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Donald E. Kieso PhD, CPA Northern Illinois University DeKalb, Illinois

Jerry J. Weygandt PhD, CPA University of Wisconsin—Madison Madison, Wisconsin

Terry D. Warfield, PhD University of Wisconsin—Madison Madison, Wisconsin

INTERMEDIATE ACCOUNTING 16E

D E D I C A T E D T O

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This book contains citations from various FASB pronouncements. Copyright © by Financial Accounting Standards Board, 401 Merritt 7, P.O. Box 5116, Norwalk, CT 06856 U.S.A. Reprinted with permission. Copies of complete documents are available from Financial Accounting Standards Board.

Material from the Certificate in Management Accounting Examinations, copyright © 1975, 1976, 1977, 1978, 1979, 1980, 1981, 1982, 1983, 1984, 1985, 1986, 1987, 1988, 1989, 1990, 1991, 1992, and 1993 by the Institute of Certified Management Accountants, 10 Paragon Drive, Montvale, NJ 07645, is adapted with permission.

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ISBN-13 978-1-118-74320-1

BRV ISBN-13 978-1-118-74297-6

The inside back cover will contain printing identification and country of origin if omitted from this page. In addition, if the ISBN on the back cover differs from the ISBN on this page, the one on the back cover is correct.

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

iii

1 Financial Accounting and Accounting Standards 2

2 Conceptual Framework for Financial Reporting 36

3 The Accounting Information System 78 4 Income Statement and Related Information 152 5 Balance Sheet and Statement of Cash

Flows 200 6 Accounting and the Time Value of Money 266 7 Cash and Receivables 324 8 Valuation of Inventories: A Cost-Basis

Approach 386 9 Inventories: Additional Valuation Issues 442 10 Acquisition and Disposition of Property, Plant,

and Equipment 502 11 Depreciation, Impairments, and Depletion 552 12 Intangible Assets 610 13 Current Liabilities and Contingencies 658 14 Long-Term Liabilities 718 15 Stockholders’ Equity 774 16 Dilutive Securities and Earnings per Share 834 17 Investments 898 18 Revenue Recognition 978 19 Accounting for Income Taxes 1052 20 Accounting for Pensions and Postretirement

Benefits 1116 21 Accounting for Leases 1194 22 Accounting Changes and Error Analysis 1266 23 Statement of Cash Flows 1330 24 Full Disclosure in Financial Reporting 1402

APPENDICES A Private Company Accounting A-1 B Specimen Financial Statements: The Procter &

Gamble Company B-1 C Specimen Financial Statements: The Coca-Cola

Company C-1 D Specimen Financial Statements: PepsiCo, Inc. D-1 E Specimen Financial Statements: Marks and

Spencer plc E-1

Brief Contents

Through many editions, this textbook has continued to reflect the constant changes taking place in the GAAP environment. This edition continues this tradition, which has become even more significant as the financial reporting environment is exploding with major change. Here are three areas of major importance that are now incorporated extensively into this edition of the textbook.

Convergence of GAAP and IFRS One of the most important innovations shaping our capital markets was the idea of GAAP. It might be said that it would be even better if we had one common set of accounting rules for the whole world, which would make it easier for interna- tional investors to compare the financial results of companies from different countries. Fortunately, GAAP and international accounting standards have converged to result in a number of common standards between GAAP and International Financial Reporting Standards (IFRS). And you have the chance to be on the ground floor as we develop for you the similarities and differences in the two systems that ultimately will be one.

A Fair Value Movement The FASB believes that fair value information is more relevant to users than historical cost. As a result, there is more information that is being reported on this basis, and even more will occur in the future. The financial press is full of articles discussing how financial institutions must fair value their assets, which has led to massive losses during the recent credit crisis. In addition, additional insight into the reliability related to fair values is being addressed and disclosed to help investors make important capital allocation decisions. We devote a considerable amount of material that discusses and illustrates fair value concepts in this edition.

A New Way of Looking at Generally Accepted Accounting Principles (GAAP) Learning GAAP used to be a daunting task, as it is comprised of many standards that vary in form, completeness, and structure. Fortunately, the profession has developed the Financial Accounting Standards Board Codification (often referred to as the Codification). This Codification provides in one place all the GAAP related to a given topic. This textbook is the first to incorporate this Codification—it will make learning GAAP easier and more interesting!

Intermediate Accounting is the market-leading textbook in providing the tools needed to under- stand what GAAP is and how it is applied in practice. With this Sixteenth Edition, we strive to con- tinue to provide the material needed to understand this subject area. The textbook is comprehen- sive and up-to-date. We also include proven pedagogical tools, designed to help you learn more effectively and to answer the changing needs of this course.

We are excited about Intermediate Accounting, Sixteenth Edition. We believe it meets an important objective of providing useful information to educators and students interested in learning about both GAAP and IFRS. Suggestions and comments from users of this textbook will be appreciated. Please feel free to e-mail any one of us at [email protected].

Donald E. Kieso Jerry J. Weygandt Terry D. Warfield Somonauk, Illinois Madison, Wisconsin Madison, Wisconsin

“If this textbook helps you appreciate the challenges, worth, and limitations of financial reporting, if it encourages you to evaluate critically and understand financial accounting concepts and practice, and if it p repares you for advanced study, profes- sional examinations, and the successful and ethical pursuit of your career in accounting or business in a global economy, then we will have attained our objectives.”

From the Authors

Author Commitment Don Kieso DONALD E. KIESO, PhD, CPA, received his bachelor's degree from Aurora University and his doctorate in accounting from the University of Illinois. He has served as chairman of the Department of Accountancy and is currently the KPMG Emeritus Professor of Accountancy at Northern Illinois University. He has public accounting experience with Price Waterhouse & Co. (San Francisco and Chicago) and Arthur Andersen & Co. (Chicago) and research experience with the Research Division of the American Institute of Certified Public Accountants (New York). He has done post-doctorate work as a Visiting Scholar at the University of California at Berkeley and is a recipient of NIU’s Teaching Excellence Award and four Golden Apple Teaching Awards. Professor Kieso is the author of other accounting and business books and is a member of the American Accounting Association, the American Institute of Certified Public Accountants, and the Illinois CPA Society. He has served as a member of the Board of Directors of the Illinois CPA Society, then AACSB’s Accounting Accreditation Committees, the State of Illinois Comptroller’s Commission, as Secretary-Treasurer of the Federation of Schools of Accountancy, and as Secretary-Treasurer of the American Accounting Association. Professor Kieso is currently serving on the Board of Trustees and Executive Committee of Aurora University, as a member of the Board of Directors of Kishwaukee Community Hospital, and as Treasurer and Director of Valley West Community Hospital. From 1989 to 1993, he served as a charter member of the National Accounting Education Change Commission. He is the recipient of the Outstanding Accounting Educator Award from the Illinois CPA Society, the FSA’s Joseph A. Silvoso Award of Merit, the NIU Foundation’s Humanitarian Award for Service to Higher Education, a Distinguished Service Award from the Illinois CPA Society, and in 2003 an honorary doctorate from Aurora University.

Jerry Weygandt JERRY J. WEYGANDT, PhD, CPA, is Arthur Andersen Alumni Emeritus Professor of Accounting at the University of Wisconsin—Madison. He holds a Ph.D. in accounting from the University of Illinois. Articles by Professor Weygandt have appeared in the Accounting Review, Journal of Accounting Research, Accounting Horizons, Journal of Accountancy, and other academic and professional j ournals. These articles have examined such financial reporting issues as accounting for price-level adjustments, pensions, convertible securities, stock option contracts, and interim reports. Professor Weygandt is author of other accounting and financial reporting books and is a member of the American Accounting Association, the American Institute of Certified Public Accountants, and the Wisconsin Society of Certified Public Accountants. He has served on numerous committees of the American Accounting Association and as a member of the editorial board of the Accounting Review; he also has served as President and Secretary-Treasurer of the American Accounting Association. In addition, he has been actively involved with the American Institute of Certified Public Accountants and has been a member of the Accounting Standards Executive Committee (AcSEC) of that organization. He has served on the FASB task force that examined the reporting issues related to accounting for income taxes and served as a trustee of the Financial Accounting Foundation. Professor Weygandt has received the Chancellor’s Award for Excellence in Teaching and the Beta Gamma Sigma Dean’s Teaching Award. He is on the board of directors of M & I Bank of Southern Wisconsin. He is the recipient of the Wisconsin Institute of CPA’s Outstanding Educator’s Award and the Lifetime Achievement Award. In 2001, he received the American Accounting Association’s Outstanding Educator Award.

Terry Warfield TERRY D. WARFIELD, PhD, is the PwC Professor in Accounting at the University of Wisconsin—Madison. He received a B.S. and M.B.A. from Indiana University and a Ph.D. in accounting from the University of Iowa. Professor Warfield’s area of expertise is financial reporting, and prior to his academic career, he worked for five years in the banking industry. He served as the Academic Accounting Fellow in the Office of the Chief Accountant at the U.S. Securities and Exchange Commission in Washington, D.C. from 1995–1996. Professor Warfield’s primary research interests concern financial accounting standards and disclosure policies. He has published scholarly articles in The Accounting Review, Journal of Accounting and Economics, Research in Accounting Regulation, and Accounting Horizons, and he has served on the editorial boards of The Accounting Review, Accounting Horizons, and Issues in Accounting Education. He has served as president of the Financial Accounting and Reporting Section, the Financial Accounting Standards Committee of the American Accounting Association (Chair 1995–1996), and on the AAA- FASB Research Conference Committee. He also served on the Financial Accounting Standards Advisory Council of the Financial Accounting Standards Board, and he currently serves as a trustee of the Financial Accounting Foundation. Professor Warfield has received teaching awards at both the University of Iowa and the University of Wisconsin, and he was named to the Teaching Academy at the University of Wisconsin in 1995. Professor Warfield has developed and published several case studies based on his research for use in accounting classes. These cases have been selected for the AICPA Professor-Practitioner Case Development Program and have been published in Issues in Accounting Education.

The Sixteenth Edition expands our emphasis on student learning and improves upon a teaching and learning package that instructors and students have rated the highest in customer satisfaction. Based on extensive reviews, focus groups, and interactions with other intermediate accounting instructors and students, we have developed a number of new pedagogical features and content changes, designed both to help students learn more effectively and to answer the changing needs of the course.

WileyPLUS with ORION Over 3,500 questions, including new medium-level, computational, and accounting-cycle- based questions, are available for practice and review. is an adaptive study and practice tool that helps students build proficiency in course topics.

WileyPLUS Videos Over 150 videos are available in WileyPLUS. The videos walk students through relevant home- work problems and solutions and review important concepts.

Review and Practice and Solutions New practice opportunities with solutions are integrated throughout the textbook and WileyPLUS course. Each textbook chapter now provides students with a Review and Practice section that includes learning objective summaries, a key term listing, and a practice problem with solution.

Updated IFRS Insights Content We have updated the end-of-chapter section, IFRS Insights, throughout the textbook. In addition, in the Relevant Facts section, we now present Similarities as well as Differences between GAAP and IFRS to increase student understanding.

Major Content Revisions In response to the changing environment, we have signifi cantly revised several chapters.

CHAPTER 4 Income Statement and Related Information

• Revised discussion and presentation of unusual and infrequent gains and losses, as well as discontinued operations, per recent accounting standards.

• Deleted discussion of extraordinary items to reflect the most recent accounting standards.

CHAPTER 9 Inventories: Additional Valuation Issues

• New discussion and end-of-chapter material on lower-of-cost-or-net realizable value and lower-of-cost-or-market to reflect the most recent accounting standards.

CHAPTER 17 Investments

• Discussion and update of material in response to the recent standard on classification and measurement.

CHAPTER 18 Revenue Recognition

• New discussion based on the recent FASB ruling on the revenue recognition principle. Legacy GAAP discussion is available online.

See the next two pages for a complete list of content revisions by chapter.

WHAT’S NEW?

vii

Content Changes by Chapter Chapter 1: Financial Accounting and Accounting

Standards • Updated discussion on diminishing role of AICPA in

standard-setting process. • Added discussion on potential abuse of historical cost

valuation within Evolving Issue box on fair value. • New discussion on whether convergence of GAAP

and IFRS will really occur. • New Concepts of Analysis case on financial crisis of

2008. • Significantly updated IFRS Insights section to include

most recent information on convergence efforts.

Chapter 2: Conceptual Framework for Financial Reporting

• New discussion on how the IASB is now moving for- ward on its own conceptual framework instead of a continuation of a joint FASB/IASB project.

• New WDNM boxes on (1) how the use of unconven- tional financial terms in statements can mislead inves- tors and (2) the use of pro forma measures.

Chapter 3: The Accounting Information System • Completely revised and updated opening story on

economic crime and importance of effective inter- nal controls of a company’s accounting information system.

Chapter 4: Income Statement and Related Information • New opening story on how Groupon’s adjusted

EBITDA reflects trend of companies employing pro forma reporting and concerns with that practice.

• Completely revised Discontinued Operations section per recent FASB standard.

• Completely revised Unusual and Infrequent Gains and Losses section per recent FASB standard.

• Deleted Extraordinary Items section per recent FASB standard.

Chapter 5: Balance Sheet and Statement of Cash Flows • New discussion of IBM’s financial flexibility within

WDNM box on importance of cash flow information for investors.

• Moved P&G’s financial statements to Appendix B at end of textbook; the complete annual report is available online.

Chapter 6: Accounting and the Time Value of Money • Changed interest rates on many of the in-chapter

examples to reflect more realistic data.

Chapter 7: Cash and Receivables • New opening story on companies moving their prof-

its to overseas operations to avoid taxes. Previous

opening story, on sources of companies’ earnings, now updated and placed as a WDNM box.

• New WDNM box, on where companies park their cash. • Thoroughly updated discussion of recognition and

valuation of accounts receivable, per latest FASB stan- dard, including deleting percentage-of-sales approach.

• Updated discussion of securitizations, now placed as a WDNM box.

• Appendix 7B, Impairments of Receivables, now Collectibility Assessment Based on Expected Cash Flows, per recent FASB standard. Impairment Evaluation Process in IFRS Insights section also delet- ed accordingly.

Chapter 8: Valuation of Inventories: A Cost-Basis Approach

• Updated discussion on ownership of goods and costs to include in inventory, per recent FASB standard.

• Inventory errors discussion moved to end of chapter, for improved flow of discussion.

Chapter 9: Inventories: Additional Valuation Issues • Updated discussion of lower-of-cost-and-net realizable

value and lower-of-cost-or-market, per recent FASB pronouncement. New EOC Exercises and Problems related to this discussion.

• New table highlighting disadvantages of the gross profit method.

• New WDNM box on price fixing, and how new tech- nology on changing store prices can reduce the cost of implementing the retail inventory method.

Chapter 10: Acquisition and Disposition of Property, Plant, and Equipment

• Updated opening story on importance of and capital expenditures related to property, plant, and equipment for many companies.

Chapter 11: Depreciation, Impairments, and Depletion • Generally updated for new design, content, and recent

developments.

Chapter 12: Intangible Assets • New WDNM boxes on (1) including internally gener-

ated intangible assets in the financial statements and (2) global R&D incentives.

• New footnotes on recent guidance for private companies in the accounting for goodwill.

• Moved up Presentation of Intangible Assets section within chapter for improved flow of topics.

Chapter 13: Current Liabilities and Contingencies • Moved discussion of current maturities of long-term

debt and short-term obligations expected to be

refinanced to end of Current Liabilities section for improved flow of discussion.

• New illustrations highlighting the entries required to record unearned revenues, payroll deductions, and bonus agreements.

• New footnote on refinancing criteria, to inform about FASB’s latest deliberations regarding them in light of the Board’s simplification initiative.

• Rewritten discussion of warranties, per latest FASB standard.

• New WDNM box, on how companies’ extension of payment terms affects their current ratios and there- fore analysis of them.

Chapter 14: Long-Term Liabilities • Updated WDNM box on bond ratings for most recent

trends and information. • New footnote explaining why the effective-interest

rate will be higher on bonds issued at a discount rate based on the reduced carrying value.

• Deleted Costs of Issuing Bonds section per latest FASB standard.

Chapter 15: Stockholders’ Equity • Moved up discussion of preferred stock for improved

flow of discussion. • New illustrations on common stock issuance, cash

dividends, property dividends, liquidating dividends, and stock dividends to highlight journal entry proce- dures.

• Updated WDNM boxes for the most recent corporate information and trends on stock buybacks, classes of stock, stock splits, and dividends.

Chapter 16: Dilutive Securities and Earnings per Share • Revised WDNM box on convertible bonds, to include

most recent information and trends. • New WDNM box on FASB’s proposal of fair value

method for accounting for stock options.

Chapter 17: Investments • Discussion reflects proposed 2016 FASB pronounce-

ment on accounting for investments. • New WDNM boxes on (1) recent trend of many large

banks shifting debt investment portfolios into the held- to-maturity category as protection against market volatility, and (2) issue of how mutual funds assign a current value to private technology companies.

• Rewrote Impairment section, as well as Fair Value Hedge section in Appendix 17A, to reflect proposed FASB pronouncement.

• Deleted Appendix 17B on variable-interest entities.

Chapter 18: Revenue Recognition • New section with extended example of the five-step

revenue recognition model, to give students a good understanding/overview before more advanced issues are discussed.

• Right of Return section completely rewritten as Sales Returns and Allowances, with more explanations and examples, per new FASB standard.

• EOC material includes many new Brief Exercises, Exercises, and Problems, to reflect new FASB stand- ard and terminology.

Chapter 19: Accounting for Income Taxes • New section on financial statement effects of future

taxable amounts and deferred taxes. • Rewrote balance sheet classification section, to reflect

recent FASB pronouncement. • Completely revised Financial Statement Presentation

section, including new material on note disclosure.

Chapter 20: Accounting for Pensions and Postretirement Benefits

• Generally updated for new design, content, and recent developments.

Chapter 21: Accounting for Leases • Updated Evolving Issue boxes, to coincide with

expected new FASB leasing rules. • New WDNM box on how GM realized losses due to

inaccurate estimates of residual value profits.

Chapter 22: Accounting Changes and Error Analysis • New WDNM box on whether changes for accounting

estimates are motivated by attempt to provide more useful information or to make financial results look better.

• Motivations for Change of Accounting Method section now a WDNM box.

Chapter 23: Statement of Cash Flows • Extraordinary Items section now Unusual and

Infrequent Items, to conform to new FASB treatment. • Expanded footnote on reporting of significant noncash

transactions, as they can significantly affect analysts’ assessments of capital expenditures and free cash flow.

• New marginal T-accounts in Use of a Worksheet section, to help demonstrate adjustments made to the accounts.

• New WDNM box, on COROA (cash operating return on assets), a new measure of profitability.

Chapter 24: Full Disclosure in Financial Reporting • Updated Evolving Issue box on issue of financial

disclosure, to include recent developments on the FASB’s Disclosure Framework project.

• Deleted discussion of extraordinary items, to conform to new FASB treatment.

New Appendices A-E • Appendix A: Private Company Accounting (private

company alternatives for intangible assets and goodwill)

• Appendix B: Financial statements for The Procter & Gamble Company

• Appendix C: Financial statements for The Coca-Cola Company

• Appendix D: Financial statements for PepsiCo, Inc. • Appendix E: Financial statements for Marks and

Spencer plc

viii

This edition continues to provide numerous key learning aids to help you master the textbook material and prepare you for a successful career.

CHAPTER PREVIEW The Chapter Preview summarizes the major issues discussed in the chapter, and provides students with a visual outline of the key topics.

PREVIEW OF CHAPTER 12 As our opening story indicates, sustainability strategies are taking on increased importance for companies like Southwest Airlines and Clorox. Reporting challenges for effective sustainability investments are similar to those for intangible assets. In this chapter, we explain the basic conceptual and reporting issues related to intangible assets. The content and organization of the chapter are as follows.

INTANGIBLE ASSETS

INTANGIBLE ASSET ISSUES

• Characteristics • Valuation • Amortization

TYPES OF INTANGIBLES

• Marketing-related • Customer-related • Artistic-related • Contract-related • Technology-related • Goodwill

IMPAIRMENT AND PRESENTATION OF INTANGIBLES

• Limited-life intangibles • Indefinite-life intangibles

other than goodwill • Goodwill • Presentation

RESEARCH AND DEVELOPMENT COSTS

• Identifying R&D • Accounting for R&D • Similar costs • Presentation

This chapter also includes numerous conceptual and international discussions that are integral to the topics presented here.

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WHAT DO THE NUMBERS MEAN? The “What do the numbers mean?” boxes further students’ understanding of key concepts with practical, real-world examples.

WHAT DO THE NUMBERS MEAN? KEEP YOUR HANDS OFF MY INTANGIBLE!

Source: “Converse Sues to Protect Its Chuck Taylor All Stars,” The New York Times (October 14, 2014).

Companies go to great extremes to protect their valuable intangible assets. Consider how the creators of the highly suc- cessful game Trivial Pursuit protected their creation. First, they copyrighted the 6,000 questions that are at the heart of the game. Then they shielded the Trivial Pursuit name by applying for a registered trademark. As a third mode of protection, they obtained a design patent on the playing board’s design as a unique graphic creation.

Another more recent example is the case of Converse and its efforts to protect its classic Chuck Taylor trademark. Converse (owned by Nike) accused 31 companies (including

Wal-Mart Stores, Inc., Kmart, and Skechers) of trademark infringement for co-opting its widely recognizable Chuck Taylor® sneakers. While Converse is suing for monetary dam- ages, its main goal is to get these imposters off store shelves. The company went as far as fi ling a separate complaint with the International Trade Commission to stop any shoes consid- ered to be counterfeit from entering the country. That Converse (Nike) is going to these ends to protect its trademark is under- standable given that Nike reinvigorated the brand by expanding the franchise, introducing more colors and styles, and helping to push All Stars® into overseas markets.

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UNDERLYING CONCEPTS The Underlying Concepts highlight and explain major conceptual topics in the chapter.

INTERNATIONAL PERSPECTIVE International Perspectives provide students with specific examples of how global companies (and countries) implement key accounting regulations. They also provide examples of how and where IFRS differs from GAAP.

UNDERLYING CONCEPTS

The controversy sur- rounding the accounting for R&D expenditures refl ects a debate about whether such expendi- tures meet the defi nition of an asset. If so, then an “expense all R&D costs” policy results in overstated expenses and understated assets.

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INTERNATIONAL PERSPECTIVE

IFRS requires the capitalization of certain development expendi- tures. This confl icts with GAAP.

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EVOLVING ISSUE The Evolving Issue feature introduces and discusses a current topic in the accounting industry in which the profession may be encountering controversy or nearing resolution. The feature shows how the key standard- setting organizations make decisions to adjust to the changing global business environment.

The requirement that companies expense immediately all R&D costs (as well as start-up costs) incurred internally is a practical solution. It ensures consistency in practice and uniformity among companies. But the practice of immediately writing off expenditures made in the expectation of benefi ting future peri- ods is conceptually incorrect.

Proponents of immediate expensing contend that from an income statement standpoint, long-run application of this stan- dard frequently makes little difference. They argue that because of the ongoing nature of most companies’ R&D activities, the amount of R&D cost charged to expense each accounting period is about the same, whether there is immediate expens- ing or capitalization and subsequent amortization.

Others criticize this practice. They believe that the balance sheet should report an intangible asset related to expenditures that have future benefi t. To preclude capitalization of all R&D expenditures removes from the balance sheet what may be a company’s most valuable asset.

Indeed, research fi ndings indicate that capitalizing R&D costs may be helpful to investors. For example, one study showed a signifi cant relationship between R&D outlays and subsequent benefi ts in the form of increased productivity, earnings, and share- holder value for R&D-intensive companies. Another study found that there was a signifi cant decline in earnings’ usefulness for companies that were forced to switch from capitalizing to expens- ing R&D costs, and that the decline appears to persist over time.

The current accounting for R&D and other internally gener- ated intangible assets represents one of the many trade-offs made among relevance, faithful representation, and cost- benefi t considerations. The FASB and IASB have completed some lim- ited-scope projects on the accounting for intangible assets, and the Boards have contemplated a joint project on the accounting for identifi able intangible assets (i.e., excluding goodwill). Such a project would address concerns that the current accounting requirements lead to inconsistent treatments for some types of intangible assets depending on how they arise.

Sources for research studies: Baruch Lev and Theodore Sougiannis, “The Capitalization, Amortization, and Value-Relevance of R&D,” Journal of Accounting and Economics (February 1996); and Martha L. Loudder and Bruce K. Behn, “Alternative Income Determination Rules and Earnings Useful- ness: The Case of R&D Costs,” Contemporary Accounting Research (Fall 1995).

EVOLVING ISSUE RECOGNITION OF R&D AND INTERNALLY GENERATED INTANGIBLES

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Key Learning Features

BRIDGE TO THE PROFESSION NEW to this edition, this section now includes FASB Codification References, Codification Exercises, and a Codification Research Case, all designed to refer students to the relevant FASB literature for key concepts in the text and provide assessment of their understanding.

REVIEW AND PRACTICE NEW Review and Practice section includes Key Terms Review, Learning Objectives Review, and a Practice Problem with Solution. In addition, multiple-choice questions with solutions, review exercises with solutions, and a full glossary of all key terms are available online.

LEARNING OBJECTIVES REVIEW 1 Describe the characteristics, valuation, and amortization of intangible assets. Intangible assets have two main

characteristics: (1) they lack physical existence, and (2) they are not financial instruments. In most cases, intangible assets provide services over a period of years and so are normally classified as long-term assets.

Intangibles are recorded at cost. Cost includes all acquisition costs and expenditures needed to make the intangible asset ready for its intended use. If intangibles are acquired in exchange for stock or other assets, the cost of the intangible is the fair value of the consideration given or the fair value of the intangible received, whichever is more clearly evident. When a company makes a “basket purchase” of several intangibles or a combination of intangibles and tangibles, it should allocate the cost on the basis of fair values.

Intangibles have either a limited useful life or an indefinite useful life. Companies amortize limited-life intangibles. They do not amortize indefinite-life intangibles. Limited-life intangibles should be amortized by systematic charges to expense over their useful life. The useful life should reflect the period over which these assets will contribute to cash flows. The amount

REVIEW AND PRACTICE KEY TERMS REVIEW

amortization, 613 bargain purchase, 622 business combination,

612(n) copyright, 616 development activities, 628 fair value test, 623

franchise, 617 goodwill, 619 impairment, 622 indefinite-life

intangibles, 613 intangible assets, 612 license (permit), 617

limited (finite)-life intangibles, 613

master valuation approach, 621

organizational costs, 631 patent, 617 recoverability test, 623

research activities, 628 research and development

(R&D) costs, 628 start-up costs, 631 trademark, trade name, 615

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PRACTICE PROBLEM

Sky Co., organized in 2017, provided you with the following information.

1. Purchased a license for $20,000 on July 1, 2017. The license gives Sky exclusive rights to sell its services in the tri-state region and will expire on July 1, 2025.

2. Purchased a patent on January 2, 2018, for $40,000. It is estimated to have a 5-year life. 3. Costs incurred to develop an exclusive Internet connection process as of June 1, 2018, were $45,000. The process has an

indefinite life. 4. On April 1, 2018, Sky purchased a small circuit board manufacturer for $350,000. Goodwill recorded in the transaction

was $90,000.

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USING YOUR JUDGMENT The Using Your Judgment section provides students with real-world homework problems covering topics such as financial reporting and financial statement analysis.

USING YOUR JUDGMENT

Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix B. The company’s complete annual report, including the notes to the financial statements, is available online.

Instructions Refer to P&G’s financial statements and the accompanying notes to answer the following questions.

(a) Does P&G report any intangible assets, especially goodwill, in its 2014 financial statements and accompanying notes? (b) How much research and development (R&D) cost was expensed by P&G in 2013 and 2014? What percentage of sales rev-

enue and net income did P&G spend on R&D in 2013 and 2014?

Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. The financial statements of Coca-Cola and PepsiCo are presented in Appendices C and D, respectively. The companies’ complete annual reports, including the notes to the financial statements, are available online.

Instructions Use the companies’ financial information to answer the following questions.

(a) (1) What amounts for intangible assets were reported in their respective balance sheets by Coca-Cola and PepsiCo at year-end 2014?

(2) What percentage of total assets is each of these reported amounts at year-end 2014? (3) What was the change in the amount of intangibles from 2013 to 2014 for Coca-Cola and PepsiCo?

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BRIDGE TO THE PROFESSION

FASB Codifi cation References [1] FASB ASC 350-10-05. [Predecessor literature: “Goodwill and Other Intangible Assets,” Statement of Financial Accounting

Standards No. 142 (Norwalk, Conn.: FASB, 2001).] [2] FASB ASC 350-30-35. [Predecessor literature: “Goodwill and Other Intangible Assets,” Statement of Financial Accounting

Standards No. 142 (Norwalk, Conn.: FASB, 2001), par. 11.] [3] FASB ASC 805-10. [Predecessor literature: “Business Combinations,” Statement of Financial Accounting Standards No. 141R

(Norwalk, Conn.: FASB, 2007).] [4] FASB ASC 350-30-35. [Predecessor literature: “Goodwill and Other Intangible Assets,” Statement of Financial Accounting

Standards No. 142 (Norwalk, Conn.: FASB, 2001), par. B55.] [5] FASB ASC 805-10-20. [Predecessor literature: “Business Combinations,” Statement of Financial Accounting Standards No.

141R (Norwalk, Conn.: FASB, 2007).] [6] FASB ASC 805-10-30. [Predecessor literature: “Business Combinations,” Statement of Financial Accounting Standards No.

141R (Norwalk, Conn.: FASB, 2007).] [7] FASB ASC 805-20-15. [Predecessor literature: None]

[8] FASB ASC 350 20 15 [Predecessor literature: None]

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IFRS INSIGHTS IFRS Insights offer students a detailed discussion and assessment material of international accounting standards at the end of each chapter.

IFRS Insights There are some significant differences between IFRS and GAAP in the accounting for both intan- gible assets and impairments. IFRS related to intangible assets is presented in IAS 38 (“Intangible Assets”). IFRS related to impairments is found in IAS 36 (“Impairment of Assets”).

RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to intangible assets.

Similarities • Like GAAP, under IFRS intangible assets (1) lack physical substance and (2) are not fi nancial

instruments. In addition, under IFRS an intangible asset is identifi able. To be identifi able, an intangible asset must either be separable from the company (can be sold or transferred) or it arises from a contractual or legal right from which economic benefi ts will fl ow to the company.

LEARNING OBJECTIVE 6 Compare the accounting for intangible assets under GAAP and IFRS.

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1 Financial Accounting and Accounting Standards 2

WE CAN DO BETTER 2

FINANCIAL REPORTING ENVIRONMENT 4

Accounting and Capital Allocation 4 What Do the Numbers Mean? It’s the

Accounting 5 Objective of Financial Reporting 5 What Do the Numbers Mean? Don’t Forget

Stewardship 6 The Need to Develop Standards 7

PARTIES INVOLVED IN STANDARD-SETTING 7

Securities and Exchange Commission (SEC) 7 American Institute of Certified Public

Accountants (AICPA) 9 Financial Accounting Standards Board (FASB) 9

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES 13

What Do the Numbers Mean? You Have to Step Back 13

FASB Codification 13

MAJOR CHALLENGES IN FINANCIAL REPORTING 15

GAAP in a Political Environment 15 Evolving Issue Fair Value, Fair Consequences? 16 The Expectations Gap 16 Financial Reporting Issues 17 International Accounting Standards 18 What Do the Numbers Mean? Can You

Do That? 20 Ethics in the Environment of Financial

Accounting 20 Conclusion 20

IFRS INSIGHTS 29

2 Conceptual Framework for Financial Reporting 36

WHAT IS IT? 36

CONCEPTUAL FRAMEWORK 38

Need for a Conceptual Framework 38 What Do the Numbers Mean? What’s Your

Principle? 39 Development of a Conceptual Framework 39 Overview of the Conceptual Framework 40

FIRST LEVEL: BASIC OBJECTIVE 40

SECOND LEVEL: FUNDAMENTAL CONCEPTS 41

Qualitative Characteristics of Accounting Information 41

What Do the Numbers Mean? Living in a Material World 44

What Do the Numbers Mean? Show Me the Earnings! 46 Basic Elements 48

THIRD LEVEL: RECOGNITION AND MEASUREMENT CONCEPTS 49

Basic Assumptions 50 What Do the Numbers Mean? Whose

Company Is It? 50 Basic Principles of Accounting 52 Cost Constraint 57 Summary of the Structure 58 What Do the Numbers Mean? Don’t

Count These Please 59

FASB CODIFICATION 73

IFRS INSIGHTS 74

3 The Accounting Information System 78

NEEDED: A RELIABLE INFORMATION SYSTEM 78

ACCOUNTING INFORMATION SYSTEM 80

Basic Terminology 80 Debits and Credits 81 The Accounting Equation 82 Financial Statements and Ownership

Structure 84 The Accounting Cycle 85

RECORD AND SUMMARIZE BASIC TRANSACTIONS 87

Journalizing 87 Posting 88 Trial Balance 92

ADJUSTING ENTRIES 92

Types of Adjusting Entries 93 Adjusting Entries for Deferrals 93 Adjusting Entries for Accruals 98 What Do the Numbers Mean?

Am I Covered? 103 Adjusted Trial Balance 104

PREPARING FINANCIAL STATEMENTS 104

What Do the Numbers Mean? 24/7 Accounting 106

Closing 106 Post-Closing Trial Balance 109 Reversing Entries—An Optional Step 109 The Accounting Cycle Summarized 110 What Do the Numbers Mean? Hey, It’s Complicated 110

Table of Contents

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FINANCIAL STATEMENTS FOR A MERCHANDISING COMPANY 110

Income Statement 110 Statement of Retained Earnings 111 Balance Sheet 111 What Do the Numbers Mean? Statements,

Please 113 Closing Entries 113

APPENDIX 3A: CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING 113

CONVERSION FROM CASH BASIS TO ACCRUAL BASIS 115

Service Revenue Computation 116 Operating Expense Computation 117

THEORETICAL WEAKNESSES OF THE CASH BASIS 118

APPENDIX 3B: USING REVERSING ENTRIES 119

ILLUSTRATION OF REVERSING ENTRIES— ACCRUALS 119

ILLUSTRATION OF REVERSING ENTRIES—DEFERRALS 120

SUMMARY OF REVERSING ENTRIES 121

APPENDIX 3C: USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED 121

WORKSHEET COLUMNS 121

Trial Balance Columns 121 Adjustments Columns 121

ADJUSTMENTS ENTERED ON THE WORKSHEET 123

Adjusted Trial Balance 123 Income Statement and Balance Sheet Columns 123

PREPARING FINANCIAL STATEMENTS FROM A WORKSHEET 124

IFRS INSIGHTS 147

4 Income Statement and Related Information 152

FINANCIAL STATEMENTS ARE CHANGING 152

INCOME STATEMENT 154

Usefulness of the Income Statement 154 Limitations of the Income Statement 154 Quality of Earnings 155 What Do the Numbers Mean? Four: The

Loneliest Number 156

FORMAT OF THE INCOME STATEMENT 156

Elements of the Income Statement 156 Intermediate Components of the

Income Statement 157 What Do the Numbers Mean? Top Line or

Bottom Line? 160 Condensed Income Statements 160 Single-Step Income Statements 161

REPORTING VARIOUS INCOME ITEMS 162

Unusual and Infrequent Gains and Losses 162 Discontinued Operations 164 Noncontrolling Interest 167 Earnings per Share 167 Summary of Various Income Items 169 What Do the Numbers Mean? Different Income

Concepts 169

OTHER REPORTING ISSUES 170

Accounting Changes and Errors 170 Retained Earnings Statement 172 Comprehensive Income 173 Evolving Issue Income Reporting 176

FASB CODIFICATION 194

IFRS INSIGHTS 195

5 Balance Sheet and Statement of Cash Flows 200

HEY, IT DOESN’T BALANCE! 200

BALANCE SHEET 202

Usefulness of the Balance Sheet 202 Limitations of the Balance Sheet 202 What Do the Numbers Mean? Grounded 203 Classification in the Balance Sheet 203 What Do the Numbers Mean? “Show Me the

Assets!” 210 What Do the Numbers Mean? Warning Signals 214 Balance Sheet Format 214

STATEMENT OF CASH FLOWS 216

What Do the Numbers Mean? Watch That Cash Flow 216

Purpose of the Statement of Cash Flows 217 Content and Format of the Statement

of Cash Flows 217 Preparation of the Statement of Cash Flows 218 Usefulness of the Statement of Cash Flows 221 What Do the Numbers Mean? “There Ought to Be a

Law” 223

ADDITIONAL INFORMATION 224

Supplemental Disclosures 224 What Do the Numbers Mean? What About Your

Commitments? 226 Techniques of Disclosure 227 Evolving Issue Balance Sheet Reporting:

Gross or Net? 230

APPENDIX 5A: RATIO ANALYSIS—A REFERENCE 231

USING RATIOS TO ANALYZE PERFORMANCE 231

FASB CODIFICATION 257

IFRS INSIGHTS 258

6 Accounting and the Time Value of Money 266

HOW DO I MEASURE THAT? 266

BASIC TIME VALUE CONCEPTS 268

Applications of Time Value Concepts 268 The Nature of Interest 269 Simple Interest 270 Compound Interest 270 What Do the Numbers Mean? A Pretty Good Start 271 Fundamental Variables 274

SINGLE-SUM PROBLEMS 274

Future Value of a Single Sum 275 Present Value of a Single Sum 276 Solving for Other Unknowns in Single-Sum Problems 278

ANNUITIES (FUTURE VALUE) 279

Future Value of an Ordinary Annuity 280 Future Value of an Annuity Due 282 What Do the Numbers Mean? Don't Wait to Make That

Contribution! 284 Examples of Future Value of Annuity Problems 284

ANNUITIES (PRESENT VALUE) 286

Present Value of an Ordinary Annuity 286 What Do the Numbers Mean? Up in Smoke 288 Present Value of an Annuity Due 288 Examples of Present Value of Annuity Problems 289

OTHER TIME VALUE OF MONEY ISSUES 291

Deferred Annuities 291 Valuation of Long-Term Bonds 293 Effective-Interest Method of Amortization of Bond

Discount or Premium 294 Present Value Measurement 295 What Do the Numbers Mean? How Low Can They Go? 297

FASB CODIFICATION 312

7 Cash and Receivables 324 LUCK OF THE IRISH 324

CASH 326

Reporting Cash 326 Summary of Cash-Related Items 328 What Do the Numbers Mean? Where Did I Park

My Cash? 329

RECEIVABLES 329

Recognition of Accounts Receivable 330 Valuation of Accounts Receivable 334

NOTES RECEIVABLE 338

Recognition of Notes Receivable 338 Valuation of Notes Receivable 342 What Do the Numbers Mean? Please Release Me? 343

SPECIAL ISSUES 343

Fair Value Option 344 Disposition of Accounts and Notes Receivable 344 What Do the Numbers Mean? Securitizations—

Good or Bad? 349 Presentation and Analysis 350 What Do the Numbers Mean? I'm Still Waiting 352

APPENDIX 7A: CASH CONTROLS 352

USING BANK ACCOUNTS 353

THE IMPREST PETTY CASH SYSTEM 353

PHYSICAL PROTECTION OF CASH BALANCES 355

RECONCILIATION OF BANK BALANCES 355

APPENDIX 7B: COLLECTABILITY ASSESSMENT BASED ON EXPECTED CASH FLOWS 358

MEASUREMENT OF COLLECTIBILITY 358

Example 358 Recording Bad Debts 359

FASB CODIFICATION 382

IFRS INSIGHTS 383

8 Valuation of Inventories: A Cost-Basis Approach 386

TO SWITCH OR NOT TO SWITCH 386

INVENTORY ISSUES 388

Classification 388 Inventory Cost Flow 389 Inventory Control 391 What Do the Numbers Mean? Staying Lean 392 Determining Cost of Goods Sold 392

GOODS AND COSTS INCLUDED IN INVENTORY 393

Goods Included in Inventory 393 What Do the Numbers Mean? No Parking! 395 Costs Included in Inventory 395 What Do the Numbers Mean? You May

Need a Map 397

WHICH COST FLOW ASSUMPTION TO ADOPT? 398

Specific Identification 398 Average-Cost 399 First-In, First-Out (FIFO) 400 Last-In, First-Out (LIFO) 401

SPECIAL ISSUES RELATED TO LIFO 402

LIFO Reserve 402 What Do the Numbers Mean? Comparing

Apples to Apples 403 LIFO Liquidation 403 Dollar-Value LIFO 405 What Do the Numbers Mean? Quite a Difference 410

xiii

Comparison of LIFO Approaches 410 Major Advantages of LIFO 411 Major Disadvantages of LIFO 412 Basis for Selection of Inventory Method 413 Evolving Issue Repeal LIFO! 415

EFFECT OF INVENTORY ERRORS 416

Ending Inventory Misstated 416 Purchases and Inventory Misstated 417

FASB CODIFICATION 441

9 Inventories: Additional Valuation Issues 442

NOT WHAT IT SEEMS TO BE 442

LOWER-OF-COST-OR-NET REALIZABLE VALUE 444

Definition of Net Realizable Value 444 Illustration of LCNRV 444 Methods of Applying LCNRV 445 Recording NRV Instead of Cost 446 Use of an Allowance 447 Use of an Allowance—Multiple Periods 447

LOWER-OF-COST-OR-MARKET 448

How Lower-of-Cost-or-Market Works 449 Methods of Applying Lower-of-Cost-or-Market 450 What Do the Numbers Mean? “Put It in Reverse” 451 Evaluation of the LCNRV and Lower-of-Cost-or-Market

Rules 451

OTHER VALUATION APPROACHES 452

Valuation at Net Realizable Value 452 Valuation Using Relative Sales Value 453 Purchase Commitments—A Special Problem 453

THE GROSS PROFIT METHOD OF ESTIMATING INVENTORY 455

Computation of Gross Profit Percentage 456 Evaluation of Gross Profit Method 458 What Do the Numbers Mean? The Squeeze 458

RETAIL INVENTORY METHOD 458

Retail-Method Concepts 459 Retail Inventory Method with Markups and Markdowns—

Conventional Method 460 What Do the Numbers Mean? Price Fixing 463 Special Items Relating to Retail Method 463 Evaluation of Retail Inventory Method 464

PRESENTATION AND ANALYSIS 464

Presentation of Inventories 464 Analysis of Inventories 465

APPENDIX 9A: LIFO RETAIL METHODS 466

STABLE PRICES—LIFO RETAIL METHOD 466

FLUCTUATING PRICES—DOLLAR-VALUE LIFO RETAIL METHOD 467

SUBSEQUENT ADJUSTMENTS UNDER DOLLAR-VALUE LIFO RETAIL 469

CHANGING FROM CONVENTIONAL RETAIL TO LIFO 470

FASB CODIFICATION 493

IFRS INSIGHTS 494

10 Acquisition and Disposition of Property, Plant, and Equipment 502

WATCH YOUR SPENDING 502

PROPERTY, PLANT, AND EQUIPMENT 504

Acquisition of Property, Plant, and Equipment 504 Self-Constructed Assets 506 Interest Costs During Construction 507 What Do the Numbers Mean? What’s in Your

Interest? 512 Observations 513

VALUATION OF PROPERTY, PLANT, AND EQUIPMENT 513

Cash Discounts 513 Deferred-Payment Contracts 513 Lump-Sum Purchases 514 Issuance of Stock 515 Exchanges of Nonmonetary Assets 516 What Do the Numbers Mean? About Those Swaps 521 Accounting for Contributions 521 Other Asset Valuation Methods 522

COSTS SUBSEQUENT TO ACQUISITION 522

What Do the Numbers Mean? Disconnected 523 Additions 524 Improvements and Replacements 524 Rearrangement and Reinstallation 525 Repairs 525 Summary of Costs Subsequent to Acquisition 526

DISPOSITION OF PROPERTY, PLANT, AND EQUIPMENT 526

Sale of Plant Assets 526 Involuntary Conversion 527 Miscellaneous Problems 527

FASB CODIFICATION 550

11 Depreciation, Impairments, and Depletion 552

HERE COME THE WRITE-OFFS 552

DEPRECIATION—A METHOD OF COST ALLOCATION 554

Factors Involved in the Depreciation Process 554 What Do the Numbers Mean? Alphabet Dupe 556 Methods of Depreciation 556

SPECIAL DEPRECIATION METHODS AND OTHER ISSUES 559

xiv

Special Depreciation Methods 559 What Do the Numbers Mean? Decelerating

Depreciation 561 Other Depreciation Issues 562 What Do the Numbers Mean? Depreciation Choices 565

IMPAIRMENTS 565

Recognizing Impairments 565 Measuring Impairments 566 Restoration of Impairment Loss 567 Impairment of Assets to Be Disposed Of 567

DEPLETION 568

Establishing a Depletion Base 569 Write-Off of Resource Cost 570 Estimating Recoverable Reserves 571 What Do the Numbers Mean? Reserve Surprise 571 Liquidating Dividends 571 Continuing Controversy 572 Evolving Issue Full-Cost or Successful-Efforts? 573

PRESENTATION AND ANALYSIS 573

Presentation of Property, Plant, Equipment, and Natural Resources 573

Analysis of Property, Plant, and Equipment 575

APPENDIX 11A: INCOME TAX DEPRECIATION 576

MODIFIED ACCELERATED COST RECOVERY SYSTEM 577

Tax Lives (Recovery Periods) 577 Tax Depreciation Methods 577 Example of MACRS 578

OPTIONAL STRAIGHT-LINE METHOD 579

TAX VERSUS BOOK DEPRECIATION 579

FASB CODIFICATION 600

IFRS INSIGHTS 601

12 Intangible Assets 610 IS THIS SUSTAINABLE? 610

INTANGIBLE ASSET ISSUES 612

Characteristics 612 Valuation 612 Amortization of Intangibles 613 What Do the Numbers Mean? Are All Brands the

Same? 614

TYPES OF INTANGIBLE ASSETS 614

Marketing-Related Intangible Assets 615 What Do the Numbers Mean? Keep Your Hands

Off My Intangible! 615 Customer-Related Intangible Assets 616 Artistic-Related Intangible Assets 616 Contract-Related Intangible Assets 617 Technology-Related Intangible Assets 617 What Do the Numbers Mean? Patent Battles 618

What Do the Numbers Mean? The Value of a Secret Formula 619

Goodwill 619

IMPAIRMENT AND PRESENTATION OF INTANGIBLE ASSETS 622

Impairment of Limited-Life Intangibles 623 Impairment of Indefinite-Life Intangibles Other Than

Goodwill 623 Impairment of Goodwill 624 Impairment Summary 625 What Do the Numbers Mean? Impairment Risk 625 Presentation of Intangible Assets 626

RESEARCH AND DEVELOPMENT COSTS 628

Identifying R&D Activities 628 Accounting for R&D Activities 629 What Do the Numbers Mean? Global R&D

Incentives 629 Costs Similar to R&D Costs 631 What Do the Numbers Mean? Branded 632 Presentation of Research and Development Costs 633 Evolving Issue Recognition of R&D and Internally

Generated Intangibles 634

FASB CODIFICATION 650

IFRS INSIGHTS 652

13 Current Liabilities and Contingencies 658

NOW YOU SEE IT, NOW YOU DON’T 658

CURRENT LIABILITIES 660

Accounts Payable 661 Notes Payable 661 Dividends Payable 663 Customer Advances and Deposits 663 Unearned Revenues 663 What Do the Numbers Mean? Microsoft’s Liabilities—

Good or Bad? 664 Sales Taxes Payable 665 Income Taxes Payable 665 Employee-Related Liabilities 666 Current Maturities of Long-Term Debt 671 Short-Term Obligations Expected to Be Refinanced 671 What Do the Numbers Mean? What About That Short-

Term Debt? 673

CONTINGENCIES 673

Gain Contingencies 673 Loss Contingencies 674 What Do the Numbers Mean? Frequent Flyers 680 Evolving Issue Greenhouse Gases: Let’s Be Standard-

Setters 682 What Do the Numbers Mean? More Disclosure,

Please 684

PRESENTATION AND ANALYSIS 684

Presentation of Current Liabilities 684 Presentation of Contingencies 686 Analysis of Current Liabilities 687 What Do the Numbers Mean? I’ll Pay You Later 688

FASB CODIFICATION 708

IFRS INSIGHTS 710

14 Long-Term Liabilities 718 GOING LONG 718

BONDS PAYABLE 720

Issuing Bonds 720 Types of Bonds 720 What Do the Numbers Mean? All About Bonds 721 Valuation and Accounting for Bonds Payable 722 What Do the Numbers Mean? How’s My Rating? 723 Extinguishment of Debt 730 What Do the Numbers Mean? Your Debt Is Killing My

Equity 731

LONG-TERM NOTES PAYABLE 731

Notes Issued at Face Value 732 Notes Not Issued at Face Value 732 Special Notes Payable Situations 734 Mortgage Notes Payable 737 Fair Value Option 737 What Do the Numbers Mean? Fair Value

Fun House 738

REPORTING AND ANALYZING LIABILITIES 739

Off-Balance-Sheet Financing 739 What Do the Numbers Mean? Obligated 741 Presentation and Analysis of Long-Term Debt 741

APPENDIX 14A: TROUBLED-DEBT RESTRUCTURING 743

SETTLEMENT OF DEBT 744

Transfer of Assets 744 Granting of Equity Interest 745

MODIFICATION OF TERMS 745

Example 1—No Gain for Debtor 746 Example 2—Gain for Debtor 748

CONCLUDING REMARKS 749

FASB CODIFICATION 767

IFRS INSIGHTS 768

15 Stockholders’ Equity 774 IT’S A GLOBAL MARKET 774

CORPORATE CAPITAL 776

Corporate Form 776 What Do the Numbers Mean? 1209 North Orange

Street 776

Components of Stockholders’ Equity 778 Issuance of Stock 779 What Do the Numbers Mean? The Case of the

Disappearing Receivable 783 Preferred Stock 783 What Do the Numbers Mean?

A Class (B) Act 785

REACQUISITION OF SHARES 786

What Do the Numbers Mean? Buybacks—Good or Bad? 787

Purchase of Treasury Stock 788 Sale of Treasury Stock 789 Retiring Treasury Stock 790

DIVIDEND POLICY 791

Financial Condition and Dividend Distributions 791 Types of Dividends 792 Stock Dividends and Stock Splits 795 What Do the Numbers Mean? Splitsville 798 What Do the Numbers Mean? Dividends Up, Dividends

Down 800

PRESENTATION AND ANALYSIS OF STOCKHOLDERS' EQUITY 800

Presentation 800 Analysis 802

APPENDIX 15A: DIVIDEND PREFERENCES AND BOOK VALUE PER SHARE 804

DIVIDEND PREFERENCES 804

BOOK VALUE PER SHARE 805

FASB CODIFICATION 826

IFRS INSIGHTS 827

16 Dilutive Securities and Earnings per Share 834

KICKING THE HABIT 834

DILUTIVE SECURITIES 836

Debt and Equity 836 Accounting for Convertible Debt 836 Convertible Preferred Stock 838 What Do the Numbers Mean? How Low Can

You Go? 839

STOCK WARRANTS 839

Stock Warrants Issued with Other Securities 840 Rights to Subscribe to Additional Shares 842 Evolving Issue Is That All Debt? 842

STOCK COMPENSATION PLANS 843

Measurement—Stock Compensation 844 What Do the Numbers Mean? What's the Debate

About? 845 Recognition—Stock Compensation 846 Restricted Stock 847

xvi

Employee Stock-Purchase Plans 849 Disclosure of Compensation Plans 849

BASIC EARNINGS PER SHARE 851

Earnings per Share—Simple Capital Structure 851 Comprehensive Example 854

DILUTED EARNINGS PER SHARE 855

Diluted EPS—Convertible Securities 856 Diluted EPS—Options and Warrants 858 Contingent Issue Agreement 859 Antidilution Revisited 859 EPS Presentation and Disclosure 860 What Do the Numbers Mean? Pro Forma EPS

Confusion 861 Summary of EPS Computation 862

APPENDIX 16A: ACCOUNTING FOR STOCK-APPRECIATION RIGHTS 863

SARS—SHARE-BASED EQUITY AWARDS 864

SARS—SHARE-BASED LIABILITY AWARDS 864

STOCK-APPRECIATION RIGHTS EXAMPLE 865

APPENDIX 16B: COMPREHENSIVE EARNINGS PER SHARE EXAMPLE 866

DILUTED EARNINGS PER SHARE 867

FASB CODIFICATION 889

IFRS INSIGHTS 890

17 Investments 898 WHAT TO DO? 898

INVESTMENTS IN DEBT SECURITIES 900

Debt Investment Classifications 900 Held-to-Maturity Securities 901 Available-for-Sale Securities 903 Trading Securities 907 What Do the Numbers Mean? To Have

and To Hold 908

INVESTMENTS IN EQUITY SECURITIES 908

Holdings of Less Than 20% 909 What Do the Numbers Mean? More Disclosure,

Please 912 Holdings Between 20% and 50% 912 Holdings of More Than 50% 914 What Do the Numbers Mean? Who’s in Control

Here? 914

OTHER FINANCIAL REPORTING ISSUES 915

Fair Value Option 915 Evolving Issue Fair Value Controversy 916 Impairment of Value 916 Reclassification Adjustments 918 Transfers Related to Debt Securities 921 Summary of Reporting Treatment of Securities 922

What Do The Numbers Mean? So You Think It Is Easy! 923

APPENDIX 17A: ACCOUNTING FOR DERIVATIVE INSTRUMENTS 923

DEFINING DERIVATIVES 924

WHO USES DERIVATIVES, AND WHY? 924

Producers and Consumers 924 Speculators and Arbitrageurs 925

BASIC PRINCIPLES IN ACCOUNTING FOR DERIVATIVES 926

Example of Derivative Financial Instrument— Speculation 926

Differences Between Traditional and Derivative Financial Instruments 929

DERIVATIVES USED FOR HEDGING 929

What Do the Numbers Mean? Risky Business 930 Fair Value Hedge 930 Cash Flow Hedge 932

OTHER REPORTING ISSUES 934

Embedded Derivatives 934 Qualifying Hedge Criteria 935 Summary of Derivatives Accounting 936

COMPREHENSIVE HEDGE ACCOUNTING EXAMPLE 937

Fair Value Hedge 937 Financial Statement Presentation of an Interest Rate

Swap 939

CONTROVERSY AND CONCLUDING REMARKS 940

APPENDIX 17B: FAIR VALUE DISCLOSURES 941

DISCLOSURE OF FAIR VALUE INFORMATION: FINANCIAL INSTRUMENTS 941

DISCLOSURE OF FAIR VALUES: IMPAIRED ASSETS OR LIABILITIES 944

CONCLUSION 944

FASB CODIFICATION 965

IFRS INSIGHTS 966

18 Revenue Recognition 978 IT’S BACK 978

FUNDAMENTALS OF REVENUE RECOGNITION 980

Background 980 New Revenue Recognition Standard 980 Overview of the Five-Step Process—Boeing

Example 981 Extended Example of the Five-Step Process:

BEAN 982

THE FIVE-STEP PROCESS REVISITED 986

Identifying the Contract with Customers—Step 1 986 Identifying Separate Performance Obligations—

Step 2 987

xvii

Determining the Transaction Price—Step 3 988 Allocating the Transaction Price to Separate Performance

Obligations—Step 4 992 Recognizing Revenue When (or as) Each Performance

Obligation Is Satisfied—Step 5 994 Summary 995

ACCOUNTING FOR REVENUE RECOGNITION ISSUES 996

Sales Returns and Allowances 996 Repurchase Agreements 999 Bill-and-Hold Arrangements 1001 Principal-Agent Relationships 1001 Consignments 1002 What Do the Numbers Mean? Grossed Out 1004 Warranties 1004 Nonrefundable Upfront Fees 1006 Summary 1006

PRESENTATION AND DISCLOSURE 1007

Presentation 1007 Disclosure 1011 Evolving Issue Revenue: “It’s Like An

Octopus” 1012

APPENDIX 18A: LONG-TERM CONSTRUCTION CONTRACTS 1013

REVENUE RECOGNITION OVER TIME 1013

Percentage-of-Completion Method 1014 Completed-Contract Method 1019 Long-Term Contract Losses 1020

APPENDIX 18B: REVENUE RECOGNITION FOR FRANCHISES 1023

FRANCHISE ACCOUNTING 1024

RECOGNITION OF FRANCHISE RIGHTS REVENUE OVER TIME 1026

FASB CODIFICATION 1050

19 Accounting for Income Taxes 1052

HEY–LET’S PAY MORE INCOME TAXES! 1052

FUNDAMENTALS OF ACCOUNTING FOR INCOME TAXES 1054

Future Taxable Amounts and Deferred Taxes 1055 What Do the Numbers Mean?

“Real Liabilities” 1059 Future Deductible Amounts and

Deferred Taxes 1059 What Do the Numbers Mean? “Real Assets” 1062 Deferred Tax Asset—Valuation Allowance 1063

ADDITIONAL CONSIDERATIONS 1064

Income Statement Presentation 1064

Specific Differences 1064 Tax Rate Considerations 1067 What Do the Numbers Mean? Global Tax Rates 1068

ACCOUNTING FOR NET OPERATING LOSSES 1069

Loss Carryback 1069 Loss Carryforward 1070 Loss Carryback Example 1070 Loss Carryforward Example 1071 What Do the Numbers Mean? NOLs:

Good News or Bad? 1075

FINANCIAL STATEMENT PRESENTATION 1076

Balance Sheet 1076 Note Disclosure 1076 What Do the Numbers Mean? Imagination at Work 1077 Income Statement 1078 Evolving Issue Uncertain Tax Positions 1081 The Asset-Liability Method 1081

APPENDIX 19A: COMPREHENSIVE EXAMPLE OF INTERPERIOD TAX ALLOCATION 1083

FIRST YEAR—2016 1083

Taxable Income and Income Taxes Payable—2016 1084

Computing Deferred Income Taxes— End of 2016 1085

Deferred Tax Expense (Benefit) and the Journal Entry to Record Income Taxes—2016 1086

Financial Statement Presentation—2016 1086

SECOND YEAR—2017 1087

Taxable Income and Income Taxes Payable—2017 1088

Computing Deferred Income Taxes—End of 2017 1088 Deferred Tax Expense (Benefit) and the Journal Entry to

Record Income Taxes—2017 1089 Financial Statement Presentation—2017 1089

FASB CODIFICATION 1109

IFRS INSIGHTS 1110

20 Accounting for Pensions and Postretirement Benefits 1116

WHERE HAVE ALL THE PENSIONS GONE? 1116

FUNDAMENTALS OF PENSION PLAN ACCOUNTING 1118

Defined Contribution Plan 1119 Defined Benefit Plan 1119 What Do the Numbers Mean? Which Plan

Is Right for You? 1120 The Role of Actuaries in Pension Accounting 1121 Measures of the Liability 1121 What Do the Numbers Mean? Roller Coaster 1123 Components of Pension Expense 1123

xviii

USING A PENSION WORKSHEET 1126

2017 Entries and Worksheet 1127 Funded Status 1128

PRIOR SERVICE COST (PSC) 1128

Amortization 1128 2018 Entries and Worksheet 1130

GAINS AND LOSSES 1131

Smoothing Unexpected Gains and Losses on Plan Assets 1131

What Do the Numbers Mean? Pension Costs Ups and Downs 1132

Smoothing Unexpected Gains and Losses on the Pension Liability 1132

Corridor Amortization 1133 Evolving Issue Bye Bye Corridor 1136 2019 Entries and Worksheet 1136

REPORTING PENSION PLANS IN FINANCIAL STATEMENTS 1138

Within the Financial Statements 1138 Within the Notes to the Financial Statements 1140 Example of Pension Note Disclosure 1142 2020 Entries and Worksheet—A Comprehensive

Example 1143 Special Issues 1144 What Do the Numbers Mean? Who Guarantees the

Guarantor? 1146 Concluding Observations 1148

APPENDIX 20A: ACCOUNTING FOR POSTRETIREMENT BENEFITS 1148

ACCOUNTING GUIDANCE 1148

DIFFERENCES BETWEEN PENSION BENEFITS AND HEALTHCARE BENEFITS 1149

What Do the Numbers Mean? OPEBs—How Big Are They? 1150

POSTRETIREMENT BENEFITS ACCOUNTING PROVISIONS 1150

Obligations Under Postretirement Benefits 1150 Postretirement Expense 1151

ILLUSTRATIVE ACCOUNTING ENTRIES 1152

2017 Entries and Worksheet 1152 Recognition of Gains and Losses 1153 2018 Entries and Worksheet 1154 Amortization of Net Gain or Loss in 2019 1155

DISCLOSURES IN NOTES TO THE FINANCIAL STATEMENTS 1155

ACTUARIAL ASSUMPTIONS AND CONCEPTUAL ISSUES 1157

What Do the Numbers Mean? Want Some Bad News? 1157

FASB CODIFICATION 1179

IFRS INSIGHTS 1180

21 Accounting for Leases 1194 MORE COMPANIES ASK, “WHY BUY?” 1194

THE LEASING ENVIRONMENT 1196

Who Are the Players? 1196 Advantages of Leasing 1198 What Do the Numbers Mean? Off-Balance-Sheet

Financing 1199 Conceptual Nature of a Lease 1199

ACCOUNTING BY THE LESSEE 1200

Capitalization Criteria 1201 Asset and Liability Accounted for Differently 1204 Capital Lease Method (Lessee) 1204 Operating Method (Lessee) 1207 What Do the Numbers Mean? Restatements on the

Menu 1207 Comparison of Capital Lease with Operating Lease 1208 Evolving Issue Are You Liable? 1209

ACCOUNTING BY THE LESSOR 1210

Economics of Leasing 1210 Classification of Leases by the Lessor 1211 Direct-Financing Method (Lessor) 1212 Operating Method (Lessor) 1215

SPECIAL LEASE ACCOUNTING PROBLEMS 1215

Residual Values 1216 What Do the Numbers Mean? Residual Value

Regret 1222 Sales-Type Leases (Lessor) 1222 What Do the Numbers Mean? Xerox

Takes on the SEC 1224 Bargain-Purchase Option (Lessee) 1225 Initial Direct Costs (Lessor) 1225 Current versus Noncurrent 1226 Disclosing Lease Data 1227 Unresolved Lease Accounting Problems 1228 Evolving Issue Lease Accounting—If It Quacks

Like a Duck 1230

APPENDIX 21A: SALE-LEASEBACKS 1231

DETERMINING ASSET USE 1231

Lessee 1232 Lessor 1232

SALE-LEASEBACK EXAMPLE 1232

FASB CODIFICATION 1254

IFRS INSIGHTS 1256

22 Accounting Changes and Error Analysis 1266

IN THE DARK 1266

ACCOUNTING CHANGES 1268

xix

Background 1268 Changes in Accounting Principle 1268 What Do the Numbers Mean? Quite a Change 1270 What Do the Numbers Mean? Change Management 1272 Impracticability 1280

OTHER ACCOUNTING CHANGES 1281

Changes in Accounting Estimates 1281 What Do the Numbers Mean? A Change for the

Better? 1283 Changes in Reporting Entity 1283

ACCOUNTING ERRORS 1284

What Do the Numbers Mean? Can I Get My Money Back? 1286

Example of Error Correction 1286 Summary of Accounting Changes and

Correction of Errors 1288 What Do the Numbers Mean? What’s Your

Motivation? 1289

ERROR ANALYSIS 1290

Balance Sheet Errors 1291 Income Statement Errors 1291 Balance Sheet and Income Statement Errors 1291 Comprehensive Example: Numerous Errors 1294 What Do the Numbers Mean? Guard the Financial

Statements! 1296 Preparation of Financial Statements with Error

Corrections 1297

APPENDIX 22A: CHANGING FROM OR TO THE EQUITY METHOD 1299

CHANGE FROM THE EQUITY METHOD 1299

Dividends in Excess of Earnings 1299

CHANGE TO THE EQUITY METHOD 1300

FASB CODIFICATION 1325

IFRS INSIGHTS 1326

23 Statement of Cash Flows 1330 SHOW ME THE MONEY! 1330

STATEMENT OF CASH FLOWS 1332

Usefulness of the Statement of Cash Flows 1332 Classification of Cash Flows 1333 What Do the Numbers Mean? How’s My

Cash Flow? 1334 Format of the Statement of Cash Flows 1335

PREPARING THE STATEMENT OF CASH FLOWS 1335

Illustrations—Tax Consultants Inc. 1336 What Do the Numbers Mean? Earnings and Cash Flow

Management? 1338 Sources of Information for the Statement of

Cash Flows 1346

Net Cash Flow from Operating Activities—Direct Method 1346

Evolving Issue Direct versus Indirect 1352

SPECIAL PROBLEMS IN STATEMENT PREPARATION 1353

Adjustments to Net Income 1353 Accounts Receivable (Net) 1356 What Do the Numbers Mean? Not What It Seems 1358 Other Working Capital Changes 1358 Net Losses 1359 Significant Noncash Transactions 1360 What Do the Numbers Mean? Better Than ROA? 1361

USE OF A WORKSHEET 1361

Preparation of the Worksheet 1362 Analysis of Transactions 1363 Preparation of Final Statement 1369

FASB CODIFICATION 1395

IFRS INSIGHTS 1396

24 Full Disclosure in Financial Reporting 1402

HIGH-QUALITY FINANCIAL REPORTING—ALWAYS IN FASHION 1402

FULL DISCLOSURE PRINCIPLE 1404

Increase in Reporting Requirements 1405 Differential Disclosure 1405 Evolving Issue Disclosure—Quantity and Quality 1406 Notes to the Financial Statements 1407 What Do the Numbers Mean? Footnote Secrets 1409

DISCLOSURE ISSUES 1409

Disclosure of Special Transactions or Events 1409 Post-Balance-Sheet Events (Subsequent Events) 1411 Reporting for Diversified (Conglomerate)

Companies 1413 Interim Reports 1417 Evolving Issue It’s Faster but Is It Better? 1423

AUDITOR’S AND MANAGEMENT’S REPORTS 1423

Auditor’s Report 1423 What Do the Numbers Mean? Heart of the Matter 1426 Management’s Reports 1427

CURRENT REPORTING ISSUES 1428

Reporting on Financial Forecasts and Projections 1428 What Do the Numbers Mean? Global Forecasts 1430 Internet Financial Reporting 1431 Fraudulent Financial Reporting 1432 What Do the Numbers Mean? Disclosure Overload 1434 Criteria for Making Accounting and Reporting

Choices 1435

APPENDIX 24A: BASIC FINANCIAL STATEMENT ANALYSIS 1435

PERSPECTIVE ON FINANCIAL STATEMENT ANALYSIS 1436

RATIO ANALYSIS 1437

Limitations of Ratio Analysis 1437

COMPARATIVE ANALYSIS 1439

PERCENTAGE (COMMON-SIZE) ANALYSIS 1440

FASB CODIFICATION 1460

IFRS INSIGHTS 1461

APPENDIX A Private Company Accounting A-1

THE PRIVATE COMPANY COUNCIL (PCC) A-1

Background on the PCC A-1 Private Company Decision-Making Framework A-1 PCC Accomplishments A-2

PRIVATE COMPANY ALTERNATIVES FOR INTANGIBLE ASSETS AND GOODWILL A-2

Accounting for Identifiable Intangible Assets A-2 Accounting for Goodwill A-4

SUMMARY A-6

APPENDIX B Specimen Financial Statements: The Procter & Gamble Company B-1

APPENDIX C Specimen Financial Statements: The Coca-Cola Company C-1

APPENDIX D Specimen Financial Statements: PepsiCo, Inc. D-1

APPENDIX E Specimen Financial Statements: Marks and Spencer plc E-1

Index I-1

xxi

xxii

Intermediate Accounting has benefited greatly from the input of focus group participants, manuscript reviewers, those who have sent comments by letter or e-mail, ancillary authors, and proofers. We greatly appreciate the constructive suggestions and innovative ideas of reviewers and the creativity and accuracy of the ancillary authors and checkers.

Melissa Aldredge Northwestern State University Elsie Ameen Sam Houston State University Sean Andre York College of Pennsylvania Jack Armitage University of Nebraska—Omaha Avinash Arya William Paterson University Jane Baldwin Baylor University

Kristin Bauer Financial Accounting Standards Board

Robert Bloom John Carroll University George Boland Queen’s University Eric Bostwick University of West Florida Naat Briscoe Northwestern State University D. Jeffrey Brothers University of Denver Stephen Brown University of Maryland Deanna Burgess Florida Gulf Coast University Andy Call Arizona State University Chuck Campbell University of British Columbia Suzanne Cansler University of Connecticut Karen Castro-González University of Puerto Rico Kam Chan Pace University Paul Cheney Vanderbilt University Xiaoyan Cheng University of Nebraska—Omaha Dhiman Chowdhury Dhaka University

Ming Lu Chun Santa Monica College Hyeesoo Chung California State University—Long Beach Lamine Conteh Saint Leo University Kelvie Crabb University of Kansas Ken Dalton University of Nevada—Las Vegas Robert Davis Canisius College Julie Dawson Carthage College Passard Dean Saint Leo University Alex Debbink Ernst & Young Andrew DeJoseph Nassau Community College Kristine Del Vecchio University of South Florida Shawna Denny Lipscomb University Mike Dugan Georgia Regents University Susetta Emery York College of Pennsylvania Cole Engel Fort Hays State University David Farber University of Texas at El Paso Barbara Farrell Pace University Linda Flaming Monmouth University Paul Foote California State University—Fullerton James Fuehrmeyer University of Notre Dame Kristen Fuhremann University of Wisconsin—Madison Pam Graybeal University of Central Florida

Tony Greig University of Wisconsin—Madison Elaine Guenthner Northern Kentucky University Amy Haas Kingsborough Community College Lizhong Hao California State University—Fresno John Hassell Kelley School of Business—Indianapolis Pamela Hillman Gateway Technical College Ken House Belmont University Pei-Hui Hsu California State University—East Bay Allen Hunt Western Kentucky University Kim Hurt Central Community College Dave Hurtt Baylor University Anthony Hurwitz UCLA Extension Christine Irujo Westfi eld State University Emil Jirik Gustavus Adolphus College Joseph Johnson University of Central Florida

Burch Kealey University of Nebraska—Omaha Marsha Keune University of Dayton Kate Konetzke PricewaterhouseCoopers Lisa Koonce University of Texas Lee Krueger UCLA Extension David Krug Johnson County Community College Jeffrey Kunz Carroll University

Acknowledgments

Prior Edition Reviewers We greatly appreciate the over 300 reviewers who have assisted with the prior editions of Intermediate Accounting. These instructors have been invaluable in the development and continued improvement of our textbook.

Sixteenth Edition

xxiii

Melissa Larson Brigham Young University Cynthia Lovick Austin Community College Daphne Main Loyola University New Orleans Leslie Mandel Fairleigh Dickinson University Anthony Masino East Tennessee State University Katie Maxwell University of Arizona Gerald Miller College of New Jersey Sally Mitzel Sheridan College Michael Motes University of Maryland University College

John Naegle University of Kansas R.D. Nair University of Wisconsin—Madison Sia Nassiripour William Paterson University Randy Nicholls Red Deer College Curt Norton Arizona State University Derek Oler Texas Tech University Steve Orpurt Arizona State University Alison Parker Camosun College Glenn Pate Palm Beach State College Denise Patterson California State University—Fresno Milo Peck Fairfi eld University Charles Pendola St Joseph’s University (NYC) Alee Phillips University of Kansas Catherine Plante University of New Hampshire Martha Pointer East Tennessee State University Theresa Presley Kansas State University Mark Riley Northern Illinois University Tracey Riley Suffolk University Francisco Roman George Mason University Eric Rothenburg Kingsborough Community College Martin Rudnick William Paterson University Mike Ruff Bentley College August Saibeni Los Rios Community College

Arpita Shroff Texas A&M University—Corpus Christi Tom Skogland Deloitte

Douglas Smith University of Montevallo Larry Stephens Austin Community College Ronald Stoltzfus Eastern Mennonite University Dan Teed Troy University

Walter Teets Gonzaga University

Tom Tierney University of Wisconsin—Madison John Valenzuela California State University—Long Beach Troy Vornholt Oglethorpe University Kat Walden Southern New Hampshire University Patricia Walters Texas Christian University Larry Walther Utah State University Suzanne Wright Pennsylvania State University Jialin Yin University of Wisconsin—Madison Brian York PricewaterhouseCoopers

Steve Zeff Rice University Mary Zenner College of Lake County Haiwen Zhang Ohio State University Special thanks to Kurt Pany, Arizona State University, for his input on auditor disclo- sure issues, and to Stephen A. Zeff, Rice University, for his comments on international accounting.

In addition, we thank the following colleagues who contributed to several of the unique features of this edition.

Codification Cases Katie Adler Deloitte LLP, Chicago Jack Cathey University of North Carolina—Charlotte Erik Frederickson Madison, Wisconsin Danielle Griffin KPMG, Chicago Jason Hart Deloitte LLP, Milwaukee Frank Heflin Florida State University Mike Katte SC Johnson, Racine, WI

Kelly Krieg Ernst & Young, Milwaukee Jeremy Kunicki Walgreens Courtney Meier Deloitte LLP, Milwaukee Andrew Prewitt KPMG, Chicago Jeff Seymour KPMG, Minneapolis Matt Sullivan Northwestern Mutual Matt Tutaj Deloitte LLP, Chicago Jen Vaughn PricewaterhouseCoopers, Chicago Erin Viel PricewaterhouseCoopers, Milwaukee

Ancillary Authors, Contributors, Proofers, and Accuracy Checkers Ellen Bartely St. Joseph’s University (NYC) LuAnn Bean Florida Institute of Technology Jack Borke University of Wisconsin—Platteville Melodi Bunting Edgewood College Bea Chiang The College of New Jersey Susetta Emery York College of Pennsylvania Jim Emig Villanova University Larry Falcetto Emporia State University Kim Hurt Central Community College Derek Jackson St. Mary’s University of Minnesota Mark Kohlbeck Florida Atlantic University Cynthia Lovick Austin Community College Kirk Lynch Sandhills Community College Anthony Masino East Tennessee University Jill Misuraca University of Tampa Barb Muller Arizona State University Alison Parker Camosun College Yvonne Phang Borough of Manhattan Community College Laura Prosser Blackhills State University Mark Riley Northern Illinois University

Alice Sineath University of Maryland University College Lynn Stallworth Appalachian State University Sheila Viel University of Wisconsin—Milwaukee Dick Wasson Southwestern College Suzanne Wright Pennsylvania State University Lori Zaher Bucks County Community College

Advisory Board We gratefully acknowledge the following members of the Intermediate Accounting Advisory Board for their advice and assis- tance with this edition. Barbara Durham University of Central Florida Pamela Graybeal University of Central Florida Jeffery Hales Georgia Institute of Technology Melissa Larson Brigham Young University—Provo

Ming Lu Santa Monica College Linda Matuszewski Northern Illinois University Kevin Rich Marquette University Angela Spencer Oklahoma State University—Stillwater

Practicing Accountants and Business Executives From the fields of corporate and public accounting, we owe thanks to the following practitioners for their technical advice and for consenting to interviews. Mike Crooch FASB (retired) Tracy Golden Deloitte LLP John Gribble PricewaterhouseCoopers (retired) Darien Griffin S.C. Johnson & Son

Michael Lehman Sun Microsystems, Inc. Tom Linsmeier FASB Michele Lippert Evoke.com Sue McGrath Vision Capital Management David Miniken Sweeney Conrad Robert Sack University of Virginia Clare Schulte Deloitte LLP Willie Sutton Mutual Community Savings Bank, Durham, NC Lynn Turner former SEC Chief Accountant Rachel Woods PricewaterhouseCoopers Arthur Wyatt Arthur Andersen & Co., and the University of Illinois—Urbana

Finally, we appreciate the exemplary support and professional com- mitment given us by the development, marketing, production, and editorial staffs of John Wiley & Sons, including the following: George Hoffman, Michael McDonald, Emily McGee, Rebecca Costantini, Valerie Vargas, Allie Morris, Greg Chaput, Harry Nolan, and Maureen Eide. Thanks, too, to Jackie Henry and the staff at Aptara®, Inc. for their work on the textbook, and the staff at SPI Global for their work on the solutions manual.

We also appreciate the cooperation of the American Institute of Certified Public Accountants and the Financial Accounting Standards Board in permitting us to quote from their pronouncements. We also acknowledge permission from the American Institute of Certified

Public Accountants, the Institute of Management Accountants, and the Institute of Internal Auditors to adapt and use material from the Uniform CPA Examinations, the CMA Examinations, and the CIA Examinations, respectively.

Suggestions and comments from users of this book will be appreciated. Please feel free to e-mail any one of us at [email protected].

Donald E. Kieso Jerry J. Weygandt Terry D. Warfield Somonauk, Illinois Madison, Wisconsin Madison, Wisconsin

xxiv

WE CAN DO BETTER A recent report says it best: “Accounting information is central to the functioning of international capital mar- kets and to managing small businesses, conducting effective government, understanding business processes, and . . . how economic decisions are made. . . . Across the globe, a common characteristic of economies that flourish is the presence of reliable accounting information.”

Many in the United States take pride in our system of financial reporting as being the most robust and transparent in the world. But most would also comment that we can do better, particularly in light of the many accounting scandals that have occurred at companies like AIG, WorldCom, and Lehman Brothers, and the financial crisis of 2008.

To better understand where we are today, the Center for Audit Quality conducts a yearly survey that measures investor confidence in such categories as U.S. capital markets, audited financial information, and U.S. publicly traded companies. As shown in the chart on the right, the results indicate that the 2008 financial crisis took a bite out of investor confidence. While investor confidence in U.S. markets has stabi- lized, it has not returned to pre-crisis levels. So the question is, how can we improve? Here are some possibilities on how we can enhance the existing system of financial reporting.

1. Today, equity securities are broadly held, with approxi- mately half of American households investing in stocks. This presents a challenge—investors have expressed con- cerns that one-size-fi ts-all fi nancial reports do not meet the needs of the spectrum of investors who rely on those reports. While many individual investors are more interested in summarized, plain-English reports, mar- ket analysts and other investment professionals may desire information at a far more detailed level than is currently provided. Technology may help customize the information that the different types of investors desire.

2. Companies also express concerns with the complexity of the fi nancial reporting system. Companies assert that when preparing fi nancial reports, it is diffi cult to ensure compliance with the voluminous and com- plex requirements contained in U.S. GAAP and SEC reporting rules. This is a particularly heavy burden on smaller, non-public companies, which may have fewer resources to comply with the wide range of rules.

3. We also need to consider the broader array of information that investors need to make informed decisions. As some have noted, the percentage of a company’s market value that can be attributed to accounting book value has declined signifi cantly from the days of a bricks-and-mortar economy. Thus, we may want to

1 1 Understand the financial reporting

environment.

2 Identify the major policy-setting bodies and their role in the standard-setting process.

3 Explain the meaning of generally accepted accounting principles (GAAP) and the role of the Codification for GAAP.

4 Describe major challenges in the financial reporting environment.

Financial Accounting and Accounting Standards LEARNING OBJECTIVES After studying this chapter, you should be able to:

90%

2007 2008 2009 2010 2011 2012 2013 2014 2015

Confidence in Capital Markets

consider a more comprehensive business reporting model, including both fi nancial and nonfi nan- cial key performance indicators.

4. Finally, we must also consider how to deliver all of this information in a timelier manner. In a world where messages can be sent across the world in a blink of an eye, it is ironic that the analysis of fi nancial information is still subject to many manual processes, resulting in delays, increased costs, and errors.

Thus, improving financial reporting involves more than simply trimming or reworking the existing accounting literature. In some cases, major change is already underway. For example:

• The FASB and IASB are working on a convergence project, which will contribute to less-complex, more- understandable standards in the important areas of revenue recognition, leasing, and financial instruments.

• Standard-setters are exploring expanded reporting of key performance indicators, including reports on sustain- ability and a disclosure framework project to improve the effectiveness of disclosures to clearly communicate the information that is most important to users of financial statements. This project, combined with the intro- duction of a private-company reporting framework, could go a long way to address one-size-fits-all challenges.

• The SEC now requires the delivery of financial reports using eXtensible Business Reporting Language (XBRL). Reporting through XBRL allows timelier reporting via the Internet and allows statement users to transform accounting reports to meet their specific needs.

Each of these projects will hopefully support improvements in the quality of financial reporting and increase confidence in U.S. capital markets.

Sources: Adapted from The Pathways Commission, “Charting a National Strategy for the Next Generation of Accountants” (AAA, AICPA, July 2012); Conrad W. Hewitt, “Opening Remarks Before the Initial Meeting of the SEC Advisory Committee on Improvements to Financial Reporting,” U.S. Securities and Exchange Commission, Washington, D.C. (August 2, 2007); and Center for Audit Quality, Main Street Investor Survey (September 2015). See www.fasb.org for updates on FASB/IASB conver- gence, disclosure, and private company decision-making projects.

PREVIEW OF CHAPTER 1 As our opening story indicates, the U.S. system of financial reporting has long been the most robust and transparent in the world. However, to ensure that it continues to provide the most relevant and reliable financial information to users, a number of financial reporting issues must be resolved. These issues include such matters as evalu- ating global standards, increasing fair value reporting, and meeting multiple user needs. This chap- ter explains the environment of financial reporting and the many factors affecting it, as follows.

FINANCIAL ACCOUNTING AND ACCOUNTING STANDARDS

This chapter also includes numerous conceptual and international discussions that are integral to the topics presented here.

FINANCIAL REPORTING ENVIRONMENT

• Accounting and capital allocation

• Objective of financial reporting

• Need to develop standards

PARTIES INVOLVED IN STANDARD-SETTING

• Securities and Exchange Commission

• American Institute of CPAs

• Financial Accounting Standards Board

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

• FASB Codification

MAJOR CHALLENGES IN FINANCIAL REPORTING

• Political environment • Expectations gap • Financial reporting issues • International accounting

standards • Ethics

REVIEW AND PRACTICE Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary review and practice problem with solution. Multiple-choice questions with annotated solutions as well as additional exercises and practice problem with solutions are also available online.

4 Chapter 1 Financial Accounting and Accounting Standards

FINANCIAL REPORTING ENVIRONMENT The essential characteristics of accounting are (1) the identification, measurement, and communication of financial information about (2) economic entities to (3) interested parties. Financial accounting is the process that culminates in the preparation of finan- cial reports on the enterprise for use by both internal and external parties. Users of these financial reports include investors, creditors, managers, unions, and government agen- cies. In contrast, managerial accounting is the process of identifying, measuring, ana- lyzing, and communicating financial information needed by management to plan, con- trol, and evaluate a company’s operations.

Financial statements are the principal means through which a company communi- cates its financial information to those outside it. These statements provide a company’s history quantified in money terms. The financial statements most frequently provided are (1) the balance sheet, (2) the income statement, (3) the statement of cash flows, and (4) the statement of owners’ or stockholders’ equity. Note disclosures are an integral part of each financial statement.

Some financial information is better provided, or can be provided only, by means of financial reporting other than formal financial statements. Examples include the president’s letter or supplementary schedules in the corporate annual report, pro- spectuses, reports filed with government agencies, news releases, management’s forecasts, and social or environmental impact statements. Companies may need to provide such information because of authoritative pronouncement, regulatory rule, or custom. Or they may supply it because management wishes to disclose it voluntarily.

In this textbook, we focus on the development of two types of financial information: (1) the basic financial statements and (2) related disclosures.

Accounting and Capital Allocation Resources are limited. As a result, people try to conserve them and ensure that they are used effectively. Efficient use of resources often determines whether a business thrives. This fact places a substantial burden on the accounting profession.

Accountants must measure performance accurately and fairly on a timely basis, so that the right managers and companies are able to attract investment capital. For example, relevant and reliable financial information allows investors and creditors to compare the income and assets employed by such companies as Nike, McDonald’s, Microsoft, and Berkshire Hathaway. Because these users can assess the relative return and risks associated with investment opportunities, they channel resources more effectively. Illustration 1-1 shows how this process of capital allocation works.

LEARNING OBJECTIVE 1 Understand the financial reporting environment.

ILLUSTRATION 1-1 Capital Allocation Process

The financial information a company provides to help users with capital allocation decisions about the company.

Investors and creditors use financial reports to make their capital allocation decisions.

Users (present and potential)

The process of determining how and at what cost money is allocated among competing interests.

Financial Reporting Capital Allocation

An effective process of capital allocation is critical to a healthy economy. It promotes productivity, encourages innovation, and provides an efficient and liquid market for buying and selling securities and obtaining and granting credit. Unreliable and

Financial Reporting Environment 5

irrelevant information leads to poor capital allocation, which adversely affects the secu- rities markets.

“It’s the accounting.” That’s what many investors seem to be saying these days. Even the slightest hint of any accounting irregularity at a company leads to a subsequent pounding of the company’s stock price. For example, the Wall Street Jour- nal has run the following headlines related to accounting and its effects on the economy:

• Stocks take a beating as accounting woes spread beyond Enron.

• Quarterly reports from IBM and Goldman Sachs sent stocks tumbling.

• VeriFone fi nds accounting issues; stock price cut in half.

• Bank of America admits hiding debt.

• Facebook, Zynga, Groupon: IPO drops due to account- ing, not valuation.

It now has become clear that investors must trust the accounting numbers, or they will abandon the market and put their resources elsewhere. With investor uncertainty, the cost of capital increases for companies who need additional resources. In short, relevant and reliable fi nancial information is necessary for markets to be effi cient.

WHAT DO THE NUMBERS MEAN? IT’S THE ACCOUNTING

1Chapter 1, “The Objective of General Purpose Financial Reporting,” and Chapter 3, “Qualitative Character- istics of Useful Financial Information,” Statement of Financial Accounting Concepts No. 8 (Norwalk, Conn.: FASB, September 2010), par. OB2.

UNDERLYING CONCEPTS

While the objective of fi nancial reporting is focused on investors and creditors, fi nancial statements may still meet the needs of others.

Objective of Financial Reporting What is the objective (or purpose) of financial reporting? The objective of general- purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other cred- itors in decisions about providing resources to the entity. Those decisions involve buy- ing, selling, or holding equity and debt instruments, and providing or settling loans and other forms of credit. Information that is decision-useful to capital providers (investors) may also be helpful to other users of financial reporting who are not investors. Let’s examine each of the elements of this objective.1

General-Purpose Financial Statements General-purpose financial statements provide financial reporting information to a wide variety of users. For example, when The Hershey Company issues its financial statements, these statements help shareholders, creditors, suppliers, employees, and regulators to better understand its financial position and related performance. Her- shey’s users need this type of information to make effective decisions. To be cost-effec- tive in providing this information, general-purpose financial statements are most appro- priate. In other words, general-purpose financial statements provide at the least cost the most useful information possible.

Equity Investors and Creditors The objective of financial reporting identifies investors and creditors as the primary users for general-purpose financial statements. Identifying investors and creditors as the primary users provides an important focus of general-purpose financial reporting. For example, when Hershey issues its financial statements, its primary focus is on inves- tors and creditors because they have the most critical and immediate need for informa- tion in financial reports. Investors and creditors need this financial information to assess Hershey’s ability to generate net cash inflow and to understand management’s ability to protect and enhance the assets of the company, which will be used to generate future

6 Chapter 1 Financial Accounting and Accounting Standards

net cash inflows. As a result, the primary user groups are not management, regulators, or some other non-investor group.

Entity Perspective As part of the objective of general-purpose financial reporting, an entity perspective is adopted. Companies are viewed as separate and distinct from their owners (present shareholders) using this perspective. The assets of Hershey are viewed as assets of the company and not of a specific creditor or shareholder. Rather, these investors have claims on Hershey’s assets in the form of liability or equity claims. The entity perspec- tive is consistent with the present business environment where most companies engaged in financial reporting have substance distinct from their investors (both shareholders and creditors). Thus, a perspective that financial reporting should be focused only on the needs of shareholders—often referred to as the proprietary perspective—is not con- sidered appropriate.

In addition to providing decision-useful information about future cash fl ows, management also is accountable to investors for the custody and safekeeping of the company’s economic resources and for their effi cient and profi table use. For example, the management of The Hershey Company has the responsi- bility for protecting its economic resources from unfavorable

effects of economic factors, such as price changes, and tech- nological and social changes. Because Hershey’s performance in discharging its responsibilities (referred to as its stewardship responsibilities) usually affects its ability to generate net cash infl ows, fi nancial reporting may also provide decision-useful information to assess management performance in this role.

WHAT DO THE NUMBERS MEAN? DON’T FORGET STEWARDSHIP

Decision-Usefulness Investors are interested in financial reporting because it provides information that is useful for making decisions (referred to as the decision-usefulness approach). As indi- cated earlier, when making these decisions, investors are interested in assessing (1) the company’s ability to generate net cash inflows and (2) management’s ability to protect and enhance the capital providers’ investments. Financial reporting should therefore help investors assess the amounts, timing, and uncertainty of prospective cash inflows from dividends or interest, and the proceeds from the sale, redemption, or maturity of securities or loans. In order for investors to make these assessments, the economic resources of an enterprise, the claims to those resources, and the changes in them must be understood. Financial statements and related explanations should be a primary source for determining this information.

The emphasis on “assessing cash flow prospects” does not mean that the cash basis is preferred over the accrual basis of accounting. Information based on accrual account- ing better indicates a company’s present and continuing ability to generate favorable cash flows than does information limited to the financial effects of cash receipts and payments.

Recall from your first accounting course the objective of accrual-basis accounting: It ensures that a company records events that change its financial statements in the periods in which the events occur, rather than only in the periods in which it receives or pays cash. Using the accrual basis to determine net income means that a company recognizes revenues when it provides the goods or services rather than when it receives cash. Similarly, it recognizes expenses when it incurs them rather than when it pays them. Under accrual accounting, a company generally recognizes revenues

Source: Chapter 1, “The Objective of General Purpose Financial Reporting,” and Chapter 3, “Qualitative Characteristics of Useful Financial Information,” Statement of Financial Accounting Concepts No. 8 (Norwalk, Conn.: FASB, September 2010), paras. OB4–OB10.

Parties Involved in Standard-Setting 7

when it makes sales. The company can then relate the revenues to the economic envi- ronment of the period in which they occurred. Over the long run, trends in revenues and expenses are generally more meaningful than trends in cash receipts and disbursements.2

The Need to Develop Standards The main controversy in setting accounting standards is, “Whose rules should we play by, and what should they be?” The answer is not immediately clear. Users of financial accounting statements have both coinciding and conflicting needs for information of various types. To meet these needs, and to satisfy the stewardship reporting responsibil- ity of management, companies prepare a single set of general-purpose financial state- ments. Users expect these statements to present fairly, clearly, and completely the com- pany’s financial operations.

The accounting profession has attempted to develop a set of standards that are generally accepted and universally practiced. Otherwise, each company would have to develop its own standards. Further, readers of financial statements would have to familiarize themselves with every company’s peculiar accounting and reporting practices. It would be almost impossible to prepare statements that could be compared.

This common set of standards and procedures is called generally accepted account- ing principles (GAAP). The term “generally accepted” means either that an authorita- tive accounting rule-making body has established a principle of reporting in a given area or that over time a given practice has been accepted as appropriate because of its universal application.3 Although principles and practices continue to provoke both debate and criticism, most members of the financial community recognize them as the standards that over time have proven to be most useful. We present a more extensive discussion of what constitutes GAAP later in this chapter.

PARTIES INVOLVED IN STANDARD-SETTING Three organizations are instrumental in the development of financial accounting stan- dards (GAAP) in the United States:

1. Securities and Exchange Commission (SEC) 2. American Institute of Certifi ed Public Accountants (AICPA) 3. Financial Accounting Standards Board (FASB)

Securities and Exchange Commission (SEC) External financial reporting and auditing developed in tandem with the growth of the industrial economy and its capital markets. However, when the stock market crashed in 1929 and the nation’s economy plunged into the Great Depression, there were calls for increased government regulation of business, especially financial institutions and the stock market.

As a result of these events, the federal government established the Securities and Exchange Commission (SEC) to help develop and standardize financial information

2As used here, cash flow means “cash generated and used in operations.” The term cash flows also frequently means cash obtained by borrowing and used to repay borrowing, cash used for investments in resources and obtained from the disposal of investments, and cash contributed by or distributed to owners. 3The terms principles and standards are used interchangeably in practice and throughout this textbook.

UNDERLYING CONCEPTS

Preparing fi nancial statements according to accepted account- ing standards contrib- utes to the compa- rability of accounting information.

INTERNATIONAL PERSPECTIVE

The International Organization of Securities Commissions (IOSCO), established in 1987, consists of more than 100 securities regulatory agencies or securities exchanges from all over the world. Collectively, its members represent a substantial proportion of the world’s capital markets. The SEC is a member of IOSCO.

LEARNING OBJECTIVE 2 Identify the major policy- setting bodies and their role in the standard- setting process.

8 Chapter 1 Financial Accounting and Accounting Standards

presented to stockholders. The SEC is a federal agency. It administers the Securities Exchange Act of 1934 and several other acts. Most companies that issue securities to the public or are listed on a stock exchange are required to file audited financial state- ments with the SEC. In addition, the SEC has broad powers to prescribe, in whatever detail it desires, the accounting practices and standards to be employed by companies that fall within its jurisdiction. The SEC currently exercises oversight over 12,000 com- panies that are listed on the major exchanges (e.g., the New York Stock Exchange and the Nasdaq).

Public/Private Partnership At the time the SEC was created, no group—public or private—issued accounting stan- dards. The SEC encouraged the creation of a private standard-setting body because it believed that the private sector had the appropriate resources and talent to achieve this daunting task. As a result, accounting standards have developed in the private sector either through the American Institute of Certified Public Accountants (AICPA) or the Financial Accounting Standards Board (FASB).

The SEC has affirmed its support for the FASB by indicating that financial state- ments conforming to standards set by the FASB are presumed to have substantial authoritative support. In short, the SEC requires registrants to adhere to GAAP. In addition, the SEC indicated in its reports to Congress that “it continues to believe that the initiative for establishing and improving accounting standards should remain in the private sector, subject to Commission oversight.”

SEC Oversight The SEC’s partnership with the private sector works well. The SEC acts with remarkable restraint in the area of developing accounting standards. Generally, the SEC relies on the FASB to develop accounting standards.

The SEC’s involvement in the development of accounting standards varies. In some cases, the SEC rejects a standard proposed by the private sector. In other cases, the SEC prods the private sector into taking quicker action on certain reporting problems, such as accounting for investments in debt and equity securities and the reporting of deriva- tive instruments. In still other situations, the SEC communicates problems to the FASB, responds to FASB exposure drafts, and provides the FASB with counsel and advice upon request.

The SEC’s mandate is to establish accounting principles. The private sector, there- fore, must listen carefully to the views of the SEC. In some sense, the private sector is the formulator and the implementor of the standards.4 However, when the private sector fails to address accounting problems as quickly as the SEC would like, the partnership between the SEC and the private sector can be strained. This occurred in the delibera- tions on the accounting for business combinations and intangible assets. It is also high- lighted by concerns over the accounting for off-balance-sheet, special purpose entities. Examples include the failure of Enron and the subprime crises that led to the failure of IndyMac Bank.

Enforcement As we indicated earlier, companies listed on a stock exchange must submit their finan- cial statements to the SEC. If the SEC believes that an accounting or disclosure

4One writer described the relationship of the FASB and SEC and the development of financial reporting standards using the analogy of a pearl. The pearl (a financial reporting standard) “is formed by the reaction of certain oysters (FASB) to an irritant (the SEC)—usually a grain of sand—that becomes embedded inside the shell. The oyster coats this grain with layers of nacre, and ultimately a pearl is formed. The pearl is a joint result of the irritant (SEC) and oyster (FASB); without both, it cannot be created.” John C. Burton, “Government Regulation of Accounting and Information,” Journal of Accoun- tancy (June 1982).

INTERNATIONAL PERSPECTIVE

The U.S. legal system is based on English com- mon law, whereby the government generally allows professionals to make the rules. The private sector, therefore, develops these rules (standards). Conversely, some countries have followed codifi ed law, which leads to government-run accounting systems.

