 $280,000 *Actual on January 1
Exhibit 189: Leed Company: Planned accounts receivable collections and balances
Inventories Leed's management must prepare a schedule of planned materials purchases and inventories.
Planned usage and cost per unit of materials are from the planned cost of goods sold schedule (Exhibit 183). We
assume no work in process inventories to simplify the illustration; there are only materials and finished goods
inventories.
In Exhibit 190, we show a schedule of planned purchases and inventories of materials for Leed Company. Leed
normally maintains its materials inventory at a level of one-half of next quarter's planned usage. The USD 40,000
beginning inventory was greater than normal because of a strike threat in the supplier company. This threat has
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now passed, and the materials inventory is reduced at the end of the first quarter to the normal planned level. In
Exhibit 183, we calculated the planned ending finished goods inventories.
Leed Company Planned materials purchases
and inventories Quarter Ending 2010 March 31 2010 June 30
Planned usage (25,000 x $2) (per Exhibit 183) $50,000 $50,000 Planned ending inventory (½ x 25,000 x2) (per discussion in text)
25,000 25,000
Planned materials available for use $ 75,000 $75,000 Inventory at beginning of quarter 40,000* 25,000 Planned purchases for the quarter $35,000 $50,000 *Actual on January 1
Exhibit 190: Leed Company: Planned materials purchases and inventories
Accounts affected by operating costs Leed's management would prepare individual schedules for each of
the accounts affected by operating costs. For illustrative purposes, however, we prepare a schedule that combines
all the accounts affected by materials purchases or operating costs. We assume that:
• All purchases of materials are made on account.
• Direct labor incurred is credited to Accrued Liabilities Payable.
• Manufacturing overhead incurred is credited to the following accounts:
Quarter Ending March 31 June 30
Accounts payable $ 16,000 $ 13,000 Accrued liabilities payable 60,000 64,000 Prepaid expenses 6,000 5,000 Accumulated depreciation – Building 5,000 5,000 Accumulated depreciation – Equipment 13,000 13,000 Total $100,000 $100,000
• Selling and administrative expenses incurred are credited to the following accounts:
Quarter Ending March 31June 30
Accounts payable $ 5,000 $ 10,000 Accrued liabilities payable 130,000 154,000 Prepaid expenses 2,000 3,000 Accumulated depreciation – Building 1,000 1,000 Accumulated depreciation – Equipment 2,000 2,000 Total $140,000 $170,000
• Planned cash payments are as follows:
Quarter Ending March 31 June 30
Accounts payable $ 80,000 $ 56,000 Accrued liabilities payable 330,000 354,000 Prepaid expenses -0- 10,000 Total $410,000 $420,000
Exhibit 191, shows analyses of the accounts credited as a result of these data. The illustration provides a
considerable amount of information needed in constructing financial budgets for the quarters ended 2010 March
31, and 2010 June 30. The balances on both dates for Accounts Payable, Accrued Liabilities Payable, Prepaid
Expenses (the only debit balance account shown), Accumulated Depreciation—Building, and Accumulated
Depreciation—Equipment are computed in the schedule.
Income taxes payable A separate schedule could be prepared showing the changes in the state and federal
Income Taxes Payable account, but in this example, a brief discussion suffices. Balances reported in the financial
budgets assume that Leed pays one-half of the USD 100,000 liability in the 2009 December 31, balance sheet in
Accounting Principles: A Business Perspective 895 A Global Text
23. Budgeting for planning and control
each of the first two quarters of 2010 (shown in Exhibit 194). The accrual for the current quarter is added (Exhibit
184). Thus, the balance on 2010 March 31, is USD 54,000, calculated as (USD 100,000 - USD 50,000 + USD
4,000). The balance on 2010 June 30, is USD 48,000, calculated as (USD 54,000 - USD 50,000 + USD 44,000).
On June 30, the balance equals the accrual for the current year, USD 4,000 for the first quarter and USD 44,000
for the second quarter.
Leed Company Analysis of accounts
For quarters ending March
Credited for materials 31 and 2010
Purchases and operating June 30
costs Accumulated depreciation
Total debits Accounts payable Accrued liabilities payable
Prepaid expenses
Building Equipment
Beginning balances, January 1 (per Exhibit 188)
$ 80,000 $ 160,000 $ 20,000* $ 400,000 $ 180,000
Purchases or operating costs, quarter ending March 31 (credits made to accounts shown at right): Direct materials (per Exhibit 190)
$ 35,000* $ 35,000
Direct labor (per Exhibit 183) 150,000* $150,000 Manufacturing overhead (per Exhibit 183 and above schedules)
100,000* 16,000 60,000 $ 6,000 $ 5,000 $ 13,000
Selling and administrative expenses (perExhibit 184 and above schedules)
140,000* 5,000 130,000 2,000 1,000 2,000
Total $425,000 $ 56,000 $ 340,000 $ 8,000 $ 6,000 $ 15,000 Total including January 1 balances
$136,000 $ 500,000 $ 12,000* $ 406,000 $ 195,000
Planned cash payments (debits made to accounts shown)
80,000* 330,000*
Planned balances, March 31 $ 56,000 $ 170,000 $12,000* $ 406,000 $ 195,000 Purchases or operating costs, quarter ending June 30 (credits made to accounts shown at right): Direct materials (per Exhibit 190)
$ 50,000* $ 50,000
Direct labor (per Exhibit 183) 150,000* $ 150,000 Manufacturing overhead (per Exhibit 183 and above schedules)
100,000* 13,000 64,000 $ 5,000 $ 5,000 $ 13,000
Selling and administrative expenses (per Exhibit 184 and above schedules)
170,000* 10,000 154,000 3,000 1,000 2,000
Total $470,000 $ 73,000 $368,000 $ 8,000 $ 6,000 $ 15,000 Total including March 31 balances
$129,000 $538,000 $ 4,000* $412,000 $210,000
Planned cash payments (debits made to accounts shown)
56,000* 354,000* 10,000*
Planned balances, June 30 $ 73,000 $ 184,000 $ 14,000* $ 412,000 $210,000 *Debit balance or debit to account.
Exhibit 191: Leed Company: Analyses of accounts credited for materials purchases and operating costs
Cash budget After the preceding analyses have been prepared, sufficient information is available to prepare
the cash budget and compute the balance in the Cash account on March 31 and 2010 June 30. Preparing a cash
budget requires information about cash receipts and cash disbursements.
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Cash receipts We can prepare the cash receipts schedule from the information used to compute the accounts
receivable schedule (Exhibit 189). In Exhibit 192, we show the schedule of planned cash receipts for Leed Company.
Cash disbursements Companies need cash to pay for purchases, wages, rent, interest, income taxes, cash
dividends, and most other expenses. We can obtain the amount of each cash disbursement from other budgets or
schedules. Look at Exhibit 193, the cash disbursements schedule for Leed Company. You can see where the
information came from, except for the payment of income taxes and dividends. Income taxes are assumed to be 40
per cent of income before income taxes. We assume that USD 20,000 of dividends will be paid in the first quarter
and USD 40,000 in the second quarter.
Leed Company Planned Cash receipts
Quarter ending 2010 March 31 2010 June 30
Collections on accounts receivable: From preceding quarter's sales $200,000 $160,000 (0.4 x $400,000) From current quarter's sales 240,000 (0.6 x
$400,000) 420,000 (0.6 x $700,000)
Total cash receipts (per Exhibit 189) $440,000 $580,000
Exhibit 192: Leed Company: Planned cash receipts
Leed Company Planned cash disbursements
Quarter Ending 2010 March 31
2010 June 30
Payment of accounts payable (per Exhibit 191) $ 80,000 $ 56,000 Payment of accrued liabilities payable (per Exhibit 191)
330,000 354,000
Payment of income tax liability 50,000 50,000 Payment of dividends 20,000 40,000 Expenses prepaid (per Exhibit 191) -0- 10,000 Total cash disbursements $480,000 $510,000
Exhibit 193: Leed Company: Planned cash disbursements
Once cash receipts and disbursements have been determined, we can prepare a cash budget for Leed Company,
as shown in Exhibit 194. The cash budget is a plan indicating expected inflows and outflows of cash.
Leed company Planned cash flows and cash balances
Quarter ending 2010 March 31
2010 June 30
Planned balance at beginning of quarter $130,000* $ 90,000 Planned cash receipts: Collections of accounts receivable (per Exhibit 192)
440,000 580,000
$570,000 $670,000 Planned cash disbursements: Payment of accounts payable (per Exhibit 191) $ 80,000 $ 56,000 Payment of accrued liabilities payable (per Exhibit 191)
330,000 354,000
Payment of income tax liability 50,000 50,000 Payment of dividends 20,000 40,000 Expenses prepaid (per Exhibit 191) -0- 10,000 Total cash disbursements $480,000 $510,000 Planned balance at end of quarter $ 90,000 $ 160,000 *Actual on January 1.
Exhibit 194: Leed Company: Planned cash flows and cash balances
This cash budget helps management to decide whether enough cash will be available for short-term needs. If a
company's cash budget indicates a cash shortage at a certain date, the company may need to borrow money on a
Accounting Principles: A Business Perspective 897 A Global Text
23. Budgeting for planning and control
short-term basis. If the company's cash budget indicates a cash excess, the company may wish to invest the extra
funds for short periods to earn interest rather than leave the cash idle. Knowing in advance that a possible cash
shortage or excess may occur allows management sufficient time to plan for such occurrences and avoid a cash
crisis.
The preparation of Leed's financial budget for the quarters ending March 31 and June 30 (Exhibit 195)
completes the master budget. Management now has information to help appraise the policies it has adopted before
implementing them. If the master budget shows the results of these policies to be unsatisfactory, the company can
change its policies before serious problems arise.
Leed Company Projected balance sheet
As of March 31 and 2010 June 30 2010 March 31
2010 June 30
Assets Current assets: Cash (per Exhibit 194) $ 90,000 $ 160,000 Accounts receivable (per Exhibit 189) 160,000 280,000 Inventories: Materials (per Exhibit 190) 25,000 25,000 Finished goods (per Exhibit 183) 180,000 60,000 Prepaid expenses (per Exhibit 191) 12,000 14,000 Total current assets $ 467,000 539,000 Property, plant, and equipment: Land (per Exhibit 188) $ 60,000 $ 60,000 Buildings, net ($1,000,000 less accumulated depreciation of $406,000 and $412,000) (per Exhibit 188 and Exhibit 191)
594,000 588,000
Equipment, net ($600,000 less accumulated depreciation of $195,000 and $210,000) (per Exhibit 188 and Exhibit 191)
405,000 390,000
Total property, plant, and equipment $1,059,000 $1,038,000 Total assets $1,526,000 $1,577,000 Liabilities and stockholders' equity Current liabilities: Accounts payable (per Exhibit 191) $ 56,000 $ 73,000 Accrued liabilities payable (per Exhibit 191) 170,000 184,000 Income taxes payable (per discussion in the text)
54,000 48,000
Total current liabilities $ 280,000 $ 305,000 Stockholders' equity: Capital stock (100,000 shares of $10 par value) (per Exhibit 188)
$1,000,000 $1,000,000
Retained earnings (see footnotes below) 246,000* 272,000† Total stockholders' equity $1,246,000 $1,272,000 Total liabilities and stockholders' equity $1,526,000 $ 1,577,000 *$260,000 (per Exhibit 188) + Income of $6,000 – Dividends of $20,000. †$246,000 + Income of $66,000 – Dividends of $40,000.
Exhibit 195: Leed Company: Projected balance sheet
For example, Leed Company's management had a policy of stable production each period. The master budget
shows that production can be stabilized even though sales fluctuate widely. However, the planned ending inventory
at June 30 may be considered somewhat low in view of the fluctuations in sales. Management now knows this in
advance and can take corrective action if necessary.
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An accounting perspective:
Uses of technology
Imagine the difficulty of coordinating budgets in companies having worldwide operations,
companies such as PepsiCo and BP. BP has oil and gas exploration, production, and marketing
facilities in various countries. The BP plant in Singapore, for example, has to transmit its budget
information to corporate headquarters in London, where managers coordinate the budgets of
various operations worldwide, request additional information, require revisions in the budgets,
and otherwise interact constantly with far-flung operations. Recent advances in
telecommunications networks and collaboration software have made this process much faster and
easier. Managers in the Singapore plant of BP can get reactions from corporate headquarters
almost immediately. Corporate headquarters can get answers to its questions fast and can
coordinate the budgets from various worldwide operations quickly.
Budgeting in merchandising companies
Budget preparation for merchandising companies and service companies is similar to budgeting for
manufacturing companies. This section discusses budgeting in merchandising companies.
Throughout this chapter, we have focused on budgeting in a manufacturing company. Suppose managers in a
retail merchandising business, such as a dress shop or a furniture store, prepare a budget. In this case, the company
prepares a purchases budget instead of a production budget. To compute the purchases for each quarter,
management must estimate the cost of the goods to be sold during the quarter and the inventory required at the
end of the quarter.
Suppose Strobel Furniture Company prepared a sales budget like the one in Exhibit 196. Assume the company
maintains sufficient inventory to cover one-half of the next quarter's sales. Cost of goods sold is 55 per cent of sales.
The ending inventory on 2009 December 31, was USD 8,250. The purchases budget can now be prepared, as shown
in Exhibit 197. For the first quarter of 2010, notice that the ending inventory is one-half of the second quarter's cost
of goods sold [0.5 X (0.55 X USD 80,000) = USD 22,000].
Strobel can now use the information in its purchases budget to prepare the cost of goods sold section of the
operating budget, to prepare cash disbursements schedules, and to prepare the inventory and accounts payable
amounts in the financial budget.
Strobel Furniture Company Sales budget
For quarters ending through 2011 March 31
2010 March 31,
2010 March 31
2010 June 30 2010 September 30 2010 December 31
2011 March 31
$30,000 $80,000 $50,000 $90,000 $40,000
Exhibit 196: Strobel furniture company: Sales budget
Accounting Principles: A Business Perspective 899 A Global Text
23. Budgeting for planning and control
Strobel Furniture Company Purchase budget For quarters ending 2010 December 31
March 31Through
2010 March 31
2010 June 30
2010 September 30
2010 December 31
Ending inventory desired* $22,000 $13,750 $24,750 $11,000 Cost of goods sold (55% of sales)
16,500 44,000 27,500 49,500
Total $38,500 $57,750 $52,520 $60,500 Less: beginning inventory 8,250 22,000 13,750 24,750 Purchases required $30,250 $35,750 $38,500 $35,750 *Next period's sales x 55% x 50%
Exhibit 197: Strobel furniture company: Purchases budget
Budgeting in service companies
The concepts discussed in this chapter are equally applicable to service companies. Service firms have service
revenues and operating expenses that must be budgeted. Projected income statements and balance sheets can be
prepared for service companies using the techniques described in this chapter.
Additional concepts related to budgeting
Two additional concepts that affect budgeting are sometimes used in industry. These concepts are just-in-time
inventory systems and zero-base budgeting.
Chapter 20 described just-in-time inventory. Recall that the just-in-time inventory system provides that
materials are bought just in time to be put into the manufacturing process; small parts, or subparts, are purchased
just in time to be assembled into a final product; and goods are produced and delivered just in time to be sold.
The overall purpose of the just-in-time inventory system is to decrease, or in some cases eliminate, inventories
in a company. By eliminating inventory, companies reduce the buffer stock between purchasing, production, and
sales. Consequently, companies using just-in-time inventory must budget purchasing, production, and sales so the
goods are purchased just in time for production and produced just in time for sales.
Zero-base budgeting became popular in the 1970s, particularly when President Jimmy Carter supported it for
state and federal governmental units. It has received less attention since then.
Under zero-base budgeting, managers in a company start each year with zero budget levels and must justify
every dollar that appears in the budget. Managers do not assume any costs incurred in previous years should be
incurred this year. Each manager prepares decision packages that describe the nature and cost of tasks that can be
performed by that unit and the consequences of not performing each task. Top organization officials rank the
decision packages and approve those that they believe are most worthy. A major drawback to the use of this concept
is the massive amounts of paperwork and time needed to prepare and rank decision packages, especially in large
organizations.
This chapter discussed the general concepts of budgeting. In Chapter 26, we will discuss another type of
budgeting known as capital budgeting.
The next chapter discusses standard costs, which are used in budgeting and are important in controlling
operations.
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Understanding the learning objectives
• A budget is a plan showing the company's objectives and how management intends to acquire and use
resources to attain those objectives.
• Several kinds of budgets are responsibility, capital, master, planned operating, and financial budgets.
• A budget: (1) shows management's operating plans for the coming periods; (2) formalizes management's
plans in quantitative terms; (3) forces all levels of management to think ahead, anticipate results, and take
action to remedy possible poor results; and (4) may motivate individuals to strive to achieve stated goals.
• Other benefits are: business activities are better coordinated; managers become aware of other managers'
plans; employees may become cost conscious and try to conserve resources; the company reviews its
organization plan and changes it when necessary; and managers foster a vision that might not otherwise be
developed.
• Top management support: All management levels must be aware of the budget's importance to the
company and must know that the budget has top management's support.
• Participation in goal setting: Employees are generally more likely to strive toward organizational goals if
they participate in setting them.
• Communicating results: People should be promptly and clearly informed of their progress.
• Flexibility: The operating budget should be restated if the basic assumptions underlying the budget change
during the year. For control purposes, after the actual level of operations is known, the actual revenues and
expenses should be compared to the expected performance at that level of operations.
• Follow-up: Managers should check budgets continuously and correct them whenever necessary because
budgets deal with projections and estimates of future operating results, cash flows, and financial position.
• Managers develop a planned operating budget in units rather than dollars. Managers forecast sales units for
the year. Then, based on the sales forecast and the company's inventory policy, they forecast production
requirements in units.
• Next, dollars must be introduced into the analysis. A forecast of expected selling prices must be made, and
costs must be analyzed.
• Management then prepares a schedule to forecast cost of goods sold.
• After forecasting the cost of goods sold, management prepares a separate budget for all selling and
administrative expenses. Several supporting schedules may be involved for other various expenses.
• The totals on the separate budgets are combined to form the planned operating budget, which shows the
budgeted income after income taxes for a certain period.
• A flexible operating budget is a special kind of budget that provides detailed information about budgeted
expenses (and revenues) at various levels of output.
• This budget shows the effect that different volume changes, in per cents of capacity, have on the expenses of
a company.
• Preparing a financial budget involves analyzing every balance sheet account in light of the planned activities
expressed in the income statement.
• Managers usually prepare a separate cash budget to show sources, uses, and net changes in cash for the
period.
Accounting Principles: A Business Perspective 901 A Global Text
23. Budgeting for planning and control
• Supporting budgets also may be developed for accounts receivable, inventories, accounts affected by
operating costs, and federal income taxes payable.
Demonstration problem
During January 2010, Ramos Company plans to sell 40,000 units of its product at a price of USD 30 per unit.
The company estimates selling expenses to be USD 120,000 plus 2 per cent of sales revenue. Administrative
expenses are estimated to be USD 90,000 plus 1 per cent of sales revenue. Federal income tax expense is estimated
to be 40 per cent of income before federal income taxes.
Ramos plans to produce 50,000 units during January with estimated variable costs per unit as follows: USD 3
for material, USD 7.50 for labor, and USD 4.50 for variable overhead. Estimated fixed overhead cost is USD 60,000
per month. The finished goods inventory at 2010 January 1, is 8,000 units with a cost per unit of USD 15. The
company uses FIFO inventory procedure.
Prepare a projected income statement for January 2010.
Solution to demonstration problem Ramos Company Projected income statement For January 2010
Sales (40,000 x $30) $1,200,000 Cost of goods sold (see planned cost of goods sold)
638,400
Gross margin $561,600 Selling expenses: Fixed $120,000 Variable (0.02 x $120,000) 24,000 Administrative expenses: Fixed 90,000 Variable (0.01 x $1,200,000) 12,000 246,000 Income before federal income taxes
$315,600
Deduct: Federal income tax expense (40%)
126,600
Net income $189,360 Ramos Company Planned cost of goods sold
Beginning finished goods inventory (8,000 x $15)
$ 120,000
Cost of goods manufactured: Direct materials (50,000 x $3) $150,000 Direct labor (50,000 x $7.50) 375,000 Variable manufacturing overhead (50,000 x $4.50)
225,000
Fixed manufacturing overhead 60,000 Cost of goods manufactured (50,000 x $16,20)
810,000
Cost of goods available for sale $ 930,000 Ending finished goods inventory (18,000 x $16,20)
291,600
Cost of goods sold $ 638,400
Key terms* Budget A plan showing a company's objectives and proposed ways of attaining the objectives. Major types of budgets are (1) master budget, (2) responsibility budget, and (3) capital budget.
Budgeting The coordination of financial and nonfinancial planning to satisfy an organization's goals.
Budget variance The difference between an actual cost incurred (or revenue earned) at a certain level of operations and the budgeted amount for the same level of operations.
Cash budget A plan indicating expected inflows (receipts) and outflows (disbursements) of cash; it helps management decide whether enough cash will be available for short-term needs.
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Financial budget The projected balance sheet portion of a master budget.
Fixed costs Costs that are unaffected in total by the relative level of production or sales.
Flexible operating budget A special budget that provides detailed information about budgeted expenses (and revenues) at various levels of output.
Just-in-time inventory system Provides that goods are produced and delivered just in time to be sold.
Master budget The projected income statement (planned operating budget) and projected balance sheet (financial budget) showing the organization's objectives and proposed ways of attaining them; includes supporting budgets for various items in the master budget; also called master profit plan. The master budget is the overall plan of the enterprise and ideally consists of all of the various segmental budgets.
Participatory budgeting A method of preparing the budget that includes the participation of all levels of management responsible for actual performance.
Planned operating budget The projected income statement portion of a master budget.
Production budget A budget that takes into account the units in the sales budget and the company's inventory policy.
Variable costs Costs that vary in total directly with production or sales and are a constant dollar amount per unit of output over different levels of output or sales.
Zero-base budgeting Managers in a company start each year with zero budget levels and must justify every dollar that will appear in the budget.
*Some terms listed in earlier chapters are repeated here for your convenience.
Self-test
True-false
Indicate whether each of the following statements is true or false.
Budgets are based on more than past results.
Cash budgets may cover a week or a month, sales and production budgets a month, a quarter, or a year, and
general operating budgets may cover a quarter or a year.
The planned operating budget is developed first in units and then in dollars.
Planned operating budgets based on planned activity levels and flexible budgets are the same if planned activity
levels and actual activity levels are not the same.
Multiple-choice
Select the best answer for each of the following questions.
Which of the following best describes some of the benefits related to the preparation and use of budgets:
a. Business activities are better coordinated.
b. Managers become aware of other managers' plans.
c. Employees may become cost conscious and try to conserve resources.
d. Managers may review the organizational plan and make necessary changes more often.
e. All of the above.
When preparing a projected income statement, which of the following budgets is prepared first?
a. Projected cost of goods sold budget.
b. Selling and administrative budget.
c. Sales budget.
d. Financial budget.
Fixed costs are USD 60,000, variable cost per unit is USD 1.20, and budgeted units of output are 200,000 units.
Determine the budgeted production costs.
a. USD 300,000.
Accounting Principles: A Business Perspective 903 A Global Text
23. Budgeting for planning and control
b. USD 360,000.
c. USD 240,000.
d. USD 276,000.
Production costs (including USD 30,000 of fixed costs) are budgeted at USD 150,000 for an expected output of
100,000 units. Actual output was 90,000 units, while actual costs were USD 142,500. What is the budget variance
and is it favorable or unfavorable?
a. USD 5,500 unfavorable.
b. USD 6,500 favorable.
c. USD 6,500 unfavorable.
d. USD 4,500 unfavorable.
Now turn to “Answers to self-test” at the end of the chapter to check your answers.
Questions
➢ What are three purposes of budgeting?
➢ What are the purposes of a master, planned operating, and financial budget?
➢ How does the management by exception concept relate to budgeting?
➢ What are five basic principles which, if followed, should improve the probability of preparing a
meaningful budget? Why is each important?
➢ What is the difference between an imposed budget and a participatory budget?
➢ Define and explain a budget variance.
➢ What are the two major budgets in the master budget? Which should be prepared first? Why?
➢ Distinguish between a master budget and a responsibility budget.
➢ The budget established at the beginning of a given period carried an item for supplies expense in the
amount of USD 40,000. At the end of the period, the supplies used amounted to USD 44,000. Can it
be concluded from these data that there was an inefficient use of supplies or that care was not
exercised in purchasing the supplies?
➢ Management must make certain assumptions about the business environment when preparing a
budget. What areas should be considered?
➢ Why is budgeted performance better than past performance as a basis for judging actual results?
➢ Describe the concepts of just-in-time inventory systems and zero-base budgeting.
➢ Real world question Refer to the financial statements for a publicly traded company. An industry
analyst has asked you to forecast sales for each of the next five years (after the current year). Assume
sales increase each year by the same percentage. That is, the percentage increase for next year is
expected to be the same as it was last year. What is your estimate of sales in each of the next five
years?
➢ Real world question Refer to your forecasts of sales for the company in the previous question.
Evaluate the simple forecasting method you were asked to use in that question. What additional
factors should be used in forecasting sales?
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➢ Real world question Do you think the sales for a particular grocery store in your neighborhood
will go up, go down, or stay the same next year compared to this year? Give your answer in sales
volume, then give it in sales dollars.
➢ Real world question The text refers to the benefits of participation in budgeting. Assume your
college bookstore is preparing a budget for next year and wants to include employees in the
budgeting process. Give examples of the people who should be included and state what information
they could provide.
Exercises
Exercise A Hike n' Run Company has decided to produce 288,000 pairs of socks at a uniform rate throughout
2010. The sales department of Hike n' Run has estimated sales for 2010 according to the following schedule:
Sales of pairs of socks First quarter 76,800 Second quarter 62,400 Third quarter 72,000 Fourth quarter 100,800 Total for 2007 312,000
Assume the 2009 December 31, inventory is estimated to be 38,400 pairs of socks. Prepare a schedule of
planned sales and production for the first two quarters of 2010.
Exercise B DePaul Company projects sales of 25,000 units during May at USD 6 per unit. Production costs are
USD 1.80 per unit. Variable selling and administrative expenses are USD 0.60 per unit; fixed selling and
administrative expenses are USD 60,000. Compute the budgeted income before income taxes.
Exercise C Skaters Plus Company plans to sell 90,000 skateboards next quarter at a price of USD 36 per unit.
Production costs are USD 14.40 per unit. Selling and administrative expenses are: variable, USD 7.20 per unit; and
fixed, USD 604,800 per quarter. What are the budgeted earnings for next quarter? (Do not consider federal income
taxes.)
Exercise D Duke Corporation considers materials and labor to be completely variable costs. Expected
production for the year is 50,000 units. At that level of production, direct materials cost is budgeted at USD
198,000, and direct labor cost is budgeted at USD 450,000. Prepare a flexible budget for materials and labor for
possible production levels of 52,500, 60,000, and 67,500 units of product.
Exercise E Assume that in the previous exercise the actual production was 60,000 units, materials cost was
USD 247,000, and labor cost was USD 510,000. What are the budget variances?
Exercise F Fixed production costs for Alexia Company are budgeted at USD 576,000, assuming 40,000 units
of production. Actual sales for the period were 35,000 units, while actual production was 40,000 units. Actual fixed
costs used in computing cost of goods sold amounted to USD 504,000. What is the budget variance?
Exercise G The shoe department of Noardstone's Department Store has prepared a sales budget for April
calling for a sales volume of USD 75,000. The department expects to begin in April with a USD 50,000 inventory
and to end the month with an USD 42,500 inventory. Its cost of goods sold averages 70 per cent of sales.
Prepare a purchases budget for the department showing the amount of goods to be purchased during April.
Problems
Problem A Joyce Corporation prepares monthly operating and financial budgets. The operating budgets for
June and July are based on the following data:
Units produced Units sold
Accounting Principles: A Business Perspective 905 A Global Text
23. Budgeting for planning and control
June 400,000 360,000 July 360,000 400,000
All sales are at USD 30 per unit. Direct materials, direct labor, and variable manufacturing overhead are
estimated at USD 3, USD 6, and USD 3 per unit, respectively. Total fixed manufacturing overhead is budgeted at
USD 1,080,000 per month. Selling and administrative expenses are budgeted at USD 1,200,000 plus 10 per cent of
sales, while federal income taxes are budgeted at 40 per cent of income before federal income taxes. The inventory
at June 1 consists of 200,000 units with a cost of USD 17.10 each.
a. Prepare monthly budget estimates of cost of goods sold assuming that FIFO inventory procedure is used.
b. Prepare planned operating budgets for June and July.
Problem B The computation of operating income for Frisco Company for 2008 follows:
Sales $1,800,000 Cost of goods manufactured and sold: Direct materials $360,000 Direct labor 240,000 Variable manufacturing overhead 120,000 Fixed manufacturing overhead 240,000 960,000 Gross margin $ 840,000 Selling expenses: Variable $132,000 Fixed 168,000 300,000 Administrative expenses: Variable $156,000 Fixed 192,000 348,000 Net operating income $ 192,000
An operating budget is prepared for 2009 with sales forecasted at a 25 per cent increase in volume. Direct
materials, direct labor, and all costs labeled as variable are completely variable. Fixed costs are expected to continue
except for a USD 24,000 increase in fixed administrative costs. Actual operating data for 2009 are:
Sales $2,160,000 Direct materials 444,000 Direct labor 288,000 Variable manufacturing overhead 148,800 Fixed manufacturing overhead 246,000 Variable selling expenses 186,000 Fixed selling expenses 157,200 Variable administrative expenses 198,000 Fixed administrative expenses 218,200
a. Prepare a budget report comparing the 2009 planned operating budget with actual 2009 data.
b. Prepare a budget report that would be useful in appraising the performance of the various persons charged
with responsibility to provide satisfactory income. (Hint: Prepare budget data on a flexible basis and use the
percentage by which sales were actually experienced.)
c. Comment on the differences revealed by the two reports.
Problem C Use the following data to prepare a planned operating budget for Hi-Lo Company for the year
ending 2009 December 31:
Plant capacity 100,000 units Expected sales volume 90,000 units Expected production 90,000 units Actual production 90,000 units Forecasted selling price $ 12,00 per unit Actual selling price $ 13,50 per unit Manufacturing costs: Variable (per unit): Direct materials $3.60 Direct labor $1.50 Manufacturing overhead $2.25
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Fixed manufacturing overhead $108,000 Selling and administrative expenses: Variable (per unit) $1.20 Fixed $60,000
Assume no beginning or ending inventory. Federal income taxes are budgeted at 40 per cent of income before
federal income taxes.
The actual operating data for the year ending 2009 December 31, follow:
Sales $1,080,000 Cost of goods sold: Direct materials $337,500 Direct labor 135,000 Variable manufacturing overhead 202,500 Fixed manufacturing overhead 108,000 Total $783,000 Less: Ending inventory ($783,000 x 10/90) 87,000 696,000 Gross margin $384,000 Selling expenses: Variable 102,000 Fixed 72,000 174,000 Income before federal income taxes $210,000 Deduct: Federal income taxes at 40% 84,000 Net income $126,000
a. Prepare a planned operating budget for the year ended 2009 December 31, for part (1).
b. Using a flexible operating budget, analyze the efficiency of operations and comment on the company's sales
policy for part (2).
Problem D Kim Company wants you to prepare a flexible budget for selling and administrative expenses. The
general manager and the sales manager have met with all the department heads, who provided the following
information regarding selling and administrative expenses:
The company presently employs 30 full-time salespersons with a base of USD 3,600 each per month plus
commissions and 10 full-time salespersons with a salary of USD 6,000 each per month plus commissions. In
addition, the company employs nine regional sales managers with a salary of USD 21,600 per month, none of whom
is entitled to any commissions.