Parties Involved in Standard-Setting 9

irregularity exists regarding the form or content of the financial statements, it sends a deficiency letter to the company. Companies usually resolve these deficiency letters quickly. If disagreement continues, the SEC may issue a “stop order,” which prevents the registrant from issuing or trading securities on the exchanges. The Department of Justice may also file criminal charges for violations of certain laws. The SEC process, private sector initiatives, and civil and criminal litigation help to ensure the integrity of financial reporting for public companies.

American Institute of Certifi ed Public Accountants (AICPA) The American Institute of Certified Public Accountants (AICPA), which is the national professional organization of practicing Certified Public Accountants (CPAs), has been an important contributor to the development of GAAP. Various committees and boards established since the founding of the AICPA have contributed to this effort.

Committee on Accounting Procedure At the urging of the SEC, the AICPA appointed the Committee on Accounting Proce- dure in 1939. The Committee on Accounting Procedure (CAP) composed of practicing CPAs, issued 51 Accounting Research Bulletins during the years 1939 to 1959. These bulletins dealt with a variety of accounting problems. But this problem-by-problem approach failed to provide the needed structured body of accounting principles. In response, in 1959 the AICPA created the Accounting Principles Board.

Accounting Principles Board The major purposes of the Accounting Principles Board (APB) were to (1) advance the written expression of accounting principles, (2) determine appropriate practices, and (3) narrow the areas of difference and inconsistency in practice. To achieve these objectives, the APB’s mission was twofold: to develop an overall conceptual framework to assist in the resolution of problems as they become evident and to substantively research individ- ual issues before the AICPA issued pronouncements. The Board’s 18 to 21 members, selected primarily from public accounting, also included representatives from industry and academia. The Board’s official pronouncements, called APB Opinions, were intended to be based mainly on research studies and be supported by reason and analysis. Between its inception in 1959 and its dissolution in 1973, the APB issued 31 opinions.

Unfortunately, the APB came under fire early, charged with lack of productivity and failing to act promptly to correct alleged accounting abuses. Later, the APB tackled numer- ous thorny accounting issues, only to meet a buzz saw of opposition from industry and CPA firms. It also ran into occasional governmental interference. In 1971, the accounting profes- sion’s leaders, anxious to avoid governmental rule-making, appointed a Study Group on Establishment of Accounting Principles. Commonly known as the Wheat Committee for its chair Francis Wheat, this group examined the organization and operation of the APB and determined the necessary changes to attain better results. The Study Group submitted its recommendations to the AICPA Council in the spring of 1972, which led to the replacement of the APB with the Financial Accounting Standards Board (FASB) in 1973.

Financial Accounting Standards Board (FASB) The Wheat Committee’s recommendations resulted in the creation of a new standard- setting structure composed of three organizations—the Financial Accounting Founda- tion (FAF), the Financial Accounting Standards Board (FASB), and the Financial Accounting Standards Advisory Council (FASAC). The Financial Accounting Founda- tion selects the members of the FASB and the Advisory Council, funds their activities, and generally oversees the FASB’s activities.

The major operating organization in this three-part structure is the Financial Accounting Standards Board (FASB). Its mission is to establish and improve standards

10 Chapter 1 Financial Accounting and Accounting Standards

of financial accounting and reporting for the guidance and education of the public, which includes issuers, auditors, and users of financial information. The expectations of success and support for the new FASB relied on several significant differences between it and its predecessor, the APB:

1. Smaller membership. The FASB consists of seven members, replacing the relatively large 18-member APB.

2. Full-time, remunerated membership. FASB members are well-paid, full-time mem- bers appointed for renewable 5-year terms. The APB members volunteered their part-time work.

3. Greater autonomy. The APB was a senior committee of the AICPA. The FASB is not part of any single professional organization. It is appointed by and answerable only to the Financial Accounting Foundation.

4. Increased independence. APB members retained their private positions with fi rms, companies, or institutions. FASB members must sever all such ties.

5. Broader representation. All APB members were required to be CPAs and members of the AICPA. Currently, it is not necessary to be a CPA to be a member of the FASB.

In addition to research help from its own staff, the FASB relies on the expertise of vari- ous task force groups formed for various projects and on the Financial Accounting Stan- dards Advisory Council (FASAC). The FASAC consults with the FASB on major policy and technical issues and also helps select task force members. Illustration 1-2 shows the current organizational structure for the development of financial reporting standards.5

5Other advisory groups, such as the Investors Technical Advisory Committee (ITAC), the Not-for-Profit Advisor Committee (NAC), the Valuation Resource Group (VRG), and the recently established Private Company Council (PCC), share their views and experience with the Board on matters related to projects on the Board’s agenda, from the perspective of various constituencies and/or in areas of specific expertise.

ILLUSTRATION 1-2 Organizational Structure for Setting Accounting Standards

To establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information.

Purpose

Financial Accounting Standards Board (FASB)

Purpose

Financial Accounting Foundation (FAF)

To select members of the FASB and their Advisory Councils, fund their activities, and exercise general oversight.

To assist Board on reporting issues by performing research, analysis, and writing functions.

Purpose

Staff and Task Forces

To consult on major policy issues, technical issues, project priorities, and selection and organization of task forces.

Purpose

Financial Accounting Standards Advisory Council (FASAC)

Parties Involved in Standard-Setting 11

ILLUSTRATION 1-3 The Due Process System of the FASB

Topics identified and placed on Board's agenda.

Research and analysis conducted and preliminary views of pros and cons issued.

Board evaluates research and public response and issues exposure draft.

Board evaluates responses and changes exposure draft, if necessary. Final standard issued.

Public hearing on proposed standard.

What do you think?

. . . .

... ......

"Any more comments? This will be your final chance."

Exposure Draft

Accounting Standards Update

"Here is GAAP."

Accounting Standards Update

Preliminary Views

xxxxxxxxxxxxxxxx

xxxxxxxxxx xxxxxxxxxx xxxxxxxxxx xxxxxxxxxx xxxxxxxxxx

xxxxxxxxxxxxxxxx xxxxxxxxxxxxxxxx

xxxxxxxxxx xxxxxxxxxx xxxxxxxxxx xxxxxxxxxx xxxxxxxxxx

xxxxxxxxxxxxxxxx

Topic A Topic B

Topic C

Pros Cons

Due Process In establishing financial accounting standards, the FASB relies on two basic prem- ises. (1) The FASB should be responsive to the needs and viewpoints of the entire eco- nomic community, not just the public accounting profession. (2) It should operate in full view of the public through a “due process” system that gives interested persons ample opportunity to make their views known. To ensure the achievement of these goals, the FASB follows specific steps to develop a typical FASB pronouncement, as Illustration 1-3 shows.

FINANCIAL ACCOUNTING SERIES

Financial Accounting Standards Board of the Financial Accounting Foundation

ACCOUNTING STANDARDS UPDATE

Accounting for Own-Share Lending Arrangements in Contemplation of Convertable

Debt Issuance or Other Financing

a consensus of the FASB Emerging Issues Task Force

An Amendment of the FASB Accounting Standards CodificationTM

No. 2009−15 October 2009

FASB

The passage of new FASB guidance in the form of an Accounting Standards Update requires the support of four of the seven Board members. FASB pronouncements are considered GAAP and thereby binding in practice. All ARBs and APB Opinions imple- mented by 1973 (when the FASB formed) continue to be effective until amended or superseded by FASB pronouncements. In recognition of possible misconceptions of the term “principles,” the FASB uses the term financial accounting standards in its pronouncements.

Types of Pronouncements The FASB issues two major types of pronouncements:

1. Accounting Standards Updates 2. Financial Accounting Concepts

Accounting Standards Updates. The FASB issues accounting pronouncements through Accounting Standards Updates (Updates). These Updates amend the Accounting Stan- dards Codification, which represents the source of authoritative accounting standards, other than standards issued by the SEC. (We discuss the Codification in more detail later in the chapter.) Each Update explains how the Codification has been amended and also includes information to help the reader understand the changes and when those changes will be effective. Common forms of amendments are accounting standards issued that address a broad area of accounting practice (such as the accounting for leases) or

12 Chapter 1 Financial Accounting and Accounting Standards

interpretations that modify or extend existing standards. Prior standard-setters such as the APB also issued interpretations of APB Opinions.

A second type of Update is a consensus of the Emerging Issues Task Force (EITF), created in 1984 by the FASB. The EITF provides implementation guidance within the framework of the Codification to reduce diversity in practice on a timely basis. The EITF was designed to minimize the need for the FASB to spend time and effort addressing narrow implementation, application, or other emerging issues that can be analyzed within existing GAAP. Examples include accounting for pension plan terminations, rev- enue from barter transactions by Internet companies, and excessive amounts paid to takeover specialists. The EITF also provided timely guidance for the accounting for loans and investments in the wake of the credit crisis.

The EITF helps the FASB in many ways. The EITF identifies controversial account- ing problems as they arise. The EITF determines whether it can quickly resolve them or whether to involve the FASB in solving them. In essence, it becomes a “problem filter” for the FASB. Thus, the FASB will hopefully work on more pervasive long-term prob- lems, while the EITF deals with short-term emerging issues.

We cannot overestimate the importance of the EITF. In one year, for example, the task force examined 61 emerging financial reporting issues and arrived at a consen- sus on approximately 75 percent of them. The FASB reviews and approves all EITF consensuses. And the SEC indicated that it will view consensus solutions as pre- ferred accounting. Further, it requires persuasive justification for departing from them.

Financial Accounting Concepts. As part of a long-range effort to move away from the problem-by-problem approach, the FASB in November 1978 issued the first in a series of Statements of Financial Accounting Concepts as part of its conceptual framework project. (The Concepts Statements can be accessed at http://www.fasb.org/.) The series sets forth fundamental objectives and concepts that the Board uses in developing future standards of financial accounting and reporting. The Board intends to form a cohesive set of interrelated concepts—a conceptual framework—that will serve as tools for solving existing and emerging problems in a consistent manner. Unlike an Accounting Standards Update, a Statement of Financial Accounting Concepts does not establish GAAP. Concepts statements, however, pass through the same due proc- ess system (preliminary views, public hearing, exposure draft, etc.) as do standards updates.

Changing Role of the AICPA At one time, the AICPA developed accounting standards, which were considered GAAP. The role of the AICPA in standard-setting is now diminished. The FASB and the AICPA agreed that the AICPA should no longer issue authoritative guidance for public companies. The AICPA does have a Financial Reporting Executive Committee (FinREC), which is authorized to make public statements on behalf of the AICPA on financial reporting matters. The mission of FinREC is to determine the AICPA’s tech- nical policies regarding financial reporting standards, with the ultimate purpose of serving the public interest by improving financial reporting. FinREC also issues audit and accounting guides, which address particular areas in financial reporting that require attention, such as specialized accounting practices, significant or unique accounting issues, and unique regulatory considerations within the construction, casino, and airline industries. These guides provide specific direction on matters not addressed by the FASB.

Furthermore, while the AICPA has been the leader in developing auditing standards through its Auditing Standards Board, the Sarbanes-Oxley Act requires the Public Company Accounting Oversight Board to oversee the development of auditing stan- dards. The AICPA continues to develop and grade the CPA examination, which is administered in all 50 states.

Financial Accounting Series

Statement of Financial Accounting

Concepts No. 6 Elements of Financial Statements

a replacement of FASB Concepts Statement No. 3 (incorporating an amendment of

FASB Concepts Statement No. 2)

APO 145 I12903NVDUS

INTERNATIONAL PERSPECTIVE

The CPA exam is ad- ministered internation- ally at testing sites in Bahrain, Kuwait, Japan, Lebanon, United Arab Emirates (UAE), and Brazil. The CPA exam now has some cover- age of IFRS knowledge as part of the fi nancial reporting section of the exam (see www.aicpa. org/cpa-exam).

Generally Accepted Accounting Principles 13

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES Generally accepted accounting principles (GAAP) have substantial authoritative sup- port. The AICPA’s Code of Professional Conduct requires that members prepare finan- cial statements in accordance with GAAP. Specifically, Rule 203 of this Code prohibits a member from expressing an unqualified opinion on financial statements that contain a material departure from generally accepted accounting principles.

What is GAAP? The major sources of GAAP come from the organizations discussed earlier in this chapter. It is composed of a mixture of over 2,000 documents that have been developed over the last 70 years or so. It includes APB Opinions, FASB Standards, and AICPA Research Bulletins. In addition, the FASB has issued interpretations and FASB Staff Positions that modified or extended existing standards. The APB also issued inter- pretations of APB Opinions. Both types of interpretations are considered authoritative for purposes of determining GAAP.

LEARNING OBJECTIVE 3 Explain the meaning of generally accepted accounting principles (GAAP) and the role of the Codification for GAAP.

Should the accounting profession have principles-based stan- dards or rules-based standards? Critics of the profession today say that over the past three decades, standard-setters have moved away from broad accounting principles aimed at ensur- ing that companies’ fi nancial statements are fairly presented.

Instead, these critics say, standard-setters have moved toward drafting voluminous rules that, if technically followed in “check-box” fashion, may shield auditors and companies from legal liability. That has resulted in companies creating complex capital structures that comply with GAAP but hide

billions of dollars of debt and other obligations. To add fuel to the fi re, the chief accountant of the enforcement division of the SEC noted, “One can violate SEC laws and still comply with GAAP.”

In short, what he is saying is that it is not enough just to check the boxes. This point was reinforced by the chief accountant of the SEC, who remarked that judgments should result in “accounting that refl ects the substance of the transaction, as well as being in accordance with the literature.” That is, you have to exercise judg- ment in applying GAAP to achieve high-quality reporting.

WHAT DO THE NUMBERS MEAN? YOU HAVE TO STEP BACK

FASB Codifi cation Historically, the documents that comprised GAAP varied in format, completeness, and structure. In some cases, these documents were inconsistent and difficult to interpret. As a result, financial statement preparers sometimes were not sure whether they had the right GAAP. Determining what was authoritative and what was not became difficult.

In response to these concerns, the FASB developed the Financial Accounting Stan- dards Board Accounting Standards Codification (or more simply, “the Codification”). The FASB’s primary goal in developing the Codification is to provide in one place all the authoritative literature related to a particular topic. This will simplify user access to all authoritative U.S. generally accepted accounting principles. The Codification changes the way GAAP is documented, presented, and updated. It explains what GAAP is and elimi- nates nonessential information such as redundant document summaries, basis for conclu- sion sections, and historical content. In short, the Codification integrates and synthesizes existing GAAP; it does not create new GAAP. It creates one level of GAAP, which is con- sidered authoritative. All other accounting literature is considered non-authoritative.6

6The FASB Codification can be accessed at http://asc.fasb.org/home. Access to the full functionality of the Codifica- tion Research System requires a subscription. Reduced-price academic access is available through the American Accounting Association (see aaahq.org/FASB/Access.cfm). Prior to the Codification, the profession relied on FASB 162, “The Hierarchy of Generally Accepted Accounting Principles,” which defined the meaning of generally accepted accounting principles. In that document, certain documents were deemed more authoritative than others, which led to various levels of GAAP. Fortunately, the Codification does not have different levels of GAAP.

Sources: Adapted from S. Liesman, “SEC Accounting Cop’s Warning: Playing by the Rules May Not Head Off Fraud Issues,” Wall Street Journal (Febru- ary 12, 2002), p. C7. See also “Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System,” SEC (July 25, 2003); and E. Orenstein, “Accounting as Art vs. Science, and the Role of Professional Judgment,” Accounting Matters, FEI Financial Reporting Blog (November 2009).

14 Chapter 1 Financial Accounting and Accounting Standards

To provide easy access to this Codification, the FASB also developed the Financial Accounting Standards Board Codification Research System (CRS). CRS is an online, real-time database that provides easy access to the Codification. The Codification and the related CRS provide a topically organized structure, subdivided into topic, subtop- ics, sections, and paragraphs, using a numerical index system.

For purposes of referencing authoritative GAAP material in this textbook, we will use the Codification framework. Here is an example of how the Codification framework is cited, using receivables as the example. The purpose of the search shown below is to determine GAAP for accounting for loans and trade receivables not held for sale subse- quent to initial measurement.

Topic Go to FASB ASC 310 to access the Receivables topic. Subtopics Go to FASB ASC 310-10 to access the Overall Subtopic of the

Topic 310. Sections Go to FASB ASC 310-10-35 to access the Subsequent Measurement

Section of the Subtopic 310-10. Paragraph Go to FASB ASC 310-10-35-47 to access the Loans and Trade Receiv-

ables not Held for Sale paragraph of Section 310-10-35.

Illustration 1-4 shows the Codification framework graphically.

ILLUSTRATION 1-4 FASB Codifi cation Framework

47—Loans and Trade Receivables Not Held for Sale

Paragraphs This level is where you will find the substantive content related to the issue researched. (All other levels exist essentially to find the material related to the paragraph level content.)

Sections Indicate the type of content in a subtopic, such as initial measurement. In some cases, subsections are used but not numbered.

Subtopics Subset of a topic and distinguished by type or scope. For example, overall and troubled-debt restructurings are two subtopics of receivables.

Topic Provides a collection of related guidance on a given subject, such as receivables or leases.

35—Subsequent Measurement

30—Initial Measurement

40—Troubled-Debt Restructurings by

Creditors 10—Overall

310—Receivables

What happens if the Codification does not cover a certain type of transaction or event? In that case, other accounting literature should be considered, such as FASB Con- cept Statements, international financial reporting standards, and other professional lit- erature. This will happen only rarely.

The expectations for the Codification are high. It is hoped that the Codification will enable users to better understand what GAAP is. As a result, the time to research accounting issues and the risk of noncompliance with GAAP will be reduced,

Major Challenges in Financial Reporting 15

sometimes substantially. In addition, the Web-based format will make updating easier, which will help users stay current with GAAP.7

For individuals (like you) attempting to learn GAAP, the Codification will be invalu- able. It streamlines and simplifies how to determine what GAAP is, which will lead to better financial accounting and reporting. We provide references to the Codification throughout this textbook, using a numbering system. For example, a bracket with a number, such as [1], indicates that the citation to the FASB Codification can be found in the Bridge to the Profes- sion section at the end of the chapter.

MAJOR CHALLENGES IN FINANCIAL REPORTING Since the implementation of GAAP may affect many interests, much discussion occurs about who should develop GAAP and to whom it should apply. We discuss some of the major issues below.

GAAP in a Political Environment User groups are possibly the most powerful force influencing the development of GAAP. User groups consist of those most interested in or affected by accounting rules. Like lobbyists in our state and national capitals, user groups play a significant role. GAAP is as much a product of political action as it is of careful logic or empirical findings. User groups may want particular economic events accounted for or reported in a particular way, and they fight hard to get what they want. They know that the most effective way to influence GAAP is to participate in the formulation of these rules or to try to influence or persuade the formulator of them.

These user groups often target the FASB, to pressure it to influence changes in the exist- ing rules and the development of new ones.8 In fact, these pressures have been multiplying. Some influential groups demand that the accounting profession act more quickly and deci- sively to solve its problems. Other groups resist such action, preferring to implement change more slowly, if at all. Illustration 1-5 shows the various user groups that apply pressure.

See the Bridge to the Profession section at the end of each chapter for Codifi cation references, exercises, and a research case.

7To increase the usefulness of the Codification for public companies, relevant authoritative content issued by the SEC is included in the Codification. In the case of SEC content, an “S” precedes the section number. 8FASB board members acknowledged that they undertook many of the Board’s projects, such as “Account- ing for Contingencies,” “Accounting for Pensions,” “Statement of Cash Flows,” and “Recognition and Measurement of Financial Assets and Liabilities,” due to political pressure.

LEARNING OBJECTIVE 4 Describe major chal- lenges in the financial reporting environment.

Generally Accepted Accounting Principles

FASB

Financial community (analysts, bankers, etc.)

Government (SEC, IRS, other agencies)

Industry associations

CPAs and accounting firms

AICPA (FinREC)

Academicians

Investing public

Business entities

Preparers (e.g., Financial Executives Institute)

ILLUSTRATION 1-5 User Groups that Infl uence the Formulation of Accounting Standards

16 Chapter 1 Financial Accounting and Accounting Standards

Should there be politics in establishing GAAP for financial accounting and report- ing? Why not? We have politics at home; at school; at the fraternity, sorority, and dormi- tory; at the office; and at church, temple, and mosque. Politics is everywhere. GAAP is part of the real world, and it cannot escape politics and political pressures.

That is not to say that politics in establishing GAAP is a negative force. Considering the economic consequences9 of many accounting rules, special interest groups should vocalize their reactions to proposed rules. What the Board should not do is issue pro- nouncements that are primarily politically motivated. While paying attention to its con- stituencies, the Board should base GAAP on sound research and a conceptual frame- work that has its foundation in economic reality.

9Economic consequences means the impact of accounting reports on the wealth positions of issuers and users of financial information, and the decision-making behavior resulting from that impact. The resulting behavior of these individuals and groups could have detrimental financial effects on the providers of the financial information. See Stephen A. Zeff, “The Rise of ’Economic Consequences’,” Journal of Accountancy (December 1978), pp. 56–63. We extend appreciation to Professor Zeff for his insights on this chapter. 10Sarbanes-Oxley Act of 2002, H. R. Rep. No. 107-610 (2002).

No recent accounting issue better illustrates the economic consequences of accounting than the current debate over the use of fair value accounting for fi nancial assets. Both the FASB and the International Accounting Standards Board (IASB) have standards requiring the use of fair value accounting for fi nancial assets, such as investments and other fi nancial instruments. Fair value provides the most relevant and reliable information for investors about these assets and liabilities. However, in the wake of the credit crisis of 2008, some countries, their central banks, and bank regulators want to suspend fair value account- ing, based on concerns that use of fair value accounting, which calls for recording signifi cant losses on poorly performing loans and investments, could scare investors and depositors and lead to a “run on the bank.”

For example, in 2009, Congress ordered the FASB to change its accounting rules so as to reduce the losses banks reported, as the values of their securities had crumbled. These changes were generally supported by banks. But these changes produced a strong reaction from some investors, with one investor group complaining that the changes would “effec- tively gut the transparent application of fair value measure- ment.” The group also says suspending fair value accounting would delay the recovery of the banking system.

Such political pressure on accounting standard-setters is not confi ned to the United States. For example, French Presi- dent Nicolas Sarkozy urged his European Union counterparts to back changes to accounting rules and give banks and insur- ers some breathing space amid the market turmoil. And more recently, international fi nance ministers are urging the FASB and IASB to accelerate their work on accounting standards, including the fair value guidance for fi nancial instruments.

Most recently, IASB chair Hans Hoogervorst indicated that work remains to be done in the fair value debate and that “the dichotomy between historical cost and fair value is not as stark as one would expect.” Mr. Hoogervorst noted that while histori- cal cost is to some extent based on fair value, it needs a degree of current measurement to maintain its relevance. It is not free from subjective updating requirements, and it is not necessarily stable. Moreover, historical cost is also vulnerable to abuse. In sum, all the vulnerabilities that are often attributed to fair value accounting can be equally pertinent to historical cost.

It is unclear whether these political pressures will have an effect on fair value accounting, but there is no question that the issue has stirred signifi cant worldwide political debate. In short, the numbers have consequences.

EVOLVING ISSUE FAIR VALUE, FAIR CONSEQUENCES?

The Expectations Gap The Sarbanes-Oxley Act was passed in response to a string of accounting scandals at companies like Enron, Cendant, Sunbeam, Rite-Aid, Xerox, and WorldCom. This law increased the resources for the SEC to combat fraud and curb poor reporting practices.10

And the SEC has increased its policing efforts, approving new auditor independence rules and materiality guidelines for financial reporting. In addition, the Sarbanes-Oxley

INTERNATIONAL PERSPECTIVE

Foreign accounting firms that provide an audit report for a U.S.-listed company are subject to the authority of the accounting oversight board (mandated by the Sarbanes-Oxley Act).

Sources: Adapted from Ben Hall and Nikki Tait, “Sarkozy Seeks EU Accounting Change,” The Financial Times Limited (September 30, 2008); Floyd Norris, “Banks Are Set to Receive More Leeway on Asset Values,” The New York Times (March 31, 2009); E. Orenstein, “G20 Finance Ministers Urge FASB, IASB Converge Key Standards by Mid-2013 at the Latest,” FEI Financial Reporting Blog (April 2012); and Speech at the Paris IFRS Conference, http://www.ifrs.org/Alerts/Conference/Documents/2015/Hans-Hoogervorst-speech-Paris-June-2015.pdf (June 2015).

Major Challenges in Financial Reporting 17

Act introduced sweeping changes to the institutional structure of the accounting profes- sion. The following are some of the key provisions of the legislation.

• Establishes an oversight board, the Public Company Accounting Oversight Board (PCAOB), for accounting practices. The PCAOB has oversight and enforcement authority and establishes auditing, quality control, and independence standards and rules.

• Implements stronger independence rules for auditors. Audit partners, for example, are required to rotate every five years, and auditors are prohibited from offering certain types of consulting services to corporate clients.

• Requires CEOs and CFOs to personally certify that financial statements and disclo- sures are accurate and complete, and requires CEOs and CFOs to forfeit bonuses and profits when there is an accounting restatement.

• Requires audit committees to be comprised of independent members and mem- bers with financial expertise.

• Requires codes of ethics for senior financial officers.

In addition, Section 404 of the Sarbanes-Oxley Act requires public companies to attest to the effectiveness of their internal controls over financial reporting. Internal controls are a system of checks and balances designed to prevent and detect fraud and errors. Most companies have these systems in place, but many have never completely documented them. Companies are finding that it is a costly process but perhaps badly needed.

While there continues to be debate about the benefits and costs of Sarbanes-Oxley (especially for smaller companies), studies at the time of the act’s implementation pro- vide compelling evidence that there was much room for improvement. For example, one study documented 424 companies with deficiencies in internal control.11 Many problems involved closing the books, revenue recognition deficiencies, reconciling accounts, or dealing with inventory. SunTrust Bank, for example, fired three officers after discovering errors in how the company calculates its allowance for bad debts. And Visteon, a car parts supplier, said it found problems recording and managing receiv- ables from its largest customer, Ford Motor.

Will these changes be enough? The expectations gap—what the public thinks accountants should do and what accountants think they can do—is difficult to close. Due to the number of fraudulent reporting cases, some question whether the profession is doing enough. Although the profession can argue rightfully that accounting cannot be responsible for every financial catastrophe, it must continue to strive to meet the needs of society. However, efforts to meet these needs will become more costly to society. The development of a highly transparent, clear, and reliable system will require consider- able resources.

Financial Reporting Issues While our reporting model has worked well in capturing and organizing financial infor- mation in a useful and reliable fashion, much still needs to be done. For example, if we move to the year 2030 and look back at financial reporting today, we might read the following.

• Nonfinancial measurements. Financial reports failed to provide some key perfor- mance measures widely used by management, such as customer satisfaction indexes, backlog information, reject rates on goods purchased, as well as the results of compa- nies’ sustainability efforts.

11Leah Townsend, “Internal Control Deficiency Disclosures—Interim Alert,” Yellow Card—Interim Trend Alert (April 12, 2005), Glass, Lewis & Co., LLC.

18 Chapter 1 Financial Accounting and Accounting Standards

• Forward-looking information. Financial reports failed to provide forward-looking information needed by present and potential investors and creditors. One individ- ual noted that financial statements in 2017 should have started with the phrase, “Once upon a time,” to signify their use of historical cost and accumulation of past events.

• Soft assets. Financial reports focused on hard assets (inventory, plant assets) but failed to provide much information about a company’s soft assets (intangibles). The best assets are often intangible. Consider Microsoft’s know-how and market domi- nance, Wal-Mart’s expertise in supply chain management, and Procter & Gamble’s brand image.

• Timeliness. Companies only prepared financial statements quarterly and provided audited financials annually. Little to no real-time financial statement information was available.

• Understandability. Investors and market regulators were raising concerns about the complexity and lack of understandability of financial reports.

We believe each of these challenges must be met for the accounting profession to provide the type of information needed for an efficient capital allocation process. We are confident that changes will occur, based on these positive signs:

• Already, some companies voluntarily disclose information deemed relevant to inves- tors. Often such information is nonfinancial. For example, banking companies now disclose data on loan growth, credit quality, fee income, operating efficiency, capital management, and management strategy. Increasingly, companies are preparing re- ports on their sustainability efforts by reporting such information as water use and conservation, carbon impacts, and labor practices. In some cases, “integrated reports” are provided, which incorporate sustainability reports into the traditional annual re- port, leading some to call for standards for sustainability reporting.

• Initially, companies used the Internet to provide limited financial data. Now, most companies publish their annual reports in several formats on the Web. The most innovative companies offer sections of their annual reports in a format that the user can readily manipulate, such as in an electronic spreadsheet format. Compa- nies also format their financial reports using eXtensible Business Reporting Lan- guage (XBRL), which permits quicker and lower-cost access to companies’ finan- cial information.

• More accounting standards now require the recording or disclosing of fair value information. For example, companies either record investments in stocks and bonds, debt obligations, and derivatives at fair value, or companies show information re- lated to fair values in the notes to the financial statements. The FASB and the IASB have a converged standard on fair value measures, which should enhance the use- fulness of fair value measures in financial statements.

• The FASB is now working on projects that address disclosure effectiveness, a report- ing framework for non-public companies, and a simplification initiative. The proj- ects could go a long way toward addressing complexity and understandability of the information in financial statements, allowing for more-effective, less-complex, and flexible reporting to meet the needs of investors.

Changes in these directions will enhance the relevance of financial reporting and provide useful information to financial statement readers.

International Accounting Standards As indicated by Lawrence Summers, former Secretary of the Treasury, the single most important innovation shaping the capital markets was the idea of generally accepted accounting principles. He went on to say that we need something similar internationally.

Major Challenges in Financial Reporting 19

Relevant and reliable financial information is a necessity for viable capital mar- kets. Unfortunately, companies outside the United States often prepare financial statements using standards different from U.S. GAAP (or simply GAAP). As a result, international companies such as Coca-Cola, Microsoft, and IBM have to develop financial information in different ways. Beyond the additional costs these companies incur, users of the financial statements often must understand at least two sets of accounting standards. (Understanding one set is hard enough!) It is not surprising, therefore, that there is a growing demand for one set of high-quality international standards.

Current Environment Presently, there are two sets of rules accepted for international use—GAAP and International Financial Reporting Standards (IFRS), issued by the London-based International Accounting Standards Board (IASB). U.S. companies that list over- seas are still permitted to use GAAP, and foreign companies listed on U.S. exchanges are permitted to use IFRS. As you will learn, there are many similarities between GAAP and IFRS.

Already over 115 countries use IFRS, and the European Union now requires all listed companies in Europe (over 7,000 companies) to use it. Most parties recognize that global markets will best be served if only one set of accounting standards is used. For example, the FASB and the IASB formalized their commitment to the convergence of GAAP and IFRS by issuing a memorandum of understanding (often referred to as the Norwalk agreement). The two Boards agreed to use their best efforts to:

• Make their existing financial reporting standards fully compatible as soon as prac- ticable, and

• Coordinate their future work programs to ensure that once achieved, compatibility is maintained.

As a result of this agreement, the two Boards identified a number of short-term and long-term projects that would lead to convergence. For example, one short-term project was for the FASB to issue a rule that permits a fair value option for financial instru- ments. This rule was issued in 2007, and now the FASB and the IASB follow the same accounting in this area. Conversely, the IASB completed a project related to borrowing costs, which makes IFRS consistent with GAAP. Long-term convergence projects relate to such issues as revenue recognition and leases.

Will Convergence Happen? Everyone seems to agree that the FASB and the IASB need to work together toward the goal of a single set of high-quality, global accounting standards. By doing so, unnecessary differences between standards used internationally can be reduced or avoided. However, it seems likely that there will continue to be two sets of financial reporting standards in the world for the foreseeable future. For example, the United States is reluctant to fully adopt IFRS. As the chief accountant of the SEC recently noted, there is virtually no support for having the SEC mandate IFRS for public com- panies, and there is little support for the SEC to provide an option allowing U.S. com- panies to prepare their financial statements under IFRS. In addition, both the FASB and the IASB seem to be taking different approaches to various financial reporting problems, such as the measurement and recognition of financial instruments. Further, the IASB has decided to move forward on the conceptual framework project indepen- dent of the FASB.

Because convergence is such an important issue, we provide a discussion of interna- tional accounting standards at the end of each chapter called IFRS Insights. This feature will help you understand the changes that are taking place in the financial reporting area. In addition, throughout the textbook, we provide International Perspectives in the margins to help you understand the international reporting environment.

INTERNATIONAL PERSPECTIVE

IFRS includes the standards, referred to as International Financial Reporting Standards (IFRS), developed by the IASB. The predecessor to the IASB issued International Accounting Standards (IAS).

INTERNATIONAL PERSPECTIVE

The adoption of IFRS by U.S. companies would make it easier to compare U.S. and foreign companies, as well as for U.S. companies to raise capital in foreign markets.

20 Chapter 1 Financial Accounting and Accounting Standards

Ethics in the Environment of Financial Accounting Robert Sack, a noted commentator on the subject of accounting ethics, observed, “Based on my experience, new graduates tend to be idealistic . . . thank goodness for that! Still it is very dangerous to think that your armor is all in place and say to yourself, ’I would have never given in to that.’ The pressures don’t explode on us; they build, and we often don’t recognize them until they have us.”

These observations are particularly appropriate for anyone entering the business world. In accounting, as in other areas of business, we frequently encounter ethical dilemmas. Some of these dilemmas are simple and easy to resolve. However, many are not, requiring difficult choices among allowable alternatives.

Companies that concentrate on “maximizing the bottom line,” “facing the challenges of competition,” and “stressing short-term results” place accountants in an environment of conflict and pressure. Basic questions such as, “Is this way of communicating financial information good or bad?” “Is it right or wrong?” and “What should I do in this circum- stance?” cannot always be answered by simply adhering to GAAP or following the rules of the profession. Technical competence is not enough when encountering ethical decisions.

Doing the right thing is not always easy or obvious. The pressures “to bend the rules,” “to play the game,” or “to just ignore it” can be considerable. For example, “Will my decision affect my job performance negatively?” “Will my superiors be upset?” and “Will my colleagues be unhappy with me?” are often questions business people face in making a tough ethical decision. The decision is more difficult because there is no com- prehensive ethical system to provide guidelines.

Time, job, client, personal, and peer pressures can complicate the process of ethical sensitivity and selection among alternatives. Throughout this textbook, we present eth- ical considerations to help sensitize you to the type of situations you may encounter in the performance of your professional responsibility.

Conclusion Bob Herz, a former FASB chair, believes that there are three fundamental considerations the FASB must keep in mind in its rule-making activities: (1) improvement in financial reporting, (2) simplification of the accounting literature and the rule-making process, and (3) international convergence. These are notable objectives, and the Board is making good progress on all three dimensions. Issues such as off-balance-sheet financing, mea- surement of fair values, enhanced criteria for revenue recognition, and stock option accounting are examples of where the Board has exerted leadership. Improvements in financial reporting should follow.

Also, the Board is making it easier to understand what GAAP is. GAAP has been contained in a number of different documents. The lack of a single source makes it difficult to access and understand generally accepted principles. As discussed earlier, the Codification now organizes existing GAAP by accounting topic regardless of its source (FASB Statements, APB Opinions, and so on). The codified standards are then

One of the more diffi cult issues related to convergence and international accounting standards is that countries have differ- ent cultures and customs. For example, the former chair of the IASB explained it this way regarding Europe:

“In the U.K. everything is permitted unless it is prohibited. In Germany, it is the other way around; everything is prohibited unless it is

permitted. In the Netherlands, everything is prohibited even if it is per- mitted. And in France, everything is permitted even if it is prohibited. Add in countries like Japan, the United States and China, it becomes very diffi cult to meet the needs of each of these countries.”

With this diversity of thinking around the world, it understand- able why accounting convergence has been so elusive.

WHAT DO THE NUMBERS MEAN? CAN YOU DO THAT?

Source: Sir D. Tweedie, “Remarks at the Robert P. Maxon Lectureship,” George Washington University (April 7, 2010).

Review and Practice 21

considered to be GAAP and to be authoritative. All other literature will be considered nonauthoritative.

Finally, international convergence is underway. Some projects already are com- pleted and differences eliminated. Many more are on the drawing board. The profession has many challenges, but it has responded in a timely, comprehensive, and effective manner.

REVIEW AND PRACTICE

LEARNING OBJECTIVES REVIEW 1 Understand the financial reporting environment. Companies provide four primary financial statements of financial

reporting: (1) the balance sheet, (2) the income statement, (3) the statement of cash flows, and (4) the statement of owners’ or stockholders’ equity. Financial reporting other than financial statements may take various forms. Examples include the presi- dent’s letter and supplementary schedules in the corporate annual report, prospectuses, reports filed with government agen- cies, news releases, management’s forecasts, and descriptions of a company’s social or environmental impact.

The objective of general-purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in decisions about providing resources to the entity through equity investments and loans or other forms of credit. Information that is decision-useful to investors may also be helpful to other users of financial reporting who are not investors.

To achieve this objective, the accounting profession has attempted to develop a set of standards that is generally accepted and universally practiced. Without this set of standards, each company would have to develop its own standards. Readers of financial statements would have to familiarize themselves with every company’s peculiar accounting and reporting practices. As a result, it would be almost impossible to prepare statements that could be compared.

2 Identify the major policy-setting bodies and their role in the standard-setting process. The Securities and Exchange Commission (SEC) is a federal agency that has the broad powers to prescribe, in whatever detail it desires, the accounting standards to be employed by companies that fall within its jurisdiction. The American Institute of Certified Public Accountants (AICPA) issued standards through its Committee on Accounting Procedure and Accounting Principles Board. The Financial Accounting Standards Board (FASB) establishes and improves standards of financial accounting and reporting for the guidance and education of the public.

YOU WILL WANT TO READ THE IFRS INSIGHTS ON PAGES 29–35 For discussion of IFRS and the inter- national reporting environment.

KEY TERMS REVIEW Accounting Principles Board

(APB), 9 Accounting Research

Bulletins, 9 Accounting Standards

Updates, 11 accrual-basis accounting, 6 American Institute of

Certified Public Ac- countants (AICPA), 9

APB Opinions, 9 Auditing Standards Board, 12 Committee on Accounting

Procedure (CAP), 9 decision-usefulness, 6 Emerging Issues Task Force

(EITF), 12

entity perspective, 6 expectations gap, 17 FASB Staff Positions, 13 financial accounting, 4 Financial Accounting Stan-

dards Board (FASB), 9 Financial Accounting

Standards Board Accounting Standards Codification (Codification), 13

Financial Accounting Standards Board Codification Research System (CRS), 14

financial reporting, 4 financial statements, 4 generally accepted

accounting principles (GAAP), 7

general-purpose finan cial statements, 5

International Accounting Standards Board (IASB), 19

International Financial Reporting Standards (IFRS), 19

interpretations, 13 objective of financial

reporting, 5

Public Company Ac- counting Oversight Board (PCAOB), 17

Sarbanes-Oxley Act, 16 Securities and Exchange

Commission (SEC), 7 Statements of Financial

Accounting Concepts, 12 Wheat Committee, 9

22 Chapter 1 Financial Accounting and Accounting Standards

3 Explain the meaning of generally accepted accounting principles (GAAP) and the role of the Codification for GAAP. Generally accepted accounting principles (GAAP) are those principles that have substantial authoritative support, such as FASB standards, interpretations, and Staff Positions, APB Opinions and interpretations, AICPA Accounting Research Bulletins, and other authoritative pronouncements. All these documents and others are now classified in one document referred to as the Codification. The purpose of the Codification is to simplify user access to all authoritative U.S. GAAP. The Codification changes the way GAAP is documented, presented, and updated.

4. Describe major challenges in the financial reporting environment. One major challenge is that user groups may want particular economic events accounted for or reported in a particular way, and they fight hard to get what they want. They especially target the FASB to influence changes in existing GAAP and in the development of new rules. A second chal- lenge is that financial reports fail to provide (1) some key performance measures widely used by management, (2) forward- looking information needed by investors and creditors, (3) sufficient information on a company’s soft assets (intangibles), (4) real-time financial information, and (5) easy-to-comprehend information. Finally, financial accountants are called on for moral discernment and ethical decision-making. Decisions sometimes are difficult because a public consensus has not emerged to formulate a comprehensive ethical system that provides guidelines in making ethical judgments.

Exercises, Problems, Problem Solution Walkthrough Videos, and many more assessment tools and resources are available for practice in WileyPLUS.

QUESTIONS

1. Differentiate broadly between financial accounting and managerial accounting.

2. Differentiate between “financial statements” and “finan- cial reporting.”

3. How does accounting help the capital allocation process? 4. What is the objective of financial reporting? 5. Briefly explain the meaning of decision-usefulness in the

context of financial reporting. 6. Of what value is a common set of standards in financial

accounting and reporting? 7. What is the likely limitation of “general-purpose finan-

cial statements”? 8. In what way is the Securities and Exchange Commission

concerned about and supportive of accounting principles and standards?

9. What was the Committee on Accounting Procedure, and what were its accomplishments and failings?

10. For what purposes did the AICPA create the Accounting Principles Board?

11. Distinguish between Opinions of the Accounting Princi- ples Board and Accounting Standards Updates.

12. If you had to explain or define “generally accepted accounting principles or standards,” what essential char- acteristics would you include in your explanation?

13. In what ways was it felt that the pronouncements issued by the Financial Accounting Standards Board would carry greater weight than the opinions issued by the Accounting Principles Board?

14. How are FASB preliminary views and FASB exposure drafts related to FASB “statements”?

15. Distinguish between FASB Accounting Standards Updates and FASB Statements of Financial Accounting Concepts.

16. What is Rule 203 of the Code of Professional Conduct? 17. The chair of the FASB at one time noted that “the flow

of standards can only be slowed if (1) producers focus less on quarterly earnings per share and tax benefits and more on quality products, and (2) accoun- tants and lawyers rely less on rules and law and more on professional judgment and conduct.” Explain his comment.

18. Explain the role of the Emerging Issues Task Force in establishing generally accepted accounting principles.

ENHANCED REVIEW AND PRACTICE Go online for multiple-choice questions with solutions and a full glossary of all key terms.

Concepts for Analysis 23

19. What is the difference between the Codification and the Codification Research System?

20. What are the primary advantages of having a Codifica- tion of generally accepted accounting principles?

21. What are the sources of pressure that change and influ- ence the development of GAAP?

22. Some individuals have indicated that the FASB must be cognizant of the economic consequences of its pro- nouncements. What is meant by “economic conse- quences”? What dangers exist if politics play too much of a role in the development of GAAP?

23. If you were given complete authority in the matter, how would you propose that GAAP should be developed and enforced?

24. One writer recently noted that 99.4 percent of all compa- nies prepare statements that are in accordance with GAAP. Why then is there such concern about fraudulent financial reporting?

25. What is the “expectations gap”? What is the profession doing to try to close this gap?

26. The Sarbanes-Oxley Act was enacted to combat fraud and curb poor reporting practices. What are some key provisions of this legislation?

27. What are some of the major challenges facing the account- ing profession?

28. How are financial accountants challenged in their work to make ethical decisions? Is technical mastery of GAAP not sufficient to the practice of financial accounting?

CONCEPTS FOR ANALYSIS

CA1-1 (FASB and Standard-Setting) Presented below are four statements which you are to identify as true or false. If false, explain why the statement is false.

1. GAAP is the term used to indicate the whole body of FASB authoritative literature. 2. Any company claiming compliance with GAAP must comply with most standards and interpretations but does not have to

follow the disclosure requirements. 3. The primary governmental body that has influence over the FASB is the SEC. 4. The FASB has a government mandate and therefore does not have to follow due process in issuing a standard.

CA1-2 (GAAP and Standard-Setting) Presented below are four statements which you are to identify as true or false. If false, explain why the statement is false.

1. The objective of financial statements emphasizes a stewardship approach for reporting financial information. 2. The purpose of the objective of financial reporting is to prepare a balance sheet, an income statement, a statement of cash

flows, and a statement of owners’ or stockholders’ equity. 3. Because they are generally shorter, FASB interpretations are subject to less due process, compared to FASB standards. 4. The objective of financial reporting uses an entity rather than a proprietary approach in determining what information to

report.

CA1-3 (Financial Reporting and Accounting Standards) Answer the following multiple-choice questions.

1. GAAP stands for: (a) governmental auditing and accounting practices. (b) generally accepted attest principles. (c) government audit and attest policies. (d) generally accepted accounting principles.

2. Accounting standard-setters use the following process in establishing accounting standards: (a) Research, exposure draft, discussion paper, standard. (b) Discussion paper, research, exposure draft, standard. (c) Research, preliminary views, discussion paper, standard. (d) Research, discussion paper, exposure draft, standard.

3. GAAP is comprised of: (a) FASB standards, interpretations, and concepts statements. (b) FASB financial standards. (c) FASB standards, interpretations, EITF consensuses, and accounting rules issued by FASB predecessor organizations. (d) any accounting guidance included in the FASB Codification.

4. The authoritative status of the conceptual framework is as follows. (a) It is used when there is no standard or interpretation related to the reporting issues under consideration. (b) It is not as authoritative as a standard but takes precedence over any interpretation related to the reporting issue. (c) It takes precedence over all other authoritative literature. (d) It has no authoritative status.

24 Chapter 1 Financial Accounting and Accounting Standards

5. The objective of financial reporting places most emphasis on: (a) reporting to capital providers. (b) reporting on stewardship. (c) providing specific guidance related to specific needs. (d) providing information to individuals who are experts in the field.

6. General-purpose financial statements are prepared primarily for: (a) internal users. (b) external users. (c) auditors. (d) government regulators.

7. Economic consequences of accounting standard-setting means: (a) standard-setters must give first priority to ensuring that companies do not suffer any adverse effect as a result of a

new standard. (b) standard-setters must ensure that no new costs are incurred when a new standard is issued. (c) the objective of financial reporting should be politically motivated to ensure acceptance by the general public. (d) accounting standards can have detrimental impacts on the wealth levels of the providers of financial information.

8. The expectations gap is: (a) what financial information management provides and what users want. (b) what the public thinks accountants should do and what accountants think they can do. (c) what the governmental agencies want from standard-setting and what the standard-setters provide. (d) what the users of financial statements want from the government and what is provided.

CA1-4 (Financial Accounting) Omar Morena has recently completed his first year of studying accounting. His instructor for next semester has indicated that the primary focus will be the area of financial accounting.

Instructions (a) Differentiate between financial accounting and managerial accounting. (b) One part of financial accounting involves the preparation of financial statements. What are the financial statements

most frequently provided? (c) What is the difference between financial statements and financial reporting?

CA1-5 (Objective of Financial Reporting) Karen Sepan, a recent graduate of the local state university, is presently employed by a large manufacturing company. She has been asked by Jose Martinez, controller, to prepare the company’s response to a cur- rent Preliminary Views published by the Financial Accounting Standards Board (FASB). Sepan knows that the FASB has a con- ceptual framework, and she believes that these concept statements could be used to support the company’s response to the Preliminary Views. She has prepared a rough draft of the response citing the objective of financial reporting.

Instructions (a) Identify the objective of financial reporting. (b) Describe the level of sophistication expected of the users of financial information by the objective of financial reporting.

CA1-6 (Accounting Numbers and the Environment) Hardly a day goes by without an article appearing on the continuing fallout from the financial crisis of 2008. An overheated real estate market, fueled by home purchase incentives, poor lending practices, and securitization through high-risk, mortgage-backed securities, led to a near collapse of global capital markets. As a consequence, many have argued that if the financial institutions had been required to report their loans (and loan-backed investments) at fair value instead of cost, large losses would have been reported earlier. This would have signaled regulators to the problems in the mortgage markets and therefore minimized the losses to U.S. taxpayers.

Instructions Explain how reported accounting numbers might affect an individual’s perceptions and actions. Cite two examples.

CA1-7 WRITING (Need for GAAP) Some argue that having various organizations establish accounting principles is wasteful and inefficient. Rather than mandating accounting rules, each company could voluntarily disclose the type of information it considered important. In addition, if an investor wants additional information, the investor could contact the company and pay to receive the additional information desired.

Instructions Comment on the appropriateness of this viewpoint.

CA1-8 (AICPA’s Role in Rule-Making) One of the major groups that has been involved in the standard-setting process is the American Institute of Certified Public Accountants. Initially, it was the primary organization that established accounting prin- ciples in the United States. Subsequently, it relinquished its power to the FASB.

Concepts for Analysis 25

Instructions (a) Identify the two committees of the AICPA that established accounting principles prior to the establishment of the FASB. (b) Speculate as to why these two organizations failed. In your answer, identify steps the FASB has taken to avoid failure. (c) What is the present role of the AICPA in the rule-making environment?

CA1-9 (FASB Role in Rule-Making) A press release announcing the appointment of the trustees of the new Financial Account- ing Foundation stated that the Financial Accounting Standards Board (to be appointed by the trustees) “. . . will become the established authority for setting accounting principles under which corporations report to the shareholders and others” (AICPA news release July 20, 1972).

Instructions (a) Identify the sponsoring organization of the FASB and the process by which the FASB arrives at a decision and issues an

accounting standard. (b) Indicate the major types of pronouncements issued by the FASB and the purposes of each of these pronouncements.

CA1-10 WRITING (Politicization of GAAP) Some accountants have said that politicization in the development and acceptance of generally accepted accounting principles (i.e., rule-making) is taking place. Some use the term “politicization” in a narrow sense to mean the influence by governmental agencies, particularly the Securities and Exchange Commission, on the development of generally accepted accounting principles. Others use it more broadly to mean the compromise that results when the bodies responsible for developing generally accepted accounting principles are pressured by interest groups (SEC, American Accounting Association, busi- nesses through their various organizations, Institute of Management Accountants, financial analysts, bankers, lawyers, and so on).

Instructions (a) The Committee on Accounting Procedure of the AICPA was established in the mid- to late 1930s and functioned until

1959, at which time the Accounting Principles Board came into existence. In 1973, the Financial Accounting Standards Board was formed and the APB went out of existence. Do the reasons these groups were formed, their methods of operation while in existence, and the reasons for the demise of the first two indicate an increasing politicization (as the term is used in the broad sense) of accounting standard-setting? Explain your answer by indicating how the CAP, the APB, and the FASB operated or operate. Cite specific developments that tend to support your answer.

(b) What arguments can be raised to support the “politicization” of accounting rule-making? (c) What arguments can be raised against the “politicization” of accounting rule-making?

(CMA adapted)

CA1-11 (Models for Setting GAAP) Presented below are three models for setting GAAP.

1. The purely political approach, where national legislative action decrees GAAP. 2. The private, professional approach, where GAAP is set and enforced by private professional actions only. 3. The public/private mixed approach, where GAAP is basically set by private-sector bodies that behave as though they were

public agencies and whose standards to a great extent are enforced through governmental agencies.

Instructions (a) Which of these three models best describes standard-setting in the United States? Provide justification for your answer. (b) Why do companies, financial analysts, labor unions, industry trade associations, and others take such an active interest

in standard-setting? (c) Cite an example of a group other than the FASB that attempts to establish accounting standards. Speculate as to why

another group might wish to set its own standards.

CA1-12 GROUPWORK (GAAP Terminology) Wayne Rogers, an administrator at a major university, recently said, “I’ve got some CDs in my IRA, which I set up to beat the IRS.” As elsewhere, in the world of accounting and finance, it often helps to be fluent in abbreviations and acronyms.

Instructions Presented below is a list of common accounting acronyms. Identify the term for which each acronym stands, and provide a brief definition of each term.

(a) AICPA (e) FAF (i) FASB (b) CAP (f) FASAC (j) SEC (c) EITF (g) GAAP (k) IASB (d) APB (h) CPA

CA1-13 ETHICS (Rule-Making Issues) When the FASB issues new pronouncements, the implementation date is usually 12 months from date of issuance, with early implementation encouraged. Karen Weller, controller, discusses with her financial vice president the need for early implementation of a rule that would result in a fairer presentation of the company’s financial condition and earnings. When the financial vice president determines that early implementation of the rule will adversely affect the reported net income for the year, he discourages Weller from implementing the rule until it is required.

26 Chapter 1 Financial Accounting and Accounting Standards

Instructions Answer the following questions.

(a) What, if any, is the ethical issue involved in this case? (b) Is the financial vice president acting improperly or immorally? (c) What does Weller have to gain by advocacy of early implementation? (d) Which stakeholders might be affected by the decision against early implementation?

(CMA adapted)

CA1-14 (Securities and Exchange Commission) The U.S. Securities and Exchange Commission (SEC) was created in 1934 and consists of five commissioners and a large professional staff. The SEC professional staff is organized into five divisions and several principal offices. The primary objective of the SEC is to support fair securities markets. The SEC also strives to foster enlight- ened stockholder participation in corporate decisions of publicly traded companies. The SEC has a significant presence in financial markets, the development of accounting practices, and corporation-shareholder relations, and has the power to exert influence on entities whose actions lie within the scope of its authority.

Instructions (a) Explain from where the Securities and Exchange Commission receives its authority. (b) Describe the official role of the Securities and Exchange Commission in the development of financial accounting theory

and practices. (c) Discuss the interrelationship between the Securities and Exchange Commission and the Financial Accounting

Standards Board with respect to the development and establishment of financial accounting theory and practices.

(CMA adapted)

CA1-15 ETHICS (Financial Reporting Pressures) Presented below is abbreviated testimony from Troy Normand in the WorldCom case. He was a manager in the corporate reporting department and is one of five individuals who pleaded guilty. He is testifying in hopes of receiving no prison time when he is ultimately sentenced.

Q. Mr. Normand, if you could just describe for the jury how the meeting started and what was said during the meeting? A. I can’t recall exactly who initiated the discussion, but right away Scott Sullivan acknowledged that he was aware we had problems with the entries, David Myers had informed him, and we were considering resigning.

He said that he respected our concerns but that we weren’t being asked to do anything that he believed was wrong. He mentioned that he acknowledged that the company had lost focus quite a bit due to the preparations for the Sprint merger, and that he was putting plans in place and projects in place to try to determine where the problems were, why the costs were so high.

He did say he believed that the initial statements that we produced, that the line costs in those statements could not have been as high as they were, that he believed something was wrong and there was no way that the costs were that high.

I informed him that I didn’t believe the entry we were being asked to do was right, that I was scared, and I didn’t want to put myself in a position of going to jail for him or the company. He responded that he didn’t believe anything was wrong, nobody was going to be going to jail, but that if it later was found to be wrong, that he would be the person going to jail, not me.

He asked that I stay, don’t jump off the plane, let him land it softly, that’s basically how he put it. And he mentioned that he had a discussion with Bernie Ebbers, asking Bernie to reduce projections going forward and that Bernie had refused. Q. Mr. Normand, you said that Mr. Sullivan said something about don’t jump out of the plane. What did you understand him to mean when he said that? A. Not to quit. Q. During this meeting, did Mr. Sullivan say anything about whether you would be asked to make entries like this in the future? A. Yes, he made a comment that from that point going forward we wouldn’t be asked to record any entries, high-level late adjustments, that the numbers would be the numbers. Q. What did you understand that to be mean, the numbers would be the numbers? A. That after the preliminary statements were issued, with the exception of any normal transaction, valid transaction, we wouldn’t be asked to be recording any more late entries. Q. I believe you testified that Mr. Sullivan said something about the line cost numbers not being accurate. Did he ask you to conduct any analysis to determine whether the line cost numbers were accurate? A. No, he did not. Q. Did anyone ever ask you to do that? A. No. Q. Did you ever conduct any such analysis? A. No, I didn’t. Q. During this meeting, did Mr. Sullivan ever provide any accounting justification for the entry you were asked to make? A. No, he did not.

Concepts for Analysis 27

Q. Did anything else happen during the meeting? A. I don’t recall anything else. Q. How did you feel after this meeting? A. Not much better actually. I left his office not convinced in any way that what we were asked to do was right. However, I did question myself to some degree after talking with him wondering whether I was making something more out of what was really there.

Instructions Answer the following questions.

(a) What appears to be the ethical issue involved in this case? (b) Is Troy Normand acting improperly or immorally? (c) What would you do if you were Troy Normand? (d) Who are the major stakeholders in this case?

CA1-16 (Economic Consequences) Presented below are comments made in the financial press.

Instructions Prepare responses to the requirements in each item.

(a) Rep. John Dingell, at one time the ranking Democrat on the House Commerce Committee, threw his support behind the FASB’s controversial derivatives accounting standard and encouraged the FASB to adopt the rule promptly. Indicate why a member of Congress might feel obligated to comment on this proposed FASB standard.

(b) In a strongly worded letter to Senator Lauch Faircloth (R-NC) and House Banking Committee Chairman Jim Leach (R-IA), the American Institute of Certified Public Accountants (AICPA) cautioned against government intervention in the accounting standard-setting process, warning that it had the potential of jeopardizing U.S. capital markets. Explain how government intervention could possibly affect capital markets adversely.

CA1-17 GROUPWORK (GAAP and Economic Consequences) The following letter was sent to the SEC and the FASB by lead- ers of the business community.

Dear Sirs:

The FASB has been struggling with accounting for derivatives and hedging for many years. The FASB has now devel- oped, over the last few weeks, a new approach that it proposes to adopt as a final standard. We understand that the Board intends to adopt this new approach as a final standard without exposing it for public comment and debate, de- spite the evident complexity of the new approach, the speed with which it has been developed and the significant changes to the exposure draft since it was released more than one year ago. Instead, the Board plans to allow only a brief review by selected parties, limited to issues of operationality and clarity, and would exclude questions as to the merits of the proposed approach.

As the FASB itself has said throughout this process, its mission does not permit it to consider matters that go beyond accounting and reporting considerations. Accordingly, the FASB may not have adequately considered the wide range of concerns that have been expressed about the derivatives and hedging proposal, including concerns related to the potential impact on the capital markets, the weakening of companies’ ability to manage risk, and the adverse control implications of implementing costly and complex new rules imposed at the same time as other major initia- tives, including the Year 2000 issues and a single European currency. We believe that these crucial issues must be considered, if not by the FASB, then by the Securities and Exchange Commission, other regulatory agencies, or Congress.

We believe it is essential that the FASB solicit all comments in order to identify and address all material issues that may ex- ist before issuing a final standard. We understand the desire to bring this process to a prompt conclusion, but the underlying issues are so important to this nation’s businesses, the customers they serve and the economy as a whole that expediency cannot be the dominant consideration. As a result, we urge the FASB to expose its new proposal for public comment, fol- lowing the established due process procedures that are essential to acceptance of its standards, and providing sufficient time to affected parties to understand and assess the new approach.

We also urge the SEC to study the comments received in order to assess the impact that these proposed rules may have on the capital markets, on companies’ risk management practices, and on management and financial controls. These vital public policy matters deserve consideration as part of the Commission’s oversight responsibilities.

We believe that these steps are essential if the FASB is to produce the best possible accounting standard while minimiz- ing adverse economic effects and maintaining the competitiveness of U.S. businesses in the international market- place.

Very truly yours,

(This letter was signed by the chairs of 22 of the largest U.S. companies.)

28 Chapter 1 Financial Accounting and Accounting Standards

Instructions Answer the following questions.

(a) Explain the “due process” procedures followed by the FASB in developing a financial reporting standard. (b) What is meant by the term “economic consequences” in accounting standard-setting? (c) What economic consequences arguments are used in this letter? (d) What do you believe is the main point of the letter? (e) Why do you believe a copy of this letter was sent by the business community to influential members of the U.S.

Congress?

USING YOUR JUDGMENT

Financial Reporting Problem Beverly Crusher, a new staff accountant, is confused because of the complexities involving accounting standard-setting. Specifi- cally, she is confused by the number of bodies issuing financial reporting standards of one kind or another and the level of au- thoritative support that can be attached to these reporting standards. Beverly decides that she must review the environment in which accounting standards are set, if she is to increase her understanding of the accounting profession.

Beverly recalls that during her accounting education there was a chapter or two regarding the environment of financial ac- counting and the development of GAAP. However, she remembers that her instructor placed little emphasis on these chapters.

Instructions (a) Help Beverly by identifying key organizations involved in accounting rule-making. (b) Beverly asks for guidance regarding authoritative support. Please assist her by explaining what is meant by authorita-

tive support. (c) Give Beverly a historical overview of how rule-making has evolved so that she will not feel that she is the only one to

be confused. (d) What authority for compliance with GAAP has existed throughout the history of rule-making?

BRIDGE TO THE PROFESSION

Codifi cation Exercises Academic access to the FASB Codification is available through university subscriptions, obtained from the American Account- ing Association (at http://aaahq.org/FASB/Access.cfm), for an annual fee of $150. This subscription covers an unlimited number of students within a single institution. Once this access has been obtained by your school, you should log in (at http://aaahq.org/ ascLogin.cfm) to prepare responses to the following exercises. CE1-1 Describe the main elements of the link labeled “Help, FAQ, Learning Guide, and About the Codification.” CE1-2 Describe the procedures for providing feedback. CE1-3 Briefly describe the purpose and content of the “What’s New” link.

Codifi cation Research Case As a newly enrolled accounting major, you are anxious to better understand accounting institutions and sources of accounting literature. As a first step, you decide to explore the FASB Conceptual Framework.

Instructions Go to the FASB website, http://www.fasb.org, to access the FASB Concepts Statements. When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following items. (Provide paragraph citations.)

(a) What is the objective of financial reporting? (b) What other means are there of communicating information, besides financial statements? (c) Indicate some of the users and the information they are most directly concerned with in economic decision-

making.

ADDITIONAL PROFESSIONAL RESOURCES Go to WileyPLUS for other career-readiness resources, such as career coaching, internship opportunities, and CPAexcel prep.

IFRS Insights 29

IFRS Insights Most agree that there is a need for one set of international accounting standards. Here is why: • Multinational corporations. Today’s companies view the entire world as their market. For

example, Coca-Cola, Intel, and McDonald’s generate more than 50 percent of their sales out- side the United States, and many foreign companies, such as Toyota, Nestlé, and Sony, fi nd their largest market to be the United States.

• Mergers and acquisitions. The mergers between Fiat/Chrysler and Vodafone/Mannesmann suggest that we will see even more such business combinations in the future.

• Information technology. As communication barriers continue to topple through advances in technology, companies and individuals in different countries and markets are becoming more comfortable buying and selling goods and services from one another.

• Financial markets. Financial markets are of international signifi cance today. Whether it is cur- rency, equity securities (stocks), bonds, or derivatives, there are active markets throughout the world trading these types of instruments.

RELEVANT FACTS Following are the key similarities and differences between GAAP (the standards issued by the Financial Accounting Standards Board) and IFRS related to the financial reporting environment.

Similarities • Generally accepted accounting principles (GAAP) for U.S. companies are developed by the

Financial Accounting Standards Board (FASB). The FASB is a private organization. The Securities and Exchange Commission (SEC) exercises oversight over the actions of the FASB. The IASB is also a private organization. Oversight over the actions of the IASB is regulated by IOSCO.

• Both the IASB and the FASB have essentially the same governance structure, that is, a Foundation that provides oversight, a Board, an Advisory Council, and an Interpretations Committee. In addition, a general body that involves the public interest is part of the governance structure.

• The FASB relies on the SEC for regulation and enforcement of its standards. The IASB relies primarily on IOSCO for regulation and enforcement of its standards.

• Both the IASB and the FASB are working together to fi nd common grounds for convergence. A good example is the recent issuance of a new standard on revenue recognition that both orga- nizations support. Also, the Boards are working together on other substantial projects, such as the accounting for leases.

Differences • GAAP is more detailed or rules-based. IFRS tends to simpler and more fl exible in its accounting

and disclosure requirements. The difference in approach has resulted in a debate about the merits of principles-based versus rules-based standards.

• Differences between GAAP and IFRS should not be surprising because standard-setters have developed standards in response to different user needs. In some countries, the primary users of fi nancial statements are private investors. In others, the primary users are tax authorities or central government planners. In the United States, investors and creditors have driven accounting- standard formulation.

ABOUT THE NUMBERS World markets are becoming increasingly intertwined. International consumers drive Japanese cars, wear Italian shoes and Scottish woolens, drink Brazilian coffee and Indian tea, eat Swiss chocolate bars, sit on Danish furniture, watch U.S. movies, and use Arabian oil. The tremendous variety and volume of both exported and imported goods indicates the extensive involvement in international trade—for many companies, the world is their market. To provide some indication of the extent of globalization of economic activity, Illustration IFRS1-1 (page 30) provides a listing of the top 20 global companies in terms of sales.

LEARNING OBJECTIVE 5 Compare the procedures related to financial accounting and accounting standards under GAAP and IFRS.

30 Chapter 1 Financial Accounting and Accounting Standards

ILLUSTRATION IFRS1-1 Global Companies

Revenues Rank Company Country ($ millions)

11 Total France 227,882 12 Chevron U.S. 220,356 13 Samsung Electronics South Korea 208,938 14 Berkshire Hathaway U.S. 182,150 15 Apple U.S. 170,910 16 AXA France 165,893 17 Gazprom Russia 165,016 18 E.ON Germany 162,560 19 Phillips 66 U.S. 161,175 20 Daimler Germany 156,628

Revenues Rank Company Country ($ millions)

1 Wal-Mart Stores U.S. 476,294 2 Royal Dutch Shell Netherlands 459,599 3 Sinopec Group China 457,201 4 China National Petroleum China 432,007 5 ExxonMobil U.S. 407,666 6 BP U.K. 396,217 7 State Grid China 333,386 8 Volkswagen Germany 261,539 9 Toyota Motor Japan 256,454 10 Glencore International Switzerland 232,694

As capital markets are increasingly integrated, companies have greater flexibility in deciding where to raise capital. In the absence of market integration, there can be company-specific factors that make it cheaper to raise capital and list/trade securities in one location versus another. With the integration of capital markets, the automatic linkage between the location of the company and location of the capital market is loosening. As a result, companies have expanded choices of where to raise capital, either equity or debt. The move toward adoption of International Financial Report- ing Standards has and will continue to facilitate this movement.

International Standard-Setting Organizations For many years, many nations have relied on their own standard-setting organizations. For example, Canada has the Accounting Standards Board, Japan has the Accounting Standards Board of Japan, Germany has the German Accounting Standards Committee, and the United States has the Financial Accounting Standards Board (FASB). The standards issued by these organizations are sometimes prin- ciples-based, rules-based, tax-oriented, or business-based. In other words, they often differ in concept and objective. Starting in 2000, two major standard-setting bodies have emerged as the primary stan- dard-setting bodies in the world. One organization is based in London, United Kingdom, and is called the International Accounting Standards Board (IASB). The IASB issues International Financial Reporting Standards (IFRS), which are used on most foreign exchanges. These standards may also be used by foreign companies listing on U.S. securities exchanges. As indicated earlier, IFRS is presently used in over 115 countries and is rapidly gaining acceptance in other countries as well.

It is generally believed that IFRS has the best potential to provide a common platform on which companies can report and investors can compare financial information. As a result, our discussion focuses on IFRS and the organization involved in developing these standards—the International Accounting Standards Board (IASB). (A detailed discussion of the U.S. system is provided in the chapter.) The two organizations that have a role in international standard-setting are the International Organization of Securities Commissions (IOSCO) and the IASB.

International Organization of Securities Commissions (IOSCO) The International Organization of Securities Commissions (IOSCO) does not set accounting stan- dards. Instead, this organization is dedicated to ensuring that the global markets can operate in an efficient and effective basis. The member agencies (such as from France, Germany, New Zealand, and the SEC) have resolved to:

• Cooperate to promote high standards of regulation in order to maintain just, effi cient, and sound markets.

• Exchange information on their respective experiences in order to promote the development of domestic markets.

• Unite their efforts to establish standards and an effective surveillance of international securities transactions.

• Provide mutual assistance to promote the integrity of the markets by a rigorous application of the standards and by effective enforcement against offenses.

A landmark year for IOSCO was 2005 when it endorsed the IOSCO Memorandum of Under- standing (MOU) to facilitate cross-border cooperation, reduce global systemic risk, protect

IFRS Insights 31

investors, and ensure fair and efficient securities markets. (For more information, go to http:// www.iosco.org/.)

International Accounting Standards Board (IASB) The standard-setting structure internationally is composed of four organizations—the Interna- tional Accounting Standards Committee Foundation, the International Accounting Standards Board (IASB), a Standards Advisory Council, and an International Financial Reporting Interpreta- tions Committee (IFRIC). The trustees of the International Accounting Standards Committee Foundation (IASCF) select the members of the IASB and the Standards Advisory Council, fund their activities, and generally oversee the IASB’s activities. The IASB is the major operating unit in this four-part structure. Its mission is to develop, in the public interest, a single set of high- quality and understandable IFRS for general-purpose financial statements.

In addition to research help from its own staff, the IASB relies on the expertise of various task force groups formed for various projects and on the Standards Advisory Council (SAC). The SAC consults with the IASB on major policy and technical issues and also helps select task force members. IFRIC develops implementation guidance for consideration by the IASB. Illustration IFRS1-2 shows the current organizational structure for the setting of international standards.

As indicated, the standard-setting structure internationally is very similar to the standard- setting structure in the United States (see Illustration 1-2 on page 10). One notable difference is the size of the Board—the IASB has 16 members, while the FASB has just seven members. The larger IASB reflects the need for broader geographic representation in the international setting. ILLUSTRATION IFRS1-2

International Standard- Setting Structure

Inf orm

s InformsA

ppo int

Appoints/ Monitors Trustees

Reports to

Oversees, Reviews Effectiveness,

Appoints, Finances

Creates

InterpretsStrategic Advice

Source: Adapted from Ernst & Young, International GAAP 2013.

Informs

Appoints, Reviews

Effectiveness,

Oversees, Finances

Monitoring Board

IFRS Foundation (22 trustees)

IFRS (High-quality, enforceable,

and global)

IFRS Advisory Council (30 or more members)

IASB (16 members)

IFRS Interpretations Committee

(22 members)

Types of Pronouncements Following a due process very similar to that used by the FASB, the IASB issues three major types of pronouncements:

1. International Financial Reporting Standards 2. The Conceptual Framework for Financial Reporting 3. International Financial Reporting Interpretations

International Financial Reporting Standards. Financial accounting standards issued by the IASB are referred to as International Financial Reporting Standards (IFRS). The IASB has issued 15 of these standards to date, covering such subjects as business combinations and share-based payments. Prior to the IASB (formed in 2001), standard-setting on the international level was

32 Chapter 1 Financial Accounting and Accounting Standards

done by the International Accounting Standards Committee, which issued International Account- ing Standards (IAS). The committee issued 41 IASs, many of which have been amended or super- seded by the IASB. Those still remaining are considered under the umbrella of IFRS.

The Conceptual Framework for Financial Reporting. As part of a long-range effort to move away from the problem-by-problem approach, the International Accounting Standards Committee (predecessor to the IASB) issued a document entitled “The Conceptual Framework for the Prepa- ration and Presentation of Financial Statements” (also referred to simply as the Framework). This Framework sets forth fundamental objectives and concepts that the Board uses in developing future standards of financial reporting. The intent of the document is to form a cohesive set of interre- lated concepts—a conceptual framework—that will serve as tools for solving existing and emerg- ing problems in a consistent manner. For example, the objective of general-purpose financial reporting discussed earlier is part of this Framework. The Framework and any changes to it pass through the same due process (discussion paper, public hearing, exposure draft, etc.) as an IFRS. However, this Framework is not an IFRS and hence does not define standards for any particular measurement or disclosure issue. Nothing in this Framework overrides any specific international accounting standard.

International Financial Reporting Interpretations. Interpretations issued by the International Fi- nancial Reporting Interpretations Committee (IFRIC) are also considered authoritative and must be followed. These interpretations cover (1) newly identified financial reporting issues not specifically dealt with in IFRS, and (2) issues where unsatisfactory or conflicting interpretations have developed, or seem likely to develop, in the absence of authoritative guidance. The IFRIC has issued over 20 of these interpretations to date. In keeping with the IASB’s own approach to setting standards, the IFRIC applies a principles-based approach in providing interpretative guid- ance. To this end, the IFRIC looks first to the Framework for the Preparation and Presentation of Financial Statements as the foundation for formulating a consensus. It then looks to the principles articulated in the applicable standard, if any, to develop its interpretative guidance and to deter- mine that the proposed guidance does not conflict with provisions in IFRS.

IFRIC helps the IASB in many ways. For example, emerging issues often attract public atten- tion. If not resolved quickly, they can lead to financial crises and scandal. They can also undercut public confidence in current reporting practices. Similar to the EITF in the United States, IFRIC can address controversial accounting problems as they arise. It determines whether it can resolve them or whether to involve the IASB in solving them. In essence, it becomes a “problem filter” for the IASB. Thus, the IASB will hopefully work on more pervasive long-term problems, while the IFRIC deals with short-term emerging issues.

Hierarchy of IFRS Because it is a private organization, the IASB has no regulatory mandate and therefore no enforce- ment mechanism. Similar to the U.S. setting, in which the Securities and Exchange Commission enforces the use of FASB standards for public companies, the IASB relies on other regulators to enforce the use of its standards. For example, effective January 1, 2005, the European Union required publicly traded member country companies to use IFRS.

Certain changes have been implemented with respect to use of IFRS in the United States. For example, under American Institute of Certified Public Accountants (AICPA) rules, a member of the AICPA can only report on financial statements prepared in accordance with standards pro- mulgated by standard-setting bodies designated by the AICPA Council. In May 2008, the AICPA Council voted to designate the IASB in London as an international accounting standard-setter for purposes of establishing international financial accounting and reporting principles, and to make related amendments to its rules to provide AICPA members with the option to use IFRS.

Any company indicating that it is preparing its financial statements in conformity with IFRS must use all of the standards and interpretations. The following hierarchy is used to determine what recognition, valuation, and disclosure requirements should be used. Companies first look to:

1. International Financial Reporting Standards; 2. International Accounting Standards; and 3. Interpretations originated by the International Financial Reporting Interpretations Com-

mittee (IFRIC) or the former Standing Interpretations Committee (SIC).

In the absence of a standard or an interpretation, the following sources in descending order are used: (1) the requirements and guidance in standards and interpretations dealing with similar and related issues; (2) the Framework for financial reporting; and (3) most recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop accounting

IFRS Insights 33

standards, other accounting literature, and accepted industry practices, to the extent they do not conflict with the above. The overriding requirement of IFRS is that the financial statements pro- vide a fair presentation (often referred to as a “true and fair view”). Fair representation is assumed to occur if a company follows the guidelines established in IFRS.

International Accounting Convergence The SEC recognizes that the establishment of a single, widely accepted set of high-quality account- ing standards benefits both global capital markets and U.S. investors. U.S. investors will make bet- ter-informed investment decisions if they obtain high-quality financial information from U.S. com- panies that is more comparable to the presently available information from non-U.S. companies operating in the same industry or line of business. Thus, the SEC appears committed to move to IFRS, assuming that certain conditions are met. These conditions are spelled out in a document, referred to as the “Roadmap” and in a policy statement issued by the SEC in early 2010.12

The FASB and the IASB have been working diligently to (1) make their existing financial reporting standards fully compatible as soon as is practicable, and (2) coordinate their future work programs to ensure that once achieved, compatibility is maintained. This process is referred to as convergence, and the Boards have made significant progress in developing high-quality converged standards. However, much work needs to be done. The Boards have identified the issuance of converged standards on finan- cial instruments (investments), revenue, and leases as a key milestone in the convergence process.

SEC Staff Paper on Incorporation of IFRS The SEC has monitored the convergence process through a staff Work Plan, which considers specific areas and factors relevant to a commission determination as to whether, when, and how the current financial reporting system for U.S. companies should be transitioned to a system incorporating IFRS. Execution of the Work Plan (which addresses such areas as independence of standard-setting, investor understanding of IFRS, and auditor readiness), combined with the completion of the con- vergence projects of the FASB and the IASB according to their current working agreement, will position the SEC to make a decision on required use of IFRS by U.S. issuers.

In July 2012, the SEC staff issued its final report related to the Work Plan elements.13 The main thrust of the report is that we will have to wait and see for a commission decision on required use of IFRS in the United States. Although the Staff Report did not set out to answer the fundamental question of whether transitioning to IFRS is in the best interests of the U.S. securities markets generally and U.S. investors specifically, it appears that it is unlikely companies would be required to change to IFRS in the near future. Rather, there would be a transition period in which this would be accomplished. With respect to this transition, the SEC staff has suggested gradual incor- poration of IFRS into the U.S. financial reporting system.14

The approach to incorporation is an “endorsement approach.” Rather than adopting IFRS at a point in time (sometimes referred to as a “big bang”), the endorsement approach specifies that the FASB and IASB continue their convergence efforts (over a 5–7-year transition period) to align GAAP and IFRS. As a result, these converged standards (which are also IFRS) could be incorporated into GAAP.

The Way Forward The endorsement framework is the last SEC staff proposal with respect to a possible use of IFRS in the United States. It is understandable that there has been little movement in the SEC position, as there is a new chair and chief accountant at the SEC and given the continuing focus at the SEC on rule-making and other follow-up to the financial crisis of 2008.

Nonetheless, in a speech to the AICPA National Conference, the SEC chief accountant reiter- ated the SEC’s support of the FASB’s and IASB’s efforts to date. He also indicated that the SEC staff will build on its prior work and will be renewing its efforts to help clarify what action, if any, the SEC will take regarding the further incorporation of IFRS into U.S. capital markets.15

12“Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards by U.S. Issuers,” SEC Release No. 33-8982 (November 14, 2008), and “Statement in Support of Convergence and Global Accounting Standards,” SEC Release Nos. 33-9109; 34-61578 (February 24, 2010). 13“Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers: Final Staff Report SEC” (July 13, 2012), http://www.sec.gov/ spotlight/globalaccountingstandards/ifrs-work-plan-final-report.pdf. 14SEC Staff Paper, “Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers: Exploring a Possible Method of Incorpora- tion” (May 26, 2011), available at www.sec.gov. 15J. Schnurr, Remarks before the 2014 AICPA National Conference on Current SEC and PCAOB Developments, http://www.sec.gov/News/Speech/Detail/Speech/1370543609306#.VOT39S4yjNQ (December 8, 2014).

34 Chapter 1 Financial Accounting and Accounting Standards

Since the publication of the Staff Paper in 2012, the SEC staff has received input from various constituents on the desirability and feasibility of a full movement, optional or otherwise, to IFRS for domestic issuers. To date, that feedback indicates that U.S. constituents generally are not sup- portive of full adoption of IFRS for a variety of reasons, including legal issues and general cost- benefit concerns. U.S. constituents have also raised similar issues with respect to an option to adopt IFRS. These issues include legal impediments, practical challenges, and an impact on com- parability that does not currently exist in the domestic reporting environment.

Given this feedback, the SEC is seeking input on other approaches to further incorporation of, or alignment with, IFRS for domestic issuers. In addition to the endorsement framework, the SEC chief accountant posed the possible development of rules that would allow U.S. companies to report IFRS- based financial information in addition to the GAAP-based information that they use for purposes of SEC filings. The rules would be needed because such additional disclosures currently would be consid- ered a “non-GAAP” financial measure for a domestic issuer. This change in rules would permit compa- nies who wish to report IFRS-based information to do so without affecting their GAAP-based informa- tion. The chief accountant noted that this supplemental IFRS reporting option is just one example of a path toward further incorporation of IFRS into GAAP and would complement the convergence efforts of the FASB and the IASB, indicating that, “Whatever the ultimate result is with respect to IFRS in the U.S., the Boards should continue to strive where practicable for aligned high-quality global standards.”

ON THE HORIZON Both the IASB and the FASB are hard at work developing standards that will lead to the elimina- tion of major differences in the way certain transactions are accounted for and reported. In fact, beginning in 2010, the IASB (and the FASB on its joint projects with the IASB) started its policy of phasing in adoption of new major standards over several years. The major reason for this policy is to provide companies time to translate and implement international standards into practice. Much has happened in a very short period of time in the international accounting environment. While adoption of IFRS in the United States is an unlikely avenue to achieve a single set of high- quality accounting standards, there continues to be strong support for the Boards to continue their work to narrow the differences between GAAP and IFRS.

1. IFRS stands for: (a) International Federation of Reporting Services. (b) Independent Financial Reporting Standards. (c) International Financial Reporting Standards. (d) Integrated Financial Reporting Services.

2. The major key players on the international side are the: (a) IASB and FASB. (c) SEC and FASB. (b) IOSCO and the SEC. (d) IASB and IOSCO.

3. IFRS is comprised of: (a) International Financial Reporting Standards and

FASB Financial Reporting Standards. (b) International Financial Reporting Standards, Inter-

national Accounting Standards, and International Accounting Interpretations.

(d) FASB Financial Reporting Standards and Interna- tional Accounting Standards.

4. The authoritative status of The Conceptual Framework for Financial Reporting is as follows:

(a) It is used when there is no standard or interpretation related to the reporting issues under consideration.

(b) It is not as authoritative as a standard but takes prece- dence over any interpretation related to the reporting issue.

(d) It has no authoritative status.

5. Which of the following statements is true? (a) The IASB has the same number of members as the

FASB. (b) The IASB structure has both advisory and interpre-

tation functions, but no trustees. (c) The IASB has been in existence longer than the FASB. (d) The IASB structure is quite similar to the FASB’s,

except the IASB has a larger number of board members.

IFRS SELF-TEST QUESTIONS

IFRS CONCEPTS AND APPLICATION

IFRS1-1 What organizations are the two key international players in the development of international accounting standards? Explain their role. IFRS1-2 What might explain the fact that different accounting standard-setters have developed accounting standards that are sometimes quite different in nature?

IFRS Insights 35

IFRS1-3 What is the benefit of a single set of high-quality accounting standards? IFRS1-4 Briefly describe the FASB/IASB convergence process and the principles that guide their convergence efforts.

Financial Reporting Case IFRS1-5 The following comments were made at an Annual Conference of the Financial Executives Institute (FEI).

There is an irreversible movement toward the harmonization of financial reporting throughout the world. The international capital markets require an end to:

1. The confusion caused by international companies announcing different results depending on the set of accounting stan- dards applied.

2. Companies in some countries obtaining unfair commercial advantages from the use of particular national accounting standards.

3. The complications in negotiating commercial arrangements for international joint ventures caused by different accounting requirements.

4. The inefficiency of international companies having to understand and use a myriad of different accounting standards depending on the countries in which they operate and the countries in which they raise capital and debt. Executive talent is wasted on keeping up to date with numerous sets of accounting standards and the never-ending changes to them.

5. The inefficiency of investment managers, bankers, and financial analysts as they seek to compare financial reporting drawn up in accordance with different sets of accounting standards.

Instructions (a) What is the International Accounting Standards Board? (b) What stakeholders might benefi t from the use of International Accounting Standards? (c) What do you believe are some of the major obstacles to convergence?

Professional Research IFRS1-6 As a newly enrolled accounting major, you are anxious to better understand accounting institutions and sources of accounting literature. As a first step, you decide to explore the IASB’s The Conceptual Framework for Financial Reporting.

Instructions Access the IASB Framework at the IASB website (http://eifrs.iasb.org/ ). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following items. (Provide paragraph citations.)

(a) What is the objective of general-purpose fi nancial reporting? (b) What other means are there of communicating information, besides fi nancial statements? (c) Indicate some of the users and the information they are most directly concerned with in economic decision-making.

International Financial Reporting Problem Marks and Spencer plc (M&S)

IFRS1-7 The financial statements of M&S are presented in Appendix E. The company’s complete annual report, including the notes to the financial statements, is available online.

Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions.

(a) What is the company’s main line of business? (b) In what countries does the company operate? (c) What is the address of the company’s corporate headquarters? (d) What is the company’s reporting currency?

ANSWERS TO IFRS SELF-TEST QUESTIONS

1. c 2. d 3. b 4. a 5. d

WHAT IS IT? Everyone agrees that accounting needs a framework—a conceptual framework, so to speak—that will help guide the development of standards. To understand the importance of developing this framework, let’s see how you would respond in the following two situations.

1 Describe the usefulness of a conceptual framework.

2 Understand the objective of financial reporting.

3 Identify the qualitative characteristics of accounting information.

4 Define the basic elements of financial statements.

5 Describe the basic assumptions of accounting.

6 Explain the application of the basic principles of accounting.

7 Describe the impact that the cost constraint has on reporting accounting information.

2 Conceptual Framework for Financial Reporting LEARNING OBJECTIVES After studying this chapter, you should be able to:

Situation 1: “Taking a Long Shot . . . ” To supplement donations collected from its general community solicitation, Tri-Cities United Charities holds an annual lottery sweepstakes. In this year’s sweepstakes, United Charities is offering a grand prize of $1,000,000 to a single winning ticket holder. A total of 10,000 tickets have been printed, and United Charities plans to sell all the tickets at a price of $150 each.

Since its inception, the sweepstakes has attracted area-wide interest, and United Charities has always been able to meet its sales target. However, in the unlikely event that it might fail to sell a sufficient number of tickets to cover the grand prize, United Charities has reserved the right to cancel the sweepstakes and to refund the price of the tickets to holders.

In recent years, a fairly active secondary market for tickets has developed. This year, buying–selling prices have varied between $75 and $95 before stabilizing at about $90.

When the tickets first went on sale this year, multimillionaire Phil N. Tropic, well-known in Tri-Cities civic circles as a generous but sometimes eccentric donor, bought one of the tickets from United Charities, paying $150 cash.

How would you answer the following questions?

1. Should Phil N. Tropic recognize his lottery ticket as an asset in his fi nancial statements? 2. Assuming that Phil N. Tropic recognizes the lottery ticket as an asset, at what amount should it be reported?

Some possible answers are $150, $100, and $90.

How would you answer the following questions?

1. Should Hard Rock recognize a liability for site restoration in conjunction with the opening of the Lone- some Doe Mine? If so, what is the amount of that liability?

2. After Hard Rock has operated the Lonesome Doe Mine for 5 years, new technology is introduced that reduces Hard Rock’s estimated future restoration costs to $7 million, $3 million of which relates to restoring the topsoil. How should Hard Rock account for this change in its estimated future liability?

The answer to the questions on the two situations depends on how assets and liabilities are defined and how they should be valued. Hopefully, this chapter will provide you with a framework to resolve questions like these.

Source: Adapted from Todd Johnson and Kim Petrone, The FASB Cases on Recognition and Measurement, Second Edition (New York: John Wiley and Sons, Inc., 1996).

Situation 2: The $20 Million Question The Hard Rock Mining Company has just completed the first year of operations at its new strip mine, the Lonesome Doe. Hard Rock spent $10 million for the land and $20 million in preparing the site for mining operations. The Mine is expected to operate for 20 years. Hard Rock is subject to environmental statutes requiring it to restore the Lonesome Doe Mine site on completion of mining operations.

Based on its experience and industry data, as well as current technology, Hard Rock forecasts that restoration will cost about $10 million when it is undertaken. Of those costs, about $4 million is for restoring the topsoil that was removed in preparing the site for mining operations (prior to opening the mine). The rest is directly propor- tional to the depth of the mine, which in turn is directly proportional to the amount of ore extracted.

PREVIEW OF CHAPTER 2 As our opening story indicates, users of financial statements can face difficult questions about the recognition and measurement of financial items. To help develop the type of financial information that can be used to answer these questions, financial accounting and reporting relies on a conceptual framework. In this chapter, we discuss the conceptual framework as follows.

CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING

This chapter also includes numerous conceptual and international discussions that are integral to the topics presented here.

CONCEPTUAL FRAMEWORK

• Need • Development • Overview

FIRST LEVEL: BASIC OBJECTIVE

SECOND LEVEL: FUNDAMENTAL CONCEPTS

• Qualitative characteristics • Basic elements

THIRD LEVEL: RECOGNITION AND MEASUREMENT CONCEPTS

• Basic assumptions • Basic principles • Cost constraint • Summary of the structure

38 Chapter 2 Conceptual Framework for Financial Reporting

CONCEPTUAL FRAMEWORK A conceptual framework establishes the concepts that underlie financial reporting. A conceptual framework is a coherent system of concepts that flow from an objective. The objective identifies the purpose of financial reporting. The other concepts provide guid- ance on (1) identifying the boundaries of financial reporting; (2) selecting the transac- tions, other events, and circumstances to be represented; (3) how they should be recog- nized and measured; and (4) how they should be summarized and reported.1

Need for a Conceptual Framework Why do we need a conceptual framework? First, to be useful, rule-making should build on and relate to an established body of concepts. A soundly developed concep- tual framework thus enables the FASB to issue more useful and consistent pro- nouncements over time; a coherent set of standards should result. Indeed, without the guidance provided by a soundly developed framework, standard-setting ends up being based on individual concepts developed by each member of the standard- setting body. The following observation by a former standard-setter highlights the problem.

“As our professional careers unfold, each of us develops a technical conceptual framework. Some individual frameworks are sharply defined and firmly held; others are vague and weakly held; still others are vague and firmly held. . . . At one time or another, most of us have felt the discomfort of listening to somebody buttress a preconceived conclusion by building a convoluted chain of shaky reasoning. Indeed, perhaps on occasion we have voiced such thinking ourselves. . . . My experience . . . taught me many lessons. A major one was that most of us have a natural tendency and an incredible talent for processing new facts in such a way that our prior conclusions remain intact.2

In other words, standard-setting that is based on personal conceptual frameworks will lead to different conclusions about identical or similar issues than it did previously. As a result, standards will not be consistent with one another, and past decisions may not be indicative of future ones. Furthermore, the framework should increase financial statement users’ understanding of and confidence in financial reporting. It should enhance comparability among companies’ financial statements.

Second, as a result of a soundly developed conceptual framework, the profession should be able to more quickly solve new and emerging practical problems by refer- ring to an existing framework of basic theory. For example, Sunshine Mining sold two issues of bonds. It can redeem them either with $1,000 in cash or with 50 ounces of silver, whichever is worth more at maturity. Both bond issues have a stated interest rate of 8.5 percent. At what amounts should Sunshine or the buyers of the bonds record them? What is the amount of the premium or discount on the bonds? And how should Sunshine amortize this amount, if the bond redemption payments are to be made in silver (the future value of which is unknown at the date of issuance)? Consider that Sunshine cannot know, at the date of issuance, the value of future silver bond redemp- tion payments.

LEARNING OBJECTIVE 1 Describe the usefulness of a conceptual frame- work.

1“Chapter 1, The Objective of General Purpose Financial Reporting” and “Chapter 3, Qualitative Character- istics of Useful Financial Information,” Statement of Financial Accounting Concepts No. 8 (Norwalk, Conn.: FASB, September 2010). Recall from our discussion in Chapter 1 that while the conceptual framework and any changes to it pass through the same due process (discussion paper, public hearing, exposure draft, etc.) as do the other FASB pronouncements, the framework is not authoritative. That is, the framework does not define standards for any particular measurement or disclosure issue, and nothing in the framework overrides any specific FASB pronouncement that is included in the Codification. 2C. Horngren, “Uses and Limitations of a Conceptual Framework,” Journal of Accountancy (April 1981), p. 90.

INTERNATIONAL PERSPECTIVE

The IASB has also issued a conceptual framework. Although the FASB and the IASB have worked together to converge elements of their conceptual frameworks (related to objectives and qualita- tive characteristics is- sued in 2010), the IASB has recently proposed additional changes to its own framework. This may result in differences with the FASB concep- tual framework.

Conceptual Framework 39

It is difficult, if not impossible, for the FASB to prescribe the proper accounting treatment quickly for situations like this or like those represented in our opening story. Practicing accountants, however, must resolve such problems on a daily basis. How? Through good judgment and with the help of a universally accepted conceptual frame- work, practitioners can quickly focus on an acceptable treatment.

The need for a conceptual framework is highlighted by account- ing scandals such as those at Enron and Lehman Brothers. To restore public confi dence in the fi nancial reporting process, many have argued that regulators should move toward princi- ples-based rules. They believe that companies exploited the detailed provisions in rules-based pronouncements to manage accounting reports, rather than report the economic substance of transactions. For example, many of the off-balance-sheet arrangements of Enron avoided transparent reporting by barely

achieving 3 percent outside equity ownership, a requirement in an obscure accounting rule interpretation. Enron’s fi nancial engi- neers were able to structure transactions to achieve a desired accounting treatment, even if that accounting treatment did not refl ect the transaction’s true nature. Under principles-based rules, hopefully top management’s fi nancial reporting focus will shift from demonstrating compliance with rules to demonstrat- ing that a company has attained the objective of fi nancial reporting.

WHAT DO THE NUMBERS MEAN? WHAT’S YOUR PRINCIPLE?

Development of a Conceptual Framework Over the years, numerous organizations developed and published their own conceptual frameworks, but no single framework was universally accepted and relied on in prac- tice. In 1976, the FASB began to develop a conceptual framework that would be a basis for setting accounting rules and for resolving financial reporting controversies. The FASB has since issued seven Statements of Financial Accounting Concepts that relate to financial reporting for business enterprises:3

1. SFAC No. 1, “Objectives of Financial Reporting by Business Enterprises,” presents the goals and purposes of accounting (superseded by SFAC No. 8, Chapter 1).

2. SFAC No. 2, “Qualitative Characteristics of Accounting Information,” examines the characteristics that make accounting information useful (superseded by SFAC No. 8, Chapter 3).

3. SFAC No. 3, “Elements of Financial Statements of Business Enterprises,” provides defi nitions of items in fi nancial statements, such as assets, liabilities, revenues, and expenses (superseded by SFAC No. 6).

4. SFAC No. 5, “Recognition and Measurement in Financial Statements of Business Enterprises,” sets forth fundamental recognition and measurement criteria and guidance on what information should be formally incorporated into fi nancial state- ments and when.

5. SFAC No. 6, “Elements of Financial Statements,” replaces SFAC No. 3 and expands its scope to include not-for-profi t organizations.

6. SFAC No. 7, “Using Cash Flow Information and Present Value in Accounting Mea- surements,” provides a framework for using expected future cash fl ows and present values as a basis for measurement.

7. SFAC No. 8, Chapter 1, “The Objective of General Purpose Financial Reporting,” and Chapter 3, “Qualitative Characteristics of Useful Financial Information,” replaces SFAC No. 1 and No. 2.

3The FASB also issued a Statement of Financial Accounting Concepts that relates to nonbusiness organiza- tions: “Objectives of Financial Reporting by Nonbusiness Organizations,” Statement of Financial Accounting Concepts No. 4 (December 1980).

INTERNATIONAL PERSPECTIVE

SFAC No. 8 is the prod- uct of a joint conceptual framework project of the FASB and IASB.

40 Chapter 2 Conceptual Framework for Financial Reporting

Overview of the Conceptual Framework Illustration 2-1 provides an overview of the FASB’s conceptual framework.4

4Adapted from William C. Norby, The Financial Analysts Journal (March–April 1982), p. 22.

The first level identifies the objective of financial reporting—that is, the purpose of financial reporting. The second level provides the qualitative characteristics that make accounting information useful and the elements of financial statements (assets, liabili- ties, and so on). The third level identifies the recognition, measurement, and disclosure concepts used in establishing and applying accounting standards and the specific con- cepts to implement the objective. These concepts include assumptions, principles, and a cost constraint that describe the present reporting environment. We examine these three levels of the conceptual framework next.

FIRST LEVEL: BASIC OBJECTIVE The objective of financial reporting is the foundation of the conceptual framework. Other aspects of the framework—qualitative characteristics, elements of financial state- ments, recognition, measurement, and disclosure—flow logically from the objective.

LEARNING OBJECTIVE 2 Understand the objective of financial reporting.

ILLUSTRATION 2-1 Framework for Financial Reporting

First level: The "why"—purpose of accounting

Second level: Bridge between levels 1 and 3

Third level: The "how"—

implementation

ASSUMPTIONS PRINCIPLES CONSTRAINT

Recognition, Measurement, and Disclosure Concepts

QUALITATIVE CHARACTERISTICS

of accounting information

OBJECTIVE of

financial reporting

ELEMENTS of

financial statements

Second Level: Fundamental Concepts 41

Those aspects of the framework help to ensure that financial reporting achieves its objective.

The objective of general-purpose financial reporting is to provide financial informa- tion about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments, and providing or settling loans and other forms of credit. To make effective decisions, these parties need information to help them assess a company’s prospects for future net cash flows, which will support payments and/or provide a return to existing and poten- tial investors, lenders, and other creditors. Information that is decision-useful to capital providers may also be useful to other users of financial reporting, who are not capital providers.5

As indicated in Chapter 1, to provide information to decision-makers, compa- nies prepare general-purpose financial statements. General-purpose financial reporting helps users who lack the ability to demand all the financial information they need from an entity and therefore must rely, at least partly, on the information provided in financial reports. However, an implicit assumption is that users need reasonable knowledge of business and financial accounting matters to understand the information contained in financial statements. This point is important. It means that financial statement preparers assume a level of competence on the part of users. This assumption impacts the way and the extent to which companies report information.

SECOND LEVEL: FUNDAMENTAL CONCEPTS The objective (first level) focuses on the purpose of financial reporting. Later, we will discuss the ways in which this purpose is implemented (third level). What, then, is the purpose of the second level? The second level provides conceptual building blocks that explain the qualitative characteristics of accounting information and define the ele- ments of financial statements.6 That is, the second level forms a bridge between the why of accounting (the objective) and the how of accounting (recognition, measurement, and financial statement presentation).

Qualitative Characteristics of Accounting Information Should companies like Walt Disney or Kellogg’s provide information in their financial statements on how much it costs them to acquire their assets (historical cost basis) or how much the assets are currently worth (fair value basis)? Should PepsiCo combine and show as one company the four main segments of its business, or should it report PepsiCo Beverages, Frito Lay, Quaker Foods, and PepsiCo International as four separate segments?

How does a company choose an acceptable accounting method, the amount and types of information to disclose, and the format in which to present it? The answer: By determining which alternative provides the most useful information for decision- making purposes (decision-usefulness). The FASB identified the qualitative charac- teristics of accounting information that distinguish better (more useful) information from inferior (less useful) information for decision-making purposes. In addition, the FASB identified a cost constraint as part of the conceptual framework (discussed later

5“Chapter 1, The Objective of General Purpose Financial Reporting,” Statement of Financial Accounting Concepts No. 8 (Norwalk, Conn.: FASB, September 2010), par. OB2. 6“Chapter 3, Qualitative Characteristics of Useful Financial Information,” Statement of Financial Accounting Concepts No. 8 (Norwalk, Conn.: FASB, September 2010).

LEARNING OBJECTIVE 3 Identify the qualitative characteristics of accounting information.

42 Chapter 2 Conceptual Framework for Financial Reporting

in the chapter). As Illustration 2-2 shows, the characteristics may be viewed as a hierarchy.

ILLUSTRATION 2-2 Hierarchy of Accounting Qualities CAPITAL PROVIDERS (Investors and Creditors)AND THEIR CHARACTERISTICS

DECISION-USEFULNESS

Predictive value

Confirmatory value Materiality

UnderstandabilityTimelinessVerifiabilityComparability

COST

Primary users of accounting information

Constraint

Pervasive criterion

Fundamental qualities

Ingredients of fundamental qualities

Enhancing qualities

Completeness Free from error

Neutrality

RELEVANCE FAITHFUL REPRESENTATION

As indicated by Illustration 2-2, qualitative characteristics are either fundamental or enhancing, depending on how they affect the decision-usefulness of information. Regardless of classification, each qualitative characteristic contributes to the decision- usefulness of financial reporting information. However, providing useful financial information is limited by a constraint on financial reporting—cost should not exceed the benefits of a reporting practice.

Fundamental Quality—Relevance Relevance is one of the two fundamental qualities that make accounting information useful for decision-making. Relevance and related ingredients of this fundamental qual- ity are shown below.

To have relevance, accounting information must be capable of making a difference in a decision. Information with no bearing on a decision is irrelevant. Financial informa- tion is capable of making a difference when it has predictive value, confirmatory value, or both.

RELEVANCE

Predictive value

Confirmatory value Materiality

Fundamental quality

Ingredients of the fundamental quality

Second Level: Fundamental Concepts 43

Financial information has predictive value if it has value as an input to predictive processes used by investors to form their own expectations about the future. For exam- ple, if potential investors are interested in purchasing common shares in UPS (United Parcel Service), they may analyze its current resources and claims to those resources, its dividend payments, and its past income performance to predict the amount, timing, and uncertainty of UPS’s future cash flows.

Relevant information also helps users confirm or correct prior expectations; it has confirmatory value. For example, when UPS issues its year-end financial statements, it confirms or changes past (or present) expectations based on previous evaluations. It fol- lows that predictive value and confirmatory value are interrelated. For example, infor- mation about the current level and structure of UPS’s assets and liabilities helps users predict its ability to take advantage of opportunities and to react to adverse situations. The same information helps to confirm or correct users’ past predictions about that ability.

Materiality is a company-specific aspect of relevance. Information is material if omitting it or misstating it could influence decisions that users make on the basis of the reported financial information. An individual company determines whether infor- mation is material because both the nature and/or magnitude of the item(s) to which the information relates must be considered in the context of an individual company’s financial report. Information is immaterial, and therefore irrelevant, if it would have no impact on a decision-maker. In short, it must make a difference or a company need not report it.

Assessing materiality is one of the more challenging aspects of accounting because it requires evaluating both the relative size and importance of an item. However, it is difficult to provide firm guidelines in judging when a given item is or is not material. Materiality varies both with relative amount and with relative importance. For example, the two sets of numbers in Illustration 2-3 indicate relative size.

ILLUSTRATION 2-3 Materiality Comparison Company A Company B

Sales $10,000,000 $100,000 Costs and expenses 9,000,000 90,000

Income from operations $ 1,000,000 $ 10,000

Unusual gain $ 20,000 $ 5,000

During the period in question, the revenues and expenses, and therefore the net incomes of Company A and Company B, are proportional. Each reported an unusual gain. In looking at the abbreviated income figures for Company A, it appears insignificant whether the amount of the unusual gain is set out separately or merged with the regular operating income. The gain is only 2 percent of the operating income. If merged, it would not seriously distort the income figure. Company B has had an unusual gain of only $5,000. However, it is relatively much more significant than the larger gain realized by Company A. For Company B, an item of $5,000 amounts to 50 percent of its income from operations. Obviously, the inclusion of such an item in operating income would affect the amount of that income materially. Thus, we see the importance of the relative size of an item in determining its materiality.

Companies and their auditors generally adopt the rule of thumb that anything under 5 percent of net income is considered immaterial. However, much can depend on specific rules. For example, one market regulator indicates that a company may use this percentage for an initial assessment of materiality, but it must also consider other fac- tors. For example, companies can no longer fail to record items in order to meet consen- sus analysts’ earnings numbers, preserve a positive earnings trend, convert a loss to a profit or vice versa, increase management compensation, or hide an illegal transaction like a bribe. In other words, companies must consider both quantitative and qualita- tive factors in determining whether an item is material.

44 Chapter 2 Conceptual Framework for Financial Reporting

Thus, it is generally not feasible to specify uniform quantitative thresholds at which an item becomes material. Rather, materiality judgments should be made in the context of the nature and the amount of an item. Materiality factors into a great many internal accounting decisions, too. Examples of such judgments that companies must make include the amount of classification required in a subsidiary expense ledger, the degree of accuracy required in allocating expenses among the departments of a com- pany, and the extent to which adjustments should be made for accrued and deferred items. Only by the exercise of good judgment and professional expertise can reason- able and appropriate answers be found with respect to materiality issues.7

The fi rst line of defense for many companies caught “cooking the books” had been to argue that a questionable accounting item is immaterial. That defense did not work so well in the wake of accounting meltdowns at Enron and Global Cross- ing and the tougher rules on materiality issued by the SEC (SAB 99).

For example, the SEC alleged in a case against Sun- beam that the company’s many immaterial adjustments added up to a material misstatement that misled investors about the company’s fi nancial position. The SEC has called for a number of companies, such as Jack in the Box, McDonald’s, and AIG, to restate prior fi nancial statements for the effects of incorrect accounting. In some cases, the

restatements did not meet traditional materiality thresholds. Don Nicholaisen, then SEC chief accountant, observed that whether the amount is material or not, some transactions appear to be “fl at out intended to mislead investors.” In essence he is saying that even small accounting errors for a transaction can represent important information to the users of fi nancial statements.

Responding to new concerns about materiality, blue-chip companies such as IBM and General Electric are providing expanded disclosures of transactions that used to fall below the materiality radar. As a result, some good may yet come from these accounting failures.

WHAT DO THE NUMBERS MEAN? LIVING IN A MATERIAL WORLD

Fundamental Quality—Faithful Representation Faithful representation is the second fundamental quality that makes accounting infor- mation useful for decision-making. Faithful representation and related ingredients of this fundamental quality are shown below.

FAITHFUL REPRESENTATION

Completeness Free from errorNeutrality

Fundamental quality

Ingredients of the fundamental quality

Sources: Adapted from K. Brown and J. Weil, “A Lot More Information Is ‘Material’ After Enron,” Wall Street Journal Online (February 22, 2002); S. D. Jones and R. Gibson, “Restaurants Serve Up Restatements,” Wall Street Journal (January 26, 2005), p. C3; and R. McTauge, “Nicholaisen Says Restatement Needed When Deal Lacks Business Purpose,” Securities Regulation & Law Reporter (May 9, 2005).

7The FASB has proposed an amendment to the conceptual framework that would modify the definition of materiality to be consistent with the legal concept of materiality (as established in the securities laws). Specifically, information is material “if there is a substantial likelihood that the omitted or misstated item would have been viewed by a reasonable resource provider as having significantly altered the total mix of information.” The FASB notes that it cannot advise or specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation. Thus, to avoid creating uncertainty or confusion, the Board makes it clear that the conceptual framework does not define materiality but instead relies on the U.S. Supreme Court’s definition in the context of the antifraud provisions of the U.S. securities laws. See Proposed Concepts Statement, Conceptual Framework for Financial Reporting Chapter 3: Qualitative Characteristics of Useful Financial Information (September 24, 2015).

Second Level: Fundamental Concepts 45

Faithful representation means that the numbers and descriptions match what really existed or happened. Faithful representation is a necessity because most users have neither the time nor the expertise to evaluate the factual content of the informa- tion. For example, if General Motors’ income statement reports sales of $180,300 million when it had sales of $155,399 million, then the statement fails to faithfully represent the proper sales amount. To be a faithful representation, information must be complete, neutral, and free of material error.

Completeness. Completeness means that all the information that is necessary for faith- ful representation is provided. An omission can cause information to be false or mis- leading and thus not be helpful to the users of financial reports. For example, when Citigroup fails to provide information needed to assess the value of its subprime loan receivables (toxic assets), the information is not complete and therefore not a faithful representation of their values.

Neutrality. Neutrality means that a company cannot select information to favor one set of interested parties over another. Unbiased information must be the overriding consid- eration. For example, in the notes to financial statements, tobacco companies such as R.J. Reynolds should not suppress information about the numerous lawsuits that have been filed because of tobacco-related health concerns—even though such disclosure is damaging to the company.

Neutrality in rule-making has come under increasing attack. Some argue that the FASB should not issue pronouncements that cause undesirable economic effects on an industry or company. We disagree. Accounting rules (and the standard-setting process) must be free from bias, or we will no longer have credible financial state- ments. Without credible financial statements, individuals will no longer use this information. An analogy demonstrates the point: Many individuals bet on boxing matches because such contests are assumed not to be fixed. But nobody bets on wrestling matches. Why? Because the public assumes that wrestling matches are rigged. If financial information is biased (rigged), the public will lose confidence and no longer use it.8

Free from Error. An information item that is free from error will be a more accurate (faithful) representation of a financial item. For example, if JPMorgan Chase misstates its loan losses, its financial statements are misleading and not a faithful representation of its financial results. However, faithful representation does not imply total freedom from error. This is because most financial reporting measures involve estimates of vari- ous types that incorporate management’s judgment. For example, management must estimate the amount of uncollectible accounts to determine bad debt expense. And determination of depreciation expense requires estimation of useful lives of plant and equipment, as well as the salvage value of the assets.

8Sometimes, in practice, it has been acceptable to invoke prudence or conservatism as a justification for an accounting treatment under conditions of uncertainty. Prudence or conservatism means when in doubt, choose the solution that will be least likely to overstate assets or income and/or understate liabilities or expenses. The conceptual framework indicates that prudence or conservatism generally is in conflict with the quality of neutrality. This is because being prudent or conservative likely leads to a bias in the reported financial position and financial performance. In fact, introducing biased understate- ment of assets (or overstatement of liabilities) in one period frequently leads to overstating financial performance in later periods—a result that cannot be described as prudent. This is inconsistent with neutrality, which encompasses freedom from bias. Accordingly, the conceptual framework does not include prudence or conservatism as desirable qualities of financial reporting information. See “Chapter 3, Qualitative Characteristics of Useful Financial Information,” Statement of Financial Accounting Concepts No. 8 (Norwalk, Conn.: FASB, September 2010), paras. BC3.27–BC3.29.

46 Chapter 2 Conceptual Framework for Financial Reporting

Enhancing Qualities Enhancing qualitative characteristics are complementary to the fundamental qualitative characteristics. These characteristics distinguish more-useful information from less- useful information. Enhancing characteristics, shown below, are comparability, verifi- ability, timeliness, and understandability.

Some young technology companies, in an effort to attract investors who will help them strike it rich, are using unconven- tional fi nancial terms in their fi nancial reports. As an example, instead of revenue, these privately held companies use terms such as “bookings,” annual recurring revenues, or other num- bers that often exceed actual revenue.

Hortonworks Inc. (a software company) is a classic illustration. It forecast in March 2014 that it would have a strong $100 million in billings by year-end. It turns out the company was not talking about revenues but rather a non- GAAP number that it uses to gauge future business. This number looked a lot smaller after Hortonworks went public and reported fi nancial results—just $46 million in revenues, as shown in the following chart.

Hortonworks

(in m

ill io

ns )

0 2014

Billings 2014

Revenue

$100

$100 million

$46 million

Another example is Uber Technologies (the sometimes controversial ride service). Uber recently noted that it is on tar- get to reach $10 billion in bookings for 2015. Uber defi nes bookings as total fares paid by customers. But Uber keeps lit- tle of the money from these bookings. As shown in the chart below, Uber gets only 25 cents on each $1 of bookings.

Uber

0 2014

Bookings 2014

Revenue

$10 $10 billion

$2.5 billion

(in b

ill io

ns )

If Uber was a public company, it would report the 25 cents as revenues, not the one dollar. The lesson for investors: Keep an eye on reliable fi nancial measures of performance and be sure to count expenses and net income according to GAAP. Using gross measures such as billings, recurring revenues, or some nonfi nancial and non-GAAP measures to determine suc- cess may be hazardous to your fi nancial health.

WHAT DO THE NUMBERS MEAN? SHOW ME THE EARNINGS!

Predictive value

Confirmatory value Materiality

UnderstandabilityTimelinessVerifiabilityComparability

Fundamental qualities

Ingredients of fundamental qualities

Enhancing qualities

Completeness Free from error

Neutrality

RELEVANCE FAITHFUL REPRESENTATION

Comparability. Information that is measured and reported in a similar manner for different companies is considered comparable. Comparability enables users to iden- tify the real similarities and differences in economic events between companies. For

Source: Telis Demos, Shira Ovide, and Susan Pulliam, “Tech Startups Play Numbers Game,” Wall Street Journal (June 10, 2015), pp. A1 and A12.

Second Level: Fundamental Concepts 47

example, historically the accounting for pensions in Japan differed from that in the United States. In Japan, companies generally recorded little or no charge to income for these costs. U.S. companies recorded pension cost as incurred. As a result, it is difficult to compare and evaluate the financial results of Toyota or Honda to General Motors or Ford. Investors can only make valid evaluations if comparable information is available.

Another type of comparability, consistency, is present when a company applies the same accounting treatment to similar events, from period to period. Through such application, the company shows consistent use of accounting standards. The idea of consistency does not mean, however, that companies cannot switch from one account- ing method to another. A company can change methods, but it must first demonstrate that the newly adopted method is preferable to the old. If approved, the company must then disclose the nature and effect of the accounting change, as well as the justification for it, in the financial statements for the period in which it made the change.9 When a change in accounting principles occurs, the auditor generally refers to it in an explana- tory paragraph of the audit report. This paragraph identifies the nature of the change and refers the reader to the note in the financial statements that discusses the change in detail.10

Verifiability. Verifiability occurs when independent measurers, using the same meth- ods, obtain similar results. Verifiability occurs in the following situations.

1. Two independent auditors count PepsiCo’s inventory and arrive at the same physical quantity amount for inventory. Verifi cation of an amount for an asset therefore can occur by simply counting the inventory (referred to as direct verifi cation).

2. Two independent auditors compute PepsiCo’s inventory value at the end of the year using the FIFO method of inventory valuation. Verifi cation may occur by check- ing the inputs (quantity and costs) and recalculating the outputs (ending inventory value) using the same accounting convention or methodology (referred to as indirect verifi cation).

Timeliness. Timeliness means having information available to decision-makers before it loses its capacity to influence decisions. Having relevant information available sooner can enhance its capacity to influence decisions. A lack of timeliness, on the other hand, can rob information of its usefulness. For example, if Dell waited to report its interim results until nine months after the period, the information would be much less useful for decision-making purposes.

Understandability. Decision-makers vary widely in the types of decisions they make, how they make decisions, the information they already possess or can obtain from other sources, and their ability to process the information. For information to be useful, there must be a connection (linkage) between these users and the decisions they make. This link, understandability, is the quality of information that lets reasonably informed users see its significance. Understandability is enhanced when information is classified, characterized, and presented clearly and concisely.

For example, assume that Google issues a three-months’ report that shows interim earnings have declined significantly. This interim report provides relevant and

9Surveys indicate that users highly value consistency. They note that a change tends to destroy the compara- bility of data before and after the change. Some companies assist users to understand the pre- and post- change data. Generally, however, users say they lose the ability to analyze over time. GAAP guidelines (discussed in Chapter 22) on accounting changes are designed to improve the comparability of the data before and after an accounting change. 10These provisions are specified in “Reports on Audited Financial Statements,” Statement on Auditing Standards No. 58 (New York: AICPA, April 1988), par. 34.

48 Chapter 2 Conceptual Framework for Financial Reporting

faithfully represented information for decision-making purposes. Some users, upon reading the report, decide to sell their shares. Other users, however, do not understand the report’s content and significance. They are surprised when Google declares a smaller year-end dividend and the share price declines. Thus, although Google presented highly relevant information that was a faithful representation, it was useless to those who did not understand it.

Thus, users of financial reports are assumed to have a reasonable knowledge of business and economic activities. In making decisions, users also should review and analyze the information with reasonable diligence. Information that is relevant and faithfully represented should not be excluded from financial reports solely because it is too complex or difficult for some users to understand without assistance.11

Basic Elements An important aspect of developing any theoretical structure is the body of basic ele- ments or definitions to be included in it. Accounting uses many terms with distinctive and specific meanings. These terms constitute the language of business or the jargon of accounting.

One such term is asset. Is it merely something we own? Or is an asset something we have the right to use, as in the case of leased equipment? Or is it anything of value used by a company to generate revenues—in which case, should we also consider the manag- ers of a company as an asset?

As this example and the lottery ticket example in the opening story illustrate, it therefore seems necessary to develop basic definitions for the elements of financial statements. SFAC No. 6 defines the 10 interrelated elements that most directly relate to measuring the performance and financial status of a business enterprise. We list them below and on the next page for review and information purposes; you need not memo- rize these definitions at this point. We will explain and examine each of these elements in more detail in subsequent chapters.

The FASB classifies the elements into two distinct groups. The first group of three elements—assets, liabilities, and equity—describes amounts of resources and claims to resources at a moment in time. The other seven elements describe transactions, events, and circumstances that affect a company during a period of time. The first class, affected by elements of the second class, provides at any time the cumulative result of all changes. This interaction is referred to as “articulation.” That is, key figures in one financial state- ment correspond to balances in another.

LEARNING OBJECTIVE 4 Define the basic elements of financial statements.

11“Chapter 3, Qualitative Characteristics of Useful Financial Information,” Statement of Financial Accounting Concepts No. 8 (Norwalk, Conn.: FASB, September 2010), paras. QC30–QC31.

ASSETS. Probable future economic benefi ts obtained or controlled by a particular entity as a result of past transactions or events.

LIABILITIES. Probable future sacrifi ces of economic benefi ts arising from present obliga- tions 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. Residual interest in the assets of an entity that remains after deducting its liabili- ties. In a business enterprise, the equity is the ownership interest.

ELEMENTS OF FINANCIAL STATEMENTS

Third Level: Recognition and Measurement Concepts 49

THIRD LEVEL: RECOGNITION AND MEASUREMENT CONCEPTS The third level of the framework consists of concepts that implement the basic objective of level one. These concepts explain how companies should recognize, measure, and report financial elements and events. The FASB sets forth most of these in its Statement of Financial Accounting Concepts No. 5, “Recognition and Measurement in Financial State- ments of Business Enterprises.” According to SFAC No. 5, to be recognized, an item (event or transaction) must meet the definition of an “element of financial statements” as defined in SFAC No. 6 and must be measurable. Most aspects of current practice fol- low these recognition and measurement concepts.

The accounting profession continues to use the concepts in SFAC No. 5 as opera- tional guidelines. Here, we identify the concepts as basic assumptions, principles, and a cost constraint. Not everyone uses this classification system, so focus your attention more on understanding the concepts than on how we classify and organize them.

INVESTMENTS BY OWNERS. Increases in net assets of a particular enterprise resulting from transfers to it from other entities of something of value 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. Decreases in net assets of a particular enterprise re- sulting from transferring assets, rendering services, or incurring liabilities by the enter- prise to owners. Distributions to owners decrease ownership interests (or equity) in an enterprise.

COMPREHENSIVE INCOME. Change in equity (net assets) of an entity during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.

REVENUES. Infl ows or other enhancements of assets of an entity or settlement of its li- abilities (or a combination of both) during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

EXPENSES. Outfl ows or other using up of assets or incurrences of liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.

GAINS. 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 during a period except those that result from revenues or investments by owners.

LOSSES. 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 during a period except those that result from expenses or distributions to owners.12

12“Elements of Financial Statements,” Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, December 1985), pp. ix and x.

LEARNING OBJECTIVE 5 Describe the basic assumptions of accounting.

50 Chapter 2 Conceptual Framework for Financial Reporting

These concepts serve as guidelines in responding to controversial financial reporting issues.

Basic Assumptions Four basic assumptions underlie the financial accounting structure: (1) economic entity, (2) going concern, (3) monetary unit, and (4) periodicity. We’ll look at each in turn.

Economic Entity Assumption The economic entity assumption means that economic activity can be identified with a particular unit of accountability. In other words, a company keeps its activity sepa- rate and distinct from its owners and any other business unit.13 At the most basic level, the economic entity assumption dictates that Panera Bread Company record the com- pany’s financial activities separate from those of its owners and managers. Equally important, financial statement users need to be able to distinguish the activities and elements of different companies, such as General Motors, Ford, and Chrysler. If users could not distinguish the activities of different companies, how would they know which company financially outperformed the other?

The entity concept does not apply solely to the segregation of activities among competing companies, such as Home Depot and Lowe’s. An individual, department, division, or an entire industry could be considered a separate entity if we choose to define it in this manner. Thus, the entity concept does not necessarily refer to a legal entity. A parent and its subsidiaries are separate legal entities, but merging their activities for accounting and reporting purposes does not violate the economic entity assumption.14

INTERNATIONAL PERSPECTIVE

One phase of the conceptual framework convergence project addresses the reporting entity.

13The FASB has proposed to link the definition of an entity to its financial reporting objective. That is, a reporting entity is described as a circumscribed area of business activity of interest to present and potential equity investors, lenders, and other capital providers. See IASB/FASB, “The Reporting Entity,” Exposure Draft ED/2010/2: Conceptual Framework for Financial Reporting (March 2010). 14The concept of the entity is changing. For example, defining the “outer edges” of companies is now harder. Public companies often consist of multiple public subsidiaries, each with joint ventures, licensing arrange- ments, and other affiliations. Increasingly, companies form and dissolve joint ventures or customer-supplier relationships in a matter of months or weeks. These “virtual companies” raise accounting issues about how to account for the entity. As discussed in footnote 13, the FASB (and IASB) is addressing these issues in the entity phase of its conceptual framework project.

The importance of the entity assumption is illustrated by scandals involving W. R. Grace and Adelphia. In both cases, senior company employees entered into transactions that blurred the line between the employee’s financial interests and those of the company. At Adelphia, among many other self-dealings, the company guaranteed over $2 billion of loans to the founding family. W. R. Grace used

company funds to pay for an apartment and chef for the company chairman. As a result of these transactions, these insiders benefi tted at the expense of shareholders. Addition- ally, the fi nancial statements failed to disclose the transac- tions. Such disclosure would have allowed shareholders to sort out the impact of the employee transactions on company results.

WHAT DO THE NUMBERS MEAN? WHOSE COMPANY IS IT?

Going Concern Assumption Most accounting methods rely on the going concern assumption—that the company will have a long life. Despite numerous business failures, most companies have a fairly high continuance rate. As a rule, we expect companies to last long enough to fulfill their objectives and commitments.

Third Level: Recognition and Measurement Concepts 51

This assumption has significant implications. The historical cost principle would be of limited usefulness if we assume eventual liquidation. Under a liquidation approach, for example, a company would better state asset values at net realizable value (sales price less costs of disposal) than at acquisition cost. Depreciation and amortization policies are justifiable and appropriate only if we assume some permanence to the company. If a company adopts the liquidation approach, the current/noncurrent clas- sification of assets and liabilities loses much of its significance. Labeling anything a fixed or long-term asset would be difficult to justify. Indeed, listing liabilities on the basis of priority in liquidation would be more reasonable.

The going concern assumption applies in most business situations. Only where liquidation appears imminent is the assumption inapplicable. In these cases, a total revaluation of assets and liabilities can provide information that closely approximates the company’s net realizable value. You will learn more about accounting problems related to a company in liquidation in advanced accounting courses.15

Monetary Unit Assumption The monetary unit assumption means that money is the common denominator of eco- nomic activity and provides an appropriate basis for accounting measurement and anal- ysis. That is, the monetary unit is the most effective means of expressing to interested parties changes in capital and exchanges of goods and services. The monetary unit is relevant, simple, universally available, understandable, and useful. Application of this assumption depends on the even more basic assumption that quantitative data are useful in communicating economic information and in making rational economic decisions.

In the United States, accounting ignores price-level changes (inflation and defla- tion) and assumes that the unit of measure—the dollar—remains reasonably stable. We therefore use the monetary unit assumption to justify adding 1990 dollars to 2017 dol- lars without any adjustment. The FASB in SFAC No. 5 indicated that it expects the dollar, unadjusted for inflation or deflation, to continue to be used to measure items recognized in financial statements. Only if circumstances change dramatically (such as if the United States experiences high inflation similar to that in some South American countries) will the FASB again consider “inflation accounting.”

Periodicity Assumption To measure the results of a company’s activity accurately, we would need to wait until it liquidates. Decision-makers, however, cannot wait that long for such information. Users need to know a company’s performance and economic status on a timely basis so that they can evaluate and compare firms, and take appropriate actions. Therefore, com- panies must report information periodically.

The periodicity (or time period) assumption implies that a company can divide its economic activities into artificial time periods. These time periods vary, but the most common are monthly, quarterly, and yearly.

15In response to the minimal guidance addressing the going concern assumption, including when it is appropriate to apply or how to apply the liquidation basis of accounting, the FASB has issued two accounting standards. The first, (“Presentation of Financial Statements—Going Concern: Disclosure of Uncertainties about an Entity’s Abillity to Continue as a Going Concern”) [1] requires additional disclosure when substantial doubt about a company’s ability to continue as a going concern occurs. The second standard (“Presentation of Financial Statements—The Liquidation Basis of Accounting“) [2] requires that companies use the liquidation basis of accounting when liquidation is imminent (when either a plan for liquidation has been approved or a plan for liquidation is being imposed by other forces, such as involuntary bankruptcy). If liquidation accounting is used, financial statements should reflect relevant information about a company’s resources and obligations in liquidation by measuring and presenting assets and liabilities at the amount of cash or other consideration that the company expects to collect or pay in liquidation, along with additional disclosures about the plan for liquidation, the methods and significant assumptions used to measure assets and liabilities, the type and amount of costs and income accrued, and the expected duration of liquidation.

See the FASB Codifi cation References (page 73).

INTERNATIONAL PERSPECTIVE

Due to their experiences with persistent inflation, several South American countries produce “constant-currency” financial reports. Typically, companies in these countries use a general price-level index to adjust for the effects of inflation.

52 Chapter 2 Conceptual Framework for Financial Reporting

The shorter the time period, the more difficult it is to determine the proper net income for the period. A month’s results usually prove less verifiable than a quarter’s results, and a quarter’s results are likely to be less verifiable than a year’s results. Investors desire and demand that a company quickly process and disseminate infor- mation. Yet the quicker a company releases the information, the more likely the infor- mation will include errors. This phenomenon provides an interesting example of the trade-off between timeliness and accuracy (free from error) in preparing financial data.

The problem of defining the time period becomes more serious as product cycles shorten and products become obsolete more quickly. Many believe that, given technol- ogy advances, companies need to provide more online, real-time financial information to ensure the availability of relevant information.

Basic Principles of Accounting We generally use four basic principles of accounting to record and report transactions: (1) measurement, (2) revenue recognition, (3) expense recognition, and (4) full disclo- sure. We look at each in turn.

Measurement Principle We presently have a “mixed-attribute” system that permits the use of various measure- ment bases. The most commonly used measurements are based on historical cost and fair value. Here, we discuss each.

Historical Cost. GAAP requires that companies account for and report many assets and liabilities on the basis of acquisition price. This is often referred to as the historical cost principle. Historical cost has an important advantage over other valuations: It is generally thought to be verifiable.

To illustrate this advantage, consider the problems if companies select current sell- ing price instead. Companies might have difficulty establishing a value for unsold items. Every member of the accounting department might value the assets differently. Further, how often would it be necessary to establish sales value? All companies close their accounts at least annually. But some compute their net income every month. Those companies would have to place a sales value on every asset each time they wished to determine income. Critics raise similar objections against current cost (replacement cost, present value of future cash flows) and any other basis of valuation except historical cost.

What about liabilities? Do companies account for them on a cost basis? Yes, they do. Companies issue liabilities, such as bonds, notes, and accounts payable, in exchange for assets (or services), for an agreed-upon price. This price, established by the exchange transaction, is the “cost” of the liability. A company uses this amount to record the liability in the accounts and report it in financial statements. Thus, many users prefer historical cost because it provides them with a verifiable benchmark for measuring historical trends.

Fair Value. Fair value is defined 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.” Fair value is therefore a market-based measure. [3] Recently, GAAP has increasingly called for use of fair value measurements in the financial statements. This is often referred to as the fair value principle. Fair value information may be more useful than historical cost for certain types of assets and liabilities and in certain industries. For example, companies report many financial instruments, including derivatives, at fair value. Certain industries, such as broker- age houses and mutual funds, prepare their basic financial statements on a fair value basis.

LEARNING OBJECTIVE 6 Explain the application of the basic principles of accounting.

Third Level: Recognition and Measurement Concepts 53

At initial acquisition, historical cost equals fair value. In subsequent periods, as market and economic conditions change, historical cost and fair value often diverge. Thus, fair value measures or estimates often provide more relevant information about the expected future cash flows related to the asset or liability. For example, when long- lived assets decline in value, a fair value measure determines any impairment loss. In this situation, the FASB believes that fair value information is more relevant to users than historical cost. Fair value measurement, it is argued, provides better insight into the value of a company’s assets and liabilities (its financial position) and a better basis for assessing future cash flow prospects.

Recently, the Board has taken the additional step of giving companies the option to use fair value (referred to as the fair value option) as the basis for measurement of financial assets and financial liabilities. [4] The Board considers fair value more rele- vant than historical cost because it reflects the current cash equivalent value of financial instruments. As a result, companies now have the option to record fair value in their accounts for most financial instruments, including such items as receivables and debt securities.

Use of fair value in financial reporting is increasing. However, measurement based on fair value introduces increased subjectivity into accounting reports when fair value information is not readily available. To increase consistency and compara- bility in fair value measures, the FASB established a fair value hierarchy that pro- vides insight into the priority of valuation techniques to use to determine fair value. As shown in Illustration 2-4, the fair value hierarchy is divided into three broad levels.

16For major groups of assets and liabilities, companies must disclose (1) the fair value measurement and (2) the fair value hierarchy level of the measurements as a whole, classified by Level 1, 2, or 3. Given the judgment involved, it follows that the more a company depends on Level 3 to determine fair values, the more information about the valuation process the company will need to disclose. Thus, additional disclo- sures are required for Level 3 measurements; we discuss these disclosures in more detail in subsequent chapters. The FASB has also issued additional guidance related to issues surrounding the use of fair value in financial statements (Accounting Standards Update 2011–04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS). A major benefit of the guidance is to provide a better definitional structure of what is meant by fair value and an improved understanding of how fair value should be measured.

Level 1: Observable inputs that reflect quoted Least Subjective prices for identical assets or liabilities in active markets. Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or through corroboration with observable data. Level 3: Unobservable inputs (for example, a company’s own data or assumptions). Most Subjective

ILLUSTRATION 2-4 Fair Value Hierarchy

As Illustration 2-4 indicates, Level 1 is the least subjective because it is based on quoted prices, like a closing stock price in the Wall Street Journal. Level 2 is more sub- jective and would rely on evaluating similar assets or liabilities in active markets. At the most subjective level, Level 3, much judgment is needed, based on the best infor- mation available, to arrive at a relevant and representationally faithful fair value measurement.16

It is easy to arrive at fair values when markets are liquid with many traders, but fair value answers are not readily available in other situations. For example, how do you value the mortgage assets of a subprime lender such as New Century given that the market for these securities has essentially disappeared? A great deal of expertise and

54 Chapter 2 Conceptual Framework for Financial Reporting

sound judgment will be needed to arrive at appropriate answers. GAAP also provides guidance on estimating fair values when market-related data is not available. In gen- eral, these valuation issues relate to Level 3 fair value measurements. These measure- ments may be developed using expected cash flow and present value techniques, as described in Statement of Financial Accounting Concepts No. 7, “Using Cash Flow Informa- tion and Present Value in Accounting,” discussed in Chapter 6.

As indicated above, we presently have a “mixed-attribute” system that permits the use of historical cost and fair value. Although the historical cost principle continues to be an important basis for valuation, recording and reporting of fair value information is increasing. The recent measurement and disclosure guidance should increase consis- tency and comparability when fair value measurements are used in the financial state- ments and related notes.

Revenue Recognition Principle When a company agrees to perform a service or sell a product to a customer, it has a performance obligation. When the company satisfies this performance obligation, it recognizes revenue. The revenue recognition principle therefore requires that compa- nies recognize revenue in the accounting period in which the performance obligation is satisfied. To illustrate, assume that Klinke Cleaners cleans clothing on June 30 but cus- tomers do not claim and pay for their clothes until the first week of July. Klinke should record revenue in June when it performed the service (satisfied the performance obliga- tion) rather than in July when it received the cash. At June 30, Klinke would report a receivable on its balance sheet and revenue in its income statement for the service performed.

To illustrate the revenue recognition principle in more detail, assume that Boeing Corporation signs a contract to sell airplanes to Delta Air Lines for $100 million. To deter- mine when to recognize revenue, Boeing uses the five steps shown in Illustration 2-5.

Many revenue transactions pose few problems because the transaction is initiated and completed at the same time. However, when to recognize revenue in other situations is often more difficult, as when a performance obligation is satisfied over time. This is common in service arrangements or in the case of long-term construction contracts. Chapter 18 discusses revenue recognition issues in more detail.17

Expense Recognition Principle As indicated in the discussion of financial statement elements, expenses are defined as outflows or other “using up” of assets or incurring of liabilities (or a combination of both) during a period as a result of delivering or producing goods and/or performing services. It follows then that recognition of expenses is related to net changes in assets and earning revenues. In practice, the approach for recognizing expenses is, “Let the expense follow the revenues.” This approach is the expense recognition principle.

To illustrate, companies recognize expenses not when they pay wages or make a product, but when the work (service) or the product actually contributes to revenue. Thus, companies tie expense recognition to revenue recognition. That is, by matching efforts (expenses) with accomplishment (revenues), the expense recognition principle is imple- mented in accordance with the definition of expense (outflows or other using up of assets or incurring of liabilities).18

17The framework illustrated here is based on the recent new standard [ASU No. 2014-09, “Revenue from Contracts with Customers” (Topic 606)]. The new guidance establishes the principles to report useful information to users of financial statements about the nature, timing, and uncertainty of revenue from contracts with customers. 18This approach is commonly referred to as the matching principle. However, there is much debate about the conceptual validity of the matching principle. A major concern is that matching permits companies to defer certain costs and treat them as assets on the balance sheet. In fact, these costs may not have future benefits. If abused, this principle permits the balance sheet to become a “dumping ground” for unmatched costs.

Third Level: Recognition and Measurement Concepts 55

ILLUSTRATION 2-5 The Five Steps of Revenue Recognition

Step 5: Recognize revenue when each performance obligation

is satisfied.

Boeing recognizes revenue of $100 million for the sale of the airplanes to Delta when it satisfies its

performance obligation—the delivery of the airplanes to Delta.

Step 2: Identify the separate performance obligations in

the contract.

Boeing has only one performance obligation—to deliver airplanes to Delta. If Boeing also agreed to

maintain the planes, a separate performance obligation is recorded for this promise.

A contract

Step 1: Identify the contract(s) with the customer.

A contract is an agreement between two parties that creates enforceable rights or obligations. In this case, Boeing has signed a contract to deliver

airplanes to Delta.

Step 4: Allocate the transaction price to the separate performance

obligations.

In this case, Boeing has only one performance obligation—to deliver airplanes to Delta.

Step 3: Determine the transaction price.

Transaction price is the amount of consideration that a company expects to receive from a customer in exchange for transferring a good or service. In

this case, the transaction price is straightforward—it is $100 million.

Some costs, however, are difficult to associate with revenue. As a result, some other approach must be developed. Often, companies use a “rational and systematic” alloca- tion policy that will approximate the expense recognition principle. This type of expense recognition involves assumptions about the benefits that a company receives as well as the cost associated with those benefits. For example, a company like Intel or Motorola allocates the cost of a long-lived asset over all of the accounting periods during which it uses the asset because the asset contributes to the generation of revenue throughout its useful life.

Companies charge some costs to the current period as expenses (or losses) simply because they cannot determine a connection with revenue. Examples of these types of costs are officers’ salaries and other administrative expenses.

Costs are generally classified into two groups: product costs and period costs. Product costs, such as material, labor, and overhead, attach to the product. Companies carry these costs into future periods if they recognize the revenue from the product in subsequent periods. Period costs, such as officers’ salaries and other administrative expenses, attach to the period. Companies charge off such costs in the immediate period even though benefits associated with these costs may occur in the future. Why?

56 Chapter 2 Conceptual Framework for Financial Reporting

Because companies cannot determine a direct relationship between period costs and revenue.

Illustration 2-6 summarizes these expense recognition procedures.

Type of Cost Relationship Recognition

Product costs: Direct relationship between Recognize in period of revenue • Material cost and revenue. (matching). • Labor • Overhead

Period costs: No direct relationship Expense as incurred. • Salaries between cost • Administrative costs and revenue.

ILLUSTRATION 2-6 Expense Recognition

Full Disclosure Principle In deciding what information to report, companies follow the general practice of pro- viding information that is of sufficient importance to influence the judgment and deci- sions of an informed user. Often referred to as the full disclosure principle, it recog- nizes that the nature and amount of information included in financial reports reflects a series of judgmental trade-offs. These trade-offs strive for (1) sufficient detail to disclose matters that make a difference to users, yet (2) sufficient condensation to make the information understandable, keeping in mind costs of preparing and using it.

Disclosure is not a substitute for proper accounting. As a former chief accountant of the SEC noted, “Good disclosure does not cure bad accounting any more than an adjec- tive or adverb can be used without, or in place of, a noun or verb.” Thus, for example, cash-basis accounting for cost of goods sold is misleading even if a company discloses accrual-basis amounts in the notes to the financial statements.

Users find information about financial position, income, cash flows, and invest- ments in one of three places: (1) within the main body of financial statements, (2) in the notes to those statements, or (3) as supplementary information.

As discussed in Chapter 1, the financial statements are the balance sheet, income statement, statement of cash flows, and statement of stockholders’ equity. They are a structured means of communicating financial information. To be recognized in the main body of financial statements, an item should meet the definition of a basic element, be measurable with sufficient certainty, and be relevant and reliable.19

The notes to financial statements generally amplify or explain the items presented in the main body of the statements. If the main body of the financial statements gives an incom- plete picture of the performance and position of the company, the notes should provide the additional information needed. Information in the notes does not have to be quantifiable, nor does it need to qualify as an element. Notes can be partially or totally narrative. Exam- ples of notes include descriptions of the accounting policies and methods used in measuring the elements reported in the statements, explanations of uncertainties and contingencies, and statistics and details too voluminous for inclusion in the statements. The notes can be essential to understanding the company’s performance and position.

Supplementary information may include details or amounts that present a differ- ent perspective from that adopted in the financial statements. It may be quantifiable information that is high in relevance but low in faithful representation. For example, oil and gas companies typically provide information on proven reserves as well as the related discounted cash flows.

Supplementary information may also include management’s explanation of the financial information and its discussion of the significance of that information. For example, many business combinations have produced financing arrangements that demand new accounting and reporting practices and principles. In each of these

19SFAC No. 5, par. 63.

Third Level: Recognition and Measurement Concepts 57

situations, the same problem must be faced: making sure the company presents enough information to ensure that the reasonably prudent investor will not be misled.

We discuss the content, arrangement, and display of financial statements, along with other facets of full disclosure, in Chapters 4, 5, and 24.20

20The FASB has recently issued an exposure draft, Conceptual Framework for Financial Reporting: Chapter 8: Notes to Financial Statements. If approved, this new Concepts statement will help the Board to identify relevant informa- tion and establish limits on information that should be included in the notes to the financial statements. A related proposed Accounting Standards Update (ASU) [Notes to Financial Statements (Topic 235): Assessing Whether Disclosures Are Material (September 24, 2015)] is intended to promote the appropriate use of discretion by companies when deciding which disclosures should be considered material in their particular circumstances. 21“Decision-Usefulness: The Overriding Objective,” FASB Viewpoints (October 19, 1983), p. 4. 22Charles Rivers and Associates, “Sarbanes-Oxley Section 404: Costs and Remediation of Deficiencies,” letter from Deloitte and Touche, Ernst and Young, KPMG, and Pricewaterhouse-Coopers to the SEC (April 11, 2005); and Protiviti, SOX Compliance—Changes Abound Amid Drive for Stability and Long-Term Value (2015), http://www.protiviti.com/soxsurvey.

Cost Constraint In providing information with the qualitative characteristics that make it useful, compa- nies must consider an overriding factor that limits (constrains) the reporting. This is referred to as the cost constraint (the cost-benefit relationship). That is, companies must weigh the costs of providing the information against the benefits that can be derived from using it. Rule-making bodies and governmental agencies use cost-benefit analysis before making final their informational requirements. In order to justify requir- ing a particular measurement or disclosure, the benefits perceived to be derived from it must exceed the costs perceived to be associated with it.

A corporate executive made the following remark to the FASB about a proposed rule: “In all my years in the financial arena, I have never seen such an absolutely ridicu- lous proposal. . . . To dignify these ’actuarial’ estimates by recording them as assets and liabilities would be virtually unthinkable except for the fact that the FASB has done equally stupid things in the past. . . . For God’s sake, use common sense just this once.”21 Although extreme, this remark indicates the frustration expressed by members of the business community about rule-making and whether the benefits of a given pronounce- ment exceed the costs.

The difficulty in cost-benefit analysis is that the costs and especially the benefits are not always evident or measurable. The costs are of several kinds: costs of collect- ing and processing, of disseminating, of auditing, of potential litigation, of disclo- sure to competitors, and of analysis and interpretation. Benefits to preparers may include greater management control and access to capital at a lower cost. Users may receive better information for allocation of resources, tax assessment, and rate regu- lation. As noted earlier, benefits are generally more difficult to quantify than are costs.

The implementation of the provisions of the Sarbanes-Oxley Act illustrates the chal- lenges in assessing costs and benefits of standards. One study estimated the increased costs of complying with the new internal-control standards related to the financial reporting process to be an average of $7.8 million per company. However, the study concluded that “quantifying the benefits of improved more reliable financial reporting is not fully possible.” More recent data on compliance indicate that after more than a decade of experience with Sarbanes-Oxley, 61 percent of companies spend less than $500,000 annually on compliance, and 28 percent spend more than $1,000,000. And that most companies continue to experience year-over-year increases in external auditing fees associated with internal control work.22

LEARNING OBJECTIVE 7 Describe the impact that the cost constraint has on reporting accounting information.

58 Chapter 2 Conceptual Framework for Financial Reporting

ILLUSTRATION 2-7 Conceptual Framework for Financial Reporting

First level: The "why"— purpose of accounting

Second level: Bridge between levels 1 and 3

Third level: The "how"—

implementation

ELEMENTS QUALITATIVE

CHARACTERISTICS 1. Fundamental qualities A. Relevance (1) Predictive value (2) Confirmatory value (3) Materiality B. Faithful representation (1) Completeness (2) Neutrality (3) Free from error 2. Enhancing qualities (1) Comparability (2) Verifiability (3) Timeliness (4) Understandability

1. Assets 2. Liabilities 3. Equity 4. Investment by owners 5. Distribution to owners 6. Comprehensive income 7. Revenues 8. Expenses 9. Gains 10. Losses

1. Economic entity 2. Going concern 3. Monetary unit 4. Periodicity

ASSUMPTIONS 1. Measurement 2. Revenue recognition 3. Expense recognition 4. Full disclosure

PRINCIPLES 1. Cost

CONSTRAINT

Recognition, Measurement, and Disclosure Concepts

Provide information about the reporting entity that is useful

to present and potential equity investors,

lenders, and other creditors in their

capacity as capital providers.

OBJECTIVE

23For example, as part of its project on “Share-Based Payment” [5], the Board conducted a field study and surveyed commercial software providers to collect information on the costs of measuring the fair values of share-based compensation arrangements.

Despite the difficulty in assessing the costs and benefits of its rules, the FASB attempts to determine that each proposed pronouncement will fill a significant need and that the costs imposed to meet the rule are justified in relation to overall benefits of the resulting information. In addition, the Board seeks input on costs and benefits as part of its due process.23

Summary of the Structure Illustration 2-7 presents the conceptual framework discussed in this chapter. It is similar to Illustration 2-1 except that it provides additional information for each level. We can- not overemphasize the usefulness of this conceptual framework in helping to under- stand many of the problem areas that we examine in later chapters.

YOU WILL WANT TO READ

THE IFRS INSIGHTS ON PAGES 74–77 For discussion of how IFRS relates to the conceptual framework.

Review and Practice 59

REVIEW AND PRACTICE KEY TERMS REVIEW

LEARNING OBJECTIVES REVIEW 1 Describe the usefulness of a conceptual framework. The accounting profession needs a conceptual framework to

(1) build on and relate to an established body of concepts and objectives, (2) provide a framework for solving new and emerging practical problems, (3) increase financial statement users’ understanding of and confidence in financial reporting, and (4) enhance comparability among companies’ financial statements.

The FASB issued seven Statements of Financial Accounting Concepts that relate to financial reporting for business enterprises. These concept statements provide the basis for the conceptual framework. They include objectives, qualitative characteristics, and elements. In addition, measurement and recognition concepts are developed.

WHAT DO THE NUMBERS MEAN? DON’T COUNT THESE PLEASE Beyond touting nonfi nancial measures to investors (see the “What Do the Numbers Mean?” box on page 46), many companies increasingly promote the performance of their companies through the reporting of various “pro forma” earnings measures. Pro forma measures are standard measures (such as earnings) that compa- nies adjust, usually for unusual or non-recurring items. Such adjustments make the numbers more comparable to numbers reported in periods without these unusual or non-recurring items.

However, rather than increasing comparability, it appears that some companies use pro forma reporting to accentuate the positive in their results. Examples include Yahoo! and Cisco, which defi ne pro forma income after adding back pay- roll tax expense. Level 8 Systems transformed an operating loss into a pro forma profi t by adding back expenses for depre- ciation and amortization of intangible assets.

And taking a more macro look, the following table shows the difference between pro forma (non-GAAP) and GAAP earn- ings per share for the three main Standard & Poor’s stock indexes for a recent year.

What this table shows is that the S&P 600 is especially biased with a variance of 32.4% (non-GAAP higher than GAAP). Lynn Turner, former chief accountant at the SEC, calls such earnings measures EBS—“Everything but Bad Stuff.” To provide inves- tors a more complete picture of company profi tability, not the story preferred by management, the SEC issued Regulation G (REG G). For example, REG G (and related item 10E) requires companies to reconcile non-GAAP fi nancial measures to GAAP, thereby giving investors a roadmap to analyze the adjustments that companies make to their GAAP numbers to arrive at pro forma results.

Index Non-GAAP Earnings GAAP Earnings

% Variance (GAAP less Non-GAAP)

S&P 400 $54.53 $45.68 −19.4% S&P 500 96.82 86.51 −11.9 S&P 600 21.62 16.33 −32.4

Sources: Adapted from Gretchen Morgenson, “How Did They Value Stocks? Count the Absurd Ways,” The New York Times (March 18, 2001), sec- tion 3, p. 1; Regulation G, “Conditions for Use of Non-GAAP Financial Measures,” Release No. 33-8176 (March 28, 2003, updated January, 2010); and J. Adamo, “Even GAAP Is Better Than These Adjustments,” Barron’s (November 4, 2013).

assumption, 50 comparability, 46 completeness, 45 conceptual framework, 38 confirmatory value, 43 conservatism, 45(n) consistency, 47 cost constraint (cost-benefit

relationship), 57 economic entity assumption, 50 elements, basic, 48 expense recognition

principle, 54

fair value, 52 fair value option, 53 fair value principle, 52 faithful representation, 45 financial statements, 56 free from error, 45 full disclosure principle, 56 general-purpose financial

reporting, 41 going concern assumption, 50 historical cost principle, 52 matching principle, 54(n)

materiality, 43 monetary unit assumption, 51 neutrality, 45 notes to financial

statements, 56 objective of financial

reporting, 40 period costs, 55 periodicity (time period)

assumption, 51 predictive value, 43 principles of accounting, 52

product costs, 55 prudence, 45(n) qualitative characteristics, 41 relevance, 42 revenue recognition

principle, 54 supplementary

information, 56 timeliness, 47 understandability, 47 verifiability, 47

2 Understand the objective of financial reporting. The objective of general-purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments, and providing or settling loans and other forms of credit. Information that is decision-useful to capital providers may also be helpful to other users of financial reporting who are not capital providers.

3 Identify the qualitative characteristics of accounting information. The overriding criterion by which accounting choices can be judged is decision-usefulness—that is, providing information that is most useful for decision-making. Rele- vance and faithful representation are the two fundamental qualities that make information decision-useful. Relevant informa- tion makes a difference in a decision by having predictive or confirmatory value and is material. Faithful representation is characterized by completeness, neutrality, and being free from error. Enhancing qualities of useful information are (1) compa- rability, (2) verifiability, (3) timeliness, and (4) understandability.

4 Define the basic elements of financial statements. The basic elements of financial statements are (1) assets, (2) liabili- ties, (3) equity, (4) investments by owners, (5) distributions to owners, (6) comprehensive income, (7) revenues, (8) expenses, (9) gains, and (10) losses. We define these 10 elements on page 48.

5 Describe the basic assumptions of accounting. Four basic assumptions underlying financial accounting are as follows. (1) Economic entity: The activity of a company can be kept separate and distinct from its owners and any other business unit. (2) Going concern: The company will have a long life. (3) Monetary unit: Money is the common denominator by which economic activity is conducted, and the monetary unit provides an appropriate basis for measurement and analysis. (4) Periodicity: The economic activities of a company can be divided into artificial time periods.

6 Explain the application of the basic principles of accounting. (1) Measurement principle: GAAP permits the use of historical cost, fair value, and other valuation bases. Although the historical cost principle (measurement based on acquisition price) continues to be an important basis for valuation, recording and reporting of fair value information is increasing. (2) Revenue recognition principle: A company recognizes revenue when it satisfies a performance obliga- tion. (3) Expense recognition principle: As a general rule, companies recognize expenses when the service or the product actually makes its contribution to revenue (commonly referred to as matching). (4) Full disclosure principle: Companies generally provide information that is of sufficient importance to influence the judgment and decisions of an informed user.

7 Describe the impact that the cost constraint has on reporting accounting information. The cost of providing the information must be weighed against the benefits that can be derived from using the information.

PRACTICE PROBLEM

Jeremy Meadow Corporation has hired you to review its accounting records prior to the closing of the revenue and expense ac- counts as of December 31, the end of the current fiscal year. The following information comes to your attention.

1. During the current year, Jeremy Meadow Corporation changed its policy in regard to expensing purchases of small tools. In the past, it had expensed these purchases because they amounted to less than 2% of net income. Now, the president has decided that the company should follow a policy of capitalization and subsequent depreciation. It is expected that pur- chases of small tools will not fluctuate greatly from year to year.

2. The company constructed a warehouse at a cost of $1,000,000. It had been depreciating the asset on a straight-line basis over 10 years. In the current year, the controller doubled depreciation expense because the replacement cost of the ware- house had increased significantly.

3. When the balance sheet was prepared, the preparer omitted detailed information as to the amount of cash on deposit in each of several banks. Only the total amount of cash under a caption “Cash in banks” was presented.

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60 Chapter 2 Conceptual Framework for Financial Reporting

Questions 61

4. On July 15 of the current year, Jeremy Meadow Corporation purchased an undeveloped tract of land at a cost of $320,000. The company spent $80,000 in subdividing the land and getting it ready for sale. An appraisal of the property at the end of the year indicated that the land was now worth $500,000. Although none of the lots were sold, the company recognized revenue of $180,000, less related expenses of $80,000, for a net income on the project of $100,000.

5. For a number of years, the company used the FIFO method for inventory valuation purposes. During the current year, the president noted that all the other companies in the industry had switched to the LIFO method. The company decided not to switch to LIFO because net income would decrease $830,000.

Instructions State whether or not you agree with the decisions made by Jeremy Meadow Corporation. Support your answers with reference, whenever possible, to the generally accepted principles, assumptions, and cost constraint applicable in the circumstances.

SOLUTION

1. From the facts, it is difficult to determine whether to agree or disagree. Consistency, of course, is violated in this situation although its violation may not be material. Furthermore, the change of accounting policies regarding the treatment of small tools cannot be judged good or bad but would depend on the circumstances. In this case, it seems that the result will be approximately the same whether the corporation capitalizes and expenses, or simply expenses each period, since the purchases are fairly uniform. Perhaps from a cost standpoint (expediency), it might be best to continue the present policy rather than become involved in detailed depreciation schedules, assuming that purchases remain fairly uniform. On the other hand, the president may believe there is a significant unrecorded asset that should be shown on the balance sheet. If such is the case, capitalization and subsequent depreciation would be more appropriate.

2. Disagree. At the present time, accountants do not recognize price level or current value adjustments in the accounts. Hence, it is misleading to deviate from the historical cost principle because conjecture or opinion can take place. Also, depreciation is not so much a matter of valuation as it is a means of cost allocation. Assets are not depreciated on the basis of a decline in their fair value. Rather, they are depreciated on the basis of a systematic charge of expired cost against revenues.

3. Agree. The full disclosure principle recognizes that reasonable condensation and summarization of the details of a corpo- ration’s operations and financial position are essential to readability and comprehension. Thus, in determining what is full disclosure, the accountant must decide whether omission will mislead readers of the financial statements. Generally, companies present only the total amount of cash on a balance sheet unless some special circumstance is involved (such as a possible restriction on the use of the cash). In most cases, however, the company’s presentation would be considered appropriate and in accordance with the full disclosure principle.

4. Disagree. The historical cost principle indicates that companies account for assets and liabilities on the basis of cost. If sales value were selected, for example, it would be extremely difficult to establish an appraisal value for the given item without selling it. Note, too, that the revenue recognition principle provides guidance on when revenue should be recognized. Revenue should be recognized when the performance obligation is satisfied. In this case, the revenue was not recognized because the critical event, “sale of the land with transfer to the buyer,” had not occurred.

5. From the facts, it is difficult to determine whether to agree or disagree with the president. The president’s approach is not a violation of any principle. Consistency requires that accounting entities give accountable events the same accounting treatment from period to period for a given business enterprise. It says nothing concerning consistency of accounting principles among business enterprises. From a comparability viewpoint, it might be useful to report the information on a LIFO basis. But, as indicated above, there is no requirement to do so.

QUESTIONS

1. What is a conceptual framework? Why is a conceptual framework necessary in financial accounting?

2. What is the primary objective of financial reporting?

3. What is meant by the term “qualitative characteristics of accounting information”?

4. Briefly describe the two fundamental qualities of useful accounting information.

Exercises, Problems, Problem Solution Walkthrough Videos, and many more assessment tools and resources are available for practice in WileyPLUS.

62 Chapter 2 Conceptual Framework for Financial Reporting

5. How is materiality (or immateriality) related to the proper presentation of financial statements? What factors and measures should be considered in assessing the material- ity of a misstatement in the presentation of a financial statement?

6. What are the enhancing qualities of the qualitative charac- teristics? What is the role of enhancing qualities in the conceptual framework?

7. According to the FASB conceptual framework, the objec- tive of financial reporting for business enterprises is based on the needs of the users of financial statements. Explain the level of sophistication that the Board assumes about the users of financial statements.

8. What is the distinction between comparability and consistency?

9. Why is it necessary to develop a definitional framework for the basic elements of accounting?

10. Expenses, losses, and distributions to owners are all decreases in net assets. What are the distinctions among them?

11. Revenues, gains, and investments by owners are all increases in net assets. What are the distinctions among them?

12. What are the four basic assumptions that underlie the financial accounting structure?

13. The life of a business is divided into specific time periods, usually a year, to measure results of operations for each such time period and to portray financial conditions at the end of each period.

(a) This practice is based on the accounting assumption that the life of the business consists of a series of time periods and that it is possible to measure accurately the results of operations for each period. Comment on the validity and necessity of this assumption.

(b) What has been the effect of this practice on account- ing? What is its relation to the accrual system? What influence has it had on accounting entries and methodology?

14. What is the basic accounting problem created by the mon- etary unit assumption when there is significant inflation? What appears to be the FASB position on a stable mone- tary unit?

15. The chairman of the board of directors of the company for which you are chief accountant has told you that he has little use for accounting figures based on historical cost. He believes that replacement values are of far more sig- nificance to the board of directors than “out-of-date costs.” Present some arguments to convince him that accounting data should still be based on historical cost.

16. What is the definition of fair value?

17. What is the fair value option? Explain how use of the fair value option reflects application of the fair value principle.

18. Briefly describe the fair value hierarchy.

19. Explain the revenue recognition principle.

20. What is a performance obligation, and how is it used to determine when revenue should be recognized?

21. What are the five steps used to determine the proper time to recognize revenue?

22. Selane Eatery operates a catering service specializing in business luncheons for large corporations. Selane requires customers to place their orders 2 weeks in advance of the scheduled events. Selane bills its cus- tomers on the tenth day of the month following the date of service and requires that payment be made within 30 days of the billing date. Conceptually, when should Selane recognize revenue related to its catering service?

23. Mogilny Company paid $135,000 for a machine. The Accumulated Depreciation—Equipment account has a balance of $46,500 at the present time. The company could sell the machine today for $150,000. The company presi- dent believes that the company has a “right to this gain.” What does the president mean by this statement? Do you agree?

24. Three expense recognition methods (associating cause and effect, systematic and rational allocation, and imme- diate recognition) were discussed in the text under the expense recognition principle. Indicate the basic nature of each of these expense recognition methods and give two examples of each.

25. Statement of Financial Accounting Concepts No. 5 identifies four characteristics that an item must have before it is rec- ognized in the financial statements. What are these four characteristics?

26. Briefly describe the types of information concerning financial position, income, and cash flows that might be provided (a) within the main body of the financial state- ments, (b) in the notes to the financial statements, or (c) as supplementary information.

27. In January 2018, Janeway Inc. doubled the amount of its outstanding stock by selling on the market an additional 10,000 shares to finance an expansion of the business. You propose that this information be shown by a footnote on the balance sheet as of December 31, 2017. The president objects, claiming that this sale took place after December 31, 2017, and therefore should not be shown. Explain your position.

28. Describe the major constraint inherent in the presentation of accounting information.

29. What are some of the costs of providing accounting infor- mation? What are some of the benefits of accounting information? Describe the cost-benefit factors that should be considered when new accounting standards are being proposed.

30. The treasurer of Landowska Co. has heard that conser- vatism is a doctrine that is followed in accounting and, therefore, proposes that several policies be followed that are conservative in nature. State your opinion with respect to each of the policies listed.

(a) The company gives a 2-year warranty to its custom- ers on all products sold. The estimated warranty costs

Brief Exercises 63

incurred from this year’s sales should be entered as an expense this year instead of an expense in the pe- riod in the future when the warranty is made good.

(b) When sales are made on account, there is always un- certainty about whether the accounts are collectible. Therefore, the treasurer recommends recording the sale when the cash is received from the customers.

(c) A personal liability lawsuit is pending against the company. The treasurer believes there is an even chance that the company will lose the suit and have to pay damages of $200,000 to $300,000. The trea- surer recommends that a loss be recorded and a lia- bility created in the amount of $300,000.

BE2-1 (L03) Match the qualitative characteristics below with the following statements.

1. Relevance 5. Comparability 2. Faithful representation 6. Completeness 3. Predictive value 7. Neutrality 4. Confirmatory value 8. Timeliness

(a) Quality of information that permits users to identify similarities in and differences between two sets of economic phenomena.

(b) Having information available to users before it loses its capacity to influence decisions. (c) Information about an economic phenomenon that has value as an input to the processes used by capital providers to

form their own expectations about the future. (d) Information that is capable of making a difference in the decisions of users in their capacity as capital providers. (e) Absence of bias intended to attain a predetermined result or to induce a particular behavior.

BE2-2 (L03) Match the qualitative characteristics below with the following statements.

1. Timeliness 5. Faithful representation 2. Completeness 6. Relevance 3. Free from error 7. Neutrality 4. Understandability 8. Confirmatory value

(a) Quality of information that assures users that information represents the economic phenomena that it purports to represent.

(b) Information about an economic phenomenon that corrects past or present expectations based on previous evaluations.

(c) The extent to which information is accurate in representing the economic substance of a transaction. (d) Includes all the information that is necessary for a faithful representation of the economic phenomena that it purports

to represent. (e) Quality of information that allows users to comprehend its meaning.

BE2-3 (L03) Discuss whether the changes described in each of the cases below require recognition in the CPA’s audit report as to consistency. (Assume that the amounts are material.)

(a) The company changed its inventory method to FIFO from weighted-average, which had been used in prior years.

(b) The company disposed of one of the two subsidiaries that had been included in its consolidated statements for prior years.

BE2-4 (L03) Identify which qualitative characteristic of accounting information is best described in each item below. (Do not use relevance and faithful representation.)

(a) The annual reports of Best Buy Co. are audited by certified public accountants. (b) Black & Decker and Cannondale Corporation both use the FIFO cost flow assumption.

BRIEF EXERCISES

64 Chapter 2 Conceptual Framework for Financial Reporting

(c) Starbucks Corporation has used straight-line depreciation since it began operations. (d) Motorola issues its quarterly reports immediately after each quarter ends.

BE2-5 (L03) Presented below are three different transactions related to materiality. Explain whether you would classify these transactions as material.

(a) Blair Co. has reported a positive trend in earnings over the last 3 years. In the current year, it reduces its bad debt allow- ance to ensure another positive earnings year. The impact of this adjustment is equal to 3% of net income.

(b) Hindi Co. has an unusual gain of $3.1 million on the sale of plant assets and a $3.3 million loss on the sale of invest- ments. It decides to net the gain and loss because the net effect is considered immaterial. Hindi Co.’s income for the current year was $10 million.

(c) Damon Co. expenses all capital equipment under $25,000 on the basis that it is immaterial. The company has followed this practice for a number of years.

BE2-6 (L04) For each item below, indicate to which category of elements of financial statements it belongs. (a) Retained earnings (e) Depreciation (h) Dividends (b) Sales (f) Loss on sale of equipment (i) Gain on sale of investment (c) Additional paid-in capital (g) Interest payable (j) Issuance of common stock (d) Inventory

BE2-7 (L04) Explain how you would decide whether to record each of the following expenditures as an asset or an expense. Assume all items are material.

(a) Legal fees paid in connection with the purchase of land are $1,500. (b) Eduardo, Inc. paves the driveway leading to the office building at a cost of $21,000. (c) A meat market purchases a meat-grinding machine at a cost of $3,500. (d) On June 30, Monroe and Meno, medical doctors, pay 6 months’ office rent to cover the month of July and the next

5 months. (e) Smith’s Hardware Company pays $9,000 in wages to laborers for construction on a building to be used in the

business. (f) Alvarez’s Florists pays wages of $2,100 for the month to an employee who serves as driver of their delivery truck.

BE2-8 (L05) Identify which basic assumption of accounting is best described in each item below. (a) The economic activities of FedEx Corporation are divided into 12-month periods for the purpose of issuing annual

reports. (b) Solectron Corporation, Inc. does not adjust amounts in its financial statements for the effects of inflation. (c) Walgreen Co. reports current and noncurrent classifications in its balance sheet. (d) The economic activities of General Electric and its subsidiaries are merged for accounting and reporting purposes.

BE2-9 (L05) If the going concern assumption is not made in accounting, discuss the differences in the amounts shown in the financial statements for the following items.

(a) Land. (d) Inventory. (b) Unamortized bond premium. (e) Prepaid insurance. (c) Depreciation expense on equipment.

BE2-10 (L06) Identify which basic principle of accounting is best described in each item below. (a) Norfolk Southern Corporation reports revenue in its income statement when the performance obligation is satisfied

instead of when the cash is collected. (b) Yahoo! recognizes depreciation expense for a machine over the 2-year period during which that machine helps the

company earn revenue. (c) Oracle Corporation reports information about pending lawsuits in the notes to its financial statements. (d) Gap, Inc. reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair value is

greater.

BE2-11 (L06) Vande Velde Company made three investments during 2017. (1) It purchased 1,000 shares of Sastre Company, a start-up company. Vande Velde made the investment based on valuation estimates from an internally developed model. (2) It

Exercises 65

purchased 2,000 shares of GE stock, which trades on the NYSE. (3) It invested $10,000 in local development authority bonds. Although these bonds do not trade on an active market, their value closely tracks movements in U.S. Treasury bonds. Where will Vande Velde report these investments in the fair value hierarchy?

BE2-12 (L06) What accounting assumption, principle, or constraint would Target Corporation use in each of the situations below?

(a) Target was involved in litigation over the last year. This litigation is disclosed in the financial statements. (b) Target allocates the cost of its depreciable assets over the life it expects to receive revenue from these assets. (c) Target records the purchase of a new Dell PC at its cash equivalent price.

EXERCISES

E2-1 (L01,2) (Usefulness, Objective of Financial Reporting) Indicate whether the following statements about the concep- tual framework are true or false. If false, provide a brief explanation supporting your position.

(a) Accounting rule-making that relies on a body of concepts will result in useful and consistent pronouncements. (b) General-purpose financial reports are most useful to company insiders in making strategic business decisions. (c) Accounting standards based on individual conceptual frameworks generally will result in consistent and comparable

accounting reports. (d) Capital providers are the only users who benefit from general-purpose financial reporting. (e) Accounting reports should be developed so that users without knowledge of economics and business can become

informed about the financial results of a company. (f) The objective of financial reporting is the foundation from which the other aspects of the framework logically

result.

E2-2 (L01,2,3) (Usefulness, Objective of Financial Reporting, Qualitative Characteristics) Indicate whether the fol- lowing statements about the conceptual framework are true or false. If false, provide a brief explanation supporting your position.

(a) The fundamental qualitative characteristics that make accounting information useful are relevance and verifiability. (b) Relevant information only has predictive value, confirmatory value, or both. (c) Information that is a faithful representation is characterized as having predictive or confirmatory value. (d) Comparability pertains only to the reporting of information in a similar manner for different companies. (e) Verifiability is solely an enhancing characteristic for faithful representation. (f) In preparing financial reports, it is assumed that users of the reports have reasonable knowledge of business and eco-

nomic activities.

E2-3 (L03,7) GROUPWORK (Qualitative Characteristics) SFAC No. 8 identifies the qualitative characteristics that make accounting information useful. Presented below are a number of questions related to these qualitative characteristics and underlying constraint.

(a) What is the quality of information that enables users to confirm or correct prior expectations? (b) Identify the pervasive constraint developed in the conceptual framework. (c) The chairman of the SEC at one time noted, “If it becomes accepted or expected that accounting principles are

determined or modified in order to secure purposes other than economic measurement, we assume a grave risk that confidence in the credibility of our financial information system will be undermined.” Which qualitative characteristic of accounting information should ensure that such a situation will not occur? (Do not use faithful representation.)

(d) Muruyama Corp. switches from FIFO to average-cost to FIFO over a 2-year period. Which qualitative characteristic of accounting information is not followed?

(e) Assume that the profession permits the savings and loan industry to defer losses on investments it sells because imme- diate recognition of the loss may have adverse economic consequences on the industry. Which qualitative characteristic of accounting information is not followed? (Do not use relevance or faithful representation.)

(f) What are the two fundamental qualities that make accounting information useful for decision-making? (g) Watteau Inc. does not issue its first-quarter report until after the second quarter’s results are reported. Which qualitative

characteristic of accounting is not followed? (Do not use relevance.)

66 Chapter 2 Conceptual Framework for Financial Reporting

(h) Predictive value is an ingredient of which of the two fundamental qualities that make accounting information useful for decision-making purposes?

(i) Duggan, Inc. is the only company in its industry to depreciate its plant assets on a straight-line basis. Which qualitative characteristic of accounting information may not be followed?

(j) Roddick Company has attempted to determine the replacement cost of its inventory. Three different appraisers arrive at substantially different amounts for this value. The president, nevertheless, decides to report the middle value for external reporting purposes. Which qualitative characteristic of information is lacking in these data? (Do not use rele- vance or faithful representation.)

E2-4 (L03) (Qualitative Characteristics) The qualitative characteristics that make accounting information useful for deci- sion-making purposes are as follows.

Relevance Neutrality Verifi ability Faithful representation Completeness Understandability Predictive value Timeliness Comparability Confi rmatory value Materiality Free from error

Instructions Identify the appropriate qualitative characteristic(s) to be used given the information provided below.

(a) Qualitative characteristic being employed when companies in the same industry are using the same accounting principles.

(b) Quality of information that confirms users’ earlier expectations. (c) Imperative for providing comparisons of a company from period to period. (d) Ignores the economic consequences of a standard or rule. (e) Requires a high degree of consensus among individuals on a given measurement. (f) Predictive value is an ingredient of this fundamental quality of information. (g) Four qualitative characteristics that are related to both relevance and faithful representation. (h) An item is not recorded because its effect on income would not change a decision. (i) Neutrality is an ingredient of this fundamental quality of accounting information. (j) Two fundamental qualities that make accounting information useful for decision-making purposes. (k) Issuance of interim reports is an example of what enhancing quality of relevance?

E2-5 (L04) (Elements of Financial Statements) Ten interrelated elements that are most directly related to measuring the performance and financial status of an enterprise are provided below.

Assets Distributions to owners Expenses Liabilities Comprehensive income Gains Equity Revenues Losses Investments by owners

Instructions Identify the element or elements associated with the 12 items below.

(a) Arises from peripheral or incidental transactions. (b) Obligation to transfer resources arising from a past transaction. (c) Increases ownership interest. (d) Declares and pays cash dividends to owners. (e) Increases in net assets in a period from nonowner sources. (f) Items characterized by service potential or future economic benefit. (g) Equals increase in assets less liabilities during the year, after adding distributions to owners and subtracting invest-

ments by owners. (h) Arises from income statement activities that constitute the entity’s ongoing major or central operations. (i) Residual interest in the assets of the enterprise after deducting its liabilities. (j) Increases assets during a period through sale of product. (k) Decreases assets during the period by purchasing the company’s own stock. (l) Includes all changes in equity during the period, except those resulting from investments by owners and distributions

to owners.

Exercises 67

Instructions Identify by number the accounting assumption, principle, or constraint that describes each situation below. Do not use a number more than once.

(a) Allocates expenses to revenues in the proper period. (b) Indicates that fair value changes subsequent to purchase are not recorded in the accounts. (Do not use revenue recogni-

tion principle.) (c) Ensures that all relevant financial information is reported. (d) Rationale why plant assets are not reported at liquidation value. (Do not use historical cost principle.) (e) Indicates that personal and business record keeping should be separately maintained. (f) Separates financial information into time periods for reporting purposes. (g) Assumes that the dollar is the “measuring stick” used to report on financial performance.

E2-7 (L05,6) (Assumptions, Principles, and Constraint) Presented below are a number of operational guidelines and prac- tices that have developed over time.

Instructions Select the assumption, principle, or constraint that most appropriately justifies these procedures and practices. (Do not use qualitative characteristics.)

(a) Fair value changes are not recognized in the accounting records. (b) Financial information is presented so that investors will not be misled. (c) Intangible assets are amortized over periods benefited. (d) Agricultural companies use fair value for purposes of valuing crops. (e) Each enterprise is kept as a unit distinct from its owner or owners. (f) All significant post-balance-sheet events are disclosed. (g) Revenue is recorded when the product is delivered. (h) All important aspects of bond indentures are presented in financial statements. (i) Rationale for accrual accounting. (j) The use of consolidated statements is justified. (k) Reporting must be done at defined time intervals. (l) An allowance for doubtful accounts is established. (m) Goodwill is recorded only at time of purchase. (n) A company charges its sales commission costs to expense.

E2-8 (L06) (Full Disclosure Principle) Presented below are a number of facts related to Weller, Inc. Assume that no mention of these facts was made in the financial statements and the related notes.

Instructions Assume that you are the auditor of Weller, Inc. and that you have been asked to explain the appropriate accounting and related disclosure necessary for each of these items.

(a) The company decided that, for the sake of conciseness, only net income should be reported on the income statement. Details as to revenues, cost of goods sold, and expenses were omitted.

(b) Equipment purchases of $170,000 were partly financed during the year through the issuance of a $110,000 notes pay- able. The company offset the equipment against the notes payable and reported plant assets at $60,000.

(c) Weller has reported its ending inventory at $2,100,000 in the financial statements. No other information related to inventories is presented in the financial statements and related notes.

(d) The company changed its method of valuing inventories from weighted-average to FIFO. No mention of this change was made in the financial statements.

1. Economic entity assumption 2. Going concern assumption 3. Monetary unit assumption 4. Periodicity assumption 5. Measurement principle (historical cost)

6. Measurement principle (fair value) 7. Expense recognition principle 8. Full disclosure principle 9. Cost constraint 10. Revenue recognition principle

E2-6 (L05,6) (Assumptions, Principles, and Constraint) Presented below are the assumptions, principles, and constraint used in this chapter.

68 Chapter 2 Conceptual Framework for Financial Reporting

E2-9 (L06) GROUPWORK (Accounting Principles and Assumptions—Comprehensive) Presented below are a number of business transactions that occurred during the current year for Gonzales, Inc.

Instructions In each of the situations, discuss the appropriateness of the journal entries in terms of generally accepted accounting principles.

(a) The president of Gonzales, Inc. used his expense account to purchase a new Suburban solely for personal use. The fol- lowing journal entry was made.

Miscellaneous Expense 29,000 Cash 29,000

(b) Merchandise inventory that cost $620,000 is reported on the balance sheet at $690,000, the expected selling price less estimated selling costs. The following entry was made to record this increase in value.

Inventory 70,000 Sales Revenue 70,000

(c) The company is being sued for $500,000 by a customer who claims damages for personal injury apparently caused by a defective product. Company attorneys feel extremely confident that the company will have no liability for damages resulting from the situation. Nevertheless, the company decides to make the following entry.

Loss from Lawsuit 500,000 Liability for Lawsuit 500,000

(d) Because the general level of prices increased during the current year, Gonzales, Inc. determined that there was a $16,000 understatement of depreciation expense on its equipment and decided to record it in its accounts. The following entry was made.

Depreciation Expense 16,000 Accumulated Depreciation—Equipment 16,000

(e) Gonzales, Inc. has been concerned about whether intangible assets could generate cash in case of liquidation. As a con- sequence, goodwill arising from a purchase transaction during the current year and recorded at $800,000 was written off as follows.

Retained Earnings 800,000 Goodwill 800,000

(f) Because of a “fire sale,” equipment obviously worth $200,000 was acquired at a cost of $155,000. The following entry was made.

Equipment 200,000 Cash 155,000 Sales Revenue 45,000

E2-10 (L06) GROUPWORK (Accounting Principles—Comprehensive) Presented below is information related to Cramer, Inc.

Instructions Comment on the appropriateness of the accounting procedures followed by Cramer, Inc.

(a) Depreciation expense on the building for the year was $60,000. Because the building was increasing in value during the year, the controller decided to charge the depreciation expense to retained earnings instead of to net income. The fol- lowing entry is recorded.

Retained Earnings 60,000 Accumulated Depreciation—Buildings 60,000

(b) Materials were purchased on January 1, 2017, for $120,000 and this amount was entered in the Materials account. On December 31, 2017, the materials would have cost $141,000, so the following entry is made.

Inventory 21,000 Gain on Inventories 21,000

(c) During the year, the company purchased equipment through the issuance of common stock. The stock had a par value of $135,000 and a fair value of $450,000. The fair value of the equipment was not easily determinable. The company recorded this transaction as follows.

Equipment 135,000 Common Stock 135,000

(d) During the year, the company sold certain equipment for $285,000, recognizing a gain of $69,000. Because the controller believed that new equipment would be needed in the near future, she decided to defer the gain and amortize it over the life of any new equipment purchased.

Concepts for Analysis 69

(e) An order for $61,500 has been received from a customer for products on hand. This order was shipped on January 9, 2018. The company made the following entry in 2017.

Accounts Receivable 61,500 Sales Revenue 61,500

CONCEPTS FOR ANALYSIS

CA2-1 (Conceptual Framework—General) Wayne Cooper has some questions regarding the theoretical framework in which GAAP is set. He knows that the FASB and other predecessor organizations have attempted to develop a conceptual framework for accounting theory formulation. Yet, Wayne’s supervisors have indicated that these theoretical frameworks have little value in the practical sense (i.e., in the real world). Wayne did notice that accounting rules seem to be established after the fact rather than before. He thought this indicated a lack of theory structure but never really questioned the process at school because he was too busy doing the homework.

Wayne feels that some of his anxiety about accounting theory and accounting semantics could be alleviated by identifying the basic concepts and definitions accepted by the profession and considering them in light of his current work. By doing this, he hopes to develop an appropriate connection between theory and practice.

Instructions (a) Help Wayne recognize the purpose of and benefit of a conceptual framework. (b) Identify any Statements of Financial Accounting Concepts issued by the FASB that may be helpful to Wayne in develop-

ing his theoretical background.

CA2-2 WRITING (Conceptual Framework—General) The Financial Accounting Standards Board (FASB) has developed a conceptual framework for financial accounting and reporting. The FASB has issued eight Statements of Financial Accounting Concepts. These statements are intended to set forth the objective and fundamentals that will be the basis for developing finan- cial accounting and reporting standards. The objective identifies the goals and purposes of financial reporting. The fundamen- tals are the underlying concepts of financial accounting that guide the selection of transactions, events, and circumstances to be accounted for; their recognition and measurement; and the means of summarizing and communicating them to interested parties.

The purpose of the statement on qualitative characteristics is to examine the characteristics that make accounting informa- tion useful. These characteristics or qualities of information are the ingredients that make information useful and the qualities to be sought when accounting choices are made.

Instructions (a) Identify and discuss the benefits that can be expected to be derived from the FASB’s conceptual framework. (b) What is the most important quality for accounting information as identified in the conceptual framework? Explain why

it is the most important. (c) Statement of Financial Accounting Concepts No. 8 describes a number of key characteristics or qualities for accounting

information. Briefly discuss the importance of any three of these qualities for financial reporting purposes. (CMA adapted)

CA2-3 (Objective of Financial Reporting) Homer Winslow and Jane Alexander are discussing various aspects of the FASB’s concepts statement on the objective of financial reporting. Homer indicates that this pronouncement provides little, if any, guidance to the practicing professional in resolving accounting controversies. He believes that the statement provides such broad guidelines that it would be impossible to apply the objective to present-day reporting problems. Jane concedes this point but indicates that the objective is still needed to provide a starting point for the FASB in helping to improve financial reporting.

Instructions (a) Indicate the basic objective established in the conceptual framework. (b) What do you think is the meaning of Jane’s statement that the FASB needs a starting point to resolve accounting

controversies?

CA2-4 GROUPWORK (Qualitative Characteristics) Accounting information provides useful information about business transactions and events. Those who provide and use financial reports must often select and evaluate accounting alternatives. The FASB statement on qualitative characteristics of accounting information examines the characteristics of accounting informa- tion that make it useful for decision-making. It also points out that various limitations inherent in the measurement and reporting process may necessitate trade-offs or sacrifices among the characteristics of useful information.

70 Chapter 2 Conceptual Framework for Financial Reporting

Instructions (a) Describe briefl y the following characteristics of useful accounting information. (1) Relevance. (4) Comparability. (2) Faithful representation. (5) Consistency. (3) Understandability. (b) For each of the following pairs of information characteristics, give an example of a situation in which one of the charac-

teristics may be sacrificed in return for a gain in the other. (1) Relevance and faithful representation. (3) Comparability and consistency. (2) Relevance and consistency. (4) Relevance and understandability. (c) What criterion should be used to evaluate trade-offs between information characteristics?

CA2-5 (Revenue Recognition Principle) After the presentation of your report on the examination of the financial state- ments to the board of directors of Piper Publishing Company, one of the new directors expresses surprise that the income statement assumes that an equal proportion of the revenue is recognized with the publication of every issue of the com- pany’s magazine. She feels that the “crucial event” in the process of earning revenue in the magazine business is the cash sale of the subscription. She says that she does not understand why most of the revenue cannot be “recognized” in the period of the cash sale.

Instructions Discuss the propriety of timing the recognition of revenue in Piper Publishing Company’s accounts with:

(a) The cash sale of the magazine subscription. (b) The publication of the magazine every month. (c) Over time, as the magazines are published and delivered to customers.

CA2-6 (Expense Recognition Principle) An accountant must be familiar with the concepts involved in determining earnings of a business entity. The amount of earnings reported for a business entity is dependent on the proper recognition, in general, of rev- enues and expenses for a given time period. In some situations, costs are recognized as expenses at the time of product sale. In other situations, guidelines have been developed for recognizing costs as expenses or losses by other criteria.

Instructions (a) Explain the rationale for recognizing costs as expenses at the time of product sale. (b) What is the rationale underlying the appropriateness of treating costs as expenses of a period instead of assigning the

costs to an asset? Explain. (c) In what general circumstances would it be appropriate to treat a cost as an asset instead of as an expense?

Explain. (d) Some expenses are assigned to specific accounting periods on the basis of systematic and rational allocation of asset

cost. Explain the underlying rationale for recognizing expenses on the basis of systematic and rational allocation of asset cost.

(e) Identify the conditions under which it would be appropriate to treat a cost as a loss. (AICPA adapted)

CA2-7 (Expense Recognition Principle) Accountants try to prepare income statements that are as accurate as possible. A basic requirement in preparing accurate income statements is to record costs and revenues properly. Proper recognition of costs and revenues requires that costs resulting from typical business operations be recognized in the period in which they expired.

Instructions (a) List three criteria that can be used to determine whether such costs should appear as charges in the income statement

for the current period. (b) As generally presented in financial statements, the following items or procedures have been criticized as improperly

recognizing costs. Briefly discuss each item from the viewpoint of matching costs with revenues and suggest corrective or alternative means of presenting the financial information.

(1) Receiving and handling costs. (2) Cash discounts on purchases.

CA2-8 (Expense Recognition Principle) Daniel Barenboim sells and erects shell houses, that is, frame structures that are com- pletely finished on the outside but are unfinished on the inside except for flooring, partition studding, and ceiling joists. Shell houses are sold chiefly to customers who are handy with tools and who have time to do the interior wiring, plumbing, wall comple- tion and finishing, and other work necessary to make the shell houses livable dwellings.

Concepts for Analysis 71

Barenboim buys shell houses from a manufacturer in unassembled packages consisting of all lumber, roofing, doors, win- dows, and similar materials necessary to complete a shell house. Upon commencing operations in a new area, Barenboim buys or leases land as a site for its local warehouse, field office, and display houses. Sample display houses are erected at a total cost of $30,000 to $44,000 including the cost of the unassembled packages. The chief element of cost of the display houses is the unas- sembled packages, inasmuch as erection is a short, low-cost operation. Old sample models are torn down or altered into new models every 3 to 7 years. Sample display houses have little salvage value because dismantling and moving costs amount to nearly as much as the cost of an unassembled package.

Instructions (a) A choice must be made between (1) expensing the costs of sample display houses in the periods in which the expendi-

ture is made and (2) spreading the costs over more than one period. Discuss the advantages of each method. (b) Would it be preferable to amortize the cost of display houses on the basis of (1) the passage of time or (2) the number of

shell houses sold? Explain. (AICPA adapted)

CA2-9 WRITING (Qualitative Characteristics) Recently, your uncle, Carlos Beltran, who knows that you always have your eye out for a profitable investment, has discussed the possibility of your purchasing some corporate bonds. He suggests that you may wish to get in on the “ground floor” of this deal. The bonds being issued by Neville Corp. are 10-year debentures which promise a 40% rate of return. Neville manufactures novelty/party items.

You have told Uncle Carlos that, unless you can take a look at Neville’s financial statements, you would not feel comfortable about such an investment. Believing that this is the chance of a lifetime, Uncle Carlos has procured a copy of Neville’s most recent, unaudited financial statements which are a year old. These statements were prepared by Mrs. Andy Neville. You peruse these statements, and they are quite impressive. The balance sheet showed a debt-to-equity ratio of 0.10 and, for the year shown, the company reported net income of $2,424,240.

The financial statements are not shown in comparison with amounts from other years. In addition, no significant note dis- closures about inventory valuation, depreciation methods, loan agreements, etc. are available.

Instructions Write a letter to Uncle Carlos explaining why it would be unwise to base an investment decision on the financial statements that he has provided to you. Be sure to explain why these financial statements are neither relevant nor representationally faithful.

CA2-10 ETHICS (Expense Recognition Principle) Anderson Nuclear Power Plant will be “mothballed” at the end of its useful life (approximately 20 years) at great expense. The expense recognition principle requires that expenses be recognized as assets are used up or liabilities are incurred. Accountants Ana Alicia and Ed Bradley argue whether it is better to allocate the expense of mothballing over the next 20 years or ignore it until mothballing occurs.

Instructions Answer the following questions.

(a) What stakeholders should be considered? (b) What ethical issue, if any, underlies the dispute? (c) What alternatives should be considered? (d) Assess the consequences of the alternatives. (e) What decision would you recommend?

CA2-11 (Cost Constraint) The AICPA Special Committee on Financial Reporting proposed the following constraints related to financial reporting.

1. Business reporting should exclude information outside of management’s expertise or for which management is not the best source, such as information about competitors.

2. Management should not be required to report information that would significantly harm the company’s competitive position. 3. Management should not be required to provide forecasted financial statements. Rather, management should provide infor-

mation that helps users forecast for themselves the company’s financial future. 4. Other than for financial statements, management need report only the information it knows. That is, management should

be under no obligation to gather information it does not have, or does not need, to manage the business. 5. Companies should present certain elements of business reporting only if users and management agree they should be re-

ported—a concept of flexible reporting. 6. Companies should not have to report forward-looking information unless there are effective deterrents to unwarranted

litigation that discourages companies from doing so.

Instructions For each item, briefly discuss how the proposed constraint addresses concerns about the costs and benefits of financial reporting.

72 Chapter 2 Conceptual Framework for Financial Reporting

USING YOUR JUDGMENT

Financial Reporting Problem

The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix B. The company’s complete annual report, including the notes to the financial statements, is available online.

Instructions Refer to P&G’s financial statements and the accompanying notes to answer the following questions.

(a) Using the notes to the consolidated financial statements, determine P&G’s revenue recognition policies. Discuss the impact of trade promotions on P&G’s financial statements.

(b) Give two examples of where historical cost information is reported in P&G’s financial statements and related notes. Give two examples of the use of fair value information reported in either the financial statements or related notes.

(c) How can we determine that the accounting principles used by P&G are prepared on a basis consistent with those of last year?

(d) What is P&G’s accounting policy related to advertising? What accounting principle does P&G follow regarding ac- counting for advertising? Where are advertising expenses reported in the financial statements?

Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. The financial statements of Coca-Cola and PepsiCo are presented in Appendices C and D, respectively. The companies’ com- plete annual reports, including the notes to the financial statements, are available online.

Instructions Use the companies’ financial information to answer the following questions.

(a) What are the primary lines of business of these two companies as shown in their notes to the financial statements? (b) Which company has the dominant position in beverage sales? (c) How are inventories for these two companies valued? What cost allocation method is used to report inventory? How

does their accounting for inventories affect comparability between the two companies? (d) What accounting policy changes do the companies discuss?

Financial Statement Analysis Case Wal-Mart Stores, Inc. Wal-Mart Stores, Inc. provided the following disclosure in a recent annual report.

New accounting pronouncement (partial) . . . the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101—“Revenue Recognition in Financial Statements” (SAB 101). This SAB deals with various revenue recognition issues, several of which are common within the retail industry. As a result of the issuance of this SAB . . . the Company is currently evaluating the effects of the SAB on its method of recognizing revenues related to layaway sales and will make any account- ing method changes necessary during the first quarter of [next year].

In response to SAB 101, Wal-Mart changed its revenue recognition policy for layaway transactions, in which Wal-Mart sets aside merchandise for customers who make partial payment. Before the change, Wal-Mart recognized all revenue on the sale at the time of the layaway. After the change, Wal-Mart does not recognize revenue until customers satisfy all payment obligations and take possession of the merchandise.

Instructions (a) Discuss the expected effect on income (1) in the year that Wal-Mart makes the changes in its revenue recognition policy,

and (2) in the years following the change. (b) Evaluate the extent to which Wal-Mart’s previous revenue policy was consistent with the revenue recognition

principle. (c) If all retailers had used a revenue recognition policy similar to Wal-Mart’s before the change, are there any concerns

with respect to the qualitative characteristic of comparability? Explain.

Bridge to the Profession 73

Accounting, Analysis, and Principles William Murray achieved one of his life-long dreams by opening his own business, The Caddie Shack Driving Range, on May 1, 2017. He invested $20,000 of his own savings in the business. He paid $6,000 cash to have a small building constructed to house the operations and spent $800 on golf clubs, golf balls, and yardage signs. Murray leased 4 acres of land at a cost of $1,000 per month. (He paid the first month’s rent in cash.) During the first month, advertising costs totaled $750, of which $150 was unpaid at the end of the month. Murray paid his three nephews $400 for retrieving golf balls. He deposited in the company’s bank ac- count all revenues from customers ($4,700). On May 15, Murray withdrew $800 in cash for personal use. On May 31, the company received a utility bill for $100 but did not immediately pay it. On May 31, the balance in the company bank account was $15,100.

Murray is feeling pretty good about results for the first month, but his estimate of profitability ranges from a loss of $4,900 to a profit of $1,650. Accounting Prepare a balance sheet at May 31, 2017. Murray appropriately records any depreciation expense on a quarterly basis. How could Murray have determined that the business operated at a profit of $1,650? How could Murray conclude that the business operated at a loss of $4,900?

Analysis Assume Murray has asked you to become a partner in his business. Under the partnership agreement, after paying him $10,000, you would share equally in all future profits. Which of the two income measures above would be more useful in deciding whether to become a partner? Explain.

Principles What is income according to GAAP? What concepts do the differences in the three income measures for The Caddie Shack Driving Range illustrate?

BRIDGE TO THE PROFESSION

FASB Codifi cation References [1] FASB ASC 205-40. [Predecessor literature: None.] [2] FASB ASC 205. [Predecessor literature: None.] [3] FASB ASC 820-10. [Predecessor literature: “Fair Value Measurement,” Statement of Financial Accounting Standards No. 157

(Norwalk, Conn.: FASB, September 2006).] [4] FASB ASC 825-10-25. [Predecessor literature: “The Fair Value Option for Financial Assets and Liabilities,” Statement of

Financial Accounting Standards No. 159 (Norwalk, Conn.: FASB, 2007).] [5] FASB ASC 718-10. [Predecessor literature: “Share-Based Payment,” Financial Accounting Standards No. 123(R) (Norwalk,

Conn.: FASB, 2004).]

Codifi cation Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE2-1 Access the glossary (“Master Glossary”) at the FASB Codification website to answer the following.

(a) What is the definition of fair value? (b) What is the definition of revenue? (c) What is the definition of comprehensive income?

CE2-2 Briefly describe how the organization of the FASB Codification corresponds to the elements of financial statements.

Codifi cation Research Case Your aunt recently received the annual report for a company in which she has invested. The report notes that the statements have been prepared in accordance with “generally accepted accounting principles.” She has also heard that certain terms have special meanings in accounting relative to everyday use. She would like you to explain the meaning of terms she has come across related to accounting.

Instructions Go to http://www.fasb.org and access the FASB Concepts Statements and respond to the following items. (Provide paragraph cita- tions.) When you have accessed the documents, you can use the search tool in your Internet browser.

(a) How is “materiality” defined in the conceptual framework?

74 Chapter 2 Conceptual Framework for Financial Reporting 74 Chapter 2 Conceptual Framework for Financial Reporting

IFRS Insights In 2004, the IASB and FASB started a joint comprehensive project on the conceptual frame- work. In 2010, the two Boards issued a converged concepts statement which covered the objective of financial reporting and a common set of desired qualitative characteristics of use- ful information. After this phase of the conceptual framework project was completed, the IASB decided to addresses the remaining phases of the project as an IASB-only comprehen- sive project.

RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to the concep- tual framework.

Similarities • In 2010, the IASB and FASB agreed on the objective of fi nancial reporting and a common set of

desired qualitative characteristics. These were presented in the Chapter 2 discussion. Note that prior to this agreement, the IASB conceptual framework gave more emphasis to the objective of providing information on management’s performance (stewardship).

• The existing conceptual frameworks underlying GAAP and IFRS are very similar. That is, they are organized in a similar manner (objective, elements, qualitative characteristics, etc.). There is no real need to change many aspects of the existing frameworks other than to converge differ- ent ways of discussing essentially the same concepts.

• Both the IASB and FASB have similar measurement principles, based on historical cost and fair value. In 2011, the Boards issued a converged standard fair value measurement so that the defi - nition of fair value, measurement techniques, and disclosures are the same between GAAP and IFRS when fair value is used in fi nancial statements.

Differences • Although both GAAP and IFRS are increasing the use of fair value to report assets, at this point

IFRS has adopted it more broadly. As examples, under IFRS, companies can apply fair value to property, plant, and equipment; natural resources; and in some cases, intangible assets.

• GAAP has a concept statement to guide estimation of fair values when market-related data is not available (Statement of Financial Accounting Concepts No. 7, “Using Cash Flow Information and Present Value in Accounting”). The IASB has not issued a similar concept statement; it has issued a fair value standard (IFRS 13) that is converged with GAAP.

• The monetary unit assumption is part of each framework. However, the unit of measure will vary depending on the currency used in the country in which the company is incorporated (e.g., Chinese yuan, Japanese yen, and British pound). IFRS makes an explicit assumption that fi nancial statements are prepared on an accrual basis.

• The economic entity assumption is also part of each framework, although some cultural differ- ences result in differences in its application. For example, in Japan many companies have formed alliances that are so strong that they act similar to related corporate divisions although they are not actually part of the same company.

LEARNING OBJECTIVE 8 Compare the conceptual frameworks underlying GAAP and IFRS.

(b) The concepts statements provide several examples in which specific quantitative materiality guidelines are provided to firms. Identity at least two of these examples. Do you think the materiality guidelines should be quantified? Why or why not?