If sales volume exceeds USD 80 million per year, the company must hire four more salespersons, each at a
salary of USD 3,600 per month plus commissions.
Sales commissions are either 10 per cent or 5 per cent of the selling price, depending on the product sold.
Typically, a 10 per cent commission applies on 60 per cent of sales, and a 5 per cent commission applies on the
remaining 40 per cent of sales.
Salespersons' travel allowances average USD 1,500 per month per salesperson (excluding managers).
Advertising expenses average USD 150,000 per month plus 3 per cent of sales.
Selling supplies expense is estimated at 1 per cent of sales.
Administrative salaries are USD 300,000 per month.
Other administrative expenses include the following:
Rent—USD 48,000 per month
Office supplies—2 per cent of sales
Other administrative expenses (telephone, etc.)—USD 12,000 per month
Prepare a flexible budget for selling and administrative expenses for sales volume of USD 36 million, USD 48
million, and USD 60 million per year.
Accounting Principles: A Business Perspective 907 A Global Text
23. Budgeting for planning and control
Problem E Galaxy Lighting Company manufactures and sells lighting fixtures. Estimated sales for the next
three months are:
September $350,000 October 500,000 November 400,000
Sales for August were USD 400,000. All sales are on account. Galaxy Lighting Company estimates that 60 per
cent of the accounts receivable are collected in the month of sale with the remaining 40 per cent collected the
following month. The units sell for USD 30 each. The cash balance for September 1 is USD 100,000.
Generally, 60 per cent of purchases are due and payable in the month of purchase with the remainder due the
following month. Purchase cost per unit for materials is USD 18. The company maintains an end-of-the-month
inventory of 1,000 units plus 10 per cent of next month's unit sales.
Prepare a cash receipts schedule for September and October and a purchases budget for August, September, and
October.
Problem F Refer to the previous problem. In addition to the information given, selling and administrative
expenses paid in cash are USD 120,000 per month.
Prepare a monthly cash budget for September and October for Galaxy Lighting Company.
Alternate problems
Alternate problem A Cougars Company prepares monthly operating and financial budgets. Estimates of sales
in units are made for each month. Production is scheduled at a level high enough to take care of current needs and
to carry into each month one-half of the next month's unit sales. Direct materials, direct labor, and variable
manufacturing overhead are estimated at USD 12, USD 6, and USD 4 per unit, respectively. Total fixed
manufacturing overhead is budgeted at USD 480,000 per month. Sales for April, May, June, and July 2009 are
estimated at 100,000, 120,000, 160,000, and 120,000 units. The inventory at 2009 April 1, consists of 50,000
units with a cost of USD 28.80 per unit.
a. Prepare a schedule showing the budgeted production in units for April, May, and June 2009.
b. Prepare a schedule showing the budgeted cost of goods sold for the same three months assuming that the
FIFO method is used for inventories.
Alternate problem B Following is a summary of operating data of Bugs Company for the year 2008:
Sales $ 7,00,000 Cost of goods manufactured and sold: Direct materials $1,200,000 Direct labor 1,100,000 Variable manufacturing overhead 300,000 Fixed manufacturing overhead 800,000 3,400,000 Gross margin $ 3,600,000 Selling expenses: Variable $ 300,000 Fixed 400,000 700,000
2,900,000 General and administrative expenses: Variable $ 100,000 Fixed 1,200,000 1,300,000 Net operating income $ 1,600,000
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Sales volume for 2009 is budgeted at 90 per cent of 2008 sales volume. Prices are not expected to change. The
2009 budget amounts for the various other costs and expenses differ from those reported in 2008 only for the
expected volume change in the variable items. Actual operating data for 2009 follow:
Sales $5,800,000 Direct materials 1,300,000 Direct labor 1,100,000 Variable manufacturing overhead 300,000 Fixed manufacturing overhead 780,000 Variable selling expenses 270,000 Fixed selling expenses 290,000 Variable administrative expenses 110,000 Fixed administrative expenses 1,100,000
a. Prepare a budget report comparing the planned operating budget for 2009 with the actual results for that
year.
b. Prepare a budget report that would be useful in pinpointing responsibility for the poor showing in 2009.
(Hint: Prepare a flexible operating budget.)
Alternate problem C Use the following data for Andrea Company in preparing its 2009 planned operating
budget:
Plant capacity 500,000 units Expected sales volume 450,000 units Expected production 500,000 units Forecasted selling price $72 per unit Variable manufacturing costs per unit: Direct materials $ 27.00 Direct labor 9.00 Manufacturing overhead 6.00 Fixed manufacturing overhead per period $900,000 Selling and administrative expenses: Variable (per unit) $ 3.00 Fixed (per period) $ 750,000
Assume no beginning inventory. Federal income taxes are budgeted at 40 per cent of income before income
taxes.
The actual results for Andrea Company for the year ended 2009 December 31, follow. (Note: The actual sales
price was USD 80 per unit. Actual unit production was equal to actual unit sales.)
Sales (500,000 units @ $80 per unit) $40,000,000 Cost of goods sold: Direct materials $12,000,000 Direct labor 4,400,000 Variable manufacturing overhead 4,000,000 Fixed manufacturing overhead 1,000,000 21,400,000 Gross margin $18,600,000 Selling and administrative expenses: Variable $ 1,400,000 Fixed 800,000 2,200,000 Income before federal income taxes $16,400,000 Deduct: Federal income taxes 6,560,000 Net income $ 9,840,000
a. Prepare a planned operating budget for the year ended 2009 December 31, for (1).
b. Using a flexible operating budget, analyze the efficiency of operations. Comment on the results of 2009 and
on the company's sales policy in (2).
Alternate problem D Rocklin Company gathered the following budget information for the quarter ending
2009 September 30:
Sales $540,000 Purchases 450,000
Accounting Principles: A Business Perspective 909 A Global Text
23. Budgeting for planning and control
Salaries and wages 194,000 Rent 10,000 Supplies 8,000 Insurance 2,000 Other cash expenses 12,000
A cash balance of USD 36,000 is planned for July 1. Accounts receivable are expected to be USD 60,000 on July
1. All but one-half of 1 per cent of the July 1 Accounts Receivable balance will be collected in the quarter ending
September 30. The company's sales collection pattern is 95 per cent in the quarter of sale and 5 per cent in the
quarter after sale. Accounts payable will be USD 30,000 on July 1 and will be paid during the coming quarter. The
company's purchases payment pattern is 75 per cent in the quarter of purchase and 25 per cent in the quarter after
purchase. Expenses are paid in the quarter in which they are incurred.
Prepare a cash budget for the quarter ending 2009 September 30.
Beyond the numbers—Critical thinking
Business decision case A Golden State Company has applied at a local bank for a short-term loan of USD
150,000 starting on 2009 October 1. The bank's loan officer has requested a cash budget from the company for the
quarter ending 2009 December 31. The following information is needed to prepare the cash budget:
Sales $600,000 Purchases 350,000 Salaries and wages to be paid 125,000 Rent payments 7,000 Supplies (payments for) 4,500 Insurance payments 1,500 Other cash payments 22,000
A cash balance of USD 24,000 is planned for October 1. Accounts receivable are expected to be USD 48,000 on
October 1. All of these accounts will be collected in the quarter ending December 31. In general, sales are collected
as follows: 90 per cent in the quarter of sale, and 10 per cent in the quarter after sale. Accounts payable will be USD
480,000 on October 1 and will be paid during the quarter ending December 31. All purchases are paid in the
quarter after purchase.
a. Prepare a cash budget for the quarter ending 2009 December 31. Assume that the USD 150,000 loan will be
made on October 1 and will be repaid with interest at 10 per cent on December 31.
b. Will the company be able to repay the loan on December 31? If the company desires a minimum cash balance
of USD 18,000, will the company be able to repay the loan as planned?
Ethics case B The state of California, USA faced large budget deficits. Meanwhile, officials in a particular
community college district were looking for ways to spend the money that had been budgeted for the district. The
community college was entering the last three months of the fiscal year with excess funds because the area had
experienced a mild winter resulting in lower than usual utilities and maintenance costs.
At a budget meeting, one official commented, "You know what will happen if we do not spend all of our budget.
The state will claim we do not need as much money next year. What happens if we have a hard winter next year? We
will need every cent we can get!"
The community college's accounting manager commented, "We are legally entitled to spend all of the money this
year that has been budgeted to us. I am concerned about the memorandum that we received requesting that we cut
expenditures wherever possible to help reduce the state's deficit."
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The first official responded, "That deficit is the state's problem, not ours. We would not have a deficit in the first
place if the state administrators were able to estimate taxes and do a better job of budgeting. Let us deal with our
problems and let them deal with theirs!"
Write a response from the point of view of the taxpayers of the state of California. Should the community college
spend all of the money that had been budgeted for it?
Broader perspective C Refer to the Broader perspective, "Planning in a changing environment". Describe and
evaluate Verizon Communications, Inc.'s new approach to planning. How would you advise company management
to communicate the company's values and plans to employees?
Group project D In groups of three, develop a budget for an organization that publishes financial statements,
such as The Coca-Cola Company or Maytag Corporation. Your budget should include three different types of
projected income statements for the coming month, quarter, or year. These three income statements should be for
optimistic, pessimistic, and expected scenarios. Collect or develop as much information as possible to prepare the
budget. For example, to prepare a budgeted income statement for a publicly traded company such as Coca-Cola,
look at previous annual reports and collect whatever additional information you can from news reports. Be sure to
state the assumptions used in preparing the budget in a memorandum you write as a team. The heading of the
memorandum should contain the date, to whom it is written, from whom, and the subject matter. Do not forget to
include the three different projected income statements.
Group project E The chief executive officer (CEO) of Rigid Plastics Corporation remarked to a colleague, "I do
not understand why other companies waste so much time in the budgeting process. I set our company goals, and
everyone strives to meet them. What is wrong with that approach?" In groups of two or three students, write a
memorandum to your instructor stating whether you agree with this comment or not and explain why. The heading
of the memorandum should contain the date, to whom it is written, from whom, and the subject matter.
Group project F Multigoal Corporation has established a bonus plan for its employees. An employee receives a
bonus if his or her department meets or is below the cost levels specified in the annual budget plan. If the
department's costs exceed the budget, its employees earn no bonus. In groups of two or three students, write a
memorandum to your instructor stating the problems that might arise with this bonus plan. The heading of the
memorandum should contain the date, to whom it is written, from whom, and the subject matter.
Using the Internet—A view of the real world
Visit the website for a high technology company that provides recent annual reports. Examples include Intel
Corporation, IBM, and Dell. Develop a budgeted income statement (operating budget) for the coming year and
include three categories for optimistic, pessimistic, and expected scenarios. Collect or develop as much information
as possible to prepare the budget. For example, look at previous annual reports and collect whatever additional
information you can from news reports. Be sure to state the assumptions used in preparing the budget in a
memorandum. The heading of the memorandum should contain the date, to whom it is written, from whom, and
the subject matter. Do not forget to include the three different projected income statements.
Visit the website for a retail company that provides recent annual reports. Develop a budgeted income statement
(operating budget) for the coming year and include three categories for optimistic, pessimistic, and expected
scenarios. Collect or develop as much information as possible to prepare the budget. For example, look at previous
annual reports and collect whatever additional information you can from news reports. Be sure to state the
assumptions used in preparing the budget in a memorandum. The heading of the memorandum should contain the
Accounting Principles: A Business Perspective 911 A Global Text
23. Budgeting for planning and control
date, to whom it is written, from whom, and the subject matter. Do not forget to include the three different
projected income statements.
Comprehensive problems
Wimerick Corporation prepares annual budgets by quarters. The company's post-closing trial balance as of 2010
December 31, is as follows:
Debits Credits Cash $138,000 Accounts receivable 360,000 Allowance for uncollectible accounts $ 12,000 Inventories 156,000 Prepaid expenses 12,000 Furniture and equipment 180,000 Accumulated depreciation – Furniture and equipment
12,000
Accounts payable 120,000 Accrued liabilities payable 36,000 Notes payable, 5% (due 2008) 480,000 Capital stock 300,000 Retained earnings (deficit) 114,000
$960,000 $960,000
All of the capital stock of the company was recently acquired by Juan Jackson. After the purchase, Jackson
loaned substantial sums of money to the corporation, which still owes him USD 480,000 on a 5 per cent note.
There are no accrued federal income taxes payable, but future earnings will be subject to income taxation.
Jackson is anxious to withdraw USD 120,000 from the corporation (as a payment on the note payable to him)
but will not do so if it reduces the corporation's cash balance below USD 120,000. Thus, he is quite interested in the
budgets for the quarter ending 2011 March 31.
Sales for the coming quarter ending 2011 March 31, are forecasted at USD 1,200,000; for the following quarter
they are forecasted at USD 1,500,000. All sales are priced to yield a gross margin of 40 per cent. Inventory is to be
maintained on hand at the end of any quarter in an amount equal to 20 per cent of the goods to be sold in the next
quarter. All sales are on account, and 95 per cent of the 2010 December 31, receivables plus 70 per cent of the
current quarter's sales will be collected during the quarter ending 2011 March 31.
Selling expenses are budgeted at USD 48,000 plus 6 per cent of sales; USD 24,000 will be incurred on account,
USD 66,000 accrued, USD 27,000 from expiration of prepaid rent and prepaid insurance, and USD 3,000 from
allocated depreciation.
Purchasing expenses are budgeted at USD 34,800 plus 5 per cent of purchases for the quarter; USD 9,000 will
be incurred on account, USD 48,000 accrued, USD 13,800 from expired prepaid expenses, and USD 1,200 from
allocated depreciation.
Administrative expenses are budgeted at USD 42,000 plus 2 per cent of sales; USD 3,000 will be incurred on
account, USD 36,000 accrued, USD 13,200 from expired prepayments, and USD 1,800 from allocated depreciation.
Uncollectible accounts are estimated at 1 per cent of sales.
Interest accrues at 5 per cent annually on the notes payable and is credited to Accrued Liabilities Payable.
All of the beginning balances in Accounts Payable and Accrued Liabilities Payable, plus 80 per cent of the
current credits to Accounts Payable, and all but USD 30,000 of the current accrued liabilities will be paid during
the quarter. An USD 18,000 insurance premium is to be paid prior to March 31, and a full year's rent of USD
144,000 is due on January 2.
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Federal income taxes are budgeted at 40 per cent of the income before federal income taxes. The taxes should be
accrued, and no payments are due in the first quarter.
a. Prepare a planned operating budget for the quarter ending 2011 March 31, including supporting schedules for
planned purchases and operating expenses.
b. Prepare a financial budget for 2011 March 31. Supporting schedules should be included that (1) analyze
accounts credited for purchases and operating expenses, (2) show planned accounts receivable collections and
balance, and (3) show planned cash flows and cash balance.
c. Will Jackson be able to collect the USD 120,000 on his note?
Davis Corporation is a rapidly expanding company. The company's post-closing balance as of 2010 December
31, is as follows:
Davis corporation Post-closing trial balance 2010 December 31 Debits Credits
Cash $240,000 Accounts receivable 480,000 Allowance for uncollectible accounts
$ 36,000
Inventories 600,000 Prepaid expenses 72,000 Land 600,000 Buildings and equipment 1,800,000 Accumulated depreciation – Buildings and equipment
240,000
Accounts payable 360,000 Accrued liabilities payable (including income taxes)
240,000
Capital stock 2,400,000 Retained earnings 516,000
$3,792,000 $3,792,000
Sales in the last quarter of 2010 amounted to USD 2,400,000 and are projected at USD 3,000,000 and USD
4,800,000 for the first two quarters of 2011. This expansion has created a need for cash. Management is especially
concerned about the probable cash balance of 2011 March 31, since a payment of USD 360,000 for some new
equipment must be made on delivery on April 2. The current cash balance of USD 240,000 is considered to be the
minimum workable balance.
Purchases, all on account, are to be scheduled so that the inventory at the end of any quarter is equal to one-
third of the goods expected to be sold in the coming quarter. Cost of goods sold averages 60 per cent of sales.
Selling expenses are budgeted at USD 120,000 plus 8 per cent of sales; USD 24,000 is expected to be incurred
on account, USD 288,000 accrued, USD 33,600 from expired prepayments, and USD 14,400 from allocated
depreciation.
Purchasing expenses are budgeted at USD 84,000 plus 5 per cent of purchases; USD 12,000 will be incurred on
account, USD 156,000 accrued, USD 13,200 from expired prepayments, and USD 10,800 from allocated
depreciation.
Administrative expenses are budgeted at USD 150,000 plus 3 per cent of sales; USD 24,000 will be incurred on
account, USD 132,000 accrued, USD 13,200 from expired prepayments, and USD 10,800 from allocated
depreciation.
Accounting Principles: A Business Perspective 913 A Global Text
23. Budgeting for planning and control
Federal income taxes are budgeted at 40 per cent of income before federal income taxes and are recorded as
accrued liabilities. Payments on these taxes are included in the payments on accrued liabilities discussed in item 6.
All 2010 December 31, accounts payable plus 80 per cent of current credits to this account will be paid in the
first quarter. All of the 2010 December 31, accrued liabilities payable (except for USD 72,000) will be paid in the
first quarter. Of the current quarter's accrued liabilities, all but USD 288,000 will be paid during the first quarter.
Cash outlays for various expenses normally prepaid will amount to USD 96,000 during the quarter.
All sales are made on account; 80 per cent of the sales are collected in the quarter in which made, and all of the
remaining sales are collected in the following quarter, except for 2 per cent which is never collected. The Allowance
for Uncollectible Accounts account shows the estimated amount of accounts receivable at 2010 December 31,
arising from 2010 sales that will not be collected.
a. Prepare an operating budget for the quarter ending 2011 March 31. Supporting schedules for planned
purchases and operating expenses should be included.
b. Prepare a financial budget for 2011 March 31. Include supporting schedules that (1) analyze accounts credited
for purchases and expenses, (2) show planned cash flows and cash balance, and (3) show planned collections of
accounts receivable and the accounts receivable balance.
c. Will sufficient cash be on hand April 2 to pay for the new equipment?
Answers to self-test
True-false
True. Budgets are estimates of the future and should consider future plans and conditions.
True. Cash budgets may cover a week or a month; sales and production budgets a month, a quarter, or a year;
and general operating budgets may cover a quarter or a year.
True. The planned operating budget is developed first in units, then in dollars.
False. Flexible budgets are based on actual activity and planned operating budgets are based on planned
activity. Planned operating budgets based on planned activity levels and flexible budgets are not the same if
planned activity levels and actual activity levels are not the same.
Multiple-choice
e. The benefits of budgeting include a through d.
c. The sales budget is first. We need to know sales before we predict cost of goods sold, selling and
administrative expenses, and the financial budget.
a. Budgeted amount = Fixed cost + (Variable cost per unit x Units of output)
= USD 60,000 + (USD 1.20 x 200,000)
= USD 60,000 + USD 240,000
= USD 300,000 budgeted amount
d. USD 150,000 – USD 30,000 = USD 120,000 variable cost
USD120,000
100,000 units =USD1.20 per unit variable cost
Budgeted costs at 90,000 units: 90,000 x USD 1.20 USD 108,000 Fixed costs 30,000
USD 138,000
Actual costs 142,500
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Unfavorable budget variance USD 4,500
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24. Control through standard costs
Learning objectives
After studying this chapter, you should be able to:
• Discuss the nature of standard costs, including how standards are set.
• Define budgets and discuss how budgets are used in a standard cost system.
• Discuss the advantages and disadvantages of using standard costs.
• Calculate the six variances from standard and determine if the variance is favorable or unfavorable.
• Discuss what each of the six variances shows and prepare journal entries to record the variance.
• Discuss the three selection guidelines used to investigate variances from standard.
• Discuss theoretical and practical methods for disposing of variances from standard.
This chapter discusses the uses of standard costs, the advantages and disadvantages of using standard costs, and
how to compute the difference, or variance, between an actual cost and a standard cost. We discuss how managers
can improve efficiency by investigating variances and taking corrective action.
Uses of standard costs
Whenever you have set goals that you have sought to achieve, these goals could have been called standards.
Periodically, you might measure your actual performance against these standards and analyze the differences to see
how close you are to your goal. Similarly, management sets goals, such as standard costs, and compares actual costs
with these goals to identify possible problems.
This section begins with a discussion of the nature of standard costs. Next, we explain how managers use
standard costs to establish budgets. Then we describe how management uses the concept of management by
exception to investigate variances from standards. We also explain setting standards and how management
decides whether to use ideal or practical standards. The section closes with a discussion of the other uses of
standard costs.
Nature of standard costs
A standard cost is a carefully predetermined measure of what a cost should be under stated conditions.
Standard costs are not only estimates of what costs will be but also goals to be achieved. When standards are
properly set, their achievement represents a reasonably efficient level of performance.
Usually, effective standards are the result of engineering studies and of time and motion studies undertaken to
determine the amounts of materials, labor, and other services required to produce a product. Also considered in
setting standards are general economic conditions because these conditions affect the cost of materials and other
services that must be purchased by a manufacturing company.
Manufacturing companies determine the standard cost of each unit of product by establishing the standard cost
of direct materials, direct labor, and manufacturing overhead necessary to produce that unit. Determining the
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24. Control through standard costs
standard cost of direct materials and direct labor is less complicated than determining the standard cost of
manufacturing overhead.
The standard direct materials cost per unit of a product consists of the standard amount of material required to
produce the unit multiplied by the standard price of the material. You must distinguish between the terms standard
price and standard cost. Standard price usually refers to the price per unit of inputs into the production process,
such as the price per pound of raw materials.
Standard cost, however, is the standard quantity of an input required per unit of output times the standard price
per unit of that input. For example, if the standard price of cloth is USD 3 per yard and the standard quantity of
material required to produce a dress is 3 yards, the standard direct materials cost of the dress is 3 yards x USD 3 per
yard = USD 9. Similarly, a company computes the standard direct labor cost per unit for a product as the standard
number of hours needed to produce one unit multiplied by the standard labor or wage rate per hour.
Standard manufacturing overhead cost To find the standard manufacturing overhead cost of a unit, use
the following steps. First, determine the expected level of output for the year. This level of output is called the
standard level of output. Second, determine the total budgeted manufacturing overhead cost at the standard
level of output. The total budgeted overhead cost includes both fixed and variable components. Total fixed cost is
the same at every level of output within a relevant range. Total variable overhead varies in direct proportion to the
number of units produced. Third, compute the standard manufacturing overhead cost per unit by dividing the total
budgeted manufacturing overhead cost at the standard level of output by the standard level of output. The result is
standard overhead cost (or rate) per unit of output.
The formula to compute the standard overhead cost per unit is:
Standard overhead cost rateper unit= Total budgeted overhead cost at thestandard level of output
Standard level of output
Sometimes accountants find the standard overhead rate per unit of input, such as direct labor-hour instead of
per unit. To find the standard overhead cost per unit, multiply the direct labor-hours per unit times the standard
overhead cost per direct labor-hour. For instance, if the standard overhead costs per direct labor-hour is USD 5 and
the standard number of direct labor-hours is two hours per unit, the standard overhead cost per unit is USD 5 x 2
hours = USD 10.
As discussed in Chapter 23, budgets are formal written plans that represent management's planned actions in
the future and the impacts of these actions on the business. As a business incurs actual expenses and revenues,
management compares them with the budgeted amounts. To control operations, management investigates any
differences between the actual and budgeted amounts and takes corrective action.
When management compares actual expenses and revenues with budgeted expenses and revenues, differences—
called variances—are likely to occur. The responsibility of management is to investigate significant variances.
Obviously, management must determine when a variance is significant. This process of focusing on only the most
significant variances is known as management by exception. The process of management by exception enables
management to concentrate its efforts on those variances that could have a big effect on the company, ignoring
those variances that are not significant.
In developing standards, management must consider the assumed conditions under which these standards can
be met. Standards generally fall into two groups—ideal and practical.
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A company attains ideal standards under the best circumstances—with no machinery problems or worker
problems. The company can attain these unrealistic standards only when it has highly efficient, skilled workers who
are working at their best effort throughout the entire period needed to complete the job.
Practical standards are strict but attainable standards that have allowances made for machinery problems
and rest periods for workers. Companies can meet these standards if average workers are efficient at their work.
These standards are generally used in planning.
Generally, management does not use ideal standards because ideal standards do not allow for normal repairs to
machinery or rest periods for workers. A company rarely runs its operations under ideal conditions. Since planning
under ideal standards is unrealistic, managers rarely use ideal standards in budgeting. Instead, management uses
practical standards in planning because these standards are more realistic, allowing for machinery repairs and rest
periods for workers. Any variances that result when practical standards are used indicate abnormal or unusual
problems.
In addition to developing budgets, companies use standard costs in evaluating management's performance,
evaluating workers' performance, and setting appropriate selling prices.
Firms evaluate management's and workers' performances through the use of a budget. When management
compares actual results with budgeted amounts, it can see how well it is performing its own duties and managing
its employees. Management also can evaluate workers based on how well they performed relative to the budgeted
amounts pertaining to the activities they performed.
Standard costs are useful in setting selling prices. The budget shows the expected expenses incurred by the
business. By considering these expenses, management can determine how much to charge for a product so that it
can produce the desired net income. As the business actually incurs these expenses, management determines if the
selling prices set are still reasonable and, when necessary, considers some price adjustments after taking
competition into account.
Advantages and disadvantages of using standard costs
Five of the benefits that result from a business using a standard cost system are:
• Improved cost control.
• More useful information for managerial planning and decision making.
• More reasonable and easier inventory measurements.
• Cost savings in record-keeping.
• Possible reductions in production costs.
Improved cost control Companies can gain greater cost control by setting standards for each type of cost
incurred and then highlighting exceptions or variances—instances where things did not go as planned. Variances
provide a starting point for judging the effectiveness of managers in controlling the costs for which they are held
responsible.
Assume, for example, that in a production center, actual direct materials costs of USD 52,015 exceeded standard
costs by USD 6,015. Knowing that actual direct materials costs exceeded standard costs by USD 6,015 is more
useful than merely knowing the actual direct materials costs amounted to USD 52,015. Now the firm can investigate
the cause of the excess of actual costs over standard costs and take action.
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24. Control through standard costs
Further investigation should reveal whether the exception or variance was caused by the inefficient use of
materials or resulted from higher prices due to inflation or inefficient purchasing. In either case, the standard cost
system acts as an early warning system by highlighting a potential hazard for management.
More useful information for managerial planning and decision making When management develops
appropriate cost standards and succeeds in controlling production costs, future actual costs should be close to the
standard. As a result, management can use standard costs in preparing more accurate budgets and in estimating
costs for bidding on jobs. A standard cost system can be valuable for top management in planning and decision
making.
More reasonable and easier inventory measurements A standard cost system provides easier inventory
valuation than an actual cost system. Under an actual cost system, unit costs for batches of identical products may
differ widely. For example, this variation can occur because of a machine malfunction during the production of a
given batch that increases the labor and overhead charged to that batch. Under a standard cost system, the
company would not include such unusual costs in inventory. Rather, it would charge these excess costs to variance
accounts after comparing actual costs to standard costs.
Thus, in a standard cost system, a company assumes that all units of a given product produced during a
particular time period have the same unit cost. Logically, identical physical units produced in a given time period
should be recorded at the same cost.
Cost savings in record-keeping Although a standard cost system may seem to require more detailed record-
keeping during the accounting period than an actual cost system, the reverse is true. For example, a system that
accumulates only actual costs shows cost flows between inventory accounts and eventually into cost of goods sold.
It records these varying amounts of actual unit costs that must be calculated during the period. In a standard cost
system, a company shows the cost flows between inventory accounts and into cost of goods sold at consistent
standard amounts during the period. It needs no special calculations to determine actual unit costs during the
period. Instead, companies may print standard cost sheets in advance showing standard quantities and standard
unit costs for the materials, labor, and overhead needed to produce a certain product.
Possible reductions in production costs A standard cost system may lead to cost savings. The use of
standard costs may cause employees to become more cost conscious and to seek improved methods of completing
their tasks. Only when employees become active in reducing costs can companies really become successful in cost
control.
Three of the disadvantages that result from a business using standard costs are:
• Controversial materiality limits for variances.
• Nonreporting of certain variances.
• Low morale for some workers.
Controversial materiality limits for variances Determining the materiality limits of the variances may be
controversial. The management of each business has the responsibility for determining what constitutes a material
or unusual variance. Because materiality involves individual judgment, many problems or conflicts may arise in
setting materiality limits.
Nonreporting of certain variances Workers do not always report all exceptions or variances. If
management only investigates unusual variances, workers may not report negative exceptions to the budget or may
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try to minimize these exceptions to conceal inefficiency. Workers who succeed in hiding variances diminish the
effectiveness of budgeting.
Low morale for some workers The management by exception approach focuses on the unusual variances.
Management often focuses on unfavorable variances while ignoring favorable variances. Workers might believe that
poor performance gets attention while good performance is ignored. As a result, the morale of these workers may
suffer.
An accounting perspective:
Business insight
A few forward-looking companies have succeeded in allowing employees to set their own work
standards. In most cases, industrial engineers shut themselves in a room and ponder how to set
standards. The industrial engineers ignored the workers, who in turn ignored the standards. In the
alternative scenario, workers themselves hold the stopwatches and set the standards. Worker team
members time each other, looking for the most efficient and safest way to do the work. They
standardize each task so everyone in the team does it the same way. The workers are more
informed about how to do the work than industrial engineers, and they are more motivated to meet
the standards they set.
Source: Based on the authors' research.
Computing variances
As stated earlier, standard costs represent goals. Standard cost is the amount a cost should be under a given set
of circumstances. The accounting records also contain information about actual costs.
The amount by which actual cost differs from standard cost is called a variance. When actual costs are less than
the standard cost, a cost variance is favorable. When actual costs exceed the standard costs, a cost variance is
unfavorable. Do not automatically equate favorable and unfavorable variances with good and bad. You must base
such an appraisal on the causes of the variance.
The following section explains how to compute the dollar amount of variances, a process called isolating
variances, using data for Beta Company. Beta manufactures and sells a single product, each unit of which has the
following standard costs:
Materials – 5 sheets at $6 $30 Direct labor – 2 hours at $10 20 Manufacturing overhead – 2 direct labor hours at $5
10
Total standard cost per unit $60
We present additional data regarding the production activities of the company as needed.
The standard materials cost of any product is simply the standard quantity of materials that should be used
multiplied by the standard price that should be paid for those materials. Actual costs may differ from standard costs
for materials because the price paid for the materials and/or the quantity of materials used varied from the
standard amounts management had set. These two factors are accounted for by isolating two variances for
materials—a price variance and a usage variance.
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24. Control through standard costs
Accountants isolate these two materials variances for three reasons. First, different individuals may be
responsible for each variance—a purchasing agent for the price variance and a production manager for the usage
variance. Second, materials might not be purchased and used in the same period. The variance associated with the
purchase should be isolated in the period of purchase, and the variance associated with usage should be isolated in
the period of use. As a general rule, the sooner a variance can be isolated, the greater its value in cost control. Third,
it is unlikely that a single materials variance—the difference between the standard cost and the actual cost of the
materials used—would be of any real value to management for effective cost control. A single variance would not
show management what caused the difference, or one variance might simply offset another and make the total
difference appear to be immaterial.
Materials price variance In a manufacturing company, the purchasing and accounting departments usually
set a standard price for materials meeting certain engineering specifications. They consider factors such as market
conditions, vendors' quoted prices, and the optimum size of a purchase order when setting a standard price. A
materials price variance (MPV) occurs when a company pays a higher or lower price than the standard price
set for materials. Materials price variance (MPV) is the difference between actual price paid (AP) and standard
price allowed (SP) multiplied by the actual quantity of materials purchased (AQ). In equation form, the materials
price variance is:
Materials price variance = (Actual price – Standard price) x Actual quantity purchased
To illustrate, assume that a new supplier entered the market enabling Beta Company to purchase 60,000 sheets
of material at a price of USD 5.90 each. Since the standard price set by management is USD 6 per sheet, the
materials price variance is computed as:
Materials pricevariance=Actual price – Standard price×Actual quantity purchased
= USD5.90−USD6.00×60,000
= USD−0.10×60,000
= USD -6,000 (favorable)
The materials price variance of USD 6,000 is considered favorable since the materials were acquired for a price
less than the standard price. If the actual price had exceeded the standard price, the variance would be unfavorable
because the costs incurred would have exceeded the standard price. The journal entry to record the purchase of
materials is:
(a) Materials inventory (+A) 360,000 Materials price variance (-A) 6,000 Accounts payable (+L) 354,000 To record the purchase of materials at less than standard cost.
Note that the Accounts Payable account shows the actual debt owed to suppliers, while the Materials Inventory
account shows the standard price of the actual quantity of materials purchased. The Materials Price Variance
account shows the difference between the actual price and standard price multiplied by the actual quantity
purchased.
Materials usage variance Because the standard quantity of materials used in making a product is largely a
matter of physical requirements or product specifications, usually the engineering department sets it. But if the
quality of materials used varies with price, the accounting and purchasing departments may perform special studies
to find the right quality.
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The materials usage variance occurs when more or less than the standard amount of materials is used to
produce a product or complete a process. The variance shows only differences from the standard quantity caused by
the quantity of materials used; it does not include any effect of variances in price. Thus, the materials usage
variance (MUV) is equal to actual quantity used (AQ) minus standard quantity allowed (SQ) multiplied by standard
price (SP):
Materials usage variance=Actualquantity used –Standard quantityallowed ×Standard price
To illustrate, assume that Beta Company used 55,500 sheets of material to produce 11,000 units of a product for
which the standard quantity allowed is 55,000 sheets (5 sheets per unit allowed x 11,000 units actually produced).
Since the standard price of the material is USD 6 per sheet, the materials usage variance of USD 3,000 would be
computed as follows:
Materials usage variance=Actual quantity used –Standard quantityallowed x Standard price
= 55,500−55,000 ×USD6
= 500×USD6
= USD 3,000 (unfavorable)
The variance is unfavorable because more materials were used than the standard quantity allowed to complete
the job. If the standard quantity allowed had exceeded the quantity actually used, the materials usage variance
would have been favorable.
The journal entry to record the use of the materials is:
(b) Work in process inventory (+A) 330,000 Materials usage variance (+A) 3,000 Materials inventory (-A) 333,000 To record the use of materials and to establish the materials usage variance.
The Materials Usage Variance account shows the standard cost of the excess materials used. Note also that the
Work in Process Inventory account contains both standard quantity and standard prices.
In the equations for both the materials variances, positive amounts were unfavorable variances and negative
amounts were favorable variances. Unfavorable variances are debits in variance accounts because they add to the
costs incurred, which are recorded as debits. Similarly, favorable variances are shown as negative amounts because
they are reductions in costs. Thus, favorable variances are recorded in variance accounts as credits. We use this
format in this text, but a word of caution is in order. Far greater understanding is achieved if you determine
whether a variance is favorable or unfavorable by reliance on reason or logic. If more materials were used than the
standard quantity, or if a price greater than the standard price was paid, the variance is unfavorable. If the reverse
is true, the variance is favorable.
Exhibit 198 below shows the relationship between standard and actual materials cost and the computation of the
materials variances; it is based on the following data relating to Beta Company:
Standard price per sheet of material $6.00 Actual price per sheet of material $5.90 Number of sheets of material purchased 60,000 Standard number of sheets of material per unit of product
5
Units of product produced in period 11,000 Actual number of sheets of material used $5,500
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24. Control through standard costs
Purchase of materials Actual cost of materials purchased:
Actual price X actual quantity purchased
5.90 X 60,000 sheets = $354,000
Standard cost of materials purchased: Standard price X actual quantity
purchased <--Price variance:
$6.00 X 60,000 sheets = $360,000
$354,000 - $360,000
Use of materials = -$6,000 (favorable)
Standard cost of materials used to
Produce 11,000 units:
Actual number of sheets used
X standard price
55,500 X $6.00 = $333,000 <--Usage variance: Standard cost of materials allowed to
Produce 11,000 units: $333,000 - $330,000 =
Standard number of
sheets allowed
X standard price $ 3,000 (unfavorable)
55,500* X $ 6.00 = $330,000 *(11,000 x 5) = 55,000.
Exhibit 198: Materials price and usage variances
The standard labor cost of any product is equal to the standard quantity of labor time allowed multiplied by the
wage rate that should be paid for this time. Here again, it follows that the actual labor cost may differ from standard
labor cost because of the wages paid for labor, the quantity of labor used, or both. Thus, two labor variances exist—a
rate variance and an efficiency variance.
Labor rate variance The labor rate variance (LRV) occurs when the average rate of pay is higher or lower
than the standard cost to produce a product or complete a process. The labor rate variance is similar to the
materials price variance.
To compute the labor rate variance (LRV), multiply the difference between the actual direct labor-hour rate paid
(AR) and the standard direct labor-hour rate allowed (SR) by the actual hours of direct labor services worked (AH):
Labor rate variance=Actual rate – Standard rate×Actual hours worked
To continue the Beta example, assume that the direct labor payroll of the company consisted of22,200 hours at a
total cost of USD 233,100 (an average actual hourly rate of USD 10.50). Because management has set a standard
direct labor-hour rate of USD 10 per hour, the labor rate variance is:
Labor rate variance=Actual rate – Standard rate×Actual hours worked
= USD10.50−USD10.00×22,200
= USD 0.50×22,200
= USD 11,100 (unfavorable)
The variance is positive and unfavorable because the actual rate paid exceeded the standard rate allowed. If the
reverse were true, the variance would be favorable.
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Labor efficiency variance Usually, the company's engineering department sets the standard amount of
direct labor-hours needed to complete a product. Engineers may base the direct labor-hours standard on time and
motion studies or on bargaining with the employees' union. The labor efficiency variance (LEV) occurs when
employees use more or less than the standard amount of direct labor-hours to produce a product or complete a
process. The labor efficiency variance is similar to the materials usage variance.
To compute the labor efficiency variance (LEV), multiply the difference between the actual direct labor-hours
worked (AH) and the standard direct labor-hours allowed (SH) by the standard direct labor-hour rate per hour
(SR):
Labor efficiency variance=Actual rate – Standard rate×Actual hours worked
= USD10.50 – USD10.00×22,200
= USD 0.50×22,200
= USD 11,100 (unfavorable)
The variance is positive and unfavorable because the actual rate paid exceeded the standard rate allowed. If the
reverse were true, the variance would be favorable.
Labor efficiency variance Usually, the company's engineering department sets the standard amount of
direct labor-hours needed to complete a product. Engineers may base the direct labor-hours standard on time and
motion studies or on bargaining with the employees' union. The labor efficiency variance (LEV) occurs when
employees use more or less than the standard amount of direct labor-hours to produce a product or complete a
process. The labor efficiency variance is similar to the materials usage variance.
To compute the labor efficiency variance (LEV), multiply the difference between the actual direct labor-hours
worked (AH) and the standard direct labor-hours allowed (SH) by the standard direct labor-hour rate per hour
(SR):
Labor efficiency variance=Actual hoursworked – Standard hoursallowed ×Standard rate
To illustrate, assume that the 22,200 hours of direct labor-hours worked by Beta Company employees resulted
in 11,000 units of production. Assume these units have a standard direct labor-hours of 22,000 hours (11,000 units
at 2 hour unit). Since the standard direct labor rate is USD 10 per hour, the labor efficiency variance is USD 2,000,
computed as follows:
Labor efficiency variance=Actual hoursworked – Standard hoursallowed ×Standard rate
= 22,200 – 20,000×USD10
= 200 X USD10
= USD 2,000 (unfavorable)
The variance is unfavorable since more hours than the standard number of hours were required to complete the
period's production. If the reverse were true, the variance would be favorable.
The standard direct labor-hours allowed for the period's output are 22,000 hours (11,000 units at 2 hours per
unit). The standard direct labor cost is USD 10 per hour; therefore, the standard direct labor cost for the output
achieved is assigned to inventory, regardless of the actual direct labor cost.
The journal entry to charge the direct labor cost to Work in Process Inventory is:
(c) Work in process inventory (+A) 220,000 Labor rate variance (+A) 11,100 Labor efficiency variance (+A) 2,000 Payroll summary (+L) 233,100 To charge work in process with direct
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24. Control through standard costs
labor and to establish the two labor variances.
With this entry, gross wages earned by direct-production employees (USD 233,100) are distributed as follows:
USD 220,000 (the standard labor cost of production) to Work in Process Inventory and the balance to the two labor
variance accounts. The unfavorable labor rate variance is not necessarily caused by paying employees more wages
than they are entitled to receive. More probable reasons are either that more highly skilled employees with higher
wage rates worked on production than originally anticipated, or that employee wage rates increased after the
standard was developed and the standard was not revised. Favorable rate variances, on the other hand, could be
caused by using less-skilled, cheaper labor in the production process. Typically, the hours of labor employed are
more likely to be under management's control than the rates that are paid. For this reason, labor efficiency
variances are generally watched more closely than labor rate variances.
In Exhibit 199, at the top of the next page, we show the relationship between standard and actual direct labor
cost and the computation of the labor variances. The illustration is based on the following data relating to Beta
Company:
Standard direct labor-hours per unit 2 hours Equivalent units produced in period 11,000 units Standard labor rate per direct labor-hour $ 10 Total direct labor wages paid (at actual rate of $10,50 per hour)
$233,100
Actual direct labor-hours worked 22,200 hours
Actual Labor Cost: Actual labor rate X actual hours worked
$ 10.50 X 22,200 = $233,100 Labor rate variance: Standard cost of actual hours worked: $233,100 - $222,000
= Standard labor rate X actual hours worked $11,100
(unfavorable) $10.00 X 22,200 = $222,000
Standard cost of hours allowed to produce 11,000 units:
Labor efficiency variance:
Standard labor rate X standard hours allowed $222,000 - $220,000 =
$10.00 X 22,000* = $220,000 $2,000 (unfavorable) * 2 hours x 11,000 units = 22,000.
Exhibit 199: Labor rate and efficiency variances
Summary of labor variances The accuracy of the two labor variances can be checked by comparing their
sum with the difference between actual and standard labor cost for a period. In the Beta Company illustration, this
difference was:
Actual labor cost incurred (22,200 hours x $10.50)
$233,100
Standard labor cost allowed (22,000 hours x $10)
220,000
Total labor variance (unfavorable) $ 13,100
This USD 13,100 is made up of two labor variances, both unfavorable:
Labor rate variance (22,200 x $0.50)
$11,100
Labor efficiency variance (200 x $10)
2,000
Total labor variance (unfavorable) $ 13,100
Labor costs are typically a major cost in service organizations. Banks, public accounting firms, law firms,
hospitals, and parking enforcement agencies are just a few organizations that monitor labor costs closely.
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University officials developed the following standards for a university's parking enforcement people. (The
university's officials explained that they do not have ticket quotas, but they expect their parking ticket writers "to be
enforcing parking laws, not hanging out at the coffee house".)
Standard direct labor time per ticket 12 minutes Number of tickets written in March 2,000 tickets Standard labor rate per hour $14 Total labor costs for ticket writing (at an average rate of $13.50 per hour)
$5,670
Actual ticket writing hours worked 420 hours
The university has calculated labor rate and efficiency variances as follows:
Labor rate variance=Actual rate – Standard rate×Actual hours
= USD13.50 – USD14.00×420 hours
= USD−0.50×420 hours
= USD -210 (favorable)
Labor rate variance=Actualhours – Standard hours ×Standard rate
Standard hours= 12 minutes
60 minutes ×2,000 tickets
= 0.2 hours×2,000 tickets
= 400 hours
Labor efficiency variance=420 hours – 400 hours ×USD14
= 20 hours×USD14
= USD 280 (unfavorable)
In a standard cost system, accountants apply the manufacturing overhead to the goods produced using a
standard overhead rate. They set the rate prior to the start of the period by dividing the budgeted manufacturing
overhead cost by a standard level of output or activity. Total budgeted manufacturing overhead varies at different
levels of standard output, but since some overhead costs are fixed, total budgeted manufacturing overhead does not
vary in direct proportion with output.
Managers use a flexible budget to isolate overhead variances and to set the standard overhead rate. Flexible
budgets show the budgeted amount of manufacturing overhead for various levels of output.
Look at Beta Company's flexible budget for the period in Exhibit 200 below. Note that Beta's flexible budget
shows the variable and fixed manufacturing overhead costs expected to be incurred at three levels of activity: 9,000
units, 10,000 units, and 11,000 units. For product costing purposes, Beta must estimate the expected level of
activity in advance and set a rate based on that level. The level chosen is called the standard volume of output. This
standard volume of output (or activity) may be expressed in terms of any of the activity bases used in setting
standard overhead rates. These activity bases include percentage of capacity, units of output machine-hours, and
direct labor-hours, among others. In our example, standard volume is assumed to be 10,000 units produced.
Management expects to use 20,000 machine-hours of services.
Accounting Principles: A Business Perspective 926 A Global Text
24. Control through standard costs
Beta Company Flexible manufacturing overhead budget Machine-hours 18,000 20,000 22,000 Units of output 9,000 10,000 11,000 Variable overhead: Indirect materials $ 7,200 $ 8,000 $ 8,800 Power 9,000 10,000 11,000 Royalties 1,800 2,000 2,200 Other 18,000 20,000 22,000 Total variable overhead $36,000 $40,000 $44,000 Fixed overhead: Insurance $4,000 $ 4,000 $ 4,000 Property taxes 6,000 6,000 6,000 Depreciation 20,000 20,000 20,000 Other 30,000 30,000 30,000 Total fixed overhead $60,000 $60,000 $
60,000 Standard overhead rate ($100,000/20,000 hours)
$5
Exhibit 200: Flexible manufacturing overhead budget
Assume that Beta applies manufacturing overhead using a rate based on machine-hours. According to the
flexible manufacturing overhead budget, the expected manufacturing overhead cost at the standard volume
(20,000 machine-hours) is USD 100,000, so the standard overhead rate is USD 5 per machine-hour (USD
100,000/20,000 machine-hours).
Knowing the separate rates for variable and fixed overhead is useful for decision making, as discussed in
Chapters 21 and 22. The variable overhead rate is USD 2 per hour (USD 40,000/20,000 hours), and the fixed
overhead rate is USD 3 per hour (USD 60,000/20,000 hours). If the expected volume had been 18,000 machine-
hours, the standard overhead rate would have been USD 5.33 (USD 96,000/18,000 hours). If the standard volume
had been 22,000 machine-hours, the standard overhead rate would have been USD 4.73 (USD 104,000/22,000
hours).
Note that the difference in rates is due solely to dividing fixed overhead by a different number of machine-hours.
That is, the variable overhead cost per unit stays constant (USD 2 per machine-hour) regardless of the number of
units expected to be produced, and only the fixed overhead cost per unit changes.
Continuing with the Beta Company illustration, assume that the company incurred USD 108,000 of actual
manufacturing overhead costs in a period during which 11,000 units of product were produced. The actual costs
would be debited to Manufacturing Overhead and credited to a variety of accounts such as Accounts Payable,
Accumulated Depreciation, Prepaid Insurance, Property Taxes Payable, and so on. According to the flexible budget,
the standard number of machine-hours allowed for 11,000 units of production is 22,000 hours. Therefore, USD
110,000 of manufacturing overhead is applied to production (USD 5 per machine-hour times 22,000 hours) by
debiting Work in Process Inventory and crediting Manufacturing Overhead for USD 110,000. The journal entry to
apply manufacturing overhead to production would be:
Work in process inventory (+A) 110,000 Manufacturing overhead (+SE) 110,000 To apply manufacturing overhead to production (22,000 hours at $5 per hour).
These accounts show that manufacturing overhead has been overapplied to production by the USD 2,000 credit
balance in the Manufacturing Overhead account. Because of its fixed component, manufacturing overhead tends to
be over applied when actual production is greater than standard production.
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Although various complex computations can be made for overhead variances, we use a simple approach in this
text. In this approach, known as the two-variance approach to overhead variances, we calculate only two variances
—an overhead budget variance and an overhead volume variance.
Overhead budget variance The overhead budget variance (OBV) shows in one amount how
economically overhead services were purchased and how efficiently they were used. This overhead variance is
similar to a combined price and usage variance for materials or labor. The overhead budget variance (OBV) is equal
to the difference between total actual overhead costs (actual OH) and total budgeted overhead costs (BOH) for the
actual output attained.
To calculate the total budgeted overhead costs, multiply the variable overhead rate times the standard machine-
hours allowed for production achieved, plus the constant amount of fixed overhead. For Beta Company, this would
be USD 2 variable overhead times 22,000 hours, or USD 44,000 variable overhead, plus USD 60,000 of fixed
overhead—a total of USD 104,000. Since the total actual overhead was USD 108,000 and the total budgeted
overhead was USD 104,000, the overhead budget variance is computed as follows:
Overhead budgetvariance=Actualoverhead−Budgeted overhead at actual production volume level
= USD 108,000−USD104,000
= USD 4,000 (unfavorable)
The variance is unfavorable because actual overhead costs were USD 108,000, while according to the flexible
budget, they should have been USD 104,000.
Overhead volume variance The overhead volume variance (OVV) is caused by producing at a level
other than that used in setting the standard overhead application rate. The OVV shows whether plant assets
produced more or fewer units than expected. Because fixed overhead is not constant on a per unit basis, any
deviation from planned production causes the overhead application rate to be incorrect. The OVV is the difference
between the budgeted amount of overhead for the actual volume achieved (BOH) and the applied overhead
(Applied OH):
Overhead volume variance=Budgeted overhead−Applied overhead
In the Beta Company illustration, the 11,000 units produced in the period have a standard allowance of 22,000
machine-hours. We calculated budgeted overhead when computing the overhead budget variance. The flexible
budget in Exhibit 200, at the top of the previous page, shows that the budgeted overhead for 22,000 machine-hours
is USD 104,000. Overhead is applied to work in process on the basis of standard hours allowed for a particular
amount of production; in this case, 22,000 hours at USD 5 per hour. The overhead volume variance then is:
Overhead volume variance=Budgeted overhead−Applied overhead
= USD104,000−USD110,000
= USD -6,000 (favorable)
Note that the amount of the overhead volume variance is related solely to fixed overhead. As we show in Exhibit
200, fixed overhead at all levels of activity is USD 60,000. Since Beta Company used 20,000 machine-hours as its
standard, the fixed overhead rate is USD 3 per machine-hour. Beta worked 2,000 more standard hours (22,000 -
20,000) than was expected. Beta also can calculate the overhead volume variance as follows:
(Number of hours used in setting predetermined overhead rates
- Number of standard hours allowed for production level achieved)
X Fixed overhead rate per hour = Overhead volume variance
(20,000 - 22,000) X USD 3 =USD -6,000 (favorable)
Accounting Principles: A Business Perspective 928 A Global Text
24. Control through standard costs
The variance is favorable because the company achieved a higher level of production than was expected.
Recording overhead variances These journal entries are related to overhead:
(d) Work in Process (+A) 110,000 Manufacturing Overhead (+SE) 110,000 To record the application of manufacturing overhead to work in process.
(e) Manufacturing overhead (-SE) 108,000 Various accounts (Varies) 108,000 To record actual manufacturing overhead.
(f) Manufacturing overhead (-SE) 2,000 Overhead budget variance (-SE) 4,000 Overhead volume variance (+SE) 6,000 To record the variances related to overhead and close the manufacturing overhead account.
The first entry applies manufacturing overhead to Work in Process at the rate of USD 5 per standard machine-
hour. The second entry records the actual manufacturing overhead costs incurred during the period by Beta
Company. The final entry reduces the Manufacturing Overhead account balance to zero and sets up the two
variances calculated for overhead; these two variance accounts reveal the causes of the overapplied manufacturing
overhead for the period.
Summary of overhead variances To easily determine the accuracy of the two overhead variances, Beta
would compare the sum of the budget and volume variances with the difference between the costs of actual
manufacturing overhead and applied manufacturing overhead (the amount of over- or underapplied overhead). For
Beta Company, the difference between actual and applied manufacturing overhead was:
Actual manufacturing overhead incurred $ 108,000 Applied manufacturing overhead allowed (22,000 machine- hours x $5 per hour) 110,000 Total overhead variance (favorable) $ -2,000
This difference is made up of the two overhead variances:
Overhead budget variance – unfavorable ($108,000 - $104,000) $ 4,000 Overhead volume variance -favorable [$104,000 – (22,000 x $5)] -6,000 Total overhead variance (favorable) $ -2,000
For a summary of the six variances from standard discussed in this chapter, see Exhibit 201 below.
Materials price variance =
(Actual price – Standard price) x Actual quantity purchased
Materials usage variance =
(Actual quantity used – Standard quantity allowed) x Standard price
Labor rate variance = (Actual rate – standard rate) x Actual hours worked Labor efficiency variance =
(Actual hours worked – standard hours allowed) x Standard rate
Overhead budget variance =
Actual overhead – budgeted overhead
Overhead volume variance =
Budgeted overhead – applied overhead
Exhibit 201: Summary of variances from standard
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An accounting perspective:
Uses of technology
Although standard costing often appears more difficult than actual costing to students, standard
costing is generally easier in the real world. The key to this simplicity is the computer's capability to
store, retrieve, and update standards. Once a firm sets standards for a product, it is relatively
simple to update these standards for changes in labor rates, product prices, and efficiency
improvements.
Goods completed and sold
To complete the standard cost system example, assume Beta Company completed and transferred 11,000 units
to finished goods and sold on account 10,000 units at a price equal to 160 per cent of standard cost. Also, there
were no beginning or ending work in process inventories, and no beginning finished goods inventory. Journal entry
(g) transfers the standard cost of the units completed, 11,000 x USD 60 = USD 660,000, from Work in Process
Inventory to Finished Goods Inventory. Entry (h) records the sales for the period, 160 per cent x USD 60 x 10,000
= USD 960,000. Entry (i) records the cost of goods sold, 10,000 x USD 60 = USD 600,000.
(g) Finished goods inventory (+A) 660,000 Work in process inventory (- A)
660,000
To record the transfer of completed units to finished goods inventory.
(h) Accounts receivable (+A) 960,000 Sales (+SE) 960,000 To record sales for the period.
(i) Cost of goods sold (-SE) 600,000 Finished goods inventory (-A) 600,000 To record cost of goods sold for the period.
Beta debits the Work in Process Inventory with the standard cost of materials, labor, and manufacturing
overhead for units put into production. Therefore, the entry recording the transfer of the standard cost of the
completed units, 11,000 x USD 60 = USD 660,000, reduces Work in Process Inventory to a zero balance.
Sales for the period amount to 10,000 units at USD 96 each (160 per cent of USD 60). It is fairly common
practice to base selling prices at least partially on standard costs. Note that Beta debited Finished Goods Inventory
with the standard cost of goods completed and credited it with the standard cost of goods sold. Thus, the ending
Finished Goods Inventory consists of the units actually on hand (1,000) at their standard cost of USD 60 each, or
USD 60,000.
Investigating variances from standard
Once all variances have been computed, management must decide which variances should be investigated
further. Because numerous variances occur, managers cannot investigate all of them. Management needs some
selection guidelines. Possible guidelines include the (1) amount of the variance; (2) size of the variance relative to
the cost incurred; and (3) controllability of the cost associated with the variance—that is, whether it is considered
Accounting Principles: A Business Perspective 930 A Global Text
24. Control through standard costs
controllable or noncontrollable. Managers also may use statistical analysis in deciding which variances to
investigate. For instance, they could determine the average value of actual costs for a period so that only those
variances deviating from the average by more than a certain percentage would be investigated. To decide which
selection guidelines are most useful, management should seek the opinions of knowledgeable operating personnel.
Any analysis of variances is likely to disclose some variances that are controllable within the company and others
that are not. For instance, quantities used are generally controllable internally. Prices paid for materials purchased
may or may not be controllable. Management may discover that the purchasing agent is not getting competitive
bids; therefore, the price paid for materials would have been more controllable had the agents sought competitive
bids. On the other hand, a raw materials shortage may exist that drives the price upward, and the price paid may be
beyond the buyer's control.
Another point to remember about the analysis of variances is that separate variances are not necessarily
independent. For example, an unfavorable labor rate variance may result from using higher paid employees in a
certain task. However, higher paid employees may be more productive, resulting in a favorable labor efficiency
variance. These employees also may be more highly skilled and may waste fewer materials, resulting in a favorable
materials usage variance. Therefore, significant variances, both favorable and unfavorable, should be investigated.
At the end of a month or quarter, management may develop performance reports that compare the actual results
and costs with the budgeted results and costs. These reports enable management to determine how well they and
their workers were able to perform within the budget. At the bottom of the performance report, the supervisor or
manager responsible for the elements mentioned in the report gives reasons for any variances. Management then
investigates any variance not supported by an acceptable reason.
Disposing of variances from standard
At the end of the year, variances from standard must be disposed of in the accounting records. The variances
may be (1) viewed as losses due to inefficiency and closed to the Income Summary; (2) allocated as adjustments to
the recorded cost of Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold; or (3) closed to
Cost of Goods Sold. Theoretically, the alternative chosen should depend on whether the standards set were
reasonably attainable and whether the variances were controllable by company employees. For instance, a firm may
consider an unfavorable materials usage or labor efficiency variance caused by carelessness or inefficiency a loss
and close it to the Income Summary because the standard was attainable and the variance was controllable. The
business may consider an unfavorable materials price variance caused by an unexpected price change an added cost
and allocate it to the inventory accounts and Cost of Goods Sold because the standard was unattainable and the
variance was uncontrollable. As a practical matter, companies usually close small variances to the Cost of Goods
Sold account rather than allocate them to the inventory accounts and to cost of goods sold.
Entry (j) reflects this practical disposition of Beta Company's variances by closing them to Cost of Goods Sold:
(j) Materials price variance (+A) 6,000 Overhead volume variance (+A) 6,000 Cost of goods sold (-SE) 8,100 Materials usage variance (-A) 3,000 Labor rate variance (-A) 11,100 Labor efficiency variance (-A) 2,000 Overhead budget variance (-A) 4,000 To close the variance accounts.
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Companies do not report variances separately in financial statements released to the public but simply include
them in the reported cost of goods sold amount. Reports prepared for internal use may list the variances separately
after the cost of goods sold is shown at standard cost.
A broader perspective:
Quality management and the Baldrige award
Many of the methods successfully used in the Japanese quality movement originated in the United
States. The use of statistical controls in assessing processes originated in the United States, but
Japanese managers applied the concept and had much greater employee involvement in quality
improvement than US companies. Although lagging in implementing quality management
programs, many US companies have jumped on the quality management bandwagon.
The US Congress created the Malcolm Baldrige National Quality Award in honor of a former
secretary of commerce. The award is given to businesses that excel in major aspects of quality, such
as quality planning, human resource development, and customer focus. Companies that have won
this award include well-known manufacturing companies such as Motorola, Westinghouse
(Commercial Nuclear Fuel Division), IBM, Texas Instruments (Defense Systems and Electronics
Group), and General Motors (Cadillac Division). The award has also been given to large service
organizations—Ritz-Carlton Hotels, Federal Express, and AT&T (Network Systems Group)—and to
small businesses such as Granite Rock Co. in Watsonville, California, USA, and Globe Metallurgical
in Cleveland, Ohio, USA. The Baldrige Award promotes sharing of information about effective
quality management programs and identifies companies with role-model quality management
systems.
Source: Authors' research.
Nonfinancial performance measures
Although variances provide important measures of performance, nonfinancial performance measures are also
important. Nonfinancial performance measures are particularly important for evaluating quality and customer
service. Chapter 20 discussed various nonfinancial measures of performance.
Businesses measure quality by the number and type of customer complaints or by the number of product
defects. If they reduce the number of product defects, firms are likely to reduce the number of customer complaints.
The objective is to increase customer satisfaction with their products, increase repeat sales, reduce the costs of
dealing with customer complaints, and reduce the costs of repairing products.
Managers can reduce materials waste by improving the quality of raw materials so there is less waste from
defective materials. Managers also can increase employee training so workers make fewer mistakes and improve
the production process. Materials waste may show up in the materials efficiency variance. Workers are generally
motivated to find ways to reduce waste if companies keep track of materials waste every day. While reporting
variances from standard costs is important to department heads and plant managers, workers are more likely to be
motivated by immediate feedback in nonfinancial language.
Accounting Principles: A Business Perspective 932 A Global Text
24. Control through standard costs
Activity-based costing, standards, and variances
Activity-based costing is commonly used with standard costing. Hewlett-Packard, a pioneer in the development
of activity-based costing, uses it to develop standard costs. In our example, we applied overhead using just one cost
driver—machine-hours. Using activity-based costing, a company uses multiple activity-bases, or cost drivers, as
discussed in Chapter 20.
By striving to meet standards, management assumes responsibility for reducing the production costs of its
products. In Chapter 25, you will learn about responsibility accounting in a broader sense. Many successful
companies rely on responsibility accounting to make their business operations profitable.
An accounting perspective:
Business insight
Managers of many companies criticize standard costing because they believe it keeps workers from
continuous improvement. These managers argue that workers who achieve standards do not try to
improve beyond those standards. We believe workers can beat the standards and strive for
continuous improvement if they are properly motivated.
Understanding the learning objectives
• A standard cost is a carefully predetermined measure of what a cost should be under stated conditions.
• Engineering studies and time and motion studies are undertaken to determine the amounts of materials,
labor, and other services required to produce a product.
• Budgets are formal written plans that represent management's planned actions in the future and the
impacts of these actions on the business.
• Comparison of actual amounts to the budgeted amounts allows management to evaluate their own
performance and that of their workers.
• Advantages of using standard costs include improved cost control, more useful information for managerial
planning and decision making, more reasonable inventory measurements, cost savings in record-keeping, and
possible reductions in production costs incurred.
• Disadvantages of using standard costs include controversial materiality limits for variances, nonreporting
of certain variances, and low morale for some workers.
• Materials price variance:
Actual price−Standard price×Actual quantity purchased .
• Materials usage variance:
Actual quantity used−Standard quantityallowed ×Standard price .
• Labor rate variance:
Actual rate−Standard rate×Actual hoursworked .
• Labor efficiency variance:
Actual hoursworked−Standard hoursallowedxStandard rate .
• Overhead budget variance:
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Actual overhead - Budgeted overhead.
• Overhead volume variance:
Budgeted overhead - Applied overhead.
• The materials price variance, shows whether the price paid for materials purchased was higher or lower
than the standard price. This journal entry records the purchase of materials:
Materials inventory (debit) Materials price variance (debit or credit) Accounts payable (credit)
The Materials Price Variance account is debited if the variance is unfavorable and credited if the variance is
favorable.
• The materials usage variance shows whether the actual quantity of materials used was higher or lower
than the standard quantity. The journal entry to record materials usage is:
Work in process inventory (debit) Materials usage variance (debit or credit) Materials inventory (credit)
The Materials Usage Variance account is debited if unfavorable and credited if favorable.
• The labor rate variance shows whether the actual direct labor-hour rate paid is higher or lower than the
standard rate.
• The labor efficiency variance shows whether the actual direct labor-hours worked were greater or less
than the standard hours. This journal entry charges the direct labor cost to Work in Process Inventory:
Work in process inventory (debit) Labor rate variance (debit or credit) Labor efficiency variance (debit or credit) Payroll Summary (credit)
The Labor Rate Variance account is debited if the variance is unfavorable and credited if the variance is
favorable. The Labor Efficiency Variance account is debited if the variance is unfavorable and credited if the
variance is favorable.
• The overhead budget variance shows the difference between total actual overhead costs and total
budgeted overhead costs.