(c) The concepts statements discuss the concept of “articulation” between financial statement elements. Briefly summarize the meaning of this term and how it relates to an entity’s financial statements.

ADDITIONAL PROFESSIONAL RESOURCES Go to WileyPLUS for other career-readiness resources, such as career coaching, internship opportunities, and CPAexcel prep.

Third Level: Recognition and Measurement Concepts 75IFRS Insights 75

• As indicated earlier, the IASB is developing a new conceptual framework. In these proposed conceptual framework amendments, the IASB has introduced two new qualitative characteris- tics: prudence and substance over form. Also, as noted in the next section, the IASB is making modifi cations to other parts of its conceptual framework by revising the defi nitions of a num- ber of the basic elements. The IASB is also introducing updated chapters on such items as measurement, classifi cation of income and expense, derecognition of assets and liabilities, and the reporting entity.

ABOUT THE NUMBERS

Financial Statement Elements While the conceptual framework that underlies IFRS is very similar to that used to develop GAAP, the elements identified and their definitions under IFRS are different. The IASB elements and their definitions are as follows.

Assets. A resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. Liabilities. A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Liabilities may be legally enforceable via a contract or law, but need not be, i.e., they can arise due to normal business practice or customs. Equity. A residual interest in the assets of the entity after deducting all its liabilities. Income. Increases in economic benefits that result in increases in equity (other than those re- lated to contributions from shareholders). Income includes both revenues (resulting from ordinary activities) and gains. Expenses. Decreases in economic benefits that result in decreases in equity (other than those related to distributions to shareholders). Expenses includes losses that are not the result of ordinary activities.

In its new conceptual framework project, it is likely that the IASB will change some definitions. For example, the IASB has proposed the following definition of as asset: “An asset is a present economic resource controlled by the entity as a result of a past event.” Thus, “expected flow of economic benefits” in the current definition is not present in the proposed definition.

Conceptual Framework Work Plan Moving ahead in its stand-alone conceptual framework project, the IASB has decided that:

1. The conceptual framework project should focus on elements of financial statements, report- ing entity, presentation, and disclosure.

2. The aim should be to work toward a single discussion paper covering all of the identified areas, rather than separate discussion papers for each area.

ON THE HORIZON The IASB and the FASB face a difficult task in attempting to update, modify, and complete a con- verged conceptual framework. There are many difficult issues. For example: How do we trade off characteristics such as highly relevant information that is difficult to verify? How do we define control when we are developing a definition of an asset? Is a liability the future sacrifice itself or the obligation to make the sacrifice? Should a single measurement method, such as historical cost or fair value, be used, or does it depend on whether it is an asset or liability that is being measured?

1. Which of the following statements about the IASB and FASB conceptual frameworks is not correct?

(a) The IASB conceptual framework does not identify the element comprehensive income.

(b) The existing IASB and FASB conceptual frameworks are organized in similar ways.

(c) The FASB and IASB agree that the objective of finan- cial reporting is to provide useful information to investors and creditors.

IFRS SELF-TEST QUESTIONS

76 Chapter 2 Conceptual Framework for Financial Reporting

IFRS CONCEPTS AND APPLICATION

IFRS2-1 What two assumptions are central to the IASB conceptual framework? IFRS2-2 Do the IASB and FASB conceptual frameworks differ in terms of the role of financial reporting? Explain. IFRS2-3 What are some of the differences in elements in the IASB and FASB conceptual frameworks? IFRS2-4 What are some of the challenges to the IASB in developing a conceptual framework?

Financial Reporting Case IFRS2-5 As discussed in Chapter 1, the International Accounting Standards Board (IASB) develops accounting standards for many international companies. The IASB also has developed a conceptual framework to help guide the setting of accounting standards. While the FASB and IASB have issued converged concepts statements on the objective and qualitative characteristics, other parts of their frameworks differ.

Instructions Briefly discuss the similarities and differences between the FASB and IASB conceptual frameworks as related to elements and their definitions.

Professional Research IFRS2-6 Your aunt recently received the annual report for a company in which she has invested. The report notes that the statements have been prepared in accordance with IFRS. She has also heard that certain terms have special meanings in account- ing relative to everyday use. She would like you to explain the meaning of terms she has come across related to accounting.

Instructions Access the IASB conceptual framework at the IASB website (http://eifrs.iasb.org/ ). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to pre- pare responses to the following items. (Provide paragraph citations.)

(a) How is “materiality” defi ned in the framework? (b) Briefl y discuss how materiality relates to (1) the relevance of fi nancial information, and (2) completeness. (c) Your aunt observes that under IFRS, the fi nancial statements are prepared on the accrual basis. According to the frame-

work, what does “accrual basis” mean?

(d) IFRS does not allow use of fair value as a measure- ment basis.

2. Which of the following statements is false? (a) The monetary unit assumption is used under IFRS. (b) Under IFRS, companies may use fair value for prop-

erty, plant, and equipment. (c) The FASB and IASB are no longer working on a joint

conceptual framework project. (d) Under IFRS, there are the same number of financial

statement elements as in GAAP.

3. Companies that use IFRS: (a) must report all their assets on the statement of finan-

cial position (balance sheet) at fair value. (b) may report property, plant, and equipment and nat-

ural resources at fair value. (c) may refer to a concept statement on estimating fair

values when market data are not available. (d) may only use historical cost as the measurement

basis in financial reporting.

4. The issues that the FASB and IASB must address in develop- ing a conceptual framework include all of the following except:

(a) should the characteristic of relevance be traded-off in favor of information that is verifiable?

(b) should a single measurement method such as his- torical cost be used?

(d) should the role of financial reporting focus on inter- nal decision-making as well as providing informa- tion to assist users in decision-making?

5. With respect to the IASB conceptual framework project: (a) work is being conducted to produce separate discus-

sion papers. (b) work is being conducted with the FASB. (c) work is being conducted to result in a discussion

paper covering all the identified areas. (d) the framework will not address elements of financial

statements.

76 Chapter 2 Conceptual Framework for Financial Reporting

Third Level: Recognition and Measurement Concepts 77

ANSWERS TO IFRS SELF-TEST QUESTIONS 1. d 2. d 3. b 4. d 5. c

Remember to check the book’s companion website to fi nd additional resources for this chapter.

International Financial Reporting Problem Marks and Spencer plc (M&S)

IFRS2-7 The financial statements of M&S are presented in Appendix E. The company’s complete annual report, including the notes to the financial statements, is available online.

Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions.

(a) Using the notes to the consolidated fi nancial statements, determine M&S’s revenue recognition policies. (b) Give two examples of where historical cost information is reported in M&S’s fi nancial statements and related

notes. Give two examples of the use of fair value information reported in either the fi nancial statements or related notes. What new accounting policies are discussed?

(c) How can we determine that the accounting principles used by M&S are prepared on a basis consistent with those of last year?

(d) What is M&S’s accounting policy related to refunds and loyalty schemes? Why does M&S include the accounting for refunds and loyalty schemes in its critical accounting estimates and judgments?

IFRS Insights 77

ANSWERS TO IFRS SELF-TEST QUESTIONS

1. d 2. d 3. b 4. d 5. c

NEEDED: A RELIABLE INFORMATION SYSTEM Maintaining a set of accounting records is not optional. Regulators require that businesses prepare and retain a set of records and documents that can be audited. The U.S. Foreign Corrupt Practices Act, for example, requires public companies to “make and keep books, records, and accounts, which, in rea- sonable detail, accurately and fairly reflect the transactions and disposi- tions of the assets.” But beyond these two reasons, a company that fails to keep an accurate record of its business transactions may lose revenue and is more likely to operate inefficiently.

One reason accurate records are not provided is because of economic crime or corruption (see the chart to the right). It is clear that economic crime remains a persistent and diffi- cult problem for many companies. For example, it was recently estimated that 45 percent of U.S. companies experienced significant economic crime. And their global counterparts are not far behind, with the overall global rate reported at 37 percent. While global rates appear lower, U.S. companies often have more stringent internal controls and are more likely to find and report crime.

As indicated, the top five economic crimes are asset misappro- priation, procurement fraud, IP infringement, cybercrime, and accounting fraud. Procurement fraud is one of the new types of fraud emerging in this area, reflecting the increasing interconnectedness of companies and ongoing trend toward outsourcing more aspects of their businesses. Businesses are especially vulnerable to procure- ment fraud when their purchasing, supply, and payment processes are susceptible to circumvention. Consider this case example:

3 1 Understand the basic accounting

information system.

2 Record and summarize basic transactions. 3 Identify and prepare adjusting entries.

4 Prepare financial statements from the adjusted trial balance.

5 Prepare closing entries. 6 Prepare financial statements for a

merchandising company.

The Accounting Information System LEARNING OBJECTIVES After studying this chapter, you should be able to:

0 10 20 30 40 100%50 60 70 9080

Accounting fraud

Human resource

Money laundering

IP Infringement, including theft of data

Types of Fraud

Cybercrime

Bribery and corruption

Asset misappropriation

Procurement fraud

16% 6%

0% 6%

4% 19%

16%

40% 44%

0% 27%

69%

13%

23%

2011 2014

93%

An operational manager had detailed knowledge of the company’s invoicing systems, which enabled this employee to create fraudu- lent invoices inflating the costs of regular supplies of goods and services from a third party. In addition, the employee had both responsibility for the management of asset disposal and the ability to write down the asset to minimal value. The asset was then sold on the secondary market for a significant profit for the manager.

Cybercrime is the second most reported economic crime. In the past, crime in this area was negligible. However, the increased usage of smartphones and tablet devices, social media, and cloud computing has led to risks related to the disclosure of sensitive and confidential data. Cybercrime is committed by many different offenders with diverse motives, such as (1) insiders who have authorized access and then abuse this access for personal gain, (2) competitors seeking unfair advantage, (3) foreign governments committing espionage for political or economic gain, (4) transnational crimi- nal enterprises stealing or extorting information to generate income, and (5) activists protesting organizational actions or policies. A second case study is presented in the box to the right.

Even large companies sometimes fail to keep an accurate record of their business transactions. Consider Adecco, the largest international employment services com- pany, which confirmed weaknesses in its internal controls systems and Adecco staffing operations in certain countries. Manipulation involved such matters as reconciliation of payroll bank accounts, accounts receivable, and documentation in revenue recognition. These irregularities forced an indefinite delay in reporting the company’s income figures, which led to a significant decline in its share price. Or consider Nortel Networks Corp., which overstated and understated its reserve accounts to manage its earnings. This eventually led to the liquidation of the company. Even the use of computers is no assurance of accuracy and efficiency. “The conversion to a new system called MasterNet fouled up data pro- cessing records to the extent that Bank of America was frequently unable to produce or deliver customer state- ments on a timely basis,”said an executive at one of the country’s largest banks. Although these situations may occur only rarely in large organizations, they illustrate the point: Companies must properly maintain accounts and detailed records or face unnecessary costs.

Sources: Adapted from “Cybercrime: Out of Obscurity and into Reality,”Sixth Annual Global Economic Crime Survey (Price- waterhouseCoopers, 2012); and “Cybercrime: Protecting against the Growing Threat,” Global Economic Crime Survey (PricewaterhouseCoopers, 2014).

Fraudsters at offshore locations produced a spoofed email from a computer, compromised a website, distributed malicious PDF documents and other URL links, and downloaded software to the company’s network without approval. This software gave the fraudsters access to the company’s corporate network.

PREVIEW OF CHAPTER 3 As the opening story indicates, a reliable informa- tion system is a necessity for all companies. The purpose of this chapter is to explain and illustrate the features of an accounting information system. The content and organization of this chapter are as follows.

THE ACCOUNTING INFORMATION SYSTEM

This chapter also includes numerous conceptual and international discussions that are integral to the topics presented here.

ACCOUNTING INFORMATION SYSTEM

• Basic terminology • Debits and credits • Accounting equation • Financial statements

and ownership structure • The accounting cycle

RECORD AND SUMMARIZE BASIC TRANSACTIONS

• Journalizing • Posting • Trial balance

ADJUSTING ENTRIES

• Types of adjusting entries

• Deferrals • Accruals • Adjusted trial

balance

FINANCIAL STATEMENTS FOR MERCHANDISERS

• Income statement • Statement of

retained earnings • Balance sheet • Closing entries

PREPARING FINANCIAL STATEMENTS

• Closing • Post-closing

trial balance • Reversing

entries • Summary

80 Chapter 3 The Accounting Information System

LEARNING OBJECTIVE 1 Understand the basic accounting information system.

ACCOUNTING INFORMATION SYSTEM An accounting information system collects and processes transaction data and then disseminates the financial information to interested parties. Accounting information systems vary widely from one business to another. Various factors shape these systems: the nature of the business and the transactions in which it engages, the size of the firm, the volume of data to be handled, and the informational demands that management and others require.

As we discussed in Chapters 1 and 2, in response to the requirements of the Sarbanes-Oxley Act (SOX), companies are placing a renewed focus on their accounting systems to ensure relevant and reliable information is reported in financial statements.1 A good accounting information system helps management answer such questions as:

• How much and what kind of debt is outstanding? • Were our sales higher this period than last? • What assets do we have? • What were our cash inflows and outflows? • Did we make a profit last period? • Are any of our product lines or divisions operating at a loss? • Can we safely increase our dividends to stockholders? • Is our rate of return on net assets increasing?

Management can answer many other questions with the data provided by an efficient accounting system. A well-devised accounting information system benefits every type of company.

Basic Terminology Financial accounting rests on a set of concepts (discussed in Chapters 1 and 2) for iden- tifying, recording, classifying, and interpreting transactions and other events relating to enterprises. You therefore need to understand the basic terminology employed in col- lecting accounting data.

1A recent survey indicates that a majority of companies have significantly or moderately improved their internal control over financial reporting (ICFR) structure since they were required to begin complying with Sarbanes-Oxley (SOX) Section 404 (b). Other findings represent even better news. In many cases, ICFR improvements and other compliance work are being used by organizations to drive continuous improve- ment of business processes related to financial reporting throughout the organization. See “Changes Abound Amid Drive for Stability and Long-Term Value,” 2015 Sarbanes-Oxley Compliance Survey (Protiviti Company, May 2015).

EVENT. A happening of consequence. An event generally is the source or cause of changes in assets, liabilities, and equity. Events may be external or internal.

TRANSACTION. An external event involving a transfer or exchange between two or more entities.

ACCOUNT. A systematic arrangement that shows the effect of transactions and other events on a specifi c element (asset, liability, and so on). Companies keep a separate account for each asset, liability, revenue, and expense, and for capital (stockholders’ equity). Because the format of an account often resembles the letter T, it is sometimes referred to as a T-account. (See Illustration 3-3, page 83.)

BASIC TERMINOLOGY

Accounting Information System 81

Debits and Credits The terms debit (Dr.) and credit (Cr.) mean left and right, respectively. These terms do not mean increase or decrease, but instead describe where a company makes entries in the recording process. That is, when a company enters an amount on the left side of an account, it debits the account. When it makes an entry on the right side, it credits the account. When comparing the totals of the two sides, an account shows a debit balance if the total of the debit amounts exceeds the credits. An account shows a credit balance if the credit amounts exceed the debits.

The positioning of debits on the left and credits on the right is simply an accounting custom. We could function just as well if we reversed the sides. However, the United States adopted the custom, now the rule, of having debits on the left side of an account and credits on the right side, similar to the custom of driving on the right-hand side of the road. This rule applies to all accounts.

REAL AND NOMINAL ACCOUNTS. Real (permanent) accounts are asset, liability, and equity accounts; they appear on the balance sheet. Nominal (temporary) accounts are rev- enue, expense, and dividend accounts; except for dividends, they appear on the income statement. Companies periodically close nominal accounts; they do not close real accounts.

LEDGER. The book (or computer printouts) containing the accounts. A general ledger is a collection of all the asset, liability, stockholders’ equity, revenue, and expense accounts. A subsidiary ledger contains the details related to a given general ledger account.

JOURNAL. The “book of original entry” where the company initially records transac- tions and selected other events. Various amounts are transferred from the book of origi- nal entry, the journal, to the ledger. Entering transaction data in the journal is known as journalizing.

POSTING. The process of transferring the essential facts and fi gures from the book of orig- inal entry to the ledger accounts.

TRIAL BALANCE. The list of all open accounts in the ledger and their balances. The trial balance taken immediately after all adjustments have been posted is called an adjusted trial balance. A trial balance taken immediately after closing entries have been posted is called a post-closing (or after-closing) trial balance. Companies may prepare a trial balance at any time.

ADJUSTING ENTRIES. Entries made at the end of an accounting period to bring all ac- counts up to date on an accrual basis, so that the company can prepare correct fi nancial statements.

FINANCIAL STATEMENTS. Statements that refl ect the collection, tabulation, and fi nal summarization of the accounting data. Four statements are involved. (1) The balance sheet shows the fi nancial condition of the enterprise at the end of a period. (2) The income state- ment measures the results of operations during the period. (3) The statement of cash fl ows reports the cash provided and used by operating, investing, and fi nancing activities during the period. (4) The statement of retained earnings reconciles the balance of the retained earnings account from the beginning to the end of the period.

CLOSING ENTRIES. The formal process by which the enterprise reduces all nominal accounts to zero and determines and transfers the net income or net loss to a stockhold- ers’ equity account. Also known as “closing the ledger,” “closing the books,” or merely “closing.”

82 Chapter 3 The Accounting Information System

The equality of debits and credits provides the basis for the double-entry system of recording transactions (sometimes referred to as double-entry bookkeeping). Under the universally used double-entry accounting system, a company records the dual (two-sided) effect of each transaction in appropriate accounts. This system provides a logical method for recording transactions. It also offers a means of proving the accu- racy of the recorded amounts. If a company records every transaction with equal deb- its and credits, then the sum of all the debits to the accounts must equal the sum of all the credits.

Illustration 3-1 presents the basic guidelines for an accounting system. Increases to all asset and expense accounts occur on the left (or debit side) and decreases on the right (or credit side). Conversely, increases to all liability and revenue accounts occur on the right (or credit side) and decreases on the left (or debit side). A company increases stock- holders’ equity accounts, such as Common Stock and Retained Earnings, on the credit side, but increases Dividends on the debit side.

The Accounting Equation In a double-entry system, for every debit there must be a credit, and vice versa. This leads us, then, to the basic equation in accounting (Illustration 3-2).

ILLUSTRATION 3-1 Double-Entry (Debit and Credit) Accounting System Asset Accounts Liability Accounts

Expense Accounts Stockholders' Equity Accounts

Revenue Accounts

+ (increase)

– (decrease)

+ (increase)

Debit + (increase)

+ (increase) Credit + (increase)

– (decrease) Debit – (decrease)

DebitNormal Balance—Debit CreditNormal Balance—Credit

Credit – (decrease)

Stockholders' Equity= +LiabilitiesAssets

ILLUSTRATION 3-2 The Basic Accounting Equation

Illustration 3-3 expands this equation to show the accounts that make up stockhold- ers’ equity. The figure also shows the debit/credit rules and effects on each type of account. Study this diagram carefully. It will help you understand the fundamentals of

Accounting Information System 83

the double-entry system. Like the basic equation, the expanded equation must also bal- ance (total debits equal total credits).

Stockholders’ Equity= +LiabilitiesAssetsBasic Equation

Expanded Equation

Debit/Credit Rules

Assets

Dr. +

Liabilities Common

Stock Retained Earnings Dividends Revenues Expenses

Cr. –

Dr. –

Cr. +

Dr. –

Cr. +

Dr. –

Cr. +

Dr. +

Cr. –

Dr. –

Cr. +

Dr. +

Cr. –

= + + – + –

ILLUSTRATION 3-3 Expanded Equation and Debit/Credit Rules and Effects

Every time a transaction occurs, the elements of the accounting equation change. However, the basic equality remains. To illustrate, consider the following eight different transactions for Perez Inc.

1. Owners invest $40,000 in exchange for common stock.

= +Assets + 40,000

Liabilities Stockholders’ Equity + 40,000

= +Assets – 600

Liabilities Stockholders’ Equity – 600 (expense)

2. Disburse $600 cash for administrative wages.

= + Stockholders’ EquityAssets+ 5,200 Liabilities +5,200

3. Purchase offi ce equipment priced at $5,200, giving a 10 percent promissory note in exchange.

= +Assets + 4,000 Liabilities

Stockholders’ Equity + 4,000 (revenue)

4. Receive $4,000 cash for services performed.

84 Chapter 3 The Accounting Information System

5. Pay off a short-term liability of $7,000.

= +Assets – 7,000

Liabilities – 7,000

Stockholders’ Equity

= +Assets Liabilities + 5,000

Stockholders’ Equity – 5,000

= +Assets Liabilities – 80,000

Stockholders’ Equity + 80,000

= + Assets

–16,000 +16,000

Liabilities Stockholders’ Equity

6. Declare a cash dividend of $5,000.

7. Convert a long-term liability of $80,000 into common stock.

8. Pay cash of $16,000 for a delivery van.

Financial Statements and Ownership Structure The stockholders’ equity section of the balance sheet reports common stock and retained earnings. The income statement reports revenues and expenses. The statement of retained earnings reports net income/loss and dividends. Because a company transfers dividends, revenues, and expenses to retained earnings at the end of the period, a change in any one of these three items affects stockholders’ equity. Illustration 3-4 shows the stockholders’ equity relationships.

The company’s ownership structure dictates the types of accounts that are part of or affect the equity section. A corporation commonly uses Common Stock, Paid-in Capital in Excess of Par, Dividends, and Retained Earnings accounts. A proprietorship or a part- nership uses an Owner’s Capital account and an Owner’s Drawings account. An Own- er’s Capital account indicates the owner’s or owners’ investment in the company. An Owner’s Drawings account tracks withdrawals by the owner(s).

Accounting Information System 85

Illustration 3-5 summarizes and relates the transactions affecting equity to the nominal (temporary) and real (permanent) classifications and to the types of business ownership.

Stockholders' Equity

Balance Sheet

Statement of Retained Earnings

Common Stock (investments by stockholders)

Retained Earnings (net income retained in business)

Net Income or Net Loss (revenues less expenses)

Income Statement Dividends

ILLUSTRATION 3-4 Financial Statements and Ownership Structure

The Accounting Cycle Illustration 3-6 (on page 86) shows the steps in the accounting cycle. A company nor- mally uses these accounting procedures to record transactions and prepare financial statements.

Identifying and Recording Transactions and Other Events The first step in the accounting cycle is analysis of transactions and selected other events. The first problem is to determine what to record. Although GAAP provides guidelines, no simple rules exist that state which events a company should record. Although

ILLUSTRATION 3-5 Effects of Transactions on Equity Accounts

Ownership Structure

Proprietorships and Impact on Partnerships Corporations

Transactions Owners’ or Nominal Real Nominal Real Affecting Owners’ Stockholders’ (Temporary) (Permanent) (Temporary) (Permanent) or Stockholders’ Equity Equity Accounts Accounts Accounts Accounts

Investment by owner(s) Increase Capital Common Stock and related accounts

Revenues recognized Increase Revenue Revenue Expenses incurred Decrease Expense Capital Expense Retained Withdrawal by owner(s) Decrease Drawings Dividends Earnings}}

86 Chapter 3 The Accounting Information System

Reversing entries (optional)

Post-closing trial balance

(optional)

Posting General ledger (usually monthly) Subsidiary ledgers (usually daily)

Closing (nominal accounts)

Trial balance preparation

Statement preparation Income statement Retained earnings Balance sheet Cash flows

When the steps have been completed, the sequence starts over again in the next accounting period.

Adjusted trial balance

Journalization General journal Cash receipts journal Cash disbursements journal Purchases journal Sales journal Other special journals

Identification and Measurement of Transactions and Other Events

THE ACCOUNTING

CYCLE

Worksheet (optional)

Adjustments Accruals Prepayments Estimated items

ILLUSTRATION 3-6 The Accounting Cycle

changes in a company’s personnel or managerial policies may be important, the com- pany should not record these items in the accounts. On the other hand, a company should record all cash sales or purchases—no matter how small.

The concepts we presented in Chapter 2 determine what to recognize in the accounts. An item should be recognized in the financial statements if it is an element, is measur- able, and is relevant and representationally faithful. Consider human resources. R. G. Barry & Co. at one time reported as supplemental data total assets of $14,055,926, including $986,094 for “Net investments in human resources.” AT&T and ExxonMobil also experimented with human resource accounting. Should we value employees for balance sheet and income statement purposes? Certainly skilled employees are an important asset (highly relevant), but the problems of determining their value and mea- suring it reliably have not yet been solved. Consequently, human resources are not recorded. Perhaps when measurement techniques become more sophisticated and accepted, such information will be presented, if only in supplemental form.

The FASB uses the phrase “transactions and other events and circumstances that affect a business enterprise” to describe the sources or causes of changes in an entity’s assets, liabilities, and equity.2 Events are of two types. (1) External events involve

2“Elements of Financial Statements of Business Enterprises,” Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, 1985), pp. 259–260.

UNDERLYING CONCEPTS

Assets are probable economic benefi ts controlled by a particular entity as a result of a past transaction or event. Do human resources of a company meet this defi nition?

Record and Summarize Basic Transactions 87

interaction between an entity and its environment, such as a transaction with another entity, a change in the price of a good or service that an entity buys or sells, a flood or earthquake, or an improvement in technology by a competitor. (2) Internal events occur within an entity, such as using buildings and machinery in operations, or transferring or consuming raw materials in production processes.

Many events have both external and internal elements. For example, hiring an employee, which involves an exchange of salary for labor, is an external event. Using the services of labor is part of production, an internal event. Further, an entity may initi- ate and control events, such as the purchase of merchandise or use of a machine. Or, events may be beyond its control, such as an interest rate change, theft, or a tax hike.

Transactions are types of external events. They may be an exchange between two entities where each receives and sacrifices value, such as purchases and sales of goods or services. Or, transactions may be transfers in one direction only. For example, an entity may incur a liability without directly receiving value in exchange, such as chari- table contributions. Other examples include investments by owners, distributions to owners, payment of taxes, gifts, casualty losses, and thefts.

In short, a company records as many events as possible that affect its financial posi- tion. As discussed earlier in the case of human resources, it omits some events because of tradition and others because of complicated measurement problems. Recently, however, the accounting profession shows more receptiveness to accepting the challenge of mea- suring and reporting events previously viewed as too complex and immeasurable.

RECORD AND SUMMARIZE BASIC TRANSACTIONS

Journalizing A company records in accounts those transactions and events that affect its assets, liabil- ities, and equities. The general ledger contains all the asset, liability, and stockholders’ equity accounts. An account (see Illustration 3-3, on page 83) shows the effect of trans- actions on particular asset, liability, equity, revenue, and expense accounts.

In practice, companies do not record transactions and selected other events origi- nally in the ledger. A transaction affects two or more accounts, each of which is on a different page in the ledger. Therefore, in order to have a complete record of each trans- action or other event in one place, a company uses a journal (also called “the book of original entry”). In its simplest form, a general journal chronologically lists transactions and other events, expressed in terms of debits and credits to accounts.

As an example, Illustration 3-7 shows the technique of journalizing, using two transactions for Softbyte, Inc. These transactions are:

September 1 Stockholders invested $15,000 cash in the corporation in exchange for shares of stock.

Purchased computer equipment for $7,000 cash.

The J1 in Illustration 3-7 indicates these two entries are on the first page of the general journal.

LEARNING OBJECTIVE 2 Record and summarize basic transactions.

GENERAL JOURNAL J1

Date Account Titles and Explanation Ref. Debit Credit

2017 Sept. 1 Cash 15,000 Common Stock 15,000 (Issued shares of stock for cash)

1 Equipment 7,000 Cash 7,000 (Purchased equipment for cash)

ILLUSTRATION 3-7 Technique of Journalizing

88 Chapter 3 The Accounting Information System

Each general journal entry consists of four parts: (1) the accounts and amounts to be debited (Dr.), (2) the accounts and amounts to be credited (Cr.), (3) a date, and (4) an expla- nation. A company enters debits first, followed by credits (slightly indented). The expla- nation begins below the name of the last account to be credited and may take one or more lines. A company completes the “Ref.” column at the time it posts the accounts.

In some cases, a company uses special journals in addition to the general journal. Spe- cial journals summarize transactions possessing a common characteristic (e.g., cash receipts, sales, purchases, cash payments). As a result, using them reduces bookkeeping time.

Posting Transferring journal entries to the ledger accounts is called posting. Posting involves the following steps.

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

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

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

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

Illustration 3-8 diagrams these four steps, using the first journal entry of Softbyte, Inc. The illustration shows the general ledger accounts in standard account form. Some companies call this form the three-column form of account because it has three money

ILLUSTRATION 3-8 Posting a Journal Entry

2017 Sept.1 Cash

Common Stock (Issued shares of stock for cash)

Date Account Titles and Explanation

GENERAL JOURNAL

Ref. Debit Credit

2017 Sept.1

Date Explanation Ref. Debit Credit Balance

No.101Cash

GENERAL LEDGER

Key: Post to debit account–date, journal page number, and amount. Enter debit account number in journal reference column. Post to credit account–date, journal page number, and amount. Enter credit account number in journal reference column.

No.311

2017 Sept.1

Date Explanation Ref. Debit Credit Balance

Common Stock

15,000 15,000

J1 15,000 15,000

101 311

columns—debit, credit, and balance. The balance in the account is determined after each transaction. The explanation space and reference columns provide special information about the transaction. The boxed numbers indicate the sequence of the steps.

The numbers in the “Ref.” column of the general journal refer to the ledger accounts to which a company posts the respective items. For example, the “101” placed in the column to the right of “Cash” indicates that the company posted this $15,000 item to Account No. 101 in the ledger.

The posting of the general journal is completed when a company records all of the posting reference numbers opposite the account titles in the journal. Thus, the number in the posting reference column serves two purposes. (1) It indicates the ledger account number of the account involved. (2) It indicates the completion of posting for the par- ticular item. Each company selects its own numbering system for its ledger accounts. Many begin numbering with asset accounts and then follow with liabilities, stockholders’ equity, revenue, and expense accounts, in that order.

The ledger accounts in Illustration 3-8 show the accounts after completion of the posting process. The reference J1 (General Journal, page 1) indicates the source of the data transferred to the ledger account.

An Expanded Example To show an expanded example of the basic steps in the recording process, we use the October transactions of Pioneer Advertising Inc. Pioneer’s accounting period is one month. Illustrations 3-9 through 3-18 show the journal entry and posting of each trans- action. For simplicity, we use a T-account form instead of the standard account form. Study the transaction analyses carefully.

The purpose of transaction analysis is (1) to identify the type of account involved, and (2) to determine whether a debit or a credit is required. You should always perform this type of analysis before preparing a journal entry. Doing so will help you understand the journal entries discussed in this chapter as well as more complex journal entries in later chapters. Keep in mind that every journal entry affects one or more of the follow- ing items: assets, liabilities, stockholders’ equity, revenues, or expenses.

1. October 1: Stockholders invest $100,000 cash in an advertising venture to be known as Pioneer Advertising Inc.

Journal Entry

Oct. 1 100,000

Cash 101

Oct. 1 100,000

Common Stock 311 Posting

Oct. 1 Cash Common Stock (Issued shares of stock for cash)

101 311

100,000 100,000

ILLUSTRATION 3-9 Investment of Cash by Stockholders

2. October 1: Pioneer purchases offi ce equipment costing $50,000 by signing a 3-month, 12%, $50,000 note payable.

Journal Entry

Oct. 1 50,000

Equipment 157

Oct. 1 50,000

Notes Payable 200 Posting

Oct. 1 Equipment Notes Payable (Issued 3-month, 12% note for office equipment)

157 200

50,000 50,000

ILLUSTRATION 3-10 Purchase of Offi ce Equipment

Record and Summarize Basic Transactions 89

90 Chapter 3 The Accounting Information System

3. October 2: Pioneer receives a $12,000 cash advance from R. Knox, a client, for adver- tising services that are expected to be completed by December 31.

Journal Entry

Posting Oct. 1 100,000 2 12,000

Cash 101 Oct. 2 12,000

Unearned Service Revenue 209

Oct. 2 101 209

12,000 12,000

Cash Unearned Service Revenue (Received cash from R. Knox for future service)

ILLUSTRATION 3-11 Receipt of Cash for Future Service

Journal Entry

Posting Oct.1 100,000 2 12,000

Cash 101 Rent Expense 729

Oct. 3 Rent Expense Cash (Paid October rent)

729 101

9,000 9,000

Oct. 3 9,000 Oct. 3 9,000

ILLUSTRATION 3-12 Payment of Monthly Rent

ILLUSTRATION 3-13 Payment for Insurance

Journal Entry

Posting Oct. 4 6,000Oct.1 100,000 2 12,000

Oct. 3 9,000 4 6,000

130 101

Cash 101 Prepaid Insurance 130

Oct. 4 Prepaid Insurance Cash (Paid one-year policy; effective date October 1)

6,000 6,000

ILLUSTRATION 3-14 Purchase of Supplies on Account JournalEntry

Posting Oct. 5 25,000

Supplies 126

Oct. 5 25,000

Accounts Payable 201

Oct. 5 Supplies Accounts Payable (Purchased supplies on account from Aero Supply)

126 201

25,000 25,000

4. October 3: Pioneer pays $9,000 offi ce rent, in cash, for October.

5. October 4: Pioneer pays $6,000 for a one-year insurance policy that will expire next year on September 30.

6. October 5: Pioneer purchases, for $25,000 on account, an estimated 3-month supply of advertising materials from Aero Supply.

7. October 9: Pioneer signs a contract with a local newspaper for online ads starting the last Sunday in November. Pioneer will start work on the content of the ads in November. Payment of $7,000 is due following the posting of the ads.

8. October 20: Pioneer’s board of directors declares and pays a $5,000 cash dividend to stockholders.

9. October 26: Pioneer pays employee salaries and wages in cash. Employees are paid every four weeks. The total payroll is $10,000 per week, or $2,000 per day. In Octo- ber, the pay period began on Monday, October 1. As a result, the pay period ended on Friday, October 26, with salaries and wages of $40,000 being paid.

ILLUSTRATION 3-15 Signing a Contract

A business transaction has not occurred. There is only an agreement between Pioneer and the newspaper for the services to be performed in November. Therefore, no journal entry is necessary in October.

ILLUSTRATION 3-16 Declaration and Payment of Dividend by CorporationJournal

Entry

Posting Oct.1 100,000 2 12,000

Cash 101

Oct. 3 9,000 4 6,000 20 5,000

Oct. 20 Dividends Cash (Declared and paid a cash dividend)

332 101

5,000 5,000

Oct. 20 5,000

Dividends 332

ILLUSTRATION 3-17 Payment of Salaries and WagesJournalEntry

Posting

Oct. 26 Salaries and Wages Expense Cash (Paid salaries to date)

726 101

40,000 40,000

Oct.3 9,000 4 6,000

20 5,000 26 40,000

Oct.1 100,000 2 12,000

Cash 101

Oct.26 40,000

Salaries and Wages Expense 726

10. October 31: Pioneer receives $28,000 in cash and bills Copa Company $72,000 for advertising services of $100,000 performed in October. ILLUSTRATION 3-18

Recognize Revenue for Services Performed

Journal Entry

Posting

Accounts Receivable

Oct. 31 100,000

Service Revenue112

Oct.1 100,000 2 12,000

31 28,000

Cash 101

Oct.3 9,000 4 6,000

20 5,000 26 40,000

Oct. 31 Cash Accounts Receivable Service Revenue (Recognize revenue for services performed)

101 112 400

28,000 72,000

100,000

Oct. 31 72,000

400

Record and Summarize Basic Transactions 91

92 Chapter 3 The Accounting Information System

Trial Balance A trial balance is a list of accounts and their balances at a given time. A company usu- ally prepares a trial balance at the end of an accounting period. The trial balance lists the accounts in the order in which they appear in the ledger, with debit balances listed in the left column and credit balances in the right column. The totals of the two columns must agree.

The trial balance proves the mathematical equality of debits and credits after post- ing. Under the double-entry system, this equality occurs when the sum of the debit account balances equals the sum of the credit account balances. A trial balance also uncovers errors in journalizing and posting. In addition, it is useful in the preparation of financial statements. The procedures for preparing a trial balance consist of:

1. List the account titles and their balances in the appropriate debit or credit column. 2. Total the debit and credit columns. 3. Prove the equality of the two columns.

Illustration 3-19 presents the trial balance prepared from the ledger of Pioneer Advertis- ing Inc. Note that the total debits ($287,000) equal the total credits ($287,000). A trial balance also often shows account numbers to the left of the account titles.

ILLUSTRATION 3-19 Trial Balance (Unadjusted)

PIONEER ADVERTISING INC. TRIAL BALANCE

OCTOBER 31, 2017

Debit Credit

Cash $ 80,000 Accounts Receivable 72,000 Supplies 25,000 Prepaid Insurance 6,000 Equipment 50,000 Notes Payable $ 50,000 Accounts Payable 25,000 Unearned Service Revenue 12,000 Common Stock 100,000 Dividends 5,000 Service Revenue 100,000 Salaries and Wages Expense 40,000 Rent Expense 9,000

$287,000 $287,000

A trial balance does not prove that a company recorded all transactions or that the ledger is correct. Numerous errors may exist even though the trial balance columns agree. For example, the trial balance may balance even when a company (1) fails to jour- nalize a transaction, (2) omits posting a correct journal entry, (3) posts a journal entry twice, (4) uses incorrect accounts in journalizing or posting, or (5) makes offsetting errors in recording the amount of a transaction. In other words, as long as a company posts equal debits and credits, even to the wrong account or in the wrong amount, the total debits will equal the total credits.

ADJUSTING ENTRIES In order for revenues to be recorded in the period in which services are performed and for expenses to be recognized in the period in which they are incurred, companies make adjusting entries. In short, adjustments ensure that a company like McDonald’s fol- lows the revenue recognition and expense recognition principles.

LEARNING OBJECTIVE 3 Identify and prepare adjusting entries.

Adjusting Entries 93

The use of adjusting entries makes it possible to report on the balance sheet the appropriate assets, liabilities, and stockholders’ equity at the statement date. Adjusting entries also make it possible to report on the income statement the proper revenues and expenses for the period. However, the trial balance—the first pulling together of the transaction data—may not contain up-to-date and complete data. This occurs for the following reasons.

1. Some events are not recorded daily because it is not effi cient to do so. Examples are the use of supplies and the earning of salaries and wages by employees.

2. Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions. Examples of such costs are building and equipment depreciation and rent and insurance.

3. Some items may be unrecorded. An example is a utility service bill that will not be received until the next accounting period.

Adjusting entries are required every time a company, such as Coca-Cola, prepares financial statements. At that time, Coca-Cola must analyze each account in the trial bal- ance to determine whether it is complete and up-to-date for financial statement pur- poses. The analysis requires a thorough understanding of Coca-Cola’s operations and the interrelationship of accounts. Because of this involved process, usually a skilled accountant prepares the adjusting entries. In gathering the adjustment data, Coca-Cola may need to make inventory counts of supplies and repair parts. Further, it may prepare supporting schedules of insurance policies, rental agreements, and other contractual commitments. Companies often prepare adjustments after the balance sheet date. How- ever, they date the entries as of the balance sheet date.

Types of Adjusting Entries Adjusting entries are classified as either deferrals or accruals. Each of these classes has two subcategories, as Illustration 3-20 shows.

ILLUSTRATION 3-20 Categories of Adjusting Entries

Deferrals:

1. Prepaid expenses: Expenses paid in cash before they are used or consumed.

2. Unearned revenues: Cash received before services are performed.

Accruals:

1. Accrued revenues: Revenues for services performed but not yet received in cash or recorded.

2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded.

We review specific examples and explanations of each type of adjustment in subse- quent sections. We base each example on the October 31 trial balance of Pioneer Adver- tising Inc. (Illustration 3-19). We assume that Pioneer uses an accounting period of one month. Thus, Pioneer will make monthly adjusting entries, dated October 31.

Adjusting Entries for Deferrals To defer means to postpone or delay. Deferrals are expenses or revenues that are recog- nized at a date later than the point when cash was originally exchanged. The two types of deferrals are prepaid expenses and unearned revenues.

If a company does not make an adjustment for these deferrals, the asset and liability are overstated, and the related expense and revenue are understated. For example, in

94 Chapter 3 The Accounting Information System

Pioneer Advertising’s trial balance (Illustration 3-19 on page 92), the balance in the asset Supplies shows only supplies purchased. This balance is overstated; the related expense account, Supplies Expense, is understated because the cost of supplies used has not been recognized. Thus, the adjusting entry for deferrals will decrease a balance sheet account and increase an income statement account. Illustration 3-21 shows the effects of adjusting entries for deferrals.

Prepaid Expenses

Unearned Revenues

Asset

Credit Adjusting Entry (–)

Unadjusted Balance

ADJUSTING ENTRIES

Expense

Debit Adjusting Entry (+)

Liability Revenue

Credit Adjusting Entry (+)

Debit Adjusting Entry (–)

Unadjusted Balance

ILLUSTRATION 3-21 Adjusting Entries for Deferrals

Prepaid Expenses Assets paid for and recorded before a company uses them are called prepaid expenses. When expenses are prepaid, a company debits an asset account to show the service or benefit it will receive in the future. Examples of common prepayments are insurance, supplies, advertising, and rent. In addition, companies make prepayments when they purchase buildings and equipment.

Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use and consumption (e.g., supplies). The expiration of these costs does not require daily entries, an unnecessary and impractical task. Accordingly, a company like Walgreens usually postpones the recognition of such cost expirations until it prepares financial statements. At each statement date, Walgreens makes adjust- ing entries to record the expenses that apply to the current accounting period and to show the remaining amounts in the asset accounts.

As shown above, prior to adjustment, assets are overstated and expenses are under- stated. Thus, an adjusting entry for prepaid expenses results in a debit to an expense account and a credit to an asset account.

Supplies. A business may use several different types of supplies. For example, a CPA firm will use office supplies such as stationery, envelopes, and accounting paper. An advertising firm will stock advertising supplies such as whiteboard markers and printer

Adjusting Entries 95

cartridges. Supplies are generally debited to an asset account when they are acquired. Recognition of supplies used is generally deferred until the adjustment process. At that time, a physical inventory (count) of supplies is taken. The difference between the bal- ance in the Supplies (asset) account and the cost of supplies on hand represents the sup- plies used (an expense) for the period.

For example, Pioneer Advertising purchased advertising supplies costing $25,000 on October 5. Pioneer therefore debited the asset Supplies. This account shows a balance of $25,000 in the October 31 trial balance (see Illustration 3-19 on page 92). An inventory count at the close of business on October 31 reveals that $10,000 of supplies are still on hand. Thus, the cost of supplies used is $15,000 ($25,000 − $10,000). The analysis and adjustment for advertising supplies is sum- marized in Illustration 3-22.

A = L + SE −15,000 −15,000 Cash Flows no effect

Debit–Credit Analysis

Journal Entry

Posting

Basic Analysis

Equation Analysis

Oct. 5 25,000 Oct. 31 Bal. 10,000

Oct. 31 Adj. 15,000 Supplies

Oct. 31 Adj. 15,000 Oct. 31 Bal. 15,000

Supplies Expense

Debits increase expenses: debit Supplies Expense $15,000. Credits decrease assets: credit Supplies $15,000.

Oct. 31 Supplies Expense Supplies (To record supplies used)

15,000 15,000

The expense Supplies Expense is increased $15,000, and the asset Supplies is decreased $15,000.

Assets Supplies –$15,000

+Liabilities Stockholders’ Equity Supplies Expense

–$15,000

(1)

ILLUSTRATION 3-22 Adjustment for Supplies

Supplies used; record supplies expense

Supplies purchased; record asset

Oct. 31

Oct. 5

Supplies

Insurance Policy Nov $500

Dec $500

Jan $500

Feb $500

March $500

April $500

May $500

June $500

July $500

Aug $500

Sept $500

Insurance = $6,000/year

Oct $500

FIRE INSURANCE 1 year

insurance policy $6,000

Insurance expired; record insurance expense.

Insurance purchased; record asset

Oct. 1

Oct. 31

Insurance

After adjustment, the asset account Supplies shows a balance of $10,000, which equals the cost of supplies on hand at the statement date. In addition, Supplies Expense shows a balance of $15,000, which equals the cost of supplies used in October. Without an adjusting entry, October expenses are understated and net income overstated by $15,000. Moreover, both assets and stockholders’ equity are overstated by $15,000 on the October 31 balance sheet.

Insurance. Most companies maintain fire and theft insurance on merchandise and equipment, personal liability insurance for accidents suffered by customers, and auto- mobile insurance on company cars and trucks. The extent of protection against loss determines the cost of the insurance (the amount of the premium to be paid). The insur- ance policy specifies the term and coverage. The minimum term usually covers one year, but three- to five-year terms are available and may offer lower annual premiums. A company usually debits insurance premiums to the asset account Prepaid Insurance when paid. At the financial statement date, it then debits Insurance Expense and credits Prepaid Insurance for the cost that expired during the period.

For example, on October 4, Pioneer Advertising paid $6,000 for a one-year fire insur- ance policy. Coverage began on October 1. Pioneer debited the cost of the premium to Prepaid Insurance at that time. This account still shows a balance of $6,000 in the Octo- ber 31 trial balance. The analysis and adjustment for insurance is summarized in Illus- tration 3-23 (page 96).

96 Chapter 3 The Accounting Information System

The asset Prepaid Insurance shows a balance of $5,500, which represents the unex- pired cost for the remaining 11 months of coverage. At the same time, the balance in Insurance Expense equals the insurance cost that expired in October. Without an adjust- ing entry, October expenses are understated by $500 and net income overstated by $500. Moreover, both assets and stockholders’ equity also are overstated by $500 on the October 31 balance sheet.

Depreciation. Companies like Caterpillar or Boeing typically own various productive facilities, such as buildings, equipment, and motor vehicles. These assets provide a ser- vice for a number of years. The term of service is commonly referred to as the useful life of the asset. Because Caterpillar, for example, expects an asset such as a building to provide service for many years, Caterpillar records the building as an asset, rather than an expense, in the year the building is acquired. Caterpillar records such assets at cost, as required by the historical cost principle.

To follow the expense recognition principle, Caterpillar reports a portion of the cost of a long-lived asset as an expense during each period of the asset’s useful life. Depre- ciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner.

Need for Depreciation Adjustment. Generally accepted accounting principles (GAAP) view the acquisition of productive facilities as a long-term prepayment for services. The need for making periodic adjusting entries for depreciation is, there- fore, the same as we described for other prepaid expenses. That is, a company recognizes the expired cost (expense) during the period and reports the unexpired cost (asset) at the end of the period. The primary causes of depreciation of a pro- ductive facility are actual use, deterioration due to the elements, and obsolescence. For example, at the time Caterpillar acquires an asset, the effects of these factors cannot be known with certainty. Therefore, Caterpillar must estimate them. Thus, depreciation is an estimate rather than a factual measurement of the expired cost.

To estimate depreciation expense, Caterpillar often divides the cost of the asset by its useful life. For example, if Caterpillar purchases equipment for $10,000 and expects its useful life to be 10 years, Caterpillar records annual depreciation of $1,000.

A = L + SE −500 −500 Cash Flows no effect

Debit–Credit Analysis

Journal Entry

Basic Analysis

Equation Analysis

Debits increase expenses: debit Insurance Expense $500. Credits decrease assets: credit Prepaid Insurance $500.

Oct. 31 Insurance Expense Prepaid Insurance (To record insurance expired)

500 500

The expense Insurance Expense is increased $500, and the asset Prepaid Insurance is decreased $500.

Assets Prepaid Insurance

!$500

(2) =

+Liabilities Insurance Expense

!$500

Equation Analysis

Posting Prepaid Insurance Insurance Expense

Oct. 4 6,000 Oct. 31 Bal. 5,500

Oct. 31 Adj. 500 Oct. 31 Adj. 500 Oct. 31 Bal. 500

Stockholders’ Equity

ILLUSTRATION 3-23 Adjustment for Insurance

Depreciation recognized; record depreciation expense

Equipment purchased; record asset

Oct. 2

Oct. 31

Depreciation

Equipment Nov $400

Dec $400

Jan $400

Feb $400

March $400

April $400

May $400

June $400

July $400

Aug $400

Sept $400

Oct $400

Depreciation = $4,800/ year

Adjusting Entries 97

In the case of Pioneer Advertising, it estimates depreciation on its office equipment to be $4,800 a year (cost $50,000 less salvage value $2,000 divided by useful life of 10 years), or $400 per month. The analysis and adjustment for depreciation is summa- rized in Illustration 3-24.

A = L + SE −400 −400 Cash Flows no effect

ILLUSTRATION 3-24 Adjustment for Depreciation

Debit–Credit Analysis

Journal Entry

Posting

Basic Analysis

Oct. 31 Adj. 400 Oct. 31 Bal. 400

Accumulated Depreciation—Equipment Oct. 31 Adj. 400 Oct. 31 Bal. 400

Depreciation Expense

Oct. 2 50,000 Oct. 31 Bal. 50,000

Equipment

Debits increase expenses: debit Depreciation Expense $400. Credits increase contra assets: credit Accumulated Depreciation—Equipment $400.

Oct. 31 Depreciation Expense Accumulated Depreciation— Equipment (To record monthly depreciation)

400 400

The expense Depreciation Expense is increased $400, and the contra asset Accumulated Depreciation—Equipment is increased $400.

Assets Accumulated

Depreciation—Equipment !$400

+Liabilities

Depreciation Expense !$400

Equation Analysis

Stockholders’ Equity

The balance in the Accumulated Depreciation—Equipment account will increase $400 each month. Therefore, after recording and posting the adjusting entry at November 30, the balance will be $800.

Statement Presentation. Accumulated Depreciation—Equipment is a contra asset account. A contra asset account offsets an asset account on the balance sheet. This means that the Accumulated Depreciation—Equipment account offsets the Equip- ment account on the balance sheet. Its normal balance is a credit. Pioneer Advertising uses this account instead of crediting Equipment in order to disclose both the original cost of the equipment and the total expired cost to date. In the balance sheet, Pioneer deducts Accumulated Depreciation—Equipment from the related asset account as follows.

ILLUSTRATION 3-25 Balance Sheet Presentation of Accumulated Depreciation

Equipment $50,000 Less: Accumulated depreciation—equipment 400 $49,600

The book value of any depreciable asset is the difference between its cost and its related accumulated depreciation. In Illustration 3-25, the book value of the equip- ment at the balance sheet date is $49,600. Note that the asset’s book value generally differs from its fair value. The reason: Depreciation is an allocation concept, not a valuation concept. That is, depreciation allocates an asset’s cost to the periods in which it is used. Depreciation does not attempt to report the actual change in the value of the asset.

98 Chapter 3 The Accounting Information System

Depreciation expense identifies that portion of the asset’s cost that expired during the period (in this case, October). Without this adjusting entry, total assets, total stockholders’ equity, and net income are overstated, and depreciation expense is understated.

A company records depreciation expense in a single account for each piece of equipment, such as trucks or machinery, and for all buildings. A company also establishes related accumulated depreciation accounts for the above, such as Accumulated Depreciation— Trucks, Accumulated Depreciation—Machinery, and Accumulated Depreciation—Buildings.

Unearned Revenues When companies receive cash before services are performed, they record a liability by increasing (crediting) a liability account called unearned revenues. In other words, a company now has a performance obligation (liability) to provide service to one of its customers. Items like rent, magazine subscriptions, and customer deposits for future service may result in unearned revenues. Airlines, such as Delta, American, and South- west, treat receipts from the sale of tickets as unearned revenue until they satisfy the performance obligation (provide the flight service). Tuition received prior to the start of a semester is another example of unearned revenue.

Unearned revenues are the opposite of prepaid expenses. Indeed, unearned rev- enue on the books of one company is likely to be a prepayment on the books of the company that made the advance payment. For example, if we assume identical accounting periods, a landlord will have unearned rent revenue when a tenant has prepaid rent.

When a company such as Intel receives payment for services to be performed in a future accounting period, it credits an unearned revenue (a liability) account to recog- nize the liability that exists. Intel subsequently recognizes revenue when it performs the service. However, making daily entries to record this revenue is impractical. Instead, Intel delays recognition of revenue until the adjustment process. Then, Intel makes an adjusting entry to record the revenue for services performed during the period and to show the liability that remains at the end of the accounting period. In the typical case, liabilities are overstated and revenues are understated prior to adjustment. Thus, the adjusting entry for unearned revenues results in a debit (decrease) to a liability account and a credit (increase) to a revenue account.

For example, Pioneer Advertising received $12,000 on October 2 from R. Knox for advertising services expected to be completed by December 31. Pioneer credited the payment to Unearned Service Revenue. This liability account shows a balance of $12,000 in the October 31 trial balance. Based on an evaluation of the service Pioneer performed for Knox during October, the company determines that it should recog- nize $4,000 of revenue in October. The liability (Unearned Service Revenue) is there- fore decreased and stockholders’ equity (Service Revenue) is increased, as shown in Illustration 3-26.

The liability Unearned Service Revenue now shows a balance of $8,000. This amount represents the remaining advertising services expected to be performed in the future. At the same time, Service Revenue shows total revenue recognized in October of $104,000. Without this adjustment, revenues and net income are under- stated by $4,000 in the income statement. Moreover, liabilities will be overstated and stockholders’ equity will be understated by $4,000 on the October 31 balance sheet.

Adjusting Entries for Accruals The second category of adjusting entries is accruals. Companies make adjusting entries for accruals to record revenues for services performed and expenses incurred in the cur- rent accounting period. Without an accrual adjustment, the revenue account (and the related asset account) or the expense account (and the related liability account) are

$12,000

Thank you in advance for

your work

I will finish by Dec. 31

Some service has been performed; some revenue

is recorded

Cash is received in advance; liability is recorded

Oct. 2

Oct. 31

Unearned Revenues

Adjusting Entries 99

understated. Thus, the adjusting entry for accruals will increase both a balance sheet and an income statement account. Illustration 3-27 shows adjusting entries for accruals.

Debit–Credit Analysis

Journal Entry

Posting

Basic Analysis

Oct. 31 Adj. 4,000 Oct. 2 12,000

Oct.31 Bal. 8,000

Oct. 3 100,000 31 Adj. 4,000

Oct. 31 Bal. 104,000

Unearned Service Revenue Service Revenue

Debits decrease liabilities: debit Unearned Service Revenue $4,000. Credits increase revenues: credit Service Revenue $4,000.

Oct. 31 Unearned Service Revenue Service Revenue (To record revenue for services performed)

4,000 4,000

The liability Unearned Service Revenue is decreased $4,000, and the revenue Service Revenue is increased $4,000.

Assets Unearned

Service Revenue

= +Liabilities Equation Analysis

!$4,000 Service Revenue

"$4,000

Stockholders’ Equity

ILLUSTRATION 3-26 Adjustment for Unearned Service Revenue

Accrued Revenues

Accrued Expenses

Asset Revenue

Debit Adjusting Entry (+)

Expense Liability

Credit Adjusting Entry (+)

Debit Adjusting Entry (+)

Credit Adjusting Entry (+)

ADJUSTING ENTRIES

ILLUSTRATION 3-27 Adjusting Entries for Accruals

A = L + SE −4,000

+4,000 Cash Flows no effect

Accrued Revenues Revenues for services performed but not yet recorded at the statement date are accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time, as in the case of interest revenue. These are unrecorded because the earning of interest does not

100 Chapter 3 The Accounting Information System

involve daily transactions. Companies do not record interest revenue on a daily basis because it is often impractical to do so. Accrued revenues also may result from services that have been performed but not yet billed nor collected, as in the case of commissions and fees. These may be unrecorded because only a portion of the total service has been performed and the clients will not be billed until the service has been completed.

An adjusting entry records the receivable that exists at the balance sheet date and the revenue for the services performed during the period. Prior to adjustment, both assets and revenues are understated. Accordingly, an adjusting entry for accrued reve- nues results in a debit (increase) to an asset account and a credit (increase) to a revenue account.

In October, Pioneer Advertising performed services worth $2,000 that were not billed to clients on or before October 31. Because these services are not billed, they are not recorded. The accrual of unrecorded service revenue increases an asset account, Accounts Receivable. It also increases stockholders’ equity by increasing a revenue account, Service Revenue, as shown in Illustration 3-28.

A = L + SE +2,000 +2,000 Cash Flows no effect

ILLUSTRATION 3-28 Accrual Adjustment for Receivable and Revenue Accounts

Debit–Credit Analysis

Journal Entry

Posting

Basic Analysis

Accounts Receivable

Debits increase assets: debit Accounts Receivable $2,000. Credits increase revenues: credit Service Revenue $2,000.

Oct. 31 Accounts Receivable Service Revenue (To record revenue for services performed)

2,000 2,000

The asset Accounts Receivable is increased $2,000, and the revenue Service Revenue is increased $2,000.

Assets =

+Liabilities Accounts Receivable "$2,000

Service Revenue "$2,000

Equation Analysis

Oct. 3 100,000 31 4,000 31 Adj. 2,000

Oct. 31 Bal. 106,000

Oct. 1 72,000 31 Adj. 2,000

Oct. 31 Bal. 74,000

Service Revenue

Stockholders’ Equity

My fee is $2,000

Revenue and receivable are recorded for unbilled services

Accrued Revenues

The asset Accounts Receivable shows that clients owe $74,000 at the balance sheet date. The balance of $106,000 in Service Revenue represents the total revenue for ser- vices performed by Pioneer during the month ($100,000 + $4,000 + $2,000). Without an adjusting entry, assets and stockholders’ equity on the balance sheet, and revenues and net income on the income statement, are understated.

Accrued Expenses Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses. Interest, rent, taxes, and salaries are common examples. Accrued expenses result from the same causes as accrued revenues. In fact, an accrued expense on the books of one company is an accrued revenue to another company. For example, the $2,000 accrual of service revenue by Pioneer Advertising is an accrued expense to the client that received the service.

Adjustments for accrued expenses record the obligations that exist at the balance sheet date and recognize the expenses that apply to the current accounting period. Prior

Adjusting Entries 101

to adjustment, both liabilities and expenses are understated. Therefore, the adjusting entry for accrued expenses results in a debit (increase) to an expense account and a credit (increase) to a liability account.

Accrued Interest. Pioneer Advertising signed a three-month note payable in the amount of $50,000 on October 1. The note requires interest at an annual rate of 12 per- cent. Three factors determine the amount of the interest accumulation: (1) the face value of the note; (2) the interest rate, which is always expressed as an annual rate; and (3) the length of time the note is outstanding. For Pioneer, the total interest due on the $50,000 note at its maturity date three months’ in the future is $1,500 ($50,000 × 12% × 3/12), or $500 for one month. Illustration 3-29 shows the formula for computing interest and its application to Pioneer. Note that the formula expresses the time period as a fraction of a year.

Face Value of Note

Annual Interest

Rate Interestx x =

x x =$50,000 12% 1/12 $500

Time in Terms of One Year

ILLUSTRATION 3-29 Formula for Computing Interest

Debit–Credit Analysis

Journal Entry

Posting

Basic Analysis

Equation Analysis

Oct. 31 Adj. 500 Oct. 31 Bal. 500

Interest Expense Interest Payable

Debits increase expenses: debit Interest Expense $500. Credits increase liabilities: credit Interest Payable $500.

Oct. 31 Interest Expense Interest Payable (To record interest on notes payable)

500 500

The expense Interest Expense is increased $500, and the liability Interest Payable is increased $500.

Assets Interest Payable

"$500

= +Liabilities Interest Expense

!$500

Stockholders’ Equity

ILLUSTRATION 3-30 Adjustment for Interest

A = L + SE −500

−500 Cash Flows no effect

As Illustration 3-30 shows, the accrual of interest at October 31 increases a liability account, Interest Payable. It also decreases stockholders’ equity by increasing an expense account, Interest Expense.

Interest Expense shows the interest charges for the month of October. Interest Pay- able shows the amount of interest owed at the statement date. Pioneer will not pay this amount until the note comes due at the end of three months. Why does Pioneer use the

102 Chapter 3 The Accounting Information System

Interest Payable account instead of crediting Notes Payable? By recording interest pay- able separately, Pioneer discloses the two different types of obligations—interest and principal—in the accounts and statements. Without this adjusting entry, liabilities and interest expense are understated, and both net income and stockholders’ equity are overstated.

Accrued Salaries and Wages. Companies pay for some types of expenses, such as employee salaries and wages, after the services have been performed. For example, Pio- neer Advertising last paid salaries and wages on October 26. It will not pay salaries and wages again until November 23. However, as shown in the calendar below, three work- ing days remain in October (October 29–31).

October

Adjustment period

Start of pay period

Payday Payday

S M Tu W Th F S 2 3 4 5 6

7 8 9 10 11 12 13 14 16 17 18 19 20 21 22 23 24 25 27 28 29 30 31

26 15

November

S M Tu W Th F S 1 2 3

4 5 6 7 8 10 11 13 14 15 16 17 18 19 20 21 22 24 25 26 27 28

23 29 30

12 9

At October 31, the salaries and wages for these days represent an accrued expense and a related liability to Pioneer. The employees receive total salaries and wages of $10,000 for a five-day work week, or $2,000 per day. Thus, accrued salaries and wages at October 31 are $6,000 ($2,000 × 3). The analysis and adjustment process is summarized in Illustration 3-31.

A = L + SE −6,000

+6,000 Cash Flows no effect

Debit–Credit Analysis

Journal Entry

Posting

Basic Analysis

Equation Analysis

Oct. 26 40,000 31 Adj. 6,000 Oct. 31 Bal. 46,000

Oct. 31 Adj. 6,000

Oct. 31 Bal. 6,000

Salaries and Wages Expense Salaries and Wages Payable

Debits increase expenses: debit Salaries and Wages Expense $6,000. Credits increase liabilities: credit Salaries and Wages Payable $6,000.

Oct. 31 Salaries and Wages Expense Salaries and Wages Payable (To record accrued salaries)

6,000 6,000

The expense Salaries and Wages Expense is increased $6,000, and the liability account Salaries and Wages Payable is increased $6,000.

Assets Salaries and Wages Payable

"$6,000

= +Liabilities Stockholders’ Equity Salaries and Wages Expense

!$6,000

ILLUSTRATION 3-31 Adjustment for Salaries and Wages Expense

Adjusting Entries 103

After this adjustment, the balance in Salaries and Wages Expense of $46,000 (23 days × $2,000) is the actual salaries and wages expense for October. The balance in Salaries and Wages Payable of $6,000 is the amount of the liability for salaries and wages owed as of October 31. Without the $6,000 adjustment for salaries, both Pioneer’s expenses and liabilities are understated by $6,000.

Pioneer pays salaries and wages every four weeks. Consequently, the next pay- day is November 23, when it will again pay total salaries and wages of $40,000. The payment consists of $6,000 of salaries and wages payable at October 31 plus $34,000 of salaries and wages expense for November (17 working days as shown in the November calendar × $2,000). Therefore, Pioneer makes the following entry on November 23.

Nov. 23

Salaries and Wages Payable 6,000 Salaries and Wages Expense 34,000 Cash 40,000 (To record November 23 payroll)

This entry eliminates the liability for Salaries and Wages Payable that Pioneer recorded in the October 31 adjusting entry. This entry also records the proper amount of Salaries and Wages Expense for the period between November 1 and November 23.

Rather than purchasing insurance to cover casualty losses and other obligations, some companies “self-insure.” That is, a company decides to pay for any possible claims, as they arise, out of its own resources. The company also purchases an insurance policy to cover losses that exceed certain amounts.

For example, Almost Family, Inc., a healthcare services company, has a self-insured employee health-benefi t program.

However, Almost Family ran into accounting problems when it failed to record an accrual of the liability for benefi ts not cov- ered by its back-up insurance policy. This led to restatement of Almost Family’s fi scal results for the accrual of the benefi t expense.

WHAT DO THE NUMBERS MEAN? AM I COVERED?

Bad Debts. Companies estimate uncollectible accounts at the end of each period. This ensures that receivables are reported on the balance sheet at their net realizable value. As a result, proper valuation of the receivable balance requires recognition of uncollectible receivables and an adjusting entry for bad debt expense.

At the end of each period, a company such as General Mills estimates the amount of receivables that will later prove to be uncollectible. General Mills bases the estimate on various factors: the amount of bad debts it experienced in past years, general eco- nomic conditions, how long the receivables are past due, and other factors that indicate the extent of uncollectibility. To illustrate, assume that, based on past experience, Pioneer Advertising reasonably estimates a bad debt expense for the month of $1,600. The analysis and adjustment process for bad debts is summarized in Illustration 3-32 (page 104).

A = L + SE −6,000

−34,000 −40,000 Cash Flows −40,000

Uncollectible accounts; record bad debt expense

Oct. 31

Bad Debts

104 Chapter 3 The Accounting Information System

A company generally computes bad debts by adjusting Allowance for Doubtful Accounts to a certain percentage of the trade accounts receivable and trade notes receiv- able at the end of the period.

Adjusted Trial Balance After journalizing and posting all adjusting entries, Pioneer Advertising prepares another trial balance from its ledger accounts (shown in Illustration 3-33 on page 105). This trial balance is called an adjusted trial balance. The purpose of an adjusted trial balance is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments. Because the accounts contain all data needed for financial statements, the adjusted trial balance is the primary basis for the preparation of financial statements.

PREPARING FINANCIAL STATEMENTS As indicated above, Pioneer Advertising can prepare financial statements directly from the adjusted trial balance. Illustrations 3-34 (page 105) and 3-35 (page 106) show the interrelationships of data in the adjusted trial balance and the financial statements.

As Illustration 3-34 shows, Pioneer prepares the income statement from the revenue and expense accounts. Next, it derives the retained earnings statement from the retained earnings and dividends accounts and the net income (or net loss) shown in the income statement.

LEARNING OBJECTIVE 4 Prepare financial statements from the adjusted trial balance.

A = L + SE −1,600 −1,600 Cash Flows no effect

ILLUSTRATION 3-32 Adjustment for Bad Debt Expense

Debit–Credit Analysis

Journal Entry

Posting

Basic Analysis

Oct. 31 Adj. 1,600 Oct. 31 Bal. 1,600

Allowance for Doubtful Accounts Oct. 31 Adj. 1,600 Oct. 31 Bal. 1,600

Bad Debt Expense

Oct. 2 72,000 31 2,000 Oct. 31 Bal. 74,000

Accounts Receivable

Debits increase expenses: debit Bad Debt Expense $1,600. Credits increase contra assets: credit Allowance for Doubtful Accounts $1,600.

Oct. 31 Bad Debt Expense Allowance for Doubtful Accounts (To record monthly bad debt expense)

1,600 1,600

The expense Bad Debt Expense is increased $1,600, and the contra asset Allowance for Doubtful Accounts is increased $1,600.

Assets Allowance for Doubtful

Accounts !$1,600

+Liabilities

Bad Debt Expense !$1,600

Equation Analysis

Stockholders’ Equity

ILLUSTRATION 3-33 Adjusted Trial BalancePIONEER ADVERTISING INC.

ADJUSTED TRIAL BALANCE OCTOBER 31, 2017

Debit Credit

Cash $ 80,000 Accounts Receivable 74,000 Allowance for Doubtful Accounts $ 1,600 Supplies 10,000 Prepaid Insurance 5,500 Equipment 50,000 Accumulated Depreciation—Equipment 400 Notes Payable 50,000 Accounts Payable 25,000 Interest Payable 500 Unearned Service Revenue 8,000 Salaries and Wages Payable 6,000 Common Stock 100,000 Dividends 5,000 Service Revenue 106,000 Salaries and Wages Expense 46,000 Supplies Expense 15,000 Rent Expense 9,000 Insurance Expense 500 Interest Expense 500 Depreciation Expense 400 Bad Debt Expense 1,600

$297,500 $297,500

PIONEER ADVERTISING INC. ADJUSTED TRIAL BALANCE

OCTOBER 31, 2017

74,000

10,000 5,500

50,000

5,000

46,000 15,000 9,000

500 500 400

1,600

400 50,000 25,000 8,000 6,000

500 100,000

–0–

106,000

$297,500 $297,500

Debit Credit

PIONEER ADVERTISING INC. INCOME STATEMENT

FOR THE MONTH ENDED OCTOBER 31, 2017

Revenues Service revenue

Expenses Salaries and wages expense Supplies expense Rent expense Insurance expense Interest expense Depreciation expense

Total expenses Net income

$46,000 15,000 9,000

500 500 400

1,600

$106,000

73,000 $ 33,000

PIONEER ADVERTISING INC. RETAINED EARNINGS STATEMENT

FOR THE MONTH ENDED OCTOBER 31, 2017

Retained earnings, October 1 Add: Net income

$ –0– 33,000 33,000

Service Revenue Salaries and Wages Expense Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense Bad Debt Expense

Retained Earnings Dividends

Account

5,000 $28,000

Less: Dividends Retained earnings, October 31

To balance sheet

Bad debt expense

Cash Accounts Receivable Allowance for Doubtful Accounts

$ 80,000

$ 1,600 Supplies Prepaid Insurance Equipment Accumulated Depreciation— Equipment Notes Payable Accounts Payable Unearned Service Revenue Salaries and Wages Payable Interest Payable Common Stock

ILLUSTRATION 3-34 Preparation of the Income Statement and Retained Earnings Statement from the Adjusted Trial Balance

106 Chapter 3 The Accounting Information System

As Illustration 3-35 shows, Pioneer then prepares the balance sheet from the asset and liability accounts, the common stock account, and the ending retained earnings bal- ance as reported in the retained earnings statement.

PIONEER ADVERTISING INC. ADJUSTED TRIAL BALANCE

OCTOBER 31, 2017

Cash Accounts Receivable Allowance for Doubtful Accounts Supplies Prepaid Insurance Equipment Accumulated Depreciation— Equipment Notes Payable Accounts Payable Unearned Service Revenue Salaries and Wages Payable Interest Payable Common Stock Retained Earnings Dividends Service Revenue Salaries and Wages Expense Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense Bad Debt Expense

$ 80,000 74,000

10,000 5,500

50,000

5,000

46,000 15,000 9,000

500 500 400

1,600

400

50,000 25,000 8,000 6,000

500 100,000

–0–

106,000

$297,500 $297,500

Account Debit Credit

PIONEER ADVERTISING INC. BALANCE SHEET

OCTOBER 31, 2017

Cash Accounts receivable Less: Allowance for doubtful accounts Supplies Prepaid insurance Equipment Less: Accumulated depreciation—equipment Total assets

50,000

400

Assets

Liabilities Notes payable Accounts payable Unearned service revenue Salaries and wages payable Interest payable Total liabilities Stockholders’ equity Common stock Retained earnings Total liabilities and stockholders’ equity

$ 80,000

72,400 10,000 5,500

49,600 $217,500

Liabilities and Stockholders’ Equity

$ 50,000 25,000 8,000

6,000 500

89,500

100,000 28,000

$217,500

Balance at Oct. 31 from retained earnings statement in Illustration 3-34 (page 105)

$ 1,600

1,600 $74,000

ILLUSTRATION 3-35 Preparation of the Balance Sheet from the Adjusted Trial Balance

To achieve the vision of “24/7 accounting,” a company must be able to update revenue, income, and balance sheet numbers every day within the quarter and publish them on the Internet. Such real-time reporting responds to the demand for more timely fi nancial information made available to all investors—not just to analysts with access to company management.

Two obstacles typically stand in the way of 24/7 accounting: having the necessary accounting systems to close the books on a daily basis, and reliability concerns associated with unaudited real-time data. Only a few companies have the necessary accounting capabilities. Cisco Systems, which pioneered the concept of the 24-hour close, is one such company.

WHAT DO THE NUMBERS MEAN? 24/7 ACCOUNTING

Closing The closing process reduces the balance of nominal (temporary) accounts to zero in order to prepare the accounts for the next period’s transactions. In the closing process, Pioneer Advertising transfers all of the revenue and expense account balances (income statement items) to a clearing or suspense account called Income Summary. The Income Summary account matches revenues and expenses.

LEARNING OBJECTIVE 5 Prepare closing entries.

Preparing Financial Statements 107

Pioneer uses this clearing account only at the end of each accounting period. The account represents the net income or net loss for the period. It then transfers this amount (the net income or net loss) to a stockholders’ equity account. (For a corporation, the stockholders’ equity account is retained earnings; for proprietorships and partnerships, it is a capital account.) Companies post all such closing entries to the appropriate gen- eral ledger accounts.

Closing Entries In practice, companies generally prepare closing entries only at the end of a company’s annual accounting period. However, to illustrate the journalizing and posting of closing entries, we will assume that Pioneer Advertising closes its books monthly. Illustration 3-36 shows the closing entries at October 31.

ILLUSTRATION 3-36 Closing Entries Journalized GENERAL JOURNAL J3

Date Account Titles and Explanation Debit Credit

Closing Entries

(1) Oct. 31 Service Revenue 106,000 Income Summary 106,000 (To close revenue account) (2) 31 Income Summary 73,000 Supplies Expense 15,000 Depreciation Expense 400 Insurance Expense 500 Salaries and Wages Expense 46,000 Rent Expense 9,000 Interest Expense 500 Bad Debt Expense 1,600 (To close expense accounts) (3) 31 Income Summary 33,000 Retained Earnings 33,000 (To close net income to retained earnings) (4) 31 Retained Earnings 5,000 Dividends 5,000 (To close dividends to retained earnings)

A couple of cautions about preparing closing entries. (1) Avoid unintentionally dou- bling the revenue and expense balances rather than zeroing them. (2) Do not close Divi- dends through the Income Summary account. Dividends are not expenses, and they are not a factor in determining net income.

Posting Closing Entries Illustration 3-37 (page 108) shows the posting of closing entries and the underlining (ruling) of accounts. All temporary accounts have zero balances after posting the closing entries. In addition, note that the balance in Retained Earnings represents the accumu- lated undistributed earnings of Pioneer Advertising at the end of the accounting period.

108 Chapter 3 The Accounting Information System

Pioneer reports the ending balance in retained earnings in the balance sheet. As noted above, Pioneer uses the Income Summary account only in closing. It does not journal- ize and post entries to this account during the year.

As part of the closing process, Pioneer totals, balances, and double-underlines the temporary accounts—revenues, expenses, and dividends—as shown in T-account form in Illustration 3-37. It does not close the permanent accounts—assets, liabilities, and stockholders’ equity (Common Stock and Retained Earnings). Instead, Pioneer draws a single underline beneath the current period entries for the permanent accounts. The account balance is then entered below the single underline and is carried forward to the next period (see, for example, Retained Earnings).

40,000 6,000

Salaries and Wages Expense

46,000

46,000(2)

726

9,000

Rent Expense

9,000(2)

729

500

Insurance Expense

500(2)

722

400

Depreciation Expense

400(2)

711

500

Interest Expense

500(2)

905

1,600

Bad Debt Expense

1,600(2)

910

15,000

Supplies Expense

15,000(2)

631

5,000

Retained Earnings

0 33,000

Bal. 28,000

(3)

320

(4)

106,000

Service Revenue

106,000

100,000 4,000 2,000

106,000

400

(1)

5,000

Dividends

5,000(4)

332

73,000 33,000

Income Summary

106,000

(1)

350

(2) (3)

Close Revenues to Income Summary. Close Expenses to Income Summary. Close Income Summary to Retained Earnings. Close Dividends to Retained Earnings.

Key: 2

ILLUSTRATION 3-37 Posting of Closing Entries

Preparing Financial Statements 109

After the closing process, each income statement account and the dividend account are balanced out to zero and are ready for use in the next accounting period.

Post-Closing Trial Balance Recall that a trial balance is prepared after entering the regular transactions of the period, and that a second trial balance (the adjusted trial balance) occurs after posting the adjusting entries. A company may take a third trial balance after posting the closing entries. The trial balance after closing is called the post-closing trial balance. The pur- pose of the post-closing trial balance is to prove the equality of the permanent account balances that the company carries forward into the next accounting period. Since all temporary accounts will have zero balances, the post-closing trial balance will contain only permanent (real)—balance sheet—accounts.

Illustration 3-38 shows the post-closing trial balance of Pioneer Advertising Inc.

ILLUSTRATION 3-38 Post-Closing Trial BalancePIONEER ADVERTISING INC.

POST-CLOSING TRIAL BALANCE OCTOBER 31, 2017

Account Debit Credit

$219,500 $219,500

A post-closing trial balance provides evidence that the company has properly jour- nalized and posted the closing entries. It also shows that the accounting equation is in balance at the end of the accounting period. However, like the other trial balances, it does not prove that Pioneer has recorded all transactions or that the ledger is correct. For example, the post-closing trial balance will balance if a transaction is not journalized and posted, or if a transaction is journalized and posted twice.

Reversing Entries—An Optional Step Some accountants prefer to reverse the effects of certain adjusting entries by making a reversing entry at the beginning of the next accounting period. A reversing entry is the exact opposite of the adjusting entry made in the previous period. Use of reversing entries is an optional bookkeeping procedure; it is not a required step in the account- ing cycle. Accordingly, we have chosen to cover this topic in Appendix 3B at the end of the chapter.

110 Chapter 3 The Accounting Information System

The Accounting Cycle Summarized A summary of the steps in the accounting cycle shows a logical sequence of the account- ing procedures used during a fiscal period:

1. Enter the transactions of the period in appropriate journals. 2. Post from the journals to the ledger (or ledgers). 3. Take an unadjusted trial balance (trial balance). 4. Prepare adjusting journal entries and post to the ledger(s). 5. Take a trial balance after adjusting (adjusted trial balance). 6. Prepare the fi nancial statements from the second trial balance. 7. Prepare closing journal entries and post to the ledger(s). 8. Take a post-closing trial balance (optional). 9. Prepare reversing entries (optional) and post to the ledger(s).

A company normally completes all of these steps in every fiscal period.

WHAT DO THE NUMBERS MEAN? HEY, IT’S COMPLICATED

FINANCIAL STATEMENTS FOR A MERCHANDISING COMPANY Pioneer Advertising Inc. is a service company. In this section, we show a detailed set of financial statements for a merchandising company, Uptown Cabinet Corp. The financial statements (see pages 111–112) are prepared from the adjusted trial balance (not shown).

Income Statement The income statement for Uptown, shown in Illustration 3-39, is self-explanatory. The income statement classifies amounts into such categories as gross profit on sales, income from operations, income before taxes, and net income. Although earnings per share information is required to be shown on the face of the income statement for a corpora- tion, we omit this item here as it will be discussed more fully later in the textbook. For homework problems, do not present earnings per share information unless required to do so.

LEARNING OBJECTIVE 6 Prepare financial statements for a merchandising company.

The economic volatility of the past few years has left companies hungering for more timely and uniform fi nancial information to help them react quickly to fast-changing conditions. As one expert noted, companies were extremely focused on trying to reduce costs and plan for the future better, but a lot of them discovered that they didn’t have the information they needed and they didn’t have the ability to get that information. The unsteady recession environment also made it risky for companies to interrupt their operations to get new systems up to speed.

So what to do? Try to piecemeal upgrades each year or start a major overhaul of their internal systems? Best Buy, for example, has standardized as many of its systems as possible and has been steadily upgrading them over the past decade.

Acquisitions can wreak havoc on reporting systems. Best Buy is choosy about when to standardize for companies it acquires, but it sometimes has to implement new systems after interna- tional deals.

In other situations, a major overhaul is needed. For exam- ple, it is common for companies with a steady stream of acqui- sitions to have 50 to 70 general ledger systems. In those cases, a company cannot react well unless its systems are made compatible. So is it the big bang (major overhaul) or the piecemeal approach? It seems to depend. One thing is cer- tain—good accounting systems are a necessity. Without one, the risk of failure is high.

Source: Emily Chasan, “The Financial-Data Dilemma,” Wall Street Journal (July 24, 2012), p. B4.

Financial Statements for a Merchandising Company 111

Statement of Retained Earnings A corporation may retain the net income earned in the business, or it may distribute it to stockholders by payment of dividends. In Illustration 3-40, Uptown added the net income earned during the year to the balance of retained earnings on January 1, thereby increasing the balance of retained earnings. Deducting dividends of $2,000 results in the ending retained earnings balance of $26,400 on December 31.

ILLUSTRATION 3-39 Income Statement for a Merchandising Company

UPTOWN CABINET CORP. INCOME STATEMENT

FOR THE YEAR ENDED DECEMBER 31, 2017

Net sales $400,000 Cost of goods sold 316,000

Gross profit on sales 84,000 Selling expenses Salaries and wages expense (sales) $20,000 Advertising expense 10,200

Total selling expenses 30,200

Administrative expenses Salaries and wages expense (general) $19,000 Depreciation expense—equipment 6,700 Property tax expense 5,300 Rent expense 4,300 Bad debt expense 1,000 Telephone and Internet expense 600 Insurance expense 360

Total administrative expenses 37,260

Total selling and administrative expenses 67,460

Income from operations 16,540 Other revenues and gains Interest revenue 800

17,340

Other expenses and losses Interest expense 1,700

Income before income taxes 15,640 Income tax 3,440

Net income $ 12,200

ILLUSTRATION 3-40 Statement of Retained Earnings for a Merchandising Company

UPTOWN CABINET CORP. STATEMENT OF RETAINED EARNINGS

FOR THE YEAR ENDED DECEMBER 31, 2017

Retained earnings, January 1 $16,200 Add: Net income 12,200

28,400 Less: Dividends 2,000

Retained earnings, December 31 $26,400

Balance Sheet The balance sheet for Uptown, shown in Illustration 3-41 (page 112), is a classified bal- ance sheet. Interest receivable, inventory, prepaid insurance, and prepaid rent are included as current assets. Uptown considers these assets current because they will be

112 Chapter 3 The Accounting Information System

converted into cash or used by the business within a relatively short period of time. Uptown deducts the amount of Allowance for Doubtful Accounts from the total of accounts, notes, and interest receivable because it estimates that only $54,800 of $57,800 will be collected in cash.

ILLUSTRATION 3-41 Balance Sheet for a Merchandising Company

UPTOWN CABINET CORP. BALANCE SHEET

AS OF DECEMBER 31, 2017

Assets

Current assets Cash $ 1,200 Notes receivable $16,000 Accounts receivable 41,000 Interest receivable 800 $57,800 Less: Allowance for doubtful accounts 3,000 54,800 Inventory 40,000 Prepaid insurance 540 Prepaid rent 500

Total current assets 97,040 Property, plant, and equipment Equipment 67,000 Less: Accumulated depreciation—equipment 18,700

Total property, plant, and equipment 48,300

Total assets $145,340

Liabilities and Stockholders’ Equity

Current liabilities Notes payable $20,000 Accounts payable 13,500 Property taxes payable 2,000 Income taxes payable 3,440

Total current liabilities $ 38,940

Long-term liabilities Bonds payable, due June 30, 2025 30,000

Total liabilities 68,940 Stockholders’ equity Common stock, $5.00 par value, issued and outstanding, 10,000 shares 50,000 Retained earnings 26,400

Total stockholders’ equity 76,400

Total liabilities and stockholders’ equity $145,340

In the property, plant, and equipment section, Uptown deducts the Accumulated Depreciation—Equipment from the cost of the equipment. The difference represents the book or carrying value of the equipment.

The balance sheet shows property taxes payable as a current liability because it is an obligation that is payable within a year. The balance sheet also shows other short-term liabilities such as accounts payable.

The bonds payable, due in 2025, are long-term liabilities. As a result, the balance sheet shows the account in a separate section. (The company paid interest on the bonds on December 31.)

Because Uptown is a corporation, the capital section of the balance sheet, called the stockholders’ equity section in the illustration, differs somewhat from the capital section for a proprietorship. Total stockholders’ equity consists of the common stock, which is the original investment by stockholders, and the earnings retained in the business. For homework purposes, unless instructed otherwise, prepare an unclassified balance sheet.

Appendix 3A: Cash-Basis Accounting versus Accrual-Basis Accounting 113

The use of a worksheet (spreadsheet) at the end of each month or quarter enables a company to prepare interim fi nancial statements even though it closes the books only at the end of each year. For example, assume that Google closes its books on December 31, but it wants monthly fi nancial statements. To do this, at the end of January, Google prepares an adjusted trial balance (using a worksheet as illustrated in Appendix 3C) to supply the information needed for statements for January.

At the end of February, it uses a worksheet again. Note that because Google did not close the accounts at the end of

January, the income statement taken from the adjusted trial balance on February 28 will present the net income for two months. If Google wants an income statement for only the month of February, the company obtains it by subtracting the items in the January income statement from the corresponding items in the income statement for the two months of January and February.

If Google executes such a process daily, it can realize “24/7 accounting” (see the “What Do the Numbers Mean?” box on page 106).

WHAT DO THE NUMBERS MEAN? STATEMENTS, PLEASE

Closing Entries Uptown makes closing entries in its general journal as shown below.

DECEMBER 31, 2017

Sales Revenue 400,000 Interest Revenue 800 Income Summary 400,800 (To close revenues to Income Summary)

Income Summary 388,600 Cost of Goods Sold 316,000 Salaries and Wages Expense (sales) 20,000 Advertising Expense 10,200 Salaries and Wages Expense (general) 19,000 Depreciation Expense 6,700 Rent Expense 4,300 Property Tax Expense 5,300 Bad Debt Expense 1,000 Telephone and Internet Expense 600 Insurance Expense 360 Interest Expense 1,700 Income Tax Expense 3,440 (To close expenses to Income Summary)

Income Summary 12,200 Retained Earnings 12,200 (To close Income Summary to Retained Earnings)

Retained Earnings 2,000 Dividends 2,000 (To close Dividends to Retained Earnings)

Most companies use accrual-basis accounting: They recognize revenue when the per- formance obligation is satisfied and expenses in the period incurred, without regard to the time of receipt or payment of cash.

Some small companies and the average individual taxpayer, however, use a strict or modified cash-basis approach. Under the strict cash basis, companies record revenue only when they receive cash. They record expenses only when they disperse cash.

APPENDIX 3A CASH-BASIS ACCOUNTING VERSUSACCRUAL-BASIS ACCOUNTING

LEARNING OBJECTIVE *7 Differentiate the cash basis of accounting from the accrual basis of accounting.

YOU WILL WANT TO READ THE IFRS INSIGHTS ON PAGES 147–151 For discussion of IFRS related to information systems.

114 Chapter 3 The Accounting Information System

Determining income on the cash basis rests upon collecting revenue and paying expenses. The cash basis ignores two principles: the revenue recognition principle and the expense recognition principle. Consequently, cash-basis financial statements are not in conformity with GAAP.

An illustration will help clarify the differences between accrual-basis and cash-basis accounting. Assume that Quality Contractor signs an agreement to construct a garage for $22,000. In January, Quality begins construction, incurs costs of $18,000 on credit, and by the end of January delivers a finished garage to the buyer. In February, Quality collects $22,000 cash from the customer. In March, Quality pays the $18,000 due the creditors. Illustrations 3A-1 and 3A-2 show the net incomes for each month under cash- basis accounting and accrual-basis accounting, respectively.

QUALITY CONTRACTOR INCOME STATEMENT—CASH BASIS

FOR THE MONTH OF

January February March Total

Cash receipts $–0– $22,000 $ –0– $22,000 Cash payments –0– –0– 18,000 18,000

Net income (loss) $–0– $22,000 $(18,000) $ 4,000

ILLUSTRATION 3A-1 Income Statements—Cash Basis

QUALITY CONTRACTOR INCOME STATEMENT—ACCRUAL BASIS

FOR THE MONTH OF

January February March Total

Revenues $22,000 $–0– $–0– $22,000 Expenses 18,000 –0– –0– 18,000

Net income (loss) $ 4,000 $–0– $–0– $ 4,000

ILLUSTRATION 3A-2 Income Statements— Accrual Basis

For the three months combined, total net income is the same under both cash-basis accounting and accrual-basis accounting. The difference is in the timing of revenues and expenses. The basis of accounting also affects the balance sheet. Illustrations 3A-3 and 3A-4 show Quality’s balance sheets at each month-end under the cash basis and the accrual basis, respectively.

ILLUSTRATION 3A-3 Balance Sheets—Cash Basis

QUALITY CONTRACTOR BALANCE SHEET—CASH BASIS

AS OF

January 31 February 28 March 31

Assets Cash $–0– $22,000 $4,000

Total assets $–0– $22,000 $4,000 Liabilities and Owners’ Equity Owners’ equity $–0– $22,000 $4,000

Total liabilities and owners’ equity $–0– $22,000 $4,000

Analysis of Quality’s income statements and balance sheets shows the ways in which cash-basis accounting is inconsistent with basic accounting theory:

1. The cash basis understates revenues and assets from the construction and delivery of the garage in January. It ignores the $22,000 of accounts receivable, representing a near-term future cash infl ow.

2. The cash basis understates expenses incurred with the construction of the garage and the liability outstanding at the end of January. It ignores the $18,000 of accounts payable, representing a near-term future cash outfl ow.

3. The cash basis understates owners’ equity in January by not recognizing the reve- nues and the asset until February. It also overstates owners’ equity in February by not recognizing the expenses and the liability until March.

In short, cash-basis accounting violates the accrual concept underlying financial reporting.

The modified cash basis is a mixture of the cash basis and the accrual basis. It is based on the strict cash basis but with modifications that have substantial support, such as capitalizing and depreciating plant assets or recording inventory. This method is often followed by professional services firms (doctors, lawyers, accountants, and con- sultants) and by retail, real estate, and agricultural operations.3

CONVERSION FROM CASH BASIS TO ACCRUAL BASIS Not infrequently, companies want to convert a cash basis or a modified cash basis set of financial statements to the accrual basis for presentation to investors and creditors. To illustrate this conversion, assume that Dr. Diane Windsor, like many small business owners, keeps her accounting records on a cash basis. In the year 2017, Dr. Windsor

ILLUSTRATION 3A-4 Balance Sheets—Accrual Basis

QUALITY CONTRACTOR BALANCE SHEET—ACCRUAL BASIS

AS OF

January 31 February 28 March 31

Assets Cash $ –0– $22,000 $4,000 Accounts receivable 22,000 –0– –0–

Total assets $22,000 $22,000 $4,000 Liabilities and Owners’ Equity Accounts payable $18,000 $18,000 $ –0– Owners’ equity 4,000 4,000 4,000

Total liabilities and owners’ equity $22,000 $22,000 $4,000

3Companies in the following situations might use a cash or modified cash basis.

(1) A company that is primarily interested in cash flows (for example, a group of physicians that distributes cash-basis earnings for salaries and bonuses).

(2) A company that has a limited number of financial statement users (small, closely held company with little or no debt).

(3) A company that has operations that are relatively straightforward (small amounts of inventory, long-term assets, or long-term debt).

Appendix 3A: Cash-Basis Accounting versus Accrual-Basis Accounting 115

116 Chapter 3 The Accounting Information System

received $300,000 from her patients and paid $170,000 for operating expenses, resulting in an excess of cash receipts over disbursements of $130,000 ($300,000 − $170,000). At January 1 and December 31, 2017, she has accounts receivable, unearned service reve- nue, accrued liabilities, and prepaid expenses as shown in Illustration 3A-5.

ILLUSTRATION 3A-5 Financial Information Related to Dr. Diane Windsor

January 1, 2017 December 31, 2017

Accounts receivable $12,000 $9,000 Unearned service revenue –0– 4,000 Accrued liabilities 2,000 5,500 Prepaid expenses 1,800 2,700

Service Revenue Computation To convert the amount of cash received from patients to service revenue on an accrual basis, we must consider changes in accounts receivable and unearned service revenue during the year. Accounts receivable at the beginning of the year represents revenues recognized last year that are collected this year. Ending accounts receivable indicates revenues recognized this year that are not yet collected. Therefore, to compute revenue on an accrual basis, we subtract beginning accounts receivable and add ending accounts receivable, as the formula in Illustration 3A-6 shows.

Similarly, beginning unearned service revenue represents cash received last year for revenues recognized this year. Ending unearned service revenue results from collec- tions this year that will be recognized as revenue next year. Therefore, to compute rev- enue on an accrual basis, we add beginning unearned service revenue and subtract ending unearned service revenue, as the formula in Illustration 3A-7 shows.

ILLUSTRATION 3A-7 Conversion of Cash Receipts to Revenue— Unearned Service Revenue

+ Beginning Unearned Cash Receipts Service Revenue from Customers − Ending Unearned Service Revenue

Revenue = on an Accrual Basis

Therefore, for Dr. Windsor’s dental practice, to convert cash collected from custom- ers to service revenue on an accrual basis, we would make the computations shown in Illustration 3A-8.

ILLUSTRATION 3A-6 Conversion of Cash Receipts to Revenue— Accounts Receivable

Cash Receipts − Beginning Accounts Receivable from Customers + Ending Accounts Receivable }}

Revenue = on an Accrual Basis

ILLUSTRATION 3A-8 Conversion of Cash Receipts to Service Revenue

Cash receipts from customers $300,000 − Beginning accounts receivable $(12,000) + Ending accounts receivable 9,000 + Beginning unearned service revenue –0– − Ending unearned service revenue (4,000) (7,000) Service revenue (accrual) $293,000

}}

Operating Expense Computation To convert cash paid for operating expenses during the year to operating expenses on an accrual basis, we must consider changes in prepaid expenses and accrued liabilities. First, we need to recognize as this year’s expenses the amount of beginning prepaid expenses. (The cash payment for these occurred last year.) Therefore, to arrive at operat- ing expense on an accrual basis, we add the beginning prepaid expenses balance to cash paid for operating expenses.

Conversely, ending prepaid expenses result from cash payments made this year for expenses to be reported next year. (Under the accrual basis, Dr. Windsor would have deferred recognizing these payments as expenses until a future period.) To con- vert these cash payments to operating expenses on an accrual basis, we deduct ending prepaid expenses from cash paid for expenses, as the formula in Illustration 3A-9 shows.

ILLUSTRATION 3A-9 Conversion of Cash Payments to Expenses— Prepaid Expenses

Expenses = on an Accrual Basis

Cash Paid for + Beginning Prepaid Expenses Operating Expenses − Ending Prepaid Expenses

Similarly, beginning accrued liabilities result from expenses recognized last year that require cash payments this year. Ending accrued liabilities relate to expenses recog- nized this year that have not been paid. To arrive at expenses on an accrual basis, we deduct beginning accrued liabilities and add ending accrued liabilities to cash paid for expenses, as the formula in Illustration 3A-10 shows.

Expenses = on an Accrual Basis

Cash Paid for − Beginning Accrued Liabilities Operating Expenses + Ending Accrued Liabilities

ILLUSTRATION 3A-10 Conversion of Cash Payments to Expenses— Accrued Liabilities

Therefore, for Dr. Windsor’s dental practice, to convert cash paid for operating expenses to operating expenses on an accrual basis, we would make the computations shown in Illustration 3A-11.

This entire conversion can be completed in worksheet form, as shown in Illustration 3A-12 (page 118).

Cash paid for operating expenses $170,000 + Beginning prepaid expense $ 1,800 − Ending prepaid expense (2,700) − Beginning accrued liabilities (2,000) + Ending accrued liabilities 5,500 2,600 Operating expenses (accrual) $172,600

ILLUSTRATION 3A-11 Conversion of Cash Paid to Operating Expenses

Appendix 3A: Cash-Basis Accounting versus Accrual-Basis Accounting 117

}}

118 Chapter 3 The Accounting Information System

Using this approach, we adjust collections and disbursements on a cash basis to revenue and expense on an accrual basis, to arrive at accrual net income. In any conver- sion from the cash basis to the accrual basis, depreciation or amortization is an addi- tional expense in arriving at net income on an accrual basis.

THEORETICAL WEAKNESSES OF THE CASH BASIS The cash basis reports exactly when cash is received and when cash is disbursed. To many people, that information represents something concrete. Isn’t cash what it is all about? Does it make sense to invent something, design it, produce it, market and sell it, if you aren’t going to get cash for it in the end? Many frequently say, “Cash is the real bottom line,” and also, “Cash is the oil that lubricates the economy.” If so, then what is the merit of accrual accounting?

Today’s economy is considerably more lubricated by credit than by cash. The accrual basis, not the cash basis, recognizes all aspects of the credit phenomenon. Investors, creditors, and other decision-makers seek timely information about a company’s future cash flows. Accrual-basis accounting provides this information by reporting the cash inflows and outflows associated with earnings activities as soon as these companies can estimate these cash flows with an acceptable degree of certainty. Receivables and pay- ables are forecasters of future cash inflows and outflows. In other words, accrual-basis accounting aids in predicting future cash flows by reporting transactions and other events with cash consequences at the time the transactions and events occur, rather than when the cash is received and paid.

ILLUSTRATION 3A-12 Conversion of Statement of Cash Receipts and Disbursements to Income Statement

Formulas Data Review ViewPage LayoutInsert

A P18 fx

EB C D

Diane Windsor.xlsDiane Windsor.xls Home

1 2 3

Accrual Basis

Cash Basis Adjustments

Add DeductAccount Titles

Collections from customers − Accounts receivable, Jan. 1 + Accounts receivable, Dec. 31 + Unearned service revenue, Jan. 1 − Unearned service revenue, Dec. 31 Service revenue Disbursement for expenses + Prepaid expenses, Jan. 1 − Prepaid expenses, Dec. 31 − Accrued liabilities, Jan. 1 + Accrued liabilities, Dec. 31 Operating expenses Excess of cash collections over disbursements—cash basis Net income—accrual basis

$300,000

170,000

$130,000

$293,000

172,600

$120,400

$9,000 —

1,800

5,500

$12,000

— 4,000

2,700 2,000

DIANE WINDSOR, D.D.S. Conversion of Income Statement Data from Cash Basis to Accrual Basis

For the Year 2017

Use of reversing entries simplifies the recording of transactions in the next accounting period. The use of reversing entries, however, does not change the amounts reported in the financial statements for the previous period.

ILLUSTRATION OF REVERSING ENTRIES—ACCRUALS A company most often uses reversing entries to reverse two types of adjusting entries: accrued revenues and accrued expenses. To illustrate the optional use of reversing entries for accrued expenses, we use the following transaction and adjustment data.

1. October 24 (initial salaries and wages entry): Paid $4,000 of salaries and wages incurred between October 10 and October 24.

2. October 31 (adjusting entry): Incurred salaries and wages between October 25 and October 31 of $1,200, to be paid in the November 8 payroll.

3. November 8 (subsequent salaries and wages entry): Paid salaries and wages of $2,500. Of this amount, $1,200 applied to accrued salaries and wages payable at October 31 and $1,300 to salaries and wages payable for November 1 through November 8.

Illustration 3B-1 shows the comparative entries.

APPENDIX 3B USING REVERSING ENTRIES

LEARNING OBJECTIVE *8 Identify adjusting entries that may be reversed.

REVERSING ENTRIES NOT USED REVERSING ENTRIES USED

Initial Salary Entry

Oct. 24 Salaries and Wages Expense 4,000 Oct. 24 Salaries and Wages Expense 4,000 Cash 4,000 Cash 4,000

Adjusting Entry

Oct. 31 Salaries and Wages Expense 1,200 Oct. 31 Salaries and Wages Expense 1,200 Salaries and Wages Payable 1,200 Salaries and Wages Payable 1,200

Closing Entry

Oct. 31 Income Summary 5,200 Oct. 31 Income Summary 5,200 Salaries and Wages Expense 5,200 Salaries and Wages Expense 5,200

Reversing Entry

Nov. 1 No entry is made. Nov. 1 Salaries and Wages Payable 1,200 Salaries and Wages Expense 1,200

Subsequent Salary Entry

Nov. 8 Salaries and Wages Payable 1,200 Nov. 8 Salaries and Wages Expense 2,500 Salaries and Wages Expense 1,300 Cash 2,500 Cash 2,500

ILLUSTRATION 3B-1 Comparison of Entries for Accruals, with and without Reversing Entries

The comparative entries show that the first three entries are the same whether or not the company uses reversing entries. The last two entries differ. The November 1 revers- ing entry eliminates the $1,200 balance in Salaries and Wages Payable, created by the October 31 adjusting entry. The reversing entry also creates a $1,200 credit balance in the Salaries and Wages Expense account. As you know, it is unusual for an expense account to have a credit balance. However, the balance is correct in this instance. Why? Because

Appendix 3B: Using Reversing Entries 119

120 Chapter 3 The Accounting Information System

the company will debit the entire amount of the first salaries and wages payment in the new accounting period to Salaries and Wages Expense. This debit eliminates the credit balance. The resulting debit balance in the expense account will equal the salaries and wages expense incurred in the new accounting period ($1,300 in this example).

When a company makes reversing entries, it debits all cash payments of expenses to the related expense account. This means that on November 8 (and every payday), the company debits Salaries and Wages Expense for the amount paid without regard to the existence of any accrued salaries and wages payable. Repeating the same entry simpli- fies the recording process in an accounting system.

ILLUSTRATION OF REVERSING ENTRIES—DEFERRALS Up to this point, we assumed the recording of all deferrals as prepaid expense or unearned revenue. In some cases, though, a company records deferrals directly in expense or revenue accounts. When this occurs, a company may also reverse deferrals.

To illustrate the use of reversing entries for prepaid expenses, we use the following transaction and adjustment data.

1. December 10 (initial entry): Purchased $20,000 of offi ce supplies with cash. 2. December 31 (adjusting entry): Determined that $5,000 of offi ce supplies are on

hand.

Illustration 3B-2 shows the comparative entries.

ILLUSTRATION 3B-2 Comparison of Entries for Deferrals, with and without Reversing Entries

REVERSING ENTRIES NOT USED REVERSING ENTRIES USED

Initial Purchase of Supplies Entry

Dec. 10 Supplies 20,000 Dec. 10 Supplies Expense 20,000 Cash 20,000 Cash 20,000

Adjusting Entry

Dec. 31 Supplies Expense 15,000 Dec. 31 Supplies 5,000 Supplies 15,000 Supplies Expense 5,000

Closing Entry

Dec. 31 Income Summary 15,000 Dec. 31 Income Summary 15,000 Supplies Expense 15,000 Supplies Expense 15,000

Reversing Entry

Jan. 1 No entry Jan. 1 Supplies Expense 5,000 Supplies 5,000

After the adjusting entry on December 31 (regardless of whether using reversing entries), the asset account Supplies shows a balance of $5,000, and Supplies Expense shows a balance of $15,000. If the company initially debits Supplies Expense when it purchases the supplies, it then makes a reversing entry to return to the expense account the cost of unconsumed supplies. The company then continues to debit Supplies Expense for additional purchases of supplies during the next period.

Deferrals are generally entered in real accounts (assets and liabilities), thus making reversing entries unnecessary. This approach is used because it is advantageous for items that a company needs to apportion over several periods (e.g., supplies and parts inventories). However, for other items that do not follow this regular pattern and that may or may not involve two or more periods, a company ordinarily enters them initially in revenue or expense accounts. The revenue and expense accounts may not require adjusting, and the company thus systematically closes them to Income Summary.

Using the nominal accounts adds consistency to the accounting system. It also makes the recording more efficient, particularly when a large number of such transac- tions occur during the year. For example, the bookkeeper knows to expense invoice items (except for capital asset acquisitions). He or she need not worry whether an item will result in a prepaid expense at the end of the period because the company will make adjustments at the end of the period.

SUMMARY OF REVERSING ENTRIES We summarize guidelines for reversing entries as follows.

1. All accruals should be reversed. 2. All deferrals for which a company debited or credited the original cash transaction

to an expense or revenue account should be reversed. 3. Adjusting entries for depreciation and bad debts are not reversed.

Recognize that reversing entries do not have to be used. Therefore, some accountants avoid them entirely.

APPENDIX 3C USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED

In this appendix, we provide an additional illustration of the end-of-period steps in the accounting cycle and illustrate the use of a worksheet (usually in an electronic spread- sheet) in this process. Using a worksheet (spreadsheet) often facilitates the end-of- period (monthly, quarterly, or annually) accounting and reporting process. Use of a worksheet helps a company prepare the financial statements on a more timely basis. How? With a worksheet; a company need not wait until it journalizes and posts the adjusting and closing entries.

A company prepares a worksheet either on columnar paper or within a computer spreadsheet. In either form, a company uses the worksheet to adjust account balances and to prepare financial statements.

The worksheet does not replace the financial statements. Instead, it is an informal device for accumulating and sorting information needed for the financial statements. Com- pleting the worksheet provides considerable assurance that a company properly handled all of the details related to the end-of-period accounting and statement preparation. The 10-column worksheet in Illustration 3C-1 (on page 122) provides columns for the first trial balance, adjustments, adjusted trial balance, income statement, and balance sheet.

WORKSHEET COLUMNS Trial Balance Columns Uptown Cabinet Corp., shown in Illustration 3C-1 (page 122), obtains data for the trial balance from its ledger balances at December 31. The amount for Inventory, $40,000, is the year-end inventory amount, which results from the application of a perpetual inven- tory system.

Adjustments Columns After Uptown enters all adjustment data on the worksheet, it establishes the equality of the adjustment columns. It then extends the balances in all accounts to the adjusted trial balance columns.

LEARNING OBJECTIVE *9 Prepare a 10-column worksheet.

Appendix 3C: Using a Worksheet: The Accounting Cycle Revisited 121

Formulas Data Review ViewPage LayoutInsert

A P18 fx

E F GB C D H I J K

Uptown Cabinet Corp.xlsUptown Cabinet Corp.xls Home

1 2 3

Trial Balance Adjustments Adjusted

Trial Balance Income

Statement Balance

Sheet Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.Account Titles

Cash Notes receivable Accounts receivable Allowance for doubtful accounts Inventory Prepaid insurance Equipment Accumulated depreciation— equipment Notes payable Accounts payable Bonds payable Common stock Retained earnings, Jan. 1, 2017 Dividends Sales revenue Cost of goods sold Salaries and wages expense (sales) Advertising expense Salaries and wages expense (general) Telephone and Internet expense Rent expense Property tax expense Interest expense Totals Depreciation expense Bad debt expense Insurance expense Interest receivable Interest revenue Prepaid rent Property taxes payable Income tax expense Income taxes payable Totals Net income Totals

1,200 16,000 41,000

40,000 900

67,000

2,000

316,000

20,000 10,200

19,000

600 4,800 3,300 1,700

543,700

1,200 16,000 41,000

40,000 540

67,000

2,000

316,000

20,000 10,200

19,000

600 4,300 5,300 1,700

6,700 1,000

360 800

500

3,440

557,640

1,200 16,000 41,000

40,000 540

67,000

2,000

800

500

169,040

3,000

18,700 20,000 13,500 30,000 50,000 16,200

2,000

3,440

12,200 169,040

316,000

20,000 10,200

19,000

600 4,300 5,300 1,700

6,700 1,000

360

3,440

388,600 12,200

400,800

3,000

18,700 20,000 13,500 30,000 50,000 16,200

400,000

800

2,000

3,440 557,640

400,000

800

400,800

2,000

12,000 20,000 13,500 30,000 50,000 16,200

400,000

543,700

(f) 2,000

(a) 6,700 (b) 1,000 (c) 360 (d) 800

(e) 500

(g) 3,440

14,800

(b) 1,000

(a) 6,700

(e) 500

(d) 800

(f) 2,000

(g) 3,440 14,800

UPTOWN CABINET CORP. Ten-Column Worksheet

For the Year Ended December 31, 2017

ILLUSTRATION 3C-1 Use of a Worksheet

122 Chapter 3 The Accounting Information System

ADJUSTMENTS ENTERED ON THE WORKSHEET Items (a) through (g) below serve as the basis for the adjusting entries made in the work- sheet for Uptown shown in Illustration 3C-1.

(a) Depreciation of equipment at the rate of 10 percent per year based on original cost of $67,000.

(b) Estimated bad debts of $1,000, based on an aging of Accounts Receivable.

(d) Interest accrued on notes receivable as of December 31, $800.

(e) The Rent Expense account contains $500 rent paid in advance, which is applicable to next year.

(f) Property taxes accrued December 31, $2,000.

(g) Income taxes payable estimated $3,440.

The adjusting entries shown on the December 31, 2017, worksheet are as follows. (a)

Depreciation Expense 6,700 Accumulated Depreciation—Equipment 6,700

(b) Bad Debt Expense 1,000 Allowance for Doubtful Accounts 1,000

(d) Interest Receivable 800 Interest Revenue 800

(e) Prepaid Rent 500 Rent Expense 500

(f) Property Tax Expense 2,000 Property Taxes Payable 2,000

(g) Income Tax Expense 3,440 Income Taxes Payable 3,440

Uptown Cabinet transfers the adjusting entries to the Adjustments columns of the worksheet, often designating each by letter. The trial balance lists any new accounts resulting from the adjusting entries, as illustrated on the worksheet. (For example, see the accounts listed in rows 32 through 40 in Illustration 3C-1.) Uptown then totals and balances the Adjustments columns.

Adjusted Trial Balance The adjusted trial balance shows the balance of all accounts after adjustment at the end of the accounting period. For example, Uptown adds the $2,000 shown opposite the Allowance for Doubtful Accounts in the Trial Balance Cr. column to the $1,000 in the Adjustments Cr. col- umn. The company then extends the $3,000 total to the Adjusted Trial Balance Cr. column. Similarly, Uptown reduces the $900 debit opposite Prepaid Insurance by the $360 credit in the Adjustments column. The result, $540, is shown in the Adjusted Trial Balance Dr. column.

Income Statement and Balance Sheet Columns Uptown extends all the debit items in the Adjusted Trial Balance columns into the Income Statement or Balance Sheet columns to the right. It similarly extends all the credit items.

Appendix 3C: Using a Worksheet: The Accounting Cycle Revisited 123

124 Chapter 3 The Accounting Information System

The next step is to total the Income Statement columns. Uptown needs the amount of net income or loss for the period to balance the debit and credit columns. The net income of $12,200 is shown in the Income Statement Dr. column because revenues exceeded expenses by that amount.

Uptown then balances the Income Statement columns. The company also enters the net income of $12,200 in the Balance Sheet Cr. column as an increase in retained earnings.

PREPARING FINANCIAL STATEMENTS FROM A WORKSHEET The worksheet provides the information needed for preparation of the financial state- ments without reference to the ledger or other records. In addition, the worksheet sorts that data into appropriate columns, which facilitates the preparation of the statements. The financial statements of Uptown Cabinet are shown in Chapter 3 (pages 111–112).

REVIEW AND PRACTICE KEY TERMS REVIEW

LEARNING OBJECTIVES REVIEW 1 Understand the basic accounting information system. Understanding the following eleven terms helps in under-

standing key accounting concepts: (1) event, (2) transaction, (3) account, (4) real and nominal accounts, (5) ledger, (6) journal, (7) posting, (8) trial balance, (9) adjusting entries, (10) financial statements, and (11) closing entries.

Using double-entry rules, the left side of any account is the debit side; the right side is the credit side. All asset and expense accounts are increased on the left or debit side and decreased on the right or credit side. Conversely, all liability and revenue accounts are increased on the right or credit side and decreased on the left or debit side. Stockholders’ equity accounts, Common Stock and Retained Earnings, are increased on the credit side. Dividends is increased on the debit side.

The basic steps in the accounting cycle are (1) identifying and measuring transactions and other events; (2) journalizing; (3) posting; (4) preparing an unadjusted trial balance; (5) making adjusting entries; (6) preparing an adjusted trial balance; (7) preparing financial statements; and (8) closing.

2 Record and summarize basic transactions. The simplest journal form chronologically lists transactions and events expressed in terms of debits and credits to particular accounts. The items entered in a general journal must be transferred (posted) to the general ledger. Companies should prepare an unadjusted trial balance at the end of a given period after they have recorded the entries in the journal and posted them to the ledger.

3 Identify and prepare adjusting entries. Adjustments achieve a proper recognition of revenues and expenses, so as to determine net income for the current period and to achieve an accurate statement of end-of-the-period balances in assets, liabilities, and equity accounts. The major types of adjusting entries are deferrals (prepaid expenses and unearned revenues) and accruals (accrued revenues and accrued expenses).

4 Prepare financial statements from the adjusted trial balance. Companies can prepare financial statements directly from the adjusted trial balance. The income statement is prepared from the revenue and expense accounts. The statement of

account, 80 accounting cycle, 85 accounting information

system, 80 *accrual-basis accounting,

113 accrued expenses, 100 accrued revenues, 99 adjusted trial balance, 81,

104 adjusting entry, 81, 92 balance sheet, 81

book value, 97 closing entries, 81, 107 closing process, 106 contra asset account, 97 credit, 81 debit, 81 depreciation, 96 double-entry accounting, 82 event, 81 financial statements, 81 general journal, 87 general ledger, 81, 87

income statement, 81 journal, 81 journalizing, 81 ledger, 81 *modified cash basis, 115 nominal accounts, 81 post-closing trial

balance, 81, 109 posting, 81, 88 prepaid expenses, 94 real accounts, 81 reversing entries, 109

special journals, 88 statement of cash flows, 81 statement of retained

earnings, 81 *strict cash basis, 113 subsidiary ledger, 81 T-account, 80 transaction, 80 trial balance, 81, 92 unearned revenues, 98 *worksheet, 121

Practice Problem 125

retained earnings is prepared from the retained earnings account, dividends, and net income (or net loss). The balance sheet is prepared from the asset, liability, and equity accounts.

5 Prepare closing entries. In the closing process, the company transfers all of the revenue and expense account balances (income statement items) to a clearing account called Income Summary, which is used only at the end of the fiscal year. Rev- enues and expenses are matched in the Income Summary account. The net result of this matching represents the net income or net loss for the period. That amount is then transferred to an equity account (Retained Earnings for a corporation and capi- tal accounts for proprietorships and partnerships).

6 Prepare financial statements for a merchandising company. The financial statements for a merchandiser differ from those for a service company, as a merchandiser must account for gross profit on sales. The accounting cycle, however, is per- formed the same.

*7 Differentiate the cash basis of accounting from the accrual basis of accounting. The cash basis of accounting records revenues when cash is received and expenses when cash is paid. Cash-basis accounting is not in conformity with GAAP. The accrual basis recognizes revenue when the performance obligation is satisfied and expenses in the period incurred, without regard to the time of the receipt or payment of cash. Accrual-basis accounting is theoretically preferable because it provides information about future cash inflows and outflows associated with earnings activities as soon as companies can estimate these cash flows with an acceptable degree of certainty.

*8 Identify adjusting entries that may be reversed. Reversing entries are most often used to reverse two types of adjusting entries: accrued revenues and accrued expenses. Deferrals may also be reversed if the initial entry to record the transaction is made to an expense or revenue account.

*9 Prepare a 10-column worksheet. The 10-column worksheet provides columns for the first trial balance, adjustments, adjusted trial balance, income statement, and balance sheet. The worksheet does not replace the financial statements. Instead, it is an informal device for accumulating and sorting information needed for the financial statements.

PRACTICE PROBLEM

Nalezny Advertising was founded by Casey Hayward in January 2008. Presented below are both the adjusted and unadjusted trial balances as of December 31, 2017.

NALEZNY ADVERTISING TRIAL BALANCE

DECEMBER 31, 2017

Unadjusted Adjusted

Dr. Cr. Dr. Cr.

Cash $ 11,000 $ 11,000 Accounts Receivable 20,000 21,500 Supplies 8,400 5,000 Equipment 60,000 60,000 Accumulated Depreciation—Equipment $ 28,000 $ 35,000 Accounts Payable 5,000 5,000 Unearned Advertising Revenue 7,000 5,600 Salaries and Wages Payable –0– 1,300 Common Stock 10,000 10,000 Retained Earnings 4,800 4,800 Advertising Revenue 58,600 61,500 Salaries and Wages Expense 10,000 11,300 Depreciation Expense 7,000 Supplies Expense 3,400 Rent Expense 4,000 4,000

$113,400 $113,400 $123,200 $123,200

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126 Chapter 3 The Accounting Information System 126 Chapter 3 The Accounting Information System

SOLUTION

(a) Dec. 31 Accounts Receivable 1,500 Advertising Revenue 1,500 31 Unearned Advertising Revenue 1,400 Advertising Revenue 1,400 31 Supplies Expense 3,400 Supplies 3,400 31 Depreciation Expense 7,000 Accumulated Depreciation—Equipment 7,000 31 Salaries and Wages Expense 1,300 Salaries and Wages Payable 1,300

(b) NALEZNY ADVERTISING

INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2017

Revenues Advertising revenue $61,500

Expenses Salaries and wages expense $11,300 Depreciation expense 7,000 Rent expense 4,000 Supplies expense 3,400

Total expenses 25,700

Net income $35,800

NALEZNY ADVERTISING BALANCE SHEET

DECEMBER 31, 2017

Assets

Cash $11,000 Accounts receivable 21,500 Supplies 5,000 Equipment $60,000 Less: Accumulated depreciation—equipment 35,000 25,000

Total assets $62,500

Liabilities and Stockholders’ Equity

Liabilities Accounts payable $ 5,000 Unearned advertising revenue 5,600 Salaries and wage payable 1,300

Total liabilities $11,900

Stockholders’ equity Common stock 10,000 Retained earnings 40,600* 50,600

Total liabilities and stockholders’ equity $62,500

*Retained earnings, Jan. 1, 2017 $ 4,800 Add: Net income 35,800

Retained earnings, Dec. 31, 2017 $40,600

(c) Following preparation of financial statements (part (b)), Nalezny would prepare closing entries to reduce the temporary accounts to zero. Some companies prepare a post-closing trial balance and reversing entries.

Instructions (a) Journalize the annual adjusting entries that were made. (b) Prepare an income statement for the year ending December 31, 2017, and a balance sheet at December 31. (c) Describe the remaining steps in the accounting cycle to be completed by Nalezny for 2017.

Questions 127

Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter.

QUESTIONS

1. Give an example of a transaction that results in:

(a) A decrease in an asset and a decrease in a liability.

(b) A decrease in one asset and an increase in another asset.

2. Do the following events represent business transactions? Explain your answer in each case.

(a) A computer is purchased on account.

(b) A customer returns merchandise and is given credit on account.

(d) The owner of the business withdraws cash from the business for personal use.

(e) Merchandise is ordered for delivery next month. 3. Name the accounts debited and credited for each of the

following transactions.

(a) Billing a customer for work done.

(b) Receipt of cash from customer on account.

(d) Purchase of 15 gallons of gasoline for the delivery truck.

4. Why are revenue and expense accounts called temporary or nominal accounts?

5. Andrea Pafko, a fellow student, contends that the double- entry system means that each transaction must be recorded twice. Is Andrea correct? Explain.

6. Is it necessary that a trial balance be taken periodically? What purpose does it serve?

7. Indicate whether each of the following items is a real or nominal account and whether it appears in the balance sheet or the income statement.

(a) Prepaid Rent.

(b) Salaries and Wages Payable.

(d) Accumulated Depreciation—Equipment.

(e) Equipment.

(f) Service Revenue.

(g) Salaries and Wages Expense.

(h) Supplies. 8. Employees are paid every Saturday for the preceding

work week. If a balance sheet is prepared on Wednesday,

December 31, what does the amount of wages earned during the first three days of the week (12/29, 12/30, 12/31) represent? Explain.

9. (a) How are the components of revenues and expenses different for a merchandising company? (b) Explain the income measurement process of a merchandising company.

10. What differences are there between the trial balance before closing and the trial balance after closing with respect to the following accounts?

(a) Accounts Payable.

(b) Expense accounts.

(d) Retained Earnings account.

(e) Cash. 11. What are adjusting entries and why are they necessary? 12. What are closing entries and why are they necessary? 13. Jay Hawk, maintenance supervisor for Boston Insurance

Co., has purchased a riding lawnmower and accessories to be used in maintaining the grounds around corporate headquarters. He has sent the following information to the accounting department.

Cost of mower and Date purchased 7/1/17 accessories $4,000 Monthly salary of Estimated useful life 5 yrs groundskeeper $1,100 Salvage value $0 Estimated annual fuel cost $150

Compute the amount of depreciation expense (related to the mower and accessories) that should be reported on Boston’s December 31, 2017, income statement. Assume straight-line depreciation.

14. Midwest Enterprises made the following entry on December 31, 2017.

Interest Expense 10,000 Interest Payable 10,000 (To record interest expense due on loan from Anaheim National Bank)

What entry would Anaheim National Bank make regard- ing its outstanding loan to Midwest Enterprises? Explain why this must be the case.

15. Distinguish between cash-basis accounting and accrual- basis accounting. Why is accrual-basis accounting accept- able for most businesses and the cash-basis unacceptable in the preparation of an income statement and a balance sheet?

Brief Exercises, Exercises, Problems, Problem Solution Walkthrough Videos, and many more learning and assessment tools and resources are available for practice in WileyPLUS.

128 Chapter 3 The Accounting Information System

16. When salaries and wages expense for the year is com- puted, why are beginning accrued salaries and wages subtracted from, and ending accrued salaries and wages added to, salaries and wages paid during the year?

17. List two types of transactions that would receive differ- ent accounting treatment using (a) strict cash-basis accounting, and (b) a modified cash basis.

18. What are reversing entries, and why are they used? 19. “A worksheet is a permanent accounting record, and its

use is required in the accounting cycle.” Do you agree? Explain.

BRIEF EXERCISES

BE3-1 (L02) Transactions for Mehta Company for the month of May are presented below. Prepare journal entries for each of these transactions. (You may omit explanations.)

May 1 B.D. Mehta invests $4,000 cash in exchange for common stock in a small welding corporation. 3 Buys equipment on account for $1,100. 13 Pays $400 to landlord for May rent. 21 Bills Noble Corp. $500 for welding work done.

BE3-2 (L02) Agazzi Repair Shop had the following transactions during the first month of business as a proprietorship. Jour- nalize the transactions. (Omit explanations.)

Aug. 2 Invested $12,000 cash and $2,500 of equipment in the business. 7 Purchased supplies on account for $500. (Debit asset account.) 12 Performed services for clients, for which $1,300 was collected in cash and $670 was billed to the clients. 15 Paid August rent $600. 19 Counted supplies and determined that only $270 of the supplies purchased on August 7 are still on hand.

BE3-3 (L02,3) On July 1, 2017, Crowe Co. pays $15,000 to Zubin Insurance Co. for a 3-year insurance policy. Both com- panies have fiscal years ending December 31. For Crowe Co., journalize the entry on July 1 and the adjusting entry on Decem- ber 31.

BE3-4 (L02,3) Using the data in BE3-3, journalize the entry on July 1 and the adjusting entry on December 31 for Zubin Insur- ance Co. Zubin uses the accounts Unearned Service Revenue and Service Revenue.

BE3-5 (L02,3) Assume that on February 1, Procter & Gamble (P&G) paid $720,000 in advance for 2 years’ insurance cover- age. Prepare P&G’s February 1 journal entry and the annual adjusting entry on June 30.

BE3-6 (L02,3) LaBouche Corporation owns a warehouse. On November 1, it rented storage space to a lessee (tenant) for 3 months for a total cash payment of $2,400 received in advance. Prepare LaBouche’s November 1 journal entry and the December 31 annual adjusting entry.

BE3-7 (L02,3) Dresser Company’s weekly payroll, paid on Fridays, totals $8,000. Employees work a 5-day week. Prepare Dresser’s adjusting entry on Wednesday, December 31, and the journal entry to record the $8,000 cash payment on Friday, January 2.

BE3-8 (L03) Included in Gonzalez Company’s December 31 trial balance is a note receivable of $12,000. The note is a 4-month, 10% note dated October 1. Prepare Gonzalez’s December 31 adjusting entry to record $300 of accrued interest, and the February 1 journal entry to record receipt of $12,400 from the borrower.

BE3-9 (L03) Prepare the following adjusting entries at August 31 for Walgreens.

(a) Interest on notes payable of $300 is accrued. (b) Services performed but unbilled total $1,400. (c) Salaries and wages earned by employees of $700 have not been recorded. (d) Bad debt expense for year is $900.

Use the following account titles: Service Revenue, Accounts Receivable, Interest Expense, Interest Payable, Salaries and Wages Expense, Salaries and Wages Payable, Allowance for Doubtful Accounts, and Bad Debt Expense.

BE3-10 (L03) At the end of its first year of operations, the trial balance of Alonzo Company shows Equipment $30,000 and zero balances in Accumulated Depreciation—Equipment and Depreciation Expense. Depreciation for the year is estimated to be $2,000. Prepare the adjusting entry for depreciation at December 31, and indicate the balance sheet presentation for the equip- ment at December 31.

Exercises 129

BE3-11 (L04) Side Kicks has year-end account balances of Sales Revenue $808,900, Interest Revenue $13,500, Cost of Goods Sold $556,200, Administrative Expenses $189,000, Income Tax Expense $35,100, and Dividends $18,900. Prepare the year-end closing entries. BE3-12 (L07) Kelly Company had cash receipts from customers in 2017 of $142,000. Cash payments for operating expenses were $97,000. Kelly has determined that at January 1, accounts receivable was $13,000, and prepaid expenses were $17,500. At December 31, accounts receivable was $18,600, and prepaid expenses were $23,200. Compute (a) service revenue and (b) operat- ing expenses.

BE3-13 (L08) Assume that Best Buy made a December 31 adjusting entry to debit Salaries and Wages Expense and credit Salaries and Wages Payable for $4,200 for one of its departments. On January 2, Best Buy paid the weekly payroll of $7,000. Pre- pare Best Buy’s (a) January 1 reversing entry; (b) January 2 entry (assuming the reversing entry was prepared); and (c) January 2 entry (assuming the reversing entry was not prepared).

EXERCISES

E3-1 (L02) (Transaction Analysis—Service Company) Beverly Crusher is a licensed CPA. During the first month of opera- tions of her business (a sole proprietorship), the following events and transactions occurred.

April 2 Invested $32,000 cash and equipment valued at $14,000 in the business. 2 Hired an administrative assistant at a salary of $290 per week payable monthly. 3 Purchased supplies on account $700. (Debit an asset account.) 7 Paid offi ce rent of $600 for the month. 11 Completed a tax assignment and billed client $1,100 for services rendered. (Use Service Revenue account.) 12 Received $3,200 advance on a management consulting engagement. 17 Received cash of $2,300 for services completed for Ferengi Co. 21 Paid insurance expense $110. 30 Paid administrative assistant $1,160 for the month. 30 A count of supplies indicated that $120 of supplies had been used. 30 Purchased a new computer for $6,100 with personal funds. (The computer will be used exclusively for business purposes.)

Instructions Journalize the transactions in the general journal. (Omit explanations.)

E3-2 (L02) (Corrected Trial Balance) The following trial balance of Wanda Landowska Company does not balance. Your review of the ledger reveals the following. (a) Each account had a normal balance. (b) The debit footings in Prepaid Insurance, Accounts Payable, and Property Tax Expense were each understated $100. (c) A transposition error was made in Accounts Receivable and Service Revenue; the correct balances for Accounts Receivable and Service Revenue are $2,750 and $6,690, respectively. (d) A debit posting to Advertising Expense of $300 was omitted. (e) A $1,500 cash drawing by the owner was deb- ited to Owner’s Capital and credited to Cash.

Instructions Prepare a correct trial balance.

WANDA LANDOWSKA COMPANY TRIAL BALANCE APRIL 30, 2017

Debit Credit Cash $ 4,800 Accounts Receivable 2,570 Prepaid Insurance 700 Equipment $ 8,000 Accounts Payable 4,500 Property Taxes Payable 560 Owner’s Capital 11,200 Service Revenue 6,960 Salaries and Wages Expense 4,200 Advertising Expense 1,100 Property Tax Expense 800

$20,890 $24,500

130 Chapter 3 The Accounting Information System

E3-3 (L02) (Corrected Trial Balance) The following trial balance of Blues Traveler Corporation does not balance.

BLUES TRAVELER CORPORATION TRIAL BALANCE APRIL 30, 2017

Debit Credit

Cash $ 5,912 Accounts Receivable 5,240 Supplies 2,967 Equipment 6,100 Accounts Payable $ 7,044 Common Stock 8,000 Retained Earnings 2,000 Service Revenue 5,200 Offi ce Expense 4,320

$24,539 $22,244

An examination of the ledger shows these errors.

1. Cash received from a customer on account was recorded (both debit and credit) as $1,380 instead of $1,830. 2. The purchase on account of a computer costing $3,200 was recorded as a debit to Office Expense and a credit to Accounts

Payable. 3. Services were performed on account for a client, $2,250, for which Accounts Receivable was debited $2,250 and Service

Revenue was credited $225. 4. A payment of $95 for telephone charges was entered as a debit to Office Expense and a debit to Cash. 5. The Service Revenue account was totaled at $5,200 instead of $5,280.

Instructions From this information prepare a corrected trial balance.

E3-4 (L02) (Corrected Trial Balance) The following trial balance of Watteau Co. does not balance.

WATTEAU CO. TRIAL BALANCE

JUNE 30, 2017

Debit Credit

Cash $ 2,870 Accounts Receivable $ 3,231 Supplies 800 Equipment 3,800 Accounts Payable 2,666 Unearned Service Revenue 1,200 Common Stock 6,000 Retained Earnings 3,000 Service Revenue 2,380 Salaries and Wages Expense 3,400 Offi ce Expense 940

$13,371 $16,916

Each of the listed accounts should have a normal balance per the general ledger. An examination of the ledger and journal reveals the following errors.

1. Cash received from a customer on account was debited for $570, and Accounts Receivable was credited for the same amount. The actual collection was for $750.

Exercises 131

2. The purchase of a computer printer on account for $500 was recorded as a debit to Supplies for $500 and a credit to Accounts Payable for $500.

3. Services were performed on account for a client for $890. Accounts Receivable was debited for $890 and Service Revenue was credited for $89.

4. A payment of $65 for telephone charges was recorded as a debit to Office Expense for $65 and a debit to Cash for $65.

5. When the Unearned Service Revenue account was reviewed, it was found that service revenue amounting to $325 was performed prior to June 30 (related to Unearned Service Revenue).

6. A debit posting to Salaries and Wages Expense of $670 was omitted. 7. A payment on account for $206 was credited to Cash for $206 and credited to Accounts Payable for $260. 8. A dividend of $575 was debited to Salaries and Wages Expense for $575 and credited to Cash for $575.

Instruction Prepare a correct trial balance. (Note: It may be necessary to add one or more accounts to the trial balance.)

E3-5 (L03) EXCEL (Adjusting Entries) The ledger of Duggan Rental Agency on March 31 of the current year includes the following selected accounts before adjusting entries have been prepared.

Debit Credit

Prepaid Insurance $ 3,600 Supplies 2,800 Equipment 25,000 Accumulated Depreciation—Equipment $ 8,400 Notes Payable 20,000 Unearned Rent Revenue 9,300 Rent Revenue 60,000 Interest Expense –0– Salaries and Wages Expense 14,000

An analysis of the accounts shows the following.

1. The equipment depreciates $250 per month. 2. One-third of the unearned rent was recognized as revenue during the quarter. 3. Interest of $500 is accrued on the notes payable. 4. Supplies on hand total $850. 5. Insurance expires at the rate of $300 per month.

Instructions Prepare the adjusting entries at March 31, assuming that adjusting entries are made quarterly. Additional accounts are Depre- ciation Expense, Insurance Expense, Interest Payable, and Supplies Expense. (Omit explanations.)

E3-6 (L03) (Adjusting Entries) Karen Weller, D.D.S., opened a dental practice on January 1, 2017. During the first month of operations, the following transactions occurred.

1. Performed services for patients who had dental plan insurance. At January 31, $750 of such services was performed but not yet billed to the insurance companies.

2. Utility expenses incurred but not paid prior to January 31 totaled $520. 3. Purchased dental equipment on January 1 for $80,000, paying $20,000 in cash and signing a $60,000, 3-year note payable.

The equipment depreciates $400 per month. Interest is $500 per month. 4. Purchased a one-year malpractice insurance policy on January 1 for $12,000. 5. Purchased $1,600 of dental supplies. On January 31, determined that $500 of supplies were on hand.

Instructions Prepare the adjusting entries on January 31. (Omit explanations.) Account titles are Accumulated Depreciation—Equipment, Depreciation Expense, Service Revenue, Accounts Receivable, Insurance Expense, Interest Expense, Interest Payable, Prepaid Insurance, Supplies, Supplies Expense, Utilities Expenses, and Accounts Payable.

132 Chapter 3 The Accounting Information System

E3-7 (L03) (Analyze Adjusted Data) A partial adjusted trial balance of Piper Company at January 31, 2017, shows the following.

Instructions Answer the following questions, assuming the year begins January 1.

(a) If the amount in Supplies Expense is the January 31 adjusting entry, and $850 of supplies was purchased in January, what was the balance in Supplies on January 1?

(b) If the amount in Insurance Expense is the January 31 adjusting entry, and the original insurance premium was for one year, what was the total premium and when was the policy purchased?

(c) If $2,500 of salaries was paid in January, what was the balance in Salaries and Wages Payable at December 31, 2016? (d) If $1,600 was received in January for services performed in January, what was the balance in Unearned Service Revenue

at December 31, 2016?

E3-8 (L03) EXCEL (Adjusting Entries) Andy Roddick is the new owner of Ace Computer Services. At the end of August 2017, his first month of ownership, Roddick is trying to prepare monthly financial statements. Below is some information related to unrecorded expenses that the business incurred during August.

1. At August 31, Roddick owed his employees $1,900 in wages that will be paid on September 1. 2. At the end of the month, he had not yet received the month’s utility bill. Based on past experience, he estimated the bill

would be approximately $600. 3. On August 1, Roddick borrowed $30,000 from a local bank on a 15-year mortgage. The annual interest rate is 8%. 4. A telephone bill in the amount of $117 covering August charges is unpaid at August 31.

Instructions Prepare the adjusting journal entries as of August 31, 2017, suggested by the information above.

E3-9 (L02,3) (Adjusting Entries) Selected accounts of Urdu Company are shown below.

Supplies Accounts Receivable

Beg. Bal. 800 10 ⁄ 31 470 10 ⁄ 17 2,400 10 ⁄ 31 1,650

Salaries and Wages Expense Salaries and Wages Payable

10 ⁄ 15 800 10 ⁄ 31 600 10 ⁄ 31 600

Unearned Service Revenue Supplies Expense

10 ⁄ 31 400 10 ⁄ 20 650 10 ⁄ 31 470

Service Revenue

10 ⁄ 17 2,400 10 ⁄ 31 1,650 10 ⁄ 31 400

Instructions From an analysis of the T-accounts, reconstruct (a) the October transaction entries, and (b) the adjusting journal entries that were made on October 31, 2017. Prepare explanations for each journal entry.

PIPER COMPANY ADJUSTED TRIAL BALANCE

JANUARY 31, 2017

Debit Credit

Supplies $ 700 Prepaid Insurance 2,400 Salaries and Wages Payable $ 800 Unearned Service Revenue 750 Supplies Expense 950 Insurance Expense 400 Salaries and Wages Expense 1,800 Service Revenue 2,000

Exercises 133

E3-10 (L03) (Adjusting Entries) Greco Resort opened for business on June 1 with eight air-conditioned units. Its trial balance on August 31 is as follows.

GRECO RESORT TRIAL BALANCE AUGUST 31, 2017

Debit Credit

Cash $ 19,600 Prepaid Insurance 4,500 Supplies 2,600 Land 20,000 Buildings 120,000 Equipment 16,000 Accounts Payable $ 4,500 Unearned Rent Revenue 4,600 Mortgage Payable 60,000 Common Stock 91,000 Retained Earnings 9,000 Dividends 5,000 Rent Revenue 76,200 Salaries and Wages Expense 44,800 Utilities Expenses 9,200 Maintenance and Repairs Expense 3,600

$245,300 $245,300

Other data:

1. The balance in prepaid insurance is a one-year premium paid on June 1, 2017. 2. An inventory count on August 31 shows $450 of supplies on hand. 3. Annual depreciation rates are buildings (4%) and equipment (10%). Salvage value is estimated to be 10% of cost. 4. Unearned Rent Revenue of $3,800 was earned prior to August 31. 5. Salaries of $375 were unpaid at August 31. 6. Rentals of $800 were due from tenants at August 31. 7. The mortgage interest rate is 8% per year.

Instructions (a) Journalize the adjusting entries on August 31 for the 3-month period June 1–August 31. (Omit explanations.) (b) Prepare an adjusted trial balance on August 31.

E3-11 (L04) (Prepare Financial Statements) The adjusted trial balance of Anderson Cooper Co. as of December 31, 2017, contains the following.

ANDERSON COOPER CO. ADJUSTED TRIAL BALANCE

DECEMBER 31, 2017

Dr. Cr.

Cash $19,472 Accounts Receivable 6,920 Prepaid Rent 2,280 Equipment 18,050 Accumulated Depreciation—Equipment $ 4,895 Notes Payable 5,700 Accounts Payable 5,472 Common Stock 20,000 Retained Earnings 11,310 Dividends 3,000 Service Revenue 11,590 Salaries and Wages Expense 6,840 Rent Expense 2,260 Depreciation Expense 145 Interest Expense 83 Interest Payable 83

$59,050 $59,050

134 Chapter 3 The Accounting Information System

Instructions

(a) Prepare an income statement. (b) Prepare a statement of retained earnings. (c) Prepare a classified balance sheet.

E3-12 (L03,4) (Prepare Financial Statements) Santo Design was founded by Thomas Grant in January 2011. Presented below is the adjusted trial balance as of December 31, 2017.

SANTO DESIGN ADJUSTED TRIAL BALANCE

DECEMBER 31, 2017

Dr. Cr.

Cash $ 11,350 Accounts Receivable 21,500 Supplies 5,000 Prepaid Insurance 2,500 Equipment 60,000 Accumulated Depreciation—Equipment $ 35,000 Accounts Payable 5,000 Interest Payable 150 Notes Payable 5,000 Unearned Service Revenue 5,600 Salaries and Wages Payable 1,300 Common Stock 10,000 Retained Earnings 3,500 Service Revenue 61,500 Salaries and Wages Expense 11,300 Insurance Expense 850 Interest Expense 150 Depreciation Expense 7,000 Supplies Expense 3,400 Rent Expense 4,000

$127,050 $127,050

Instructions

(a) Prepare an income statement and a statement of retained earnings for the year ending December 31, 2017, and an unclassified balance sheet at December 31.

(b) Answer the following questions. (1) If the note has been outstanding 6 months, what is the annual interest rate on that note? (2) If the company paid $17,500 in salaries in 2017, what was the balance in Salaries and Wages Payable on December

31, 2016?

E3-13 (L05,6) (Closing Entries) The adjusted trial balance of Lopez Company shows the following data pertaining to sales at the end of its fiscal year, October 31, 2017: Sales Revenue $800,000, Delivery Expense $12,000, Sales Returns and Allowances $24,000, and Sales Discounts $15,000.

Instructions (a) Prepare the revenues section of the income statement. (b) Prepare separate closing entries for (1) sales and (2) the contra accounts to sales.

E3-14 (L05) (Closing Entries) Presented below is information related to Gonzales Corporation for the month of January 2017.

Cost of goods sold $208,000 Salaries and wages expense $ 61,000 Delivery expense 7,000 Sales discounts 8,000 Insurance expense 12,000 Sales returns and allowances 13,000 Rent expense 20,000 Sales revenue 350,000

Instructions Prepare the necessary closing entries.

Exercises 135

E3-15 (L06) (Missing Amounts) Presented below is financial information for two different companies.

Alatorre Company Eduardo Company

Sales revenue $90,000 (d) Sales returns and allowances (a) $ 5,000 Net sales 81,000 95,000 Cost of goods sold 56,000 (e) Gross profi t (b) 38,000 Operating expenses 15,000 23,000 Net income (c) 15,000

Instructions Compute the missing amounts.

E3-16 (L05) (Closing Entries for a Corporation) Presented below are selected account balances for Homer Winslow Co. as of December 31, 2017.

Inventory 12/31/17 $ 60,000 Cost of Goods Sold $225,700 Common Stock 75,000 Selling Expenses 16,000 Retained Earnings 45,000 Administrative Expenses 38,000 Dividends 18,000 Income Tax Expense 30,000 Sales Returns and Allowances 12,000 Sales Discounts 15,000 Sales Revenue 410,000

Instructions Prepare closing entries for Homer Winslow Co. on December 31, 2017. (Omit explanations.)

E3-17 (L02) (Transactions of a Corporation, Including Investment and Dividend) Scratch Miniature Golf and Driving Range Inc. was opened on March 1 by Scott Verplank. The following selected events and transactions occurred during March.

Mar. 1 Invested $50,000 cash in the business in exchange for common stock. 3 Purchased Michelle Wie’s Golf Land for $38,000 cash. The price consists of land $10,000, building $22,000, and equipment

$6,000. (Make one compound entry.) 5 Advertised the opening of the driving range and miniature golf course, paying advertising expenses of $1,600. 6 Paid cash $1,480 for a one-year insurance policy. 10 Purchased golf equipment for $2,500 from Singh Company, payable in 30 days. 18 Received golf fees of $1,200 in cash. 25 Declared and paid a $500 cash dividend. 30 Paid wages of $900. 30 Paid Singh Company in full. 31 Received $750 of fees in cash.

Scratch uses the following accounts: Cash, Prepaid Insurance, Land, Buildings, Equipment, Accounts Payable, Common Stock, Dividends, Service Revenue, Advertising Expense, and Salaries and Wages Expense.

Instructions Journalize the March transactions. (Provide explanations for the journal entries.)

*E3-18 (L07) (Cash to Accrual Basis) Jill Accardo, M.D., maintains the accounting records of Accardo Clinic on a cash basis. During 2017, Dr. Accardo collected $142,600 from her patients and paid $55,470 in expenses. At January 1, 2017, and December 31, 2017, she had accounts receivable, unearned service revenue, accrued expenses, and prepaid expenses as follows. (All long- lived assets are rented.)

January 1, 2017 December 31, 2017

Accounts receivable $9,250 $15,927 Unearned service revenue 2,840 4,111 Accrued expenses 3,435 2,108 Prepaid expenses 1,917 3,232

Instructions Prepare a schedule that converts Dr. Accardo’s “excess of cash collected over cash disbursed” for the year 2017 to net income on an accrual basis for the year 2017.

*E3-19 (L07) (Cash and Accrual Basis) Wayne Rogers Corp. maintains its financial records on the cash basis of accounting. Interested in securing a long-term loan from its regular bank, Wayne Rogers Corp. requests you as its independent CPA to

136 Chapter 3 The Accounting Information System

convert its cash-basis income statement data to the accrual basis. You are provided with the following summarized data cover- ing 2016, 2017, and 2018.

2016 2017 2018

Cash receipts from sales: On 2016 sales $295,000 $160,000 $ 30,000 On 2017 sales –0– 355,000 90,000 On 2018 sales 408,000 Cash payments for expenses: On 2016 expenses 185,000 67,000 25,000 On 2017 expenses 40,000a 160,000 55,000 On 2018 expenses 45,000b 218,000 aPrepayments of 2017 expenses. bPrepayments of 2018 expenses.

Instructions

(a) Using the data above, prepare abbreviated income statements for the years 2016 and 2017 on the cash basis. (b) Using the data above, prepare abbreviated income statements for the years 2016 and 2017 on the accrual basis.

*E3-20 (L03,8) (Adjusting and Reversing Entries) When the accounts of Daniel Barenboim Inc. are examined, the adjusting data listed below are uncovered on December 31, the end of an annual fiscal period.

1. The prepaid insurance account shows a debit of $5,280, representing the cost of a 2-year fire insurance policy dated August 1 of the current year.

2. On November 1, Rent Revenue was credited for $1,800, representing revenue from a subrental for a 3-month period begin- ning on that date.

3. Purchase of advertising materials for $800 during the year was recorded in the Advertising Expense account. On December 31, advertising materials of $290 are on hand.

4. Interest of $770 has accrued on notes payable.

Instructions Prepare the following in general journal form.

(a) The adjusting entry for each item. (b) The reversing entry for each item where appropriate.

*E3-21 (L09) (Worksheet) Presented below are selected accounts for Alvarez Company as reported in the worksheet at the end of May 2017.

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Adjusted Trial Balance

Income Statement

Balance Sheet

Dr. Cr. Dr. Cr. Dr. Cr.Account Titles

Cash Inventory Sales Revenue Sales Returns and Allowances Sales Discounts Cost of Goods Sold

9,000 80,000

10,000 5,000

250,000

450,000

ALVAREZ CO. Worksheet

For The Month Ended May 31, 2017

Instructions Complete the worksheet by extending amounts reported in the adjusted trial balance to the appropriate columns in the work- sheet. Do not total individual columns.

Exercises 137

*E3-22 (L09) (Worksheet and Balance Sheet Presentation) The adjusted trial balance for Ed Bradley Co. is presented in the following worksheet for the month ended April 30, 2017.

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Adjusted Trial Balance

Income Statement

Balance Sheet

Dr. Cr. Dr. Cr. Dr. Cr.Account Titles

Cash Accounts Receivable Prepaid Rent Equipment Accumulated Depreciation—Equipment Notes Payable Accounts Payable Common Stock Retained Earnings—April 1, 2017 Dividends Service Revenue Salaries and Wages Expense Rent Expense Depreciation Expense Interest Expense Interest Payable

18,972 6,920 2,280

18,050

6,650

6,840 3,760

145 83

4,895 5,700 4,472

34,960 1,000

12,590

ED BRADLEY CO. Worksheet (PARTIAL)

For The Month Ended April 30, 2017

Instructions Complete the worksheet and prepare a classified balance sheet.

*E3-23 (L09) (Partial Worksheet Preparation) Jurassic Park Co. prepares monthly financial statements from a worksheet. Selected portions of the January worksheet showed the following data.

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Trial Balance Dr. Cr. Dr. Cr. Dr. Cr.Account Titles

Supplies Accumulated Depreciation—Equipment Interest Payable Supplies Expense Depreciation Expense Interest Expense

3,256 1,756

1,500 257 50

6,939 150

6,682 100

(a) 1,500 (b) 257 (c) 50

JURASSIC PARK CO. Worksheet (PARTIAL)

For The Month Ended Jan. 31, 2017

During February, no events occurred that affected these accounts. But at the end of February, the following information was available.

(a) Supplies on hand $715 (b) Monthly depreciation $257 (c) Accrued interest $ 50

Instructions Reproduce the data that would appear in the February worksheet, and indicate the amounts that would be shown in the February income statement.

138 Chapter 3 The Accounting Information System

PROBLEMS

P3-1 (L02,4,5) (Transactions, Financial Statements—Service Company) Listed below are the transactions of Yasunari Kawa- bata, D.D.S., for the month of September.

Sept. 1 Kawabata begins practice as a dentist and invests $20,000 cash. 2 Purchases dental equipment on account from Green Jacket Co. for $17,280. 4 Pays rent for office space, $680 for the month. 4 Employs a receptionist, Michael Bradley. 5 Purchases dental supplies for cash, $942. 8 Receives cash of $1,690 from patients for services performed. 10 Pays miscellaneous office expenses, $430. 14 Bills patients $5,820 for services performed. 18 Pays Green Jacket Co. on account, $3,600. 19 Withdraws $3,000 cash from the business for personal use. 20 Receives $980 from patients on account. 25 Bills patients $2,110 for services performed. 30 Pays the following expenses in cash: salaries and wages $1,800; miscellaneous office expenses $85. 30 Dental supplies used during September, $330.

Instructions (a) Enter the transactions shown above in appropriate general ledger accounts (use T-accounts). Use the following ledger

accounts: Cash, Accounts Receivable, Supplies, Equipment, Accumulated Depreciation—Equipment, Accounts Pay- able, Owner’s Capital, Service Revenue, Rent Expense, Office Expense, Salaries and Wages Expense, Supplies Expense, Depreciation Expense, and Income Summary. Allow 10 lines for the Cash and Income Summary accounts, and 5 lines for each of the other accounts needed. Record depreciation using a 5-year life on the equipment, the straight-line method, and no salvage value. Do not use a drawing account.

(b) Prepare a trial balance. (c) Prepare an income statement, a statement of owner’s equity, and an unclassified balance sheet. (d) Close the ledger. (e) Prepare a post-closing trial balance.

P3-2 (L03,4) EXCEL (Adjusting Entries and Financial Statements) Mason Advertising was founded in January 2013. Presented below are adjusted and unadjusted trial balances as of December 31, 2017.

MASON ADVERTISING TRIAL BALANCE

DECEMBER 31, 2017

Unadjusted Adjusted

Dr. Cr. Dr. Cr.

Cash $ 11,000 $ 11,000 Accounts Receivable 20,000 23,500 Supplies 8,400 3,000 Prepaid Insurance 3,350 2,500 Equipment 60,000 60,000 Accumulated Depreciation—Equipment $ 28,000 $ 33,000 Accounts Payable 5,000 5,000 Interest Payable –0– 150 Notes Payable 5,000 5,000 Unearned Service Revenue 7,000 5,600 Salaries and Wages Payable –0– 1,300 Common Stock 10,000 10,000 Retained Earnings 3,500 3,500 Service Revenue 58,600 63,500 Salaries and Wages Expense 10,000 11,300 Insurance Expense 850 Interest Expense 350 500 Depreciation Expense 5,000 Supplies Expense 5,400 Rent Expense 4,000 4,000

$117,100 $117,100 $127,050 $127,050

Instructions (a) Journalize the annual adjusting entries that were made. (Omit explanations.) (b) Prepare an income statement and a statement of retained earnings for the year ending December 31, 2017, and an

unclassified balance sheet at December 31.

Problems 139

(1) If the note has been outstanding 3 months, what is the annual interest rate on that note? (2) If the company paid $12,500 in salaries and wages in 2017, what was the balance in Salaries and Wages Payable on

December 31, 2016?

P3-3 (L03) (Adjusting Entries) A review of the ledger of Baylor Company at December 31, 2017, produces the following data pertaining to the preparation of annual adjusting entries.

1. Salaries and Wages Payable $0. There are eight employees. Salaries and wages are paid every Friday for the current week. Five employees receive $700 each per week, and three employees earn $600 each per week. December 31 is a Tuesday. Employees do not work weekends. All employees worked the last 2 days of December.

2. Unearned Rent Revenue $429,000. The company began subleasing office space in its new building on November 1. Each tenant is required to make a $5,000 security deposit that is not refundable until occupancy is terminated. At December 31, the company had the following rental contracts that are paid in full for the entire term of the lease.

Date Term (in months) Monthly Rent Number of Leases

Nov. 1 6 $6,000 5 Dec. 1 6 $8,500 4

3. Prepaid Advertising $13,200. This balance consists of payments on two advertising contracts. The contracts provide for monthly advertising in two trade magazines. The terms of the contracts are as shown below.

Contract Date Amount Number of Magazine Issues

A650 May 1 $6,000 12 B974 Oct. 1 7,200 24

The first advertisement runs in the month in which the contract is signed. 4. Notes Payable $60,000. This balance consists of a note for one year at an annual interest rate of 12%, dated June 1.

Instructions Prepare the adjusting entries at December 31, 2017. (Show all computations).

P3-4 (L03,4,5,6) (Financial Statements, Adjusting and Closing Entries) The trial balance of Bellemy Fashion Center con- tained the following accounts at November 30, the end of the company’s fiscal year.

Adjustment data: 1. Supplies on hand totaled $1,500. 2. Depreciation is $15,000 on the equipment. 3. Interest of $11,000 is accrued on notes payable at November 30.

BELLEMY FASHION CENTER TRIAL BALANCE

NOVEMBER 30, 2017

Debit Credit

Cash $ 28,700 Accounts Receivable 33,700 Inventory 45,000 Supplies 5,500 Equipment 133,000 Accumulated Depreciation—Equipment $ 24,000 Notes Payable 51,000 Accounts Payable 48,500 Common Stock 90,000 Retained Earnings 8,000 Sales Revenue 757,200 Sales Returns and Allowances 4,200 Cost of Goods Sold 495,400 Salaries and Wages Expense 140,000 Advertising Expense 26,400 Utilities Expenses 14,000 Maintenance and Repairs Expense 12,100 Delivery Expense 16,700 Rent Expense 24,000

$978,700 $978,700

140 Chapter 3 The Accounting Information System

Other data: 1. Salaries expense is 70% selling and 30% administrative. 2. Rent expense and utilities expenses are 80% selling and 20% administrative. 3. $30,000 of notes payable are due for payment next year. 4. Maintenance and repairs expense is 100% administrative.

Instructions (a) Journalize the adjusting entries. (b) Prepare an adjusted trial balance. (c) Prepare a multiple-step income statement and retained earnings statement for the year and a classified balance sheet as

of November 30, 2017. (d) Journalize the closing entries. (e) Prepare a post-closing trial balance.

P3-5 (L03) (Adjusting Entries) The accounts listed below appeared in the December 31 trial balance of the Savard Theater.

Instructions

(a) From the account balances listed above and the information given below, prepare the annual adjusting entries neces- sary on December 31. (Omit explanations.)

(1) The equipment has an estimated life of 16 years and a salvage value of $24,000 at the end of that time. (Use straight- line method.)

(2) The note payable is a 90-day note given to the bank October 20 and bearing interest at 8%. (Use 360 days for denominator.) (3) In December, 2,000 coupon admission books were sold at $30 each and recorded as Admissions Revenue. They

could be used for admission any time after January 1. (4) Advertising expense paid in advance and included in Advertising Expense $1,100. (5) Salaries and wages accrued but unpaid $4,700.

(b) What amounts should be shown for each of the following on the income statement for the year?

(1) Interest expense. (3) Advertising expense. (2) Admissions revenue. (4) Salaries and wages expense.

P3-6 (L03,4) (Adjusting Entries and Financial Statements) The following are the trial balance and the other information related to Yorkis Perez, a consulting engineer.

YORKIS PEREZ, CONSULTING ENGINEER TRIAL BALANCE

DECEMBER 31, 2017

Debit Credit

Cash $ 29,500 Accounts Receivable 49,600 Allowance for Doubtful Accounts $ 750 Supplies 1,960 Prepaid Insurance 1,100 Equipment 25,000 Accumulated Depreciation—Equipment 6,250 Notes Payable 7,200 Owner’s Capital 35,010 Service Revenue 100,000 Rent Expense 9,750 Salaries and Wages Expense 30,500 Utilities Expenses 1,080 Offi ce Expense 720

$149,210 $149,210

Debit Credit

Equipment $192,000 Accumulated Depreciation—Equipment $ 60,000 Notes Payable 90,000 Admissions Revenue 380,000 Advertising Expense 13,680 Salaries and Wages Expense 57,600 Interest Expense 1,400

Problems 141

1. Fees received in advance from clients $6,000, which were recorded as revenue. 2. Services performed for clients that were not recorded by December 31, $4,900. 3. Bad debt expense for the year is $1,430. 4. Insurance expired during the year $480. 5. Equipment is being depreciated at 10% per year. 6. Yorkis Perez gave the bank a 90-day, 10% note for $7,200 on December 1, 2017. 7. Rent of the building is $750 per month. The rent for 2017 has been paid, as has that for January 2018, and recorded as

Rent Expense. 8. Office salaries and wages earned but unpaid December 31, 2017, $2,510.

Instructions (a) From the trial balance and other information given, prepare annual adjusting entries as of December 31, 2017. (Omit

explanations.) (b) Prepare an income statement for 2017, a statement of owner’s equity, and a classified balance sheet. Yorkis Perez with-

drew $17,000 cash for personal use during the year.

P3-7 (L03,4,5) (Adjusting Entries and Financial Statements) Rolling Hills Golf Inc. was organized on July 1, 2017. Quar- terly financial statements are prepared. The unadjusted trial balance and adjusted trial balance on September 30 are shown below.

Instructions (a) Journalize the adjusting entries that were made. (b) Prepare an income statement and a retained earnings statement for the 3 months ending September 30 and a classified

balance sheet at September 30. (c) Identify which accounts should be closed on September 30. (d) If the note bears interest at 12%, how many months has it been outstanding?

P3-8 (L03,4,5) (Adjusting Entries and Financial Statements) Vedula Advertising was founded by Murali Vedula in January 2015. On the next page are both the adjusted and unadjusted trial balances as of December 31, 2017.

ROLLING HILLS GOLF INC. TRIAL BALANCE

SEPTEMBER 30, 2017

Unadjusted Adjusted

Dr. Cr. Dr. Cr.

Cash $ 6,700 $ 6,700 Accounts Receivable 400 1,000 Prepaid Rent 1,800 900 Supplies 1,200 180 Equipment 15,000 15,000 Accumulated Depreciation—Equipment $ 350 Notes Payable $ 5,000 5,000 Accounts Payable 1,070 1,070 Salaries and Wages Payable 600 Interest Payable 50 Unearned Rent Revenue 1,000 800 Common Stock 14,000 14,000 Retained Earnings 0 0 Dividends 600 600 Service Revenue 14,100 14,700 Rent Revenue 700 900 Salaries and Wages Expense 8,800 9,400 Rent Expense 900 1,800 Depreciation Expense 350 Supplies Expense 1,020 Utilities Expenses 470 470 Interest Expense 50

$35,870 $35,870 $37,470 $37,470

142 Chapter 3 The Accounting Information System

Instructions (a) Journalize the annual adjusting entries that were made. (b) Prepare an income statement and a retained earnings statement for the year ended December 31, and a classified bal-

ance sheet at December 31. (c) Identify which accounts should be closed on December 31. (d) If the note has been outstanding 10 months, what is the annual interest rate on that note? (e) If the company paid $10,500 in salaries and wages in 2017, what was the balance in Salaries and Wages Payable on

December 31, 2016?

P3-9 (L02,3,4,5) (Adjusting and Closing) Presented below is the trial balance of the Crestwood Golf Club, Inc. as of Decem- ber 31. The books are closed annually on December 31.

VEDULA ADVERTISING TRIAL BALANCE

DECEMBER 31, 2017

Unadjusted Adjusted

Dr. Cr. Dr. Cr.

Cash $ 11,000 $ 11,000 Accounts Receivable 16,000 19,500 Supplies 9,400 6,500 Prepaid Insurance 3,350 1,790 Equipment 60,000 60,000 Accumulated Depreciation—Equipment $ 25,000 $ 30,000 Notes Payable 8,000 8,000 Accounts Payable 2,000 2,000 Interest Payable 0 560 Unearned Service Revenue 5,000 3,100 Salaries and Wages Payable 0 820 Common Stock 20,000 20,000 Retained Earnings 5,500 5,500 Dividends 10,000 10,000 Service Revenue 57,600 63,000 Salaries and Wages Expense 9,000 9,820 Insurance Expense 1,560 Interest Expense 560 Depreciation Expense 5,000 Supplies Expense 2,900 Rent Expense 4,350 4,350

$123,100 $123,100 $132,980 $132,980

CRESTWOOD GOLF CLUB, INC. TRIAL BALANCE

DECEMBER 31

Debit Credit

Cash $ 15,000 Accounts Receivable 13,000 Allowance for Doubtful Accounts $ 1,100 Prepaid Insurance 9,000 Land 350,000 Buildings 120,000 Accumulated Depreciation—Buildings 38,400 Equipment 150,000 Accumulated Depreciation—Equipment 70,000 Common Stock 400,000 Retained Earnings 82,000 Dues Revenue 200,000 Green Fees Revenue 5,900 Rent Revenue 17,600 Utilities Expenses 54,000 Salaries and Wages Expense 80,000 Maintenance and Repairs Expense 24,000

$815,000 $815,000

Problems 143

Instructions (a) Enter the balances in ledger accounts. Allow five lines for each account. (b) From the trial balance and the information given below, prepare annual adjusting entries and post to the ledger accounts.

(Omit explanations.)

(1) The buildings have an estimated life of 30 years with no salvage value (straight-line method). (2) The equipment is depreciated at 10% per year. (3) Insurance expired during the year $3,500. (4) The rent revenue represents the amount received for 11 months for dining facilities. The December rent has not yet

been received. (5) It is estimated that 12% of the accounts receivable will be uncollectible. (6) Salaries and wages earned but not paid by December 31, $3,600. (7) Dues received in advance from members $8,900 were recorded as Dues Revenue.

P3-10 (L02,3,5,6) (Adjusting and Closing) Presented below is the December 31 trial balance of New York Boutique.

NEW YORK BOUTIQUE TRIAL BALANCE

DECEMBER 31

Debit Credit

Cash $ 18,500 Accounts Receivable 32,000 Allowance for Doubtful Accounts $ 700 Inventory, December 31 80,000 Prepaid Insurance 5,100 Equipment 84,000 Accumulated Depreciation—Equipment 35,000 Notes Payable 28,000 Common Stock 80,600 Retained Earnings 10,000 Sales Revenue 600,000 Cost of Goods Sold 408,000 Salaries and Wages Expense (sales) 50,000 Advertising Expense 6,700 Salaries and Wages Expense (administrative) 65,000 Supplies Expense 5,000

$754,300 $754,300

Instructions (a) Construct T-accounts and enter the balances shown. (b) Prepare adjusting journal entries for the following and post to the T-accounts. (Omit explanations.) Open additional

T-accounts as necessary. (The books are closed yearly on December 31.)

(1) Bad debt expense is estimated to be $1,400. (2) Equipment is depreciated based on a 7-year life (no salvage value). (3) Insurance expired during the year $2,550. (4) Interest accrued on notes payable $3,360. (5) Sales salaries and wages earned but not paid $2,400. (6) Advertising paid in advance $700. (7) Office supplies on hand $1,500, charged to Supplies Expense when purchased.

*P3-11 (L07) (Cash and Accrual Basis) On January 1, 2017, Norma Smith and Grant Wood formed a computer sales and service company in Soapsville, Arkansas, by investing $90,000 cash. The new company, Arkansas Sales and Service, has the fol- lowing transactions during January.

1. Pays $6,000 in advance for 3 months’ rent of office, showroom, and repair space. 2. Purchases 40 personal computers at a cost of $1,500 each, 6 graphics computers at a cost of $2,500 each, and 25 printers at

a cost of $300 each, paying cash upon delivery.

144 Chapter 3 The Accounting Information System

3. Sales, repair, and office employees earn $12,600 in salaries and wages during January, of which $3,000 was still payable at the end of January.

4. Sells 30 personal computers at $2,550 each, 4 graphics computers for $3,600 each, and 15 printers for $500 each; $75,000 is received in cash in January, and $23,400 is sold on a deferred payment basis.

5. Other operating expenses of $8,400 are incurred and paid for during January; $2,000 of incurred expenses are payable at January 31.

Instructions (a) Using the transaction data above, prepare (1) a cash-basis income statement and (2) an accrual-basis income statement

for the month of January. (b) Using the transaction data above, prepare (1) a cash-basis balance sheet and (2) an accrual-basis balance sheet as of

January 31, 2017. (c) Identify the items in the cash-basis financial statements that make cash-basis accounting inconsistent with the theory

underlying the elements of financial statements.

*P3-12 (L03,4,5,9) (Worksheet, Balance Sheet, Adjusting and Closing Entries) Cooke Company has a fiscal year ending on September 30. Selected data from the September 30 worksheet are presented below.

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Trial Balance Adjusted Trial Balance Account Titles

Cash Supplies Prepaid Insurance Land Equipment Accumulated Depreciation—Equipment Accounts Payable Unearned Service Revenue Mortgage Payable Common Stock Retained Earnings, Sept. 1, 2017 Dividends Service Revenue Salaries and Wages Expense Maintenance and Repairs Expense Advertising Expense Utilities Expenses Property Tax Expense Interest Expense Totals Insurance Expense Supplies Expense Interest Payable Depreciation Expense Property Taxes Payable Totals

COOKE COMPANY Worksheet

For The Month Ended September 30, 2017

37,400 4,200 3,900

80,000 120,000

14,000

109,000 30,500 9,400

16,900 21,000 12,000

28,000 14,400

5,800

506,500

36,200 14,600 2,700

50,000 107,700

2,000

278,500

491,700

42,000 14,600

700 50,000

107,700 2,000

280,500

6,000

3,000 506,500

37,400 18,600 31,900 80,000

120,000

14,000

109,000 30,500 9,400

16,900 18,000 6,000

491,700

Dr. Cr. Dr. Cr.

Instructions (a) Prepare a complete worksheet. (b) Prepare a classified balance sheet. (Note: $10,000 of the mortgage payable is due for payment in the next fiscal year.) (c) Journalize the adjusting entries using the worksheet as a basis.

Using Your Judgment 145

(d) Journalize the closing entries using the worksheet as a basis. (e) Prepare a post-closing trial balance.

USING YOUR JUDGMENT

Financial Reporting Problem

Instructions Refer to these financial statements and the accompanying notes to answer the following questions.

(a) What were P&G’s total assets at June 30, 2014? At June 30, 2013? (b) How much cash (and cash equivalents) did P&G have on June 30, 2014? (c) What were P&G’s research and development costs in 2013? In 2014? (d) What were P&G’s revenues in 2013? In 2014? (e) Using P&G’s financial statements and related notes, identify items that may result in adjusting entries for deferrals and accruals. (f) What were the amounts of P&G’s depreciation and amortization expense in 2012, 2013, and 2014?

Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. The financial statements of Coca-Cola and PepsiCo are presented in Appendices C and D, respectively. The companies’ com- plete annual reports, including the notes to the financial statements, are available online.

Instructions Use the companies’ financial information to answer the following questions.

(a) Which company had the greater percentage increase in total assets from 2013 to 2014? (b) Using the Selected Financial Data section of these two companies, determine their 5-year average growth rates related

to net sales and income from continuing operations. (c) Which company had more depreciation and amortization expense for 2014? Provide a rationale as to why there is a

difference in these amounts between the two companies.

Financial Statement Analysis Case Kellogg Company has its headquarters in Battle Creek, Michigan. The company manufactures and sells ready-to-eat breakfast cereals and convenience foods including cookies, toaster pastries, and cereal bars.

Selected data from Kellogg Company’s 2014 annual report follows (dollar amounts in millions).

2014 2013 2012

Sales $ 14,580 $ 14,792 $ 14,197 Gross profit % 34.73 41.26 38.28 Operating profit 1,024 2,837 1,562 Net cash flow less capital expenditures 1,211 1,170 1,225 Net earnings 633 1,808 961

In its annual reports, Kellogg Company has indicated that it plans to achieve sustainability of its operating results with operating principles that emphasize profit-rich, sustainable sales growth, as well as cash flow and return on invested capital. Kellogg believes its steady earnings growth, strong cash flow, and continued investment during a multi-year period demonstrates the strength and flexibility of its business model.

Instructions (a) Compute the percentage change in sales, operating profit, net cash flow less capital expenditures, and net earnings

from year to year for the years presented. (b) Evaluate Kellogg’s performance. Which trend seems most favorable? Which trend seems least favorable? What are the

implications of these trends for Kellogg’s sustainable performance objectives? Explain.

Accounting, Analysis, and Principles The Amato Theater is nearing the end of the year and is preparing for a meeting with its bankers to discuss the renewal of a loan. The accounts listed below appeared in the December 31, 2017, trial balance.

146 Chapter 3 The Accounting Information System

Debit Credit Prepaid Advertising $ 6,000 Equipment 192,000 Accumulated Depreciation—Equipment $ 60,000 Notes Payable 90,000 Unearned Service Revenue 17,500 Ticket Revenue 360,000 Advertising Expense 18,680 Salaries and Wages Expense 67,600 Interest Expense 1,400

Additional information is available as follows.

1. The equipment has an estimated useful life of 16 years and a salvage value of $40,000 at the end of that time. Amato uses the straight-line method for depreciation.

2. The note payable is a one-year note given to the bank January 31 and bearing interest at 10%. Interest is calculated on a monthly basis.

3. Late in December 2017, the theater sold 350 coupon ticket books at $50 each. Two hundred of these ticket books have been used by year-end. The cash received was recorded as Unearned Service Revenue.

4. Advertising paid in advance was $6,000 and was debited to Prepaid Advertising. The company has used $2,500 of the ad- vertising as of December 31, 2017.

5. Salaries and wages accrued but unpaid at December 31, 2017, were $3,500.

Accounting Prepare any adjusting journal entries necessary for the year ended December 31, 2017.

Analysis Determine Amato’s income before and after recording the adjusting entries. Use your analysis to explain why Amato’s bankers should be willing to wait for Amato to complete its year-end adjustment process before making a decision on the loan renewal.

Principles Although Amato’s bankers are willing to wait for the adjustment process to be completed before they receive financial informa- tion, they would like to receive financial reports more frequently than annually or even quarterly. What trade-offs, in terms of relevance and faithful representation, are inherent in preparing financial statements for shorter accounting time periods?

BRIDGE TO THE PROFESSION

Codifi cation Research Case Recording transactions in the accounting system requires knowledge of the important characteristics of the elements of financial statements, such as assets and liabilities. In addition, accountants must understand the inherent uncertainty in accounting mea- sures and distinctions between related accounting concepts that are important in evaluating the effects of transactions on the financial statements.

Instructions Go to http://aaahq.org/asclogin.cfm to log in and provide explanations for the following items. (Provide paragraph citations.) When you have accessed the documents, you can use the search tool in your Internet browser.

(a) The three essential characteristics of assets. (b) The three essential characteristics of liabilities. (c) Uncertainty and its effect on financial statements. (d) The difference between realization and recognition.

ADDITIONAL PROFESSIONAL RESOURCES Go to WileyPLUS for other career-readiness resources, such as career coaching, internship opportunities, and CPAexcel prep.

IFRS Insights 147

LEARNING OBJECTIVE 10 Compare the accounting information systems under GAAP and IFRS.

IFRS Insights As indicated in this chapter, companies must have an effective accounting system. In the wake of accounting scandals at U.S. companies like Sunbeam, Rite-Aid, Xerox, and WorldCom, U.S. lawmakers demanded higher assurance on the quality of accounting reports. Since the passage of the Sarbanes-Oxley Act (SOX), companies that trade on U.S. exchanges are required to place renewed focus on their accounting systems to ensure accurate reporting.

RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to accounting information systems.

Similarities • International companies use the same set of procedures and records to keep track of transaction

data. Thus, the material in Chapter 3 dealing with the account, general rules of debit and credit, and steps in the recording process—the journal, ledger, and chart of accounts—is the same under both GAAP and IFRS.

• Transaction analysis is the same under GAAP and IFRS but, as you will see in later chapters, different standards sometimes impact how transactions are recorded.

• Both the FASB and IASB go beyond the basic defi nitions provided in this textbook for the key elements of fi nancial statements, that is, assets, liabilities, equity, revenues, and expenses.

• A trial balance under IFRS follows the same format as shown in the textbook. As shown in the textbook, dollar signs are typically used only in the trial balance and the fi nancial statements. The same practice is followed under IFRS, using the currency of the country in which the reporting company is headquartered.

Differences • Rules for accounting for specifi c events sometimes differ across countries. For example, Euro-

pean companies rely less on historical cost and more on fair value than U.S. companies. Despite the differences, the double-entry accounting system is the basis of accounting systems worldwide.

• Internal controls are a system of checks and balances designed to prevent and detect fraud and errors. While most public U.S. companies have these systems in place, many non-U.S. companies have never completely documented them nor had an independent auditor attest to their effectiveness. Both of these actions are required under SOX. These enhanced internal control standards apply only to large public companies listed on U.S. exchanges.

ABOUT THE NUMBERS

Accounting System Internal Controls There is continuing debate over whether foreign issuers should have to comply with the extra layer of regulation related to internal controls attestation.4 Companies find that internal control review is a costly process but needed. One study estimates the cost of compliance for U.S. com- panies at over $35 billion, with audit fees doubling in the first year of compliance. At the same time, examination of internal controls indicates lingering problems in the way companies oper- ate. One study of first compliance with the internal control testing provisions documented

4See Greg Ip, Kara Scannel, and Deborah Solomon, “Trade Winds in Call to Deregulate Business, A Global Twist,” Wall Street Journal (January 25, 2007), p. A1.

148 Chapter 3 The Accounting Information System

Asia Pacific Emerging

Source: Maulik Tewari, “Chinese Companies Lead the Global IPO Chart,” http://www. thehindubusinessline.com/news/international/chinese-companies-lead-the-global-ipo-chart/ article7119473.ece (April 19, 2015).

Asia Pacific Developed

Europe North America

IPO Boom for Emerging Asia and Europe

Middle East and Africa

100

200

300

400

500

270 265 248

Count in 2014–2015 Year-on-year change (%)

492

9 39 −40

−5

Note the North American (including the United States) share of IPOs has declined. Some critics of the SOX provisions attribute the decline to the increased cost of complying with the internal con- trol rules. Others, looking at these same trends, are not so sure about SOX being the cause of the relative decline of U.S. IPOs. These commentators argue that growth in non-U.S. markets is a natural consequence of general globalization of capital flows.

First-Time Adoption of IFRS As discussed in Chapter 1, IFRS is growing in acceptance around the world. For example, recent statistics indicate 40 percent of the Global Fortune 500 companies use IFRS. And the chair of the IASB predicts that IFRS adoption will grow from its current level of over 115 countries to nearly 150 countries in the near future.

When countries accept IFRS for use as accepted accounting policies, companies need guid- ance to ensure that their first IFRS financial statements contain high-quality information. Specifi- cally, IFRS 1 requires that information in a company’s first IFRS statements (1) be transparent, (2) provide a suitable starting point, and (3) have a cost that does not exceed the benefits. As a result, many companies will be going through a substantial conversion process to switch from their reporting standards to IFRS.

The overriding principle in converting to IFRS is full retrospective application of IFRS. Retro- spective application—recasting prior financial statements on the basis of IFRS—provides finan- cial statement users with comparable information. As indicated, the objective of the conversion process is to present a set of IFRS statements as if the company always reported using IFRS. To achieve this objective, a company follows these steps:

1. Identify the timing of its first IFRS statements. 2. Prepare an opening balance sheet at the date of transition to IFRS.

material weaknesses for about 13 percent of companies reporting in 2004 and 2005. As indicated in footnote 1 (page 80), SOX compliance costs remain substantial 10 years after the passage of the act.

Debate about requiring foreign companies to comply with SOX centers on whether the higher costs of a good information system are making the U.S. securities markets less competitive. Pre- sented below are recent statistics for initial public offerings (IPOs) around the world.

IFRS Insights 149

3. Select accounting principles that comply with IFRS, and apply these principles retro- spectively.

4. Make extensive disclosures to explain the transition to IFRS.

Once a company decides to convert to IFRS, it must decide on the transition date and the report- ing date. The transition date is the beginning of the earliest period for which full comparative IFRS information is presented. The reporting date is the closing balance sheet date for the first IFRS financial statements.

To illustrate, assume that FirstChoice Company plans to provide its first IFRS statements for the year ended December 31, 2019. FirstChoice decides to present comparative information for one year only. Therefore, its date of transition to IFRS is January 1, 2018, and its reporting date is December 31, 2019. The timeline for first-time adoption is presented in the following graphic.

Last Statements under Prior GAAP

Comparable Period First IFRS Reporting Period

IFRS Financial Statements

Date of Transition Beginning of First Reporting Date (Opening IFRS Statement IFRS Reporting Period of Financial Position)

January 1, 2018 January 1, 2019 December 31, 2019

The graphic shows the following.

1. The opening IFRS statement of financial position for FirstChoice on January 1, 2018, serves as the starting point (date of transition) for the company’s accounting under IFRS.

2. The first full IFRS statements are shown for FirstChoice for December 31, 2019. In other words, a minimum of two years of IFRS statements must be presented before a conversion to IFRS occurs. As a result, FirstChoice must prepare at least one year of comparative finan- cial statements for 2019 using IFRS.

3. FirstChoice presents financial statements in accordance with GAAP annually to December 31, 2018.

Following this conversion process, FirstChoice provides users of the financial statements with comparable IFRS statements for 2018 and 2019. Upon first-time adoption of IFRS, a company must present at least one year of comparative information under IFRS.

ON THE HORIZON The basic recording process shown in this textbook is followed by companies around the globe. It is unlikely to change in the future. The definitional structure of assets, liabilities, equity, revenues, and expenses may change over time as the IASB and FASB evaluate their overall conceptual framework for establishing accounting standards. In addition, high-quality international account- ing requires both high-quality accounting standards and high-quality auditing. Similar to the convergence of GAAP and IFRS, there is a movement to improve international auditing stan- dards. The International Auditing and Assurance Standards Board (IAASB) functions as an inde- pendent standard-setting body. It works to establish high-quality auditing and assurance and quality-control standards throughout the world. Whether the IAASB adopts internal control pro- visions similar to those in SOX remains to be seen. You can follow developments in the interna- tional audit arena at http://www.ifac.org/iaasb/.

150 Chapter 3 The Accounting Information System

1. Which statement is correct regarding IFRS? (a) IFRS reverses the rules of debits and credits, that is,

debits are on the right and credits are on the left. (b) IFRS uses the same process for recording transac-

tions as GAAP. (c) The chart of accounts under IFRS is different because

revenues follow assets. (d) None of the above statements are correct.

2. Information in a company’s first IFRS statements must: (a) have a cost that does not exceed the benefits. (b) be transparent. (c) provide a suitable starting point. (d) All the above.

3. The transition date is the date: (a) when a company no longer reports under its national

standards. (b) when the company issues its most recent financial

statement under IFRS. (c) three years prior to the reporting date. (d) None of the above.

4. When converting to IFRS, a company must: (a) recast previously issued financial statements in

accordance with IFRS. (b) use GAAP in the reporting period but subsequently

use IFRS. (c) prepare at least three years of comparative state-

ments. (d) use GAAP in the transition year but IFRS in the

reporting year.

5. The purpose of presenting comparative information in the transition to IFRS is:

(a) to ensure that the information is a faithful represen- tation.

(b) to be in accordance with the Sarbanes-Oxley Act. (c) to provide users of the financial statements with

information on GAAP in one period and IFRS in the other period.

(d) to provide users of the financial statements with information on IFRS for at least two periods.

IFRS CONCEPTS AND APPLICATION

IFRS3-1 How is the date of transition and the date of reporting determined in first-time adoption of IFRS? IFRS3-2 What are the characteristics of high-quality information in a company’s first IFRS financial statements? IFRS3-3 What are the steps to be completed in preparing the opening IFRS statement of financial position? IFRS3-4 Becker Ltd. is planning to adopt IFRS and prepare its first IFRS financial statements at December 31, 2018. What is the date of Becker’s opening balance sheet, assuming one year of comparative information? What periods will be covered in Beck- er’s first IFRS financial statements?

Professional Research IFRS3-5 Recording transactions in the accounting system requires knowledge of the important characteristics of the elements of financial statements, such as assets and liabilities. In addition, accountants must understand the inherent uncertainty in accounting measures and distinctions between related accounting concepts that are important in evaluating the effects of trans- actions on the financial statements.

Instructions Access the IASB Framework at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following items. (Provide paragraph citations.)

(a) Provide the defi nition of an asset and discuss how the economic benefi ts embodied in an asset might fl ow to a company. (b) Provide the defi nition of a liability and discuss how a company might satisfy a liability. (c) What is “accrual basis”? How do adjusting entries illustrate application of the accrual basis?

IFRS SELF-TEST QUESTIONS

IFRS Insights 151

International Financial Reporting Problem Marks and Spencer plc (M&S)

IFRS3-6 The financial statements of (M&S) are presented in Appendix E. The company's complete annual report, includ- ing the notes to the financial statements, is available online.

Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions.

(a) What were M&S’s total assets at 28 March 2015? At 29 March 2014? (b) How much cash (and cash equivalents) did M&S have on 28 March 2015? (c) What were M&S’s selling and marketing expenses in 2015? In 2014? (d) What were M&S’s revenues in 2015? In 2014? (e) Using M&S’s fi nancial statements and related notes, identify items that may result in adjusting entries for prepay-

ments and accruals. (f) What were the amounts of M&S’s depreciation and amortization expense in 2014 and 2015?

ANSWERS TO IFRS SELF-TEST QUESTIONS

1. b 2. d 3. d 4. a 5. d

FINANCIAL STATEMENTS ARE CHANGING The 2014 annual report of Groupon presents the following additional information in its financial statements:

4 1 Understand the uses and limitations of

an income statement.

2 Describe the content of the income statement.

3 Prepare an income statement. 4 Explain how to report various income

items.

5 Understand the reporting of accounting changes and errors.

6 Prepare a retained earnings statement. 7 Explain how to report other

comprehensive income.

Income Statement and Related Information LEARNING OBJECTIVES After studying this chapter, you should be able to:

Groupon management indicates that adjusted EBITDA is a non-GAAP financial measure that comprises net loss excluding income taxes, interest and other nonoperating items, depreciation and amortization, stock-based compensation, and acquisition-related expense (benefit), net. Management also indicates that the definition of adjusted EBITDA may differ from similar measures used by other companies, even when similar terms are used to identify such measures: “Adjusted EBITDA is a key measure used by our management and Board of Directors to evaluate operating performance, generate future operating plans and make strategic decisions for the allocation of capital. Accordingly, we believe that adjusted EBITDA provides useful information to investors and others in under- standing and evaluating our operating results in the same manner as our management and Board of Directors.”

Why do companies report these adjusted income numbers (sometimes referred to as pro forma measures)? One major reason is that companies believe some items on the income statement are not representative of operating results. These pro forma advocates defend pro forma reporting, saying it gives better insight into the fundamental operations of the business. However, while management asserts pro forma is useful to investors, others raise concerns.

The following is a reconciliation of Adjusted EBITDA to the most comparable U.S. GAAP financial mea- sure, “Net loss,” for the years ended December 31, 2014 and 2013 (in thousands):

Year Ended December 31,

2014 2013

Net loss $ (63,919) $ (88,946) Adjustments: Stock-based compensation 122,019 121,462 Acquisition-related expense (benefit), net 1,269 (11) Depreciation and amortization 144,921 89,449 Other expense, net 33,353 94,663 Provision for income taxes 15,724 70,037

Total adjustments 317,286 375,600

Adjusted EBITDA $253,367 $286,654

153

Skeptics of pro forma reporting often note that these adjustments generally lead to higher adjusted net income and, as a result, often report earnings before bad stuff (EBS). In Groupon’s case, the add-backs took a GAAP net loss of $63.9 million and adjusted it to a non-GAAP profit of $253.4 million in 2014. Groupon is not alone, as 40 (18%) of the 222 companies that had initial public offerings in 2014 reported losses under standard accounting rules but showed profits using their own tailor-made measures. According to consulting firm Audit Analytics, this represents the highest level of such companies in the past several years.

Another concern with pro forma reporting is that it is difficult to compare these adjusted numbers because companies have different views as to what is fundamental to their business. In many ways, the pro forma reporting practices by companies like Groupon represent implied criticisms of certain financial reporting standards, includ- ing how the information is presented on the income statement. In response, the SEC issued Regulation G, which requires companies to reconcile non-GAAP financial measures to GAAP. This regulation provides investors with a roadmap to analyze adjustments that companies make to their GAAP numbers to arrive at pro forma results. Regulation G helps investors compare one company’s pro forma measures with results reported by another company.

The FASB is working on a project on financial statement presentation to address users’ concerns about these practices. Users believe too many alternatives exist for classifying and reporting income statement information. As a result, it is difficult to assess the financial performance of the company and compare its results with other companies. The FASB’s focus on more transparent income reporting is encouraging, but managers still like pro forma reporting, as indicated by a recent survey. Over 55 percent polled indicated they would continue to practice pro forma reporting, even with a revised income statement format.

Sources: A. Stuart, “A New Vision for Accounting: Robert Herz and FASB Are Preparing a Radical New Format for Financial Statements,” CFO Magazine (February 2008), pp. 49–53; SEC Regulation G, “Conditions for Use of Non-GAAP Financial Measures,” Release No. 33-8176 (March 28, 2003) and Compliance & Disclosure Interpretations: Non-GAAP Financial Mea- sures (January 15, 2010), available at www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm; and M. Rapoport, “What Companies Strip Out of ‘Non-GAAP’ Earnings: Fines, Exec Bonuses, Severance, Rebranding Costs…” Wall Street Journal (January 8, 2015).

PREVIEW OF CHAPTER 4 As indicated in the opening story, companies are at- tempting to provide income statement information they believe is useful for decision-making. Investors need complete and comparable information on income and its components to assess company profitability correctly. In this chapter, we examine the many different types of revenues, expenses, gains, and losses that affect the income statement and related information, as follows.

INCOME STATEMENT AND RELATED INFORMATION

This chapter also includes numerous conceptual and international discussions that are integral to the topics presented here.

INCOME STATEMENT

• Usefulness • Limitations • Quality of earnings

FORMAT OF THE INCOME STATEMENT

• Elements • Intermediate

components • Condensed income

statements • Single-step income

statements

REPORTING VARIOUS INCOME ITEMS

• Unusual and infrequent gains and losses

• Discontinued operations • Noncontrolling interest • Earnings per share • Summary

OTHER REPORTING ISSUES

• Accounting changes and errors

• Retained earnings statement

• Comprehensive income

154 Chapter 4 Income Statement and Related Information

INCOME STATEMENT The income statement is the report that measures the success of company operations for a given period of time. (It is also often called the statement of income or statement of earnings.1) The business and investment community uses the income statement to determine profitability, investment value, and creditworthiness. It provides investors and creditors with information that helps them predict the amounts, timing, and uncer- tainty of future cash flows.

Usefulness of the Income Statement The income statement helps users of financial statements predict future cash flows in a number of ways. For example, investors and creditors use the income statement infor- mation to:

1. Evaluate the past performance of the company. Examining revenues and expenses indicates how the company performed and allows comparison of its performance to its competitors. For example, analysts use the income data provided by Ford to compare its performance to that of Toyota.

2. Provide a basis for predicting future performance. Information about past perfor- mance helps to determine important trends that, if continued, provide information about future performance. For example, General Electric at one time reported con- sistent increases in revenues. Obviously, past success does not necessarily translate into future success. However, analysts can better predict future revenues, and hence earnings and cash fl ows, if a reasonable correlation exists between past and future performance.

3. Help assess the risk or uncertainty of achieving future cash fl ows. Information on the various components of income—revenues, expenses, gains, and losses— highlights the relationships among them. It also helps to assess the risk of not achieving a particular level of cash fl ows in the future. For example, investors and creditors often segregate IBM’s operating performance from other non-recurring sources of income because IBM primarily generates revenues and cash through its operations. Thus, results from continuing operations usually have greater signifi cance for predicting future performance than do results from non-recurring activities and events.

In summary, information in the income statement—revenues, expenses, gains, and losses—helps users evaluate past performance. It also provides insights into the likeli- hood of achieving a particular level of cash flows in the future.

Limitations of the Income Statement Because net income is an estimate and reflects a number of assumptions, income state- ment users need to be aware of certain limitations associated with its information. Some of these limitations include:

1. Companies omit items from the income statement that they cannot measure reli- ably. Current practice prohibits recognition of certain items from the determina- tion of income even though the effects of these items can arguably affect the com- pany’s performance. For example, a company may not record unrealized gains and losses on certain investment securities in income when there is uncertainty that it

1We will use the term income statement except in situations where a company reports other comprehensive income (discussed later in the chapter). In that case, we will use the terms statement of comprehensive income or comprehensive income statement.

Ford Toyota

Revenues – Expenses

$ Profits

Revenues – Expenses

$ Profits <

Which company did better last year?

Where am I headed?

GE Profits

IBM Income for Year Ended

12/31/17

Revenues – Operating expenses

Recurring items are more certain in the future.

Yes

Recurring?

± Unusual items

No ?

Operating income

$ Net Income

You left something out!

Brand value

Exp Exp Rev Rev Rev

Profits

Unrealized earnings

LEARNING OBJECTIVE 1 Understand the uses and limitations of an income statement.

Income Statement 155

will ever realize the changes in value. In addition, more and more companies, like Cisco Systems and Microsoft, experience increases in value due to brand recogni- tion, customer service, and product quality. A common framework for identifying and reporting these types of values is still lacking.

2. Income numbers are affected by the accounting methods employed. One company may depreciate its plant assets on an accelerated basis; another chooses straight-line depreciation. Assuming all other factors are equal, the fi rst company will report lower income. In effect, we are comparing apples to oranges.

3. Income measurement involves judgment. For example, one company in good faith may estimate the useful life of an asset to be 20 years, while another company uses a 15-year estimate for the same type of asset. Similarly, some companies may make optimistic estimates of future warranty costs and bad debt write-offs, which result in lower expense and higher income.

In summary, several limitations of the income statement reduce the usefulness of its information for predicting the amounts, timing, and uncertainty of future cash flows.

Quality of Earnings So far, our discussion has highlighted the importance of information in the income state- ment for investment and credit decisions, including the evaluation of the company and its managers.2 Companies try to meet or beat Wall Street expectations so that the market price of their stock and the value of management’s stock compensation packages increase. As a result, companies have incentives to manage income to meet earnings targets or to make earnings look less risky.

The SEC has expressed concern that the motivations to meet earnings targets may override good business practices. This erodes the quality of earnings and the quality of financial reporting. As indicated by one SEC chairperson, “Managing may be giving way to manipulation; integrity may be losing out to illusion.”3 As a result, the SEC has taken decisive action to prevent the practice of earnings management.

What is earnings management? It is often defined as the planned timing of reve- nues, expenses, gains, and losses to smooth out bumps in earnings. In most cases, com- panies use earnings management to increase income in the current year at the expense of income in future years. For example, they prematurely recognize sales in order to boost earnings. As one commentator noted, “it’s like popping a cork in [opening] a bottle of wine before it is ready.”

Companies also use earnings management to decrease current earnings in order to increase income in the future. The classic case is the use of “cookie jar” reserves. Companies establish these reserves by using unrealistic assumptions to estimate liabilities for such items as loan losses, restructuring charges, and warranty returns. The companies then reduce these reserves in the future to increase reported income in the future.

Such earnings management negatively affects the quality of earnings if it distorts the information in a way that is less useful for predicting future earnings and cash flows. Markets rely on trust. The bond between shareholders and the company must remain strong. Investors or others losing faith in the numbers reported in the financial state- ments will damage U.S. capital markets. As we mentioned in the opening story, we need

2In support of the usefulness of income information, accounting researchers have documented an association between companies’ market prices and reported incomes. See W. H. Beaver, “Perspectives on Recent Capital Markets Research,” The Accounting Review (April 2002), pp. 453–474. 3A. Levitt, “The Numbers Game,” Remarks to NYU Center for Law and Business, September 28, 1998 (Securities and Exchange Commission, 1998).

Hmm... Is the income the same?

Straight-Line Depreciation

Income Using:

Accelerated Depreciation

Estimates • High useful lives • Low warranty costs • Low bad debts

Hey...you might be too optimistic!

$ High Income

UNDERLYING CONCEPTS

The income statement provides important infor- mation to help assess the amounts, timing, and uncertainty of future cash fl ows—the central element of the objective of fi nancial reporting.

156 Chapter 4 Income Statement and Related Information

4The most common alternative to the transaction approach is the capital maintenance approach to income measurement. Under this approach, a company determines income for the period based on the change in equity, after adjusting for capital contributions (e.g., investments by owners) or distributions (e.g., dividends). The main drawback associated with the capital maintenance approach is that the components of income are not evident in its measurement. The Internal Revenue Service uses the capital maintenance approach to identify unreported income and refers to this approach as the “net worth check.”

FORMAT OF THE INCOME STATEMENT Elements of the Income Statement Net income results from revenue, expense, gain, and loss transactions. The income statement summarizes these transactions. This method of income measurement, the transaction approach, focuses on the income-related activities that have occurred during the period.4 The statement can further classify income by customer, product

LEARNING OBJECTIVE 2 Describe the content of the income statement.

heightened scrutiny of income measurement and reporting to ensure the quality of earnings and investors’ confidence in the income statement.

WHAT DO THE NUMBERS MEAN? FOUR: THE LONELIEST NUMBER Managing earnings up or down adversely affects the quality of earnings. Why do companies engage in such practices? Some recent research concludes that many companies tweak quar- terly earnings to meet investor expectations. How do they do it? Research fi ndings indicate that companies tend to nudge their earnings numbers up by a 10th of a cent or two. That lets them round results up to the highest cent, as illustrated in the following chart.

signifi cantly less often than would be expected by chance. This effect is called “quadrophobia.” For the typical company in the study, an increase of $31,000 in quarterly net income would boost earnings per share by a 10th of a cent. A more recent analysis of quarterly results for more than 2,600 com- panies found that rounding up remains more common than rounding down.

Another recent study reinforces the concerns about earn- ings management. Based on a survey of 169 public-company chief fi nancial offi cers (and with in-depth interviews of 12), the study concludes that high-quality earnings are sustainable when backed by actual cash fl ows and “avoiding unreliable long-term estimates.” However, about 20 percent of fi rms manage earnings to misrepresent their economic performance. And when they do manage earnings, it could move EPS by an average of 10 percent.