• The overhead volume variance shows the difference between the budgeted amount of overhead for the
actual volume achieved and the applied overhead. This journal entry records the overhead variance:
Manufacturing overhead (debit or credit) Overhead budget variance (debit or credit) Overhead volume variance (debit or credit)
The debit or credit to Manufacturing Overhead closes that account. The Overhead Budget Variance account is
debited if the variance is unfavorable and credited if the variance is favorable. The Overhead Volume Variance
account is credited if the variance is favorable and debited if the variance is unfavorable.
• Three possible selection guidelines are (1) amount of variance, (2) size of the variance relative to cost
incurred, and (3) controllability of the cost associated with the variance.
• Significant variances, both favorable and unfavorable, should be investigated.
• Variances may be viewed as losses due to inefficiency and closed to the Income Summary account; allocated
as adjustments to the recorded cost of Work in Process Inventory, Finished Goods Inventory, and Cost of
Goods Sold; or closed to Cost of Goods Sold.
• Practically, variances are usually closed to Cost of Goods Sold.
Accounting Principles: A Business Perspective 934 A Global Text
24. Control through standard costs
Demonstration problem
Gleim Company manufactures children's toys that are identical. The standard cost of each toy is:
Direct materials: Three blocks of wood at $0.24 $0.72 Direct labor (1 hour at $6) 6.00 Overhead: Fixed ($21,600/60,000 units) 0.36 Variable 0.48
$7.56
Gleim bases the standard overhead rate on a volume of 60,000 units per month. In May, it manufactured
50,000 units. Using the following detailed data relative to production, compute the six variances from standard for
the month.
Materials purchased: 160,000 blocks of wood at $ 0.26 Materials used: 152,000 blocks of wood Direct labor: 49,000 hours at $ 6.12 Fixed manufacturing overhead $ 21,840 Variable manufacturing overhead
$ 24,420
Solution to demonstration problem Materials price variance: ($.026 - $0.24) x 160,000 $ 3,200
(unfavorable) Materials usage variance: (152,000 – 150,000*) x $0.24 480 (unfavorable) Total materials variance $ 3,680
(unfavorable) Labor rate variance: ($6.12 - $6.00) x 49,000 $ 5,880
(unfavorable) Labor efficiency variance: (49,000 – 50,000) x $6.00 -6,000 (favorable) Net labor variance $ -120 (favorable) Overhead budget variance: Actual ($21,840 + $24,420) $46,260 Budgeted [$21,600 x (50,000 x $0.48)]45,600 Overhead budget variance $660 (unfavorable) Overhead volume variance: Budget – Applied [$45,600 – (50,000 x $0.84)]
$ 3,600 (unfavorable)
Total overhead variance $ 4,260 (unfavorable)
Total variance for month $ 7,820 (unfavorable)
*50,000 units x 3 blocks per unit.
Key terms Budgets Formal written plans that represent management's planned actions in the future and the impacts of these actions on the business.
Flexible budget A budget that shows the budgeted amount of manufacturing overhead for various levels of output; used in isolating overhead variances and setting standard overhead rates.
Ideal standards Standards that can be attained under the best circumstances—that is, with no machinery problems or worker problems. These unrealistic standards can only be met when the company has highly efficient, skilled workers who are working at their best effort throughout the entire period needed to complete the job.
Labor efficiency variance (LEV) A variance from standard caused by using more or less than the standard amount of direct labor-hours to produce a product or complete a process; computed as (Actual hours worked - Standard hours allowed) x Standard rate per hour.
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Labor rate variance (LRV) A variance from standard caused by paying a higher or lower average rate of pay than the standard cost to produce a product or complete a process; computed as (Actual rate -Standard rate) x Actual hours worked.
Management by exception The process where management only investigates those variances that are unusually favorable or unfavorable or that have a material effect on the company.
Materials price variance (MPV) A variance from standard caused by paying a higher or lower price than the standard for materials purchased; computed as (Actual price - Standard price) x Actual quantity purchased.
Materials usage variance (MUV) A variance from standard caused by using more or less than the standard amount of materials to produce a product or complete a process; computed as (Actual quantity used - Standard quantity allowed) x Standard price.
Overhead budget variance (OBV) A variance from standard caused by incurring more or less than the standard manufacturing overhead for the actual production volume achieved, as shown by a flexible budget; computed as Actual overhead - Budgeted overhead at the actual production volume level.
Overhead volume variance (OVV) A variance from standard caused by producing at a level other than that used in setting the standard overhead application rates; computed as Budgeted overhead - Applied overhead.
Practical standards Standards that are strict but attainable. Allowances are made for machinery problems and rest periods for workers. These standards are generally used in planning.
Standard cost A carefully predetermined measure of what a cost should be under stated conditions.
Standard level of output A carefully predetermined measure of what the expected level of output should be for a specified period of time, usually one year.
Variance A deviation of actual costs from standard costs; may be favorable or unfavorable. That is, actual costs may be less than or more than standard costs. Variances may relate to materials, labor, or manufacturing overhead.
Self-test
True-false
Indicate whether each of the following statements is true or false.
Standard cost usually refers to the standard price per unit of inputs into the production process.
Standard costs are useful in evaluating management's and workers' performance.
Under a standard cost system, all units of a given product produced during a particular period are typically in
inventory at the same unit cost.
This journal entry records the use of materials and establishes a Materials Usage Variance account: debit
Accounts Payable and Materials Usage Variance; credit Materials Inventory.
Favorable variances are credits in variance accounts.
Multiple-choice
Select the best answer for each of the following questions.
Which of the following explain why accountants separate materials variances into a purchase price variance and
a usage variance?
a. Different individuals may be responsible for each variance.
b. Materials might not be purchased and used in the same period.
c. These two variances are likely to be more informative to top management than one overall materials variance.
d. All of the above.
Determine the materials usage variance and materials price variance from the following data:
Materials purchased 30,000 units Price per unit purchased $3.00 Standard price per unit $3.10 Materials used 25,000 units
Accounting Principles: A Business Perspective 936 A Global Text
24. Control through standard costs
Standard quantity allowed 22,000 units
a. USD 9,300 favorable (MUV)
USD 3,000 unfavorable (MPV).
b. USD 9,300 unfavorable (MUV)
USD 3,000 favorable (MPV).
c. USD 9,000 unfavorable (MUV)
USD 2,200 favorable (MPV).
d. USD 9,000 favorable (MUV)
USD 2,500 unfavorable (MPV).
To which account would an unfavorable materials usage or labor efficiency variance caused by carelessness or
inefficiency be closed?
a. Materials Inventory.
b. Income Summary.
c. Work in Process.
d. Finished Goods Inventory.
Which of the following journal entries is correct for closing out the variance accounts?
a. Sales
Materials Usage Variance
Labor Rate Variance
Materials Price Variance
Overhead Volume Variance
Labor Efficiency Variance
Overhead Budget Variance
b. Materials Price Variance
Overhead Volume Variance
Accounts Payable
Materials Usage Variance
Labor Rate Variance
Labor Efficiency Variance
Overhead Budget Variance
c. Materials Price Variance
Overhead Volume Variance
Cost of Goods Sold
Materials Usage Variance
Labor Rate Variance
Labor Efficiency Variance
Overhead Budget Variance
d. Materials Price Variance
Overhead Budget Variance
Accounts Receivable
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Materials Usage Variance
Overhead Volume Variance
Labor Efficiency Variance
Labor Rate Variance
Now turn to “Answers to self-test” at the end of the chapter to check your answers.
Questions
➢ Is a standard cost an estimated cost? What is the primary objective of employing standard costs in a
cost system?
➢ What is a budget?
➢ What is the difference between ideal and practical standards? Which standard generally is used in
planning?
➢ What is meant by the term management by exception?
➢ What are some advantages of using standard costs? What are some disadvantages?
➢ Describe how the materials price and usage variances would be computed from the following data:
➢ Standard—1 unit of material at USD 20 per unit. Purchased—1,200 units of material at USD 20.30;
used—990 units. Production—1,000 units of finished goods.
➢ When might a given company have a substantial favorable materials price variance and a substantial
unfavorable materials usage variance?
➢ What is the usual cause of a favorable or unfavorable labor rate variance? What other labor variance
is isolated in a standard cost system? Of the two variances, which is more likely to be under the
control of management? Explain.
➢ Identify the type of variance indicated by each of the following situations and indicate whether it is
favorable or unfavorable:
➢ The cutting department of a company during the week ending July 15 cut 12 size-S cogged wheels
out of three sheets of 12-inch high-tempered steel. Usually three wheels of such size are cut out of
each sheet.
➢ A company purchased and installed an expensive new cutting machine to handle expanding
orders. This purchase and the related depreciation had not been anticipated when the overhead
was budgeted.
➢ Edwards, the band saw operator, was on vacation last week. Lands took her place for the normal
40-hour week. Edwards' wage rate is USD 12 per hour, while Lands' is USD 10 per hour.
Production was at capacity last week and the week before.
➢ Theoretically, how would an accountant dispose of variances from standard? How does an
accountant typically dispose of variances?
➢ Why are variances typically isolated as soon as possible?
➢ Is it correct to consider favorable variances as always being desirable? Explain.
➢ How does the use of standard costs permit the application of the principle of management by
exception?
➢ How do standards help in controlling production costs?
Accounting Principles: A Business Perspective 938 A Global Text
24. Control through standard costs
➢ Real world question Refer to the discussion of employees setting standards in "An accounting
perspective: Business insight". What are the advantages and disadvantages of having employees set
their own standards?
➢ Real world question Imagine you are making and selling pizzas for Domino's Pizza. How would
you set standards for one pizza to be made and delivered?
Exercises
Exercise A During July, the cutting department completed 8,000 units of a product that had a standard
materials cost of 2 square feet per unit at USD 2.40 per square foot. The actual materials purchased consisted of
16,400 square feet at USD 2.20 per square foot, for a total cost of USD 36,080. The actual material used this period
was 16,160 square feet. Compute the materials price and usage variances. Indicate whether each is favorable or
unfavorable.
Direct materials – 4 pounds at $5 per pound
$20
Direct labor – 3 hours at $6 per hour 18 Manufacturing overhead – 150% of direct labor
27
$65
Exercise B Whitewater's purchasing agent took advantage of a special offer from one of its suppliers to
purchase 44,000 pounds of material at USD 4.10 per pound. Assume 5,500 units were produced and 34,100
pounds of material were used. Compute the variances for materials. Comment on the purchasing agent's decision to
take the special offer.
Exercise C Compute the labor variances in the following situation:
Actual direct labor payroll (51,600 hours at $18) $928,800 Standard direct labor allowed per unit, 4.20 hours at $19.20
80.64
Production for month (in units) 10,000
Exercise D Blackman Company manufactures a product that has a standard direct labor cost of four hours per
unit at USD 24 per hour. In producing 6,000 units, the foreman used a different crew than usual, which resulted in
a total labor cost of USD 26 per hour for 22,000 hours. Compute the labor variances and comment on the foreman's
decision to use a different crew.
Exercise E The following data relates to the manufacturing activities of Strauss Company for the first quarter
of the current year:
Standard activity (in units) 30,000 Actual production (units) 24,000 Budgeted fixed manufacturing overhead
$36,000
Variable overhead rate (per unit) $ 4.00 Actual fixed manufacturing overhead
$37,200
Actual variable manufacturing overhead
$88,800
Compute the overhead budget variance and the overhead volume variance. (Assume overhead is applied based
on units produced.)
Exercise F Assume that the actual production in the previous exercise was 26,000 units rather than 24,000.
What was the overhead volume variance?
Exercise G The standard cost variance accounts of Sun City Company at the end of its fiscal year had the
following balances:
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Materials price variance (unfavorable) $18,000 Materials usage variance (unfavorable) 14,400 Labor rate variance (favorable) 10,800 Labor efficiency variance (unfavorable) 39,600 Overhead budget variance (favorable) 2,000 Overhead volume variance (unfavorable) 21,600
Prepare one journal entry to record the closing of the variance accounts to Cost of Goods Sold.
Problems
Problem A A product has a standard materials usage and cost of 4 pounds per unit at USD 7.00 per pound.
During the month, 2,400 pounds of materials were purchased at USD 7.30 per pound. Production for the month
totaled 550 units requiring 2,100 pounds of materials.
Compute the materials variances.
Problem B During December, a department completed 2,500 units of a product that has a standard materials
usage and cost of 1.2 square feet per unit at USD 0.48 per square foot. The actual material used consisted of 3,050
square feet at an actual cost of USD 2,664.48. The actual purchase of this material amounted to 4,500 square feet at
a total cost of USD 3,931.20.
Prepare journal entries (a) for the purchase of the materials and (b) for the issuance of materials to production.
Problem C Martin Company makes plastic garbage bags. One box of bags requires one hour of direct labor at
an hourly rate of USD 6. The company produced 200,000 boxes of bags using 208,000 hours of direct labor at a
total cost of USD 1,144,000.
Compute the labor variances.
Problem D The finishing department of Mozart Company produced 25,000 units during November. The
standard number of direct labor-hours per unit is two hours. The standard rate per hour is USD 37.80. During the
month, 51,250 direct labor-hours were worked at a cost of USD 1,742,500.
a. Compute labor variances. Record the labor data in a journal entry.
b. Record the journal entry to dispose of any variances (close to Cost of Goods Sold).
Problem E The standard amount of output for the Chicago plant of Worldworth Company is 50,000 units per
month. Overhead is applied based on units produced. The flexible budget of the month for manufacturing overhead
allows USD 180,000 for fixed overhead and USD 4.80 per unit of output for variable overhead. Actual overhead for
the month consisted of USD 181,440 of fixed overhead; the actual variable overhead follows.
Compute the overhead budget variance and the overhead volume variance assuming the following actual
production in units and actual variable overhead in dollars:
a. 37,500 and USD 182,400.
b. 55,000 and USD 270,480.
Problem F Based on a standard volume of output of 96,000 units per month, the standard cost of the product
manufactured by Tahoe Company consists of:
Direct materials (0.25 pounds x $8 per pound)
$2.00
Direct labor (0.5 hours x $7.60 per hour) 3.80 Variable manufacturing overhead 2.50 Fixed manufacturing overhead ($144,000 in total)
1.50
Total $9.80
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24. Control through standard costs
A total of 25,200 pounds of materials was purchased at USD 8.40 per pound. During May, 98,400 units were
produced with the following costs:
Direct materials used (24,000 pounds at $8.40)
$201,600
Direct labor (50,000 hours at $7.80) 390,000 Variable manufacturing overhead 249,000 Fixed manufacturing overhead 145,000
Compute the materials price and usage variances, the labor rate and efficiency variances, and the overhead
budget and volume variances. (Overhead is applied based on units produced.)
Alternate problems
Alternate problem A The following data apply to Roseanne Company for August, when 2,500 units were
produced:
Materials used: 16,000 pounds standard materials per unit: 6 pounds at 5 per pound Materials purchased: 24,000 pounds at$4.80 per pound Direct labor: 5,800 hours at a total cost of $69,600
Standard labor per unit: 2 hours at $11 per hour.
a. Compute the materials and labor variances.
b. Prepare journal entries to record the transactions involving these variances.
Alternate problem B During April, Shakespeare Company produced 15,000 units of a product called
Creative. Creative has a standard materials cost of two pieces per unit at USD 8 per piece. The actual materials used
consisted of 30,000 pieces at a cost of USD 230,000. Actual purchases of the materials amounted to 40,000 pieces
at a cost of USD 300,000.
Compute the two materials variances.
Alternate problem C Some of the records of Gonzaga Company's repair and maintenance division were
accidentally shredded. Salvaged records indicate that actual direct labor-hours for the period were 2,000 hours.
The total labor variance was USD 6,000, favorable. The standard labor rate was USD 7 per direct labor-hour, and
the labor rate variance was USD 2,000, unfavorable.
Compute the actual direct labor rate per hour and prepare the journal entry to record the labor rate and the
labor efficiency variances.
Alternate problem D All Fixed Overhead Company computes its overhead rate based on a standard level of
output of 20,000 units. Fixed manufacturing overhead for the current year is budgeted at USD 30,000. Actual fixed
manufacturing overhead for the current year was USD 31,000. Overhead is applied based on units produced.
Compute the amount of overhead volume variance for the year under each of the following assumptions
regarding actual output:
a. 12,500 units.
b. 22,500 units.
Beyond the numbers—Critical thinking
Business decision case A Turn to the Sun City Company exercise in this chapter. For each of the variances
listed, give a possible reason for its existence.
Business decision case B Diane La Hoya, the president of the Rebokk Company, has a problem that does not
involve substantial dollar amounts but does involve the important question of responsibility for variances from
standard costs. She has just received the following report:
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Standard materials at standard price for the actual production in May $9,000 Unfavorable materials price variance ($3.60 - $3.00) x 3,450 pounds 2,070 Unfavorable materials usage variance (3,450 – 3,000 pounds) x $3 1,350 Total actual materials cost for the month of May (3,450 pounds at $3.60 per pound) $12,420
La Hoya has discussed the unfavorable price variance with Jim Montel, the purchasing officer. Montel agrees
that under the circumstances he should be held responsible for most of the materials price variance. But he objects
to the inclusion of USD 270 (450 pounds of excess materials used at USD 0.60 per pound). This, he argues, is the
responsibility of the production department. If the production department had not been so inefficient in the use of
materials, he would not have had to purchase the extra 450 pounds.
On the other hand, Ken Kechum, the production manager, agrees that he is basically responsible for the excess
quantity of materials used. But, he does not agree that the materials usage variance should be revised to include the
USD 270 of unfavorable price variance on the excess materials used. "That is Jim's responsibility," he says.
La Hoya now turns to you for help. Specifically, she wants you to tell her:
a. Who is responsible for the USD 270 in dispute?
b. If responsibility cannot be clearly assigned, how should the accounting department categorize the variance
(price or usage)? Why?
c. Are there likely to be other circumstances where materials variances cannot be considered the responsibility
of the manager most closely involved with them? Explain.
Prepare written answers to the three questions La Hoya asked.
A broader perspective C Refer to "A broader perspective: Quality management and Balridge award". The
Baldrige Award has been criticized for fostering a winner-versus-loser mentality, instead of encouraging every
organization to improve its quality. Further, the award has been criticized for grading on the curve by awarding
companies that are the best in US industry but still do not compete well against foreign competition.
Write a response to each of these criticisms of the Baldrige Award.
Group project D Many workers hate standards. Some people claim standards reduce morale and productivity.
Others believe standards are necessary to motivate people. Based on your own experience in school or on a job,
what do you think?
In groups of three, choose an organization or business to use as an example. List all the possible standards you
could set for this organization or business. Then decide whether your group favors setting standards. If the group
does, decide who should set each of the standards on your list. If the group does not favor standards, discuss your
reasons. Choose one member to report for your group to the class.
Group project E The chief executive officer (CEO) of Tax Preparation Services, Incorporated, remarked to a
colleague, "Establishing standard costs and performing variance analysis is only useful for companies with
inventories. As a service organization, how could we possibly benefit from implementing such a system?" In groups
of two or three students, write a memorandum to your instructor stating whether you agree with this comment or
not and explain why. The heading of the memorandum should contain the date, to whom it is written, from whom,
and the subject matter.
Group project F The controller of Plastics Manufacturing, Incorporated, states: "Let us figure the materials
price variances when the materials are used rather than at the time of purchase. This way we can prepare the price
Accounting Principles: A Business Perspective 942 A Global Text
24. Control through standard costs
and usage variances at the same time and directly link the price variance to production." In groups of two or three
students, write a memorandum to your instructor stating whether you agree with this suggestion or not and explain
why. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject
matter.
Using the Internet—A view of the real world
Using any Internet search engine enter "standard costs" (be sure to include the quotation marks). Select an
article that directly discusses standard costs and print a copy of the article. You are encouraged (but not required)
to find an article that answers some of the following questions: When is the use of standard costing appropriate?
How do certain industries use standard costing? How are standard costs established? How do standard costs help
management in production?
Write a memorandum to your instructor summarizing the key points of the article. The heading of the
memorandum should contain the date, to whom it is written, from whom, and the subject matter. Be sure to
include a copy of the article used for this assignment.
Using any Internet search engine select one of the new terms at the end of the chapter and perform a key word
search. Be sure to include quotation marks (for example: "Management by exception"). Select an article that
directly discusses the new term used and print a copy of the article. Write a memorandum to your instructor
summarizing the key points of the article. The heading of the memorandum should contain the date, to whom it is
written, from whom, and the subject matter. Be sure to include a copy of the article used for this assignment.
Answers to self-test
True-false
False. Standard cost is the standard quantity of an input required per unit of output times the standard price
per unit of that input.
True. Standard costs are useful in evaluating the performance of management and workers.
True. Under a standard cost system all units of a given product are carried in inventory at the same unit cost.
False. The general journal entry to record the use of materials and establish the materials usage variance debits
Work in Process Inventory (not Accounts Payable) and Materials Usage Variance and credits Materials Inventory.
True. Favorable variances are shown as credits.
Multiple-choice
d. All of these answers are correct. Different people are often responsible for the two variances, materials are
sometimes purchased and used in different accounting periods, and the two separate variances are likely to provide
more information to top management than just one materials variance.
b.
Materials usage variance=Actual quantity used−Standard quantityallowed ×Standard price
= 25,000−22,000×USD3.10
= 3,000×USD 3.10
= USD 9,300 (unfavorable)
Materials pricevariance=Actual price – Standard price×Actual quantity purchased
= USD3.00 – USD3.10×30,000
= −USD0.10×30,000
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= -USD 3,000 (favorable)
b. An unfavorable materials usage or labor efficiency variance caused by carelessness or inefficiency may be
considered a loss and closed to Income Summary because the standard was attainable and the variance was
controllable.
c. The other answers incorrectly close the variance accounts. The variance accounts are closed to Cost of Goods
Sold.
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25. Responsibility accounting: Segmental analysis
Learning objectives
After studying this chapter, you should be able to:
• Explain responsibility accounting and its use in a business entity.
• Prepare responsibility accounting reports.
• Prepare a segmental income statement using the contribution margin format.
• Calculate return on investment, margin, and turnover for a segment.
• Calculate the residual income of a segment.
• Allocate costs from service departments to operating departments (Appendix).
When a business is small, the owner usually supervises many different activities in the business. As a business
grows, responsibility for some of these activities must be given to other persons. Obviously, the success of a
business depends to a great extent on the persons responsible for these activities.
In this chapter, you learn about delegating authority to lower level managers for managing various business
activities and holding these lower level managers responsible for the activities under their control. You also learn
how to assess the performance of these managers. A company's activities are grouped into responsibility centers.
The company measures the performance of each center manager in terms of the items of revenue and expense over
which that manager has control.
Responsibility accounting
The term responsibility accounting refers to an accounting system that collects, summarizes, and reports
accounting data relating to the responsibilities of individual managers. A responsibility accounting system provides
information to evaluate each manager on the revenue and expense items over which that manager has primary
control (authority to influence).
A responsibility accounting report contains those items controllable by the responsible manager. When both
controllable and uncontrollable items are included in the report, accountants should clearly separate the categories.
The identification of controllable items is a fundamental task in responsibility accounting and reporting.
To implement responsibility accounting in a company, the business entity must be organized so that
responsibility is assignable to individual managers. The various company managers and their lines of authority
(and the resulting levels of responsibility) should be fully defined. The organization chart in Exhibit 202
demonstrates lines of authority and responsibility that could be used as a basis for responsibility reporting.
Accounting Principles: A Business Perspective 945 A Global Text
25. Responsibility accounting: Segmental analysis
Exhibit 202: A corporate functional organization chart including four levels of management
To identify the items over which each manager has control, the lines of authority should follow a specified path.
For example, in Exhibit 202 we show that a department supervisor may report to a store manager, who reports to
the vice president of operations, who reports to the president. The president is ultimately responsible to
stockholders or their elected representatives, the board of directors. In a sense, the president is responsible for all
revenue and expense items of the company, since at the presidential level all items are controllable over some
period. The president often carries the title, Chief Executive Officer (CEO) and usually delegates authority to lower
level managers since one person cannot keep fully informed of the day-to-day operating details of all areas of the
business.
The manager's level in the organization also affects those items over which that manager has control. The
president is usually considered a first-level manager. Managers (usually vice presidents) who report directly to the
president are second-level managers. Notice on the organization chart in Exhibit 202 that individuals at a specific
management level are on a horizontal line across the chart. Not all managers at that level, however, necessarily have
equal authority and responsibility. The degree of a manager's authority varies from company to company.
While the president may delegate much decision-making power, some revenue and expense items remain
exclusively under the president's control. For example, in some companies, large capital (plant and equipment)
expenditures may be approved only by the president. Therefore, depreciation, property taxes, and other related
expenses should not be designated as a store manager's responsibility since these costs are not primarily under that
manager's control.
The controllability criterion is crucial to the content of performance reports for each manager. For example, at
the department supervisor level, perhaps only direct materials and direct labor cost control are appropriate for
measuring performance. A plant manager, however, has the authority to make decisions regarding many other
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costs not controllable at the supervisory level, such as the salaries of department supervisors. These other costs
would be included in the performance evaluation of the store manager, not the supervisor.
A broader perspective:
Employee buyouts
Traditional organization lines of responsibility have workers reporting to supervisors or department
managers, who in turn report to higher managers, who report to even higher managers, and so forth
on up the organization. Top management is accountable to stockholders.
What happens when those stockholders are also employees, as in the case of many employee
buyouts (such as The Chilcote Company – http://www.chilcotecompany.com)? Now, employees
report to managers who are accountable back to the employees in their role as stockholders.
Employees wear two hats: They own the company and they work for the company. In some sense,
this makes each employee like a proprietor of a business. Presumably, after employees buy their
company, they have greater incentives to make the company successful.
Source: Based on the authors' research.
Responsibility reports
Responsibility accounting provides reports to different levels of management. The amount of detail varies
depending on the manager's level in the organization. A performance report to a department manager of a retail
store would include actual and budgeted dollar amounts of all revenue and expense items under that supervisor's
control. The report issued to the store manager would show only totals from all the department supervisors'
performance reports and any additional items under the store manager's control, such as the store's administrative
expenses. The report to the company's president includes summary totals of all the stores' performance levels plus
any additional items under the president's control. In effect, the president's report should include all revenue and
expense items in summary form because the president is responsible for controlling the profitability of the entire
company.
Management by exception is the principle that upper level management does not need to examine operating
details at lower levels unless there appears to be a problem. As businesses become increasingly complex,
accountants have found it necessary to filter and condense accounting data so that these data may be analyzed
quickly. Most executives do not have time to study detailed accounting reports and search for problem areas.
Reporting only summary totals highlights any areas needing attention and makes the most efficient use of the
executive's time.
The condensation of data in successive levels of management reports is justified on the basis that the
appropriate manager will take the necessary corrective action. Thus, specific performance details need not be
reported to superiors.
For example, if sales personnel costs have been excessively high in a particular department, that departmental
manager should find and correct the cause of the problem. When the store manager questions the unfavorable
budget variance of the department, the departmental supervisor can inform the store manager that corrective
action was taken. Hence, it is not necessary to report to any higher authority that a particular department within
one of the stores is not operating satisfactorily because the matter has already been resolved. Alternatively, if a
Accounting Principles: A Business Perspective 947 A Global Text
25. Responsibility accounting: Segmental analysis
manager's entire store has been performing poorly, summary totals reported to the vice president of operations
discloses this situation, and an investigation of the store manager's problems may be indicated.
In preparing responsibility accounting reports, companies use two basic methods to handle revenue or expense
items. In the first approach, only those items over which a manager has direct control are included in the
responsibility report for that management level. Any revenue and expense items that cannot be directly controlled
are not included. The second approach is to include all revenue and expense items that can be traced directly or
allocated indirectly to a particular manager, whether or not they are controllable. This second method represents a
full-cost approach, which means all costs of a given area are disclosed in a single report. When this approach is
used, care must be taken to separate controllable from noncontrollable items to differentiate those items for which
a manager can and should be held responsible.
For accounting reports to be of maximum benefit, they must be timely. That is, accountants should prepare
reports as soon as possible after the end of the performance measurement period. Timely reporting allows prompt
corrective action to be taken. When reports are delayed excessively, they lose their effectiveness as control devices.
For example, a report on the previous month's operations that is not received until the end of the current month is
virtually useless for analyzing poor performance areas and taking corrective action.
Companies also should issue reports regularly so that managers can spot trends. Then, appropriate management
action can be initiated before major problems occur. Regular reporting allows managers to rely on reports and
become familiar with their contents.
Firms should make the format of their responsibility reports relatively simple and easy to read. Confusing
terminology should be avoided. Where appropriate, expressing results in physical units may be more familiar and
understandable to some managers. To assist management in quickly spotting budget variances, companies can
report both budgeted (expected) and actual amounts. A budget variance is the difference between the budgeted
and actual amounts of an item. Because variances highlight problem areas (exceptions), they are helpful in applying
the management-by-exception principle. To help management evaluate performance to date, responsibility reports
often include both a current period and year-to-date analysis.
Responsibility reports—An illustration
Exhibit 203 on the next page, shows how Macy's Corporation could relate its responsibility accounting reports.
Assume Macy's has four management levels—the president, vice president of operations, store manager, and
department manager. In Exhibit 203 on the next page, we show that a responsibility report would be prepared for
each management level.
Note in Exhibit 204, the detailed information included in the responsibility reports for each manager. Only the
individual manager's controllable expenses are contained in these reports. For example, the store manager's report
includes only totals from the Men's Clothing Department manager's report. In turn, the report to the vice president
includes only totals from the store manager's report, and so on. Detailed data from the lower levels are summarized
or condensed and reported at the next higher level.
You can see that at each level, more and more costs become controllable. Also, the company introduces
controllable costs not included on lower level reports into the reports for levels 3, 2, and 1. The only store cost not
included at the store manager's level is the store manager's salary because it is noncontrollable by that store
manager. It is, however, controllable by the store manager's supervisor, the vice president of operations.
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Based on an analysis of these reports, the Men's Clothing Department manager probably would take immediate
action to see why supplies and overtime were significantly over budget this month. The store manager may ask the
department manager what the problems were and whether they are now under control. The vice president may ask
the same question of the store manager. The president may ask each vice president why the budget was exceeded
this month and what corrective action has been taken.
Exhibit 203: Organization chart-Macy's corporation
Responsibility centers
A segment is a fairly autonomous unit or division of a company defined according to function or product line.
Traditionally, owners have organized their companies along functional lines. The segments or departments
organized along functional lines perform a specified function such as marketing, finance, purchasing, production,
Accounting Principles: A Business Perspective 949 A Global Text
25. Responsibility accounting: Segmental analysis
or shipping. Recently, large companies have tended to organize segments according to product lines such as an
electrical products division, shoe department, or food division.
A responsibility center is a segment of an organization for which a particular executive is responsible. There
are three types of responsibility centers—expense (or cost) centers, profit centers, and investment centers. In
designing a responsibility accounting system, management must examine the characteristics of each segment and
the extent of the responsible manager's authority. Care must be taken to ensure that the basis for evaluating the
performance of an expense center, profit center, or investment center matches the characteristics of the segment
and the authority of the segment's manager. The following sections of the chapter discuss the characteristics of each
of these centers and the appropriate bases for evaluating the performance of each type.