Is such earnings management a problem for investors? It is if they cannot determine the impact on earnings quality. Indeed, the surveyed CFOs “believe that it is diffi cult for outside observers to unravel earnings management, espe- cially when such earnings are managed using subtle unob- servable choices or real actions.” What’s an investor to do? The survey authors say the CFOs “advocate paying close attention to the key managers running the fi rm, the lack of correlation between earnings and cash fl ows, signifi cant deviations between fi rm and peer experience, and unusual behavior in accruals.”

Sources: S. Thurm, “For Some Firms, a Case of ‘Quadrophobia’,” Wall Street Journal (February 14, 2010); and H. Greenberg, “CFOs Concede Earnings Are ‘Managed’,” www.cnbc.com (July 19, 2012). (The study referred to is by I. Dichev, J. Graham, C. Harvey, and S. Rajgopal, “Earnings Quality: Evidence from the Field,” Emory University Working Paper (July 2012).)

Round down

Digit Frequency of the Digit

Round up

2 4 6 8 10 12%

Least common

Companies are more likely to round up earnings per share figures to the next- highest cent than to round down, a new study found. The chart shows the frequency of the digits in the 10th-of-a-cent place for nearly 489,000 quarterly reports from 1980 to 2006.

Hitting the Target

Source: Joseph Grundfest and Nadya Malenko, Stanford University.

What the research shows is that the number “4” appeared less often in the 10th’s place than any other digit and

Format of the Income Statement 157

Revenues take many forms, such as sales, fees, interest, dividends, and rents. Expenses also take many forms, such as cost of goods sold, depreciation, interest, rent, salaries and wages, and taxes. Gains and losses also are of many types, resulting from the sale of investments or plant assets, settlement of liabilities, and write-offs of assets due to impairments or casualty.

The distinction between revenues and gains, and between expenses and losses, depend to a great extent on the typical activities of the company. For example, when McDonald’s sells a hamburger, it records the selling price as revenue. However, when McDonald’s sells land, it records any excess of the selling price over the book value as a gain. This difference in treatment results because the sale of the hamburger is part of McDonald’s regular operations. The sale of land is not.

We cannot overemphasize the importance of reporting these elements. Most deci- sion-makers find the parts of a financial statement to be more useful than the whole. As we indicated earlier, investors and creditors are interested in predicting the amounts, timing, and uncertainty of future income and cash flows. Having income statement ele- ments shown in some detail and in comparison with prior years’ data allows decision- makers to better assess future income and cash flows.

Intermediate Components of the Income Statement It is common for companies to present some or all of the following sections and totals within the income statement as shown in Illustration 4-1 (on page 158). This format is often referred to as the multiple-step income statement.

REVENUES. Infl ows or other enhancements of assets of an entity or settlements of its li- abilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

EXPENSES. Outfl ows or other using-up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.

GAINS. Increases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from revenues or investments by owners.

LOSSES. Decreases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from expenses or distributions to owners.6

ELEMENTS OF FINANCIAL STATEMENTS

5The term “non-recurring” encompasses transactions and other events that are derived from developments outside the normal operations of the business. 6“Elements of Financial Statements,” Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, 1985), paras. 78–89.

line, or function, or by operating and nonoperating, continuing and discontinued, and regular and non-recurring categories.5 The following lists more formal defini- tions of income-related items, referred to as the major elements of the income statement.

LEARNING OBJECTIVE 3 Prepare an income statement.

158 Chapter 4 Income Statement and Related Information

As indicated, companies report all revenues, gains, expenses, and losses on the income statement. This statement separates operating transactions from nonoperating transactions, and matches costs and expenses with related revenues. It highlights cer- tain intermediate components of income that analysts use to compute ratios for assess- ing the performance of the company. Companies present nonoperating revenues, gains, expenses, and losses in a separate section, before income taxes and income from opera- tions. Companies report discontinued operations as a separate element in the income statement. Segregating income with different characteristics and providing intermedi- ate income figures helps readers evaluate earnings information in assessing the amounts, timing, and uncertainty of future cash flows.

Illustration 4-2 presents an income statement for Cabrera Company. Cabrera’s income statement includes all of the major items shown in Illustration 4-1, except for discontinued operations and noncontrolling interest. In arriving at net income, the state- ment presents the following subtotals and totals: gross profit, income from operations, income before income tax, and net income.8

7Although the content of the operating section is always the same, the organization of the material can differ. The breakdown above uses a natural expense classification. Manufacturing concerns and merchandising companies in the wholesale trade commonly use this. Another classification of operating expenses, recommended for retail stores, uses a functional expense classification of administrative, occupancy, publicity, buying, and selling expenses. 8Companies must include earnings per share or net loss per share on the face of the income statement. In this chapter, we discuss only earnings per share or net loss per share where a company has only common stock. Another measure shown on the face of the income statement (when applicable) is fully diluted earnings per share, which gives effect to all dilutive potential common shares that were outstanding during the reporting period. This concept is discussed in Chapter 16.

1. OPERATING SECTION. A report of the revenues and expenses of the company’s prin- cipal operations.

(a) Sales or Revenue. A subsection presenting sales, discounts, allowances, returns, and other related information. Its purpose is to arrive at the net amount of sales revenue.

(b) Cost of Goods Sold. A subsection that shows the cost of goods that were sold to produce the sales.

(d) Administrative or General Expenses. A subsection reporting expenses of general administration.7

2. NONOPERATING SECTION. A report of revenues and expenses resulting from sec- ondary or auxiliary activities of the company. In addition, special gains and losses that are infrequent or unusual, or both, are normally reported in this section. Generally these items break down into two main subsections:

(a) Other Revenues and Gains. A list of the revenues recognized or gains incurred, generally net of related expenses, from nonoperating transactions.

(b) Other Expenses and Losses. A list of the expenses or losses incurred, generally net of any related incomes, from nonoperating transactions.

3. INCOME TAX. A section reporting federal and state taxes levied on income from con- tinuing operations.

4. DISCONTINUED OPERATIONS. Material gains or losses resulting from the disposi- tion of a component of the business.

5. NONCONTROLLING INTEREST. Allocation of income to noncontrolling share- holders.

6. EARNINGS PER SHARE. A measure of performance over the reporting period.

ILLUSTRATION 4-1 Income Statement Sections

Format of the Income Statement 159

The disclosure of net sales is useful because Cabrera reports regular revenues as a separate item. It discloses non-recurring or incidental revenues elsewhere in the income statement. As a result, analysts can more easily understand and assess trends in revenue from continuing operations.

Similarly, the reporting of gross profit provides a useful number for evaluating per- formance and predicting future earnings. Statement readers may study the trend in gross profits to determine how successfully a company uses its resources. They also may use that information to understand how competitive pressure affected profit margins.

Finally, disclosing income from operations highlights the difference between regu- lar and non-recurring or incidental activities. This disclosure helps users recognize that incidental or non-recurring activities are unlikely to continue at the same level. Further- more, disclosure of operating earnings may assist in comparing different companies and assessing operating efficiencies.

ILLUSTRATION 4-2 Multiple-Step Income Statement

CABRERA COMPANY INCOME STATEMENT

FOR THE YEAR ENDED DECEMBER 31, 2017

Sales Sales revenue $3,053,081 Less: Sales discounts $ 24,241 Sales returns and allowances 56,427 80,668

Net sales 2,972,413 Cost of goods sold 1,982,541

Gross profit 989,872

Operating expenses Selling expenses Sales salaries and commissions $202,644 Sales office salaries 59,200 Travel and entertainment 48,940 Advertising expense 38,315 Delivery expense 41,209 Shipping supplies and expense 24,712 Postage and stationery 16,788 Telephone and Internet expense 12,215 Depreciation of sales equipment 9,005 453,028

Administrative expenses Officers’ salaries 186,000 Office salaries 61,200 Legal and professional services 23,721 Utilities expense 23,275 Insurance expense 17,029 Depreciation of building 18,059 Depreciation of office equipment 16,000 Stationery, supplies, and postage 2,875 Miscellaneous office expenses 2,612 350,771 803,799

Income from operations 186,073

Other revenues and gains Dividend revenue 98,500 Rent revenue 72,910 171,410

357,483 Other expenses and losses Interest on bonds and notes 126,060

Income before income tax 231,423 Income tax 66,934

Net income for the year $ 164,489

Earnings per common share $1.74

160 Chapter 4 Income Statement and Related Information

Condensed Income Statements In some cases, a single income statement cannot possibly present all the desired expense detail. To solve this problem, a company includes only the totals of expense groups in the statement of income. It then also prepares supplementary schedules to support the totals. This format may thus reduce the income statement itself to a few lines on a single sheet. For this reason, readers who wish to study all the reported data on operations must give their attention to the supporting schedules. For example, consider the income statement shown in Illustration 4-3 for Cabrera Company. This statement is a condensed version of the more detailed multiple-step statement pre- sented in Illustration 4-2 (page 159). It is more representative of the type found in practice. Illustration 4-4 then shows an example of a supporting schedule, cross-refer- enced as Note D and detailing the selling expenses.

CABRERA COMPANY INCOME STATEMENT

FOR THE YEAR ENDED DECEMBER 31, 2017

Net sales $2,972,413 Cost of goods sold 1,982,541

Gross profit 989,872 Selling expenses (see Note D) $453,028 Administrative expenses 350,771 803,799

Income from operations 186,073 Other revenues and gains 171,410

357,483 Other expenses and losses 126,060

Income before income tax 231,423 Income tax 66,934

Net income for the year $ 164,489

Earnings per common share $1.74

ILLUSTRATION 4-3 Condensed Income Statement

The importance of the components of income, as well as the bottom line, is illustrated in the recent case of Chipotle. Its stock had climbed fourfold in fi ve years and for good reason. The company had been reporting surprisingly high bottom-line income and investors were clamoring to buy. However, in a recent month, that pattern was broken—that is, Chipotle posted solid earnings, but investors sold. The reason? Analysts attribute the sell-off to Chipotle missing its target for revenues. The stock fell 21 percent, from $404 to $317, in a day. And Chipotle was not alone. Six in 10 large companies reported results in that same quarter that missed revenue targets. In response to the bad revenue news, Priceline.com fell $117 to $562 after reporting revenue that was lower than analysts had expected. The story has been the same for dozens of compa- nies across industries, from Coach, a luxury goods retailer, to

Boston Scientifi c, which sells medical devices, to glass- container maker Owens-Illinois.

The recent focus on the top line, revenue, arises because market expectations for revenues do not seem to jive with the companies’ optimistic profi t picture. And while companies might report a surprise in earnings, analysts will be focusing on reve- nues. Companies have been able to cut costs to compensate— laying off workers, squeezing remaining staff, and using technol- ogy to run more effi ciently—but there’s a limit to how much you can squeeze your workers and use technology to produce more. U.S. companies are just about as lean as any time in history.

As one analyst noted (in this economic environment), “you won’t be able to grow earnings much faster than revenue. . . . Analysts will have to revise down their earnings.” So watch the top line, as well as the bottom line.

WHAT DO THE NUMBERS MEAN? TOP LINE OR BOTTOM LINE?

Source: Associated Press, “Why Some Stocks Are Sinking Despite Big Profits,” The New York Times (August 12, 2012).

Format of the Income Statement 161

ILLUSTRATION 4-4 Sample Supporting Schedule

Note D: Selling expenses Sales salaries and commissions $202,644 Sales office salaries 59,200 Travel and entertainment 48,940 Advertising expense 38,315 Delivery expense 41,209 Shipping supplies and expense 24,712 Postage and stationery 16,788 Telephone and Internet expense 12,215 Depreciation of sales equipment 9,005

Total selling expenses $453,028

How much detail should a company include in the income statement? On the one hand, a company wants to present a simple, summarized statement so that readers can readily discover important factors. On the other hand, it wants to disclose the results of all activities and to provide more than just a skeleton report. As we show in Illustrations 4-3 and 4-4, the income statement always includes certain basic elements, but compa- nies can present them in various formats.

Single-Step Income Statements In reporting revenues, gains, expenses, and losses, some companies often use a format known as the single-step income statement instead of a multiple-step income state- ment. The single-step statement consists of just two groupings: revenues and expenses. Expenses are deducted from revenues to arrive at net income or loss, hence the expres- sion “single-step.” Frequently, companies report income tax separately as the last item before net income to indicate its relationship to income before income tax. Illustration 4-5 shows the single-step income statement of Cabrera Company.

9Accounting Trends and Techniques (New York: AICPA) recently reported that of the 500 companies surveyed, 411 employed the multiple-step form, and 89 employed the single-step income statement format.

ILLUSTRATION 4-5 Single-Step Income Statement

CABRERA COMPANY INCOME STATEMENT

FOR THE YEAR ENDED DECEMBER 31, 2017

Revenues

Net sales $2,972,413 Dividend revenue 98,500 Rent revenue 72,910

Total revenues 3,143,823

Expenses

Cost of goods sold 1,982,541 Selling expenses 453,028 Administrative expenses 350,771 Interest expense 126,060 Income tax expense 66,934

Total expenses 2,979,334

Net income $ 164,489

Earnings per common share $1.74

Companies that use the single-step income statement in financial reporting typi- cally do so because of its simplicity. That is, the primary advantage of the single-step format lies in its simple presentation and the absence of any implication that one type of revenue or expense item has priority over another. This format thus eliminates potential classification problems.9

162 Chapter 4 Income Statement and Related Information

REPORTING VARIOUS INCOME ITEMS Companies are generally allowed flexibility in the presentation of the components of income. However, the FASB developed specific guidelines in two important areas: what to include in income and how to report certain unusual or infrequent items.

What should be reported in net income and where it should be reported is contro- versial. For example, should companies report a gain or loss on sale of an investment as part of net income or report it directly in retained earnings? Should a company report a loss on discontinued operations differently than interest expense? What we therefore need is consistent and comparable income reporting practices. Develop- ing a framework for reporting income components is important to ensure useful information.

Furthermore, as our opening story discusses, we need consistent and comparable income reporting practices to avoid “promotional” information reported by compa- nies.10 Some users advocate a current operating performance approach to income reporting. These analysts argue that the most useful income measure reflects only regu- lar and recurring revenue and expense elements. Some unusual or infrequent (non- recurring) items do not reflect a company’s future earning power.

In contrast, others warn that a focus on operating income potentially misses important information about a company’s performance. Any gain or loss experienced by the company, whether directly or indirectly related to operations, contributes to its long-run profitability. As one analyst notes, “write-offs matter. . . . They speak to the volatility of (past) earnings.”11 As a result, analysts can use some nonoperating items to assess the riskiness of future earnings. Furthermore, determining which items are operating and which are infrequent or unusual requires judgment. This might lead to differences in the treatment of these items and to possible manipulation of income measures.

So, what to do? The accounting profession has adopted a modified all-inclusive concept. In this approach, companies record most items, including unusual or infre- quent ones, as part of net income.12 In addition, companies are required to highlight these items in the financial statements so that users can better determine the long-run earning power of the company. These income items fall into four general categories, which we discuss in the following sections:

1. Unusual and infrequent gains and losses 2. Discontinued operations 3. Noncontrolling interest 4. Earnings per share

Unusual and Infrequent Gains and Losses Companies that have unusual or infrequent gains and losses or both are required to disclose this information in the income statement or in the notes to the financial

LEARNING OBJECTIVE 4 Explain how to report various income items.

10The FASB and the IASB are working on a joint project on financial statement presentation, which is studying how to best report income as well as information presented in the balance sheet and the statement of cash flows. See http://www.fasb.org/project/financial_statement_presentation.shtml. 11A survey of 500 large public companies (Accounting Trends and Techniques (New York: AICPA)) documented that 106 of the 500 survey companies reported a write-down of assets (see also Illustration 4-6 on page 163). This highlights the importance of good reporting for these unusual or infrequent items. 12The FASB issued a statement of concepts that offers some guidance on this topic: “Recognition and Measurement in Financial Statements of Business Enterprises,” Statement of Financial Accounting Concepts No. 5 (Stamford, Conn.: FASB, 1984).

INTERNATIONAL PERSPECTIVE

In many countries, the “modified all-inclusive” income statement approach does not parallel that of the United States. For example, companies in these countries take some gains and losses directly to own- ers’ equity accounts instead of reporting them on the income statement.

Reporting Various Income Items 163

statements. In addition, additional disclosure is often needed in the notes to the finan- cial statements so that the users of the income statement understand the effect of these gains or losses on net income and future cash flows. These gains or losses are defined as follows:

(a) Unusual. High degree of abnormality and of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the company, taking into account the environment in which it operates.

(b) Infrequency of occurrence. Type of transaction that is not reasonably expected to recur in the foreseeable future, taking into account the environment in which the company operates.

Common types of unusual or infrequent gains and losses or both are as follows:

• Losses on write-down (impairment) of receivables; inventories; property, plant, and equipment; goodwill or other intangible assets.

• Restructuring charges. • Other gains and losses from sale or abandonment of property, plant and equipment. • Effects of a strike, including those against competitors and major suppliers. • Gains and losses on extinguishment (redemption) of debt obligations. • Gains and losses related to casualties such as fires, floods, and earthquakes. • Gains or losses on sale of investment securities. [1]

Illustration 4-6 identifies the most common types of unusual gains and losses reported in a survey of 500 large companies. Note that more than 40 percent of the sur- veyed firms reported restructuring charges, and nearly 60 percent of the companies reported write-downs or gains or losses on asset sales.

100

150

200

250

500

N um

be r

of C

om pa

ni es

Restructuring Charges

202

Write-Downs, Gains/Losses on Asset Sales

289

ILLUSTRATION 4-6 Number of Unusual Items Reported in a Recent Year by 500 Large Companies

See the FASB Codifi cation References (page 194).

As indicated earlier, revenues and expenses, other revenues and gains, and other expenses and losses should be reported as part of income before income taxes. Therefore, gains and losses from unusual or infrequent gains or losses or both are not reported net of tax. In practice, companies will generally itemize each gain or loss on the income statement or show one amount for all these items and then item- ize these items in the notes to the financial statements. For homework purposes, these unusual or infrequent gains or losses or both should be itemized and reported in the Other revenues and gains section or the Other expenses and losses section of the income statement. Gains and losses shown in the homework should be considered material and unusual or infrequent in nature or both.

164 Chapter 4 Income Statement and Related Information

Discontinued Operations A discontinued operation occurs when two things happen:

1. A company eliminates the results of operations of a component of the business. A component comprises operations and cash fl ows that can be clearly distinguished, operationally and for fi nancial reporting purposes.

2. The elimination of a component that represents a strategic shift, having a major effect on the company’s operations and fi nancial results. A strategic shift generally includes the disposal of (1) a major line of business, (2) a major geographical area, or (3) a major equity method investment. [2]

To illustrate, Softso has the following product lines that it manufactures and sells— beauty care, health care, and baby care. Within these product lines, it has a total of 18 brands. Each brand is considered a separate component because each brand comprises operations and cash flows that can be clearly distinguished, operationally and for finan- cial reporting purposes. Each product line represents a major line of business. Softso decides to eliminate the baby-care product line because it is suffering substantial losses. Softso should report the elimination of the baby-care product line as a discontinued operation because the baby-care line represents a major line of business and its disposal represents a major part of Softso’s operations (a strategic shift).

On the other hand, assume that Softso decides to remain in the baby-care business but will discontinue one brand in this product line because it is very unprofitable. Softso should not report the elimination of this brand as a discontinued operation because it does not represent a major part of Softso’s operations (disposing of it is not considered a strategic shift).

As indicated, the reporting of a discontinued operation involves strategic shifts that are substantial in nature. Here are some additional examples:

1. The sale of a product line that represents 15 percent of a company’s total revenues.

2. The sale of a geographical area that represents 20 percent of a company’s total assets. 3. The sale of a component that is an equity investment that represents 20 percent of a

company’s total assets.

Companies report as discontinued operations (in a separate income statement cate- gory) the gain or loss from disposal of a component of a business. In addition, companies report the results of operations of a component that has been or will be disposed of separately from continuing operations. Companies show the effects of discontinued operations net of tax as a separate category, after continuing opera- tions. [3]

To illustrate, Multiplex Products, Inc., a highly diversified company, decides to dis- continue its electronics division. During the current year, the electronics division lost $300,000 (net of tax). Multiplex sold the division at the end of the year at a loss of $500,000 (net of tax). Multiplex determines that the electronics division discontinuation meets the strategic shift criteria because the division is a major line of business (its assets exceed 20 percent of Multiplex’s total assets). Illustration 4-7 shows the reporting of discontin- ued operations for Multiplex.

ILLUSTRATION 4-7 Income Statement Presentation of Discontinued Operations

Income from continuing operations $20,000,000 Discontinued operations Loss from operation of discontinued electronics division (net of tax) $300,000 Loss from disposal of electronics division (net of tax) 500,000 (800,000)

Net income $19,200,000

Reporting Various Income Items 165

Companies use the phrase “Income from continuing operations” only when gains or losses on discontinued operations occur.

A company that reports a discontinued operation must report on the face of the income statement the per share effect of income from continuing operations and net income. In addition, it must report per share amounts for discontinued items either on the face of the income statement or in the notes to the financial statements.13 To illus- trate, consider the income statement for Poquito Industries Inc., shown in Illustration 4-8. Poquito had 100,000 shares outstanding for the entire year. Notice the order in which Poquito shows the data, with per share information at the bottom. The Poquito income statement, as Illustration 4-8 shows, is highly condensed. Poquito would need to describe items such as “Other expenses and losses” and “Discontinued operations” fully and appropriately in the statement or related notes.

13In practice, a company will generally report only one line on the income statement, such as “Loss on discontinued operations, net of tax,” and then in the notes explain the two components of the loss that total $800,000. For homework purposes, report both amounts on the face of the income statement, net of tax, if both amounts are provided.

Intraperiod Tax Allocation As indicated in Illustrations 4-7 and 4-8, companies report discontinued operations on the income statement net of tax. The allocation of tax to this item is called intraperiod tax allocation, that is, allocation within the income statement of a period. It relates the income tax expense (sometimes referred to as the income tax provision) of the fiscal period to the specific items that give rise to the amount of the income tax provision.

Intraperiod tax allocation helps financial statement users better understand the impact of income taxes on the various components of net income. For example, readers of financial statements will understand how much income tax expense relates to “Income

POQUITO INDUSTRIES INC. INCOME STATEMENT

FOR THE YEAR ENDED DECEMBER 31, 2017

Sales revenue $1,420,000 Cost of goods sold 600,000

Gross profit 820,000 Selling and administrative expenses 320,000

Income from operations 500,000 Other revenues and gains Interest revenue 10,000 Other expenses and losses Loss on disposal of part of Textile Division $ 5,000 Loss on sale of investments 30,000 Interest expense 15,000 50,000

Income before income tax 460,000 Income tax 184,000

Income from continuing operations 276,000 Discontinued operations Income from operations of Pizza Division, less applicable income tax of $24,800 54,000 Loss on disposal of Pizza Division, less applicable income tax of $41,000 90,000 36,000

Net income $ 240,000

Per share Income from continuing operations $2.76 Income from operations of discontinued division, net of tax 0.54 Loss on disposal of discontinued operation, net of tax 0.90

Net income $2.40

ILLUSTRATION 4-8 Income Statement

166 Chapter 4 Income Statement and Related Information

from continuing operations” and how much to discontinued operations. This approach helps users to better predict the amount, timing, and uncertainty of future cash flows. In addition, intraperiod tax allocation discourages statement readers from using pretax measures of performance when evaluating financial results, and thereby recognizes that income tax expense is a real cost.

Companies use intraperiod tax allocation on the income statement for (1) income from continuing operations and (2) discontinued operations. The general concept is “let the tax follow the income.”

To compute the income tax expense attributable to “Income from continuing opera- tions,” a company computes the income tax expense related to both the revenue and expense transactions as well as other income and expense used in determining this income subtotal. (In this computation, the company does not consider the tax conse- quences of items excluded from the determination of “Income from continuing opera- tions.”) Companies then associate a separate tax effect for discontinued operations. Here, we look in more detail at the calculation of intraperiod tax allocation for a discon- tinued gain or discontinued loss.

Discontinued Operations (Gain) In applying the concept of intraperiod tax allocation, assume that Schindler Co. has income before income tax of $250,000. It has a gain of $100,000 from a discontinued operation. Assuming a 30 percent income tax rate, Schindler presents the following information on the income statement.

ILLUSTRATION 4-9 Intraperiod Tax Allocation, Discontinued Operations Gain

Income before income tax $250,000 Income tax 75,000

Income from continuing operations 175,000 Gain on discontinued operations $100,000 Less: Applicable income tax 30,000 70,000

Net income $245,000

Schindler determines the income tax of $75,000 ($250,000 × 30%) attributable to “Income before income tax” from revenue and expense transactions related to this income. Schindler omits the tax consequences of items excluded from the determination of “Income before income tax.” The company shows a separate tax effect of $30,000 related to the “Gain on discontinued operations.”

Discontinued Operations (Loss) To illustrate the reporting of a loss from discontinued operations, assume that Schindler Co. has income before income tax of $250,000. It also has a loss from discon- tinued operations of $100,000. Assuming a 30 percent tax rate, Schindler presents the income tax on the income statement as shown in Illustration 4-10. In this case, the loss provides a positive tax benefit of $30,000. Schindler, therefore, subtracts it from the $100,000 loss.

Income before income tax $250,000 Income tax 75,000

Income from continuing operations 175,000 Loss from discontinued operations $100,000 Less: Applicable income tax reduction 30,000 70,000

Net income $105,000

ILLUSTRATION 4-10 Intraperiod Tax Allocation, Discontinued Operations Loss

Reporting Various Income Items 167

Companies may also report the tax effect of a discontinued item by means of a note disclosure, as illustrated below.

Income before income tax $250,000 Income tax 75,000

Income from continuing operations 175,000 Loss on discontinued operations, less applicable income tax reduction (Note 1) 70,000

Net income $105,000

Note 1: During the year, the Company suffered a loss on discontinuing operations of $70,000, net of applicable income tax reduction of $30,000.

ILLUSTRATION 4-11 Note Disclosure of Intraperiod Tax Allocation

Noncontrolling Interest A company like The Coca-Cola Company owns substantial interests in other companies. Coca-Cola generally consolidates the financial results of these companies into its own financial statements. In these cases, Coca-Cola is referred to as the parent, and the other companies are referred to as subsidiaries. Noncontrolling interest is then the portion of equity (net assets) interest in a subsidiary not attributable to the parent company.

To illustrate, assume that Coca-Cola acquires 70 percent of the outstanding stock of Koch Company. Because Coca-Cola owns more than 50 percent of Koch, it consolidates Koch’s financial results with its own. Consolidated net income is then allocated to the controlling (Coca-Cola) and noncontrolling stockholders’ percentage of ownership in Koch. In other words, under this arrangement, the ownership of Koch is divided into two classes: (1) the majority interest represented by stockholders who own the control- ling interest, and (2) the noncontrolling interest (sometimes referred to as the minority interest) represented by stockholders who are not part of the controlling group. When Coca-Cola prepares a consolidated income statement, GAAP requires that net income be allocated to the controlling and noncontrolling interest. This allocation is reported at the bottom of the income statement, after net income.

An example of how Coca-Cola reports its noncontrolling interest is shown in Illus- tration 4-12.

ILLUSTRATION 4-12 Presentation of Noncontrolling Interest

The noncontrolling interest amounts are not an expense or dividend, but are allocations of net income (loss) to the noncontrolling interest. [4]

Earnings per Share A company customarily sums up the results of its operations in one important figure: net income. However, the financial world has widely accepted an even more distilled and compact figure as the most significant business indicator—earnings per share (EPS).

The computation of earnings per share is usually straightforward. Earnings per share is net income minus preferred dividends (income available to common stock- holders), divided by the weighted average of common shares outstanding.14

14In calculating earnings per share, companies deduct preferred dividends from net income if the dividends are declared or if they are cumulative though not declared. Only the net income attributable to the controlling interest should be used in computing earnings per share.

The Coca-Cola Company (in millions)

Consolidated net income $7,124 Less: Net income attributable to noncontrolling interests 26

Net income attributable to stockholders of The Coca-Cola Company $7,098

168 Chapter 4 Income Statement and Related Information

To illustrate, assume that Lancer, Inc. reports net income of $350,000. It declares and pays preferred dividends of $50,000 for the year. The weighted-average number of com- mon shares outstanding during the year is 100,000 shares. Lancer computes earnings per share of $3, as shown in Illustration 4-13.

ILLUSTRATION 4-13 Equation Illustrating Computation of Earnings per Share

Note that EPS measures the number of dollars earned by each share of common stock. It does not represent the dollar amount paid to stockholders in the form of dividends.

Prospectuses, proxy material, and annual reports to stockholders commonly use the “net income per share” or “earnings per share” ratio. The financial press, statistical ser- vices like Standard & Poor’s, and Wall Street securities analysts also highlight EPS. Because of its importance, companies must disclose earnings per share on the face of the income statement. A company that reports a discontinued operation must report per share amounts for this line item either on the face of the income statement or in the notes to the financial statements. [5]

To illustrate, an excerpt from the income statement for Poquito Industries Inc. is presented in Illustration 4-14 (taken from Illustration 4-8 on page 165). Notice the per share information presented at the bottom. Assume that the company had 100,000 shares outstanding for the entire year. The Poquito income statement, as Illustration 4-14 shows, is highly condensed. As discussed, Poquito would need to describe items such as “Discontinued operations” fully and appropriately in the statement or related notes.

ILLUSTRATION 4-14 Income Statement POQUITO INDUSTRIES INC.INCOME STATEMENT (partial)

FOR THE YEAR ENDED DECEMBER 31, 2017

Income from continuing operations $276,000 Discontinued operations Income from operations of Pizza Division, less applicable income tax of $24,800 $54,000 Loss on disposal of Pizza Division, less applicable income tax of $41,000 90,000 36,000

Net income $240,000

Per share of common stock Income from continuing operations $2.76 Income from operations of discontinued division, net of tax 0.54 Loss on disposal of discontinued operation, net of tax 0.90

Net income $2.40

Net Income − Preferred Dividends Weighted-Average Common Shares Outstanding

= Earnings per Share

$350,000 − $50,000 100,000

= $3

As indicated earlier, many corporations have simple capital structures that include only common stock. For these companies, a presentation such as “Earnings per common share” is appropriate on the income statement. In many instances, however, companies’

Reporting Various Income Items 169

earnings per share are subject to dilution (reduction) in the future because existing con- tingencies permit the issuance of additional common shares. [6]15

Summary of Various Income Items Because of the numerous intermediate income figures created by the reporting of non- recurring items, readers must carefully evaluate earnings information reported by the financial press. Illustration 4-15 summarizes the basic concepts that we previously dis- cussed. Although simplified, the chart provides a useful framework for determining the treatment of special items affecting the income statement.

15The earnings per share effects of noncontrolling interest should also be presented. In addition, the amounts of income from continuing operations and discontinued operations (if present) attributable to the controlling interest should be disclosed. We discuss the computational problems involved in these situations for earnings per share computations in Chapter 16.

Type of Situation Criteria Examples Placement on Income Statement

Unusual or Material unusual, infrequent, Write-downs of receivables, Reported in “Other revenues and infrequent gains or both. inventories, property, and gains” or “Other expenses and or losses intangibles; restructurings; losses” section. (Not shown gains or losses from sales of net of tax.) assets used in business.

Discontinued Elimination of the results of Sale by diversified company of Show in separate section after operations operations of a component of major division that represents continuing operations. (Shown the business with cash flows only activities in electronics in- net of tax.) that can be clearly distinguished dustry. Food distributor that and for which the elimination sells wholesale to supermarket represents a strategic shift. chains and through fast-food restaurants decides to discontinue the division that sells to one of two classes of customers.

Noncontrolling Allocation of net income or loss Net income (loss) attributable to Report as a separate item interest divided between two classes: noncontrolling shareholders. below net income or loss as an (1) the majority interest allocation of the net income or represented by the shareholders loss (not as an item of who own the controlling interest, income or expense). and (2) the noncontrolling interest (often referred to as the minority interest).

Earnings per share Must be reported on the face of the Net income minus preferred dividends Report separate EPS for income statement. divided by weighted-average income from continuing shares outstanding operations (if applicable) and net income.

ILLUSTRATION 4-15 Summary of Various Items in the Income Statement

WHAT DO THE NUMBERS MEAN? DIFFERENT INCOME CONCEPTS As mentioned in the opening story, the FASB has a project related to presentation of financial statements. In 2008, it issued an exposure draft that presented examples of what these new financial statements might look like. The Board also conducted field tests on two groups: preparers and users. Preparers were asked to recast their financial statements and then comment on the results. Users

examined the recast statements and commented on their usefulness.

One part of the fi eld test asked analysts to indicate which primary performance metric they use or create from a com- pany’s income statement. They were provided with the foll- owing options: (a) Net income; (b) Pretax income; (c) Income before interest and taxes (EBIT); (d) Income before interest,

170 Chapter 4 Income Statement and Related Information

OTHER REPORTING ISSUES In this section, we discuss reporting issues related to (1) accounting changes and errors, (2) retained earnings statement, and (3) comprehensive income.

Accounting Changes and Errors Changes in accounting principle, change in estimates, and corrections of errors require unique reporting provisions.

Changes in Accounting Principle Changes in accounting occur frequently in practice because important events or condi- tions may be in dispute or uncertain at the statement date. One type of accounting change results when a company adopts a different accounting principle. Changes in accounting principle include a change in the method of inventory pricing from FIFO to average-cost, or a change in accounting for construction contracts from the percentage- of-completion to the completed-contract method. [7]16

A company recognizes a change in accounting principle by making a retrospective adjustment to the financial statements. Such an adjustment recasts the prior years’ statements on a basis consistent with the newly adopted principle. The company records the cumulative effect of the change for prior periods as an adjustment to beginning retained earnings of the earliest year presented.

To illustrate, Gaubert Inc. decided in March 2017 to change from FIFO to weighted- average inventory pricing. Gaubert’s income before income tax, using the new weighted- average method in 2017, is $30,000. Illustration 4-16 presents the pretax income data for 2015 and 2016 for this example.

LEARNING OBJECTIVE 5 Understand the reporting of accounting changes and errors.

16In Chapter 22, we examine in greater detail the problems related to accounting changes, and changes in estimates and errors.

UNDERLYING CONCEPTS

Companies can change principles, but they must demonstrate that the newly adopted principle is preferable to the old one. Such changes result in lost consistency from period to period.

ILLUSTRATION 4-16 Calculation of a Change in Accounting Principle

Excess of Weighted- FIFO Average over Weighted- Year FIFO Method Average Method

2015 $40,000 $35,000 $5,000 2016 30,000 27,000 3,000

Total $8,000

taxes, depreciation, and amortization (EBITDA); (e) Operating income; (f) Comprehensive income; and (g) Other. The adja- cent chart highlights their responses.

As indicated, Operating income (31%) and EBITDA (27%) were identifi ed as the two primary performance metrics that respondents use or create from a company’s income state- ment. A majority of the respondents identifi ed a primary perfor- mance metric that uses net income as its foundation (pretax income would be in this group). Clearly, users and preparers look at more than just the bottom-line income number, which supports the common practice of providing subtotals within the income statement.

Source: “FASB-IASB Report on Analyst Field Test Results,” Financial Statement Presentation Informational Board Meeting (September 21, 2009).

What Metrics Do Analysts Create from the Income Statement?

Net income

Comprehensive income

Operating income

EBIT

Pretax income

Other

EBITDA

31%

6% 6% 10% 7%

13%

27%

Other Reporting Issues 171

Thus, under the retrospective approach, the company recasts the prior years’ income numbers under the newly adopted method. This approach therefore preserves compa- rability across years.

Changes in Accounting Estimates Changes in accounting estimates are inherent in the accounting process. For exam- ple, companies estimate useful lives and salvage values of depreciable assets, uncol- lectible receivables, inventory obsolescence, and the number of periods expected to benefit from a particular expenditure. Not infrequently, due to time, circumstances, or new information, even estimates originally made in good faith must be changed. A company accounts for such changes in estimates in the period of change if they affect only that period, or in the period of change and future periods if the change affects both.

To illustrate a change in estimate that affects only the period of change, assume that DuPage Materials Corp. consistently estimated its bad debt expense at 1 percent of accounts receivable. In 2017, however, DuPage determines that it must revise upward the estimate of bad debts for accounts receivable outstanding to 2 percent, or double the prior years’ percentage. The 2 percent rate is necessary to reduce accounts receivable to net realizable value. Using 2 percent results in a bad debt charge of $240,000, or double the amount using the 1 percent estimate for prior years. DuPage records the bad debt expense and related allowance at December 31, 2017 (assuming a zero balance in the allowance), as follows.

Bad Debt Expense 240,000 Allowance for Doubtful Accounts 240,000

DuPage includes the entire change in estimate in 2017 income because the change does not affect future periods. Companies do not handle changes in estimate retro- spectively. That is, such changes are not carried back to adjust prior years. Changes in estimate are not considered errors.

Corrections of Errors Errors occur as a result of mathematical mistakes, mistakes in the application of accounting principles, or oversight or misuse of facts that existed at the time finan- cial statements were prepared. In recent years, many companies have corrected for errors in their financial statements. The errors involved such items as improper reporting of revenue, accounting for stock compensation, allowances for receivables, inventories, and other provisions.

Companies correct errors by making proper entries in the accounts and reporting the corrections in the financial statements. Corrections of errors are treated as prior period adjustments, similar to changes in accounting principles. Companies record a correction of an error in the year in which it is discovered. They report the error in the financial statements as an adjustment to the beginning balance of retained earnings. If a

ILLUSTRATION 4-17 Income Statement Presentation of a Change in Accounting Principle

2017 2016 2015

Income before income tax $30,000 $27,000 $35,000 Income tax 9,000 8,100 10,500

Net income $21,000 $18,900 $24,500

Illustration 4-17 shows the information Gaubert presented in its comparative income statements, based on a 30 percent tax rate.

172 Chapter 4 Income Statement and Related Information

company prepares comparative financial statements, it should restate the prior state- ments for the effects of the error.

To illustrate, in 2018, Hillsboro Co. determined that it incorrectly overstated its accounts receivable and sales revenue by $100,000 in 2017. In 2018, Hillsboro makes the following entry to correct for this error (ignore income taxes).

Retained Earnings 100,000 Accounts Receivable 100,000

Beginning retained earnings is debited in 2018 because sales revenue, and there- fore net income, was overstated in 2017 (hence, Retained Earnings was overstated). Accounts Receivable is credited to reduce this overstated balance to the correct amount.

Summary The impact of changes in accounting principle and error corrections are debited or cred- ited directly to retained earnings for the amounts related to prior periods. Illustration 4-18 summarizes the basic concepts related to these two items, as well as the accounting and reporting for changes in estimates. Although simplified, the chart provides a useful framework for determining the treatment of special items affecting the income statement.

Type of Situation Criteria Examples Placement on Income Statement

Changes in Change from one generally Change in the basis of inventory Recast prior years’ income accounting accepted accounting principle pricing from FIFO to average- statement on the same basis as principle to another. cost. the newly adopted principle. (Shown net of tax.)

Changes in Normal, recurring corrections and Changes in the realizability of Show change only in the affected estimates adjustments. receivables and inventories; accounts in current and future changes in estimated lives of periods. (Not shown net of tax.) equipment, intangible assets; changes in estimated liability for warranty costs, income taxes, and salary payments.

Corrections of Mistake, misuse of facts. Error in reporting income and Treat as prior period adjustment; errors expenses. restate prior years’ income statements to correct for error. (Shown net of tax.)

ILLUSTRATION 4-18 Summary of Accounting Changes and Errors

Retained Earnings Statement Net income increases retained earnings. A net loss decreases retained earnings. Both cash and stock dividends decrease retained earnings. Changes in accounting principles (generally) and prior period adjustments may increase or decrease retained earnings. Companies charge or credit these adjustments (net of tax) to the opening balance of retained earnings. This excludes the adjustments from the determination of net income for the current period.

Companies may show retained earnings information in different ways. For exam- ple, some companies prepare a separate retained earnings statement, as Illustration 4-19 shows.

LEARNING OBJECTIVE 6 Prepare a retained earnings statement.

Other Reporting Issues 173

17Accounting Trends and Techniques indicates that most companies (490 of 500 surveyed) present changes in retained earnings either within the statement of stockholders’ equity (486 firms) or in a separate statement of retained earnings (4 firms). Only 1 of the 500 companies prepares a combined statement of income and retained earnings. 18We further discuss available-for-sale debt investments in Chapter 17. Additional examples of other comprehensive items are translation gains and losses on foreign currency, unrealized gains and losses on certain hedging transactions, and adjustments related to pensions. Corrections of errors and changes in accounting principles are not considered other comprehensive income items.

The reconciliation of the beginning to the ending balance in retained earnings pro- vides information about why net assets increased or decreased during the year.17 The association of dividend distributions with net income for the period indicates what management is doing with earnings: It may be “plowing back” into the business part or all of the earnings, distributing all current income, or distributing current income plus the accumulated earnings of prior years.

Restrictions of Retained Earnings Companies often restrict retained earnings to comply with contractual requirements, board of directors’ policy, or current necessity. Generally, companies disclose in the notes to the financial statements the amounts of restricted retained earnings. In some cases, companies transfer the amount of retained earnings restricted to an account titled Appro- priated Retained Earnings. The retained earnings section may therefore report two sepa- rate amounts—(1) retained earnings free (unrestricted) and (2) retained earnings appro- priated (restricted). The total of these two amounts equals the total retained earnings.

Comprehensive Income Companies generally include in net income all revenues, expenses, gains, and losses rec- ognized during the period. These items are classified within the income statement so that financial statement readers can better understand the significance of various components of net income. Changes in accounting principles and corrections of errors are excluded from the calculation of net income because their effects relate to prior periods.

In recent years, the use of fair values for measuring assets and liabilities has increased. As a result, reporting of gains and losses related to changes in fair value have placed a strain on income reporting. Because fair values are continually changing, some argue that recognizing these gains and losses in net income is misleading. The FASB agrees and has identified a limited number of transactions that should be recorded in other comprehensive income. The aggregate amount of the other comprehensive income item is reported in stockholders’ equity as Accumulated Other Comprehensive Income. One example is unrealized gains and losses on available-for-sale debt investments.18 These gains and losses are excluded from net income, thereby reducing volatility in net

LEARNING OBJECTIVE 7 Explain how to report other comprehensive income.

ILLUSTRATION 4-19 Retained Earnings Statement

STRICKER INC. RETAINED EARNINGS STATEMENT

FOR THE YEAR ENDED DECEMBER 31, 2017

Retained earnings, January 1, as reported $1,050,000 Correction for understatement of net income in prior period (net of tax) (inventory error) 50,000

Retained earnings, January 1, as adjusted 1,100,000 Add: Net income 360,000

1,460,000

Less: Cash dividends $100,000 Stock dividends 200,000 300,000

Retained earnings, December 31 $1,160,000

174 Chapter 4 Income Statement and Related Information

income due to fluctuations in fair value. At the same time, disclosure of the potential gain or loss is provided.

Companies include these items that bypass the income statement in a measure called comprehensive income. Comprehensive income includes all changes in equity during a period except those resulting from investments by owners and dis- tributions to owners. Comprehensive income, therefore, includes the following: all revenues and gains, expenses and losses reported in net income, and all gains and losses that bypass net income but affect stockholders’ equity. These items—non- owner changes in equity that bypass the income statement—are referred to as other comprehensive income.

Companies must display the components of other comprehensive income in one of two ways: (1) a single continuous statement (one statement approach) or (2) two sepa- rate, but consecutive statements of net income and other comprehensive income (two statement approach). The one statement approach is often referred to as the statement of comprehensive income. The two statement approach uses the traditional term income statement for the first statement and the comprehensive income statement for the sec- ond statement. [8]

Under either approach, companies display each component of net income and each component of other comprehensive income. In addition, net income and comprehensive income are reported. Companies are not required to report earnings per share informa- tion related to comprehensive income.19

We illustrate these two alternatives in the next two sections. In each case, assume that V. Gill Inc. reports the following information for 2017: sales revenue $800,000, cost of goods sold $600,000, operating expenses $90,000, and an unrealized holding gain on available-for-sale debt investments of $30,000, net of tax.

One Statement Approach In this approach, the traditional net income is a subtotal, with total comprehensive income shown as a final total. The combined statement has the advantage of not requir- ing the creation of a new financial statement. However, burying net income as a sub- total on the statement is a disadvantage. Illustration 4-20 shows the one statement for- mat for V. Gill.

19A company must display the components of other comprehensive income either (1) net of related tax effects, or (2) before related tax effects, with one amount shown for the aggregate amount of tax related to the total amount of other comprehensive income. Both alternatives must show each component of other comprehensive income, net of related taxes either in the face of the statement or in the notes. Accounting Trends and Techniques indicates that 89 of 490 surveyed companies reporting tax effects provided it in the notes.

INTERNATIONAL PERSPECTIVE

GAAP and IFRS are now converged with re- spect to comprehensive income reporting.

V. GILL INC. STATEMENT OF COMPREHENSIVE INCOME

FOR THE YEAR ENDED DECEMBER 31, 2017

Sales revenue $800,000 Cost of goods sold 600,000

Gross profit 200,000 Operating expenses 90,000

Net income 110,000 Other comprehensive income Unrealized holding gain, net of tax 30,000

Comprehensive income $140,000

ILLUSTRATION 4-20 One Statement Format: Comprehensive Income

Other Reporting Issues 175

Two Statement Approach Illustration 4-21 shows the two statement format for V. Gill. Reporting compre- hensive income in a separate statement indicates that the gains and losses identi- fied as other comprehensive income have the same status as traditional gains and losses.

Statement of Stockholders’ Equity In addition to a comprehensive income statement, companies also present a state- ment of stockholders’ equity (often referred to as statement of changes in stockhold- ers’ equity). This statement reports the changes in each stockholders’ equity account and in total stockholders’ equity during the year. Companies often prepare in colum- nar form the statement of stockholders’ equity. In this format, they use columns for each account and for total stockholders’ equity. Stockholders’ equity is generally comprised of contributed capital (common and preferred stock and additional paid- in capital), retained earnings, and the accumulated balances in other comprehensive income. The statement reports the change in each stockholders’ equity account and in total stockholders’ equity for the period. The following items are disclosed in this statement.

1. Contributions (issuances of shares) and distributions (dividends) to owners. 2. Reconciliation of the carrying amount of each component of stockholders’ equity

from the beginning to the end of the period.

To illustrate, assume the same information for V. Gill (on page 174). The com- pany has the following stockholders’ equity account balances at the beginning of 2017: Common Stock $300,000, Retained Earnings $50,000, and Accumulated Other Comprehensive Income $60,000. No changes in the Common Stock account occurred during the year. Illustration 4-22 (on page 176) shows a statement of stockholders’ equity for V. Gill.

ILLUSTRATION 4-21 Two Statement Format: Comprehensive Income

V. GILL INC. INCOME STATEMENT

FOR THE YEAR ENDED DECEMBER 31, 2017

Sales revenue $800,000 Cost of goods sold 600,000

Gross profit 200,000 Operating expenses 90,000

Net income $110,000

V. GILL INC. COMPREHENSIVE INCOME STATEMENT

FOR THE YEAR ENDED DECEMBER 31, 2017

Net income $110,000 Other comprehensive income Unrealized holding gain, net of tax 30,000

Comprehensive income $140,000

176 Chapter 4 Income Statement and Related Information

Balance Sheet Presentation Regardless of reporting in one statement or two, V. Gill reports accumulated other com- prehensive income of $90,000 in the stockholders’ equity section of the balance sheet as follows.

By providing information on the components of comprehensive income, as well as accu- mulated other comprehensive income, the company communicates information about all changes in net assets. With this information, users will better understand the quality of the company’s earnings.

ILLUSTRATION 4-23 Presentation of Accumulated Other Comprehensive Income in the Balance Sheet

V. GILL INC. BALANCE SHEET

AS OF DECEMBER 31, 2017 (STOCKHOLDERS’ EQUITY SECTION)

Stockholders’ equity Common stock $300,000 Retained earnings 160,000 Accumulated other comprehensive income 90,000

Total stockholders’ equity $550,000

YOU WILL WANT TO READ THE IFRS INSIGHTS ON PAGES 195–199 For discussion of IFRS related to the income statement.

As indicated in the chapter, information reported in the income statement is important to meeting the objective of fi nancial reporting. However, there is debate over income reporting practices, be it the controversy over pro forma reporting or whether to report comprehensive income in a one statement or a two statement format. In response to these debates and to differences between income reporting under U.S. GAAP and IFRS, standard-setters are working on a project to improve the usefulness of the income statement.

Work to date has resulted in two core principles for fi nan- cial statement presentation (for the income statement, balance sheet, and the statement of cash fl ows) based on the objective of fi nancial reporting:

1. Disaggregate information so that it is useful in pre- dicting an entity’s future cash fl ows. Disaggregation means separating resources by the activity in which they are used and by their economic characteristics.

2. Portray a cohesive fi nancial picture of a company’s activities. A cohesive fi nancial picture means that the relationship between items across fi nancial statements is clear and that a company’s fi nancial statements comple- ment each other as much as possible.

Cohesiveness could be addressed by using the same classifi cations across the balance sheet, income statement, and statement of cash fl ows. The proposed model classifi es

EVOLVING ISSUE INCOME REPORTING

ILLUSTRATION 4-22 Presentation of Comprehensive Income in Stockholders’ Equity Statement

V. GILL INC. STATEMENT OF STOCKHOLDERS’ EQUITY

FOR THE YEAR ENDED DECEMBER 31, 2017

Accumulated Other Retained Comprehensive Common Total Earnings Income Stock

Beginning balance $410,000 $ 50,000 $60,000 $300,000 Net income 110,000 110,000 Other comprehensive income Unrealized holding gain, net of tax 30,000 30,000

Ending balance $550,000 $160,000 $90,000 $300,000

Review and Practice 177

activities as business or fi nancing, although some have sug- gested that each statement be segregated into operating, investing, and fi nancing activities.

The statement presentation project is currently inactive on the Boards’ joint agenda (see www.fasb.org and click on

Inactive Joint FASB/IASB Projects under the Projects tab), but it is expected to restart once the projects on fi nancial instruments, revenue recognition, and leases are completed.

REVIEW AND PRACTICE KEY TERMS REVIEW

LEARNING OBJECTIVES REVIEW 1 Understand the uses and limitations of an income statement. The income statement is useful because it provides

investors and creditors with information that helps them predict the amounts, timing, and uncertainty of future cash flows. Also, the income statement helps users determine the risk (level of uncertainty) of not achieving particular cash flows. The limitations of an income statement are as follows. (1) The statement does not include many items that contribute to general growth and well-being of a company. (2) Income numbers are often affected by the accounting methods used. (3) Income measures are subject to estimates.

The transaction approach focuses on the activities that occurred during a given period. Instead of presenting only a net change in net assets, it discloses the components of the change. The transaction approach to income measurement requires the use of revenue, expense, loss, and gain accounts.

2 Describe the content of the income statement. The major elements of the income statement are as follows. (1) Revenues: Inflows or other enhancements of assets of an entity or settlements of its liabilities during a period from de-

livering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

(2) Expenses: Outflows or other using-up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.

(3) Gains: Increases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from revenues or investments by owners.

(4) Losses: Decreases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from expenses or distributions to owners.

3 Prepare an income statement. In a single-step income statement, just two groupings exist: revenues and expenses. Expenses are deducted from revenues to arrive at net income or loss—a single subtraction. Frequently, companies report income tax separately as the last item before net income.

accumulated other comprehensive income, 176

Appropriated Retained Earnings, 173

capital maintenance approach, 156(n)

changes in accounting estimates, 171

changes in accounting principle, 170

comprehensive income, 174

current operating performance approach, 162

discontinued operation, 164 earnings management, 155 earnings per share, 167 income statement, 154 intraperiod tax allocation,

165

modified all-inclusive concept, 162

multiple-step income statement, 157

noncontrolling (minority) interest, 167

other comprehensive income, 174

prior period adjustments, 171

quality of earnings, 155 single-step income

statement, 161 statement of comprehensive

income (comprehensive income statement), 154(n)

statement of stockholders’ equity, 175

transaction approach, 156

A multiple-step income statement shows two further classifications: (1) a separation of operating results from those obtained through the nonoperating activities of the company, and (2) a classification of expenses by functions, such as merchandising or manufacturing, selling, and administration.

4 Explain how to report various income items. Companies generally include unusual or infrequent gains or losses or both or non-recurring items in the income statement as follows. (1) Other items of a material amount that are of an unusual or infrequent nature or both are separately disclosed as a component of continuing operations. (2) Discontinued operations are classified as a separate item, after income from continuing operations. (3) If a company holds a noncontrolling interest in a subsidiary company, it must present an allocation of net income or loss that is attributable to the noncontrolling interest.

Companies must disclose earnings per share on the face of the income statement. If the company has a discontinued item, it must also report income from continuing operations, discontinued operations, and net income on a per share basis.

5 Understand the reporting of accounting changes and errors. Changes in accounting principles and corrections of errors are adjusted through retained earnings. Changes in estimates are a normal part of the accounting process. The effects of these changes are handled prospectively, with the effects recorded in income in the period of change and in future periods without adjustment to retained earnings.

6 Prepare a retained earnings statement. The retained earnings statement should disclose net income (loss), dividends, adjustments due to changes in accounting principles, error corrections, and restrictions of retained earnings.

7 Explain how to report other comprehensive income. Companies report the components of other comprehensive income in one of two ways: (1) a single statement of comprehensive income (one statement format) or (2) in a second statement (two statement format).

ENHANCED REVIEW AND PRACTICE Go online for multiple-choice questions with solutions, review exercises with solutions, and a full glossary of all key terms.

178 Chapter 4 Income Statement and Related Information

PRACTICE PROBLEM Presented below are 11 income statement items from Braun Company for the year ended December 31, 2017.

Sales revenue $2,700,000 Cost of goods sold 1,150,000 Interest revenue 15,000 Loss from abandonment of plant assets 45,000 Gain from extinguishment of debt 28,000 Selling expenses 290,000 Administrative expenses 190,000 Effect of change in estimated useful lives of fixed assets (included in administrative expenses) 35,000 Loss from earthquake 30,000 Gain on disposal of discontinued operation 50,000

Instructions (a) Using the information above, prepare a condensed multiple-step income statement. Assume a tax rate of 30% and 100,000

shares of common stock outstanding during 2017. (b) Compute comprehensive income for Braun in 2017, assuming Braun had an unrealized holding loss on an available-for-

sale debt investment, net of tax, $12,000.

Questions 179

1. What kinds of questions about future cash flows do investors and creditors attempt to answer with informa- tion in the income statement?

2. How can information based on past transactions be used to predict future cash flows?

3. Identify at least two situations in which important changes in value are not reported in the income statement.

4. Identify at least two situations in which application of different accounting methods or accounting estimates results in difficulties in comparing companies.

5. Explain the transaction approach to measuring income. Why is the transaction approach to income measurement preferable to other ways of measuring income?

6. What is earnings management? 7. How can earnings management affect the quality of

earnings?

8. Why should caution be exercised in the use of the net income figure derived in an income statement? What are the objectives of generally accepted accounting princi- ples in their application to the income statement?

9. A Wall Street Journal article noted that Apple reported higher income than its competitors by using a more aggressive policy for recognizing revenue on future upgrades to its products. Some contend that Apple’s quality of earnings is low. What does the term “quality of earnings” mean?

10. What is the major distinction (a) between revenues and gains and (b) between expenses and losses?

11. What are the advantages and disadvantages of the single-step income statement?

12. What is the basis for distinguishing between operating and nonoperating items?

QUESTIONS

Exercises, Problems, Problem Solution Walkthrough Videos, and many more assessment tools and resources are available for practice in WileyPLUS.

SOLUTION

(a) BRAUN COMPANY INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2017

Sales revenue $2,700,000 Cost of goods sold 1,150,000

Gross profit 1,550,000 Selling expenses $290,000 Administrative expenses 190,000 480,000

Income from operations 1,070,000 Other revenues and gains Interest revenue 15,000 Gain on debt extinguishment 28,000 43,000

Other expenses and losses Loss from plant abandonment 45,000 Loss from earthquake 30,000 75,000

Income before income tax 1,038,000 Income tax (30%) 311,400

Income from continuing operations 726,600 Discontinued operations Gain from disposal of discontinued operation 50,000 Less: Applicable income tax 15,000 35,000

Net income $ 761,600 Per share of common stock Income from continuing operations $ 7.27 Discontinued operations 0.35

Net income $ 7.62

(b) Net income $761,600 Unrealized holding loss on available-for-sale investment, net of tax 12,000

Comprehensive income $749,600

180 Chapter 4 Income Statement and Related Information

13. Distinguish between the modified all-inclusive income statement and the current operating performance income statement. According to present generally accepted accounting principles, which is recommended? Explain.

14. How should correction of errors be reported in the finan- cial statements?

15. Discuss the appropriate treatment in the financial state- ments of each of the following.

(a) Gain on sale of investment securities.

(b) A profit-sharing bonus to employees computed as a percentage of net income.

(d) Rent received from subletting a portion of the office space.

(e) A patent infringement suit, brought 2 years ago against the company by another company, was set- tled this year by a cash payment of $725,000.

(f) A reduction in the Allowance for Doubtful Accounts balance because the account appears to be consider- ably in excess of the probable loss from uncollectible receivables.

16. Indicate where the following items would ordinarily appear on the financial statements of Boleyn, Inc. for the year 2017.

(a) The service life of certain equipment was changed from 8 to 5 years. If a 5-year life had been used previ- ously, additional depreciation of $425,000 would have been charged.

(b) In 2017, a flood destroyed a warehouse that had a book value of $1,600,000. Floods are rare in this locality.

(d) In 2014, a supply warehouse with an expected useful life of 7 years was erroneously expensed.

(e) Boleyn, Inc. changed from weighted-average to FIFO inventory pricing.

17. Indicate the section of a multiple-step income statement in which each of the following is shown.

(a) Loss on inventory write-down.

(b) Loss from strike.

(d) Loss on disposal of a discontinued operation.

(e) Gain on sale of machinery.

(f) Interest revenue.

(g) Depreciation expense.

(h) Material write-offs of notes receivable. 18. Perlman Land Development, Inc. purchased land for

$70,000 and spent $30,000 developing it. It then sold the land for $160,000. Sheehan Manufacturing purchased

land for a future plant site for $100,000. Due to a change in plans, Sheehan later sold the land for $160,000. Should these two companies report the land sales, both at gains of $60,000, in a similar manner?

19. You run into Greg Norman at a party and begin discuss- ing financial statements. Greg says, “I prefer the single- step income statement because the multiple-step format generally overstates income.” How should you respond to Greg?

20. Santo Corporation has eight expense accounts in its gen- eral ledger which could be classified as selling expenses. Should Santo report these eight expenses separately in its income statement or simply report one total amount for selling expenses?

21. Cooper Investments reported an unusual gain from the sale of certain assets in its 2017 income statement. How does intraperiod tax allocation affect the reporting of this unusual gain?

22. Discuss the appropriate treatment in the income state- ment for the following items:

(a) Loss on discontinued operations.

(b) Noncontrolling interest allocation.

(d) Gain on sale of equipment. 23. Lebron Co. owns most but not all of the shares of its sub-

sidiary Bryant Inc. Lebron reported net income of $124,700. The amount to be attributed to the noncontrol- ling interest in Bryant is $30,000. Indicate how Lebron will report the noncontrolling interest in its income statement.

24. What effect does intraperiod tax allocation have on reported net income?

25. Neumann Company computed earnings per share as follows. Net income

Common shares outstanding at year-end Neumann has a simple capital structure. What possible

errors might the company have made in the computa- tion? Explain.

26. Qualls Corporation reported 2017 earnings per share of $7.21. In 2018, Qualls reported earnings per share as follows.

On income from continuing operations $6.40 On discontinued operations 1.88

On net income $8.28

Is the increase in earnings per share from $7.21 to $8.28 a favorable trend?

27. What is meant by “tax allocation within a period”? What is the justification for such practice?

28. When does tax allocation within a period become neces- sary? How should this allocation be handled?

29. During 2017, Liselotte Company reported income of $1,500,000 before income taxes and realized a gain of $450,000 on the disposal of assets related to a discontinued operation. The criteria for classification as a discontinued

operation is appropriate for this sale. The income is subject to income taxation at the rate of 34%. The gain on the sale of the plant is taxed at 30%. Indicate an appropriate presentation of these items in the income statement.

30. On January 30, 2016, a suit was filed against Frazier Cor- poration under the Environmental Protection Act. On August 6, 2017, Frazier Corporation agreed to settle the action and pay $920,000 in damages to certain current and former employees. How should this settlement be reported in the 2017 financial statements? Discuss.

31. Linus Paper Company decided to close two small pulp mills in Conway, New Hampshire, and Corvallis, Oregon. These two closings do not represent a major shift in strategy for the company. Would these closings be reported in a separate section entitled “Discontinued operations after income from continuing operations”? Discuss.

32. What major types of items are reported in the retained earnings statement?

33. Generally accepted accounting principles usually require the use of accrual accounting to “fairly present” income. If the cash receipts and disbursements method of account- ing will “clearly reflect” taxable income, why does this method not usually also “fairly present” income?

34. State some of the more serious problems encountered in seeking to achieve the ideal measurement of periodic net income. Explain what accountants do as a practical alternative.

35. What is meant by the terms elements and items as they relate to the income statement? Why might items have to be disclosed in the income statement?

36. What are the two ways that other comprehensive income may be displayed (reported)?

37. How should the disposal of a component of a business be disclosed in the income statement?

Brief Exercises 181

BE4-1 (L03) Starr Co. had sales revenue of $540,000 in 2017. Other items recorded during the year were:

Cost of goods sold $330,000 Salaries and wages expense 120,000 Income tax expense 25,000 Increase in value of company reputation 15,000 Other operating expenses 10,000 Unrealized gain on value of patents 20,000

Prepare a single-step income statement for Starr for 2017. Starr has 100,000 shares of stock outstanding. BE4-2 (L03) Brisky Corporation had net sales of $2,400,000 and interest revenue of $31,000 during 2017. Expenses for 2017 were cost of goods sold $1,450,000, administrative expenses $212,000, selling expenses $280,000, and interest expense $45,000. Brisky’s tax rate is 30%. The corporation had 100,000 shares of common stock authorized and 70,000 shares issued and outstand- ing during 2017. Prepare a single-step income statement for the year ended December 31, 2017. BE4-3 (L03) Using the information provided in BE4-2, prepare a condensed multiple-step income statement for Brisky Corporation. BE4-4 (L02,3,4) Finley Corporation had income from continuing operations of $10,600,000 in 2017. During 2017, it disposed of its restaurant division at an after-tax loss of $189,000. Prior to disposal, the division operated at a loss of $315,000 (net of tax) in 2017 (assume that the disposal of the restaurant division meets the criteria for recognition as a discontinued operation). Finley had 10,000,000 shares of common stock outstanding during 2017. Prepare a partial income statement for Finley beginning with income from continuing operations. BE4-5 (L02,3,4) Stacy Corporation had income from operations of $7,200,000. In addition, it suffered an unusual and infre- quent pretax loss of $770,000 from a volcano eruption, interest revenue of $17,000, and a write-down on buildings of $53,000. The corporation’s tax rate is 30%. Prepare a partial income statement for Stacy beginning with Income from operations. The corpora- tion had 5,000,000 shares of common stock outstanding during 2017. BE4-6 (L05) During 2017, Williamson Company changed from FIFO to weighted-average inventory pricing. Pretax income in 2016 and 2015 (Williamson’s first year of operations) under FIFO was $160,000 and $180,000, respectively. Pretax income using weighted-average pricing in the prior years would have been $145,000 in 2016 and $170,000 in 2015. In 2017, Williamson reported pretax income (using weighted-average pricing) of $180,000. Show comparative income statements for Williamson, beginning with “Income before income tax,” as presented on the 2017 income statement. (The tax rate in all years is 30%.) BE4-7 (L05) Vandross Company has recorded bad debt expense in the past at a rate of 1½% of accounts receivable, based on an aging analysis. In 2017, Vandross decides to increase its estimate to 2%. If the new rate had been used in prior years, cumulative bad debt expense would have been $380,000 instead of $285,000. In 2017, bad debt expense will be $120,000 instead of $90,000. If Vandross’s tax rate is 30%, what amount should it report as the cumulative effect of changing the estimated bad debt rate?

BRIEF EXERCISES

182 Chapter 4 Income Statement and Related Information

BE4-8 (L04) In 2017, Hollis Corporation reported net income of $1,000,000. It declared and paid preferred stock dividends of $250,000. During 2017, Hollis had a weighted average of 190,000 common shares outstanding. Compute Hollis’s 2017 earnings per share. BE4-9 (L06) Portman Corporation has retained earnings of $675,000 at January 1, 2017. Net income during 2017 was $1,400,000, and cash dividends declared and paid during 2017 totaled $75,000. Prepare a retained earnings statement for the year ended December 31, 2017. BE4-10 (L05,6) Using the information from BE4-9, prepare a retained earnings statement for the year ended December 31, 2017. Assume an error was discovered: land costing $80,000 (net of tax) was charged to maintenance and repairs expense in 2014. BE4-11 (L07) On January 1, 2017, Richards Inc. had cash and common stock of $60,000. At that date, the company had no other asset, liability, or equity balances. On January 2, 2017, it purchased for cash $20,000 of debt securities that it classified as available-for-sale. It received interest of $3,000 during the year on these securities. In addition, it has an unrealized holding gain on these securities of $4,000 net of tax. Determine the following amounts for 2017: (a) net income, (b) comprehensive income, (c) other comprehensive income, and (d) accumulated other comprehensive income (end of 2017).

EXERCISES

E4-1 (L02) (Computation of Net Income) Presented below are changes in all the account balances of Fritz Mayhew Furniture Co. during the current year, except for retained earnings.

Increase Increase (Decrease) (Decrease)

Cash $ 79,000 Accounts Payable $ (51,000) Accounts Receivable (net) 45,000 Bonds Payable 82,000 Inventory 127,000 Common Stock 125,000 Investments (47,000) Paid-In Capital in Excess of Par—Common Stock 13,000

Instructions Compute the net income for the current year, assuming that there were no entries in the Retained Earnings account except for net income and a dividend declaration of $19,000 which was paid in the current year.

E4-2 (L02,4) (Compute Income Measures) Presented below is information related to Viel Company at December 31, 2017, the end of its first year of operations.

Sales revenue $310,000 Cost of goods sold 140,000 Selling and administrative expenses 50,000 Gain on sale of plant assets 30,000 Unrealized gain on available-for-sale investments 10,000 Interest expense 6,000 Loss on discontinued operations 12,000 Dividends declared and paid 5,000

Instructions Compute the following: (a) income from operations, (b) net income, (c) comprehensive income, and (d) retained earnings bal- ance at December 31, 2017. (Ignore income tax effects.)

E4-3 (L02,4) (Income Statement Items) Presented below are certain account balances of Paczki Products Co.

Rent revenue $ 6,500 Sales discounts $ 7,800 Interest expense 12,700 Selling expenses 99,400 Beginning retained earnings 114,400 Sales revenue 390,000 Ending retained earnings 125,000 Income tax expense 31,000 Dividend revenue 71,000 Cost of goods sold 184,400 Sales returns and allowances 12,400 Administrative expenses 82,500 Allocation to noncontrolling interest 17,000

Instructions From the foregoing, compute the following: (a) total net revenue, (b) net income, (c) dividends declared, and (d) income attribut- able to controlling stockholders. E4-4 (L02,3) (Single-Step Income Statement) The financial records of LeRoi Jones Inc. were destroyed by fire at the end of 2017. Fortunately, the controller had kept certain statistical data related to the income statement as follows.

1. The beginning merchandise inventory was $92,000 and decreased 20% during the current year. 2. Sales discounts amount to $17,000. 3. 20,000 shares of common stock were outstanding for the entire year. 4. Interest expense was $20,000. 5. The income tax rate is 30%. 6. Cost of goods sold amounts to $500,000. 7. Administrative expenses are 20% of cost of goods sold but only 8% of gross sales. 8. Four-fifths of the operating expenses relate to sales activities.

Instructions From the foregoing information prepare an income statement for the year 2017 in single-step form.

E4-5 (L02,3) EXCEL (Multiple-Step and Single-Step Statements) Two accountants for the firm of Elwes and Wright are arguing about the merits of presenting an income statement in a multiple-step versus a single-step format. The discussion involves the following 2017 information related to P. Bride Company ($000 omitted).

Administrative expense Offi cers’ salaries $ 4,900 Depreciation of offi ce furniture and equipment 3,960 Cost of goods sold 60,570 Rent revenue 17,230 Selling expense Delivery expense 2,690 Sales commissions 7,980 Depreciation of sales equipment 6,480 Sales revenue 96,500 Income tax 9,070 Interest expense 1,860

Instructions (a) Prepare an income statement for the year 2017 using the multiple-step form. Common shares outstanding for 2017 total

40,550 (000 omitted). (b) Prepare an income statement for the year 2017 using the single-step form. (c) Which one do you prefer? Discuss.

E4-6 (L02,3,4) (Multiple-Step Statement) The following balances were taken from the books of Alonzo Corp. on December 31, 2017.

Interest revenue $ 86,000 Accumulated depreciation—equipment $ 40,000 Cash 51,000 Accumulated depreciation—buildings 28,000 Sales revenue 1,380,000 Notes receivable 155,000 Accounts receivable 150,000 Selling expenses 194,000 Prepaid insurance 20,000 Accounts payable 170,000 Sales returns and allowances 150,000 Bonds payable 100,000 Allowance for doubtful accounts 7,000 Administrative and general expenses 97,000 Sales discounts 45,000 Accrued liabilities 32,000 Land 100,000 Interest expense 60,000 Equipment 200,000 Notes payable 100,000 Buildings 140,000 Loss from earthquake damage 150,000 Cost of goods sold 621,000 Common stock 500,000 Retained earnings 21,000

Assume the total effective tax rate on all items is 34%.

Instructions Prepare a multiple-step income statement; 100,000 shares of common stock were outstanding during the year.

E4-7 (L02,3,4) (Multiple-Step and Single-Step Statements) The accountant of Latifa Shoe Co. has piled the following information from the company’s records as a basis for an income statement for the year ended December 31, 2017.

Rent revenue $ 29,000 Interest expense 18,000 Market appreciation on land above cost 31,000 Salaries and wages expense (selling) 114,800 Supplies (selling) 17,600 Income tax 37,400

Exercises 183

184 Chapter 4 Income Statement and Related Information

Salaries and wages expense (administrative) $135,900 Other administrative expenses 51,700 Cost of goods sold 496,000 Net sales 980,000 Depreciation on plant assets (70% selling, 30% administrative) 65,000 Cash dividends declared 16,000

There were 20,000 shares of common stock outstanding during the year.

Instructions (a) Prepare a multiple-step income statement. (b) Prepare a single-step income statement. (c) Which format do you prefer? Discuss.

E4-8 (L03,4) (Income Statement, EPS) Presented below are selected ledger accounts of Tucker Corporation as of December 31, 2017.

Cash $ 50,000 Administrative expenses 100,000 Selling expenses 80,000 Net sales 540,000 Cost of goods sold 210,000 Cash dividends declared (2017) 20,000 Cash dividends paid (2017) 15,000 Discontinued operations (loss before income taxes) 40,000 Depreciation expense, not recorded in 2016 30,000 Retained earnings, December 31, 2016 90,000 Effective tax rate 30%

Instructions (a) Compute net income for 2017. (b) Prepare a partial income statement beginning with income from continuing operations before income tax, and includ-

ing appropriate earnings per share information. Assume 10,000 shares of common stock were outstanding during 2017.

E4-9 (L03,4,6) (Multiple-Step Statement with Retained Earnings Statement) Presented below is information related to Ivan Calderon Corp. for the year 2017.

Net sales $1,300,000 Write-off of inventory due to obsolescence $ 80,000 Cost of goods sold 780,000 Depreciation expense omitted by accident in 2016 55,000 Selling expenses 65,000 Casualty loss 50,000 Administrative expenses 48,000 Cash dividends declared 45,000 Dividend revenue 20,000 Retained earnings at December 31, 2016 980,000 Interest revenue 7,000 Effective tax rate of 34% on all items

Instructions (a) Prepare a multiple-step income statement for 2017. Assume that 60,000 shares of common stock are outstanding for the

entire year. (b) Prepare a separate retained earnings statement for 2017.

E4-10 (L04) (Earnings per Share) The stockholders’ equity section of Hendly Corporation appears below as of December 31, 2017.

8% preferred stock, $50 par value, authorized 100,000 shares, outstanding 90,000 shares $ 4,500,000 Common stock, $1.00 par, authorized and issued 10 million shares 10,000,000 Additional paid-in capital 20,500,000 Retained earnings $134,000,000 Net income 33,000,000 167,000,000

$202,000,000

Net income for 2017 reflects a total effective tax rate of 34%. Included in the net income figure is a loss of $18,000,000 (before tax) as a result of a non-recurring major casualty. Preferred stock dividends of $360,000 were declared and paid in 2017. Divi- dends of $1,000,000 were declared and paid to common stockholders in 2017.

Instructions Compute earnings per share data as it should appear on the income statement of Hendly Corporation.

E4-11 (L03,4) (Condensed Income Statement—Periodic Inventory Method) The following are selected ledger accounts of Spock Corporation at December 31, 2017.

Cash $ 185,000 Salaries and wages expense (sales) $284,000 Inventory 535,000 Salaries and wages expense (offi ce) 346,000 Sales revenue 4,275,000 Purchase returns 15,000 Unearned sales revenue 117,000 Sales returns and allowances 79,000 Purchases 2,786,000 Freight-in 72,000 Sales discounts 34,000 Accounts receivable 142,500 Purchase discounts 27,000 Sales commissions 83,000 Selling expenses 69,000 Telephone and Internet expense (sales) 17,000 Accounting and legal services 33,000 Utilities expense (offi ce) 32,000 Insurance expense (offi ce) 24,000 Miscellaneous offi ce expenses 8,000 Advertising expense 54,000 Rent revenue 240,000 Delivery expense 93,000 Casualty loss (before tax) 70,000 Depreciation expense (offi ce equipment) 48,000 Interest expense 176,000 Depreciation expense (sales equipment) 36,000 Common stock ($10 par) 900,000

Spock’s effective tax rate on all items is 34%. A physical inventory indicates that the ending inventory is $686,000.

Instructions Prepare a condensed 2017 income statement for Spock Corporation.

E4-12 (L06) EXCEL (Retained Earnings Statement) Eddie Zambrano Corporation began operations on January 1, 2017. During its first 3 years of operations, Zambrano reported net income and declared dividends as follows.

Net Income Dividends Declared

2014 $ 40,000 $ –0– 2015 125,000 50,000 2016 160,000 50,000

The following information relates to 2017.

Income before income tax $240,000 Prior period adjustment: understatement of 2015 depreciation expense (before taxes) $ 25,000 Cumulative decrease in income from change in inventory methods (before taxes) $ 35,000 Dividends declared (of this amount, $25,000 will be paid on Jan. 15, 2018) $100,000 Effective tax rate 40%

Instructions (a) Prepare a 2017 retained earnings statement for Eddie Zambrano Corporation. (b) Assume Eddie Zambrano Corporation restricted retained earnings in the amount of $70,000 on December 31, 2017.

After this action, what would Zambrano report as total retained earnings in its December 31, 2017, balance sheet?

E4-13 (L04) (Earnings per Share) At December 31, 2016, Shiga Naoya Corporation had the following stock outstanding.

10% cumulative preferred stock, $100 par, 107,500 shares $10,750,000 Common stock, $5 par, 4,000,000 shares 20,000,000

During 2017, Shiga Naoya did not issue any additional common stock. The following also occurred during 2017.

Income from continuing operations before taxes $23,650,000 Discontinued operations (loss before taxes) $ 3,225,000 Preferred dividends declared $ 1,075,000 Common dividends declared $ 2,200,000 Effective tax rate 35%

Instructions Compute earnings per share data as it should appear in the 2017 income statement of Shiga Naoya Corporation. (Round to two decimal places.)

E4-14 (L05) (Change in Accounting Principle) Tim Mattke Company began operations in 2015 and for simplicity reasons, adopted weighted-average pricing for inventory. In 2017, in accordance with other companies in its industry, Mattke changed its inventory pricing to FIFO. The pretax income data is reported below.

Weighted- Year Average FIFO

2015 $370,000 $395,000 2016 390,000 430,000 2017 410,000 450,000

Exercises 185

186 Chapter 4 Income Statement and Related Information

Instructions (a) What is Mattke’s net income in 2017? Assume a 35% tax rate in all years. (b) Compute the cumulative effect of the change in accounting principle from weighted-average to FIFO inventory

pricing. (c) Show comparative income statements for Tim Mattke Company, beginning with income before income tax, as pre-

sented on the 2017 income statement.

E4-15 (L03,7) (Comprehensive Income) Roxanne Carter Corporation reported the following for 2017: net sales $1,200,000, cost of goods sold $750,000, selling and administrative expenses $320,000, and an unrealized holding gain on available-for-sale securities $18,000.

Instructions Prepare a statement of comprehensive income, using (a) the one statement format, and (b) the two statement format. (Ignore income taxes and earnings per share.)

E4-16 (L06,7) (Comprehensive Income) C. Reither Co. reports the following information for 2017: sales revenue $700,000, cost of goods sold $500,000, operating expenses $80,000, and an unrealized holding loss on available-for-sale securities for 2017 of $60,000. It declared and paid a cash dividend of $10,000 in 2017.

C. Reither Co. has January 1, 2017, balances in common stock $350,000; accumulated other comprehensive income $80,000; and retained earnings $90,000. It issued no stock during 2017.

Instructions Prepare a statement of stockholders’ equity.

E4-17 (L03,4,6,7) (Various Reporting Formats) The following information was taken from the records of Roland Carlson Inc. for the year 2017: income tax applicable to income from continuing operations $187,000, income tax applicable to loss on discontinued operations $25,500, and unrealized holding gain on available-for-sale securities (net of tax) $15,000.

Gain on sale of equipment $ 95,000 Cash dividends declared $ 150,000 Loss on discontinued operations 75,000 Retained earnings January 1, 2017 600,000 Administrative expenses 240,000 Cost of goods sold 850,000 Rent revenue 40,000 Selling expenses 300,000 Loss on write-down of inventory 60,000 Sales revenue 1,900,000

Shares outstanding during 2017 were 100,000.

Instructions (a) Prepare a single-step income statement. (b) Prepare a comprehensive income statement for 2017, using the two statement format. (c) Prepare a retained earnings statement for 2017.

PROBLEMS

P4-1 (L03,4,6) (Multiple-Step Statement, Retained Earnings Statement) The following information is related to Dickin- son Company for 2017.

Retained earnings balance, January 1, 2017 $ 980,000 Sales revenue 25,000,000 Cost of goods sold 16,000,000 Interest revenue 70,000 Selling and administrative expenses 4,700,000 Write-off of goodwill 820,000 Income taxes for 2017 1,244,000 Gain on the sale of investments 110,000 Loss due to fl ood damage 390,000 Loss on the disposition of the wholesale division (net of tax) 440,000 Loss on operations of the wholesale division (net of tax) 90,000

Dividends declared on common stock $ 250,000

Dividends declared on preferred stock 80,000

Dickinson Company decided to discontinue its entire wholesale operations (considered a discontinued operation) and to retain its manufacturing operations. On September 15, Dickinson sold the wholesale operations to Rogers Company. During 2017, there were 500,000 shares of common stock outstanding all year.

Instructions Prepare a multiple-step income statement and a retained earnings statement.

P4-2 (L03,4,6) EXCEL (Single-Step Statement, Retained Earnings Statement, Periodic Inventory) Presented below is the trial balance of Thompson Corporation at December 31, 2017.

THOMPSON CORPORATION TRIAL BALANCE

DECEMBER 31, 2017

Debit Credit

Purchase Discounts $ 10,000 Cash $ 189,700 Accounts Receivable 105,000 Rent Revenue 18,000 Retained Earnings 160,000 Salaries and Wages Payable 18,000 Sales Revenue 1,100,000 Notes Receivable 110,000 Accounts Payable 49,000 Accumulated Depreciation—Equipment 28,000 Sales Discounts 14,500 Sales Returns and Allowances 17,500 Notes Payable 70,000 Selling Expenses 232,000 Administrative Expenses 99,000 Common Stock 300,000 Income Tax Expense 53,900 Cash Dividends 45,000 Allowance for Doubtful Accounts 5,000 Supplies 14,000 Freight-In 20,000 Land 70,000 Equipment 140,000 Bonds Payable 100,000 Gain on Sale of Land 30,000 Accumulated Depreciation—Buildings 19,600 Inventory 89,000 Buildings 98,000 Purchases 610,000

Totals $1,907,600 $1,907,600

A physical count of inventory on December 31 resulted in an inventory amount of $64,000; thus, cost of goods sold for 2017 is $645,000.

Instructions Prepare a single-step income statement and a retained earnings statement. Assume that the only changes in retained earnings during the current year were from net income and dividends. Thirty thousand shares of common stock were outstanding the entire year.

P4-3 (L03,4,5) EXCEL GROUPWORK (Various Income-Related Items) Maher Inc. reported income from continuing operations before taxes during 2017 of $790,000. Additional transactions occurring in 2017 but not considered in the $790,000 are as follows. 1. The corporation experienced an uninsured flood loss in the amount of $90,000 during the year. 2. At the beginning of 2015, the corporation purchased a machine for $54,000 (salvage value of $9,000) that had a useful life

of 6 years. The bookkeeper used straight-line depreciation for 2015, 2016, and 2017, but failed to deduct the salvage value in computing the depreciation base.

Problems 187

188 Chapter 4 Income Statement and Related Information

3. Sale of securities held as a part of its portfolio resulted in a loss of $57,000 (pretax). 4. When its president died, the corporation realized $150,000 from an insurance policy. The cash surrender value of this

policy had been carried on the books as an investment in the amount of $46,000 (the gain is nontaxable). 5. The corporation disposed of its recreational division at a loss of $115,000 before taxes. Assume that this transaction meets

the criteria for discontinued operations. 6. The corporation decided to change its method of inventory pricing from average-cost to the FIFO method. The effect of

this change on prior years is to increase 2015 income by $60,000 and decrease 2016 income by $20,000 before taxes. The FIFO method has been used for 2017. The tax rate on these items is 40%.

Instructions Prepare an income statement for the year 2017 starting with income from continuing operations before taxes. Compute earnings per share as it should be shown on the face of the income statement. Common shares outstanding for the year are 120,000 shares. (Assume a tax rate of 30% on all items, unless indicated otherwise.)

P4-4 (L03,4,5,6) (Multiple- and Single-Step Statements, Retained Earnings Statement) The following account balances were included in the trial balance of Twain Corporation at June 30, 2017.

Sales revenue $1,578,500 Depreciation expense (offi ce Sales discounts 31,150 furniture and equipment) $ 7,250 Cost of goods sold 896,770 Property tax expense 7,320 Salaries and wages expense (sales) 56,260 Bad debt expense (selling) 4,850 Sales commissions 97,600 Maintenance and repairs Travel expense (salespersons) 28,930 expense (administration) 9,130 Delivery expense 21,400 Offi ce expense 6,000 Entertainment expense 14,820 Sales returns and allowances 62,300 Telephone and Internet expense (sales) 9,030 Dividends received 38,000 Depreciation expense (sales equipment) 4,980 Interest expense 18,000 Maintenance and repairs expense (sales) 6,200 Income tax expense 102,000 Miscellaneous selling expenses 4,715 Depreciation understatement Offi ce supplies used 3,450 due to error—2014 (net of tax) 17,700 Telephone and Internet expense Dividends declared on (administration) 2,820 preferred stock 9,000 Dividends declared on common stock 37,000

The Retained Earnings account had a balance of $337,000 at July 1, 2016. There are 80,000 shares of common stock outstanding.

Instructions (a) Using the multiple-step form, prepare an income statement and a retained earnings statement for the year ended June 30,

2017. (b) Using the single-step form, prepare an income statement and a retained earnings statement for the year ended June 30,

2017.

P4-5 (L03,4,5,6) (Unusual or Infrequent Items) Presented below is a combined single-step income and retained earnings statement for Nerwin Company for 2017.

(000 omitted)

Net sales revenue $640,000 Costs and expenses Cost of goods sold $500,000 Selling, general, and administrative expenses 66,000 Other, net 17,000 583,000

Income before income tax 57,000 Income tax 19,400

Net income 37,600 Retained earnings at beginning of period, as previously reported 141,000 Adjustment required for correction of error (7,000)

Retained earnings at beginning of period, as restated 134,000 Dividends on common stock (12,200)

Retained earnings at end of period $159,400

Additional facts are as follows. 1. “Selling, general, and administrative expenses” for 2017 included a charge of $8,500,000 that was usual but infrequently

occurring.

2. “Other, net” for 2017 included a loss on sale of equipment of $6,000,000. 3. “Adjustment required for correction of an error” was a result of a change in estimate (useful life of certain assets reduced

to 8 years and a catch-up adjustment made). 4. Nerwin Company disclosed earnings per common share for net income in the notes to the financial statements.

Instructions Determine from these additional facts whether the presentation of the facts in the Nerwin Company income and retained earnings statement is appropriate. If the presentation is not appropriate, describe the appropriate presentation and discuss its theoretical rationale. (Do not prepare a revised statement.)

P4-6 (L04,5,6) (Retained Earnings Statement, Prior Period Adjustment) Below is the Retained Earnings account for the year 2017 for Acadian Corp.

Retained earnings, January 1, 2017 $257,600 Add: Gain on sale of investments (net of tax) $41,200 Net income 84,500 Refund on litigation with government, related to the year 2014 (net of tax) 21,600 Recognition of income earned in 2016, but omitted from income statement in that year (net of tax) 25,400 172,700

430,300

Deduct: Loss on discontinued operations (net of tax) 35,000 Write-off of goodwill (net of tax) 60,000 Cumulative effect on income of prior years in changing from LIFO to FIFO inventory valuation in 2017 (net of tax) 23,200 Cash dividends declared 32,000 150,200

Retained earnings, December 31, 2017 $280,100

Instructions (a) Prepare a corrected retained earnings statement. Acadian Corp. normally sells investments of the type mentioned above.

FIFO inventory was used in 2017 to compute net income. (b) State where the items that do not appear in the corrected retained earnings statement should be shown.

P4-7 (L03,4,5) GROUPWORK (Income Statement, Irregular Items) Wade Corp. has 150,000 shares of common stock out- standing. In 2017, the company reports income from continuing operations before income tax of $1,210,000. Additional transac- tions not considered in the $1,210,000 are as follows.

1. In 2017, Wade Corp. sold equipment for $40,000. The machine had originally cost $80,000 and had accumulated deprecia- tion of $30,000. The gain or loss is considered non-recurring.

2. The company discontinued operations of one of its subsidiaries during the current year at a loss of $190,000 before taxes. Assume that this transaction meets the criteria for discontinued operations. The loss from operations of the discontinued subsidiary was $90,000 before taxes; the loss from disposal of the subsidiary was $100,000 before taxes.

3. An internal audit discovered that amortization of intangible assets was understated by $35,000 (net of tax) in a prior pe- riod. The amount was charged against retained earnings.

4. The company recorded a non-recurring gain of $125,000 on the condemnation of some of its property (included in the $1,210,000).

Instructions Analyze the above information and prepare an income statement for the year 2017, starting with income from continuing opera- tions before income tax. Compute earnings per share as it should be shown on the face of the income statement. (Assume a total effective tax rate of 38% on all items, unless otherwise indicated.)

CONCEPTS FOR ANALYSIS

CA4-1 (Identification of Income Statement Deficiencies) O’Malley Corporation was incorporated and began business on Janu- ary 1, 2017. It has been successful and now requires a bank loan for additional working capital to finance expansion. The bank has requested an audited income statement for the year 2017. The accountant for O’Malley Corporation provides you with the follow- ing income statement which O’Malley plans to submit to the bank.

Problems 189

190 Chapter 4 Income Statement and Related Information

O’MALLEY CORPORATION INCOME STATEMENT

Sales revenue $850,000 Dividends 32,300 Gain on recovery of insurance proceeds from earthquake loss 38,500

920,800 Less: Selling expenses $101,100 Cost of goods sold 510,000 Advertising expense 13,700 Loss on obsolescence of inventories 34,000 Loss on discontinued operations 48,600 Administrative expense 73,400 780,800

Income before income tax 140,000 Income tax 56,000

Net income $ 84,000

Instructions Indicate the deficiencies in the income statement presented above. Assume that the corporation desires a single-step income statement.

CA4-2 GROUPWORK (Earnings Management) Bobek Inc. has recently reported steadily increasing income. The company reported income of $20,000 in 2014, $25,000 in 2015, and $30,000 in 2016. A number of market analysts have recommended that investors buy the stock because they expect the steady growth in income to continue. Bobek is approaching the end of its fiscal year in 2017, and it again appears to be a good year. However, it has not yet recorded warranty expense.

Based on prior experience, this year’s warranty expense should be around $5,000, but some managers have approached the controller to suggest a larger, more conservative warranty expense should be recorded this year. Income before warranty expense is $43,000. Specifically, by recording a $7,000 warranty accrual this year, Bobek could report an increase in income for this year and still be in a position to cover its warranty costs in future years.

Instructions (a) What is earnings management? (b) Assume income before warranty expense is $43,000 for both 2017 and 2018 and that total warranty expense over the

2-year period is $10,000. What is the effect of the proposed accounting in 2017? In 2018? (c) What is the appropriate accounting in this situation?

CA4-3 ETHICS (Earnings Management) Charlie Brown, controller for Kelly Corporation, is preparing the company’s income statement at year-end. He notes that the company lost a considerable sum on the sale of some equipment it had decided to replace. Since the company has sold equipment routinely in the past, Brown knows the losses cannot be reported as an unusual item. He also does not want to highlight it as a material loss since he feels that will reflect poorly on him and the company. He reasons that if the company had recorded more depreciation during the assets’ lives, the losses would not be so great. Since depreciation is included among the company’s operating expenses, he wants to report the losses along with the company’s expenses, where he hopes it will not be noticed.

Instructions (a) What are the ethical issues involved? (b) What should Brown do?

CA4-4 (Income Reporting Items) Simpson Corp. is an entertainment firm that derives approximately 30% of its income from the Casino Knights Division, which manages gambling facilities. As auditor for Simpson Corp., you have recently overheard the fol- lowing discussion between the controller and financial vice president.

Vice President: If we sell the Casino Knights Division, it seems ridiculous to segregate the results of the sale in the income statement. Separate categories tend to be absurd and confusing to the stockholders. I believe that we should simply report the gain on the sale as other income or expense without detail.

Controller: Professional pronouncements would require that we report this information separately in the income statement. If a sale of this type is considered unusual and infrequent, it must be reported separate from income from continuing operations.

Vice President: What about the walkout we had last month when employees were upset about their commission income? Would this situation not also be subject to reporting outside operating income?

Controller: I am not sure whether this item should get special reporting or not.

Vice President: Oh well, it doesn’t make any difference because the net effect of all these items is immaterial, so no dis- closure is necessary.

Instructions (a) On the basis of the foregoing discussion, answer the following questions. Who is correct about handling the sale? What

would be the correct income statement presentation for the sale of the Casino Knights Division? (b) How should the walkout by the employees be reported? (c) What do you think about the vice president’s observation on materiality? (d) What are the earnings per share implications of these topics?

CA4-5 (Identification of Income Statement Weaknesses) The following financial statement was prepared by employees of Walters Corporation.

WALTERS CORPORATION INCOME STATEMENT

YEAR ENDED DECEMBER 31, 2017

Revenues Gross sales, including sales taxes $1,044,300 Less: Returns, allowances, and cash discounts 56,200

Net sales 988,100 Dividends, interest, and purchase discounts 30,250 Recoveries of accounts written off in prior years 13,850

Total revenues 1,032,200

Costs and expenses Cost of goods sold, including sales taxes 465,900 Salaries and related payroll expenses 60,500 Rent 19,100 Delivery expense and freight-in 3,400 Bad debt expense 27,800

Total costs and expenses 576,700

Income before other items 455,500

Other items Loss on discontinued styles (Note 1) 71,500 Loss on sale of marketable securities (Note 2) 39,050 Loss on sale of warehouse (Note 3) 86,350

Total other items 196,900

Net income $ 258,600

Net income per share of common stock $2.30

Note 1: New styles and rapidly changing consumer preferences resulted in a $71,500 loss on the disposal of discontinued styles and related accessories.

Note 2: The corporation sold an investment in marketable securities at a loss of $39,050. The corporation normally sells securities of this nature.

Note 3: The corporation sold one of its warehouses at an $86,350 loss.

Instructions Identify and discuss the weaknesses in classification and disclosure in the single-step income statement above. You should explain why these treatments are weaknesses and what the proper presentation of the items would be in accor- dance with GAAP.

CA4-6 ETHICS (Classification of Income Statement Items) As audit partner for Grupo and Rijo, you are in charge of reviewing the classification of unusual items that have occurred during the current year. The following material items have come to your attention.

1. A merchandising company incorrectly overstated its ending inventory 2 years ago. Inventory for all other periods is cor- rectly computed.

2. An automobile dealer sells for $137,000 an extremely rare 1930 S type Invicta which it purchased for $21,000 10 years ago. The Invicta is the only such display item the dealer owns.

3. A drilling company during the current year extended the estimated useful life of certain drilling equipment from 9 to 15 years. As a result, depreciation for the current year was materially lowered.

4. A retail outlet changed its computation for bad debt expense from 1% to ½ of 1% of sales because of changes in its customer clientele.

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192 Chapter 4 Income Statement and Related Information

5. A mining concern sells a foreign subsidiary engaged in uranium mining, although it (the seller) continues to engage in uranium mining in other countries.

6. A steel company changes from the average-cost method to the FIFO method for inventory costing purposes. 7. A construction company, at great expense, prepared a major proposal for a government loan. The loan is not approved. 8. A water pump manufacturer has had large losses resulting from a strike by its employees early in the year. 9. Depreciation for a prior period was incorrectly understated by $950,000. The error was discovered in the current year. 10. A large sheep rancher suffered a major loss because the state required that all sheep in the state be killed to halt the spread

of a rare disease. Such a situation has not occurred in the state for 20 years. 11. A food distributor that sells wholesale to supermarket chains and to fast-food restaurants (two distinguishable classes of

customers) decides to discontinue the division that sells to one of the two classes of customers. This represents a strategic shift in the company business.

Instructions From the foregoing information, indicate in what section of the income statement or retained earnings statement these items should be classified. Provide a brief rationale for your position.

CA4-7 (Comprehensive Income) Willie Nelson, Jr., controller for Jenkins Corporation, is preparing the company’s financial state- ments at year-end. Currently, he is focusing on the income statement and determining the format for reporting comprehensive income. During the year, the company earned net income of $400,000 and had unrealized gains on available-for-sale securities of $15,000. In the previous year, net income was $410,000, and the company had no unrealized gains or losses.

Instructions (a) Show how income and comprehensive income will be reported on a comparative basis for the current and prior years,

using the two statement format. (b) Show how income and comprehensive income will be reported on a comparative basis for the current and prior years,

using the one statement format. (c) Which format should Nelson recommend?

USING YOUR JUDGMENT

Financial Reporting Problem

Instructions Refer to P&G’s financial statements and the accompanying notes to answer the following questions.

(a) What type of income statement format does P&G use? Indicate why this format might be used to present income state- ment information.

(b) What are P&G’s primary revenue sources? (c) Compute P&G’s gross profit for each of the years 2012–2014. Explain why gross profit decreased in 2014. (d) Why does P&G make a distinction between operating and nonoperating revenue? (e) What financial ratios did P&G choose to report in its “Financial Summary” section covering the years 2009–2014?

Instructions Use the companies’ financial information to answer the following questions.

(a) What type of income format(s) is used by these two companies? Identify any differences in income statement format between these two companies.

(b) What are the gross profits, operating profits, net incomes, and net incomes attributable to noncontrolling interests for these two companies over the 3-year period 2012–2014? Which company has had better financial results over this period of time?