First Level Macy's Corporation
President
Amount Over or (Under) Budget
Controllable Expenses
This Month
Year to Date
This Month
Year to Date
President's office expense
$ 11,000 $ 55,000 $ 1,000 $ 2,000
Vice president of operations
128,720 700,000 6,000 8,000
Vice president of marketing
18,700 119,000 4,000 8,000
Vice president of finance
14,000 115,000 8,000 9,000
Vice presidents' salaries
29,000 145,000 -0- -0-
Total $ 201,420 $ 1,134,000 $ 19,000 $ 27,000
Second Level Macy's Corporation
Vice President of Operations
Amount Over or (Under) Budget
Controllable Expenses
This Month
Year to Date
This Month
Year to Date
Vice president's office expense
$ 2,840 $ 9,500 $ (500) $ (8,000)
Store manager 88,800 490,000 2,500 5,000
Purchasing 5,300 32,500 1,000 2,000
Receiving 4,700 33,000 3,000 9,000
Salaries of store managers and heads of purchasing and receiving
27,000 135,000 -0- -0-
Total (include in report for next higher level)
$ 128,720 $ 700,000 $ 6,000 $ 8,000
Fourth Level Macy's Corporation
Manger, Men's Clothing Department
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Amount Over or (Under) Budget
Controllable Expenses
This Month
Year to Date
This Month
Year to Date
Inventory losses $ 2,000 $ 10,000 $ 100 $ 400 Supplies 1,800 8,500 800 950 Salaries 11,000 53,000 (100) 810 Overtime 2,000 14,500 800 140 Total (include in report for next higher level)
$ 16,800 $ 86,000 $ 1,600 $ 2,300
Exhibit 204: Responsibility reports for Macy's corporation
An expense center is a responsibility center incurring only expense items and producing no direct revenue
from the sale of goods or services. Examples of expense centers are service centers (e.g. the maintenance
department or accounting department) or intermediate production facilities that produce parts for assembly into a
finished product. Managers of expense centers are held responsible only for specified expense items.
The appropriate goal of an expense center is the long-run minimization of expenses. Short-run minimization of
expenses may not be appropriate. For example, a production supervisor could eliminate maintenance costs for a
short time, but in the long run, total costs might be higher due to more frequent machine breakdowns.
A profit center is a responsibility center having both revenues and expenses. Because segmental earnings
equal segmental revenues minus related expenses, the manager must be able to control both of these categories.
The manager must have the authority to control selling price, sales volume, and all reported expense items. To
properly evaluate performance, the manager must have authority over all of these measured items. Controllable
profits of a segment result from deducting the expenses under a manager's control from revenues under that
manager's control.
Closely related to the profit center concept is an investment center. An investment center is a responsibility
center having revenues, expenses, and an appropriate investment base. When a firm evaluates an investment
center, it looks at the rate of return it can earn on its investment base. Accountants compute the return on
investment (ROI), also called the rate of return, by dividing segmental income by the appropriate investment
base. For example, a segment that earns USD 500,000 on an investment base of USD 5,000,000 has an ROI of 10
per cent.
Determining the investment base to be used in the ROI calculation is a tricky matter. Normally, the assets
available for use by the division make up its investment base. But accountants disagree on whether depreciable
assets should be included in the ROI calculation at original cost, original cost less accumulated depreciation, or
current replacement cost. Original cost is the price paid to acquire the assets. Original cost less accumulated
depreciation is the book value of the assets—the amount paid less total depreciation taken. Current
replacement cost is the cost of replacing the present assets with similar assets in the same condition as those
now in use. A different rate of return results from each of these measures. Therefore, management must select and
agree on an appropriate measure of investment base prior to making ROI calculations or interdivision comparisons.
Even after the investment base is defined, problems may still remain because many segment managers have
limited control over some of the items included in the investment base of their segment. For instance, top-level
management often makes capital expenditure decisions for major store assets rather than allowing the segment
managers to do so. Therefore, the segment manager may have little control over the store assets used by the
segment. Another problem area may be the company's centralized credit and collection department. The segment
Accounting Principles: A Business Perspective 951 A Global Text
25. Responsibility accounting: Segmental analysis
manager may have little or no control over the amount of accounts receivable included as segment assets because
the manager cannot change the credit-granting or collection policies of the company.
Usually these problems are overcome when managers realize that if all segments are treated in the same
manner, the inclusion of noncontrollable items in the investment base may have negligible effects. Then,
comparisons of the ROI for all segments are based on a consistent treatment of items. To avoid adverse reactions or
decreased motivation, segment managers must agree to this treatment.
Companies prefer to evaluate segments as investment centers because the ROI criterion facilitates performance
comparisons between segments. Segments with more resources should produce more profits than segments with
fewer resources, so it is difficult to compare the performance of segments of different sizes on the basis of profits
alone. However, when ROI is a performance measure, performance comparisons take into account the differences
in the sizes of the segments. The segment with the highest percentage ROI is presumably the most effective in using
whatever resources it has.
Typical investment centers are large, autonomous segments of large companies. The centers are often separated
from one another by location, types of products, functions, and/or necessary management skills. Segments such as
these often seem to be separate companies to an outside observer. But the investment center concept can be applied
even in relatively small companies in which the segment managers have control over the revenues, expenses, and
assets of their segments.
Transfer prices
Profit centers and investment centers inside companies often exchange products with each other. The Pontiac,
Buick, and other divisions of General Motors buy and sell automobile parts from each other, for example. No
market exchange takes place, so the company sets transfer prices that represent revenue to the selling division and
costs to the buying division.
A transfer price is an artificial price used when goods or services are transferred from one segment to another
segment within the same company. Accountants record the transfer price as a revenue of the producing segment
and as a cost, or expense, of the receiving segment. Usually no cash actually changes hands between the segments.
Instead, the transfer price is an internal accounting transaction.
Segments are generally evaluated based on some measure of profitability. The transfer price is important
because it affects the profitability of the buying and selling segments. The higher the transfer price, the better for
the seller. The lower the transfer price, the better for the buyer.
Ideally, a transfer price provides incentives for segment managers to make decisions not only in their best
interests but also in the interests of the entire company. For example, if the selling segment can sell everything it
produces for USD 100 per unit, the buying segment should pay the market price of USD 100 per unit. A seller with
excess capacity, however, should be willing to transfer a product to the buying segment for any price at or above the
differential cost of producing and transferring the product to the buying segment (typically all variable costs).
In practice, companies mostly base transfer prices on (1) the market price of the product, (2) the cost of the
product, or (3) some amount negotiated by the buying and selling segment managers.
Use of segmental analysis
So far we have described only the fundamentals of responsibility accounting. In this section we focus specifically
on segmental analysis.
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Decentralization is the dispersion of decision-making authority among individuals at lower levels of the
organization. In other words, the extent of decentralization refers to the degree of control that segment managers
have over the revenues, expenses, and assets of their segments. When a segment manager has control over these
elements, the investment center concept can be applied to the segment. Thus, the more decentralized the decision
making is in an organization, the more applicable is the investment center concept to the segments of the company.
The more centralized the decision making is, the more likely responsibility centers are to be established as expense
centers.
Some advantages of decentralized decision making are:
• Managing segments trains managers for high-level positions in the company. The added authority and
responsibility also represent job enlargement and often increase job satisfaction and motivation.
• Top management can be more removed from day-to-day decision making at lower levels of the company
and can manage by exception. When top management is not involved with routine problem solving, it can
devote more time to long-range planning and to the company's most significant problem areas.
• Decisions can be made at the point where problems arise. It is often difficult for top managers to make
appropriate decisions on a timely basis when they are not intimately involved with the problem they are trying
to solve.
• Since decentralization permits the use of the investment center concept, performance evaluation criteria
such as ROI and residual income (to be explained later) can be used.
Concepts used in segmental analysis
To understand segmental analysis, you need to know about the concepts of variable cost, fixed cost, direct cost,
indirect cost, net income of a segment, and contribution to indirect expenses. Next, we describe each concept.
Costs may be either directly or indirectly related to a particular cost object. A cost object is a segment, product,
or other item for which costs may be accumulated. In other words, a cost is not direct or indirect in and of itself. It
is only direct or indirect in relation to a given cost object.
A direct cost (expense) is specifically traceable to a given cost object. An indirect cost (expense) is not
traceable to a given cost object but has been allocated to it. Accountants can designate a particular cost (expense) as
direct or indirect by reference to a given cost object. Thus, a cost that is direct to one cost object may be indirect to
another. For instance, the salary of a segment manager may be a direct cost of a given manufacturing segment but
an indirect cost of one of the products manufactured by that segment. In this example, the segment and the product
are two distinct cost objects.
Because a direct cost is traceable to a cost object, the cost is likely to be eliminated if the cost object is
eliminated. For instance, if the plastics segment of a business closes down, the salary of the manager of that
segment probably is eliminated. Sometimes a direct cost would remain even if the cost object were eliminated, but
this is the exception rather than the rule.
An indirect cost is not traceable to a particular cost object; therefore, it only becomes an expense of the cost
object through an allocation process. For example, consider the depreciation expense on the company headquarters
building that is allocated to each segment of the company. The depreciation expense is a direct cost for the company
headquarters, but it is an indirect cost to each segment. If a segment of the company is eliminated, the indirect cost
for depreciation assigned to that segment does not disappear; the cost is simply allocated among the remaining
Accounting Principles: A Business Perspective 953 A Global Text
25. Responsibility accounting: Segmental analysis
segments. In a given situation, it may be possible to identify an indirect cost that would be eliminated if the cost
object were eliminated, but this would be the exception to the general rule.
Because the direct costs of a segment are clearly identified with that segment, these costs are often controllable
by the segment manager. In contrast, indirect costs become segment costs only through allocation; therefore, most
indirect costs are noncontrollable by the segment manager. Be careful, however, not to equate direct costs with
controllable costs. For example, the salary of a segment manager may be direct to that segment and yet is
noncontrollable by that manager because managers cannot specify their own salaries.
When preparing internal reports on the performance of segments of a company, management often finds it is
important to classify expenses as fixed or variable and as direct or indirect to the segment. These classifications may
be more useful to management than the traditional classifications of cost of goods sold, operating expenses, and
nonoperating expenses that are used for external reporting in the company's financial statements. As a result, many
companies prepare an income statement for internal use with the format shown in Exhibit 205(A).
A. All Expenses Allocated to Segments Segment A Segment B Total
Sales $ 2,500,000 $ 1,500,000 $ 4,000,000 Less: Variable expenses (all of which are direct expenses)
700,000 650,000 1,350,000
Contribution margin $ 1,800,000 $ 850,000 $ 2,650,000 Less: Direct fixed expenses 450,000 550,000 1,000,000 Contribution to indirect expenses
$ 1,350,000 $ 300,000 $ 1,650,000
Less: Indirect fixed expenses
270,000 330,000 600,000
Net Income $ 1,080,000 $ (30,000) $ 1,050,000 B. Indirect Expenses not allocated to Segments
Segment A Segment B Total
Sales $ 2,500,000 $ 1,500,000 $ 4,000,000
Less: Variable expenses 700,000 650,000 1,350,000
Contribution margin $ 1,800,000 $ 850,000 $ 2,650,000
Less: Direct fixed expenses
450,000 550,000 1,000,000
Contribution to indirect expenses
$ 1,350,000 $ 300,000 $ 1,650,000
Less: Indirect fixed expenses
600,000
Net income $ 1,050,000
Exhibit 205: Contribution margin format income Statement
This format is called the contribution margin format for an income statement (first introduced in Chapter
22) because it shows the contribution margin. Contribution margin is defined as sales revenue less variable
expenses. Notice in Exhibit 205(A) that all variable expenses are direct expenses of the segment. The second
subtotal in the contribution margin format income statement is the segment's contribution to indirect expenses.
Contribution to indirect expenses is defined as sales revenue less all direct expenses of the segment (both
variable direct expenses and fixed direct expenses). The final total in the income statement is segmental net
income, defined as segmental revenues less all expenses (direct expenses and allocated indirect expenses).
Earlier we stated that the performance of a profit center is evaluated on the basis of the segment's profits. It is
tempting to use segmental net income to make this evaluation since total net income is used to evaluate the
performance of the entire company. The problem with using segmental net income to evaluate performance is that
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segmental net income includes certain indirect expenses that have been allocated to the segment but are not
directly related to it or its operations. Because segmental contribution to indirect expenses includes only revenues
and expenses directly related to the segment, this amount is often more appropriate for evaluation purposes.
Given the facts in Exhibit 205(A), if management relied on segmental net income to judge segmental
performance, management might conclude that Segment B should be eliminated because it shows a loss of USD
30,000. But this action would reduce overall company income by USD 300,000, as shown here:
Reduction in corporate revenues $ 1,500,000 Reduction in corporate expenses: Variable expenses $ 650,000 Direct fixed expenses 550,000 1,200,000 Reduction in corporate income $ 300,000
Notice that the elimination of Segment B would not eliminate the USD 330,000 of allocated fixed costs. These
costs would need to be allocated to Segment A if Segment B no longer existed.
To stress the importance of a segment's contribution to indirect expenses, many companies prefer the
contribution margin income statement format in Exhibit 205(B), over that in Exhibit 205(A). The difference is that
indirect fixed costs are not allocated to individual segments in Exhibit 205(B). Indirect fixed expenses appear only
in the total column for the computation of net income for the entire company. The computation for each segment
stops with the segment's contribution to indirect expenses; this is the appropriate figure to use for evaluating the
earnings performance of a segment. Only for the company as a whole is net income (revenues minus all expenses)
computed; this is, of course, the appropriate figure to use for evaluating the company as a whole.
Arbitrary allocations of indirect fixed expenses As stated earlier, indirect fixed expenses, such as
depreciation on the corporate administration building or on the computer facility maintained at company
headquarters, can only be allocated to segments on some arbitrary basis. The two basic guidelines for allocating
indirect fixed expenses are by the benefit received and by the responsibility for the incurrence of the expense.
Accountants can make an allocation on the basis of benefit received for certain indirect expenses. For instance,
assume the entire company used a corporate computer for a total of 10,000 hours. If it used 4,000 hours, Segment
K could be charged (allocated) with 40 per cent of the computer's depreciation for the period because it received 40
per cent of the total benefits for the period.
For certain other indirect expenses, accountants base allocation on responsibility for incurrence. For instance,
assume that Segment M contracts with a magazine to run an advertisement benefiting Segment M and various
other segments of the company. Some companies would allocate the entire cost of the advertisement to Segment M
because it was responsible for incurring the advertising expense.
To further illustrate the allocation of indirect expenses based on a measure of benefit or responsibility for
incurrence, assume that Daily Company operates two segments, X and Y. It allocates the following indirect
expenses to its two segments using the designated allocation bases:
Expense Allocation Base Administrative office building occupancy expense, $ 50,000
Net sales
Insurance expense, $ 35,000 Cost of segmental plant assets
General administrative expenses, $ 40,000 Number of employees
The following additional data are provided:
Segment X Segment Y Total Net sales $ 400,000 $ 500,000 $ 900,000 Segmental plant assets$ 250,000 $ 400,000 $ 650,000
Accounting Principles: A Business Perspective 955 A Global Text
25. Responsibility accounting: Segmental analysis
Number of employees 50 80 130
The following expense allocation schedule shows the allocation of indirect expenses:
Segment X Segment Y Total
Administrative office building occupancy expense
$ 22,222a $ 27,778b $ 50,000
Insurance expense 13,462c 21,538d 35,000
General administrative expenses
15,385e 24,615f 40,000
A $ 400,000/$ 900,000 x $ 50,000 = $ 22,222 D $400,000/$650,000 x $35,000 = $ 21,538
B $500,000/$900,000 x $50,000 = $27,778 e 50/130 x $40,000 = $ 15,385
c $250,000/$650,000 x $35,000 = $13,462 F 80/130 x $40,000 = $24,615
When it uses neither benefit nor responsibility to allocate indirect fixed expenses, a company must find some
other reasonable, but arbitrary, basis. Often, for lack of a better approach, a firm may allocate indirect expenses
based on net sales. For instance, if Segment X's net sales were 60 per cent of total company sales, then 60 per cent
of the indirect expenses would be allocated to Segment X. Allocating expenses based on sales is not recommended
because it reduces the incentive of a segment manager to increase sales because this would result in more indirect
expenses being allocated to that segment.
Having covered some basic concepts essential to segmental analysis, we next present some specific procedures
for performance evaluation.
Investment center analysis
To this point, the segmental analysis discussion has concentrated on the contribution to indirect expenses and
segmental net income approaches. Now we introduce the investment base concept into the analysis. Two evaluation
bases that include the concept of investment base in the analysis are ROI (return on investment) and RI (residual
income).
A segment that has a large amount of assets usually earns more in an absolute sense than a segment that has a
small amount of assets. Therefore, a firm cannot use absolute amounts of segmental income to compare the
performance of different segments. To measure the relative effectiveness of segments, a company might use return
on investment (ROI), which calculates the return (income) as a percentage of the assets employed (investment).
The formula for ROI is:
ROI= Income
Investment
To illustrate the difference between using absolute amounts and using percentages in evaluating a segment's
performance, consider the data in Exhibit 206, for a company with three segments.
Segment A Segment B Segment C Total (a) Income $ 250,000 $1,000,000 $ 500,000 $1,750,000 (b) Investment 2,500,000 5,000,000 2,000,000 9,500,000 Return on investment (a) ÷ (b) 10 per cent 20 per cent 25 per cent 18.42 per cent
Exhibit 206: Computation of return on investment (ROI)
When using absolute dollars of income to evaluate performance, Segment B appears to be doing twice as well as
Segment C. However, using ROI to evaluate the segments indicates that Segment C is really performing the best (25
per cent), Segment B is next (20 per cent), and Segment A is performing the worst (10 per cent). Therefore, ROI is a
more useful indicator of the relative performance of segments than absolute income.
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Although ROI appears to be a quite simple and straightforward computation, there are several alternative
methods for making the calculation. These alternatives focus on what is meant by income and investment. Exhibit
207, shows various definitions and applicable situations for each type of computation.
Situation Definition of Income Definition of Investment 1. Evaluation of the earning power of the company. Do not use for segments or segment managers due to inclusion of non controllable expenses.
Net income of the company.* Total assets of the company.†
2. Evaluation of rate of income contribution of segment. Do not use for segment managers due to inclusion of non controllable expenses.
Contribution to indirect expenses. Assets directly used by and identified with the segment.
3. Evaluation of income performance of segment manager.
Controllable income. Begin with contribution to indirect expenses and eliminate any revenues and direct expenses not under the control of the segment manager.
Assets under the control of the segment manager.
* Often net operating income is used; this term is defined as income before interest and taxes. † Operating assets are often used in the calculation. This definition excludes assets not used in normal operations.
Exhibit 207: Possible definitions of income and investment
As discussed earlier in the chapter, alternative valuation bases include cost less accumulated depreciation,
original cost, and current replacement cost. Each of the valuation bases has merits and drawbacks, as we discuss
next. First, cost less accumulated depreciation is probably the most widely used valuation base and is easily
determined. Because of the many types of depreciation methods, comparisons between segments or companies may
be difficult. Also, as book value decreases, a constant income results in a steadily increasing ROI even though the
segment's performance is unchanged. Second, the use of original cost eliminates the problem of decreasing book
value but has its own drawback. The cost of old assets is much less than an investment in new assets, so a segment
with old assets can earn less than a segment with new assets and realize a higher ROI. Third, current replacement
cost is difficult to use because replacement cost figures often are not available, but this base does eliminate some of
the problems caused by the other two methods. Whichever valuation basis is adopted, all ROI calculations that are
to be used for comparative purposes should be made consistently.
An accounting perspective:
Business insight
Although financial performance measures such as ROI are important for providing incentives to
perform well, so is the company's culture. For example, Johnson & Johnson has a culture
emphasizing high ethical standards. The Johnson & Johnson Credo, published in its annual report
and displayed throughout the company, is a famous example of this culture. HP is known as a
people-oriented company that emphasizes personal development and long-term employment.
To encourage long-term growth, 3M requires that at least 25 per cent of each division's sales come
from new products. This encourages constant innovation and new product development. In
addition, the company allows employees to spend 15 per cent of their time on innovative projects,
encourages sharing of technology across divisions, and provides "seed" grants for employees to
develop new products. With this corporate culture, 3M has a worldwide reputation for innovation.
Accounting Principles: A Business Perspective 957 A Global Text
25. Responsibility accounting: Segmental analysis
Expanded form of ROI computation The ROI formula breaks into two component parts:
ROI= Income
Sales ×
Sales
Investment
The first part of the formula, Income/Sales, is called margin or return on sales. The margin refers to the
percentage relationship of income or profits to sales. This percentage shows the number of cents of profit generated
by each dollar of sales. The second part of the formula, Sales/Investment, is called turnover. Turnover shows the
number of dollars of sales generated by each dollar of investment. Turnover measures how effectively each dollar of
assets was used.
A manager can increase ROI in the following three ways. In Exhibit 208, note the possible outcomes of some of
these strategies to increase ROI.
• By concentrating on increasing the profit margin while holding turnover constant: Pursuing this strategy
means keeping selling prices constant and making every effort to increase efficiency and thereby reduce
expenses.
• By concentrating on increasing turnover by reducing the investment in assets while holding income and
sales constant: For example, working capital could be decreased, thereby reducing the investment in assets.
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Past year's return on investment:
ROI=Margin×Turnover
ROI= Income
Sales ×
Sales
Investment
ROI= USD100,000
USD 2,000,000 ×
USD2,000,000
USD1,000,000
ROI=5 per cent×2 time
ROI = 10 per cent
• Increase margin through reducing expenses by USD 40,000; no effect on sales or investment.
ROI= USD 140,000
USD 2,000,000 ×
USD 2,000,000
USD 1,000,000
ROI=7 per cent×2 time
ROI = 14 per cent
• Increase turnover through reducing investment in assets by USD 200,000; no effect on sales or investment.
ROI= USD 100,000
USD 2,000,000 ×
USD 2,000,000
USD 800,000
ROI=5 percent×2.5time
ROI = 12.5 per cent
• (a) Increase margin and turnover by disposing of nonproductive depreciable assets; income increased by USD 10,000;
investment decreased by USD 200,000; no effect on sales.
ROI= USD 110,000
USD 2,000,000 ×
USD 2,000,000
USD 800,000
ROI=5.5 per cent×2.5 time
ROI = 13.75 per cent
• (b) Increase margin and turnover through increased advertising; sales increased by USD 500,000 and income by USD
50,000; no effect on investment.
ROI= USD 150,000
USD 2,500,000 ×
USD 2,500,000
USD 1,000,000
ROI=6 per cent×2.5time
ROI = 15 per cent
• (c) Increase turnover through increased advertising; sales increased by USD 500,000 and income by USD 12,500; no effect
on investment.
ROI = USD 112,500 X USD 2,500,000 USD 2,500,000 USD 1,000,000
ROI = 4.5 % X 2.5 times ROI = 11.25%
Exhibit 208: Strategies for increasing return on investment (ROI)
• By taking actions that affect both margin and turnover: For example, disposing of nonproductive
depreciable assets would decrease investment while also increasing income (through the reduction of
depreciation expense). Thus, both margin and turnover would increase. An advertising campaign would
probably increase sales and income. Turnover would increase, and margin might increase or decrease
depending on the relative amounts of the increases in income and sales.
Accounting Principles: A Business Perspective 959 A Global Text
25. Responsibility accounting: Segmental analysis
Economic value added and residual income
When a company uses ROI to evaluate performance, managers have incentives to focus on the average returns
from their segments' assets. However, the company's best interest is served if managers also focus on the marginal
returns.
To illustrate, assume the manager of Segment 3 in Exhibit 209, has an opportunity to take on a project involving
an investment of USD 100,000 that is estimated to return USD 22,000, or 22 per cent, on the investment. Since the
segment's ROI is currently 25 per cent, or USD 250,000/USD 1,000,000, the manager may decide to reject the
project because accepting the project will cause the segment's ROI to decline. Suppose however, from the
company's point of view, all projects earning greater than a 10 per cent return should be accepted, even if they are
lower than a particular segment's ROI.
Before acceptance of the project by Segment 3, the amounts are as follows:
Segment 1 Segment 2 Segment 3 a. Income $ 100,000 $ 500,000 $ 250,000 b. Investment 1,000,000 2,500,000 1,000,000 c. Cost of capital 10% 10% 10% d. Desired minimum income $ 100,000 $ 250,000 $ 100,000 e. Residual Income (RI) -0- 250,000 150,000
With acceptance of the project by Segment 3, the amounts would be as follows:
Segment 1
Segment 2
Segment 3
a. Income $ 100,000 $ 500,000 $ 272,000† b. Investment 1,000,000 2,500,000 1,100,000‡ c. Cost of capital 10% 10% 10% d. Desired minimum income$ 100,000 $ 250,000 $ 110,000 e. Residual Income (RI) -0- 250,000 162,000 † $250,000 + (22% of $100,000). ‡ $1,000,000 original investment + $100,000 new investment.
Exhibit 209: Computation of Residual Income (RI)
The rejection by a segment manager of a project that exceeds the 10 per cent desired minimum return is an
example of suboptimization. Suboptimization occurs when a segment manager takes an action that is in the
segment's best interest but is not in the best interest of the company as a whole.
To deal with this type of suboptimization, many companies use the concept of economic value added which
computes the residual income of a business segment. Residual income (RI) is defined as the amount of income a
segment has in excess of the segment's investment base times its cost of capital percentage. Each company based on
debt costs establishes its cost of capital coverage and desired returns to stockholders. The formula for residual
income (RI) is:
RI=Income−Investment×Cost of capital percentage
When a company uses RI to evaluate performance, the segment rated as the best is the segment with the greatest
amount of RI rather than the one with the highest ROI.
Returning to our example, the project opportunity for Segment 3 could earn in excess of the desired minimum
ROI of 10 per cent. In fact, the project generates RI of USD 12,000, calculated as (USD 22,000 - [10 per cent X USD
100,000]). If RI were applied as the basis for evaluating segmental performance, the manager of Segment 3 would
accept the project because doing so would improve the segment's performance. That choice would also be beneficial
to the entire company.
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Critics of the RI method complain that larger segments are likely to have the highest RI. In a given situation, it
may be advisable to look at both ROI and RI in assessing performance or to scale RI for size.
A manager tends to make choices that improve the segment's performance. The challenge is to select evaluation
bases for segments that result in managers making choices that benefit the entire company. When performance is
evaluated using RI, choices that improve a segment's performance are more likely also to improve the entire
company's performance.
When calculating RI for a segment, the income and investment definitions are contribution to indirect expenses
and assets directly used by and identified with the segment. When calculating RI for a manager of a segment, the
income and investment definitions should be income controllable by the manager and assets under the control of
the segment manager.
In evaluating the performance of a segment or a segment manager, comparisons should be made with (1) the
current budget, (2) other segments or managers within the company, (3) past performance of that segment or
manager, and (4) similar segments or managers in other companies. Consideration must be given to factors such as
general economic conditions and market conditions for the product being produced. A superior segment in
Company A may be considered superior because it is earning a return of 12 per cent, which is above similar
segments in other companies but below other segments in Company A. However, segments in Company A may be
more profitable because of market conditions and the nature of the company's products rather than because of the
performance of the segment managers. Top management must use careful judgment whenever performance is
evaluated.
Segmental reporting in external financial statements
In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards
No. 131, "Disclosures about Segments of an Enterprise and Related Information". This statement requires publicly
held companies to publish certain segmental information in their annual and interim financial statements. It also
requires that these companies report certain information about their products and services, the geographic areas in
which they operate, and their major customers. Thus, external users of financial statements of a company can (1)
better understand the company's performance, (2) better assess the prospects for future net cash flows, and (3)
make more informed judgments about the company.
In this chapter you learned about responsibility accounting and segmental analysis. Chapter 26 discusses capital
budgeting and long-term planning.
Understanding the learning objectives
• Responsibility accounting refers to an accounting system that collects, summarizes, and reports accounting
data relating to the responsibilities of individual managers.
• Although the amount of detail varies, reports issued under a responsibility accounting system are
interrelated. Totals from the report on one level of management are carried forward in the report to the
management level immediately above.
• The contribution margin format for the income statement shows the contribution margin for the company.
• Contribution to indirect expenses is defined as sales revenue less all direct expenses of the segment.
• The final total in the income statement is segmental net income, defined as segmental revenues less all
expenses (direct expenses and allocated indirect expenses).
Accounting Principles: A Business Perspective 961 A Global Text
25. Responsibility accounting: Segmental analysis
• Return on investment measures the relative effectiveness of segments. The formula for return on
investment is:
Return on investment= Income
Investment
• Alternatively, the formula for return on investment can be broken into two components:
Return on investment= Income
Sales ×
Sales
Investment
• Margin refers to the percentage relationship of income or profits to sales. This percentage shows the
number of cents of profit generated by each dollar of sales. The formula for margin can be expressed as:
Margin= Income
Sales
• Turnover shows the number of dollars of sales generated by each dollar of investment. Turnover measures
how effectively each dollar of assets was used. The formula for turnover can be expressed as:
Turnover= Sales
Investment
• Residual income is defined as the amount of income a segment has in excess of its investment base times its
cost of capital percentage.
• Each company sets its cost of capital based on debt costs and desired returns to stockholders.
• The formula for residual income is:
RI=Income−Investment×Cost of capital percentage
• Two basic methods exist for allocating service department costs: (1) the direct method and (2) the step
method.
Appendix: Allocation of service department costs
Throughout this text, we have emphasized cost allocations only in the operating departments of a company.
These operating departments perform the primary purpose of the company—to produce goods and services for
consumers. Examples of operating departments are the assembly departments of manufacturing firms and the
departments in hotels that take and confirm reservations.
The costs of service departments are allocated to the operating departments because they exist to support the
operating departments. Examples of service departments are maintenance, administration, cafeterias, laundries,
and receiving. Service departments aid multiple production departments at the same time, and accountants must
allocate and account for all of these costs. It is crucial that these service department costs be allocated to the
operating departments so that the costs of conducting business in the operating departments are clearly and
accurately reflected.
Accountants allocate service department costs using some type of base. When the companies' managers choose
bases to use, they consider such criteria as the types of services provided, the benefits received, and the fairness of
the allocation method. Examples of bases used to allocate service department costs are number of employees,
machine-hours, direct labor-hours, square footage, and electricity usage.
Two basic methods exist for allocating service department costs. The first method, the direct method, is the
simplest of the two. The direct method allocates costs of each of the service departments to each operating
department based on each department's share of the allocation base. Services used by other service departments are
ignored. For example, if Service Department A uses some of Service Department B's services, these services would
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be ignored in the cost allocation process. Because these services are not allocated to other service departments,
some accountants believe the direct method is not accurate.
The second method of allocating service department costs is the step method. This method allocates service
costs to the operating departments and other service departments in a sequential process. The sequence of
allocation generally starts with the service department that has incurred the greatest costs. After this department's
costs have been allocated, the service department with the next highest costs has its costs allocated, and so forth
until the service department with the lowest costs has had its costs allocated. Costs are not allocated back to a
department that has already had all of its costs allocated.
To illustrate the direct method and the step method, we use the following data:
Service Department Operating Departments Maintenance Administration 1 2
Costs $ 8,000 $ 4,000 $ 32,000 $ 36,000 Machine-hours used 1,000 2,000 1,500 2,500 Number of employees 100 200 250 150
The costs of the maintenance department are allocated based on the machine-hours used. For the
administration department, the cost allocation is based on the number of employees.
Using the preceding data, an example of the direct method follows:
Service Departments Operating Departments
Maintenance Administration 1 2
Costs $ 8,000 $ 4,000 $ 32,000 $ 36,000
Allocation of maintenance department's costs*
(8,000) 3,000 5,000
$ -0-
Allocation of administration department's costs†
(4,000) 2,500 1,500
$ -0- $ 37,500 $ 42,500
* Department 1's 2,500/4,000.
fraction is 1,500/4,000; Department 2's fraction is
† Department 1's 150/400.
fraction is 250/400; Department 2's fraction is
Using the same data, an example of the step method follows:
Service Departments Operating Departments
Maintenance Administration 1 2
Costs $ 8,000 $ 4,000 $ 32,000 $ 36,000
Allocation of maintenance department's costs*
(8,000) 2,667 2,000 3,333
$ -0-
Allocation of administration department's costs†
(6,667) 4,167 2,500
$ -0- $ 38,167 $ 41,833
* Administration 1's 1,500/6,000;
fraction is Department
2,000/6,000; 2's fraction:
Department 2,500/6,000.
1's fraction:
† Department 1's 150/400.
fraction: 250/400; Department 2's fraction is
Accounting Principles: A Business Perspective 963 A Global Text
25. Responsibility accounting: Segmental analysis
Note in the preceding examples that the maintenance department costs were not allocated to the administration
department under the direct method but were allocated under the step method. Also, to eliminate the
administration department's costs, under the step method those costs allocated to the administration department
from the maintenance department must be allocated to the operating departments as part of the total
administration department's cost.
Demonstration problem
The results of operations for Alan Company's two segments in 2009 follow:
Segment 1 Segment 2 Total Sales $ 90,000 $ 135,000 $ 225,000 Variable expenses 63,000 81,000 144,000 Fixed expenses: Direct 9,000 25,200 34,200 Indirect 12,600
The company has total operating assets of USD 315,000; USD 288,000 of these assets are identified with
particular segments as follows:
Segment 1 Segment 2 Assets directly used by and identified with the segment
$ 108,000 $ 180,000
a. Prepare a statement showing the contribution margin, contribution to indirect expenses for each segment,
and the total income for Alan Company.
b. Determine the return on investment for each segment and then for the entire company.
c. Comment on the results of (a) and (b).
Solution to demonstration problem a. Alan Company
Income statement showing segmental contribution to indirect expenses For the year ended 2009 December 31
Segment 1 Segment 2 Total Sales $ 90,000 $ 135,000 $ 225,000 Less: Variable expenses 63,000 81,000 144,000 Contribution margin $ 27,000 $ 54,000 $ 81,000 Less: Direct fixed expenses 9,000 25,2000 34,200 Contribution to indirect expenses $ 18,000 $ 28,800 $ 46,800 Less: Indirect fixed expenses 12,600 Net income $ 34,200
b. 1. ROI= Contribution for indirect expenses
Assetsdirectly used byalsoidentified with thesegment
Segment 1 Segment 2 ROI = USD 18,000 = 16.67% ROI = USD 28,800 = 16%
USD 108,000 USD 180,000
2. ROI= Netoperating income
Operatingassets =
USD34,200
USD315,000 =10.9 per cent
c. In part (a), Segment 2 showed a higher contribution to indirect expenses. But in (b), Segment 1 showed a
higher return on investment. The difference between these calculations shows that when a segment is evaluated as a
profit center, the center with the highest investment base usually shows the best results. But when the segment is
evaluated as an investment center, the segment with the highest investment base does not necessarily show the
highest return. The computations in (b) also demonstrate that the return on investment for the company as a whole
will be lower than that of each segment because of the increased investment base.
Key terms* Budget variance The difference between the budgeted and actual amounts of an item.
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Contribution margin Sales revenues less variable expenses.
Contribution margin format An income statement format that shows the contribution margin (Sales - Variable expenses) for a segment.
Contribution to indirect expenses Sales revenue less all direct expenses of the segment.
Controllable profits of a segment Profit of a segment when expenses under a manager's control are deducted from revenues under that manager's control.
Cost object A segment, product, or other item for which costs may be accumulated.
Current replacement cost The cost of replacing the present assets with similar assets in the same condition as those now in use.
Decentralization The dispersion of decision-making authority among individuals at lower levels of the organization.
Direct cost (expense) A cost that is specifically traceable to a given cost object.
Expense center A responsibility center incurring only expense items and producing no direct revenue from the sale of goods or services. Examples include the accounting department and the maintenance department.
Indirect cost (expense) A cost that is not traceable to a given cost object but has been allocated to it.
Investment center A responsibility center having revenues, expenses, and an appropriate investment base.
Management by exception The principle that upper level management does not need to examine operating details at lower levels unless there appears to be a problem (an exception).
Margin (as used in ROI) The percentage relationship of income (or profits) to sales.
Margin= Income
Sales
Original cost The price paid to acquire an asset.
Original cost less accumulated depreciation The book value of an asset—the amount paid less total depreciation taken.
Profit center A responsibility center having both revenues and expenses.
Residual income (RI), Economic Value Added The amount of income a segment has in excess of the investment base times the cost of capital percentage. Residual income is equal to Income - (Investment X Cost of capital percentage).
Responsibility accounting Refers to an accounting system that collects, summarizes, and reports accounting data relating to the responsibility of the individual managers. A responsibility accounting system provides information to evaluate each manager on revenue and expense items over which that manager has primary control.
Responsibility center A segment of an organization for which a particular executive is responsible.
Return on investment (ROI) Calculates the return (income) as a percentage of the assets employed (investment).
Return on investment= Income
Investment Or
Income
Sales ×
Sales
Investment
Segment A fairly autonomous unit or division of a company defined according to function or product line.
Segmental net income The final total in the income statement; segmental revenues less all expenses (direct expenses and allocated indirect expenses).
Suboptimization A situation when a segment manager takes an action in the segment's best interest but not in the best interest of the company as a whole.
Transfer price An artificial price used when goods or services are transferred from one segment to another segment within the same company.
Turnover (as used in ROI) The number of dollars of sales generated by each dollar of investment.
Turnover= Sales
Investment
*Some terms listed in earlier chapters are repeated here for your convenience.
Self-test
True-false
Indicate whether each of the following statements is true or false.
Accounting Principles: A Business Perspective 965 A Global Text
25. Responsibility accounting: Segmental analysis
Items that a manager has direct control over are included in responsibility accounting reports for that
management level.
An appropriate goal of an expense center is the long-run minimization of expenses.
The salary of a segment manager would be considered a direct cost as well as an uncontrollable cost to that
segment.
Segmental net income is the most appropriate figure to use when evaluating the performance of a segment.
When calculating RI for a segment, the income and investment definitions are income controlled by a manager,
and assets directly used by and identified with the segment.
Multiple-choice
Select the best answer for each of the following questions.
The investment base used when determining the ROI calculation could be which of the following?
a. Current replacement cost.
b. Original cost.
c. Original cost less accumulated depreciation.
d. Any of the above.
Which of the following actions would increase ROI?
a. Reduce operating expenses with no effect on sales or assets.
b. Increase investment in assets, with no change in income.
c. Increase sales with no change in income or assets.
d. None of the above.
Calculate ROI using the expanded form (margin times turnover) from the following data:
Sales $1,000,000 Investment 500,000 Income 50,000
a. 20 per cent.
b. 10 per cent.
c. 15 per cent.
d. None of the above.
In evaluating the performance of a segment or manager, comparisons should be made with:
a. Other segments and managers within the company and in other companies.
b. Past performance of the segment manager.
c. The current budget.
d. All of the above.
Calculate the ROI and RI for each of the following segments and determine if a segment should be dropped
based on RI.
Segment 1Segment 2 Segment 3 Income $ 180,000 $ 1,000,000 $ 500,000 Investment 2,000,000 5,000,000 2,000,000 ROI ? ? ? Desired minimum ROI (10%)
200,000 500,000 200,000
RI ? ? ?
a. 9 per cent, 20 per cent, 20 per cent
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USD 0, USD 500,000, USD 200,000
Consider dropping Segment 1.
b. 20 per cent, 20 per cent, 20 per cent
USD 200,000, USD 500,000, USD 200,000
Do not drop any segment.
c. 9 per cent, 20 per cent, 25 per cent
USD (20,000), USD 500,000, USD 300,000
Consider dropping Segment 1.
d. 20 per cent, 20 per cent, 25 per cent
USD 200,000, USD 500,000, USD 300,000
Do not drop any segment.
Now turn to “Answers to self-test” at the back of the chapter to check your answers.
Questions
➢ What is the fundamental principle of responsibility accounting?
➢ List five important factors that should be considered in designing reports for a responsibility
accounting system.
➢ How soon should accounting reports be prepared after the end of the performance measurement
period? Explain.
➢ Name and describe three types of responsibility centers.
➢ Describe a segment of a business enterprise that is best treated as an expense center. List four
indirect expenses that may be allocated to such an expense center.
➢ Compare and contrast an expense center and an investment center.
➢ What purpose is served by setting transfer prices?
➢ What is the advantage of using investment centers as a basis for performance evaluation?
➢ Which categories of items must a segment manager have control over for the investment center
concept to be applicable?
➢ What is the connection between the extent of decentralization and the investment center concept?
➢ Give some of the advantages of decentralization.
➢ Differentiate between a direct cost and an indirect cost of a segment. What happens to these
categories if the segment to which they are related is eliminated?
➢ Is it possible for a cost to be direct to one cost object and indirect to another cost object? Explain.
➢ Describe some of the methods by which indirect expenses are allocated to a segment.
➢ Give the general formula for return on investment (ROI). What are its two components?
➢ Give the three sets of definitions for income and investment that can be used in ROI calculations,
and explain when each set is applicable.
➢ Give the various valuation bases that can be used for plant assets in investment center calculations.
Discuss some of the advantages and disadvantages of these methods.
➢ In what way is the use of the residual income (RI) concept superior to the use of ROI?
➢ How is residual income (RI) determined?
Accounting Principles: A Business Perspective 967 A Global Text
25. Responsibility accounting: Segmental analysis
➢ If the RI for segment manager A is USD 50,000 while the RI for segment manager B is USD
100,000, does this necessarily mean that B is a better manager than A? Explain.
➢ Real world question Refer to the annual report of a publicly traded company. Which of the
company's geographic regions performed better? Explain.
➢ (Based on Appendix) Briefly discuss the two methods of allocating service department costs.
Exercises
Exercise A The following information refers to the inspection department of a chemical packaging plant for
September:
Over or Amount (Under) Budget
Supplies $ 54,000 $ (10,800) Repairs and maintenance 270,000 21,600 Overtime paid to inspectors 108,000 10,800 Salary of inspection department manager
32,400 (5,400)
Salary of plant manager 43,200 -0- Allocation of company accounting costs
32,400 10,800
Allocation of building depreciation to the inspection department
21,600 (5,400)
Using this information, prepare a responsibility report for the manager of the inspection department for
September. Include those items for which you think the inspection department manager would be held responsible.
Exercise B Present the following information for the Hardware Division of ABC Computer Company,
Sales $ 1,400,000 Variable selling and administrative expenses
100,000
Fixed direct manufacturing expenses 35,000 Fixed indirect manufacturing expenses 56,000 Variable manufacturing expenses 400,000 Fixed direct selling and administrative expenses
175,000
Fixed indirect selling and administrative expenses
28,000
Exercise C Given the following data, prepare a schedule that shows contribution margin, contribution to
indirect expenses, and net income of the Sharks Division of Hockey, Inc.:
Direct fixed expenses $ 324,000
Indirect fixed expenses 259,200
Sales 2,100,000
Variable expenses 1,500,000
What would be the effect on the company income if the segment were eliminated?
Exercise D Three segments (A, B, and C) of Trump Enterprises have net sales of USD 300,000, USD 150,000,
and USD 50,000, respectively. A decision is made to allocate the pool of USD 25,000 of administrative overhead
expenses of the home office to the segments, using net sales as the basis for allocation.
a. How much of the USD 25,000 should be allocated to each segment?
b. If Segment C is eliminated, how much of the USD 25,000 will be allocated to A and B?
Exercise E Two segments (Mountain Bike and Road Bike) showed the following data for the most recent year:
Mountain bike
Road bike
Contribution to indirect expenses $ 840,000 $ 504,000 Assets directly used by and identified 2,520,000 2,184,000
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with the segment Sales 3,360,000 6,720,000
a. Calculate return on investment for each segment in the most direct manner.
b. Calculate return on investment using the margin and turnover components.
Exercise F Calculate the new margin, turnover, and return on investment of the Mountain Bike segment for
each of the following changes. Consider each change independently of the others.
a. Direct variable expenses were reduced by USD 33,600. Sales and assets were unaffected.
b. Assets used by the segment were reduced by USD 540,000, while income and sales were unaffected.
c. An advertising campaign increased sales by USD 336,000 and income by USD 50,000. Assets directly used by
the segment were unaffected.
Exercise G The following data are available for Segment A of ABC Company:
Net income of the segment $ 50,000 Contribution to indirect expenses 40,000 Controllable income by manager 48,000 Assets directly used by the manager 360,000 Assets under the control of the segment manager
240,000
Determine the return on investment for evaluating (a) the income performance of the manager of Segment A
and (b) the rate of income contribution of the segment.
Exercise H Travel Company has three segments: Air, Land, and Sea. Data concerning income and investment
follow:
Air Land Sea Contribution to indirect expenses $ 43,200 $ 86,400 $ 115,200 Assets directly used by and identified with the segment
288,000 576,000 1,296,000
Assuming that the cost of capital on investment is 12 per cent, calculate the residual income of each of the
segments. Do the results indicate that any of the segments should be eliminated?
Problems
Problem A You are given the following information for Farflung Company for the year ended 2009 December
31. The company is organized according to functions:
Plant Manager
Vice Of
President Manufacturing
President
Controllable expenses
Budget Actual Budget Actual Budget Actual
Office expense $ 7,200 $ 9,600 $ 12,000
$ 16,800 $ 24,000 $ 16,800
Printing 19,200 16,800 Paging 2,400 2,160 Binding 4,800 4,800 Purchasing 24,000 26,400 Receiving 12,000 14,400 Inspection 19,200 16,800 Vice president of marketing
192,000 168,000
Controller 144,000 120,000 Treasurer 96,000 72,000 Vice president of personnel
48,000 72,000
Prepare the responsibility accounting reports for the three levels of management—plant manager, vice president
of manufacturing, and president.
Accounting Principles: A Business Perspective 969 A Global Text
25. Responsibility accounting: Segmental analysis
Problem B Joey Bauer Corporation has production plants in Sacramento, Dallas, and Seattle. Following is a
summary of the results for 2009:
Plant Revenues Expenses Investment base (gross assets)
Sacramento $ 450,000 $ 225,000 $ 4,500,000 Dallas 450,000 180,000 3,375,000 Seattle 675,000 247,500 7,200,000
a. If the plants are treated as profit centers, which plant manager appears to have done the best job?
b. If the plants are treated as investment centers, which plant manager appears to have done the best job?
(Assume the plant managers are evaluated by return on investment on gross assets.)
c. Do the results of profit center analysis and investment center analysis give different findings? If so, why?
Problem C Quinn Company allocates all of its home office expenses to its two segments, A and B. Allocations
are based on the following selected expense account balances and additional data:
Expenses (allocation bases) Home office building expense (net sales) $ 76,800 Buying expense (net purchases) 67,200 Uncollectible accounts (net sales) 8,000 Depreciation of home office equipment (net sales) 21,120 Advertising expense (indirect, allocated on basis of relative amounts of direct advertising)
86,400
Insurance expense (relative amounts of equipment plus average inventory in department)
23,040
Segment A Segment B Total
Purchases (net) $ 243,200 $ 76,800 $ 320,000
Sales (net) 512,000 128,000 640,000
Equipment (cost) 96,000 64,000 160,000
Advertising (cost) 25,600 12,800 38,400
Average inventory 160,000 64,000 224,000
a. Prepare a schedule showing the amounts of each type of expense allocable to Segments X and Y using these
data and bases of allocation.
b. Evaluate and criticize these allocation bases.
Problem D Allentown, Inc., is a company with two segments, X and Y. Its revenues and expenses for 2009
follow:
Segment X Segment Y Total Net sales $ 96,000 $ 144,000 $ 240,000 Direct expenses:* Cost of goods sold 45,000 99,000 144,000 Selling 13,680 7,200 20,880 Administrative: Uncollectible accounts 3,000 1,800 4,800 Insurance 2,400 1,200 3,600 Interest 480 240 720 Indirect expenses (all fixed): Selling 18,000 Administrative 25,200 * All the direct expenses are variable except insurance and interest, which are fixed.
a. Prepare a schedule showing the contribution margin, the contribution to indirect expenses of each segment,
and net income for the company as a whole. Do not allocate indirect expenses to the segments.
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b. Assume that indirect selling expenses are to be allocated on the basis of net sales and that indirect
administrative expenses are to be allocated on the basis of direct administrative expenses. Prepare a statement
(starting with the contribution to indirect expenses) that shows the net income of each segment.
c. Comment on the appropriateness of the income amounts shown in parts (a) and (b) for determining the
income contribution of the segments.
Problem E The following data pertain to the operating revenues and expenses for Golden State Company for
2009:
Los Angeles (LA) Segment
San Francisco (SF) Segment
Total
Sales $ 180,000 $ 360,000 $ 540,000 Variable expenses 96,000 240,000 336,000 Direct fixed expenses 24,000 30,000 54,000 Indirect fixed expenses 72,000
Regarding the company's total operating assets of USD 900,000, the following facts exist:
Los Angeles Segment
San Francisco Segment
Assets directly used by and identified with the segment
$ 180,000 $ 360,000
a. Prepare a statement showing the contribution margin of each segment, the contribution to indirect expenses
of each segment, and the total income of Golden State Company.
b. Determine the return on investment for evaluating (1) the earning power of the entire company and (2) the
performance of each segment.
c. Comment on the results of part (b).
Problem F Shaq Company operates with three segments, Louisiana, Orlando, and LA. Data regarding these
segments follow:
Louisiana segment
Orlando segment
LA segment
Contribution to indirect expenses
$ 324,000 $ 180,000 $ 144,000
Assets directly used and identified with the segment
1,800,000 1,440,000 720,000
a. Calculate the return on investment for each segment. Rank them from highest to lowest.
b. Assume the cost of capital is 12 per cent for a segment. Calculate residual income for each segment. Rank
them from highest to lowest.
c. Repeat (b), but assume the cost of capital is 17 per cent for a segment. Rank them from highest to lowest.
d. Comment on the rankings achieved.
Problem G The manager of the Winston Company faced the following data for the year 2009:
Contribution to indirect expenses $ 1,800,000 Assets directly used by and identified with the segment
22,500,000
Sales 36,000,000
a. Determine the margin, turnover, and return on investment for the segment in 2009.
b. Determine the effect on margin, turnover, and return on investment of the segment in 2010 if each of the
following changes were to occur. Consider each change separately and assume that any items not specifically
mentioned remain the same as in 2009:
A campaign to control costs resulted in USD 180,000 of reduced expenses.
Accounting Principles: A Business Perspective 971 A Global Text
25. Responsibility accounting: Segmental analysis
Certain nonproductive assets were eliminated. As a result, investment decreased by USD 900,000, and expenses
decreased by USD 72,000.
An advertising campaign resulted in increasing sales by USD 3,600,000, cost of goods sold by USD 2,700,000,
and advertising expense by USD 540,000.
An investment was made in productive assets costing USD 900,000. As a result, sales increased by USD
360,000, and expenses increased by USD 54,000.
Problem H For the year ended 2009 December 31, Fore Company reported the following information for the
company as a whole and for the sports segment of Fore Corporation:
Sports Segment Fore company
Woods Project
Irons Project
Total
Sales $ 12,000,000 $ 1,350,000 $ 600,000 $ 1,950,000 Income 1,125,000 300,000 37,500 337,500 Investment 4,500,000 900,000 105,000 1,005,000
Fore Company anticipates that these relationships (return on investment, margin, and turnover) will hold true
for the upcoming year. The sports segment is faced with the possibility of adding a new project in 2010, with the
following projected data:
Putters Project
Sales $ 450,000 Income 52,500 Investment 187,500
a. Determine the return on investment for Fore Company, for the sports segment, and for the Woods and Irons
projects separately for the year ended 2009 December 31.
b. Using this information, determine the effect of adding the Putters project on the sports segment's return on
investment. What problem may be encountered?
Using the data provided in the previous problem, determine the residual income (1) for all three projects and (2)
for the sports segment with and without the Putters project, if the cost of capital is 25 per cent. What is the effect on
the sport segment's residual income if the Putter project is added? How does this result compare with your answer
to the previous problem?
Alternate problems
Alternate problem A Swiss Corporation has three production plants (X, Y, and Z). Following is a summary of
the results for January 2009:
Investment Plant Revenues Expenses Base
(gross assets) X $ 720,000 $ 300,000 $ 1,440,000 Y 960,000 180,000 1,920,000 Z 5,040,000 1,920,000 13,200,000
a. If the plants are treated as profit centers, which plant manager appears to have done the best job?
b. If the plants are treated as investment centers, which plant manager appears to have done the best job?
(Assume the plant managers are evaluated by return on investment.)
c. Do the results of profit center analysis and investment center analysis give different findings? If so, why?
Alternate problem B Easy Loans, Inc., allocates expenses and revenues to the two segments that it operates.
Easy Loans extends credit to customers under a revolving charge plan whereby all account balances not paid within
30 days are charged interest at the rate of 11/2 per cent per month.
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Following are selected revenue and expense accounts and some additional data needed to complete the
allocation of the one revenue amount and the expenses.
Revenue and Expenses (allocation bases) Revolving charge service revenue (net sales) $ 600,000 Home office building occupancy expense (net sales) 45,000 Buying expenses (net purchases) 150,000 General administrative expenses (number of employees in department)
75,000
Insurance expense (relative average inventory plus cost of equipment and fixtures in each department)
18,000
Depreciation expense on home office equipment (net sales)
30,000
High Risk Segment
Low Risk Segment
Total
Number of employees 3 7 10 Net sales $ 300,000 $ 600,000 $ 900,000 Net purchases 240,000 360,000 600,000 Averaging inventory 60,000 120,000 180,000 Cost of equipment fixtures 90,000 180,000 270,000
a. Prepare a schedule showing allocation of these items to the High and Low Risk segments.
b. Do you think these are good allocation bases? Why or why not?
Alternate problem C Student Painters, Inc., operates two segments, interior and exterior. The revenue and
expense data for 2009 follow:
Interior Exterior Total Net sales $ 335,700 553,800 $ 889,500 Direct expenses:* Cost of goods sold 186,000 282,000 468,000 Selling 31,800 27,000 58,800 Administrative 9,000 6,000 15,000 Uncollectible accounts 2,400 6,600 9,000 Indirect expenses (all fixed): Selling 126,000 Administrative 156,000 *All the direct expenses are variable except administrative expense, which is fixed.
a. Prepare a schedule showing the contribution margin, the contribution to indirect expenses of each segment,
and net income for the company as a whole. Do not allocate indirect expenses to the segments.
b. Assume that indirect selling expenses are to be allocated to segments on the basis of net sales (round to the
nearest per cent) and that indirect administrative expenses are to be allocated on the basis of direct administrative
expenses. Prepare a statement (starting with the contribution to indirect expenses) which shows the net income of
each segment.
c. Comment on the appropriateness of the income amounts shown in parts (a) and (b) for determining the
income contribution of the segments.
Alternate problem D Elliott Corporation has three segments. Following are the results of operations for
2009:
Segment A Segment B Segment C Total Sales $36,000,000 $ 21,600,000 $ 14,400,000 $ 72,000,000 Variable expenses 25,920,000 12,240,000 9,720,000 47,880,000 Fixed expenses: Direct 5,040,000 1,800,000 720,000 7,560,000 Indirect 3,600,000
For the company's total operating assets of USD 100,800,000, the following facts exist:
Accounting Principles: A Business Perspective 973 A Global Text
25. Responsibility accounting: Segmental analysis
Segment A Segment B Segment C Assets directly used by and identified with the segment
$ 50,400,000 $ 28,800,000 $ 14,400,000
a. Prepare a statement (in thousands of dollars) showing the contribution margin, the contribution to indirect
expenses for each segment, and the total income of the Elliott Corporation.
b. Determine the return on investment for evaluating (1) the performance of the entire company and (2)
performance of each segment.
c. Comment on the results of part (a).
Alternative problem E Goodwin Company has three segments, 1,2, and 3. Data regarding these segments
follow:
Segment 1 Segment 2Segment 3 Contribution to indirect expenses
$ 432,000 $ 208,800 $ 72,000
Assets directly used by and identified with the segment
3,600,000 1,440,000 360,000
a. Calculate the return on investment for each segment. Rank them from highest to lowest.
b. Assume the cost of capital is 10 per cent for a segment. Calculate the residual income for each segment. Rank
them from highest to lowest.
c. Repeat (b), but assume the desired cost of capital is 14 per cent. Rank the segments from highest to lowest.
d. Comment on the rankings achieved.
Beyond the numbers—Critical thinking
Business decision case A Texas Company manufactures skateboards. Because the company's business is
seasonal, between August and December skilled manufacturing employees are laid off. To improve morale, the
financial vice president suggested that 10 employees not be laid off in the future. Instead, she suggested that they
work in general labor from August to December but still be paid their manufacturing wages of USD 10 per hour.
General labor personnel earn USD 6.60 per hour. What are the implications of this plan for the assignment of costs
to the various segments of the business?
Business decision case B Piero Company builds new homes. Sarah Richards is in charge of the construction
department. Among other responsibilities, Sarah hires and supervises the carpenters and other workers who build
the homes. Piero Company does not do its own foundation work. The construction of foundations is done by
subcontractors hired by Leslie Larue of the procurement department.
To start the development of a 500-home community, Larue hired Dire Company to build the foundations for the
homes. On the day construction was to begin, Dire Company went out of business. Consequently, construction was
delayed six weeks while Larue hired a new subcontractor. Which department should be charged with the cost of the
delay in construction? Why?
Business decision case C Ken Silva is the supervisor of Department 103 of Laguna Company. The annual
budget for Silva's department is as follows:
Annual budget for Department 103 Small tools $ 6,750 Set up 7,500 Direct labor 8,250 Direct materials 15,000 Supplies 3,750 Supervision 22,500 Property taxes 3,750
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Property insurance 750 Depreciation, machinery 1,500 Depreciation, building 1,500 Total $ 71,250
Silva's salary of USD 15,000 is included in supervision. The remaining USD 7,500 in supervision is the salary of
the assistant supervisor directly responsible to Silva. Identify the budget items that Silva controls.
Broader perspective – Writing experience D Refer to "A broader perspective: Employee buyouts". Write a
brief report explaining the effects of employee buyouts on employee motivation.
Group project E Macrofast Software, Inc., faces stiff competition in selling its products. Macrofast's top
management feels considerable pressure from the company's stockholders to increase earnings.
Mac Washington, the vice president of marketing at the company's Production Software Division, received a
memorandum from top management that said, in effect, "Increase your division's earnings or look for a new job".
Washington could think of only one way to increase earnings by the end of the year. The Production Software
Division had several installations that should be completed early the following year, probably in February or March.
For each of those jobs, he asked the customers to sign a Completed Installation document stating the job was
completed to the customer's satisfaction. He did this because Macrofast's accounting department would record the
revenue from the job when it received the Completed Installation document.
Several customers signed Completed Installation documents even though the jobs were not complete because
Washington gave them a personally signed letter stating the Completion Installation document was not legally
binding.
The scheme initially worked. Revenues were prematurely recorded for these jobs, sales and earnings for the year
were up, Macrofast's top management was delighted with the results, and Washington was rewarded with a large
bonus and a promotion to a vice presidency at corporate headquarters.
The following June, a staff accountant discovered the scheme when a customer called to complain that he was
being billed for a job that was not yet completed. When the accountant produced the customer's Completed
Installation document, the customer produced Washington's letter saying the document was not binding. The
accountant did some detective work and unearthed the scheme. When she presented the results to her supervisor,
the supervisor said, "This practice is unfortunate and is against company policy. But what is done is done. Do not
worry about last year's financial statements. Just be sure it does not happen again."
a. In teams of four, discuss what the staff accountant should do.
b. Then, decide how your solution would change if all jobs had been completed to the customers' satisfaction.
c. As a team, write a memorandum to your instructor describing your solutions. The heading of the memo
should contain the date, to whom it is written, from whom, and the subject matter.
Group project F Bleak Prospects, Inc., found that its market share was slipping. Division managers were
encouraged to maximize ROI and made decisions consistent with that goal. Nonetheless, there were frequent
customer complaints, with resulting loss of business. Moreover, Bleak depended on an established product line and
was unable to find new products for expansion while its competitors seemed to be able to generate new products
almost yearly. What would you suggest Bleak Prospects' management do to improve the situation? In groups of two
or three students, write a memorandum to your instructor addressing this question. The heading of the
memorandum should contain the date, to whom it is written, from whom, and the subject matter.
Accounting Principles: A Business Perspective 975 A Global Text
25. Responsibility accounting: Segmental analysis
Group project G Management of Division A is evaluated based on residual income measures. The division can
either rent or buy a certain asset. Will the performance evaluation technique have an impact on the rent-or-buy
decision? Why or why not? In groups or three students, write a memorandum to your instructor addressing this
question. The heading of the memorandum should contain the date, to whom it is written, from whom, and the
subject matter.
Using the Internet—A view of the real world
Visit the website for PepsiCo, Incorporated.
http://www.pepsico.com
Go to the company's most recent annual report. Compare the performance of PepsiCo's three business
segments: (1) beverages, (2) snack foods, and (3) restaurants. (You will find business segment information in the
notes to the financial statements.) Which business segment had the most operating profits? Which business
performed better using ROI, profit margin, and asset turnover as the performance measures? Use end-of-year
"identifiable assets" to measure investment, "operating profits" to measure income, and "net sales" to measure
sales. Be sure to submit a copy of PepsiCo's business segment information from the annual report.
Visit the website for PepsiCo, Incorporated.
http://www.pepsico.com
Go to the company's most recent annual report. Using financial information for the most recent year, which of
the company's geographic areas had the highest ROI? (You will find business segment information in the notes to
the financial statements, including geographic segments.) Use end-of-year "identifiable assets" to measure
investment, "operating profits" to measure income, and "net sales" to measure sales. Be sure to submit a copy of
PepsiCo's business segment information from the annual report.
Answers to self-test
True-false
True. Those items that a manager has direct control over are included in responsibility reports for that
management level.
True. An appropriate goal of an expense center is the long-run minimization of expenses.
True. The manager's salary would be a direct cost of the segment but not controllable at that level. (The salary
would be controllable by someone higher in the organization.)
False. Segments should be evaluated using their revenues and direct expenses.
False. The income and investment definitions when calculating RI for a segment are contribution to indirect
expenses and assets directly used by and identified with the segment.
Multiple-choice
d. Any of these bases—current replacement cost, original cost, or original cost less accumulated depreciation—
could be used.
a. ROI would increase if operating expenses were reduced, all other things remaining constant.
b.
ROI= Income
Sales ×
Sales
Investment
ROI= 50,000
1,000,000 ×
1,000,000
500,000
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ROI=.05×2
ROI = 10 per cent
d. All of these should be used to evaluate managerial performance.
c.
Segment 1 Segment 2 Segment 3 Income $ 180,000 $ 1,000,000 $ 500,000 Investment 2,000,000 5,000,000 2,000,000 ROI 9% 20% 25% Desired minimum ROI (10%) 200,000 500,000 200,000 RI $ (20,000) $ 500,000 $ 300,000
Consider dropping Segment 1.
Accounting Principles: A Business Perspective 977 A Global Text
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26. Capital budgeting:Long- range planning
Learning objectives
After studying this chapter, you should be able to:
• Define capital budgeting, explain budgeting and explain the effects of making poor capital-budgeting
decisions.
• Determine the net cash inflows, after taxes, for both an asset addition and an asset replacement.
• Evaluate projects using the payback period.
• Evaluate projects using the unadjusted rate of return.
• Evaluate projects using the net present value.
• Evaluate projects using the profitability index.
• Evaluate projects using the time-adjusting rate of return.
• Determine for project evaluation, the effect of an investment in working capital.
In your personal life, you make many short-run decisions, such as where to go on vacation this year, and many
long-run decisions, such as whether to buy a home. The quality of these decisions determines, to a large extent, the
success of your life. Businesses also face short-run and long-run decisions.
In previous chapters, you studied how accountants help management make short-run decisions, such as what
prices to charge for their products this year. Accountants also play an important role in advising management on
long-range decisions that will benefit the company for many years, such as investing in new buildings and
equipment. Long-run decisions have a great impact on the long-run success of a company. Incorrect long-run
decisions can threaten the survival of a company.