Financial Statement Analysis Cases

Case 1: Bankruptcy Prediction The Z-score bankruptcy prediction model uses balance sheet and income information to arrive at a Z-Score, which can be used to predict financial distress:

Z = × 1.2 + × 1.4 + × 3.3 + × 0.99 + × 0.6

EBIT is earnings before interest and taxes. MV equity is the market value of common equity, which can be determined by mul- tiplying stock price by shares outstanding. Following extensive testing, it has been shown that companies with Z-scores above 3.0 are unlikely to fail; those with Z-scores below 1.81 are very likely to fail. While the original model was developed for publicly held manufacturing companies, the model has been modified to apply to companies in various industries, emerging companies, and companies not traded in public markets.

Instructions

(a) Use information in the financial statements of Walgreens or Deere & Co. to compute the Z-score for the past 2 years (2014 and 2013).

(b) Interpret your result. Where does the company fall in the financial distress range? (c) The Z-score uses EBIT as one of its elements. Why do you think this income measure is used?

Case 2: P/E Ratios One of the more closely watched ratios by investors is the price/earnings (P/E) ratio. By dividing price per share by earnings per share, analysts get insight into the value the market attaches to a company’s earnings. More specifically, a high P/E ratio (in comparison to companies in the same industry) may suggest the stock is overpriced. Also, there is some evidence that companies with low P/E ratios are underpriced and tend to outperform the market. However, the ratio can be misleading. P/E ratios are sometimes misleading because the E (earnings) is subject to a number of assumptions and estimates that could result in overstated earnings and a lower P/E. Some analysts conduct “revenue analysis” to evaluate the quality of an earnings number. Revenues are less subject to management estimates and all earnings must begin with revenues. These analysts also compute the price-to-sales ratio (PSR = price per share ÷ sales per share) to assess whether a company is performing well compared to similar companies. If a company has a price-to-sales ratio significantly higher than its competitors, investors may be betting on a stock that has yet to prove itself. [Source: Janice Revell, “Beyond P/E,” Fortune (May 28, 2001), p. 174.]

Instructions

(a) Identify some of the estimates or assumptions that could result in overstated earnings. (b) Compute the P/E ratio and the PSR for Tootsie Roll and Hershey for 2014. (c) Use these data to compare the quality of each company’s earnings.

Accounting, Analysis, and Principles Counting Crows Inc. provided the following information for the year 2017.

Retained earnings, January 1, 2017 $ 600,000 Administrative expenses 240,000 Selling expenses 300,000 Sales revenue 1,900,000 Cash dividends declared 80,000 Cost of goods sold 850,000 Loss on discontinued operations 110,000 Rent revenue 102,700 Unrealized holding gain on available-for-sale securities 17,000 Income tax applicable to continuing operations 187,000 Income tax benefi t applicable to loss on discontinued operations 60,500 Income tax applicable to unrealized holding gain on available-for-sale securities 2,000

Accounting Prepare (a) a single-step income statement for 2017, (b) a retained earnings statement for 2017, and (c) a statement of comprehen- sive income using the two statement format. Shares outstanding during 2017 were 100,000.

Analysis Explain how a multiple-step income statement format can provide useful information to a financial statement user.

Using Your Judgment 193

EBIT Total assets

Sales Total assets

MV equity Total liabilities

Working capital Total assets

Retained earnings Total assets

194 Chapter 4 Income Statement and Related Information

Principles In a recent meeting with its auditor, Counting Crows’ management argued that the company should be able to prepare a pro forma income statement with some one-time administrative expenses reported similar to discontinued operations. Is such report- ing consistent with the qualitative characteristics of accounting information as discussed in the conceptual framework? Explain.

BRIDGE TO THE PROFESSION

FASB Codifi cation References [1] FASB ASC 225-20-45-4. [Predecessor literature: “Reporting the Results of Operations,” Opinions of the Accounting Principles

Board No. 30 (New York: AICPA, 1973), par. 23, as amended by “Accounting for the Impairment or Disposal of Long-lived Assets,” Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001).]

[2] FASB ASC 224-20-45-2. [Predecessor literature: “Reporting the Results of Operations,” Opinions of the Accounting Principles Board No. 30 (New York: AICPA, 1973), par. 20.]

[3] FASB ASC 205-20-45. [Predecessor literature: “Accounting for the Impairment or Disposal of Long-lived Assets,” Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001), par. 4.]

[4] FASB ASC 810-10-45. [Predecessor literature: “Consolidated Financial Statements,” Accounting Research Bulletin No. 51 (August 1959).] [5] FASB ASC 260. [Predecessor literature: “Earnings Per Share,” Statement of Financial Accounting Standards No. 128 (Norwalk,

Conn.: FASB, 1996).] [6] FASB ASC 260-10-10-2. [Predecessor literature: “Earnings Per Share,” Statement of Financial Accounting Standards No. 128

(Norwalk, Conn.: FASB, 1996), par. 11.] [7] FASB ASC 250. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting

Standards No. 154 (Norwalk, Conn.: FASB, 2005).] [8] FASB ASC 220. [Predecessor literature: “Reporting Comprehensive Income,” Statement of Financial Accounting Standards No.

130 (Norwalk, Conn.: FASB, 1997).]

Codifi cation Exercises If your school has a subscription to the FASB Codification, go to http://aahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE4-1 Access the glossary (“Master Glossary”) to answer the following.

(a) What is a change in accounting estimate? (b) How is a change in accounting principle distinguished from a “change in accounting estimate effected by a change in

accounting principle”? (c) What is the formal definition of comprehensive income?

CE4-2 Enyart Company has a noncontrolling interest in a subsidiary. Enyart’s controller is unsure how to report losses in the subsidiary that exceed the value of Enyart’s interest in the subsidiary. Advise the controller. CE4-3 What guidance does the SEC provide for public companies with respect to the reporting of the “effect of preferred stock dividends and accretion of carrying amount of preferred stock on earnings per share”?

Codifi cation Research Case Your client took accounting a number of years ago and was unaware of comprehensive income reporting. He is not convinced that any accounting standards exist for comprehensive income.

Instructions Go to http://aahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.

(a) What authoritative literature addresses comprehensive income? When was it issued? (b) Provide the definition of comprehensive income. (c) Define classifications within net income and give examples. (d) Define classifications within other comprehensive income and give examples. (e) What are reclassification adjustments?

ADDITIONAL PROFESSIONAL RESOURCES Go to WileyPLUS for other career-readiness resources, such as career coaching, internship opportunities, and CPAexcel prep.

LEARNING OBJECTIVE 8 Compare the accounting procedures for income reporting under GAAP and IFRS.

IFRS Insights As in GAAP, the income statement is a required statement for IFRS. In addition, the content and presentation of an IFRS income statement is similar to the one used for GAAP. IAS 1, “Presentation of Financial Statements,” provides general guidelines for the reporting of income statement information. Subsequently, a number of international standards have been issued that provide additional guidance to issues related to income statement presentation.

RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to the income statement.

Similarities • Both GAAP and IFRS require companies to indicate the amount of net income attributable to

noncontrolling interest. • With the recent FASB Accounting Standards Update, under both IFRS and GAAP, unusual and

infrequent income items are reported in Income before income taxes (i.e., not an extraordinary item treatment).

• Both GAAP and IFRS follow the same presentation guidelines for discontinued operations, but IFRS defi nes a discontinued operation more narrowly. Both standard-setters have indicated a willingness to develop a similar defi nition to be used in the joint project on fi nancial statement presentation.

• Both GAAP and IFRS have items that are recognized in equity as part of comprehensive income but do not affect net income. Both GAAP and IFRS allow a one statement or two statement approach to preparing the statement of comprehensive income.

Differences • Presentation of the income statement under GAAP follows either a single-step or multiple-step

format. IFRS does not mention a single-step or multiple-step approach. • Under IFRS, companies must classify expenses by either nature or function. GAAP does not

have that requirement, but the SEC requires a functional presentation. • IFRS identifi es certain minimum items that should be presented on the income statement.

GAAP has no minimum information requirements. However, the SEC rules have more rigor- ous presentation requirements.

• IFRS does not defi ne key measures like income from operations. SEC regulations defi ne many key measures and provide requirements and limitations on companies reporting non-GAAP/ IFRS information.

• Under IFRS, revaluation of property, plant, and equipment, and intangible assets is permitted, with gains reported as other comprehensive income. The effect of this difference is that applica- tion of IFRS results in more transactions affecting equity but not net income.

ABOUT THE NUMBERS

Income Reporting Illustration IFRS4-1 (on page 196) provides a summary of the primary income items under IFRS. As indicated in the table, similar to GAAP, companies report all revenues, gains, expenses, and losses on the income statement and, at the end of the period, close them to Retained Earnings. They provide useful subtotals on the income statement, such as gross profit, income from operations, income before income tax, and net income. Companies pre- sent other income and expense in a separate section, before income from operations. Compa- nies classify discontinued operations of a component of a business as a separate item in the income statement, after “Income from continuing operations.” Providing intermediate income figures helps readers evaluate earnings information in assessing the amounts, tim- ing, and uncertainty of future cash flows.

IFRS Insights 195

196 Chapter 4 Income Statement and Related Information

Type of Situation Criteria Examples Placement on Income Statement

Sales or service revenues

Cost of goods sold

Selling and administrative expenses

Other income and expense

Financing costs

Income tax

Discontinued operations

Non-controlling interest

Revenue arising from the ordinary activities of the company

Expense arising from the cost of inventory sold or services provided

Expenses arising from the ordinary activities of the company

Gains and losses and other ancillary revenues and expenses

Separates cost of fi nancing from operating costs

Levies imposed by governmental bodies on the basis of income

A component of a company that has either been disposed of or is

classifi ed as held-for-sale

Allocation of net income or loss divided between two classes:

(1) the majority interest represented by the shareholders who own the controlling interest, and (2) the non-controlling interest (often referred to as the minority interest)

Sales revenue, service revenue

In a merchandising company, cost of goods sold; in a service company, cost of services

Sales salaries, delivery expense, rent, depreciation, utilities

Gain on sale of long-lived assets, impairment loss on intangible

assets, investment revenue, dividend and interest revenue, casualty losses

Interest expense

Taxes computed on income before income tax

A sale by diversifi ed company of a major division representing its

only activities in the electronics industry

Food distributor that sells wholesale to supermarkets

decides to discontinue the division in a major geographic area

Net profi t (loss) attributable to non-controlling shareholders

Sales or revenue section

Deduct from sales (to arrive at gross profi t) or service revenue

Deduct from gross profi t; if the function-of-expense approach

is used, depreciation and amortization expense and labor costs must be disclosed

Report as part of income from operations

Report in separate section between income from operations and

income before income tax

Report in separate section between income before income tax and net

income

Report gains or losses on discontinued operations net of

tax in a separate section between income from continuing operations and net income

Report as a separate item below net income or loss as an allocation of

the net income or loss (not as an item of income or expense)

ILLUSTRATION IFRS4-1 Summary of Income Items under IFRS

Expense Classifi cations Companies are required to present an analysis of expenses classified either by their nature (such as cost of materials used, direct labor incurred, delivery expense, advertising expense, employee benefits, depreciation expense, and amortization expense) or their function (such as cost of goods sold, selling expenses, and administrative expenses).

An advantage of the nature-of-expense method is that it is simple to apply because alloca- tions of expense to different functions are not necessary. For manufacturing companies that must allocate costs to the product produced, using a nature-of-expense approach permits companies to report expenses without making arbitrary allocations.

The function-of-expense method, however, is often viewed as more relevant because this method identifies the major cost drivers of the company and therefore helps users assess whether these amounts are appropriate for the revenue generated. As indicated, a disadvantage of this method is that the allocation of costs to the varying functions may be arbitrary and therefore the expense classification becomes misleading.

To illustrate these two methods, assume that the accounting firm of Telaris Co. performs audit, tax, and consulting services. It has the following revenues and expenses.

If Telaris Co. uses the nature-of-expense approach, its income statement presents each expense item but does not classify the expenses into various subtotals, as follows.

IFRS Insights 197

Service revenues $400,000

Cost of services Staff salaries (related to various services performed) 145,000 Supplies expense (related to various services performed) 10,000

Selling expenses Advertising costs 20,000 Entertainment expense 3,000

Administrative expenses Utilities expense 5,000 Depreciation on building 12,000

TELARIS CO. INCOME STATEMENT

FOR THE MONTH OF JANUARY 2017

Service revenues $400,000 Staff salaries 145,000 Supplies expense 10,000 Advertising costs 20,000 Utilities expense 5,000 Depreciation on building 12,000 Entertainment expense 3,000

Net income $205,000

If Telaris uses the function-of-expense approach, its income statement is as follows.

TELARIS CO. INCOME STATEMENT

FOR THE MONTH OF JANUARY 2017

Service revenues $400,000 Cost of services 155,000 Selling expenses 23,000 Administrative expenses 17,000

Net income $205,000

The function-of-expense method is generally used in practice although many companies believe both approaches have merit. These companies use the function-of-expense approach on the income statement but provide detail of the expenses (as in the nature-of-expense approach) in the notes to the financial statements. The IASB/FASB discussion paper on financial statement presentation also recommends the dual approach.

ON THE HORIZON The IASB and FASB are working on a project that would rework the structure of financial state- ments. One stage of this project will address the issue of how to classify various items in the income statement. A main goal of this new approach is to provide information that better repre- sents how businesses are run. The FASB and IASB have issued a proposal to require comprehen- sive income be reported in a combined statement of comprehensive income. This approach draws attention away from just one number—net income.

198 Chapter 4 Income Statement and Related Information

IFRS CONCEPTS AND APPLICATION

IFRS4-1 Explain the difference between the “nature-of-expense” and “function-of-expense” classifications.

IFRS4-2 Discuss the appropriate treatment in the income statement for the following items: (a) Loss on discontinued operations. (b) Non-controlling interest allocation.

IFRS4-3 Bradshaw Company experienced a loss that was deemed to be both unusual in nature and infrequent in occurrence. How should Bradshaw report this item in accordance with IFRS?

IFRS4-4 Presented below is information related to Viel Company at December 31, 2017, the end of its first year of operations.

Sales revenue $310,000 Cost of goods sold 140,000 Selling and administrative expenses 50,000 Gain on sale of plant assets 30,000 Unrealized gain on non-trading equity securities 10,000 Interest expense 6,000 Loss on discontinued operations 12,000 Allocation to non-controlling interest 40,000 Dividends declared and paid 5,000

Instructions Compute the following: (a) income from operations, (b) net income, (c) net income attributable to Viel Company controlling shareholders, (d) comprehensive income, and (e) retained earnings balance at December 31, 2017. (Ignore income taxes.)

IFRS4-5 The income statement for a British company, Avon Rubber plc, is presented on the next page. Avon prepares its financial statements in accordance with IFRS.

Instructions (a) Review the Avon Rubber income statement and identify at least three differences between the IFRS income statement

and an income statement of a U.S. company as presented in the chapter. (b) Identify any irregular items reported by Avon Rubber. Is the reporting of these irregular items in Avon’s income state-

ment similar to reporting of these items in U.S. companies’ income statements? Explain.

Professional Research IFRS4-6 Your client took accounting a number of years ago and was unaware of comprehensive income reporting. He is not convinced that any accounting standards exist for comprehensive income. (See page 199 for Instructions.)

1. Which of the following is not reported in an income state- ment under IFRS?

(a) Discontinued operations. (b) Extraordinary items. (c) Cost of goods sold. (d) Income tax.

2. Which of the following statements is correct regarding income reporting under IFRS?

(a) IFRS does not permit revaluation of property, plant, and equipment, and intangible assets.

(b) IFRS provides the same options for reporting com- prehensive income as GAAP.

the income statement. 3. Which statement is correct regarding IFRS?

(a) An advantage of the nature-of-expense method is that it is simple to apply because allocations of expense to different functions are not necessary.

(b) The function-of-expense approach never requires arbitrary allocations.

(c) An advantage of the function-of-expense method is that allocation of costs to the varying functions is rarely arbitrary.

(d) IFRS requires use of the nature-of-expense approach. 4. The non-controlling interest section of the income state- ment is:

(a) required under GAAP but not under IFRS. (b) required under IFRS but not under GAAP. (c) required under IFRS and GAAP. (d) not reported under GAAP or IFRS.

5. Which of the following is not an acceptable way of dis- playing the components of other comprehensive income under IFRS?

(a) Within the statement of retained earnings. (b) Second income statement. (c) Combined statement of comprehensive income. (d) All of these choices are acceptable.

IFRS SELF-TEST QUESTIONS

Instructions Access the IFRS authoritative literature at the IASB website (http://www.iasb.org/ ). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.)

(a) What IFRS addresses reporting in the statement of comprehensive income? When was it issued? (b) Provide the defi nition of total comprehensive income. (c) Explain the rationale for presenting additional line items, headings, and subtotals in the statement of comprehensive income. (d) What items of income or expense may be presented either in the statement of comprehensive income or in the notes?

IFRS Insights 199

Avon Rubber plc Consolidated Income Statement (pounds in thousands)

Current Year Prior Year Continuing operations Revenue 107,600 117,574 Cost of sales (77,892) (89,256)

Gross profi t 29,708 28,318 Distribution costs (4,832) (4,527) Administrative expenses (13,740) (14,536) Other operating income — —

Operating profi t/(loss) from continuing operations 11,136 9,255 Operating profi t/(loss) is analysed as: Before depreciation, amortization and exceptional items 15,723 13,577 Depreciation and amortization (4,587) (4,322)

Operating profi t/(loss) before exceptional items 11,136 9,255 Exceptional operating items Finance income 5 16 Finance costs (486) (985) Other fi nance income (443) (1,152)

Profi t/(loss) before taxation 10,212 7,134 Taxation (3,094) (2,808)

Profi t/(loss) for the year from continuing operations 7,118 4,326

Earnings/(loss) per share Basic 25.2p 15.2p Diluted 23.3p 14.4p

Earnings/(loss) per share from continuing operations Basic 25.2p 15.2p Diluted 23.3p 14.4p

International Financial Reporting Problem

Marks and Spencer plc (M&S)

IFRS4-7 The financial statements of M&S are presented in Appendix E. The company’s complete annual report, includ- ing the notes to the financial statements, is available online.

Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions.

(a) What type of income statement format does M&S use? Indicate why this format might be used to present income statement information.

(b) What are M&S’s primary revenue sources? (c) Compute M&S’s gross profi t for each of the years 2014 and 2015. (d) Why does M&S make a distinction between operating and non-operating profi t? (e) Does M&S report any non-GAAP measures? Explain.

ANSWERS TO IFRS SELF-TEST QUESTIONS

1. b 2. b 3. a 4. c 5. a

5 1 Explain the uses and limitations of a

balance sheet.

2 Identify the major classifications of the balance sheet.

3 Prepare a classified balance sheet using the report and account formats.

4 Identify the purpose and content of the statement of cash flows.

5 Prepare a basic statement of cash flows. 6 Understand the usefulness of the

statement of cash flows.

7 Determine which balance sheet information requires supplemental disclosure.

8 Describe the major disclosure techniques for the balance sheet.

Balance Sheet and Statement of Cash Flows LEARNING OBJECTIVES After studying this chapter, you should be able to:

HEY, IT DOESN’T BALANCE! A good accounting student knows by now that Total Assets = Total Liabilities + Total Equity. From this equa- tion, we can also determine net assets, which are determined as follows: Total Assets − Total Liabilities = Net Assets. O.K., this is simple so far. But let’s look at a discussion paper by the FASB/IASB on how the statement of financial position (the balance sheet) should be structured.

The statement of financial position is divided into five major parts, with many assets and liabilities netted against one another. Here is the general framework for the new statement of financial position:

BUSINESS Operating assets and liabilities Investing assets and liabilities FINANCING Financing assets Financing liabilities INCOME TAXES DISCONTINUED OPERATIONS EQUITY

The statement does look a bit different than the traditional balance sheet. Let’s put some numbers to the state- ment and see how it works. (See the example on the next page.)

Well, it does balance—in that net assets equal equity—but isn’t it important to know total assets and total liabili- ties? As some have observed, the statement of financial position will not balance the way we expect it to. That is, assets won’t equal liabilities and equity. This is because the assets and liabilities are grouped into the business, financ- ing, discontinued operations, and income taxes categories. This new model raises a number of questions, such as:

• Does separating “business activities from financing activities” provide information that is more decision- useful?

• Does information on income taxes and discontinued operations merit separate categories?

The FASB and IASB are working to get answers to these and other questions about this proposed model. One thing is for sure—adoption of the new financial statements will be a dramatic change but hopefully one for the better.

STATEMENT OF FINANCIAL POSITION

BUSINESS Operating Inventories $ 400,000 Receivables 200,000

Total short-term assets $ 600,000 Property (net) 500,000 Intangible assets 50,000

Total long-term assets 550,000 Accounts payable 30,000 Wages payable 40,000

Total short-term liabilities (70,000) Lease liability 10,000 Other long-term debt 35,000

Total long-term liabilities (45,000)

Net operating assets 1,035,000 Investing Trading securities 45,000 Other securities 5,000

Total investing assets 50,000

TOTAL NET BUSINESS ASSETS 1,085,000 FINANCING Financing assets Cash 30,000

Total financing assets 30,000 Financing liabilities Short- and long-term borrowing 130,000

Total financing liabilities (130,000)

NET FINANCING LIABILITIES (100,000) DISCONTINUED OPERATIONS Assets held for sale 420,000 INCOME TAXES Deferred income taxes 70,000 NET ASSETS $1,475,000 EQUITY Share capital—ordinary $1,000,000 Retained earnings 475,000 TOTAL EQUITY $1,475,000

Sources: Marie Leone and Tim Reason, “How Extreme Is the Makeover?” CFO Magazine (March 1, 2009); and Preliminary Views on Financial Statement Presentation, FASB/IASB Discussion Paper (October 2008).

PREVIEW OF CHAPTER 5 As the opening story indicates, the FASB and IASB are working to improve the presentation of financial information on the balance sheet, as well as other financial statements. In this chapter, we examine the many different types of assets, liabilities, and equity items that affect the balance sheet and the statement of cash flows. The content and organization of the chapter are as follows.

BALANCE SHEET AND STATEMENT OF CASH FLOWS

This chapter also includes numerous conceptual and international discussions that are integral to the topics presented here.

BALANCE SHEET

• Usefulness • Limitations • Classification • Format

STATEMENT OF CASH FLOWS

• Purpose • Content and format • Preparation • Usefulness

ADDITIONAL INFORMATION

• Supplemental disclosures • Techniques of disclosure

202 Chapter 5 Balance Sheet and Statement of Cash Flows

BALANCE SHEET The balance sheet, sometimes referred to as the statement of financial position, reports the assets, liabilities, and stockholders’ equity of a business enterprise at a specific date. This financial statement provides information about the nature and amounts of invest- ments in enterprise resources, obligations to creditors, and the owners’ equity in net resources. It therefore helps in predicting the amounts, timing, and uncertainty of future cash flows.

Usefulness of the Balance Sheet By reporting information on assets, liabilities, and stockholders’ equity, the balance sheet provides a basis for computing rates of return and evaluating the capital structure of the enterprise. Analysts also use information in the balance sheet to assess a compa- ny’s risk1 and future cash flows. In this regard, analysts use the balance sheet to assess a company’s liquidity, solvency, and financial flexibility.

Liquidity describes “the amount of time that is expected to elapse until an asset is realized or otherwise converted into cash or until a liability has to be paid.”2

Creditors are interested in short-term liquidity ratios, such as the ratio of cash (or near cash) to short-term liabilities. These ratios indicate whether a company, like Amazon.com, will have the resources to pay its current and maturing obligations. Similarly, stockholders assess liquidity to evaluate the possibility of future cash div- idends or the buyback of shares. In general, the greater Amazon’s liquidity, the lower its risk of failure.

Solvency refers to the ability of a company to pay its debts as they mature. For exam- ple, when a company carries a high level of long-term debt relative to assets, it has lower solvency than a similar company with a low level of long-term debt. Companies with higher debt are relatively more risky because they will need more of their assets to meet their fixed obligations (interest and principal payments).

Liquidity and solvency affect a company’s financial flexibility, which measures the “ability of an enterprise to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities.”3 For example, a com- pany may become so loaded with debt—so financially inflexible—that it has little or no sources of cash to finance expansion or to pay off maturing debt. A company with a high degree of financial flexibility is better able to survive bad times, to recover from unex- pected setbacks, and to take advantage of profitable and unexpected investment oppor- tunities. Generally, the greater an enterprise’s financial flexibility, the lower its risk of failure.

Limitations of the Balance Sheet Some of the major limitations of the balance sheet are:

1. Most assets and liabilities are reported at historical cost. As a result, the information provided in the balance sheet is often criticized for not reporting a more relevant fair value. For example, Georgia-Pacifi c owns timber and other assets that may appreciate in value after purchase. Yet, Georgia-Pacifi c reports any increase only if and when it sells the assets.

2. Companies use judgments and estimates to determine many of the items reported in the balance sheet. For example, in its balance sheet, Dell estimates the amount of

LEARNING OBJECTIVE 1 Explain the uses and limitations of a balance sheet.

1Risk conveys the unpredictability of future events, transactions, circumstances, and results of the company. 2“Reporting Income, Cash Flows, and Financial Position of Business Enterprises,” Proposed Statement of Financial Accounting Concepts (Stamford, Conn.: FASB, 1981), par. 29. 3“Reporting Income, Cash Flows, and Financial Position of Business Enterprises,” Proposed Statement of Financial Accounting Concepts (Stamford, Conn.: FASB, 1981), par. 25.

How quickly will my assets convert to cash?

Liquidity Operations

We are drowning in a sea of debt!

Obligation Ocean

Solvency S.O.S

Hmm... I wonder if they will pay me back?

$ IOU

Balance Sheet 203

receivables that it will collect, the useful life of its warehouses, and the number of computers that will be returned under warranty.

3. The balance sheet necessarily omits many items that are of fi nancial value but that a company cannot record objectively. For example, the knowledge and skill of Intel employees in developing new computer chips are arguably the compa- ny’s most signifi cant assets. However, because Intel cannot reliably measure the value of its employees and other intangible assets (such as customer base, research superiority, and reputation), it does not recognize these items in the balance sheet. Similarly, many liabilities are reported in an “off-balance-sheet” manner, if at all.

The bankruptcy of Enron, the seventh-largest U.S. company at the time, high- lights the omission of important items in the balance sheet. In Enron’s case, it failed to disclose certain off-balance-sheet financing obligations in its main financial statements.4

PPEInventory

Cash AR

Balance Sheet

Hey....we left out the value of the employees!

4We discuss several of these omitted items (such as leases and other off-balance-sheet arrangements) in later chapters. See Wayne Upton, Jr., Special Report: Business and Financial Reporting, Challenges from the New Economy (Norwalk, Conn.: FASB, 2001); U.S. Securities and Exchange Commission, “Disclosure in Manage- ment’s Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations,” http://www.sec.gov/rules/final/33-8182.htm (May 2003); and Commission Guidance on Presentation of Liquidity and Capital Resources Disclosures in Management’s Discussion and Analysis Release Nos. 33–9144; 34–62934 (September 17, 2010).

WHAT DO THE NUMBERS MEAN? GROUNDED

Sources: R. Seaney, “Airline Mergers: Good for Travelers?” http://abcnews.go.com/Travel/airline-merger-mania-cost/story?id=16227892 (April 27, 2012); and T. Reed, “Buffett Decries Airline Investing Even Though at Worst He Broke Even,” Forbes (May 13, 2013).

The terrorist attacks of September 11, 2001, showed how vul- nerable the major airlines are to falling demand for their ser- vices. Since that infamous date, major airlines have reduced capacity and slashed jobs to avoid bankruptcy. United Air- lines, Northwest Airlines, US Airways, and several smaller competitors fi led for bankruptcy in the wake of 9/11.

Delta Airlines made the following statements in its annual report issued shortly after 9/11:

“If we are unsuccessful in further reducing our operating costs . . . we will need to restructure our costs under Chapter 11 of the U.S. Bankruptcy Code. . . . We have substantial liquidity needs and there is no assurance that we will be able to obtain the necessary fi nancing to meet those needs on acceptable terms, if at all.”

These fi nancial fl exibility challenges have continued, exacerbated by volatile fuel prices, labor costs, and the unpredictability of the global economic environment. Not surprisingly, several of the major airlines (Delta and North- west, Continental and United, Airtran and Southwest, and American Airlines and US Airways) merged recently as a way to build some competitive synergies and to bolster their fi nancial fl exibility. There is no question that running an airline is a diffi cult task. As superstar investor Warren Buffett said, “I have an 800 number now that I call if I get the urge to buy an airline stock,” adding that his “aeroholic” buddies “talk me down.”

Classifi cation in the Balance Sheet Balance sheet accounts are classified. That is, balance sheets group together similar items to arrive at significant subtotals. Furthermore, the material is arranged so that important relationships are shown.

The FASB has often noted that the parts and subsections of financial statements can be more informative than the whole. Therefore, the FASB discourages the reporting of summary accounts alone (total assets, net assets, total liabilities, etc.). Instead, compa- nies should report and classify individual items in sufficient detail to permit users to assess the amounts, timing, and uncertainty of future cash flows. Such classification also

LEARNING OBJECTIVE 2 Identify the major classifications of the balance sheet.

204 Chapter 5 Balance Sheet and Statement of Cash Flows

makes it easier for users to evaluate the company’s liquidity, financial flexibility, profit- ability, and risk.

To classify items in financial statements, companies group those items with similar characteristics and separate items with different characteristics.5 For example, compa- nies should report separately:

1. Assets that differ in their type or expected function in the company’s central opera- tions or other activities. For example, IBM reports merchandise inventories sepa- rately from property, plant, and equipment.

2. Assets and liabilities with different implications for the company’s fi nancial fl ex- ibility. For example, a company that uses assets in its operations, like Walgreens, should report those assets separately from assets held for investment and assets subject to restrictions, such as leased equipment.

3. Assets and liabilities with different general liquidity characteristics. For example, Boeing Company reports cash separately from inventories.

The three general classes of items included in the balance sheet are assets, liabilities, and equity. We defined them in Chapter 2 as follows.

5“Reporting Income, Cash Flows, and Financial Positions of Business Enterprises,” Proposed Statement of Financial Accounting Concepts (Stamford, Conn.: FASB, 1981), par. 51. 6“Elements of Financial Statements of Business Enterprises,” Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, 1985), paras. 25, 35, and 49.

1. ASSETS. Probable future economic benefi ts obtained or controlled by a particular entity as a result of past transactions or events.

2. LIABILITIES. Probable future sacrifi ces of economic benefi ts arising from present obli- gations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

3. EQUITY. Residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest.6

ELEMENTS OF THE BALANCE SHEET

Companies then further divide these items into several subclassifications. Illustration 5-1 indicates the general format of balance sheet presentation.

Assets Liabilities and Owners’ Equity

Current assets Current liabilities Long-term investments Long-term debt Property, plant, and equipment Owners’ (stockholders’) equity Intangible assets Other assets

ILLUSTRATION 5-1 Balance Sheet Classifi cations

A company may classify the balance sheet in some other manner, but in practice you usually see little departure from these major subdivisions. A proprietorship or partner- ship does present the classifications within the owners’ equity section a little differently, as we will show later in the chapter.

Balance Sheet 205

Current Assets Current assets are cash and other assets a company expects to convert into cash, sell, or consume either in one year or in the operating cycle, whichever is longer. The oper- ating cycle is the average time between when a company acquires materials and sup- plies and when it receives cash for sales of the product (for which it acquired the materials and supplies). The cycle operates from cash through inventory, production, receivables, and back to cash. When several operating cycles occur within one year (which is generally the case for service companies), a company uses the one-year period. If the operating cycle is more than one year, a company uses the longer period.

Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current assets section, and their bases of valuation, are shown in Illustration 5-2.

ILLUSTRATION 5-2 Current Assets and Basis of Valuation

Item Basis of Valuation

Cash and cash equivalents Fair value Short-term investments Generally, fair value Receivables Estimated amount collectible Inventories Lower-of-cost-or-net realizable value/market Prepaid expenses Cost

A company does not report these five items as current assets if it does not expect to realize them in one year or in the operating cycle, whichever is longer. For example, a company excludes from the current assets section cash restricted for purposes other than payment of current obligations or for use in current operations. Generally, if a company expects to convert an asset into cash or to use it to pay a current liability within a year or the operating cycle, whichever is longer, it classifies the asset as current.

This rule, however, is subject to interpretation. A company classifies an investment in common stock as either a current asset or a noncurrent asset depending on manage- ment’s intent. When it has small holdings of common stocks or bonds that it will hold long-term, it should not classify them as current.

Although a current asset is well defined, certain theoretical problems also develop. For example, how is including prepaid expenses in the current assets section justified? The rationale is that if a company did not pay these items in advance, it would instead need to use other current assets during the operating cycle. If we follow this logic to its ultimate conclusion, however, any asset previously purchased saves the use of cur- rent assets during the operating cycle and would be considered current.

Another problem occurs in the current-asset definition when a company con- sumes plant assets during the operating cycle. Conceptually, it seems that a com- pany should place in the current assets section an amount equal to the current depreciation charge on the plant assets, because it will consume them in the next operating cycle. However, this conceptual problem is ignored. This example illus- trates that the formal distinction made between some current and noncurrent assets is somewhat arbitrary.

Cash. Cash is generally considered to consist of currency and demand deposits (monies available on demand at a financial institution). Cash equivalents are short-term highly liquid investments that will mature within three months or less. Most companies use the caption “Cash and cash equivalents,” and they indicate that this amount approxi- mates fair value.

A company must disclose any restrictions or commitments related to the availabil- ity of cash. As an example, see the excerpt from the annual report of Alterra Healthcare Corp. in Illustration 5-3 (page 206).

206 Chapter 5 Balance Sheet and Statement of Cash Flows

Alterra Healthcare restricted cash to meet an obligation due currently. Therefore, Alterra included this restricted cash under current assets.

If a company restricts cash for purposes other than current obligations, it excludes the cash from current assets. Illustration 5-4 shows an example of this, from the annual report of Owens Corning, Inc.

Alterra Healthcare Corp. Current assets

Cash $18,728,000 Restricted cash and investments (Note 7) 7,191,000

Note 7: Restricted Cash and Investments. Restricted cash and investments consist of certificates of deposit restricted as collateral for lease arrangements and debt service with interest rates ranging from 4.0% to 5.5%.

ILLUSTRATION 5-3 Balance Sheet Presentation of Restricted Cash

ILLUSTRATION 5-4 Balance Sheet Presentation of Current and Noncurrent Restricted Cash

Owens Corning, Inc. (in millions)

Current assets

Cash and cash equivalents $ 70 Restricted securities—Fibreboard—current portion (Note 23) 900

Other assets

Restricted securities—Fibreboard (Note 23) 938

Note 23 (in part). The Insurance Settlement funds are held in and invested by the Fibreboard Settle- ment Trust (the “Trust”) and are available to satisfy Fibreboard’s pending and future asbestos related liabilities. . . . The assets of the Trust are comprised of cash and marketable securities (collectively, the “Trust Assets”) and are reflected on Owens Corning’s consolidated balance sheet as restricted assets. These assets are reflected as current assets or other assets, with each category denoted “Restricted securities—Fibreboard.”

Short-Term Investments. All equity securities are recorded at fair value with changes reported in net income (unless accounted for under the equity method or if it is not practicable to determine fair value). Companies group investments in debt securities into three separate portfolios for valuation and reporting purposes:

Held-to-maturity: Debt securities that a company has the positive intent and ability to hold to maturity. Trading: Debt securities bought and held primarily for sale in the near term to gen- erate income on short-term price differences. Available-for-sale: Debt securities not classifi ed as held-to-maturity or trading securities.

A company should report trading securities as current assets. It classifies individual equity investments and held-to-maturity and available-for-sale debt securities as cur- rent or noncurrent depending on the circumstances (based on management’s intent). It should report held-to- maturity securities at amortized cost. All trading and available- for-sale debt securities are reported at fair value. [1]7 Note that only debt securities are classified as available-for-sale with changes reported in stockholders’ equity.

7Under the fair value option, companies may elect to use fair value as the measurement basis for selected financial assets and liabilities. For these companies, some of their financial assets (and liabilities) may be recorded at historical cost, while others are recorded at fair value. [2]

See the FASB Codifi cation References (page 257).

Balance Sheet 207

For example, Illustration 5-5 is an excerpt from the annual report of Intuit Inc. with respect to its available-for-sale investments.

Receivables. A company should clearly identify any expected loss due to uncollect- ibles, the amount and nature of any nontrade receivables, and any receivables used as collateral. Major categories of receivables should be shown in the balance sheet or the related notes. For receivables arising from unusual transactions (such as sale of prop- erty, or a loan to affiliates or employees), companies should separately classify these as long-term, unless collection is expected within one year. Stanley Black & Decker reported its receivables as shown in Illustration 5-6.

Inventories. To present inventories properly, a company discloses the basis of valu- ation (e.g., lower-of-cost-or-net realizable value or lower-of-cost-or-market) and the cost flow assumption used (e.g., FIFO or LIFO). A manufacturing concern (like Acer Incorporated, shown in Illustration 5-7 on page 208) also indicates the stage of com- pletion of the inventories.

Intuit Inc. (in thousands)

Assets

Cash and cash equivalents $ 170,043 Short-term investments (Note 2) 1,036,758

Note 2 (in part). The following schedule summarizes the estimated fair value of our short-term invest- ments (all available-for-sale):

Corporate notes $ 50,471 Municipal bonds 931,374 U.S. government securities 54,913

ILLUSTRATION 5-5 Balance Sheet Presentation of Investments in Securities

ILLUSTRATION 5-6 Balance Sheet Presentation of Receivables

Stanley Black & Decker (in millions)

Current assets

Cash and cash equivalents $ 906.9 Accounts and notes receivable, net 1,553.2 Inventories, net 1,438.6 Prepaid expenses 209.0 Other current assets 215.0

Total current assets 4,322.7

Note B (in part): Accounts and Notes Receivable

Trade accounts receivable $1,484.0 Trade notes receivable 100.3 Other accounts receivables 32.8

Gross accounts and notes receivable 1,617.1 Allowance for doubtful accounts (63.9)

Accounts and notes receivable, net $1,553.2

208 Chapter 5 Balance Sheet and Statement of Cash Flows

Weyerhaeuser Company, a forestry company and lumber manufacturer with several finished-goods product lines, reported its inventory as shown in Illustration 5-8.

Prepaid Expenses. A company includes prepaid expenses in current assets if it will receive benefits (usually services) within one year or the operating cycle, whichever is longer. As we discussed earlier, these items are current assets because if they had not already been paid, they would require the use of cash during the next year or the operat- ing cycle. A company reports prepaid expenses at the amount of the unexpired or unconsumed cost.

A common example is the prepayment for an insurance policy. A company classifies it as a prepaid expense because the payment precedes the receipt of the benefit of cover- age. Other common prepaid expenses include prepaid rent, advertising, taxes, and office or operating supplies. Hasbro, Inc., for example, listed its prepaid expenses in current assets as shown in Illustration 5-9.

Weyerhaeuser Company Current assets

Inventories Logs and chips $ 68,471,000 Lumber, plywood and panels 86,741,000 Pulp, newsprint and paper 47,377,000 Containerboard, paperboard, containers and cartons 59,682,000 Other products 161,717,000

Total product inventories 423,988,000 Materials and supplies 175,540,000

ILLUSTRATION 5-8 Balance Sheet Presentation of Inventories, Showing Product Lines

ILLUSTRATION 5-9 Balance Sheet Presentation of Prepaid Expenses

Hasbro, Inc. (in thousands)

Current assets

Cash and cash equivalents $ 715,400 Accounts receivable, less allowances of $27,700 556,287 Inventories 203,337 Prepaid expenses and other current assets 243,291

Total current assets $1,718,315

Acer Incorporated (in thousands)

Current assets

Raw materials $ 442,706 Work in process 1,506 Finished goods 515,202 Spare parts 138,477 Inventories in transit 281,364 Less: Provision for inventory obsolescence and net realizable value (159,553)

$1,219,702

Note 8 (in part): Inventories. Inventories are measured at the lower of standard cost and net realizable value. The differences between standard and actual cost are fully recognized in cost of sales. Net realizable value represents the estimated selling price in the ordinary course of business, less all estimated costs of completion and necessary selling expenses.

ILLUSTRATION 5-7 Balance Sheet Presentation of Inventories, Showing Stage of Completion

Balance Sheet 209

Noncurrent Assets Noncurrent assets are those not meeting the definition of current assets. They include a variety of items, as we discuss in the following sections.

Long-Term Investments. Long-term investments, often referred to simply as invest- ments, normally consist of one of four types:

1. Investments in securities, such as bonds, common stock, or long-term notes. 2. Investments in tangible fi xed assets not currently used in operations, such as land

held for speculation. 3. Investments set aside in special funds, such as a sinking fund, pension fund, or

plant expansion fund. This includes the cash surrender value of life insurance. 4. Investments in nonconsolidated subsidiaries or affi liated companies.

Companies expect to hold long-term investments for many years. They usually present them on the balance sheet just below “Current assets,” in a separate section called “Investments.” Realize that many securities classified as long-term investments are, in fact, readily marketable. But a company does not include them as current assets unless it intends to convert them to cash in the short-term—that is, within a year or in the operating cycle, whichever is longer. As indicated earlier, debt investments clas- sified as available-for-sale are reported at fair value, and held-to-maturity debt invest- ments are reported at amortized cost. Equity investments are reported at fair value.

Motorola, Inc. reported its investments section, located between “Property, plant, and equipment” and “Other assets,” as shown in Illustration 5-10.

Property, Plant, and Equipment. Property, plant, and equipment are tangible long- lived assets used in the regular operations of the business. These assets consist of physi- cal property such as land, buildings, machinery, furniture, tools, and wasting resources (timberland, minerals). With the exception of land, a company either depreciates (e.g., buildings) or depletes (e.g., timberlands or oil reserves) these assets.

Mattel, Inc. presented its property, plant, and equipment in its balance sheet as shown in Illustration 5-11 (page 210). A company discloses the basis it uses to value property, plant, and equipment; any liens against the properties; and accumulated depreciation—usually in the notes to the financial statements.

Intangible Assets. Intangible assets lack physical substance and are not financial instruments (see page 226 for the definition of a financial instrument). They include patents, copyrights, franchises, goodwill, trademarks, trade names, and customer lists. A company writes off (amortizes) limited-life intangible assets over their useful lives. It periodically assesses indefinite-life intangibles (such as goodwill) for impairment.

Motorola, Inc. (in millions)

Investments

Equity investments $ 872 Other investments 2,567 Fair value adjustment to available-for-sale securities 2,487

Total $5,926

ILLUSTRATION 5-10 Balance Sheet Presentation of Long-Term Investments

210 Chapter 5 Balance Sheet and Statement of Cash Flows

Intangibles can represent significant economic resources, yet financial analysts often ignore them, because valuation is difficult.

PepsiCo, Inc. reported intangible assets in its balance sheet as shown in Illustra- tion 5-12.

ILLUSTRATION 5-11 Balance Sheet Presentation of Property, Plant, and Equipment

Mattel, Inc. Property, plant, and equipment

Land $ 32,793,000 Buildings 257,430,000 Machinery and equipment 564,244,000 Capitalized leases 23,271,000 Leasehold improvements 74,988,000

952,726,000 Less: Accumulated depreciation 472,986,000

479,740,000 Tools, dies and molds, net 168,092,000

Property, plant, and equipment, net 647,832,000

Other Assets. The items included in the section “Other assets” vary widely in practice. Some include items such as long-term prepaid expenses, prepaid pension cost, and non- current receivables. Other items that might be included are assets in special funds, deferred income taxes, property held for sale, and restricted cash or securities. A com- pany should limit this section to include only unusual items sufficiently different from assets included in specific categories.

PepsiCo, Inc. (in millions)

Intangible assets

Goodwill $3,374 Trademarks 1,320 Other identifiable intangibles 147

Total intangibles $4,841

ILLUSTRATION 5-12 Balance Sheet Presentation of Intangible Assets

Before the dot-com bubble burst, concerns about liquidity and solvency led creditors of many dot-com companies to demand more assurances that these companies could pay their bills when due. A key indicator for creditors is the amount of work- ing capital. For example, when a report predicted that Amazon. com’s working capital would turn negative, the company’s vendors began to explore steps that would ensure that Amazon would pay them.

Some vendors demanded that their dot-com customers sign notes stating that the goods shipped to them would serve as col- lateral for the transaction. Other vendors began shipping goods on consignment—an arrangement whereby the vendor retains own- ership of the goods until a third party buys and pays for them.

Another recent bubble in the real estate market created a working capital and liquidity crisis for no less a revered fi nancial institution than Bear Stearns. What happened? Bear Stearns

WHAT DO THE NUMBERS MEAN? “SHOW ME THE ASSETS!”

Balance Sheet 211

Liabilities Similar to assets, companies classify liabilities as current or long-term.

Current Liabilities. Current liabilities are the obligations that a company reasonably expects to liquidate either through the use of current assets or the creation of other cur- rent liabilities. This concept includes:

1. Payables resulting from the acquisition of goods and services: accounts payable, wages payable, taxes payable, and so on.

2. Collections received in advance for the delivery of goods or performance of services, such as unearned rent revenue or unearned subscriptions revenue.

3. Other liabilities whose liquidation will take place within the operating cycle, such as the portion of long-term bonds to be paid in the current period or short-term obliga- tions arising from the purchase of equipment.

At times, a liability that is payable within the next year is not included in the current liabilities section. This occurs either when the company expects to refinance the debt through another long-term issue [3] or to retire the debt out of noncurrent assets. This approach is used because liquidation does not result from the use of current assets or the creation of other current liabilities.

Companies do not report current liabilities in any consistent order. In general, though, companies most commonly list notes payable, accounts payable, or short-term debt as the first item. Income taxes payable, current maturities of long-term debt, or other current liabilities are commonly listed last. For example, see Halliburton Company’s current liabilities section in Illustration 5-13.

ILLUSTRATION 5-13 Balance Sheet Presentation of Current Liabilities

Halliburton Company (in millions)

Current liabilities

Short-term notes payable $1,570 Accounts payable 782 Accrued employee compensation and benefits 267 Unearned revenues 386 Income taxes payable 113 Accrued special charges 6 Current maturities of long-term debt 8 Other current liabilities 694

Total current liabilities 3,826

was one of the biggest investors in mortgage-backed securi- ties. But when the housing market cooled off and the value of the collateral backing Bear Stearns’ mortgage securities dropped dramatically, the market began to question Bear Stearns’ ability to meet its obligations. The result: The Federal Reserve stepped in to avert a collapse of the company,

backing a bailout plan that guaranteed $30 billion of Bear Stearns’ investments. This paved the way for a buy-out by JPMorgan Chase at $2 per share (later amended to $10 a share)—quite a bargain since Bear Stearns had been trading above $80 a share just a month earlier.

Source: Robin Sidel, Greg Ip, Michael M. Phillips, and Kate Kelly, “The Week That Shook Wall Street: Inside the Demise of Bear Stearns,” Wall Street Journal (March 18, 2008), p. A1.

212 Chapter 5 Balance Sheet and Statement of Cash Flows

Current liabilities include such items as trade and nontrade notes and accounts pay- able, advances received from customers, and current maturities of long-term debt. If the amounts are material, companies classify income taxes and other accrued items sepa- rately. A company should fully describe in the notes any information about a secured liability—for example, stock held as collateral on notes payable—to identify the assets providing the security.

The excess of total current assets over total current liabilities is referred to as working capital (or sometimes net working capital). Working capital represents the net amount of a company’s relatively liquid resources. That is, it is the liquidity buffer available to meet the financial demands of the operating cycle.

Companies seldom disclose on the balance sheet an amount for working capital. But bankers and other creditors compute it as an indicator of the short-run liquidity of a company. To determine the actual liquidity and availability of working capital to meet current obligations, however, requires analysis of the composition of the current assets and their nearness to cash.

Long-Term Liabilities. Long-term liabilities are obligations that a company does not reasonably expect to liquidate within the normal operating cycle. Instead, it expects to pay them at some date beyond that time. The most common examples are bonds pay- able, notes payable, deferred income tax liabilities, lease obligations, and pension obli- gations. Companies classify long-term liabilities that mature within the current oper- ating cycle as current liabilities if payment of the obligation requires the use of current assets.

Generally, long-term liabilities are of three types:

1. Obligations arising from specifi c fi nancing situations, such as the issuance of bonds, long-term lease obligations, and long-term notes payable.

2. Obligations arising from the ordinary operations of the company, such as pension obligations and deferred income tax liabilities.

3. Obligations that depend on the occurrence or non-occurrence of one or more future events to confi rm the amount payable, the payee, or the date payable, such as service or product warranties and other contingencies.

Companies generally provide a great deal of supplementary disclosure for long- term liabilities because most long-term debt is subject to various covenants and restric- tions for the protection of lenders.8

Companies frequently describe the terms of all long-term liability agreements (including maturity date or dates, rates of interest, nature of obligation, and any security pledged to support the debt) in notes to the financial statements. Illustration 5-14 provides an example of this, taken from an excerpt from The Great Atlantic & Pacific Tea Company’s financials.

Owners’ Equity The owners’ equity (stockholders’ equity) section is one of the most difficult sections to prepare and understand. This is due to the complexity of capital stock agreements and

8Companies usually explain the pertinent rights and privileges of the various securities (both debt and equity) outstanding in the notes to the financial statements. Examples of information that companies should disclose are dividend and liquidation preferences, participation rights, call prices and dates, conversion or exercise prices or rates and pertinent dates, sinking fund requirements, unusual voting rights, and signifi- cant terms of contracts to issue additional shares. [4]

Balance Sheet 213

ILLUSTRATION 5-14 Balance Sheet Presentation of Long-Term Debt

The Great Atlantic & Pacific Tea Company, Inc. Total current liabilities $978,109,000 Long-term debt (See note) 254,312,000 Obligations under capital leases 252,618,000 Deferred income taxes 57,167,000 Other non-current liabilities 127,321,000

Note: Indebtedness. Debt consists of: 9.5% senior notes, due in annual installments of $10,000,000 $ 40,000,000 Mortgages and other notes due (average interest rate of 9.9%) 107,604,000 Bank borrowings at 9.7% 67,225,000 Commercial paper at 9.4% 100,102,000

314,931,000 Less: Current portion (60,619,000)

Total long-term debt $254,312,000

the various restrictions on stockholders’ equity imposed by state corporation laws, liability agreements, and boards of directors. Companies usually divide the section into six parts:

1. CAPITAL STOCK. The par or stated value of the shares issued.

2. ADDITIONAL PAID-IN CAPITAL. The excess of amounts paid in over the par or stated value.

3. RETAINED EARNINGS. The corporation’s undistributed earnings.

4. ACCUMULATED OTHER COMPREHENSIVE INCOME. The aggregate amount of the other comprehensive income items.

5. TREASURY STOCK. Generally, the cost of shares repurchased.

6. NONCONTROLLING INTEREST (MINORITY INTEREST). A portion of the equity of subsidiaries not wholly owned by the reporting company.

STOCKHOLDERS’ EQUITY SECTION

For capital stock, companies must disclose the par value and the authorized, issued, and outstanding share amounts. A company usually presents the additional paid-in capital in one amount although subtotals are informative if the sources of additional capital are varied and material. The retained earnings amount may be divided between the unappro- priated (the amount that is usually available for dividend distribution) and restricted (e.g., by bond indentures or other loan agreements) amounts. In addition, companies show any capital stock reacquired (treasury stock) as a reduction of stockholders’ equity. Accumu- lated other comprehensive income includes such items as unrealized gains and losses on available-for-sale debt investments and unrealized gains and losses on certain derivative transactions. Noncontrolling interest (discussed in Chapter 4 and sometimes referred to as minority interest) is also shown as a separate item (where applicable) as a part of equity.

Illustration 5-15 (page 214) presents an example of the stockholders’ equity section from Las Vegas Sands Corporation.

214 Chapter 5 Balance Sheet and Statement of Cash Flows

The ownership or stockholders’ equity accounts in a corporation differ considerably from those in a partnership or proprietorship. Partners show separately their permanent capi- tal accounts and the balance in their temporary accounts (drawing accounts). Proprietorships ordinarily use a single capital account that handles all of the owner’s equity transactions.

Balance Sheet Format One common arrangement that companies use in presenting a classified balance sheet is the account form. It lists assets, by sections, on the left side, and liabilities and stockholders’ equity, by sections, on the right side. The main disadvantage is the need for a sufficiently wide space in which to present the items side by side. Often, the account form requires two facing pages.

To avoid this disadvantage, the report form lists the sections one above the other, on the same page. See, for example, Illustration 5-16, which lists assets, followed by liabili- ties and stockholders’ equity directly below, on the same page.9

9Accounting Trends and Techniques (New York: AICPA) recently indicates that all of the 500 companies surveyed use either the “report form” (484) or the “account form” (16), sometimes collectively referred to as the “customary form.”

LEARNING OBJECTIVE 3 Prepare a classified balance sheet using the report and account formats.

Las Vegas Sands Corporation

Equity

Preferred stock, $0.001 par value, 50,000,000 shares authorized, 3,614,923 shares issued and outstanding $ 207,356 Common stock, $0.001 par value, 1,000,000,000 shares authorized, 707,507,982 shares issued and outstanding 708 Capital in excess of par value 5,444,705 Accumulated other comprehensive income 129,519 Retained earnings 880,703

Total Las Vegas Sands Corp. stockholders’ equity 6,662,991 Noncontrolling interests 1,268,197

Total equity $7,931,188

ILLUSTRATION 5-15 Balance Sheet Presentation of Stockholders’ Equity

WHAT DO THE NUMBERS MEAN? WARNING SIGNALS

Following extensive testing, Altman found that companies with Z-scores above 3.0 are unlikely to fail. Those with Z-scores below 1.81 are very likely to fail.

Altman developed the original model for publicly held manufacturing companies. He and others have modifi ed the model to apply to companies in various industries, emerging companies, and companies not traded in public markets.

Analysts use balance sheet information in models designed to predict fi nancial distress. Researcher E. I. Altman pioneered a bankruptcy-prediction model that derives a “Z-score” by

combining balance sheet and income measures in the follow- ing equation.

At one time, the use of Z-scores was virtually unheard of among practicing accountants. Today, auditors, management consultants, and courts of law use this measure to help evalu- ate the overall fi nancial position and trends of a fi rm. In addi- tion, banks use Z-scores for loan evaluation. While a low score does not guarantee bankruptcy, the model has been proven accurate in many situations.

Source: Adapted from E. I. Altman and E. Hotchkiss, Corporate Financial Distress and Bankruptcy, Third Edition (New York: John Wiley and Sons, 2006).

Z = Working capital

× 1.2 + Retained earnings

× 1.4 Total assets Total assets

EBIT Sales +

Total assets × 3.3 +

Total assets × 0.99

MV equity +

Total liabilities × 0.6

Balance Sheet 215

ILLUSTRATION 5-16 Classifi ed Report Form Balance Sheet

SCIENTIFIC PRODUCTS, INC. BALANCE SHEET

DECEMBER 31, 2017

Assets Current assets

Cash $ 42,485 Investments (available-for-sale) 28,250 Accounts receivable $165,824 Less: Allowance for doubtful accounts 1,850 163,974

Notes receivable 23,000 Inventories—at average-cost 489,713 Supplies on hand 9,780 Prepaid expenses 16,252

Total current assets $ 773,454

Long-term investments

Equity investments 87,500

Property, plant, and equipment

Land—at cost 125,000 Buildings—at cost 975,800 Less: Accumulated depreciation 341,200 634,600

Total property, plant, and equipment 759,600

Intangible assets

Goodwill 100,000

Total assets $1,720,554

Liabilities and Stockholders’ Equity

Current liabilities

Notes payable to banks $ 50,000 Accounts payable 197,532 Accrued interest on notes payable 500 Income taxes payable 62,520 Accrued salaries, wages, and other liabilities 9,500 Deposits received from customers 420

Total current liabilities $ 320,472

Long-term debt

Twenty-year 12% debentures, due January 1, 2025 500,000

Total liabilities 820,472

Stockholders’ equity

Paid in on capital stock Preferred, 7%, cumulative Authorized, issued, and outstanding, 30,000 shares of $10 par value $300,000 Common— Authorized, 500,000 shares of $1 par value; issued and outstanding, 400,000 shares 400,000 Additional paid-in capital 37,500 737,500

Retained earnings 153,182 Accumulated other comprehensive income 8,650 Less: Treasury stock 12,750

Equity attributable to Scientific Products, Inc. 886,582 Equity attributable to noncontrolling interest 13,500

Total stockholders’ equity 900,082

Total liabilities and stockholders’ equity $1,720,554

UNDERLYING CONCEPTS

The presentation of bal- ance sheet information meets the objective of fi nancial reporting—to provide information about entity resources, claims to resources, and changes in them.

216 Chapter 5 Balance Sheet and Statement of Cash Flows

Infrequently, companies use other balance sheet formats. For example, companies sometimes deduct current liabilities from current assets to arrive at working capital. Or, they deduct all liabilities from all assets.

STATEMENT OF CASH FLOWS Chapter 2 indicated that an important element of the objective of financial reporting is “assessing the amounts, timing, and uncertainty of cash flows.” The three financial state- ments we have looked at so far—the income statement, the statement of stockholders’ equity, and the balance sheet—each present some information about the cash flows of an enterprise during a period. But they do so to a limited extent. For instance, the income state- ment provides information about resources provided by operations but not exactly cash. The statement of stockholders’ equity shows the amount of cash used to pay dividends or purchase treasury stock. Comparative balance sheets might show what assets the company has acquired or disposed of, and what liabilities it has incurred or liquidated.

Useful as they are, none of these statements presents a detailed summary of all the cash inflows and outflows, or the sources and uses of cash during the period. To fill this need, the FASB requires the statement of cash flows (also called the cash flow statement). [5]

LEARNING OBJECTIVE 4 Identify the purpose and content of the statement of cash flows.

WHAT DO THE NUMBERS MEAN? WATCH THAT CASH FLOW Investors usually focus on net income measured on an accrual basis. However, information on cash fl ows can be important for assessing a company’s liquidity, fi nancial fl exibility, and overall fi nancial performance. The graph below shows W. T. Grant’s fi nancial performance over 7 years.

case, illustrating the importance of cash fl ows as an early- warning signal of fi nancial problems.

The recent picture at IBM is similar and raises some red fl ags as to the company’s fi nancial fl exibility. As shown in the following chart, IBM’s earnings per share (EPS) growth has held steady, but growth in free cash fl ow is on the decline.

1 Year

(in m

ill io

ns )

$ 50

−30

−60 2 3 4 5 6 7

Income

Cash Flow from Operations

Although W. T. Grant showed consistent profi ts and even some periods of earnings growth, its cash fl ow began to “go south” starting in about year 3. The company fi led for bank- ruptcy shortly after year 7. Financial statement readers who studied the company’s cash fl ows would have found early warnings of its problems. The Grant experience is a classic

2010

IBM’s Financial Flexibility

−20

40%

−40

−60

−80

−100 2011 2012 2013 Q1 2014

Debt

EPS

FCF

% Growth in total debt % Growth in free cash flow (FCF) % Growth in EPS

Statement of Cash Flows 217

Purpose of the Statement of Cash Flows The primary purpose of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an enterprise during a period. To achieve this purpose, the statement of cash flows reports the following: (1) the cash effects of operations during a period, (2) investing transactions, (3) financing transactions, and (4) the net increase or decrease in cash during the period.10

Reporting the sources, uses, and net increase or decrease in cash helps investors, creditors, and others know what is happening to a company’s most liquid resource. Because most individuals maintain a checkbook and prepare a tax return on a cash basis, they can comprehend the information reported in the statement of cash flows.

The statement of cash flows provides answers to the following simple but impor- tant questions:

1. Where did the cash come from during the period? 2. What was the cash used for during the period? 3. What was the change in the cash balance during the period?

Content and Format of the Statement of Cash Flows Companies classify cash receipts and cash payments during a period into three different activities in the statement of cash flows—operating, investing, and financing activities, defined as follows.

1. Operating activities involve the cash effects of transactions that enter into the deter- mination of net income.

2. Investing activities include making and collecting loans and acquiring and dispos- ing of investments (both debt and equity) and property, plant, and equipment.

3. Financing activities involve liability and owners’ equity items. They include (a) obtaining resources from owners and providing them with a return on their investment, and (b) borrowing money from creditors and repaying the amounts borrowed.

Illustration 5-17 shows the basic format of the statement of cash flows.

UNDERLYING CONCEPTS

The statement of cash fl ows meets the objective of fi nancial reporting—to help assess the amounts, timing, and uncertainty of future cash fl ows.

10The FASB recommends the basis as “cash and cash equivalents.” Cash equivalents are liquid investments that mature within three months or less.

STATEMENT oF CASH FLOWS

Cash flows from operating activities $XXX Cash flows from investing activities XXX Cash flows from financing activities XXX

Net increase (decrease) in cash XXX Cash at beginning of year XXX

Cash at end of year $XXX

ILLUSTRATION 5-17 Basic Format of Cash Flow Statement

A look under the hood indicates that while debt levels are increasing, IBM has been using free cash fl ow for increased dividends and share buybacks. Recall that buybacks increase EPS by reducing shares outstanding. However, some analysts

believe that many of the funds should be allocated to R&D. That is, free cash fl ow going toward dividends and share repur- chases indicates IBM’s “low quality of earnings.”

Source: A. Shields, “Why IBM Has Generated Higher Earnings Despite Falling Revenue,” Market Realist, http://marketrealist.com/2014/07/why-ibm- has-generated-higher-earnings-despite-falling-revenues/ (July 11, 2014).

218 Chapter 5 Balance Sheet and Statement of Cash Flows

ILLUSTRATION 5-18 Cash Infl ows and Outfl ows

Operating Activities

Inflows of Cash

Outflows of Cash

Inflows of Cash

Outflows of Cash

Operating Activities

Financing Activities

Investing Activities

Cash Pool

The statement’s value is that it helps users evaluate liquidity, solvency, and finan- cial flexibility. As stated earlier, liquidity refers to the “nearness to cash” of assets and liabilities. Solvency is the firm’s ability to pay its debts as they mature. Financial flexi- bility is a company’s ability to respond and adapt to financial adversity and unexpected needs and opportunities.

We have devoted Chapter 23 entirely to the detailed preparation and content of the statement of cash flows. The intervening chapters will cover several elements and com- plex topics that affect the content of a typical statement of cash flows. The presentation in this chapter is introductory—a reminder of the existence of the statement of cash flows and its usefulness.

Preparation of the Statement of Cash Flows Sources of Information Companies obtain the information to prepare the statement of cash flows from several sources: (1) comparative balance sheets, (2) the current income statement, and (3) selected transaction data. The following example demonstrates how companies use these sources in preparing a statement of cash flows.

On January 1, 2017, in its first year of operations, Telemarketing Inc. issued 50,000 shares of $1 par value common stock for $50,000 cash. The company rented its office space, furniture, and telecommunications equipment and performed marketing ser- vices throughout the first year. In June 2017, the company purchased land for $15,000. Illustration 5-19 shows the company’s comparative balance sheets at the beginning and end of 2017.

LEARNING OBJECTIVE 5 Prepare a basic statement of cash flows.

Illustration 5-18 graphs the inflows and outflows of cash classified by activity.

Statement of Cash Flows 219

Preparing the Statement of Cash Flows Preparing the statement of cash flows from these sources involves four steps:

1. Determine the net cash provided by (or used in) operating activities. 2. Determine the net cash provided by (or used in) investing and fi nancing activities. 3. Determine the change (increase or decrease) in cash during the period. 4. Reconcile the change in cash with the beginning and the ending cash balances.

Net cash provided by operating activities is the excess of cash receipts over cash payments from operating activities. Companies determine this amount by converting net income on an accrual basis to a cash basis. To do so, they adjust net income for items that do not affect cash. This procedure requires that a company analyze not only the current year’s income statement but also the comparative balance sheets and selected transaction data.

Analysis of Telemarketing’s comparative balance sheets reveals two items that will affect the computation of net cash provided by operating activities:

1. The increase in accounts receivable refl ects a noncash increase of $41,000 in revenues. 2. The increase in accounts payable refl ects a noncash increase of $12,000 in expenses.

Therefore, to arrive at net cash provided by operating activities, Telemarketing deducts from net income the increase in accounts receivable ($41,000), and it adds back to net income the increase in accounts payable ($12,000). As a result of these adjust- ments, the company determines net cash provided by operating activities to be $10,000, computed as shown in Illustration 5-21 (page 220).

TELEMARKETING INC. BALANCE SHEETS

Dec. 31, 2017 Jan. 1, 2017 Increase/Decrease

Assets

Cash $31,000 $–0– $31,000 Increase Accounts receivable 41,000 –0– 41,000 Increase Land 15,000 –0– 15,000 Increase

Total $87,000 $–0–

Liabilities and Stockholders’ Equity

Accounts payable $12,000 $–0– 12,000 Increase Common stock 50,000 –0– 50,000 Increase Retained earnings 25,000 –0– 25,000 Increase

Total $87,000 $–0–

ILLUSTRATION 5-19 Comparative Balance Sheets

Illustration 5-20 presents the income statement and additional information.

ILLUSTRATION 5-20 Income Statement DataTELEMARKETING INC.INCOME STATEMENT

FOR THE YEAR ENDED DECEMBER 31, 2017

Revenues $172,000 Operating expenses 120,000

Income before income tax 52,000 Income tax 13,000

Net income $ 39,000

Additional information: Dividends of $14,000 were paid during the year.

220 Chapter 5 Balance Sheet and Statement of Cash Flows

Net income $ 39,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $(41,000) Increase in accounts payable 12,000 (29,000)

Net cash provided by operating activities $ 10,000

ILLUSTRATION 5-21 Computation of Net Cash Provided by Operating Activities

INTERNATIONAL PERSPECTIVE

IFRS requires a statement of cash fl ows. Both IFRS and GAAP specify that the cash fl ows must be classi- fi ed as operating, investing, or fi nancing.

Next, the company determines its investing and financing activities. Telemarket- ing’s only investing activity was the land purchase. It had two financing activities: (1) common stock increased $50,000 from the issuance of 50,000 shares for cash, and (2) the company paid $14,000 cash in dividends. Knowing the amounts provided/ used by operating, investing, and financing activities, the company determines the net increase in cash. Illustration 5-22 presents Telemarketing’s statement of cash flows for 2017.

TELEMARKETING INC. STATEMENT OF CASH FLOWS

FOR THE YEAR ENDED DECEMBER 31, 2017

Cash flows from operating activities Net income $39,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $(41,000) Increase in accounts payable 12,000 (29,000)

Net cash provided by operating activities 10,000

Cash flows from investing activities Purchase of land (15,000)

Net cash used by investing activities (15,000)

Cash flows from financing activities Issuance of common stock 50,000 Payment of cash dividends (14,000)

Net cash provided by financing activities 36,000

Net increase in cash 31,000 Cash at beginning of year –0–

Cash at end of year $31,000

ILLUSTRATION 5-22 Statement of Cash Flows

Signifi cant Noncash Activities Not all of a company’s significant activities involve cash. Examples of significant non- cash activities are:

1. Issuance of common stock to purchase assets. 2. Conversion of bonds into common stock. 3. Issuance of debt to purchase assets. 4. Exchanges of long-lived assets.

Significant financing and investing activities that do not affect cash are not reported in the body of the statement of cash flows. Rather, these activities are reported in either a sepa- rate schedule at the bottom of the statement of cash flows or in separate notes to the financial statements. Such reporting of these noncash activities satisfies the full disclosure principle.

Illustration 5-23 shows an example of a comprehensive statement of cash flows. Note that the company purchased equipment through the issuance of $50,000 of bonds, which

The increase in cash of $31,000 reported in the statement of cash flows agrees with the increase of $31,000 in cash calculated from the comparative balance sheets.

Statement of Cash Flows 221

is a significant noncash transaction. In solving homework assignments, you should present significant noncash activities in a separate schedule at the bottom of the statement of cash flows.

ILLUSTRATION 5-23 Comprehensive Statement of Cash Flows

NESTOR COMPANY STATEMENT OF CASH FLOWS

FOR THE YEAR ENDED DECEMBER 31, 2017

Cash flows from operating activities Net income $320,750 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $ 88,400 Amortization of intangibles 16,300 Gain on sale of plant assets (8,700) Increase in accounts receivable (net) (11,000) Decrease in inventory 15,500 Decrease in accounts payable (9,500) 91,000

Net cash provided by operating activities 411,750 Cash flows from investing activities Sale of plant assets 90,500 Purchase of equipment (182,500) Purchase of land (70,000)

Net cash used by investing activities (162,000) Cash flows from financing activities Payment of cash dividend (19,800) Issuance of common stock 100,000 Redemption of bonds (50,000)

Net cash provided by financing activities 30,200

Net increase in cash 279,950 Cash at beginning of year 135,000

Cash at end of year $414,950

Noncash investing and financing activities Purchase of equipment through issuance of $50,000 of bonds

LEARNING OBJECTIVE 6 Understand the usefulness of the statement of cash flows.

Usefulness of the Statement of Cash Flows “Happiness is a positive cash flow” is certainly true. Although net income provides a long-term measure of a company’s success or failure, cash is its lifeblood. Without cash, a company will not survive. For small and newly developing companies, cash flow is the single most important element for survival. Even medium and large companies must control cash flow.

Creditors examine the cash flow statement carefully because they are concerned about being paid. They begin their examination by finding net cash provided by operating activi- ties. A high amount indicates that a company is able to generate sufficient cash from opera- tions to pay its bills without further borrowing. Conversely, a low or negative amount of net cash provided by operating activities indicates that a company may have to borrow or issue equity securities to acquire sufficient cash to pay its bills. Consequently, creditors look for answers to the following questions in the company’s cash flow statements.

1. How successful is the company in generating net cash provided by operating activities? 2. What are the trends in net cash fl ow provided by operating activities over time? 3. What are the major reasons for the positive or negative net cash provided by operat-

ing activities?

You should recognize that companies can fail even though they report net income. The difference between net income and net cash provided by operating activities can be substantial. Companies such as W. T. Grant Company and Prime Motor Inn, for exam- ple, reported high net income numbers but negative net cash provided by operating activities. Eventually, both companies filed for bankruptcy.

222 Chapter 5 Balance Sheet and Statement of Cash Flows

In addition, substantial increases in receivables and/or inventory can explain the difference between positive net income and negative net cash provided by operating activities. For example, in its first year of operations, Hu Inc. reported a net income of $80,000. Its net cash provided by operating activities, however, was a negative $95,000, as shown in Illustration 5-24.

ILLUSTRATION 5-24 Negative Net Cash Provided by Operating Activities

HU INC. NET CASH FLOW FROM OPERATING ACTIVITIES

Cash flows from operating activities Net income $ 80,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in receivables $ (75,000) Increase in inventories (100,000) (175,000)

Net cash provided by operating activities $(95,000)

Hu could easily experience a “cash crunch” because it has its cash tied up in receivables and inventory. If Hu encounters problems in collecting receivables, or if inventory moves slowly or becomes obsolete, its creditors may have difficulty collecting on their loans.

Financial Liquidity Readers of financial statements often assess liquidity by using the current cash debt coverage. It indicates whether the company can pay off its current liabilities from its operations in a given year. Illustration 5-25 shows the formula for this ratio.

The higher the current cash debt coverage, the less likely a company will have liquidity problems. For example, a ratio near 1:1 is good. It indicates that the company can meet all of its current obligations from internally generated cash flow.

Financial Flexibility The cash debt coverage provides information on financial flexibility. It indicates a company’s ability to repay its liabilities from net cash provided by operating activities, without having to liquidate the assets employed in its operations. Illustration 5-26 shows the formula for this ratio. Notice its similarity to the current cash debt coverage. However, because it uses average total liabilities in place of average current liabilities, it takes a somewhat longer-range view.

Net Cash Provided by Operating Activities =

Current Cash Average Current Liabilities Debt Coverage

ILLUSTRATION 5-25 Formula for Current Cash Debt Coverage

Net Cash Provided by Operating Activities =

Cash Debt Average Total Liabilities Coverage

ILLUSTRATION 5-26 Formula for Cash Debt Coverage

The higher this ratio, the less likely the company will experience difficulty in meet- ing its obligations as they come due. It signals whether the company can pay its debts and survive if external sources of funds become limited or too expensive.

Free Cash Flow A more sophisticated way to examine a company’s financial flexibility is to develop a free cash flow analysis. Free cash flow is the amount of discretionary cash flow a com- pany has. It can use this cash flow to purchase additional investments, retire its debt, purchase treasury stock, or simply add to its liquidity. Financial statement users calcu- late free cash flow as shown in Illustration 5-27.

Statement of Cash Flows 223

ILLUSTRATION 5-27 Formula for Free Cash Flow Net Cash Provided Capital Free

by Operating − − Cash Dividends = Activities Expenditures Cash Flow

NESTOR COMPANY FREE CASH FLOW ANALYSIS

Net cash provided by operating activities $411,750 Less: Capital expenditures 252,500 Dividends 19,800

Free cash flow $139,450

ILLUSTRATION 5-28 Free Cash Flow Computation

This computation shows that Nestor has a positive, and substantial, net cash pro- vided by operating activities of $411,750. Nestor’s statement of cash flows reports that the company purchased equipment of $182,500 and land of $70,000 for total capital spending of $252,500. Nestor has more than sufficient cash flow to meet its dividend payment and therefore has satisfactory financial flexibility.

As you can see from looking back at Illustration 5-23 (page 221), Nestor used its free cash flow to redeem bonds and add to its liquidity. If it finds additional invest- ments that are profitable, it can increase its spending without putting its dividend or basic capital spending in jeopardy. Companies that have strong financial flexibil- ity can take advantage of profitable investments even in tough times. In addition, strong financial flexibility frees companies from worry about survival in poor eco- nomic times. In fact, those with strong financial flexibility often fare better in a poor economy because they can take advantage of opportunities that other companies cannot.

In a free cash flow analysis, we first deduct capital spending, to indicate it is the least discretionary expenditure a company generally makes. (Without continued efforts to maintain and expand facilities, it is unlikely that a company can continue to maintain its competitive position.) We then deduct dividends. Although a company can cut its dividend, it usually will do so only in a financial emergency. The amount resulting after these deductions is the company’s free cash flow. Obviously, the greater the amount of free cash flow, the greater the company’s financial flexibility.

Questions that a free cash flow analysis answers are:

1. Is the company able to pay its dividends without resorting to external fi nancing? 2. If business operations decline, will the company be able to maintain its needed

capital investment? 3. What is the amount of discretionary cash fl ow that can be used for additional invest-

ment, retirement of debt, purchase of treasury stock, or addition to liquidity?

Illustration 5-28 is a free cash flow analysis using the cash flow statement for Nestor Company (shown in Illustration 5-23 on page 221).

WHAT DO THE NUMBERS MEAN? “THERE OUGHT TO BE A LAW” As one manager noted, “There ought to be a law that before you can buy a stock, you must be able to read a balance sheet.” We agree, and the same can be said for a statement of cash fl ows.

Krispy Kreme Doughnuts provides an example of how stunning earnings growth can hide real problems. Not long ago,

the doughnut maker was a glamour stock with a 60 percent earnings per share growth rate and a price-earnings ratio around 70. Seven months later, its stock price had dropped 72 percent. What happened? Stockholders alleged that Krispy Kreme may have been infl ating its revenues and not taking enough

224 Chapter 5 Balance Sheet and Statement of Cash Flows

ADDITIONAL INFORMATION In both Chapter 4 and this chapter, we have discussed the primary financial statements that all companies prepare in accordance with GAAP. However, the primary financial statements cannot provide the complete picture related to the financial position and financial performance of the company. Additional descriptive information in supple- mental disclosures and certain techniques of disclosure expand on and amplify the items presented in the main body of the statements.

Supplemental Disclosures The balance sheet is not complete if a company simply lists the asset, liability, and owners’ equity accounts. It still needs to provide important supplemental information. This may be information not presented elsewhere in the statement, or it may elaborate on items in the balance sheet. The four types of information that are usually supplemen- tal to account titles and amounts presented in the balance sheet are as follows.

LEARNING OBJECTIVE 7 Determine which balance sheet information requires supplemental disclosure.

1. CONTINGENCIES. Material events that have an uncertain outcome.

2. ACCOUNTING POLICIES. Explanations of the valuation methods used or the basic assumptions made concerning inventory valuations, depreciation methods, investments in subsidiaries, etc.

3. CONTRACTUAL SITUATIONS. Explanations of certain restrictions or covenants attached to specifi c assets or, more likely, to liabilities.

4. FAIR VALUES. Disclosures of fair values, particularly for fi nancial instruments.

SUPPLEMENTAL BALANCE SHEET INFORMATION

bad debt expense (which infl ated both assets and income). In addition, Krispy Kreme’s operating cash fl ow was negative. Most fi nancially sound companies generate positive cash fl ow.

The following are additional examples of how one rating agency rated the earnings quality of some companies, using some key balance sheet and statement of cash fl ow measurements.

Sources: Adapted from Gretchen Morgenson, “How Did They Value Stocks? Count the Absurd Ways,” New York Times on the Web (March 18, 2001); K. Badanhausen, J. Gage, C. Hall, and M. Ozanian, “Beyond Balance Sheet: Earnings Quality,” Forbes.com (January 28, 2005); and H. Karp, “Avon’s Investments Fall Short,” Wall Street Journal (December 8, 2011).

Earnings-Quality Earnings-Quality Winners Company Indicators

Avon Products Strong cash fl ow

Capital One Conservatively Financial capitalized

Ecolab Good management of working capital

Timberland Minimal off-balance- sheet commitments

Earnings-Quality Earnings-Quality Losers Company Indicators

Ford Motor High debt and underfunded pension plan

Kroger High goodwill and debt

Ryder System Negative free cash fl ow

Teco Energy Selling assets to meet liquidity needs

Another rating organization uses a metric to adjust for shortcomings in amounts reported in the balance sheet. Just as improving balance sheet and cash fl ow information is a leading indicator of improved earnings, a deteriorating balance sheet and statement of cash fl ows warn of earnings

declines (and falling stock prices). This was the case at Avon; its strong cash fl ow rating subsequently declined, such that its free cash fl ow was just 76 percent of net income. This raised red fl ags about the results on foreign investments by Avon.

Additional Information 225

Contingencies A contingency is an existing situation involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) that will ultimately be resolved when one or more future events occur or fail to occur. In short, contingencies are material events with an uncertain future. Examples of gain contingencies are tax operating-loss carryfor- wards or company litigation against another party. Typical loss contingencies relate to litigation, environmental issues, possible tax assessments, or government investiga- tions. We examine the accounting and reporting requirements involving contingencies more fully in Chapter 13.

Accounting Policies GAAP recommends disclosure for all significant accounting principles and methods that involve selection from among alternatives or those that are peculiar to a given industry. [6] For instance, companies can compute inventories under several cost flow assumptions (e.g., LIFO and FIFO), depreciate plant and equipment under several accepted methods (e.g., double-declining-balance and straight-line), and carry invest- ments at different valuations (e.g., amortized cost, equity, and fair value). Sophisticated users of financial statements know of these possibilities and examine the statements closely to determine the methods used.

Companies must also disclose information about the nature of their operations, the use of estimates in preparing financial statements, certain significant estimates, and vulnerabilities due to certain concentrations. [7] Illustration 5-29 shows an example of such a disclosure.

Disclosure of significant accounting principles and methods and of risks and uncer- tainties is particularly useful if given in a separate Summary of Significant Accounting Policies preceding the notes to the financial statements or as the initial note.

Contractual Situations Companies should disclose contractual situations, if significant, in the notes to the financial statements. For example, they must clearly state the essential provisions of lease contracts, pension obligations, and stock compensation plans in the notes. Ana- lysts want to know not only the amount of the liabilities but also how the different contractual provisions affect the company at present and in the future.

Companies must disclose the following commitments if the amounts are mate- rial: commitments related to obligations to maintain working capital, to limit the payment of dividends, to restrict the use of assets, and to require the maintenance of certain financial ratios. Management must exercise considerable judgment to deter- mine whether omission of such information is misleading. The rule in this situation is, “When in doubt, disclose.” It is better to disclose a little too much information than not enough.

UNDERLYING CONCEPTS

The basis for including additional information should meet the full disclosure principle. That is, the information should be of suffi cient importance to infl uence the judgment of an informed user.

ILLUSTRATION 5-29 Balance Sheet Disclosure of Signifi cant Risks and Uncertainties

Chesapeake Corporation

Risks and Uncertainties. Chesapeake operates in three business segments which offer a diversity of products over a broad geographic base. The Company is not dependent on any single customer, group of customers, market, geographic area or supplier of materials, labor or services. Financial statements in- clude, where necessary, amounts based on the judgments and estimates of management. These esti- mates include allowances for bad debts, accruals for landfill closing costs, environmental remediation costs, loss contingencies for litigation, self-insured medical and workers’ compensation insurance and determinations of discount and other rate assumptions for pensions and postretirement benefit expenses.

226 Chapter 5 Balance Sheet and Statement of Cash Flows

Fair Values As we have discussed, fair value information may be more useful than historical cost for certain types of assets and liabilities. This is particularly so in the case of financial instru- ments. Financial instruments are defined as cash, an ownership interest, or a contrac- tual right to receive or obligation to deliver cash or another financial instrument. Such contractual rights to receive cash or other financial instruments are assets. Contractual obligations to pay are liabilities. Cash, investments, accounts receivable, and payables are examples of financial instruments.

Given the expanded use of fair value measurements, as discussed in Chapter 2, GAAP also has expanded disclosures about fair value measurements. [8] To increase consistency and comparability in the use of fair value measures, companies follow a fair value hierarchy that provides insight into how to determine fair value. The hierarchy has three levels. Level 1 measures (the least subjective) are based on observable inputs, such as market prices for identical assets or liabilities. Level 2 measures (more subjective) are based on market-based inputs other than those included in Level 1, such as those based on market prices for similar assets or liabilities. Level 3 measures (most subjective) are based on unobservable inputs, such as a company’s own data or assumptions.11

For major groups of assets and liabilities, companies must make the following fair value disclosures: (1) the fair value measurement and (2) the fair value hierarchy level of the measurements as a whole, classified by Level 1, 2, or 3. Illustration 5-30 provides a disclosure for Devon Energy for its assets and liabilities measured at fair value.

WHAT DO THE NUMBERS MEAN? WHAT ABOUT YOUR COMMITMENTS? Many of the recent accounting scandals related to the non- disclosure of significant contractual obligations. In response, the SEC has mandated that companies disclose contrac- tual obligations in a tabular summary in the management

discussion and analysis section of the company’s annual report.

Presented below, as an example, is a disclosure from The Procter & Gamble Company.

(1) As of June 30, 2014, the Company’s Consolidated Balance Sheet refl ects a liability for uncertain tax positions of $1.9 billion, including $443 million of interest and penalties. Due to the high degree of uncertainty regarding the timing of future cash outfl ows of liabilities for uncertain tax positions beyond one year, a reasonable estimate of the period of cash settlement beyond twelve months from the balance sheet date of June 30, 2014, cannot be made. (2) Operating lease obligations are shown net of guaranteed sublease income. (3) Represents future pension payments to comply with local funding requirements. These future pension payments assume the Company con- tinues to meet its future statutory funding requirements. Considering the current economic environment in which the Company operates, the Company believes its cash fl ows are adequate to meet the future statutory funding requirements. The projected payments beyond fi scal year 2017 are not currently determinable. (4) Primarily refl ects future contractual payments under various take-or-pay arrangements entered into as part of the normal course of business.

Less Than 1–3 3–5 After 5 Total 1 Year Years Years Years

Recorded Liabilities Total debt $35,229 $15,576 $4,391 $3,939 $11,323 Capital leases 83 19 34 23 7 Uncertain tax positions (1) 37 37 — — — Other Interest payments relating to long-term debt 7,929 831 1,385 1,195 4,518 Operating leases (2) 1,944 288 509 404 743 Minimum pension funding (3) 817 264 553 — — Purchase obligations (4) 1,985 1,068 432 164 321

Total Contractual Commitments $48,024 $18,083 $7,304 $5,725 $16,912

11Level 3 fair value measurements may be developed using expected cash flow and present value techniques, as described in “Using Cash Flow Information and Present Value in Accounting,” Statement of Financial Accounting Concepts No. 7, as discussed in Chapter 6.

Contractual Commitments, as of June 30, 2014 (in millions of dollars)

Additional Information 227

In addition, companies must provide significant additional disclosure related to Level 3 measurements. The disclosures related to Level 3 are substantial and must iden- tify what assumptions the company used to generate the fair value numbers and any related income effects. Companies will want to use Level 1 and 2 measurements as much as possible. In most cases, these valuations should be very reliable, as the fair value measurements are based on market information. In contrast, a company that uses Level 3 measurements extensively must be carefully evaluated to understand the impact these valuations have on the financial statements.

Techniques of Disclosure Companies should disclose as completely as possible the effect of various contingencies on financial condition, the methods of valuing assets and liabilities, and the company’s con- tracts and agreements. To disclose this pertinent information, companies may use paren- thetical explanations, notes, cross-reference and contra items, and supporting schedules.

Parenthetical Explanations Companies often provide additional information by parenthetical explanations following the item. For example, Illustration 5-31 shows a parenthetical explanation of the number of shares issued by Ford Motor Company on the balance sheet under “Stockholders’ equity.”

LEARNING OBJECTIVE 8 Describe the major disclosure techniques for the balance sheet.

ILLUSTRATION 5-31 Parenthetical Disclosure of Shares Issued—Ford Motor Company

Ford Motor Company

Stockholders’ Equity (in millions)

Common stock, par value $0.01 per share (1,837 million shares issued) $18

This additional pertinent balance sheet information adds clarity and completeness. It has an advantage over a note because it brings the additional information into the

ILLUSTRATION 5-30 Disclosure of Fair ValuesDevon Energy Corporation

Note 7: Fair Value Measurements (in part). Certain of Devon’s assets and liabilities are reported at fair value in the accompanying balance sheets. The following table provides fair value measurement information for such assets and liabilities.

Fair Value Measurements Using:

Quoted Significant Prices in Other Significant Active Observable Unobservable Total Markets Inputs Inputs Fair Value (Level 1) (Level 2) (Level 3)

(In millions) Assets: Short-term investments $ 341 $ 341 $ — $ — Investment in Chevron common stock 1,327 1,327 — — Financial instruments 8 — 8 —

Liabilities: Financial instruments 497 — 497 — Asset retirement obligation (ARO) 1,300 — — 1,300

GAAP establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. As presented in the table above, this hierarchy consists of three broad levels. Level 1 inputs on the hierarchy consist of unadjusted quoted prices in active markets for identical assets and liabilities and have the highest priority. Level 3 inputs have the lowest priority. Devon uses appropriate valuation techniques based on the available inputs to measure the fair values of its assets and liabilities. When available, Devon measures fair value using Level 1 inputs because they generally provide the most reliable evidence of fair value.

228 Chapter 5 Balance Sheet and Statement of Cash Flows

body of the statement where readers will less likely overlook it. Companies, however, should avoid lengthy parenthetical explanations, which might be distracting.

Notes Companies use notes if they cannot conveniently show additional explanations as parenthetical explanations. Illustration 5-32 shows how International Paper Company reported its inventory costing methods in its accompanying notes.

UNDERLYING CONCEPTS

The user-specifi c qual- ity of understandability requires accountants to be careful in describ- ing transactions and events.

12 As indicated in Chapter 2, the FASB has recently issued an exposure draft, Conceptual Framework for Financial Reporting: Chapter 8: Notes to Financial Statements. If approved, this new Concepts Statement will help the Board to identify relevant information and establish limits on information that should be included in the notes to the financial statements.

ILLUSTRATION 5-32 Note Disclosure

Companies commonly use notes to disclose the following: the existence and amount of any preferred stock dividends in arrears, the terms of or obligations imposed by purchase commitments, special financial arrangements and instruments, depreciation policies, any changes in the application of accounting principles, and the existence of contingencies.

Notes therefore must present all essential facts as completely and succinctly as possible. Careless wording may mislead rather than aid readers. Notes should add to the total information made available in the financial statements, not raise unanswered questions or contradict other portions of the statements. The note disclosures in Illustra- tion 5-33 show the presentation of such information.12

ILLUSTRATION 5-33 More Note Disclosures

UNDERLYING CONCEPTS

The FASB recently issued an invitation to comment on disclosure effectiveness, in order to get input on how disclo- sures in the footnotes can be made more useful.

International Paper Company

Note 11

Inventories by major category were (millions):

Raw materials $ 371 Finished pulp, paper and packaging products 1,796 Finished lumber and panel products 184 Operating supplies 351 Other 16

Total inventories $2,718

The last-in, first-out inventory method is used to value most of International Paper’s U.S. inventories. Approximately 70% of total raw materials and finished products inventories were valued using this method. If the first-in, first-out method had been used, it would have increased total inventories balances by approximately $170 million.

Apple Inc.

Note: 10: Commitments and Contingencies Operating Leases

The Company leases various equipment and facilities, including retail space, under noncancelable oper- ating lease arrangements. The Company does not currently utilize any other off-balance sheet financing arrangements. The major facility leases are typically for terms not exceeding 10 years and generally contain multi-year renewal options. Leases for retail space are for terms ranging from five to 20 years, the majority of which are for 10 years, and often contain multi-year renewal options. As of September 27, 2014, the Company’s total future minimum lease payments under noncancelable operating leases were $5.0 billion, of which $3.6 billion related to leases for retail space.

Alberto-Culver Company

Note 3: Long-Term Debt. Various borrowing arrangements impose restrictions on such items as total debt, working capital, dividend payments, treasury stock purchases and interest expense. The company was in compliance with these arrangements and $68 million of consolidated retained earnings was not restricted as to the payment of dividends and purchases of treasury stock.

Additional Information 229

Cross-Reference and Contra Items Companies “cross-reference” a direct relationship between an asset and a liability on the balance sheet. For example, as shown in Illustration 5-34, on December 31, 2017, a company might show the following entries—one listed among the current assets, and the other listed among the current liabilities.

ILLUSTRATION 5-33 (Continued)Willamette Industries, Inc.

Note 4: Property, Plant, and Equipment (partial): The company changed its accounting estimates relating to depreciation. The estimated service lives for most machinery and equipment were extended five years. The change was based upon a study performed by the company’s engineering department, comparisons to typical industry practices, and the effect of the company’s extensive capital investments which have resulted in a mix of assets with longer productive lives due to technological advances. As a result of the change, net income was increased $51,900, or $0.46 per diluted share.

ILLUSTRATION 5-34 Cross-Referencing and Contra Items

Current Assets (in part)

Cash on deposit with sinking fund trustee for redemption of bonds payable—see Current liabilities $800,000

Current Liabilities (in part)

Bonds payable to be redeemed in 2018—see Current assets $2,300,000

This cross-reference points out that the company will redeem $2,300,000 of bonds payable currently, for which it has only set aside $800,000. Therefore, it needs addi- tional cash from unrestricted cash, from sales of investments, from profits, or from some other source. Alternatively, the company can show the same information parenthetically.

Another common procedure is to establish contra or adjunct accounts. A contra account on a balance sheet reduces either an asset, liability, or owners’ equity account. Examples include Accumulated Depreciation—Equipment and Discount on Bonds Payable. Contra accounts provide some flexibility in presenting the finan- cial information. With the use of the Accumulated Depreciation—Equipment account, for example, a reader of the statement can see the original cost of the asset as well as the depreciation to date.

An adjunct account, on the other hand, increases either an asset, liability, or owners’ equity account. An example is Premium on Bonds Payable, which, when added to the Bonds Payable account, describes the total bond liability of the company.

Supporting Schedules Often a company needs a separate schedule to present more detailed information about certain assets or liabilities, as shown in Illustration 5-35 (page 230).

Terminology The account titles in the general ledger do not necessarily represent the best termi- nology for balance sheet purposes. Companies often use brief account titles and include technical terms that only accountants understand. But many persons unac- quainted with accounting terminology examine balance sheets. Thus, balance sheets should contain descriptions that readers will generally understand and clearly interpret.

INTERNATIONAL PERSPECTIVE

Internationally, accounting terminology is a problem. Confusion arises even between nations that share a language. For example, U.S. investors nor- mally think of “stock” as “equity” or “ownership.” To the British, “stocks” means inventory. In the United States, “fi xed assets” generally refers to “property, plant, and equipment.” In Britain, the category includes more items.

230 Chapter 5 Balance Sheet and Statement of Cash Flows

ILLUSTRATION 5-35 Disclosure through Use of Supporting Schedules

Property, plant, and equipment

Land, buildings, equipment, and other fixed assets—net (see Schedule 3) $643,300

SCHEDULE 3 LAND, BUILDINGS, EQUIPMENT, AND OTHER FIXED ASSETS

Other Fixed Total Land Buildings Equip. Assets

Balance January 1, 2017 $740,000 $46,000 $358,000 $260,000 $76,000 Additions in 2017 161,200 120,000 38,000 3,200

901,200 46,000 478,000 298,000 79,200 Assets retired or sold in 2017 31,700 27,000 4,700

Balance December 31, 2017 869,500 46,000 478,000 271,000 74,500 Depreciation taken to January 1, 2017 196,000 102,000 78,000 16,000 Depreciation taken in 2017 56,000 28,000 24,000 4,000

252,000 130,000 102,000 20,000 Depreciation on assets retired in 2017 25,800 22,000 3,800

Depreciation accumulated December 31, 2017 226,200 130,000 80,000 16,200

Book value of assets $643,300 $46,000 $348,000 $191,000 $58,300

For example, companies have used the term “reserve” in differing ways: to describe amounts deducted from assets (contra accounts such as accumulated depre- ciation and allowance for doubtful accounts), as a part of the title of contingent or estimated liabilities, and to describe an appropriation of retained earnings. Because of the different meanings attached to this term, misinterpretation often resulted from its use. Therefore, the profession has recommended that companies use the word reserve only to describe an appropriation of retained earnings. The use of the term in this narrower sense—to describe appropriated retained earnings—has resulted in a better understanding of its significance when it appears in a balance sheet. However, the term “appropriated” appears more logical, and we encourage its use.

For years, the profession has recommended that the use of the word surplus be discontinued in balance sheet presentations of stockholders’ equity. The use of the terms capital surplus, paid-in surplus, and earned surplus is confusing. Although con- demned by the profession, these terms appear all too frequently in current financial statements.

YOU WILL WANT TO READ THE

IFRS INSIGHTS ON PAGES 258–264 For a discussion of IFRS related to the balance sheet and statement of cash flows.

In addition to the issue of fi nancial statement presentation discussed in the opening story, a second area of controversy for balance sheet reporting is the issue of offsetting (or netting) of assets and liabilities. It is generally accepted that offsetting of recognized assets and recognized liabilities detracts from the ability of users both to understand the transactions and condi- tions that have occurred and to assess the company’s future cash fl ows. In other words, providing information on assets, liabilities, and stockholders’ equity helps users to compute rates of return and evaluate capital structure. However, netting

assets and liabilities can limit a user’s ability to assess the future economic benefi ts and obligations. That is, offsetting hides the existence of assets and liabilities, making it diffi cult to evaluate liquidity, solvency, and fi nancial fl exibility. As a result, GAAP does not permit the reporting of summary accounts alone (e.g., total assets, net assets, and total liabilities).

Recently, the IASB and FASB have worked to develop common criteria for offsetting on the balance sheet. Current offsetting rules under IFRS are more restrictive than GAAP. The rules proposed would allow offsetting only in rare circumstances

EVOLVING ISSUE BALANCE SHEET REPORTING: GROSS OR NET?

APPENDIX 5A RATIO ANALYSIS—A REFERENCE

LEARNING OBJECTIVE *9 Identify the major types of financial ratios and what they measure.

USING RATIOS TO ANALYZE PERFORMANCE Analysts and other interested parties can gather qualitative information from financial statements by examining relationships between items on the statements and identifying trends in these relationships. A useful starting point in developing this information is ratio analysis.

A ratio expresses the mathematical relationship between one quantity and another. Ratio analysis expresses the relationship among pieces of selected financial statement data, in a percentage, a rate, or a simple proportion.

To illustrate, IBM Corporation recently had current assets of $46,970 million and current liabilities of $39,798 million. We find the ratio between these two amounts by dividing current assets by current liabilities. The alternative means of expression are:

Percentage: Current assets are 118% of current liabilities. Rate: Current assets are 1.18 times as great as current liabilities. Proportion: The relationship of current assets to current liabilities is 1.18:1.