Whereas short-run decisions involve items such as selling prices, costs, volume, and profits in the current year,
long-run decisions involve investments in capital assets, such as buildings and equipment, affecting the current
year and many future years. Planning for these investments is referred to as capital budgeting.
This chapter introduces the general concepts behind capital budgeting. Then, it discusses and illustrates four
methods for selecting the best alternatives among capital projects. Two of these methods involve the use of present
value concepts. Finally, the chapter stresses the importance of the postaudit review of capital project decisions.
Capital budgeting defined
Capital budgeting is the process of considering alternative capital projects and selecting those alternatives
that provide the most profitable return on available funds, within the framework of company goals and objectives. A
capital project is any available alternative to purchase, build, lease, or renovate buildings, equipment, or other
long-range major items of property. The alternative selected usually involves large sums of money and brings about
a large increase in fixed costs for a number of years in the future. Once a company builds a plant or undertakes
some other capital expenditure, its future plans are less flexible.
Accounting Principles: A Business Perspective 978 A Global Text
26. Capital budgeting:Long-range planning
Poor capital-budgeting decisions can be costly because of the large sums of money and relatively long periods
involved. If a poor capital budgeting decision is implemented, the company can lose all or part of the funds
originally invested in the project and not realize the expected benefits. In addition, other actions taken within the
company regarding the project, such as finding suppliers of raw materials, are wasted if the capital-budgeting
decision must be revoked. Poor capital-budgeting decisions may also harm the company's competitive position
because the company does not have the most efficient productive assets needed to compete in world markets.
Investment of funds in a poor alternative can create other problems as well. Workers hired for the project might
be laid off if the project fails, creating morale and unemployment problems. Many of the fixed costs still remain
even if a plant is closed or not producing. For instance, advertising efforts would be wasted, and stock prices could
be affected by the decline in income.
On the other hand, failure to invest enough funds in a good project also can be costly. Ford's Mustang is an
excellent example of this problem. At the time of the original capital-budgeting decision, if Ford had correctly
estimated the Mustang's popularity, the company would have expended more funds on the project. Because of an
undercommitment of funds, Ford found itself short on production capacity, which caused lost and postponed sales
of the automobile.
Finally, the amount of funds available for investment is limited. Thus, once a company makes a capital
investment decision, alternative investment opportunities are normally lost. The benefits or returns lost by
rejecting the best alternative investment are the opportunity cost of a given project.
For all these reasons, companies must be very careful in their analysis of capital projects. Capital expenditures
do not occur as often as ordinary expenditures such as payroll or inventory purchases but involve substantial sums
of money that are then committed for a long period. Therefore, the means by which companies evaluate capital
expenditure decisions should be much more formal and detailed than would be necessary for ordinary purchase
decisions.
Project selection: A general view
Making capital-budgeting decisions involves analyzing cash inflows and outflows. This section shows you how to
calculate the benefits and costs used in capital-budgeting decisions. Because money has a time value, these benefits
and costs are adjusted for time under the last two methods covered in the chapter.
Money received today is worth more than the same amount of money received at a future date, such as a year
from now. This principle is known as the time value of money. Money has time value because of investment
opportunities, not because of inflation. For example, USD 100 today is worth more than USD 100 to be received
one year from today because the USD 100 received today, once invested, grows to some amount greater than USD
100 in one year. Future value and present value concepts are extremely important in assessing the desirability of
long-term investments (capital budgeting). If you need to review these concepts, refer back to the appendix to
Chapter 15, which covers these concepts.
The net cash inflow (as used in capital budgeting) is the net cash benefit expected from a project in a period.
The net cash inflow is the difference between the periodic cash inflows and the periodic cash outflows for a
proposed project.
Asset acquisition Assume, for example, that a company is considering the purchase of new equipment for
USD 120,000. The equipment is expected (1) to have a useful life of 15 years and no salvage value, and (2) to
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produce cash inflows (revenue) of USD 75,000 per year and cash outflows (costs) of USD 50,000 per year. Ignoring
depreciation and taxes, the annual net cash inflow is computed as follows:
Cash inflows $75,000.00
Cash outflows 50,000
Net cash inflow $ 25,000
Depreciation and taxes The computation of the net cash inflow usually includes the effects of depreciation
and taxes. Although depreciation does not involve a cash outflow, it is deductible in arriving at federal taxable
income. Thus, depreciation reduces the amount of cash outflow for federal income taxes. This reduction is a tax
savings made possible by a depreciation tax shield. A tax shield is the total amount by which taxable income is
reduced due to the deductibility of an item. For example, if depreciation is USD 8,000, the tax shield is USD 8,000.
To simplify the illustration, we assume the use of the straight-line depreciation for tax purposes throughout the
chapter. Straight-line depreciation can be elected for tax purposes, even under the new tax law.
The tax shield results in a tax savings. The amount of the tax savings can be found by multiplying the tax rate by
the amount of the depreciation tax shield. The formula is:
Tax rate×Depreciation tax shield=Tax savings
Using the data in the previous example and assuming straight-line depreciation of USD 8,000 per year and a 40
per cent tax rate, the amount of the tax savings is USD 3,200 (40 per cent x USD 8,000 depreciation tax shield).
Now, considering taxes and depreciation, we compute the annual net cash inflow from the USD 120,000 of
equipment as follows:
Change in net income
Change in cash flow
Cash inflows $ 75,000 $75,000
Cash outflows 50,000 50,000
Net cash inflow before taxes $25,000 $25,000
Depreciation 8,000
Income before income taxes $17,000
Deduct: Income at 40% 6,800 6,800
Net income after taxes $10,200
Net cash inflow (after taxes) $18,200
If there were no depreciation tax shield, federal income tax expense would have been USD 10,000, or (USD
25,000 x 40 per cent), and the net after-tax cash inflow from the investment would have been USD 15,000, found
by (USD 25,000 - USD 10,000), or [USD 25,000 x (1 - 40 per cent)].
The depreciation tax shield, however, reduces federal income tax expense by USD 3,200, or (USD 8,000 x 40
per cent), and increases the investment's after-tax net cash inflow by the same amount. Therefore, the following
formula also can be used to determine the after-tax net cash inflow from an investment:
Net cash inflow after taxes= [Net cash inflow before taxesX (1 – Tax rate)] + [Depreciation expense X Tax rate] v v
Net cash inflow after taxes (ignoring depreciation)
Tax savings attributable To depreciation tax shield
= USD 25,000×1−.4USD8,000×.4=USD18,200
Accounting Principles: A Business Perspective 980 A Global Text
26. Capital budgeting:Long-range planning
Asset replacement Sometimes a company must decide whether or not it should replace existing plant assets.
Such replacement decisions often occur when faster and more efficient machinery and equipment appear on the
market.
The computation of the net cash inflow is more complex for a replacement decision than for an acquisition
decision because cash inflows and outflows for two items (the asset being replaced and the new asset) must be
considered. To illustrate, assume that a company operates two machines purchased four years ago at a cost of USD
18,000 each. The estimated useful life of each machine is 12 years (with no salvage value). Each machine will
produce 40,000 units of product per year. The annual cash operating expenses (labor, repairs, etc.) for the two
machines together total USD 14,000. After the old machines have been used for four years, a new machine becomes
available. The new machine can be acquired for USD 28,000 and has an estimated useful life of eight years (with no
salvage value). The new machine produces 60,000 units annually and entails annual cash operating expenses of
USD 10,000. The USD 4,000 reduction in operating expenses (USD 14,000 - USD 10,000) is a USD 4,000 increase
in net cash inflow (savings) before taxes.
The firm pays USD 28,000 in the first year to acquire the new machine. In addition to this initial outlay, the
annual net cash inflow from replacement is computed as follows:
Net cash inflow after taxes=Annual net cash inflows savings before taxes×1 – tax rateAdditional annual depreciation expense×Tax rate
Using these data, the following display shows how you can use this formula to find the net cash flow after taxes:
Annual cash operating expenses:
Old machines $ 14,000
New machines 10,000
Annual net cash inflow (savings) before taxes
$ 4,000
1 – Tax rate X 60%
Annual net cash inflow (savings)* after taxes ignoring depreciation (1)
$ 2,400
Annual depreciation expense:
Old machines $ 3,000
New machine 3,500
Additional annual depreciation expense $ 500
Tax rate X 40%
Tax savings from additional depreciation (2) 200
Net cash inflow after taxes (1) + (2) $ 2,600
*Cash savings are considered to be cash inflows.
In formula format, the calculation is:
Net cash inflow after taxes = USD 4,000×1−.4USD500×.4=USD2,600
Notice that these figures concentrated only on the differences in costs for each of the two alternatives. Two other
items also are relevant to the decision. First, the purchase of the new machine creates a USD 28,000 cash outflow
immediately after acquisition. Second, the two old machines can probably be sold, and the selling price or salvage
value of the old machines creates a cash inflow in the period of disposal. Also, the previous example used straight-
line depreciation. If the modified Accelerated Cost Recovery System (modified ACRS) had been used, the tax shield
would have been larger in the early years and smaller in the later years of the asset's life.
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Out-of-pocket and sunk costs A distinction between out-of-pocket costs and sunk costs needs to be made for
capital budgeting decisions. An out-of-pocket cost is a cost requiring a future outlay of resources, usually cash.
Out-of-pocket costs can be avoided or changed in amount. Future labor and repair costs are examples of out-of-
pocket costs.
Sunk costs are costs already incurred. Nothing can be done about sunk costs at the present time; they cannot
be avoided or changed in amount. The price paid for a machine becomes a sunk cost the minute the purchase has
been made (before that moment it was an out-of-pocket cost). The amount of that past outlay cannot be changed,
regardless of whether the machine is scrapped or used. Thus, depreciation is a sunk cost because it represents a
past cash outlay. Depletion and amortization of assets, such as ore deposits and patents, are also sunk costs.
A sunk cost is a past cost, while an out-of-pocket cost is a future cost. Only the out-of-pocket costs (the future
cash outlays) are relevant to capital budgeting decisions. Sunk costs are not relevant, except for any effect they have
on the cash outflow for taxes.
Initial cost and salvage value Any cash outflows necessary to acquire an asset and place it in a position and
condition for its intended use are part of the initial cost of the asset. If an investment has a salvage value, that
value is a cash inflow in the year of the asset's disposal.
The cost of capital The cost of capital is important in project selection. Certainly, any acceptable proposal
should offer a return that exceeds the cost of the funds used to finance it. Cost of capital, usually expressed as a
rate, is the cost of all sources of capital (debt and equity) employed by a company. For convenience, most current
liabilities, such as accounts payable and federal income taxes payable, are treated as being without cost. Every other
item on the right (equity) side of the balance sheet has a cost. The subject of determining the cost of capital is a
controversial topic in the literature of accounting and finance and is not discussed here. We give the assumed rates
for the cost of capital in this book. Next, we describe several techniques for deciding whether to invest in capital
projects.
Project selection: Payback period
The payback period is the time it takes for the cumulative sum of the annual net cash inflows from a project to
equal the initial net cash outlay. In effect, the payback period answers the question: How long will it take the capital
project to recover, or pay back, the initial investment? If the net cash inflows each year are a constant amount, the
formula for the payback period is:
Payback period= Initial cash outlay
Annual net cash inflow benefit
For the two assets discussed in the previous section, you can compute the payback period as follows. The
purchase of the USD 120,000 equipment creates an annual net cash inflow after taxes of USD 18,200, so the
payback period is 6.6 years, computed as follows:
Payback period = USD120,000
USD18,200 =6.6years
The payback period for the replacement machine with a USD 28,000 cash outflow in the first year and an
annual net cash inflow of USD 2,600, is 10.8 years, computed as follows:
Payback period = USD 28,000/USD 2,600 = 10.8 years
Remember that the payback period indicates how long it will take the machine to pay for itself. The replacement
machine being considered has a payback period of 10.8 years but a useful life of only 8 years. Therefore, because the
Accounting Principles: A Business Perspective 982 A Global Text
26. Capital budgeting:Long-range planning
investment cannot pay for itself within its useful life, the company should not purchase a new machine to replace
the two old machines.
In each of the previous examples, the projected net cash inflow per year was uniform. When the annual returns
are uneven, companies use a cumulative calculation to determine the payback period, as shown in the following
situation.
Neil Company is considering a capital investment project that costs USD 40,000 and is expected to last 10 years.
The projected annual net cash inflows are:
Year Investment Annual net cash inflow
Cumulative net cash inflows
0 $ 40,000 ----- ---
1 --- $ 8,00 $ 8,000
2 --- 6,000 14,000
3 --- 7,000 21,000
4 ---- 5,000 26,000
5 --- 8,000 34,000
6 --- 6,000 40,000
7 --- 3,000 43,000
8 --- 2,000 45,000
10 --- 1,000 49,000
The payback period in this example is six years—the time it takes to recover the USD 40,000 original
investment.
When using payback period analysis to evaluate investment proposals, management may choose one of these
rules to decide on project selection:
• Select the investments with the shortest payback periods.
• Select only those investments that have a payback period of less than a specified number of years.
Both decision rules focus on the rapid return of invested capital. If capital can be recovered rapidly, a firm can
invest it in other projects, thereby generating more cash inflows or profits.
Some managers use payback period analysis in capital budgeting decisions due to its simplicity. However, this
type of analysis has two important limitations:
• Payback period analysis ignores the time period beyond the payback period. For example, assume Allen
Company is considering two alternative investments; each requires an initial outlay of USD 30,000. Proposal Y
returns USD 6,000 per year for five years, while proposal Z returns USD 5,000 per year for eight years. The
payback period for Y is five years (USD 30,000/USD 6,000) and for Z is six years (USD 30,000/USD 5,000).
But, if the goal is to maximize income, proposal Z should be selected rather than proposal Y, even though Z has
a longer payback period. This is because Z returns a total of USD 40,000, while Y simply recovers the initial
USD 30,000 outlay.
• Payback analysis also ignores the time value of money. For example, assume the following net cash inflows
are expected in the first three years from two capital projects:
Net Cash Inflows
Project A Project B
First year $ 15,000 $ 9,000
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Second year 12,000 12,000
Third year 9,000 15,000
Total $ 36,000 $ 36,000
Assume that both projects have the same net cash inflow each year beyond the third year. If the cost of each
project is USD 36,000, each has a payback period of three years. But common sense indicates that the projects are
not equal because money has time value and can be reinvested to increase income. Because larger amounts of cash
are received earlier under Project A, it is the preferable project.
Project selection: Unadjusted rate of return
Another method of evaluating investment projects that you are likely to encounter in practice is the
unadjusted rate of return method. To compute the unadjusted rate of return, divide the average annual income
after taxes by the average amount of investment in the project. The average investment is the (Beginning balance +
Ending balance)/2. If the ending balance is zero (as we assume), the average investment equals the original cash
investment divided by 2. The formula for the unadjusted rate of return is:
Unadjusted rate of return= Average annual income after taxes
Average amount of investment
Notice that this calculation uses annual income rather than net cash inflow.54
To illustrate the use of the unadjusted rate of return, assume Thomas Company is considering two capital
project proposals, each having a useful life of three years. The company does not have enough funds to undertake
both projects. Information relating to the projects follows:
Average annual Before-tax Average
Proposal Initial cost Salvage Value Net cash inflow Annual depreciation
1 $ 76,000 $ 4,000 $ 45,000 $ 24,000
2 95,000 5,000 55,000 30,000
Assuming a 40 per cent tax rate, Thomas Company can determine the unadjusted rate of return for each project
as follows:
Proposal 1 Proposal 2
Average investment: (original outlay + Salvage value)/2
(1) $ 40,000 $ 50,000
Annual net cash inflow (before income taxes) $ 45,000 $ 55,000
Annual depreciation 24,000 30,000
Annual income (before income taxes) $ 21,000 $ 25,000
54 Some formulas use the initial investment in the denominator instead of the average investment. We prefer the
average investment because it approximates the use of assets throughout the year not just at the beginning of the
year.
51 These general comments about the use of averages in a ratio apply to the other ratios involving averages
discussed in this chapter.
52 Accounting Principles Board, Opinion No. 15, "Reporting Earnings per Share" (New York: AICPA, 1969), par. 12.
FASB Statement No. 128, "Earnings per Share" (Norwalk, Connecticut: FASB, 1997), simplified the standards
for computing earnings per share and made them comparable to international EPS standards.
55 "Texas Instruments: Cost of Quality (A)" (Boston: Harvard Business School, Case 9-189-029).
Accounting Principles: A Business Perspective 984 A Global Text
26. Capital budgeting:Long-range planning
Deduct: Income taxes at 40% 8,400 10,000
Average annual net income from investment (2) $ 12,600 $ 15,000
Rate of return (2)/(1) 31.5% 30%
From these calculations, if Thomas Company makes an investment decision solely on the basis of the unadjusted
rate of return, it would select Proposal 1 since it has a higher rate.
Also, the company could compute the unadjusted rate of return with the following formula:
Rate of return= Average annual before−tax net cash inflow – Averageannual depreciation×1 – Tax rate
Averageinvestment
For Proposal 1, the computation is as follows:
Rate of return= USD 45,000– USD24,000×1– 0.4
USD76,000USD4,000 /2
= USD21,000×0.6
USD40,000 =
USD12,600
USD50,000 =30 per cent
For Proposal 2, the computation is as follows:
Rate of return= USD55,000 – USD30,000 ×1−0.4
USD95,000USD5,000/2
= USD25,000×0.6
USD50,000 =
USD15,000
USD50,000 =30 per cent
Sometimes companies receive information on the average annual after-tax net cash inflow. Average annual
after-tax net cash inflow is equal to annual before-tax cash inflow minus taxes. Given this information, the firms
could deduct the depreciation to arrive at average net income. For instance, for Proposal 2, Thomas Company
would compute average net income as follows:
After-tax net cash inflow ($55,000- $10,000)
$ 45,000
Less: Depreciation 30,000
Average net income $ 15,000
The unadjusted rate of return, like payback period analysis, has several limitations:
• The length of time over which the return is earned is not considered.
• The rate allows a sunk cost, depreciation, to enter into the calculation. Since depreciation can be calculated
in so many different ways, the rate of return can be manipulated by simply changing the method of
depreciation used for the project.
• The timing of cash flows is not considered. Thus, the time value of money is ignored.
Unlike the two project selection methods just illustrated, the remaining two methods—net present value and
time-adjusted rate of return—take into account the time value of money in the analysis. In both of these methods,
we assume that all net cash inflows occur at the end of the year. Often used in capital budgeting analysis, this
assumption makes the calculation of present values less complicated than if we assume the cash flows occurred at
some other time.
Project selection: Net present value method
In this section, you learn to calculate the net present value of capital projects. Then you learn how to use the
profitability index to evaluate projects costing different amounts. The profitability index is a refinement of the net
present value method.
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The net present value method uses the company's required minimum rate of return as a discount rate and
discounts all expected after-tax cash inflows and outflows from the proposed investment back to their present
values. The net present value of the proposed investment is the difference between the present value of the annual
net cash inflows and the present value of the required cash outflows.
In many projects, the only cash outflow is the initial investment, and since it occurs immediately, the initial
investment does not need to be discounted. Therefore, in such projects, a company may compute the net present
value of the proposed project as the present value of the annual net cash inflows minus the initial investment. Other
types of projects require that additional investments, such as a major repair, be made at later dates in the life of the
project. In those cases, the company must discount the cash outflows to their present value before comparing them
to the present value of the net cash inflows.
A major issue in acknowledging the time value of money in the net present value method is determining an
appropriate discount rate to use in computing the present value of cash flows. Management requires some
minimum rate of return on its investments. This rate should be the company's cost of capital, but that rate is
difficult to determine. Therefore, under the net present value method, management often selects a target rate that it
believes to be at or above the company's cost of capital, and then uses that rate as a basis for present value
calculations.
To illustrate the net present value method, assume Morris Company is considering a capital investment project
that will cost USD 25,000. Morris expects net cash inflows after taxes for the next four years to be USD 8,000, USD
7,500, USD 8,000, and USD 7,500, respectively. Management requires a minimum rate of return of 14 per cent and
wants to know if the project is acceptable. The following analysis uses the tables in the Appendix at the end of this
text:
Annual net Present value of Total
Cash inflow (after taxes) $ 1 at 14% (from table A.3)
Present value
First year $ 8,000 .87719 $ 7,018
Second year 7,500 .76947 5,771
Third year 8,000 .67497 5,400
Fourth year 7,500 .59208 4,441
Present value of net cash inflows $22,630
Cost of investment 25,000
Net present value $ (2,370)
Because the present value of the net cash inflows, USD 22,630, is less than the initial outlay of USD 25,000, the
project is not acceptable. The net present value for the project is equal to the present value of its net cash inflows
less the present value of its cost (the investment amount), which in this instance is -USD 2,370, calculated as (USD
22,630 - USD 25,000).
When a company uses the net present value method to screen alternative projects, it considers the project with
the higher net present value to be more desirable. In general, a proposed capital investment is acceptable if it has a
positive net present value. In the previous example, if the expected net cash inflows from the investment had been
USD 10,000 per year for four years, the present value of the benefits would have been (from Table A.4 in the
Appendix):
USD10,000×2.9137=USD29,137
Accounting Principles: A Business Perspective 986 A Global Text
26. Capital budgeting:Long-range planning
This calculation yields a net present value of USD 4,137, or USD 29,137 - USD 25,000. Since the net present
value is positive, the investment proposal is acceptable. However, a competing project may have an even higher net
present value.
When comparing investment projects costing different amounts, the net present value method does not provide
a valid means by which to rank the projects in order of desirability assuming limited financial resources. A
profitability index provides this additional information to management.
Profitability index
A profitability index is the ratio of the present value of the expected net cash inflows (after taxes) divided by
the initial cash outlay (or present value of cash outlays if future outlays are required). The profitability index
formula is:
Profitability index= Present value of net cash inflows
Initial cash outlaypresent valueof cash outlays if future outlays are required
Management should consider only those proposals having a profitability index greater than or equal to 1.00.
Proposals with a profitability index of less than 1.00 cannot yield the minimum rate of return because the present
value of the projected cash inflows is less than the initial cost.
To illustrate use of the profitability index, assume that a company is considering two alternative capital outlay
proposals that have the following initial costs and expected net cash inflows after taxes:
Proposal X Proposal Y
Initial outlay $ 7,000 $ 9,500
Expected net cash inflow (after taxes):
Year 1 $ 5,000 $ 9,000
Year 2 4,000 6,000
Year 3 6,000 3,000
Management's minimum desired rate of return is 20 per cent.
The net present values and profitability indexes can be computed as follows, using Table A.3 in the Appendix at
the end of this book:
Present value
Proposal X Proposal Y
Year 1 (net cash inflow in year 1 x 0.83333) $ 4,167 $ 7,500
Year 2 (net cash inflow in year 2 x 0.69444) 2,778 4,167
Year 3 (net cash inflow in year 3 x 0.57870) 3,472 1,736
Present value of net cash inflows $ 10,417 $ 13,403
Initial outlay 7,000 9,500
Net present value $ 3,417 $ 3,903
Proposal X Proposal Y
Profitability index $ 10,417 =1.49 $ 13,403 = 1.41
$ 7,000 $ 9,500
When the net present values are compared, Proposal Y appears to be more favorable than Proposal X because its
net present value is higher. However, the profitability indexes indicate Proposal X is the more desirable investment
because it has the higher profitability index. The higher the profitability index, the more profitable the project per
dollar of investment. Proposal X earns a higher rate of return on a smaller investment than Proposal Y.
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Another technique for evaluating capital projects that accounts for the time value of money is the time-adjusted
rate of return method. The next section discusses this method.
An accounting perspective:
Business insight
Like US managers, Japanese managers incorporate the cost of capital into their capital investment
decisions. However, Japanese managers tend to rely more on consensus decision making, less on
the numbers. Discount rates in Japan are generally lower than in the United States.
Project selection: The time-adjusted rate of return (or internal rate of return)
The time-adjusted rate of return, also called the internal rate of return, equates the present value of
expected after-tax net cash inflows from an investment with the cost of the investment. It does this by finding the
rate at which the net present value of the project is zero. If the time-adjusted rate of return equals or exceeds the
cost of capital or target rate of return, a firm should consider the investment further. If the proposal's time-adjusted
rate of return is less than the minimum rate, the firm should reject the proposal. Ignoring other considerations, the
higher the time-adjusted rate of return, the more desirable the project.
Calculators and computer software with time-adjusted rate of return functions are readily available. Present
value tables also can approximate the time-adjusted rate of return. To illustrate, assume Young Company is
considering a USD 90,000 investment expected to last 25 years with no salvage value. The investment yields a USD
15,000 annual after-tax net cash inflow. This USD 15,000 is referred to as an annuity, which is a series of equal
cash inflows.
The first step in computing the rate of return is to determine the payback period. In this case, the payback
period is six years (USD 90,000/USD 15,000). The second step is to examine Table A.4 in the Appendix (present
value of an annuity) to find the present value factor that is nearest in amount to the payback period of 6. Since the
investment is expected to yield returns for 25 years, look at that row in the table. In that row, the factor nearest to 6
is 5.92745, which appears under the 16.5 per cent interest column. The third step is to multiply the annual return of
USD 15,000 by the 5.92745 factor; the result is USD 88,912, which is just below the USD 90,000 cost of the project.
Thus, the actual rate of return is slightly less than 16.5 per cent. The rate of return is less than 16.5 per cent but
more than 16 per cent because as interest rates increase, present values decrease because less investment is needed
to generate the same income.
A broader perspective:
Caterpillar, Inc.
Caterpillar, Inc., invested USD 1.5 billion in a worldwide factory modernization program.
Caterpillar's management realized it must continually monitor the performance of this
modernization if the project was to realize its potential.
Accounting Principles: A Business Perspective 988 A Global Text
26. Capital budgeting:Long-range planning
At Caterpillar, the projects are grouped into "bundles" of related projects. For example, all of the
new assets used for a new product would be bundled together. "Each bundle is monitored every six
months at Caterpillar, although a few key characteristics of some bundles are monitored monthly"
[p. 32]. Characteristics used in monitoring performance include the amount of money projected
versus the amount actually spent on the projects, the number of people expected to be used on the
projects versus the number actually used, and the estimated reduction in product cost versus the
reduction in product cost actually achieved.
Many firms believe their evaluation of project performance leaves much to be desired. Caterpillar's
idea of "bundling" similar projects should be helpful to other firms making significant changes in
their production processes and product lines.
Source: Based on the article by James A. Hendricks, Robert C. Bastian, and Thomas L. Sexton,
"Bundle Monitoring of Strategic Projects," Management Accounting, February 1992, pp. 31-35.
The preceding example involves uniform net cash inflows from year to year. But what happens when net cash
inflows are not uniform? In such instances, a trial and error procedure is necessary if present value tables are used.
For example, assume that Young Company is considering a USD 200,000 project that will last four years and yield
the following returns:
Net cash inflow
Year (after taxes)
1 $ 20,000
2 40,000
3 80,000
4 150,000
Total $ 290,000
The average annual cash inflow is USD 290,000/4 = USD 72,500. Based on this average net cash inflow, the
payback period is USD 200,000/USD 72,500 = 2.76 years. Looking in the four-year row of Table A.4 in the
Appendix, we find that the factor 2.77048 is nearest to the payback period of 2.76. In this case, however, cash flows
are not uniform. The largest returns occur in the later years of the asset's life. Since the early returns have the
largest present value, the rate of return is likely to be less than the 16.5 per cent rate that corresponds to the present
value factor 2.77048. If the returns had been greater during the earlier years of the asset's life, the correct rate of
return would have been higher than 16.5 per cent. To find the specific discount rate that yields a present value
closest to the initial outlay of USD 200,000, we try out several interest rates less than 16 per cent. The rate of return
is found by trial and error. The following computation reveals the rate to be slightly higher than 12 per cent:
Present value Present value of net
Year Return Factor at 12% Cash inflows
1 $ 20,000 0.89286 $ 17,857
2 40,000 0.79719 31,888
3 80,000 0.71178 56,942
4 150,000 0.63553 95,330
$ 202,017
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Since the cost of capital is not a precise percentage, some financial theorists argue that the time-adjusted rate of
return method is preferable to the net present value method. Under the time-adjusted rate of return method, the
cost of capital is used only as a cutoff point in deciding which projects are acceptable and should be given more
consideration.
No matter which time value of money concept is considered better, these methods are both theoretically
superior to the payback period and the unadjusted rate of return methods. However, the time value of money
methods are more difficult to compute unless you use a business calculator or a microcomputer spreadsheet
program. In reality, no single method should be used by itself to make capital-budgeting decisions. Managers
should consider all aspects of the investment, including such nonquantitative factors as employee morale (layoff of
workers due to higher efficiency of a new machine) and company flexibility (versatility of production of one
machine over another). The company commits itself to its investment in a capital project for a long time and should
use the best selection techniques and judgment available.
Too often, in capital project selection decisions, investments in working capital are ignored. The next section
shows how to incorporate this factor into the analysis.
An accounting perspective:
Use of technology
People use PC spreadsheets extensively in evaluating capital projects. Decisions about investing in
capital projects require a lot of thinking about the future. Because no one can predict the future
with certainty, people often make numerous estimates of future cash flows—some optimistic, some
pessimistic, and some simply best guesses. PC spreadsheets make the preparation of numerous
forecasts (scenarios) feasible, and even fun.
Investments in working capital
An investment in a capital asset usually must be supported by an investment in working capital, such as
accounts receivable and inventory. For example, companies often invest in a capital project expecting to increase
sales. Increased sales usually bring about an increase in accounts receivable from customers and an increase in
inventory to support the higher sales level. The increases in current assets—accounts receivable and inventory—are
investments in working capital that usually are recovered in full at the end of a capital project's life. Such working
capital investments should be considered in capital-budgeting decisions.
To illustrate, assume that a company is considering a capital project involving a USD 50,000 investment in
machinery and a USD 40,000 investment in working capital. The machine, which will produce a new product, has
an estimated useful life of eight years and no salvage value. The annual cash inflows (before taxes) are estimated at
USD 25,000, with annual cash outflows (before taxes) of USD 5,000. The annual net cash inflow from the project is
computed as follows (assuming straight-line depreciation and a 40 per cent tax rate):
Cash inflows $ 25,000
Cash outflows 5,000
Net cash inflow before taxes $ 20,000
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26. Capital budgeting:Long-range planning
1 – Tax rate X 60%
Net cash inflow after taxes (ignoring depreciation) (1)
$ 12,000
Depreciation tax shield ($ 50,000/8 years) $ 6,250
Income tax rate X 40%
Depreciation tax savings (2) $ 2,500
Annual net cash inflow, years 1-8 (1) + (2) $ 14,500
The annual net cash inflow from the machine is USD 14,500 each year for eight years. However, the working
capital investment must be considered. The investment of USD 40,000 in working capital at the start of the project
is an additional outlay that must be made when the project is started. The USD 40,000 would be tied up every year
until the project is finished, or in this case, until the end of the life of the machine. At that point, the working capital
would be released, and the USD 40,000 could be used for other investments. Therefore, the USD 40,000 is a cash
outlay at the start of the project and a cash inflow at the end of the project.
The net present value of the project is computed as follows (assuming a 14 per cent minimum desired rate of
return):
Net cash inflow, years 1-8 ($ 14,500 x 4.63886) $ 67,263
Recovery of investment in working capital ($ 40,000 x 0.35056)
14,022
Present value of net cash inflows $ 81,285
Initial cash outlay ($ 50,000 + $ 40,000) 90,000
Net present value $ (8,715)
The discount factor for the cash inflows, 4.63886, comes from Table A.4 in the Appendix at the end of the book,
because the cash inflows in this example are a series of equal payments—an annuity. The recovery of the investment
in working capital is assumed to represent a single lump sum received at the end of the project's life. As such, it is
discounted using a factor (0.35056) that comes from Table A.3 in the Appendix.
The investment is not acceptable because it has a negative net present value. If the working capital investment
had been ignored, the proposal would have had a rather large positive net present value of USD 17,263 (USD 67,263
- USD 50,000). Thus, it should be obvious that investments in working capital must be considered if correct capital-
budgeting decisions are to be made.
The next topic discussed in the chapter is the postaudit. This important step improves the chances that future
capital project selection decisions are based on realistic projections of benefits and costs.
The postaudit
The last step in the capital-budgeting process is a postaudit review that should be performed by a person not
involved in the capital-budgeting decision-making process. Such a person can provide an impartial judgment on the
project's worthiness. This step should be performed early in the project's life, but enough time should have passed
for any operational bugs to have been worked out. Actual operating costs and revenues should be determined and
compared with those estimated when the project was originally reviewed and accepted. The postaudit review
performs these functions:
• Let management know if the projections were accurate and if the particular project is performing as
expected regarding cash inflows and outflows.
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• May identify additional factors for management to consider in upcoming capital-budgeting decisions, such
as cash outflows that were forgotten in a particular project.
• Provides a review of the capital-budgeting process to determine how effectively and efficiently it is working.
The postaudit provides information that allows management to compare the actual results of decisions with
the expectations it had during the planning and selection phases of the capital-budgeting process.
Investing in high technology projects
Many companies have found it hard to justify high technology investments. A US auto manufacturer, for
example, found it difficult to justify investing in a new computer-based flexible manufacturing system because its
cost savings occurred so far in the future. When discounted, the present value of these savings did not justify the
initial outlay. The president of the company was convinced, however, that the new system had benefits not
quantified in the cash flow estimates, so he approved the investment even though it had a negative net present
value.
Companies have difficulty in justifying an investment in high technology projects for several reasons. First, often
several years pass before companies see the cash inflows from the investment. Even if the cash inflows are high,
their net present value is low if they come several years in the future.
Second, management has difficulty identifying and measuring all of the benefits of new technology. When
personal computers replaced typewriters, for example, people learned many new ways of creating and storing
documents by using the computer. These benefits occurred because people used computers and experimented with
them. These benefits would have been difficult to predict, much less measure, back when companies were trying to
justify investment in personal computers. Managers believe that sometimes they just have to have faith that the
investment is a good one, even though they cannot justify it on quantifiable economic grounds.
Capital budgeting in not-for-profit organizations
The concepts discussed in this chapter also apply to not-for-profit organizations, such as universities, school
districts, cities, and not-for-profit hospitals. Since these organizations are not subject to as many taxes as profit-
making organizations, the cash flows related to taxes are usually zero or near zero.
Epilogue
You have now completed the last chapter in this text. Thank you for using our textbook. The knowledge you have
gained will serve you well in any career you choose. Good luck!
Understanding the learning objectives
• Capital budgeting is the process of considering alternative capital projects and selecting those alternatives
that provide the most profitable return on available funds, within the framework of company goals and
objectives.
• Poor capital budgeting decisions can cause a company to lose all or part of the funds originally invested in a
project and can harm the company's competitive position in world markets.
• Asset addition:
Net cash inflowafter taxes=Net cash inflow before taxes×1 – Tax rate Depreciation expense×Tax rate
• Asset replacement:
Net cash inflow after taxes=Annual net cash inflows savings before taxes×1 – Tax rate Additional annual depreciation expense×Tax rate
Accounting Principles: A Business Perspective 992 A Global Text
26. Capital budgeting:Long-range planning
• Payback period= Initial cashoutlay
Annual net cash inflows benefits
• Unadjusted rate of return= Average annual income after taxes
Average amount of investment
• All expected after-tax cash inflows and outflows from the proposed investment are discounted to their
present values using the company's required minimum rate of return as a discount rate. The net present value
of the proposed investment is the difference between the present value of the annual net cash in flows and the
present value of the required cash outflows
• Profitability index= Present value of net cash inflows
Initial cashoutlay present valueof cashoutlays if future outlays are required
• The time-adjusted rate of return equates the present value of expected after-tax net cash inflows from an
investment with the cost of the investment by finding the rate at which the net present value of the project is
zero. If the time-adjusted rate of return equals or exceeds the cost of capital or the target rate of return, the
project should be considered. If the rate is less than the minimum rate, the project should be rejected.
• The investment in working capital causes the net present value to be lower than it would be if the working
capital investment is ignored. Therefore, the required return of a project must be higher to account for the
investment in working capital.
Demonstration problem
Barkley Company is considering three different investments; the following data relate to these investments:
Expected Before-Tax Net
Expected after-tax net
Expected life
Investment Initial cash outlay
Cash inflow per year Cash inflow per year Of proposals* (years)
A $ 50,000 $ 13,333 $ 10,000 10
B 60,000 12,000 8,800 15
C 75,000 15,000 10,500 20
*No estimated salvage value. Use straight-line depreciation.
The income tax rate is 40 per cent. The salvage value of each investment is zero. Management requires a
minimum return on investments of 14 per cent.
Rank these proposals using the following selection techniques:
a. Payback period.
b. Unadjusted rate of return.
c. Profitability index.
d. Time-adjusted rate of return.
Solution to demonstration problem
a. Payback period:
(a) (b) (a)/(b)
Annual after-tax Payback period
Proposal Investment Cash inflow (years)
A $ 50,000 $ 10,000 5.00
B 60,000 8,800 6.82
C 75,000 10,500 7.14
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b. Unadjusted rate of return:
(a) (b) (c) (d)=[(b – c) x (1 - . 4)]
(d)/(a)
Average annual before -tax net
Average Average Rate
Proposal Average investment Cash inflow Depreciation Annual income Of Return
A $ 25,000 $ 13,333 $ 5,000 $ 5,000 20%
B 30,000 12,000 4,000 4,800 16%
C 37,500 15,000 3,750 6,750 18%
The proposals in order of desirability are A, C, and B.
c. Profitability index:
(a) (b) (c) = (a) x (b) (d) (c) x (d)
Annual after-tax net
Present Present value of Annual
Initial cash Profitability
Proposal Cash inflow Value factor at 14%
Net cash inflow Outlay Index
A $ 10,000* 5.21612 $ 52,161 $ 50,000 1.04
B 8,800 6.14217 54,051 60,000 0.90
C 10,500 6.62313 69,543 75,000 0.93
*This amount was given. However, the amount can also be calculated as follows:
Expected before-tax net cash inflow $ 13,333
Less depreciation 5,000
Taxable income $ 8,333
1 – Tax rate X 60%
After-tax annual income $ 5,000
Add back depreciation 5,000
Annual after-tax net cash inflow $ 10,000
The proposals in order of desirability are A, C, and B. (But neither B nor C should be considered acceptable since
each has a profitability index of less than one.)
d. Time-adjusted rate of return:
Proposal Rate How found
A 15% (slightly above) ($ 50,000/$ 10,000) = Factor of 5 in 10 period row
B 12% (slightly below) ($ 60,000/$ 8,800) = Factor of 6.82 in 15 period row
C 13% (slightly below) ($ 75,000/$ 10,500) = Factor of 7.14 in 20 period row
The proposals in order of desirability are A, C, and B. (But neither B nor C earns the minimum rate of return.)
Key terms* Annuity A series of equal cash inflows.
Capital budgeting The process of considering alternative capital projects and selecting those alternatives that provide the most profitable return on available funds, within the framework of company goals and objectives.
Capital project Any available alternative to purchase, build, lease, or renovate equipment, buildings, property, or other long-term assets.
Cost of capital The cost of all sources of capital (debt and equity) employed by a company.
Initial cost of an asset Any cash outflows necessary to acquire an asset and place it in a position and condition for its intended use.
Accounting Principles: A Business Perspective 994 A Global Text
26. Capital budgeting:Long-range planning
Net cash inflow The periodic cash inflows from a project less the periodic cash outflows related to the project.
Net present value A project selection technique that discounts all expected after-tax cash inflows and outflows from the proposed investment to their present values using the company's minimum rate of return as a discount rate. If the amount obtained by this process exceeds or equals the investment amount, the proposal is considered acceptable for further consideration.
Opportunity cost The benefits or returns lost by rejecting the best alternative investment.
Out-of-pocket cost A cost requiring a future outlay of resources, usually cash.
Payback period The period of time it takes for the cumulative sum of the annual net cash inflows from a project to equal the initial net cash outlay.
Profitability index The ratio of the present value of the expected net cash inflows (after taxes) divided by the initial cash outlay (or present value of cash outlays if future outlays are required).
Sunk costs Costs that have already been incurred. Nothing can be done about sunk costs at the present time; they cannot be avoided or changed in amount.
Tax shield The total amount by which taxable income is reduced due to the deductability of an item.
Time-adjusted rate of return A project selection technique that finds a rate of return that will equate the present value of future expected net cash inflows (after taxes) from an investment with the cost of the investment; also called internal rate of return.
Unadjusted rate of return The rate of return computed by dividing average annual income after taxes from a project by the average amount of the investment.
*Some terms listed in earlier chapters are repeated here for your convenience.
Self-test
True-false
Indicate whether each of the following is true or false.
Depreciation does not involve a cash outflow; it is deductible in arriving at federal taxable income.
The price a company is going to pay for a machine is an out-of-pocket cost.
Sunk costs and out-of-pocket costs are relevant to capital-budgeting decisions.
A formula for unadjusted rate of return is as follows:
Unadjusted rate of return = Average annual income after taxes/Average amount of investment
When investment projects cost different amounts are being compared, the net present value does not provide a
valid means by which to rank projects in order of contribution to income or desirability assuming limited financial
resources.
Multiple-choice
Choose the best answer for each of the following questions.
Which of the following is incorrect regarding the payback period method?
a. The payback period ignores the time period beyond the payback period.
b. When using payback analysis for investment decisions, one rule is to select the shortest payback period
investment.
c . The formula for the payback period is:
Payback period = Initial cash outlay/Annual amount of investment
d. Payback analysis ignores the time value of money.
When using time value of money concepts, all aspects of the investment should be considered including which of
the following?
a. Employee morale.
b. No single time value of money method should be used by itself to make capital budgeting decisions.
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c. Company flexibility.
d. All of the above.
Which of the following correctly describe(s) the limitations when using the unadjusted rate of return.
a. Timing of cash flows is not considered.
b. It allows a sunk cost, depreciation, to enter into the calculation.
c. The length of time over which the return will be earned is not considered.
d. All of the above.
Which of the following statements is (are) true regarding the profitability index?
a. Only proposals with profitability indexes greater than 1.00 should be considered.
b. Only proposals with profitability indexes less than 1.00 should be considered.
c. The profitability index is the ratio of the initial cash outlay divided by the present value of cash benefits
(before taxes).
d. b and c.
Which of the following statements is (are) true regarding net present value?
a. When determining an appropriate discount rate, management uses net cash outflow.
b. With projects that require an investment at a later date, management must discount the cash outflow to its
present value before it is compared to the present value of cash inflows.
c. When using the net present value to screen alternative projects, as long as the project's net present value is
equal to the investment the project is desirable.
d. b and c.
Which of the following statements is (are) true regarding the time-adjusted rate of return?
a. The first step in computing the rate of return is determining the payback period.
b. The annual after-tax net cash inflow also is called an annuity.
c. The cost of capital is used only as a cutoff point in deciding which projects should be considered further.
d. All of the above.
Now turn to “Answers to self-test” at the back of the chapter to check your answers.
Questions
➢ How do capital expenditures differ from ordinary expenditures?
➢ What effects can capital-budgeting decisions have on a company?
➢ What effect does depreciation have on cash flow?
➢ Give an example of an out-of-pocket cost and a sunk cost by describing a situation in which both are
encountered.
➢ A machine is being considered for purchase. The salesperson attempting to sell the machine says that
it will pay for itself in five years. What is meant by this statement?
➢ Discuss the limitations of the payback period method.
➢ What is the profitability index, and of what value is it?
➢ What is the time-adjusted rate of return on a capital investment?
➢ What role does the cost of capital play in the time-adjusted rate of return method and in the net
present value method?
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26. Capital budgeting:Long-range planning
➢ What is the purpose of a postaudit? When should a postaudit be performed?
➢ A friend who knows nothing about the concepts in this chapter is considering purchasing a house for
rental to students. In just a few words, what would you tell your friend to think about in making this
decision?
Exercises
Exercise A Diane Manufacturing Company is considering investing USD 600,000 in new equipment with an
estimated useful life of 10 years and no salvage value. The equipment is expected to produce USD 240,000 in cash
inflows and USD 160,000 in cash outflows annually. The company uses straight-line depreciation, and has a 40 per
cent tax rate. Determine the annual estimated net income and net cash inflow.
Exercise B Zen Manufacturing Company is considering replacing a four-year-old machine with a new,
advanced model. The old machine was purchased for USD 60,000, has an estimated useful life of 10 years with no
salvage value, and has annual maintenance costs of USD 15,000. The new machine would cost USD 45,000, but
annual maintenance costs would be only USD 6,000. The new machine would have an estimated useful life of 10
years with no salvage value. Using straight-line depreciation and an assumed 40 per cent tax rate, compute the
additional annual cash inflow if the old machine is replaced.
Exercise C Given the following annual costs, compute the payback period for the new machine if its initial cost
is USD 420,000.
Old machine New machine
Depreciation $ 18,000 $ 42,000
Labor 72,000 63,000
Repairs 21,000 4,500
Other costs 12,000 3,600
$ 123,000 $ 113,100
Exercise D Jefferson Company is considering investing USD 33,000 in a new machine. The machine is
expected to last five years and to have a salvage value of USD 8,000. Annual before-tax net cash inflow from the
machine is expected to be USD 7,000. Calculate the unadjusted rate of return. The income tax rate is 40 per cent.
Exercise E Compute the profitability index for each of the following two proposals assuming the desired
minimum rate of return is 20 per cent. Based on the profitability indexes, which proposal is better?
Proposal 1 Proposal 2
Initial cash outlay $ 16,000 $ 10,300
Net cash inflow (after taxes):
First year 10,000 6,000
Second year 9,000 6,000
Third year 6,000 4,000
Fourth year -0- 2,500
Exercise F Ross Company is considering three alternative investment proposals. Using the following
information, rank the proposals in order of desirability using the payback period method.
Proposal A B C
Initial outlay $ 360,000 $ 360,000 $ 360,000 Net cash inflow (after taxes): First year $ -0- $ 90,000 $ 90,000 Second year 180,000 270,000 180,000
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Third year 180,000 90,000 270,000 Fourth year 90,000 180,000 450,000
$ 450,000 $ 630,000 $ 990,000
Exercise G Simone Company is considering the purchase of a new machine costing USD 50,000. It is expected
to save USD 9,000 cash per year for 10 years, has an estimated useful life of 10 years, and no salvage value.
Management will not make any investment unless at least an 18 per cent rate of return can be earned. Using the net
present value method, determine if the proposal is acceptable. Assume all tax effects are included in these numbers.
Exercise H Refer to the data in previous exercise. Calculate the time-adjusted rate of return.
Exercise I Rank the following investments for Renate Company in order of their desirability using the (a)
payback period method, (b) net present value method, and (c) time-adjusted rate of return method. Management
requires a minimum rate of return of 14 per cent.
Initial Expected after-tax net cash Expected life of proposal
Investment Cash outlay Inflow per year (years)
A $ 120,000 $ 15,000 8
B 150,000 26,000 20
C 240,000 48,000 10
Problems
Problem A Hamlet Company is considering the purchase of a new machine that would cost USD 300,000 and
would have an estimated useful life of 10 years with no salvage value. The new machine is expected to have annual
before-tax cash inflows of USD 100,000 and annual before-tax cash outflows of USD 40,000. The company will
depreciate the machine using straight-line depreciation, and the assumed tax rate is 40 per cent.
a. Determine the net after-tax cash inflow for the new machine.
b. Determine the payback period for the new machine.
Problem B Graham Company currently uses four machines to produce 400,000 units annually. The machines
were bought three years ago for USD 50,000 each and have an expected useful life of 10 years with no salvage value.
These machines cost a total of USD 30,000 per year to repair and maintain.
The company is considering replacing the four machines with one technologically superior machine capable of
producing 400,000 units annually by itself. The machine would cost USD 140,000 and have an estimated useful
life of seven years with no salvage value. Annual repair and maintenance costs are estimated at USD 14,000.
Assuming straight-line depreciation and a 40 per cent tax rate, determine the annual additional after-tax net
cash inflow if the new machine is acquired.
Problem C Macro Company owns five machines that it uses in its manufacturing operations. Each of the
machines was purchased four years ago at a cost of USD 120,000. Each machine has an estimated life of 10 years
with no expected salvage value. A new machine has become available. One new machine has the same productive
capacity as the five old machines combined; it can produce 800,000 units each year. The new machine will cost
USD 648,000, is estimated to last six years, and will have a salvage value of USD 72,000. A trade-in allowance of
USD 24,000 is available for each of the old machines. These are the operating costs per unit:
Five old Machines New Machines
Repairs $ 0.6796 $ 0.0856
Depreciation 0.1500 0.2400
Power 0.1890 0.1036
Accounting Principles: A Business Perspective 998 A Global Text
26. Capital budgeting:Long-range planning
Other operating costs 0.1620 0.0496
$ 1.1806 $ 0.4788
Ignore federal income taxes. Use the payback period method for (a) and (b).
a. Do you recommend replacing the old machines? Support your answer with computations. Disregard all
factors except those reflected in the data just given.
b. If the old machines were already fully depreciated, would your answer be different? Why?
c. Using the net present value method with a discount rate of 20 per cent, present a schedule showing whether
or not the new machine should be acquired.
Problem D Span Fruit Company has used a particular canning machine for several years. The machine has a
zero salvage value. The company is considering buying a technologically improved machine at a cost of USD
232,000. The new machine will save USD 50,000 per year after taxes in cash operating costs. If the company
decides not to buy the new machine, it can use the old machine for an indefinite time by incurring heavy repair
costs. The new machine would have an estimated useful life of eight years.
a. Compute the time-adjusted rate of return for the new machine.
b. Management thinks the estimated useful life of the new machine may be more or less than eight years.
Compute the time-adjusted rate of return for the new machine if its useful life is (1) 5 years and (2) 12 years, instead
of 8 years.
c. Suppose the new machine's useful life is eight years, but the annual after-tax cost savings are only USD
45,000. Compute the time-adjusted rate of return.
d. Assume the annual after-tax cost savings from the new machine will be USD 35,000 and its useful life will be
10 years. Compute the time-adjusted rate of return.
Problem E Merryll, Inc., is considering three different investments involving depreciable assets with no
salvage value. The following data relate to these investments:
Initial cash Expected before-tax net
Expected after-tax net
Life of proposal
Investment Outlay Cash inflow per year Cash inflow per year (years)
1 $ 140,000 $ 37,333 $ 28,000 10
2 240,000 72,000 48,000 20
3 360,000 89,333 68,000 10
The income tax rate is 40 per cent. Management requires a minimum return on investment of 12 per cent.
Rank these proposals using the following selection techniques:
a. Payback period.
b. Unadjusted rate of return.
c. Profitability index.
d. Time-adjusted rate of return.
Problem F Slow to Change Company has decided to computerize its accounting system. The company has two
alternatives—it can lease a computer under a three-year contract or purchase a computer outright.
If the computer is leased, the lease payment will be USD 5,000 each year. The first lease payment will be due on
the day the lease contract is signed. The other two payments will be due at the end of the first and second years. The
lessor will provide all repairs and maintenance.
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If the company purchases the computer outright, it will incur the following costs:
Acquisition cost $ 10,500
Repairs and maintenance:
First year 300
Second year 250
Third year 350
The computer is expected to have only a three-year useful life because of obsolescence and technological
advancements. The computer will have no salvage value and be depreciated on a double-declining-balance basis.
Slow to Change Company's cost of capital is 16 per cent.
a. Calculate the net present value of out-of-pocket costs for the lease alternative.
b. Calculate the net present value of out-of-pocket costs for the purchase alternative.
c. Do you recommend that the company purchase or lease the machine?
Problem G Van Gogh Sports Company is trying to decide whether to add tennis equipment to its existing line
of football, baseball, and basketball equipment. Market research studies and cost analyses have provided the
following information:
Van Gogh will need additional machinery and equipment to manufacture the tennis equipment. The machines
and equipment will cost USD 450,000, have an estimated 10-year useful life, and have a USD 10,000 salvage value.
Sales of tennis equipment for the next 10 years have been projected as follows:
Years Sales in dollars
1 $ 75,000
2 112,500
3 168,750
4 187,500
5 206,250
6 – 10 (each year) 225,000
Variable costs are 60 per cent of selling price, and fixed costs (including straight-line depreciation) will total
USD 88,500 per year.
The company must advertise its new product line to gain rapid entry into the market. Its advertising campaign
costs will be:
Years Annual advertising cost 1 – 3 $ 75,000 4 – 10 37,500
The company requires a 14 per cent minimum rate of return on investments.
Using the net present value method, decide whether or not Van Gogh Sports Company should add the tennis
equipment to its line of products. (Ignore federal income taxes.) Round to the nearest dollar.
Problem H Jordan Company is considering purchasing new equipment costing USD 2,400,000. Jordan
estimates that the useful life of the equipment will be five years and that it will have a salvage value of USD
600,000. The company uses straight-line depreciation. The new equipment is expected to have a net cash inflow
(before taxes) of USD 258,000 annually. Assume that the tax rate is 40 per cent and that management requires a
minimum return of 14 per cent.
Using the net present value method, determine whether the equipment is an acceptable investment.
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26. Capital budgeting:Long-range planning
Problem I Penny Company has an opportunity to sell some equipment for USD 40,000. Such a sale will result
in a tax-deductible loss of USD 4,000. If the equipment is not sold, it is expected to produce net cash inflows after
taxes of USD 8,000 for the next 10 years. After 10 years, the equipment can be sold for its book value of USD 4,000.
Assume a 40 per cent federal income tax rate.
Management currently has other opportunities that will yield 18 per cent. Using the net present value method,
show whether the company should sell the equipment. Prepare a schedule to support your conclusion.
Alternate problems
Alternate problem A Mark's Manufacturing Company is currently using three machines that it bought seven
years ago to manufacture its product. Each machine produces 10,000 units annually. Each machine originally cost
USD 25,500 and has an estimated useful life of 17 years with no salvage value.
The new assistant manager of Mark's Manufacturing Company suggests that the company replace the three old
machines with two technically superior machines for USD 22,500 each. Each new machine would produce 15,000
units annually and would have an estimated useful life of 10 years with no salvage value.
The new assistant manager points out that the cost of maintaining the new machines would be much lower.
Each old machine costs USD 2,500 per year to maintain; each new machine would cost only USD 1,500 a year to
maintain.
Compute the increase in after-tax annual net cash inflow that would result from replacing the old machines; use
straight-line depreciation and an assumed tax rate of 40 per cent.
Alternate problem B Fed Extra Company is considering replacing 10 of its delivery vans that originally cost
USD 30,000 each; depreciation of USD 18,750 has already been taken on each van. The vans were originally
estimated to have useful lives of eight years and no salvage value. Each van travels an average of 150,000 miles per
year. The 10 new vans, if purchased, will cost USD 36,000 each. Each van will be driven 150,000 miles per year and
will have no salvage value at the end of its three-year estimated useful life. A trade-in allowance of USD 3,000 is
available for each of the old vans. Following is a comparison of costs of operation per mile:
Old vans New vans Fuel, lubricants, etc. $ 0.152 $ 0.119 Tires 0.067 0.067 Repairs 0.110 0.087 Depreciation 0.025 0.080 Other operating costs 0.051 0.043 Operating costs per mile $ 0.405 $ 0.396
Use the payback period method for (a) and (b).
a. Do you recommend replacing the old vans? Support your answer with computations and disregard all factors
not related to the preceding data.
b. If the old vans were already fully depreciated, would your answer be different? Why?
c. Assume that all cost flows for operating costs fall at the end of each year and that 18 per cent is an appropriate
rate for discounting purposes. Using the net present value method, present a schedule showing whether or not the
new vans should be acquired.
Alternate problem C Mesa Company has been using an old-fashioned computer for many years. The
computer has no salvage value. The company is considering buying a computer system at a cost of USD 35,000. The
new computer system will save USD 7,000 per year after taxes in cash (including tax effects of depreciation). If the
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company decides not to buy the new computer system, it can use the old one for an indefinite time. The new
computer system will have an estimated useful life of 10 years.
a. Compute the time-adjusted rate of return for the new computer system.
b. The company is uncertain about the new computer system's 10-year useful life. Compute the time-adjusted
rate of return for the new computer system if its useful life is (1) 6 years and (2) 15 years, instead of 10 years.
c. Suppose the computer system has a useful life of 10 years, but the annual after-tax cost savings are only USD
4,500. Compute the time-adjusted rate of return.
d. Assume the annual after-tax cost savings will be USD 7,500 and the useful life will be eight years. Compute
the time-adjusted rate of return.
Alternate problem D Ott's Fresh Produce Company has always purchased its trucks outright and sold them
after three years. The company is ready to sell its present fleet of trucks and is trying to decide whether it should
continue to purchase trucks or whether it should lease trucks. If the trucks are purchased, the company will incur
the following costs:
Costs per fleet
Acquisition cost $ 312,000
Repairs:
First year 3,600
Second year 6,600
Third year 9,000
Other annual costs 9,600
At the end of three years, the trucks could be sold for a total of USD 96,000. Another fleet of trucks would then
be purchased. The costs just listed, including the same acquisition cost, also would be incurred with respect to the
second fleet of trucks. The second fleet also could be sold for USD 96,000 at the end of three years.
If the company leases the trucks, the lease contract will run for six years. One fleet of trucks will be provided
immediately, and a second fleet of trucks will be provided at the end of three years. The company will pay USD
126,000 per year under the lease contract. The first lease payment will be due on the day the lease contract is
signed. The lessor bears the cost of all repairs.
Using the net present value method, determine if the company should buy or lease the trucks. Assume the
company's cost of capital is 18 per cent. (Ignore federal income taxes.)
Beyond the numbers—Critical thinking
Business decision case A Lloyd's Company wishes to invest USD 750,000 in capital projects that have a
minimum expected rate of return of 14 per cent. The company is evaluating five proposals. Acceptance of one
proposal does not preclude acceptance of any of the other proposals. The company's criterion is to select proposals
that meet its 14 per cent minimum required rate of return. The relevant information related to the five proposals is
as follows:
Initial cash Expected after-tax net Expected life of
Investment Outlay Cash inflow per year Proposal (years)
A $ 150,000 $ 45,000 5
B 300,000 60,000 8
C 375,000 82,500 10
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26. Capital budgeting:Long-range planning
D 450,000 78,000 12
E 150,000 31,500 10
a. Compute the net present value of each of the five proposals.
b. Which projects should be undertaken? Why? Rank them in order of desirability.
Business decision case B Slick Company is considering a capital project involving a USD 225,000
investment in machinery and a USD 45,000 investment in working capital. The machine has an expected useful life
of 10 years and no salvage value. The annual cash inflows (before taxes) are estimated at USD 90,000 with annual
cash outflows (before taxes) of USD 30,000. The company uses straight-line depreciation. Assume the federal
income tax rate is 40 per cent.
The company's new accountant computed the net present value of the project using a minimum required rate of
return of 16 per cent (the company's cost of capital). The accountant's computations follow:
Cash inflows $ 90,000 Cash outflows 30,000 Net cash inflow $ 60,000 Present value of net cash at 16% X 4.833 Present value of net cash inflow $283,980 Initial cash outlay 225,000 Net present value $ 64,980
a. Are the accountant's computations correct? If not, compute the correct net present value.
b. Is this capital project acceptable to the company? Why or why not?
An accounting perspective – Writing experience C Refer to "An accounting perspective: Business
insight". Write a brief paper explaining why managers in Japan might use lower measures of the cost of capital than
US managers.
Ethics case – Writing experience D Rebecca Peters just learned that First Bank's investment review
committee rejected her pet project, a new computerized method of storing data that would enable customers to
have instant access to their bank records. Peters' software consulting firm specializes in working with financial
institutions. This project for First Bank was her first as project manager.
Following up, Peters learned that First Bank's investment review committee liked the idea but were not
convinced that the new software's financial benefits would justify the cost of the software. When she told a
colleague about the rejection at First Bank, the colleague said, "Why not tell the committee this software will
increase the bank's profits? After we installed the software in the bank in Indianapolis, Indiana, USA their profits
increased substantially. We even have data from that bank that you could present."
Peters thought about the suggestion. She knew First Bank would be pleased with the software if they installed it,
and she wanted to make the sale. She also knew that the situation in Indianapolis, Indiana, USA was different;
profits there had increased primarily because of other software that had reduced the bank's operating costs.
What should Rebecca Peters do? Write her a letter telling what you would do.
Group assignment E For summer employment, a friend is considering investing in a coffee stand on a busy
street near office buildings. Being unfamiliar with the concepts in this chapter, your friend does not know how to
make the decision. In teams of four, help your friend get started by providing a framework and questions that your
friend should answer. (For example, how much will the investment be? How much are the estimated cash flows
from sales?) Prepare a memorandum from the group to your instructor; list your questions and suggestions for
your friend. In the heading, include the date, to whom it is written, from whom, and the subject matter.
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Group project F You have the option of choosing between two projects with equal total cash flows over five
years but different annual cash flows. In groups of two or three students, determine which project should be
selected for investment. Write a memorandum to your instructor addressing this issue. Be sure to provide examples
to reinforce your answer. The heading of the memorandum should contain the date, to whom it is written, from
whom, and the subject matter.
Group project G A manager comments to her superior, "There is no need to perform a postaudit. The project
was justified based on our initial projections and we were given the green light to proceed. It has been a year since
we started the project, a postaudit would be a waste of time." In groups of two or three students, respond to this
comment. Do you agree? Do you disagree? If this manager is right, why bother with a postaudit? Write a
memorandum to your instructor addressing these questions. The heading of the memorandum should contain the
date, to whom it is written, from whom, and the subject matter.
Using the Internet—A view of the real world
Using any Internet search engine enter "budgeting" . Select an article that directly discusses budgeting in an
organization or industry and print a copy of the article. You are encouraged (but not required) to find an article that
answers some of the following questions: What is the purpose of budgeting? How are budgets developed? How is
budgeting used to motivate employees? How might budgeting create ethical dilemmas?
Write a memorandum to your instructor summarizing the key points of the article. The heading of the
memorandum should contain the date, to whom it is written, from whom, and the subject matter. Be sure to
include a copy of the article used for this assignment.
Using any Internet search engine select one of the new terms at the end of the chapter and perform a key word
search. Be sure to include quotation marks (for example: "Payback period"). Select an article that directly discusses
the new term used, and print a copy of the article. Write a memorandum to your instructor summarizing the key
points of the article. The heading of the memorandum should contain the date, to whom it is written, from whom,
and the subject matter. Be sure to include a copy of the article used for this assignment.
Answers to self-test
True-false
True. Depreciation does not involve a cash outflow; it is deductible in arriving at federal taxable income.
True. The price paid for a machine becomes a sunk cost the minute the purchase has been made.
False. Only the out-of-pocket costs (the future cash outlays) are relevant to capital-budgeting decisions.
True. Unadjusted rate of return= Average annual income after taxes
Average amount of investment
True. The profitability index should be used to rank these projects.
Multiple-choice
c. The correct formula is:
Payback period= Initial cash outlay
Annual net cash inflow benefit
d. All of the above choices are correct answers.
d. All of the above choices are correct answers.
a. A profitability index is the ratio of the present value of the expected net cash inflows (after taxes) divided by
the initial cash outlay (or present value of cash outlays if future outlays are required).
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26. Capital budgeting:Long-range planning
b. With projects that require an investment at a later date, management must discount the cash outflow to its
present value before it is compared to the present value of cash inflows.
d. All of the choices are correct answers.
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