To analyze financial statements, we classify ratios into four types, as follows.

LIQUIDITY RATIOS. Measures of the company’s short-term ability to pay its maturing obligations.

ACTIVITY RATIOS. Measures of how effectively the company uses its assets.

PROFITABILITY RATIOS. Measures of the degree of success or failure of a given company or division for a given period of time.

COVERAGE RATIOS. Measures of the degree of protection for long-term creditors and investors.

MAJOR TYPES OF RATIOS

(e.g., when right of offset is legally enforceable). Implementation of these new rules in the United States would result in a dramatic “grossing up” of balance sheets (particularly for fi nancial institu- tions). For example, one study estimated that the new rules would gross up U.S. banks’ balance sheets by $900 billion (or an average of 68%, ranging from a 31.4% increase for Citigroup to 104.7% for Morgan Stanley).* Not surprisingly, the FASB received signifi cant push-back from some of its constituents (particularly fi nancial institutions) to the proposed rules.

As a result, to date the Boards have not been able to agree on a converged standard, thereby stalling this project.

However, the Boards have issued converged disclosure requirements. The disclosure rules require companies to dis- close both gross information and net information about instruments and transactions that are eligible for offset in the balance sheet. While the Boards have not been able to develop a converged set of criteria for offsetting, the informa- tion provided under the new converged disclosure rules should enable users of a company’s fi nancial statements to evaluate the effects of netting arrangements on its fi nancial position. In doing so, the new rules support the full disclosure principle.

*See Y. N’Diaye, “S&P: Accounting Rule Could Boost Bank Balance Sheets by Average 68%,” https://mninews.deutsche-boerse.com (September 22, 2011).

Appendix 5A: Ratio Analysis—A Reference 231

232 Chapter 5 Balance Sheet and Statement of Cash Flows

In Chapter 5, we discussed three measures related to the statement of cash flows (current cash debt coverage, cash debt coverage, and free cash flow). Throughout the remainder of the textbook, we provide ratios to help you understand and interpret the information presented in financial statements. Illustration 5A-1 presents the ratios that we will use throughout the textbook. You should find this chart helpful as you examine these ratios in more detail in the following chapters. An appendix to Chapter 24 further discusses financial statement analysis.

ILLUSTRATION 5A-1 A Summary of Financial Ratios

Total liabilities Total assets

Net income + Interest expense + Income tax expense

Interest expense Net cash provided by operating activities

Average total liabilities

Common stockholders’ equity Outstanding shares

Net cash provided by operating activities − Capital expenditures − Cash dividends

Current assets Current liabilities

Cash + Short-term investments + Accounts receivable (net)

Current liabilities Net cash provided by

operating activities Average current liabilities

Net sales Average net accounts receivable

Cost of goods sold Average inventory

Net sales Average total assets

Net income Net sales

Net income Average total assets

Net income − Preferred dividends Average common stockholders’ equity

Net income − Preferred dividends Weighted-average common shares outstanding

Market price per share Earnings per share

Cash dividends Net income

Ratio Formula Purpose or Use

I. Liquidity 1. Current ratio Measures short-term debt-paying ability

2. Quick or acid-test Measures immediate short-term liquidity ratio

3. Current cash debt Measures a company’s ability to pay off its coverage current liabilities in a given year from its

operations

II. Activity 4. Accounts receivable Measures liquidity of receivables

turnover

5. Inventory turnover Measures liquidity of inventory

6. Asset turnover Measures how efficiently assets are used to generate sales

III. Profitability 7. Profit margin on sales Measures net income generated by each dollar

of sales

8. Return on assets Measures overall profitability of assets

9. Return on Measures profitability of owners’ investment common stockholders’ equity

10. Earnings per share Measures net income earned on each share of common stock

11. Price-earnings ratio Measures the ratio of the market price per share to earnings per share

12. Payout ratio Measures percentage of earnings distributed in the form of cash dividends

IV. Coverage 13. Debt to assets ratio Measures the percentage of total assets

provided by creditors 14. Times interest earned Measures ability to meet interest payments as

they come due

15. Cash debt coverage Measures a company’s ability to repay its total liabilities in a given year from its operations

16. Book value per share Measures the amount each share would receive if the company were liquidated at the amounts reported on the balance sheet

17. Free cash flow Measures the amount of discretionary cash flow

REVIEW AND PRACTICE KEY TERMS REVIEW

LEARNING OBJECTIVES REVIEW 1 Explain the uses and limitations of a balance sheet. The balance sheet is useful because it provides information about

the nature and amounts of investments in a company’s resources, obligations to creditors, and owners’ equity. The balance sheet contributes to financial reporting by providing a basis for (1) computing rates of return, (2) evaluating the capital struc- ture of the enterprise, and (3) assessing the liquidity, solvency, and financial flexibility of the enterprise.

Three limitations of a balance sheet are as follows. (1) The balance sheet does not reflect fair value because accountants use a historical cost basis in valuing and reporting most assets and liabilities. (2) Companies must use judgments and estimates to determine certain amounts, such as the collectibility of receivables and the useful life of long-term tangible and intangible assets. (3) The balance sheet omits many items that are of financial value to the business but cannot be recorded objectively, such as human resources, customer base, and reputation.

2 Identify the major classifications of the balance sheet. The general elements of the balance sheet are assets, liabilities, and equity. The major classifications of assets are current assets; long-term investments; property, plant, and equipment; intan- gible assets; and other assets. The major classifications of liabilities are current and long-term liabilities. The balance sheet of a corporation generally classifies owners’ equity as capital stock, additional paid-in capital, and retained earnings.

3 Prepare a classified balance sheet using the report and account formats. The report form lists liabilities and stockholders’ equity directly below assets on the same page. The account form lists assets, by sections, on the left side, and liabilities and stockholders’ equity, by sections, on the right side.

4 Identify the purpose and content of the statement of cash flows. The primary purpose of a statement of cash flows is to provide relevant information about a company’s cash receipts and cash payments during a period. Reporting the sources, uses, and net change in cash enables financial statement readers to know what is happening to a company’s most liquid resource.

In the statement of cash flows, companies classify the period’s cash receipts and cash payments into three different activities. (1) Operating activities: Involve the cash effects of transactions that enter into the determination of net income. (2) Investing activities: Include making and collecting loans, and acquiring and disposing of investments (both debt and equity) and of property, plant, and equipment. (3) Financing activities: Involve liability and owners’ equity items. Financing activities include (a) obtaining capital from owners and providing them with a return on their investment, and (b) borrowing money from creditors and repaying the amounts borrowed.

5 Prepare a basic statement of cash flows. The information to prepare the statement of cash flows usually comes from comparative balance sheets, the current income statement, and selected transaction data. Companies follow four steps to pre- pare the statement of cash flows from these sources. (1) Determine the net cash provided by (or used in) operating activities. (2) Determine the net cash provided by (or used in) investing and financing activities. (3) Determine the change (increase or decrease) in cash during the period. (4) Reconcile the change in cash with the beginning and ending cash balances.

6 Understand the usefulness of the statement of cash flows. Creditors examine the statement of cash flows carefully because they are concerned about being paid. The net cash flow provided by operating activities in relation to the company’s liabilities is helpful in making this assessment. Two ratios used in this regard are the current cash debt ratio and the cash debt

Review and Practice 233

account form, 214 *activity ratios, 231 adjunct account, 229 available-for-sale

investments, 206 balance sheet, 202 cash debt coverage, 222 contingency, 225 contra account, 229 *coverage ratios, 231

current assets, 205 current cash debt

coverage, 222 current liabilities, 211 financial flexibility, 202 financial instruments, 226 financing activities, 217 free cash flow, 222 held-to-maturity

investments, 206

intangible assets, 209 investing activities, 217 liquidity, 202 *liquidity ratios, 231 long-term

investments, 209 long-term liabilities, 212 operating activities, 217 owners’ (stockholders’)

equity, 212

*profitability ratios, 231 property, plant, and

equipment, 209 *ratio analysis, 231 report form, 214 reserve, 230 solvency, 202 statement of cash flows, 216 trading investments, 206 working capital, 212

234 Chapter 5 Balance Sheet and Statement of Cash Flows

ratio. In addition, the amount of free cash flow provides creditors and stockholders with a picture of the company’s financial flexibility.

7 Determine which balance sheet information requires supplemental disclosure. Four types of information nor- mally are supplemental to account titles and amounts presented in the balance sheet. (1) Contingencies: Material events that have an uncertain outcome. (2) Accounting policies: Explanations of the valuation methods used or the basic assumptions made concerning inventory valuation, depreciation methods, investments in subsidiaries, etc. (3) Contractual situations: Explana- tions of certain restrictions or covenants attached to specific assets or, more likely, to liabilities. (4) Fair values: Disclosures related to fair values, particularly related to financial instruments.

8 Describe the major disclosure techniques for the balance sheet. Companies use four methods to disclose per- tinent information in the balance sheet. (1) Parenthetical explanations: Parenthetical information provides additional infor- mation or description following the item. (2) Notes: A company uses notes if it cannot conveniently show additional explanations or descriptions as parenthetical explanations. (3) Cross-reference and contra items: Companies “cross-refer- ence” a direct relationship between an asset and a liability on the balance sheet. (4) Supporting schedules: Often a company uses a separate schedule to present more detailed information than just the single summary item shown in the balance sheet.

9 Identify the major types of financial ratios and what they measure. Ratios express the mathematical relationship between one quantity and another, expressed as a percentage, a rate, or a proportion, Liquidity ratios measure the short-term ability to pay maturing obligations. Activity ratios measure the effectiveness of asset usage. Profitability ratios measure the success or failure of an enterprise. Coverage ratios measure the degree of protection for long-term creditors and investors.

ENHANCED REVIEW AND PRACTICE Go online for multiple-choice questions with solutions, review exercises with solutions, and a full glossary of all key terms.

PRACTICE PROBLEMS 1. Assume that Sanchez Company has the following accounts at December 31, 2017.

1. Common Stock. 2. Discount on Bonds Payable. 3. Treasury Stock (at cost). 4. Notes Payable (short-term). 5. Raw Materials. 6. Preferred Stock Investments (long-term). 7. Unearned Rent Revenue. 8. Work in Process. 9. Copyrights. 10. Buildings. 11. Notes Receivable (short-term). 12. Cash. 13. Salaries and Wages Payable. 14. Accumulated Depreciation—Buildings. 15. Accumulated Other Comprehensive Income. 16. Cash Restricted for Plant Expansion. 17. Land Held for Future Plant Site. 18. Noncontrolling Interest. 19. Allowance for Doubtful Accounts—Accounts Receivable.

Practice Problems 235

20. Retained Earnings. 21. Paid-in Capital in Excess of Par—Common Stock. 22. Unearned Subscriptions Revenue. 23. Receivables—Officers (due in one year). 24. Finished Goods. 25. Accounts Receivable. 26. Bonds Payable (due in 4 years).

Instructions Prepare a classified balance sheet in good form. (No monetary amounts are necessary.)

SOLUTION

SANCHEZ COMPANY BALANCE SHEET

DECEMBER 31, 2017

Assets

Current assets

Cash (less cash restricted for plant expansion $XXX

Accounts receivable $XXX Less: Allowance for doubtful accounts XXX XXX Notes receivable XXX Receivables—offi cers XXX Inventory Finished goods XXX Work in process XXX Raw materials XXX XXX

Total current assets $XXX

Long-term investments

Preferred stock investments XXX Land held for future plant site XXX Cash restricted for plant expansion XXX Total long-term investments XXX

Property, plant, and equipment

Buildings XXX Less: Accumulated depreciation— buildings XXX XXX

Intangible assets

Copyrights XXX Total assets $XXX

Liabilities and Stockholders’ Equity

Current liabilities

Salaries and wages payable $XXX Notes payable (short-term) XXX Unearned subscriptions revenue XXX Unearned rent revenue XXX Total current liabilities $XXX

Long-term debt

Bonds payable (due in four years) XXX Discount on bonds payable (XXX) XXX Total liabilities XXX

Stockholders’ equity

Capital stock: Common stock $XXX Additional paid-in capital: Paid in capital in excess of par— common stock XXX Total paid-in capital XXX Retained earnings XXX Accumulated other comprehensive

income XXX Treasury stock (at cost) (XXX) Total equity attributable to Sanchez

shareholders XXX Equity attributable to noncontrolling

interest XXX Total liabilities and stockholders’ equity $XXX

2. Cassy Corporation’s balance sheet at the end of 2016 included the following items.

Current assets $282,000 Current liabilities $180,000 Land 36,000 Bonds payable 120,000 Buildings 144,000 Common stock 216,000 Equipment 108,000 Retained earnings 52,800 Accumulated depreciation—buildings (36,000) Total $568,800 Accumulated depreciation—equipment (13,200) Patents 48,000

Total $568,800

236 Chapter 5 Balance Sheet and Statement of Cash Flows236 Chapter 5 Balance Sheet and Statement of Cash Flows

SOLUTION

2. (a) CASSY CORPORATION BALANCE SHEET

DECEMBER 31, 2017

Assets

Current assets ($282,000 + $34,800 + $39,000) $355,800 Long-term investments 19,200 Property, plant, and equipment Land $ 36,000 Buildings ($144,000 + $32,400) $176,400 Less: Accumulated depreciation—buildings

($36,000 + $4,800) 40,800 135,600 Equipment ($108,000 − $24,000) 84,000 Less: Accumulated depreciation—equipment ($13,200 − $9,600 + $10,800) 14,400 69,600 Total 241,200 Intangible assets—patents ($48,000 − $3,000) 45,000 Total assets $661,200

Liabilities and Stockholders’ Equity

Current liabilities ($180,000 + $15,600) $195,600 Long-term liabilities Bonds payable ($120,000 + $60,000) 180,000 Total liabilities 375,600 Stockholders’ equity Common stock $216,000 Retained earnings ($52,800 + $66,000 − $36,000) 82,800 Total 298,800 Less: Cost of treasury stock (13,200) Total stockholders’ equity 285,600 Total liabilities and stockholders’ equity $661,200

Notes: The amount determined for current assets is computed last and is a “plug” fi gure. That is, total liabilities and stockholders’ equity is computed because information is available to determine this amount. Because the total assets amount is the same as the total liabilities and stockholders’ equity amount, the amount of total assets is determined. Information is available to compute all the asset amounts except current assets. Therefore, current assets can be determined by deducting the total of all the other asset balances from the total asset balance (i.e., $661,200 − $45,000 − $241,200 − $19,200).

The following information is available for 2017.

1. Treasury stock was purchased at a cost of $13,200. 2. Cash dividends of $36,000 were declared and paid. 3. A long-term investment in stock was purchased for $19,200. 4. Current assets other than cash increased by $34,800. Current liabilities increased by $15,600. 5. Depreciation expense was $4,800 on the building and $10,800 on equipment. 6. Net income was $66,000. 7. Bonds payable of $60,000 were issued. 8. An addition to the building was completed at a cost of $32,400. 9. Patent amortization was $3,000. 10. Equipment (cost $24,000 and accumulated depreciation $9,600) was sold for $12,000.

Instructions (a) Prepare a balance sheet at December 31, 2017. (b) Prepare a statement of cash flows for 2017.

Questions 237

2. (b) CASSY CORPORATION STATEMENT OF CASH FLOWS

FOR THE YEAR ENDED DECEMBER 31, 2017

Cash fl ows from operating activities Net income $66,000 Adjustments to reconcile net income

to net cash provided by operating activities: Loss on sale of equipment $ 2,400 Depreciation expense 15,600 Patent amortization 3,000 Increase in current liabilities 15,600 Increase in current assets (other than cash) (34,800) 1,800

Net cash provided by operating activities 67,800

Cash fl ows from investing activities Sale of equipment 12,000 Addition to building (32,400) Investment in stock (19,200)

Net cash used by investing activities (39,600)

Cash fl ows from fi nancing activities Issuance of bonds 60,000 Payment of dividends (36,000) Purchase of treasury stock (13,200) Net cash provided by fi nancing activities 10,800

Net increase in cash $39,000

Exercises, Problems, Problem Solution Walkthrough Videos, and many more assessment tools and resources are available for practice in WileyPLUS.

1. How does information from the balance sheet help users of the financial statements?

2. What is meant by solvency? What information in the balance sheet can be used to assess a company’s solvency?

3. A recent financial magazine indicated that the airline industry has poor financial flexibility. What is meant by financial flexibility, and why is it important?

4. Discuss at least two situations in which estimates could affect the usefulness of information in the balance sheet.

5. Perez Company reported an increase in inventories in the past year. Discuss the effect of this change on the current ratio (current assets ÷ current liabilities). What does this tell a statement user about Perez Company’s liquidity?

6. What is meant by liquidity? Rank the following assets from one to five in order of liquidity. (a) Goodwill. (d) Short-term investments. (b) Inventory. (e) Accounts receivable. (c) Buildings.

7. What are the major limitations of the balance sheet as a source of information?

8. Discuss at least two items that are important to the value of companies like Intel or IBM but that are not recorded in their balance sheets. What are some reasons why these items are not recorded in the balance sheet?

9. How does separating current assets from property, plant, and equipment in the balance sheet help analysts?

10. In its December 31, 2017, balance sheet Oakley Corpora- tion reported as an asset, “Net notes and accounts receiv- able, $7,100,000.” What other disclosures are necessary?

11. Should available-for-sale securities always be reported as a current asset? Explain.

12. What is the relationship between current assets and cur- rent liabilities?

13. The New York Knicks, Inc. sold 10,000 season tickets at $2,000 each. By December 31, 2017, 16 of the 40 home games had been played. What amount should be reported as a current liability at December 31, 2017?

14. What is working capital? How does working capital relate to the operating cycle?

15. In what section of the balance sheet should the following items appear, and what balance sheet terminology would you use?

QUESTIONS

238 Chapter 5 Balance Sheet and Statement of Cash Flows

(a) Treasury stock (recorded at cost).

(b) Checking account at bank.

(d) Sinking fund.

(e) Unamortized premium on bonds payable.

(f) Copyrights.

(g) Pension fund assets.

(h) Premium on common stock.

(i) Long-term investments (pledged against bank loans payable).

16. Where should the following items be shown on the balance sheet, if shown at all?

(a) Allowance for doubtful accounts.

(b) Merchandise held on consignment.

(d) Cash surrender value of life insurance.

(e) Land.

(f) Merchandise out on consignment.

(g) Franchises.

(h) Accumulated depreciation of equipment.

(i) Materials in transit—purchased f.o.b. destination. 17. According to generally accepted accounting principles, what

is the balance sheet valuation of each of the following assets?

(a) Trade accounts receivable.

(b) Land.

(d) Trading securities (common stock of other companies).

(e) Prepaid expenses. 18. Refer to the definition of assets on page 204. Discuss how

a leased building might qualify as an asset of the lessee (tenant) under this definition.

19. Kathleen Battle says, “Retained earnings should be reported as an asset, since it is earnings which are rein- vested in the business.” How would you respond to Battle?

20. The creditors of Chester Company agree to accept promis- sory notes for the amount of its indebtedness with a pro- viso that two-thirds of the annual profits must be applied to their liquidation. How should these notes be reported on the balance sheet of the issuing company? Give a rea- son for your answer.

21. What is the purpose of a statement of cash flows? How does it differ from a balance sheet and an income statement?

22. The net income for the year for Genesis, Inc. is $750,000, but the statement of cash flows reports that the net cash provided by operating activities is $640,000. What might account for the difference?

23. Net income for the year for Carrie, Inc. was $750,000, but the statement of cash flows reports that net cash provided by operating activities was $860,000. What might account for the difference?

24. Differentiate between operating activities, investing activ- ities, and financing activities.

25. Each of the following items must be considered in prepar- ing a statement of cash flows. Indicate where each item is to be reported in the statement, if at all. Assume that net income is reported as $90,000.

(a) Accounts receivable increased from $34,000 to $39,000 from the beginning to the end of the year.

(b) During the year, 10,000 shares of preferred stock with a par value of $100 per share were issued at $115 per share.

(d) Land increased from $10,000 to $30,000. 26. Sergey Co. has net cash provided by operating activities of

$1,200,000. Its average current liabilities for the period are $1,000,000, and its average total liabilities are $1,500,000. Comment on the company’s liquidity and financial flexibility, given this information.

27. Net income for the year for Tanizaki, Inc. was $750,000, but the statement of cash flows reports that net cash pro- vided by operating activities was $860,000. Tanizaki also reported capital expenditures of $75,000 and paid divi- dends in the amount of $30,000. Compute Tanizaki’s free cash flow.

28. What is the purpose of a free cash flow analysis? 29. What are some of the techniques of disclosure for the

balance sheet? 30. What is a “Summary of Significant Accounting Policies”? 31. What types of contractual obligations must be disclosed

in great detail in the notes to the balance sheet? Why do you think these detailed provisions should be disclosed?

32. What is the profession’s recommendation in regard to the use of the term “surplus”? Explain.

BRIEF EXERCISES

BE5-1 (L03) Harding Corporation has the following accounts included in its December 31, 2017, trial balance: Accounts Receivable $110,000, Inventory $290,000, Allowance for Doubtful Accounts $8,000, Patents $72,000, Prepaid Insurance $9,500, Accounts Payable $77,000, and Cash $30,000. Prepare the current assets section of the balance sheet, listing the accounts in proper sequence.

BE5-2 (L03) Koch Corporation’s adjusted trial balance contained the following asset accounts at December 31, 2017: Cash $7,000, Land $40,000, Patents $12,500, Accounts Receivable $90,000, Prepaid Insurance $5,200, Inventory $30,000, Allowance for

Brief Exercises 239

Doubtful Accounts $4,000, and Equity Investments (trading) $11,000. Prepare the current assets section of the balance sheet, list- ing the accounts in proper sequence.

BE5-3 (L03) Included in Outkast Company’s December 31, 2017, trial balance are the following accounts: Prepaid Rent $5,200, Debt Investments (to be held to maturity until 2020) $56,000, Unearned Fees $17,000, Land (held for investment) $39,000, and Notes Receivable (long-term) $42,000. Prepare the long-term investments section of the balance sheet.

BE5-4 (L03) Lowell Company’s December 31, 2017, trial balance includes the following accounts: Inventory $120,000, Build- ings $207,000, Accumulated Depreciation—Equipment $19,000, Equipment $190,000, Land (held for investment) $46,000, Accu- mulated Depreciation—Buildings $45,000, Land $71,000, and Timberland $70,000. Prepare the property, plant, and equipment section of the balance sheet.

BE5-5 (L03) Crane Corporation has the following accounts included in its December 31, 2017, trial balance: Equity Invest- ments (trading) $21,000, Goodwill $150,000, Prepaid Insurance $12,000, Patents $220,000, and Franchises $130,000. Prepare the intangible assets section of the balance sheet.

BE5-6 (L03) Patrick Corporation’s adjusted trial balance contained the following asset accounts at December 31, 2017: Pre- paid Rent $12,000, Goodwill $50,000, Franchise Fees Receivable $2,000, Franchises $47,000, Patents $33,000, and Trademarks $10,000. Prepare the intangible assets section of the balance sheet.

BE5-7 (L03) Thomas Corporation’s adjusted trial balance contained the following liability accounts at December 31, 2017: Bonds Payable (due in 3 years) $100,000, Accounts Payable $72,000, Notes Payable (due in 90 days) $22,500, Salaries and Wages Payable $4,000, and Income Taxes Payable $7,000. Prepare the current liabilities section of the balance sheet.

BE5-8 (L03) Included in Adams Company’s December 31, 2017, trial balance are the following accounts: Accounts Payable $220,000, Pension Liability $375,000, Discount on Bonds Payable $29,000, Unearned Rent Revenue $41,000, Bonds Payable $400,000, Salaries and Wages Payable $27,000, Interest Payable $12,000, and Income Taxes Payable $29,000. Prepare the current liabilities section of the balance sheet.

BE5-9 (L03) Use the information presented in BE5-8 for Adams Company to prepare the long-term liabilities section of the balance sheet.

BE5-10 (L03) Hawthorn Corporation’s adjusted trial balance contained the following accounts at December 31, 2017: Retained Earnings $120,000, Common Stock $750,000, Bonds Payable $100,000, Paid-in Capital in Excess of Par—Common Stock $200,000, Goodwill $55,000, Accumulated Other Comprehensive Loss $150,000, and Noncontrolling Interest $35,000. Prepare the stockholders’ equity section of the balance sheet.

BE5-11 (L03) Stowe Company’s December 31, 2017, trial balance includes the following accounts: Investment in Common Stock $70,000, Retained Earnings $114,000, Trademarks $31,000, Preferred Stock $152,000, Common Stock $55,000, Deferred Income Taxes $88,000, Paid-in Capital in Excess of Par—Common Stock $174,000, and Noncontrolling Interest $63,000. Prepare the stockholders’ equity section of the balance sheet.

BE5-12 (L05) Keyser Beverage Company reported the following items in the most recent year.

Net income $40,000 Dividends paid 5,000 Increase in accounts receivable 10,000 Increase in accounts payable 7,000 Purchase of equipment (capital expenditure) 8,000 Depreciation expense 4,000 Issue of notes payable 20,000

Compute net cash provided by operating activities, the net change in cash during the year, and free cash flow.

BE5-13 (L05) Ames Company reported 2017 net income of $151,000. During 2017, accounts receivable increased by $13,000 and accounts payable increased by $9,500. Depreciation expense was $44,000. Prepare the cash flows from operating activities section of the statement of cash flows.

BE5-14 (L05) Martinez Corporation engaged in the following cash transactions during 2017.

Sale of land and building $191,000 Purchase of treasury stock 40,000 Purchase of land 37,000 Payment of cash dividend 95,000 Purchase of equipment 53,000 Issuance of common stock 147,000 Retirement of bonds 100,000

Compute the net cash provided (used) by investing activities.

240 Chapter 5 Balance Sheet and Statement of Cash Flows

BE5-15 (L05) Use the information presented in BE5-14 for Martinez Corporation to compute the net cash used (provided) by financing activities.

BE5-16 (L06) Using the information in BE5-14, determine Martinez’s free cash flow, assuming that it reported net cash pro- vided by operating activities of $400,000.

EXERCISES

E5-1 (L02,3) (Balance Sheet Classifications) Presented below are a number of balance sheet accounts of Deep Blue Something, Inc.

(a) Debt Investments. (h) Interest Payable. (b) Treasury Stock. (i) Deficit. (c) Common Stock. (j) Equity Investments (ownership stake of

less than 20%). (d) Dividends Payable. (k) Income Taxes Payable. (e) Accumulated Depreciation—Equipment. (l) Unearned Subscriptions Revenue. (f) Construction in Process. (m) Work in Process. (g) Petty Cash. (n) Salaries and Wages Payable.

Instructions For each of the accounts above, indicate the proper balance sheet classification. In the case of borderline items, indicate the addi- tional information that would be required to determine the proper classification. E5-2 (L02,3) (Classification of Balance Sheet Accounts) Presented below are the captions of Faulk Company’s balance sheet.

(a) Current assets. (f) Current liabilities. (b) Investments. (g) Noncurrent liabilities. (c) Property, plant, and equipment. (h) Capital stock. (d) Intangible assets. (i) Additional paid-in capital. (e) Other assets. (j) Retained earnings.

Instructions Indicate by letter where each of the following items would be classified.

1. Preferred stock. 11. Cash surrender value of life insurance. 2. Goodwill. 12. Notes payable (due next year). 3. Salaries and wages payable. 13. Supplies. 4. Accounts payable. 14. Common stock. 5. Buildings. 15. Land. 6. Equity investments (trading). 16. Bond sinking fund. 7. Current maturity of long-term debt. 17. Inventory. 8. Premium on bonds payable. 18. Prepaid insurance. 9. Allowance for doubtful accounts. 19. Bonds payable. 10. Accounts receivable. 20. Income taxes payable.

E5-3 (L02,3) (Classification of Balance Sheet Accounts) Assume that Fielder Enterprises uses the following headings on its balance sheet.

(a) Current assets. (g) Long-term liabilities. (b) Investments. (h) Capital stock. (c) Property, plant, and equipment. (i) Equity attributed to noncontrolling interest. (d) Intangible assets. (j) Paid-in capital in excess of par. (e) Other assets. (k) Retained earnings. (f) Current liabilities.

Exercises 241

14. Accumulated Depreciation—Buildings. 15. Restricted Cash for Plant Expansion. 16. Land Held for Future Plant Site. 17. Allowance for Doubtful Accounts. 18. Retained Earnings. 19. Paid-in Capital in Excess of Par—Common Stock. 20. Unearned Subscriptions Revenue. 21. Receivables—Officers (due in one year). 22. Inventory (finished goods). 23. Accounts Receivable. 24. Bonds Payable (due in 4 years). 25. Noncontrolling Interest.

Instructions Prepare a classified balance sheet in good form. (No monetary amounts are necessary.)

E5-5 (L03) (Preparation of a Corrected Balance Sheet) Uhura Company has decided to expand its operations. The book- keeper recently completed the balance sheet presented below in order to obtain additional funds for expansion.

Instructions Indicate by letter how each of the following usually should be classified. If an item should appear in a note to the financial statements, use the letter “N” to indicate this fact. If an item need not be reported at all on the balance sheet, use the letter “X.”

1. Prepaid insurance. 2. Stock owned in affiliated companies. 3. Unearned service revenue. 4. Advances to suppliers. 5. Unearned rent revenue. 6. Preferred stock. 7. Additional paid-in capital on preferred stock. 8. Copyrights. 9. Petty cash fund. 10. Sales taxes payable. 11. Accrued interest on notes receivable. 12. Twenty-year issue of bonds payable that will mature within the next year. (No sinking fund exists, and refunding is not

planned.) 13. Machinery retired from use and held for sale. 14. Fully depreciated machine still in use. 15. Accrued interest on bonds payable. 16. Salaries that company budget shows will be paid to employees within the next year. 17. Discount on bonds payable. (Assume related to bonds payable in item 12.) 18. Accumulated depreciation—buildings. 19. Shares held by noncontrolling stockholders.

E5-4 (L02,3) (Preparation of a Classified Balance Sheet) Assume that Denis Savard Inc. has the following accounts at the end of the current year.

242 Chapter 5 Balance Sheet and Statement of Cash Flows

Instructions Prepare a revised balance sheet given the available information. Assume that the accumulated depreciation balance for the buildings is $160,000 and for the equipment, $105,000. The allowance for doubtful accounts has a balance of $17,000. The pension obligation is considered a long-term liability.

E5-6 (L02,3) (Corrections of a Balance Sheet) The bookkeeper for Geronimo Company has prepared the following balance sheet as of July 31, 2017.

UHURA COMPANY BALANCE SHEET

FOR THE YEAR ENDED 2017

Current assets Cash $230,000 Accounts receivable (net) 340,000 Inventory (lower-of-average-cost-or-market) 401,000 Equity investments (trading)—at cost (fair value $120,000) 140,000 Property, plant, and equipment Buildings (net) 570,000 Equipment (net) 160,000 Land held for future use 175,000 Intangible assets Goodwill 80,000 Cash surrender value of life insurance 90,000 Prepaid expenses 12,000 Current liabilities Accounts payable 135,000 Notes payable (due next year) 125,000 Pension obligation 82,000 Rent payable 49,000 Premium on bonds payable 53,000 Long-term liabilities Bonds payable 500,000 Stockholders’ equity Common stock, $1.00 par, authorized 400,000 shares, issued 290,000 290,000 Additional paid-in capital 160,000 Retained earnings ?

The following additional information is provided. 1. Cash includes $1,200 in a petty cash fund and $15,000 in a bond sinking fund. 2. The net accounts receivable balance is comprised of the following two items: (a) accounts receivable $44,000 and (b) allow-

ance for doubtful accounts $3,500. 3. Inventory costing $5,300 was shipped out on consignment on July 31, 2017. The ending inventory balance does not include

the consigned goods. Receivables in the amount of $5,300 were recognized on these consigned goods. 4. Equipment had a cost of $112,000 and an accumulated depreciation balance of $28,000. 5. Income taxes payable of $6,000 were accrued on July 31. Geronimo Company, however, had set up a cash fund to meet this

obligation. This cash fund was not included in the cash balance but was offset against the income taxes payable amount.

Instructions Prepare a corrected classified balance sheet as of July 31, 2017, from the available information, adjusting the account balances using the additional information.

GERONIMO COMPANY BALANCE SHEET

AS OF JULY 31, 2017

Cash $ 69,000 Notes and accounts payable $ 44,000 Accounts receivable (net) 40,500 Long-term liabilities 75,000 Inventory 60,000 Stockholders’ equity 155,500 Equipment (net) 84,000 $274,500 Patents 21,000 $274,500

Inventory (fi nished goods) $ 52,000 Cost of Goods Sold $2,100,000 Unearned Service Revenue 90,000 Notes Receivable 40,000 Equipment 253,000 Accounts Receivable 161,000 Inventory (work in process) 34,000 Inventory (raw materials) 207,000 Cash 37,000 Supplies Expense 60,000 Debt Investments (short-term) 31,000 Allowance for Doubtful Accounts 12,000 Customer Advances 36,000 Licenses 18,000 Restricted Cash for Plant Expansion 50,000 Additional Paid-in Capital 88,000 Treasury Stock 22,000

Exercises 243

E5-7 (L03) EXCEL (Current Assets Section of the Balance Sheet) Presented below are selected accounts of Yasunari Kawabata Company at December 31, 2017.

ALLESSANDRO SCARLATTI COMPANY BALANCE SHEET (PARTIAL)

DECEMBER 31, 2017

Cash $ 40,000 Accounts payable $ 61,000 Accounts receivable $89,000 Notes payable 67,000

Less: Allowance for $128,000 doubtful accounts 7,000 82,000

Inventory 171,000 Prepaid expenses 9,000

$302,000

The following additional information is available. 1. Inventories are valued at lower-of-cost-or-market using LIFO. 2. Equipment is recorded at cost. Accumulated depreciation, computed on a straight-line basis, is $50,600. 3. The short-term investments have a fair value of $29,000. (Assume they are trading securities.) 4. The notes receivable are due April 30, 2019, with interest receivable every April 30. The notes bear interest at 6%. (Hint:

Accrue interest due on December 31, 2017.) 5. The allowance for doubtful accounts applies to the accounts receivable. Accounts receivable of $50,000 are pledged as

collateral on a bank loan. 6. Licenses are recorded net of accumulated amortization of $14,000. 7. Treasury stock is recorded at cost.

Instructions Prepare the current assets section of Yasunari Kawabata Company’s December 31, 2017, balance sheet, with appropriate disclosures.

E5-8 (L02) (Current vs. Long-term Liabilities) Frederic Chopin Corporation is preparing its December 31, 2017, balance sheet. The following items may be reported as either a current or long-term liability. 1. On December 15, 2017, Chopin declared a cash dividend of $2.50 per share to stockholders of record on December 31. The

dividend is payable on January 15, 2018. Chopin has issued 1,000,000 shares of common stock, of which 50,000 shares are held in treasury.

2. At December 31, bonds payable of $100,000,000 are outstanding. The bonds pay 12% interest every September 30 and mature in installments of $25,000,000 every September 30, beginning September 30, 2018.

3. At December 31, 2016, customer advances were $12,000,000. During 2017, Chopin collected $30,000,000 of customer advances; advances of $25,000,000 should be recognized in income.

Instructions For each item above, indicate the dollar amounts to be reported as a current liability and as a long-term liability, if any.

E5-9 (L02,3) (Current Assets and Current Liabilities) The current assets and current liabilities sections of the balance sheet of Allessandro Scarlatti Company appear as follows.

244 Chapter 5 Balance Sheet and Statement of Cash Flows

The following errors in the corporation’s accounting have been discovered: 1. January 2018 cash disbursements entered as of December 2017 included payments of accounts payable in the amount of

$39,000, on which a cash discount of 2% was taken. 2. The inventory included $27,000 of merchandise that had been received at December 31 but for which no purchase invoices

had been received or entered. Of this amount, $12,000 had been received on consignment; the remainder was purchased f.o.b. destination, terms 2/10, n/30.

3. Sales for the first four days in January 2018 in the amount of $30,000 were entered in the sales journal as of December 31, 2017. Of these, $21,500 were sales on account and the remainder were cash sales.

4. Cash, not including cash sales, collected in January 2018 and entered as of December 31, 2017, totaled $35,324. Of this amount, $23,324 was received on account after cash discounts of 2% had been deducted; the remainder represented the proceeds of a bank loan.

Instructions (a) Restate the current assets and current liabilities sections of the balance sheet in accordance with good accounting

practice. (Assume that both accounts receivable and accounts payable are recorded gross.) (b) State the net effect of your adjustments on Allessandro Scarlatti Company’s retained earnings balance.

E5-10 (L02,3) (Current Liabilities) Norma Smith is the controller of Baylor Corporation and is responsible for the prepara- tion of the year-end financial statements. The following transactions occurred during the year.

(a) On December 20, 2017, a former employee filed a legal action against Baylor for $100,000 for wrongful dismissal. Management believes the action to be frivolous and without merit. The likelihood of payment to the employee is remote.

(b) Bonuses to key employees based on net income for 2017 are estimated to be $150,000. (c) On December 1, 2017, the company borrowed $600,000 at 8% per year. Interest is paid quarterly. (d) Accounts receivable at December 31, 2017, is $10,000,000. An aging analysis indicates that Baylor’s expense provision

for doubtful accounts is estimated to be 3% of the receivables balance. (e) On December 15, 2017, the company declared a $2.00 per share dividend on the 40,000 shares of common stock out-

standing, to be paid on January 5, 2018. (f) During the year, customer advances of $160,000 were received; $50,000 of this amount was earned by December 31,

2017.

Instructions For each item above, indicate the dollar amount to be reported as a current liability. If a liability is not reported, explain why.

E5-11 (L03) EXCEL (Balance Sheet Preparation) Presented below is the adjusted trial balance of Kelly Corporation at December 31, 2017.

Additional information: 1. Net loss for the year was $2,500. 2. No dividends were declared during 2017.

Debit Credit

Cash $ ? Supplies 1,200 Prepaid Insurance 1,000 Equipment 48,000 Accumulated Depreciation—Equipment $ 4,000 Trademarks 950 Accounts Payable 10,000 Salaries and Wages Payable 500 Unearned Service Revenue 2,000 Bonds Payable (due 2024) 9,000 Common Stock 10,000 Retained Earnings 25,000 Service Revenue 10,000 Salaries and Wages Expense 9,000 Insurance Expense 1,400 Rent Expense 1,200 Interest Expense 900

Total $ ? $ ?

Exercises 245

Instructions Prepare a classified balance sheet as of December 31, 2017.

E5-12 (L03) (Preparation of a Balance Sheet) Presented below is the trial balance of Scott Butler Corporation at December 31, 2017.

Debit Credit

Cash $ 197,000 Sales Revenue $ 8,100,000 Debt Investments (trading) (at cost, $145,000) 153,000 Cost of Goods Sold 4,800,000 Debt Investments (long-term) 299,000 Equity Investments (long-term) 277,000 Notes Payable (short-term) 90,000 Accounts Payable 455,000 Selling Expenses 2,000,000 Investment Revenue 63,000 Land 260,000 Buildings 1,040,000 Dividends Payable 136,000 Accrued Liabilities 96,000 Accounts Receivable 435,000 Accumulated Depreciation—Buildings 152,000 Allowance for Doubtful Accounts 25,000 Administrative Expenses 900,000 Interest Expense 211,000 Inventory 597,000 Gain 80,000 Notes Payable (long-term) 900,000 Equipment 600,000 Bonds Payable 1,000,000 Accumulated Depreciation—Equipment 60,000 Franchises 160,000 Common Stock ($5 par) 1,000,000 Treasury Stock 191,000 Patents 195,000 Retained Earnings 78,000 Paid-in Capital in Excess of Par 80,000

Totals $12,315,000 $12,315,000

Instructions Prepare a balance sheet at December 31, 2017, for Scott Butler Corporation. (Ignore income taxes.)

E5-13 (L04) (Statement of Cash Flows—Classifications) The major classifications of activities reported in the statement of cash flows are operating, investing, and financing. Classify each of the transactions listed below as:

1. Operating activity—add to net income. 2. Operating activity—deduct from net income. 3. Investing activity. 4. Financing activity. 5. Reported as significant noncash activity.

The transactions are as follows.

(a) Issuance of common stock. (h) Payment of cash dividends. (b) Purchase of land and building. (i) Exchange of furniture for office equipment. (c) Redemption of bonds. (j) Purchase of treasury stock. (d) Sale of equipment. (k) Loss on sale of equipment. (e) Depreciation of machinery. (l) Increase in accounts receivable during the year. (f) Amortization of patent. (m) Decrease in accounts payable during the year. (g) Issuance of bonds for plant assets.

246 Chapter 5 Balance Sheet and Statement of Cash Flows

Net income of $44,000 was reported, and dividends of $23,000 were paid in 2017. New equipment was purchased and none was sold.

Instructions Prepare a statement of cash flows for the year 2017.

E5-15 (L05,6) (Preparation of a Statement of Cash Flows) Presented below is a condensed version of the comparative balance sheets for Zubin Mehta Corporation for the last two years at December 31.

CONSTANTINE CAVAMANLIS INC. BALANCE SHEETS

Assets Dec. 31, 2017 Jan. 1, 2017 Inc./Dec.

Cash $ 45,000 $ 13,000 $32,000 Inc. Accounts receivable 91,000 88,000 3,000 Inc. Equipment 39,000 22,000 17,000 Inc. Less: Accumulated depreciation—equipment 17,000 11,000 6,000 Inc.

Total $158,000 $112,000

Liabilities and Stockholders’ Equity

Accounts payable $ 20,000 $ 15,000 5,000 Inc. Common stock 100,000 80,000 20,000 Inc. Retained earnings 38,000 17,000 21,000 Inc.

Total $158,000 $112,000

2017 2016

Cash $177,000 $ 78,000 Accounts receivable 180,000 185,000 Investments 52,000 74,000 Equipment 298,000 240,000 Accumulated depreciation—equipment (106,000) (89,000) Current liabilities 134,000 151,000 Common stock 160,000 160,000 Retained earnings 307,000 177,000

Additional information:

Investments were sold at a loss of $10,000; no equipment was sold; cash dividends paid were $30,000; and net income was $160,000.

Instructions (a) Prepare a statement of cash flows for 2017 for Zubin Mehta Corporation. (b) Determine Zubin Mehta Corporation’s free cash flow.

E5-16 (L05,6) (Preparation of a Statement of Cash Flows) A comparative balance sheet for Shabbona Corporation is pre- sented below.

December 31

Assets 2017 2016

Cash $ 73,000 $ 22,000 Accounts receivable 82,000 66,000 Inventory 180,000 189,000 Land 71,000 110,000 Equipment 260,000 200,000 Accumulated depreciation—equipment (69,000) (42,000)

Total $597,000 $545,000

Liabilities and Stockholders’ Equity

Accounts payable $ 34,000 $ 47,000 Bonds payable 150,000 200,000 Common stock ($1 par) 214,000 164,000 Retained earnings 199,000 134,000

Total $597,000 $545,000

E5-14 (L05) (Preparation of a Statement of Cash Flows) The comparative balance sheets of Constantine Cavamanlis Inc. at the beginning and the end of the year 2017 are as follows.

Exercises 247

Additional information:

1. Net income for 2017 was $125,000. No gains or losses were recorded in 2017. 2. Cash dividends of $60,000 were declared and paid. 3. Bonds payable amounting to $50,000 were retired through issuance of common stock.

Instructions (a) Prepare a statement of cash flows for 2017 for Shabbona Corporation. (b) Determine Shabbona Corporation’s current cash debt coverage, cash debt coverage, and free cash flow. Comment on its

liquidity and financial flexibility.

E5-17 (L03,5) (Preparation of a Statement of Cash Flows and a Balance Sheet) Grant Wood Corporation’s balance sheet at the end of 2016 included the following items.

Current assets (Cash $82,000) $235,000 Current liabilities $150,000 Land 30,000 Bonds payable 100,000 Buildings 120,000 Common stock 180,000 Equipment 90,000 Retained earnings 44,000

Accum. depr.—buildings (30,000) Total $474,000 Accum. depr.—equipment (11,000) Patents 40,000

Total $474,000

The following information is available for 2017.

1. Net income was $55,000. 2. Equipment (cost $20,000 and accumulated depreciation $8,000) was sold for $10,000. 3. Depreciation expense was $4,000 on the building and $9,000 on equipment. 4. Patent amortization was $2,500. 5. Current assets other than cash increased by $29,000. Current liabilities increased by $13,000. 6. An addition to the building was completed at a cost of $27,000. 7. A long-term investment in stock was purchased for $16,000. 8. Bonds payable of $50,000 were issued. 9. Cash dividends of $30,000 were declared and paid. 10. Treasury stock was purchased at a cost of $11,000.

Instructions (Show only totals for current assets and current liabilities.)

(a) Prepare a statement of cash flows for 2017. (b) Prepare a balance sheet at December 31, 2017.

E5-18 (L05,6) (Preparation of a Statement of Cash Flows, Analysis) The comparative balance sheets of Madrasah Corpora- tion at the beginning and end of the year 2017 appear below.

MADRASAH CORPORATION BALANCE SHEETS

Assets Dec. 31, 2017 Jan. 1, 2017 Inc./Dec.

Cash $ 20,000 $ 13,000 $ 7,000 Inc. Accounts receivable 106,000 88,000 18,000 Inc. Equipment 39,000 22,000 17,000 Inc. Less: Accumulated depreciation—equipment 17,000 11,000 6,000 Inc.

Total $148,000 $112,000

Liabilities and Stockholders’ Equity

Accounts payable $ 20,000 $ 15,000 5,000 Inc. Common stock 100,000 80,000 20,000 Inc. Retained earnings 28,000 17,000 11,000 Inc.

Total $148,000 $112,000

Net income of $44,000 was reported, and dividends of $33,000 were paid in 2017. New equipment was purchased and none was sold.

248 Chapter 5 Balance Sheet and Statement of Cash Flows

Instructions (a) Prepare a statement of cash flows for the year 2017. (b) Compute the current ratio (current assets ÷ current liabilities) as of January 1, 2017, and December 31, 2017, and com-

pute free cash flow for the year 2017. (c) In light of the analysis in (b), comment on Madrasah’s liquidity and financial flexibility.

PROBLEMS

P5-1 (L03) (Preparation of a Classified Balance Sheet, Periodic Inventory) Presented below is a list of accounts in alpha- betical order.

Accounts Receivable Inventory—Ending Accumulated Depreciation—Buildings Land Accumulated Depreciation—Equipment Land for Future Plant Site Accumulated Other Comprehensive Income Loss from Flood Advances to Employees Noncontrolling Interest Advertising Expense Notes Payable (due next year) Allowance for Doubtful Accounts Paid-in Capital in Excess of Par—Preferred Stock Bond Sinking Fund Patents Bonds Payable Payroll Taxes Payable Buildings Pension Liability Cash (in bank) Petty Cash Cash (on hand) Preferred Stock Cash Surrender Value of Life Insurance Premium on Bonds Payable Commission Expense Prepaid Rent Common Stock Purchase Returns and Allowances Copyrights Purchases Debt Investments (trading) Retained Earnings Dividends Payable Salaries and Wages Expense (sales) Equipment Salaries and Wages Payable Freight-In Sales Discounts Gain on Disposal of Equipment Sales Revenue Interest Receivable Treasury Stock (at cost) Inventory—Beginning Unearned Subscriptions Revenue

Instructions Prepare a classified balance sheet in good form. (No monetary amounts are to be shown.)

P5-2 (L03) EXCEL (Balance Sheet Preparation) Presented below are a number of balance sheet items for Montoya, Inc., for the current year, 2017.

Goodwill $ 125,000 Accumulated depreciation—equipment $ 292,000 Payroll taxes payable 177,591 Inventory 239,800 Bonds payable 300,000 Rent payable (short-term) 45,000 Discount on bonds payable 15,000 Income taxes payable 98,362 Cash 360,000 Rent payable (long-term) 480,000 Land 480,000 Common stock, $1 par value 200,000 Notes receivable 445,700 Preferred stock, $10 par value 150,000 Notes payable (to banks) 265,000 Prepaid expenses 87,920 Accounts payable 490,000 Equipment 1,470,000 Retained earnings ? Debt investments (trading) 121,000 Income taxes receivable 97,630 Accumulated depreciation—buildings 270,200 Notes payable (long-term) 1,600,000 Buildings 1,640,000

Instructions Prepare a classified balance sheet in good form. Common stock authorized was 400,000 shares, and preferred stock authorized was 20,000 shares. Assume that notes receivable and notes payable are short-term, unless stated otherwise. Cost and fair value of equity investments (trading) are the same.

P5-3 (L03) (Balance Sheet Adjustment and Preparation) The adjusted trial balance of Eastwood Company and other related information for the year 2017 are presented as follows.

Problems 249

EASTWOOD COMPANY ADJUSTED TRIAL BALANCE

DECEMBER 31, 2017

Debit Credit

Cash $ 41,000 Accounts Receivable 163,500 Allowance for Doubtful Accounts $ 8,700 Prepaid Insurance 5,900 Inventory 208,500 Equity Investments (long-term) 339,000 Land 85,000 Construction in Process (building) 124,000 Patents 36,000 Equipment 400,000 Accumulated Depreciation—Equipment 240,000 Discount on Bonds Payable 20,000 Accounts Payable 148,000 Accrued Liabilities 49,200 Notes Payable 94,000 Bonds Payable 200,000 Common Stock 500,000 Paid-in Capital in Excess of Par—Common Stock 45,000 Retained Earnings 138,000

$1,422,900 $1,422,900

Additional information:

1. The LIFO method of inventory value is used. 2. The cost and fair value of the long-term investments that consist of stocks (with ownership less than 20% of total shares)

are the same. 3. The amount of the Construction in Progress account represents the costs expended to date on a building in the process of

construction. (The company rents factory space at the present time.) The land on which the building is being constructed cost $85,000, as shown in the trial balance.

4. The patents were purchased by the company at a cost of $40,000 and are being amortized on a straight-line basis. 5. Of the discount on bonds payable, $2,000 will be amortized in 2018. 6. The notes payable represent bank loans that are secured by long-term investments carried at $120,000. These bank loans

are due in 2018. 7. The bonds payable bear interest at 8% payable every December 31, and are due January 1, 2028. 8. 600,000 shares of common stock of a par value of $1 were authorized, of which 500,000 shares were issued and outstanding.

Instructions Prepare a balance sheet as of December 31, 2017, so that all important information is fully disclosed.

P5-4 (L03) GROUPWORK (Preparation of a Corrected Balance Sheet) The balance sheet of Kishwaukee Corporation as of December 31, 2017, is as follows.

KISHWAUKEE CORPORATION BALANCE SHEET

DECEMBER 31, 2017

Assets

Goodwill (Note 2) $ 120,000 Buildings (Note 1) 1,640,000 Inventory 312,100 Land 950,000 Accounts receivable 170,000 Treasury stock (50,000 shares) 87,000 Cash on hand 175,900 Assets allocated to trustee for plant expansion Cash in bank 70,000 Debt investments (held-to-maturity) 138,000

$3,663,000

250 Chapter 5 Balance Sheet and Statement of Cash Flows

Note 1: Buildings are stated at cost, except for one building that was recorded at appraised value. The excess of appraisal value over cost was $570,000. Depreciation has been recorded based on cost.

Note 2: Goodwill in the amount of $120,000 was recognized because the company believed that book value was not an accurate representation of the fair value of the company. The gain of $120,000 was credited to Retained Earnings.

Note 3: Notes payable are long-term except for the current installment due of $100,000.

Instructions Prepare a corrected classified balance sheet in good form. The notes above are for information only.

P5-5 (L03) GROUPWORK (Balance Sheet Adjustment and Preparation) Presented below is the balance sheet of Sargent Corporation for the current year, 2017.

Equities

Notes payable (Note 3) $ 600,000 Common stock, authorized and issued, 1,000,000 shares, no par 1,150,000 Retained earnings 803,000 Noncontrolling interest 55,000 Appreciation capital (Note 1) 570,000 Income tax payable 75,000 Reserve for depreciation recorded to date on the building 410,000

$3,663,000

SARGENT CORPORATION BALANCE SHEET

DECEMBER 31, 2017

Current assets $ 485,000 Current liabilities $ 380,000 Investments 640,000 Long-term liabilities 1,000,000 Property, plant, and equipment 1,720,000 Stockholders’ equity 1,770,000 Intangible assets 305,000 $3,150,000

$3,150,000

The following information is presented.

1. The current assets section includes cash $150,000, accounts receivable $170,000 less $10,000 for allowance for doubtful accounts, inventories $180,000, and unearned rent revenue $5,000. Inventory is stated on the lower-of-FIFO-cost-or-net realizable value.

2. The investments section includes the cash surrender value of a life insurance contract $40,000; investments in common stock, short-term $80,000 and long-term $270,000; and bond sinking fund $250,000. The cost and fair value of investments in common stock are the same.

3. Property, plant, and equipment includes buildings $1,040,000 less accumulated depreciation $360,000, equipment $450,000 less accumulated depreciation $180,000, land $500,000, and land held for future use $270,000.

4. Intangible assets include a franchise $165,000, goodwill $100,000, and discount on bonds payable $40,000. 5. Current liabilities include accounts payable $140,000, notes payable—short-term $80,000 and long-term $120,000, and

income taxes payable $40,000. 6. Long-term liabilities are composed solely of 7% bonds payable due 2025. 7. Stockholders’ equity has preferred stock, no par value, authorized 200,000 shares, issued 70,000 shares for $450,000; and

common stock, $1.00 par value, authorized 400,000 shares, issued 100,000 shares at an average price of $10. In addition, the corporation has retained earnings of $320,000.

Instructions Prepare a balance sheet in good form, adjusting the amounts in each balance sheet classification as affected by the information given above.

P5-6 (L03,5,6) EXCEL (Preparation of a Statement of Cash Flows and a Balance Sheet) Lansbury Inc. had the following balance sheet at December 31, 2016.

Problems 251

During 2017, the following occurred.

1. Lansbury Inc. sold part of its debt investment portfolio for $15,000. This transaction resulted in a gain of $3,400 for the firm. The company classifies these investments as available-for-sale.

2. A tract of land was purchased for $13,000 cash. 3. Long-term notes payable in the amount of $16,000 were retired before maturity by paying $16,000 cash. 4. An additional $20,000 in common stock was issued at par. 5. Dividends of $8,200 were declared and paid to stockholders. 6. Net income for 2017 was $32,000 after allowing for depreciation of $11,000. 7. Land was purchased through the issuance of $35,000 in bonds. 8. At December 31, 2017, Cash was $37,000, Accounts Receivable was $41,600, and Accounts Payable remained at $30,000.

Instructions (a) Prepare a statement of cash flows for 2017. (b) Prepare an unclassified balance sheet as it would appear at December 31, 2017. (c) How might the statement of cash flows help the user of the financial statements? Compute two cash flow ratios.

P5-7 (L01,3,5,6) GROUPWORK (Preparation of a Statement of Cash Flows and Balance Sheet) Aero Inc. had the follow- ing balance sheet at December 31, 2016.

LANSBURY INC. BALANCE SHEET

DECEMBER 31, 2016

Cash $ 20,000 Accounts payable $ 30,000 Accounts receivable 21,200 Notes payable (long-term) 41,000 Investments 32,000 Common stock 100,000 Plant assets (net) 81,000 Retained earnings 23,200 Land 40,000 $194,200 $194,200

AERO INC. BALANCE SHEET

DECEMBER 31, 2016

Cash $ 20,000 Accounts payable $ 30,000 Accounts receivable 21,200 Bonds payable 41,000 Investments 32,000 Common stock 100,000 Plant assets (net) 81,000 Retained earnings 23,200 Land 40,000 $194,200 $194,200

During 2017, the following occurred.

1. Aero liquidated its available-for-sale debt investment portfolio at a loss of $5,000. 2. A tract of land was purchased for $38,000. 3. An additional $30,000 in common stock was issued at par. 4. Dividends totaling $10,000 were declared and paid to stockholders. 5. Net income for 2017 was $35,000, including $12,000 in depreciation expense. 6. Land was purchased through the issuance of $30,000 in additional bonds. 7. At December 31, 2017, Cash was $70,200, Accounts Receivable was $42,000, and Accounts Payable was $40,000.

Instructions (a) Prepare a statement of cash flows for the year 2017 for Aero. (b) Prepare the unclassified balance sheet as it would appear at December 31, 2017. (c) Compute Aero’s free cash flow and current cash debt coverage for 2017. (d) Use the analysis of Aero to illustrate how information in the balance sheet and statement of cash flows helps the user of

the financial statements.

252 Chapter 5 Balance Sheet and Statement of Cash Flows

CONCEPTS FOR ANALYSIS

CA5-1 (Reporting the Financial Effects of Varied Transactions) In an examination of Arenes Corporation as of December 31, 2017, you have learned that the following situations exist. No entries have been made in the accounting records for these items.

1. The corporation erected its present factory building in 2001. Depreciation was calculated by the straight-line method, using an estimated life of 35 years. Early in 2017, the board of directors conducted a careful survey and estimated that the factory building had a remaining useful life of 25 years as of January 1, 2017.

2. An additional assessment of 2016 income taxes was levied and paid in 2017. 3. When calculating the accrual for officers’ salaries at December 31, 2017, it was discovered that the accrual for officers’ sala-

ries for December 31, 2016, had been overstated. 4. On December 15, 2017, Arenes Corporation declared a cash dividend on its common stock outstanding, payable February 1,

2018, to the common stockholders of record December 31, 2017.

Instructions Describe fully how each of the items above should be reported in the financial statements of Arenes Corporation for the year 2017.

CA5-2 (Identifying Balance Sheet Deficiencies) The assets of Fonzarelli Corporation are presented below (000s omitted).

FONZARELLI CORPORATION BALANCE SHEET (PARTIAL)

DECEMBER 31, 2017

Assets

Current assets Cash $ 100,000 Unclaimed payroll checks 27,500 Debt investments (trading) (fair value $30,000) at cost 37,000 Accounts receivable (less bad debt reserve) 75,000 Inventory—at lower-of-cost (determined by the next-in, fi rst-out method)-or-net realizable value 240,000

Total current assets 479,500

Tangible assets Land (less accumulated depreciation) 80,000 Buildings and equipment $800,000 Less: Accumulated depreciation 250,000 550,000

Net tangible assets 630,000

Long-term investments Stocks and bonds 100,000 Treasury stock 70,000

Total long-term investments 170,000

Other assets Discount on bonds payable 19,400 Sinking fund 975,000

Total other assets 994,400

Total assets $2,273,900

Instructions Indicate the deficiencies, if any, in the foregoing presentation of Fonzarelli Corporation’s assets.

CA5-3 WRITING (Critique of Balance Sheet Format and Content) The following is the balance sheet of Sameed Brothers Corporation (000s omitted).

Concepts for Analysis 253

Instructions Evaluate the balance sheet presented. State briefly the proper treatment of any item criticized.

CA5-4 ETHICS (Presentation of Property, Plant, and Equipment) Carol Keene, corporate comptroller for Dumaine Industries, is trying to decide how to present “Property, plant, and equipment” in the balance sheet. She realizes that the statement of cash flows will show that the company made a significant investment in purchasing new equipment this year, but overall she knows the company’s plant assets are rather old. She feels that she can disclose one figure titled “Property, plant, and equipment, net of depreciation,” and the result will be a low figure. However, it will not disclose the age of the assets. If she chooses to show the cost less accumulated depreciation, the age of the assets will be apparent. She proposes the following.

Property, plant, and equipment, net of depreciation $10,000,000

rather than Property, plant, and equipment $50,000,000 Less: Accumulated depreciation 40,000,000

Net book value $10,000,000

Instructions Answer the following questions.

(a) What are the ethical issues involved? (b) What should Keene do?

SAMEED BROTHERS CORPORATION BALANCE SHEET

DECEMBER 31, 2017

Assets

Current assets Cash $26,000 Marketable securities 18,000 Accounts receivable 25,000 Inventory 20,000 Supplies 4,000 Stock investment in subsidiary company 20,000 $113,000

Investments Treasury stock 25,000 Property, plant, and equipment Buildings and land 91,000 Less: Reserve for depreciation 31,000 60,000

Other assets Cash surrender value of life insurance 19,000

Total assets $217,000

Liabilities and Stockholders’ Equity

Current liabilities Accounts payable $22,000 Reserve for income taxes 15,000 Customers’ accounts with credit balances 1 $ 37,001

Deferred credits Unamortized premium on bonds payable 2,000 Long-term liabilities Bonds payable 60,000

Total liabilities 99,001 Common stock Common stock, par $5 85,000 Earned surplus 24,999 Cash dividends declared 8,000 117,999

Total liabilities and stockholders’ equity $217,000

254 Chapter 5 Balance Sheet and Statement of Cash Flows

CA5-5 WRITING (Cash Flow Analysis) The partner in charge of the Kappeler Corporation audit comes by your desk and leaves a letter he has started to the CEO and a copy of the cash flow statement for the year ended December 31, 2017. Because he must leave on an emergency, he asks you to finish the letter by explaining: (1) the disparity between net income and cash flow, (2) the importance of operating cash flow, (3) the renewable source(s) of cash flow, and (4) possible suggestions to improve the cash position.

Date

President Kappeler, CEO Kappeler Corporation 125 Wall Street Middleton, Kansas 67458

Dear Mr. Kappeler:

I have good news and bad news about the financial statements for the year ended December 31, 2017. The good news is that net income of $100,000 is close to what we predicted in the strategic plan last year, indicating strong performance this year. The bad news is that the cash balance is seriously low. Enclosed is the Statement of Cash Flows, which best illustrates how both of these situations occurred simultaneously . . .

Instructions Complete the letter to the CEO, including the four components requested by your boss.

USING YOUR JUDGMENT

Instructions Refer to P&G’s financial statements and the related information in the annual report to answer the following questions.

(a) What alternative formats could P&G have adopted for its balance sheet? Which format did it adopt? (b) Identify the various techniques of disclosure P&G might have used to disclose additional pertinent financial informa-

tion. Which technique does it use in its financials?

KAPPELER CORPORATION STATEMENT OF CASH FLOWS

FOR THE YEAR ENDED DECEMBER 31, 2017

Cash fl ows from operating activities Net income $ 100,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $ 10,000 Amortization expense 1,000 Loss on sale of fi xed assets 5,000 Increase in accounts receivable (net) (40,000) Increase in inventory (35,000) Decrease in accounts payable (41,000) (100,000)

Net cash provided by operating activities –0– Cash fl ows from investing activities Sale of plant assets 25,000 Purchase of equipment (100,000) Purchase of land (200,000)

Net cash used by investing activities (275,000) Cash fl ows from fi nancing activities Payment of dividends (10,000) Redemption of bonds (100,000)

Net cash used by fi nancing activities (110,000)

Net decrease in cash (385,000) Cash balance, January 1, 2017 400,000

Cash balance, December 31, 2017 $ 15,000

Using Your Judgment 255

(c) In what classifications are P&G’s investments reported? What valuation basis does P&G use to report its investments? How much working capital did P&G have on June 30, 2014? On June 30, 2013?

(d) What were P&G’s cash flows from its operating, investing, and financing activities for 2014? What were its trends in net cash provided by operating activities over the period 2012–2014? Explain why the change in accounts payable and in accrued and other liabilities is added to net income to arrive at net cash provided by operating activities.

(e) Compute P&G’s (1) current cash debt coverage, (2) cash debt coverage, and (3) free cash flow for 2014. What do these ratios indicate about P&G’s financial condition?

Instructions Use the companies’ financial information to answer the following questions.

(a) What format(s) did these companies use to present their balance sheets? (b) How much working capital did each of these companies have at the end of 2014? Speculate as to their rationale for the

amount of working capital they maintain. (c) What are the companies’ annual and 5-year (2010–2014) growth rates in total assets and long-term debt 2012? (d) What were these two companies’ trends in net cash provided by operating activities over the period 2012–2014? (e) Compute both companies’ (1) current cash debt coverage, (2) cash debt coverage, and (3) free cash flow. What do these

ratios indicate about the financial condition of the two companies?

Financial Statement Analysis Cases Case 1: Uniroyal Technology Corporation Uniroyal Technology Corporation (UTC), with corporate offices in Sarasota, Florida, is organized into three operating segments. The high-performance plastics segment is responsible for research, development, and manufacture of a wide variety of products, including orthopedic braces, graffiti-resistant seats for buses and airplanes, and a static-resistant plastic used in the central pro- cessing units of microcomputers. The coated fabrics segment manufactures products such as automobile seating, door and instru- ment panels, and specialty items such as waterproof seats for personal watercraft and stain-resistant, easy-cleaning upholstery fabrics. The foams and adhesives segment develops and manufactures products used in commercial roofing applications. The following items relate to operations in a recent year. 1. Serious pressure was placed on profitability by sharply increasing raw material prices. Some raw materials increased in

price 50% during the past year. Cost containment programs were instituted and product prices were increased whenever possible, which resulted in profit margins actually improving over the course of the year.

2. The company entered into a revolving credit agreement, under which UTC may borrow the lesser of $15,000,000 or 80% of eligible accounts receivable. At the end of the year, approximately $4,000,000 was outstanding under this agreement. The company plans to use this line of credit in the upcoming year to finance operations and expansion.

Instructions (a) Should investors be informed of raw materials price increases, such as described in item 1? Does the fact that the com-

pany successfully met the challenge of higher prices affect the answer? Explain. (b) How should the information in item 2 be presented in the financial statements of UTC?

Case 2: Sherwin-Williams Company Sherwin-Williams, based in Cleveland, Ohio, manufactures a wide variety of paint and other coatings, which are marketed through its specialty stores and in other retail outlets. The company also manufactures paint for automobiles. The Automotive Division has had financial difficulty. During a recent year, five branch locations of the Automotive Division were closed, and new management was put in place for the branches remaining.

The following titles were shown on Sherwin-Williams’s balance sheet for that year. Accounts payable Machinery and equipment Accounts receivable, less allowance Other accruals Accrued taxes Other capital Buildings Other current assets Cash and cash equivalents Other long-term liabilities Common stock Postretirement obligations other than pensions Employee compensation payable Retained earnings Finished goods inventories Short-term investments Intangibles and other assets Taxes payable Land Work in process and raw materials inventories Long-term debt

256 Chapter 5 Balance Sheet and Statement of Cash Flows

Instructions (a) Organize the accounts in the general order in which they would have been presented in a classified balance sheet. (b) When several of the branch locations of the Automotive Division were closed, what balance sheet accounts were most

likely affected? Did the balance in those accounts decrease or increase?

Case 3: Deere & Company Presented below is the SEC-mandated disclosure of contractual obligations provided by Deere & Company in a recent annual report. Deere & Company reported current assets of $50,060 and total current liabilities of $21,394 at year-end. (All dollars are in millions.)

Instructions (a) Compute Deere & Company’s working capital and current ratio (current assets ÷ current liabilities) with and without

the off-balance-sheet contractual obligations reported in the schedule. (b) Briefly discuss how the information provided in the contractual obligation disclosure would be useful in evaluating

Deere & Company for loans (1) due in one year and (2) due in five years.

Case 4: Amazon.com The incredible growth of Amazon.com has put fear into the hearts of traditional retailers. Amazon’s stock price has soared to amazing levels. However, it is often pointed out in the financial press that it took the company several years to report its first profit. The following financial information is taken from a recent annual report.

Aggregate Contractual Obligations The payment schedule for the company’s contractual obligations at year-end in millions of dollars is as follows:

Less More than 1–3 4 and 5 than Total 1 year years years 5 years Debt Equipment operations $ 5,091 $ 434 $ 270 $ 775 $ 3,612 Financial services 31,692 9,962 11,477 6,578 3,675

Total 36,783 10,396 11,747 7,353 7,287 Interest on debt 4,777 609 1,069 745 2,354 Accounts payable 2,743 2,611 90 39 3 Capital leases 87 39 42 4 2 Purchasing obligations 3,007 2,970 37 — — Operating leases 371 121 134 70 46

Total $ 47,768 $ 16,746 $13,119 $ 8,211 $ 9,692

($ in millions) Current Year Prior Year

Current assets $ 31,327 $ 24,625 Total assets 54,505 40,159 Current liabilities 28,089 22,980 Total liabilities 43,764 30,413 Cash provided by operations 6,842 5,475 Capital expenditures 4,893 3,444 Dividends paid — — Net income (loss) (241) 274 Sales 88,988 74,452

Instructions (a) Calculate free cash flow for Amazon for the current and prior years, and discuss its ability to finance expansion from

internally generated cash. Thus far Amazon has avoided purchasing large warehouses. Instead, it has used those of others. It is possible, however, that in order to increase customer satisfaction the company may have to build its own warehouses. If this happens, how might your impression of its ability to finance expansion change?

(b) Discuss any potential implications of the change in Amazon’s cash provided by operations from the prior year to the current year.

Accounting, Analysis, and Principles Early in January 2018, Hopkins Company is preparing for a meeting with its bankers to discuss a loan request. Its bookkeeper provided the following accounts and balances at December 31, 2017.

Bridge to the Profession 257

Debit Credit

Cash $ 75,000 Accounts Receivable (net) 38,500 Inventory 65,300 Equipment (net) 84,000 Patents 15,000 Notes and Accounts Payable $ 52,000 Notes Payable (due 2019) 75,000 Common Stock 100,000 Retained Earnings 50,800

$277,800 $277,800

Except for the following items, Hopkins has recorded all adjustments in its accounts.

1. Cash includes $500 petty cash and $15,000 in a bond sinking fund. 2. Net accounts receivable is comprised of $52,000 in accounts receivable and $13,500 in allowance for doubtful accounts. 3. Equipment had a cost of $112,000 and accumulated depreciation of $28,000. 4. On January 8, 2018, one of Hopkins’ customers declared bankruptcy. At December 31, 2017, this customer owed

Hopkins $9,000.

Accounting Prepare a corrected December 31, 2017, balance sheet for Hopkins Company.

Analysis Hopkins’ bank is considering granting an additional loan in the amount of $45,000, which will be due December 31, 2018. How can the information in the balance sheet provide useful information to the bank about Hopkins’ ability to repay the loan?

Principles In the upcoming meeting with the bank, Hopkins plans to provide additional information about the fair value of its equipment and some internally generated intangible assets related to its customer lists. This information indicates that Hopkins has sig- nificant unrealized gains on these assets, which are not reflected on the balance sheet. What objections is the bank likely to raise about the usefulness of this information in evaluating Hopkins for the loan renewal?

BRIDGE TO THE PROFESSION

FASB Codifi cation References [1] FASB ASC 320-10-35-1. [Predecessor literature: “Accounting for Certain Investments in Debt and Equity Securities,” Statement

of Financial Accounting Standards No. 115 (Norwalk, Conn.: FASB, 1993).] [2] FASB ASC 825-10-25-1. [Predecessor literature: “The Fair Value Option for Financial Assets and Liabilities, Including an

Amendment of FASB Statement No. 115,” Statement of Financial Accounting Standards No. 159 (Norwalk, Conn.: FASB, February 2007).]

[3] FASB ASC 470-10-05-6. [Predecessor literature: “Classification of Short-term Obligations Expected to Be Refinanced,” Statement of Financial Accounting Standards No. 6 (Stamford, Conn.: FASB, 1975).]

[4] FASB ASC 505-10-50. [Predecessor literature: “Disclosure of Information about Capital Structure,” Statement of Financial Accounting Standards No. 129 (Norwalk: FASB, 1997), par. 4).]

[5] FASB ASC 230-10-05. [Predecessor literature: “Statement of Cash Flows,” Statement of Financial Accounting Standards No. 95 (Stamford, Conn.: FASB, 1987).]

[6] FASB ASC 235-10-05. [Predecessor literature: “Disclosure of Accounting Policies,” Opinions of the Accounting Principles Board No. 22 (New York: AICPA, 1972).]

[7] FASB ASC 275-10-05. [Predecessor literature: “Disclosure of Certain Significant Risks and Uncertainties,” Statement of Position 94-6 (New York: AICPA, 1994).]

[8] FASB ASC 820-10-15. [Predecessor literature: “Fair Value Measurement,” Statement of Financial Accounting Standards No. 157 (Norwalk, Conn.: FASB, September 2006).]

258 Chapter 5 Balance Sheet and Statement of Cash Flows

Codifi cation Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE5-1 Access the Codification glossary (“Master Glossary”) to answer the following.

(a) What is the definition provided for current assets? (b) What is the definition of an intangible asset? In what section of the Codification are intangible assets addressed? (c) What are cash equivalents? (d) What are financing activities?

CE5-2 What guidance does the Codification provide on the classification of current liabilities? CE5-3 What guidance does the Codification provide concerning the format of accounting disclosures? CE5-4 What are the objectives related to the statement of cash flows?

Codifi cation Research Case In light of the full disclosure principle, investors and creditors need to know the balances for assets, liabilities, and equity as well as the accounting policies adopted by management to measure the items reported in the balance sheet.

Instructions If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.

(a) Identify the literature that addresses the disclosure of accounting policies. (b) How are accounting policies defined in the literature? (c) What are the three scenarios that would result in detailed disclosure of the accounting methods used? (d) What are some examples of common disclosures that are required under this statement?

IFRS Insights As in GAAP, the balance sheet and the statement of cash flows are required statements for IFRS. However, the content and presentation of an IFRS statement of financial position (balance sheet) are different, while those for the cash flow statement are similar to those used for GAAP. In general, the disclosure requirements related to the balance sheet and the statement of cash flows are much more extensive and detailed in the United States. IAS 1, “Presentation of Financial State- ments,” provides the overall IFRS requirements for balance sheet information. IAS 7, “Cash Flow Statements,” provides the overall IFRS requirements for cash flow information. IFRS insights on the statement of cash flows are presented in Chapter 23.

RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to the balance sheet.

Similarities • Both IFRS and GAAP allow the use of title “balance sheet” or “statement of fi nancial position.”

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

• Both IFRS and GAAP require disclosures about (1) accounting policies followed, (2) judgments that management has made in the process of applying the entity’s accounting policies, and (3) the key assumptions and estimation uncertainty that could result in a material adjustment to the carrying amounts of assets and liabilities within the next fi nancial year. Comparative prior period information must be presented and fi nancial statements must be prepared annually.

LEARNING OBJECTIVE 10 Compare the accounting procedures related to the balance sheet under GAAP and IFRS.

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IFRS Insights 259

• IFRS and GAAP require presentation of non-controlling interests in the equity section of the balance sheet.

Differences • IFRS requires a classifi ed statement of fi nancial position except in very limited situations. IFRS

follows the same guidelines as this textbook for distinguishing between current and non- current assets and liabilities. However, under GAAP, public companies must follow SEC regu- lations, which require specifi c line items. In addition, specifi c GAAP mandates certain forms of reporting for this information.

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

• IFRS has many differences in terminology that you will notice in this textbook. For example, in the sample statement of fi nancial position illustrated on pages 259–260, notice in the equity sec- tion common stock is called share capital—ordinary.

• Use of the term “reserve” is discouraged in GAAP, but there is no such prohibition in IFRS.

ABOUT THE NUMBERS

Classifi cation in the Statement of Financial Position Statement of financial position accounts are classified. That is, a statement of financial position groups together similar items to arrive at significant subtotals. Furthermore, the material is arranged so that important relationships are shown. The IASB indicates that the parts and subsections of financial statements are more informative than the whole. There- fore, the IASB discourages the reporting of summary accounts alone (total assets, net assets, total liabilities, etc.). Instead, companies should report and classify individual items in sufficient detail to permit users to assess the amounts, timing, and uncertainty of future cash flows. Such classification also makes it easier for users to evaluate the company’s liquidity and financial flexibility, profitability, and risk. Companies then further divide these items into several subclassifications. A representa- tive statement of financial position presentation is shown as below and on page 260.

SCIENTIFIC PRODUCTS, INC. STATEMENT OF FINANCIAL POSITION

DECEMBER 31, 2017

Assets

Non-current assets Long-term investments Investments in held-for-collection securities $ 82,000 Land held for future development 5,500 $ 87,500

Property, plant, and equipment Land 125,000 Buildings $975,800 Less: Accumulated depreciation 341,200 634,600

Total property, plant, and equipment 759,600

Intangible assets Capitalized development costs 6,000 Goodwill 66,000 Other identifiable intangible assets 28,000 100,000

Total non-current assets 947,100

Current assets Inventories 489,713 Prepaid expenses 16,252 Accounts receivable 165,824 Less: Allowance for doubtful accounts 1,850 163,974 Short-term investments 51,030 Cash and cash equivalents 52,485 Total current assets 773,454

Total assets $1,720,554

260 Chapter 5 Balance Sheet and Statement of Cash Flows

Equity and Liabilities

Equity Share capital—preference $300,000 Share capital—ordinary 400,000 Share premium—preference 10,000 Share premium—ordinary 27,500 Retained earnings 153,182 Accumulated other comprehensive income 8,650 Less: Treasury shares 12,750

Equity attributable to Scientific Products, Inc. $886,582 Equity attributable to non-controlling interest 13,500

Total equity $ 900,082

Non-current liabilities Bond liabilities due January 31, 2025 425,000 Provisions related to pensions 75,000

Total non-current liabilities 500,000

Current liabilities Notes payable 80,000 Accounts payable 197,532 Interest payable 20,500 Salary and wages payable 5,560 Provisions related to warranties 12,500 Deposits received from customers 4,380

Total current liabilities 320,472

Total liabilities 820,472

Total equity and liabilities $1,720,554

The statement presented is in “report form” format. Some companies use other statement of financial position formats. For example, companies sometimes deduct current liabilities from cur- rent assets to arrive at working capital. Or, they deduct all liabilities from all assets. Some compa- nies report the subtotal net assets, which equals total assets minus total liabilities.

Equity The equity (also referred to as shareholders’ equity) section is one of the most difficult sections to prepare and understand. This is due to the complexity of ordinary and preference share agree- ments and the various restrictions on equity imposed by corporation laws, liability agreements, and boards of directors. Companies usually divide the section into six parts:

1. SHARE CAPITAL. The par or stated value of shares issued. It includes ordinary shares (sometimes referred to as common shares) and preference shares (sometimes referred to as preferred shares).

2. SHARE PREMIUM. The excess of amounts paid-in over the par or stated value.

3. RETAINED EARNINGS. The corporation’s undistributed earnings.

4. ACCUMULATED OTHER COMPREHENSIVE INCOME. The aggregate amount of the other comprehensive income items.

5. TREASURY SHARES. Generally, the amount of ordinary shares repurchased.

6. NON-CONTROLLING INTEREST (MINORITY INTEREST). A portion of the equity of subsidiaries not owned by the reporting company.

EQUITY SECTION

Using Ratios to Analyze Performance 261IFRS Insights 261

For ordinary shares, companies must disclose the par value and the authorized, issued, and out- standing share amounts. The same holds true for preference shares. A company usually presents the share premium (for both ordinary and preference shares) in one amount, although subtotals are informative if the sources of additional capital are varied and material. The retained earnings amount may be divided between the unappropriated (the amount that is usually available for divi- dend distribution) and restricted (e.g., by bond indentures or other loan agreements) amounts. In addition, companies show any shares reacquired (treasury shares) as a reduction of equity. Accumulated other comprehensive income (sometimes referred to as reserves or other reserves) includes such items as unrealized gains and losses on non-trading equity investments and unreal- ized gains and losses on certain derivative transactions. Non-controlling interest, sometimes referred to as minority interest, is also shown as a separate item (where applicable) as a part of equity. Delhaize Group presented its equity section as follows.

Delhaize Group (in millions)

Share capital € 50 Share premium 2,725 Treasury shares (56) Retained earnings 2,678 Other reserves (1,254)

Shareholders’ equity 4,143 Minority interests 52

Total equity € 4,195

Many companies reporting under IFRS often use the term “reserve” as an all-inclusive catch-all for items such as retained earnings, share premium, and accumulated other comprehensive income.

Revaluation Equity GAAP and IFRS differ in the IFRS provision for balance sheet revaluations of property, plant, and equipment. Under the revaluation model, revaluations are recorded and reported as part of equity. To illustrate, Richardson Company uses IFRS and has property and equipment on an historical cost basis of $2,000,000. At the end of the year, Richardson appraises its property and equipment and determines it had a revaluation increase of $243,000. Richardson records this revaluation under IFRS with an increase to property and equipment as well as a valuation reserve in equity. A note to the financial statements explains the change in the revaluation equity account from one period to the next, as shown below for Richardson Com- pany, assuming a beginning balance of $11,345,000.

Note 30. Reserves (in part) (in thousands) 2017

Properties Revaluation Reserve

Balance at beginning of year $11,345 Increase (decrease) on revaluation of plant and equipment 243 Impairment losses — Reversals of impairment losses — Balance at end of year $11,588

Fair Presentation Companies must present fairly the financial position, financial performance, and cash flows of the company. Fair presentation means the faithful representation of transactions and events using the definitions and recognition criteria in the IASB conceptual framework. It is presumed that the use of IFRS with appropriate disclosure results in financial statements that are fairly presented. In other words, inappropriate use of accounting policies cannot be overcome by explanatory notes to the financial statements. In some rare cases, as indicated in Chapter 2, companies can use a “true and fair” override. This situation develops, for example, when the IFRS for a given company

262 Chapter 5 Balance Sheet and Statement of Cash Flows

appears to conflict with the objective of financial reporting. This situation might occur when a regulatory body indicates that a specific IFRS may be misleading. As indicated earlier, a true and fair override is highly unlikely in today’s reporting environment. One highly publicized exception is the case of Société Générale (SocGen), a French bank. The bank used the true and fair rule to justify reporting losses that occurred in 2008 in the prior year. Although allowed under the true and fair rule, such reporting was questioned because it permit- ted the bank to “take a bath,” that is, record as many losses as possible in 2007, which was already a bad year for the bank. As a result, SocGen’s 2008 reports looked better. [See F. Norris, “SocGen Changes Its Numbers,” The New York Times (May 13, 2008).]

ON THE HORIZON The FASB and the IASB have worked on a project to converge their standards related to financial statement presentation. A key feature of the proposed framework is that each of the statements will be organized, in the same format, to separate an entity’s financing activities from its operat- ing and investing activities and, further, to separate financing activities into transactions with owners and creditors. Thus, the same classifications used in the statement of financial position would also be used in the statement of comprehensive income and the statement of cash flows. The project has three phases. You can follow the joint financial presentation project at the follow- ing link: http://www.fasb.org/project/financial_statement_ presentation.shtml.

1. Which of the following statements about IFRS and GAAP accounting and reporting requirements for the balance sheet is not correct?

(a) Both IFRS and GAAP distinguish between current and non-current assets and liabilities.

(b) The presentation formats required by IFRS and GAAP for the balance sheet are similar.

(d) One difference between the reporting requirements under IFRS and those of the GAAP balance sheet is that an IFRS balance sheet may list long-term assets fi rst.

2. Current assets under IFRS are listed generally: (a) by importance. (b) in the reverse order of their expected conversion to

cash. (c) by longevity. (d) alphabetically.

3. Companies that use IFRS: (a) may report all their assets on the statement of fi nan-

cial position at fair value. (b) are not allowed to net assets (assets − liabilities) on

their statement of fi nancial positions.

(d) do not have any guidelines as to what should be reported on the statement of fi nancial position.

4. Franco Company uses IFRS and owns property, plant, and equipment with a historical cost of $5,000,000. At December 31, 2016, the company reported a valuation reserve of $690,000. At December 31, 2017, the property, plant, and equipment was appraised at $5,325,000. The valuation reserve will show what balance at December 31, 2017?

(a) $365,000. (b) $325,000. (c) $690,000. (d) $0.

5. A company has purchased a tract of land and expects to build a production plant on the land in approximately 5 years. During the 5 years before construction, the land will be idle. Under IFRS, the land should be reported as:

(a) land expense. (b) property, plant, and equipment. (c) an intangible asset. (d) a long-term investment.

IFRS SELF-TEST QUESTIONS

IFRS CONCEPTS AND APPLICATION

IFRS5-1 Where can authoritative IFRS guidance be found related to the statement of financial position (balance sheet) and the statement of cash flows?

IFRS5-2 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to statement of finan- cial position (balance sheet) reporting.

IFRS5-3 Briefly describe the convergence efforts related to financial statement presentation.

IFRS5-4 Rainmaker Company prepares its financial statements in accordance with IFRS. In 2017, Rainmaker recorded the following revaluation adjustments related to its buildings and land: The company’s building increased in value by $200,000; its land declined by

Using Ratios to Analyze Performance 263IFRS Insights 263

$35,000. How will these revaluation adjustments affect Rainmaker’s statement of financial position? Will the reporting differ under GAAP? Explain.

International Reporting Case IFRS5-5 Presented below is the balance sheet for Tomkins plc, a British company.

Tomkins plc Consolidated Balance Sheet (amounts in £ millions)

Non-current assets Goodwill 436.0 Other intangible assets 78.0 Property, plant and equipment 1,122.8 Investments in associates 20.6 Trade and other receivables 81.1 Deferred tax assets 82.9 Post-employment benefit surpluses 1.3 1,822.7

Current assets Inventories 590.8 Trade and other receivables 753.0 Income tax recoverable 49.0 Available-for-sale investments 1.2 Cash and cash equivalents 445.0

1,839.0

Assets held for sale 11.9

Total assets 3,673.6 Current liabilities Bank overdrafts 4.8 Bank and other loans 11.2 Obligations under finance leases 1.0 Trade and other payables 677.6 Income tax liabilities 15.2 Provisions 100.3

810.1

Non-current liabilities Bank and other loans 687.3 Obligations under finance leases 3.6 Trade and other payables 27.1 Post-employment benefit obligations 343.5 Deferred tax liabilities 25.3 Income tax liabilities 79.5 Provisions 19.2

1,185.5

Total liabilities 1,995.6

Net assets 1,678.0

Capital and reserves Ordinary share capital 79.6 Share premium account 799.2 Own shares (8.2) Capital redemption reserve 921.8 Currency translation reserve (93.0) Available-for-sale reserve (0.9) Accumulated deficit (161.9)

Shareholders’ equity 1,536.6

Minority interests 141.4

Total equity 1,678.0

264 Chapter 5 Balance Sheet and Statement of Cash Flows

Instructions (a) Identify at least three differences in balance sheet reporting between British and U.S. fi rms, as shown in Tomkins’ bal-

ance sheet. (b) Review Tomkins’ balance sheet and identify how the format of this fi nancial statement provides useful information, as

illustrated in the chapter.

Professional Research IFRS5-6 In light of the full disclosure principle, investors and creditors need to know the balances for assets, liabilities, and equity, as well as the accounting policies adopted by management to measure the items reported in the statement of financial position.

Instructions Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (If necessary, click on the IFRS tab and then register for eIFRS free access.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.)

(a) Identify the literature that addresses the disclosure of accounting policies. (b) How are accounting policies defi ned in the literature? (c) What are the guidelines concerning consistency in applying accounting policies? (d) What are some examples of common disclosures that are required under this statement?

International Financial Reporting Problem

Marks and Spencer plc (M&S)

IFRS5-7 The financial statements of M&S are presented in Appendix E. The company’s complete annual report, includ- ing the notes to the financial statements, is available online.

Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions.

(a) What alternative formats could M&S have adopted for its statement of fi nancial position? Which format did it adopt? (b) Identify the various techniques of disclosure M&S might have used to disclose additional pertinent fi nancial infor-

mation. Which technique does it use in its fi nancials? (c) In what classifi cations are M&S’s investments reported? What valuation basis does M&S use to report its invest-

ments? How much working capital did M&S have on 28 March 2015? On 29 March 2014? (d) What were M&S’s cash fl ows from its operating, investing, and fi nancing activities for 2015? What were its trends

in net cash provided by operating activities over the period 2014 to 2015? Explain why the change in accounts pay- able and in accrued and other liabilities is added to net income to arrive at net cash provided by operating activities.

(e) Compute M&S’s (1) current cash debt coverage, (2) cash debt coverage, and (3) free cash fl ow for 2015. What do these ratios indicate about M&S’s fi nancial conditions?

ANSWERS TO IFRS SELF-TEST QUESTIONS

1. b 2. b 3. c 4. b 5. d

HOW DO I MEASURE THAT? A significant part of accounting is measurement. And as we discussed in Chapter 2, we have a mixed-attribute measurement model. That is, many items are measured based on historical cost (e.g., property, plant, and equip- ment, inventory), but increasingly accounting measurements are based on fair value (e.g., financial instruments, impairments). Determining fair value of an item is fairly straightforward when market prices are available (Level 1 in the fair value hierarchy). However, when a market price is not available, accountants must rely on valuation models to develop a fair value estimate (Level 3 of the fair value hierarchy).

Developing fair value estimates based on a valuation model generally involves discounted cash flow tech- niques, which have three primary elements: (1) estimating the amounts and timing of future cash flows, (2) developing probability estimates for those cash flows, and (3) determining the appropriate discount rate to apply to the expected cash flows to arrive at a fair value estimate. Seems pretty straightforward, right? Actually, this can be a challenging process when applied to the variety of complex assets and liabilities for which GAAP requires a fair value estimate.

Many companies, particularly financial institutions, faced this challenge during the financial crisis when secu- rities markets seized up to the point where valid market prices for investments and loans were not readily avail- able. Major banks, such as HSBC Holdings, Wells Fargo, and Bank of America, confronted this issue with respect to their mortgage-backed securities and interest rate swaps used to hedge interest rate risk. Kohl’s Depart- ment Stores dealt with a similar situation for its investment in auction rates securities (ARS). The fair value of ARS is generally determined at quarterly auctions. However, these auctions failed during the financial crisis, and Kohl’s and other ARS investors were forced to use a valuation model rather than market prices to determine fair value.

The FASB provides fair value estimation guidance (FASB ASC 820), but the Board also performs ongoing assessment of whether and to what extent additional valuation guidance is needed. In this regard, the Board established the Valuation Resource Group (VRG). The VRG is comprised of accounting and valuation pro- fessionals, preparers and users of financial statements, regulators, and other industry representatives. The VRG provides the Board and the FASB staff with multiple viewpoints on application issues relating to fair value for financial reporting purposes. Here is a sampling of the issues discussed by the VRG:

• Measurement of contingent consideration in a business combination.

• Incorporating multi-period excess earnings in valuing intangible assets.

• Effects of premiums and discounts in fair value measurements.

• Determining the carrying amount of a reporting unit when performing the goodwill impairment test.

• Measurement uncertainty analysis disclosures.

6 1 Describe the fundamental concepts

related to the time value of money.

2 Solve future and present value of 1 problems.

3 Solve future value of ordinary and annuity due problems.

4 Solve present value of ordinary and annuity due problems.

5 Solve present value problems related to deferred annuities, bonds, and expected cash flows.

Accounting and the Time Value of Money LEARNING OBJECTIVES After studying this chapter, you should be able to:

267

As indicated, the list of topics is revealing as to the variety and complexity of the issues that must be addressed in implementing the fair value measurement principle. Discussion of these items by the VRG helped the FASB develop appropriate approaches for applying fair value guidance to specific examples. For example, with respect to the contingent consideration topic, the VRG noted that taxes must be considered when developing future cash flow estimates and that, in some cases, these tax effects are different for assets and liabilities.

The VRG has and will provide good counsel to the FASB with respect to applying the fair value measure- ment principle. After studying this chapter, you should have a better understanding of time value of money principles and discounted cash flow techniques as they are applied in accounting measurements.

Sources: Ernst and Young, “Valuation Resource Group: Highlights of November 2010 Meeting,” Hot Topic—Update on Major Accounting and Auditing Activities, No. 2010-59 (5 November 2010); and http://www.fasb.org/project/valuation_resource_group. shtml#background (March 24, 2011).

PREVIEW OF CHAPTER 6 As we indicated in the opening story, as a financial expert in today’s accounting environment, you will be expected to make present and future value measurements and to understand their implications. The purpose of this chapter is to present the tools and techniques that will help you measure the present value of future cash inflows and outflows. The content and organization of the chapter are as follows.

As the time value of money concept is universal, this chapter does not include an IFRS Insights section.

ACCOUNTING AND THE TIME VALUE OF MONEY

BASIC TIME VALUE CONCEPTS

• Applications • The nature of

interest • Simple interest • Compound

interest • Fundamental

variables

SINGLE-SUM PROBLEMS

• Future value of single sum

• Present value of single sum

• Solving for other unknowns

ANNUITIES (FUTURE VALUE)

• Future value of ordinary annuity

• Future value of annuity due

• Examples of FV of annuity

OTHER TIME VALUE OF MONEY ISSUES

• Deferred annuities

• Valuation of long-term bonds

• Effective-interest method of bond discount/premium amortization

• Present value measurement

ANNUITIES (PRESENT VALUE)

• Present value of ordinary annuity

• Present value of annuity due

• Examples of PV of annuity

268 Chapter 6 Accounting and the Time Value of Money

BASIC TIME VALUE CONCEPTS In accounting (and finance), the phrase time value of money indicates a relationship between time and money—that a dollar received today is worth more than a dollar promised at some time in the future. Why? Because of the opportunity to invest today’s dollar and receive interest on the investment. Yet, when deciding among investment or borrowing alternatives, it is essential to be able to compare today’s dollar and tomor- row’s dollar on the same footing—to compare “apples to apples.” Investors do that by using the concept of present value, which has many applications in accounting.

Applications of Time Value Concepts Financial reporting uses different measurements in different situations—historical cost for equipment, net realizable value for inventories, fair value for investments. As we discussed in Chapters 2 and 5, the FASB increasingly is requiring the use of fair values in the measurement of assets and liabilities. According to the FASB’s recent guidance on fair value measurements, the most useful fair value measures are based on market prices in active markets. Within the fair value hierarchy, these are referred to as Level 1. Recall that Level 1 fair value measures are the least subjective because they are based on quoted prices, such as a closing stock price in the Wall Street Journal.

However, for many assets and liabilities, market-based fair value information is not readily available. In these cases, fair value can be estimated based on the expected future cash flows related to the asset or liability. Such fair value estimates are generally consid- ered Level 3 (most subjective) in the fair value hierarchy because they are based on unobservable inputs, such as a company’s own data or assumptions related to the expected future cash flows associated with the asset or liability. As discussed in the fair value guidance, present value techniques are used to convert expected cash flows into present values, which represent an estimate of fair value. [1]

Because of the increased use of present values in this and other contexts, it is impor- tant to understand present value techniques.1 We list some of the applications of present value-based measurements to accounting topics below; we discuss many of these in the following chapters.

LEARNING OBJECTIVE 1 Describe the fundamental concepts related to the time value of money.

1GAAP addresses present value as a measurements basis for a broad array of transactions, such as accounts and loans receivable [2], leases [3], postretirement benefits [4], asset impairments [5], and stock-based compensation [6].

See the FASB Codifi cation References (page 312).

1. NOTES. Valuing noncurrent receivables and payables that carry no stated interest rate or a lower than market interest rate.

2. LEASES. Valuing assets and obligations to be capitalized under long-term leases and measuring the amount of the lease payments and annual leasehold amortization.

3. PENSIONS AND OTHER POSTRETIREMENT BENEFITS. Measuring service cost components of employers’ postretirement benefi ts expense and postretirement benefi ts obligation.

4. LONG-TERM ASSETS. Evaluating alternative long-term investments by discounting future cash fl ows. Determining the value of assets acquired under deferred payment contracts. Measuring impairments of assets.

5. STOCK-BASED COMPENSATION. Determining the fair value of employee services in compensatory stock-option plans.

PRESENT VALUE-BASED ACCOUNTING MEASUREMENTS

Basic Time Value Concepts 269

In addition to accounting and business applications, compound interest, annuity, and present value concepts apply to personal finance and investment decisions. In pur- chasing a home or car, planning for retirement, and evaluating alternative investments, you will need to understand time value of money concepts.

The Nature of Interest Interest is payment for the use of money. It is the excess cash received or repaid over and above the amount lent or borrowed (principal). For example, Corner Bank lends Hillfarm Company $10,000 with the understanding that it will repay $11,500. The excess over $10,000, or $1,500, represents interest expense for Hillfarm and interest revenue for Corner Bank.

The lender generally states the amount of interest as a rate over a specific period of time. For example, if Hillfarm borrowed $10,000 for one year before repaying $10,600, the rate of interest is 6 percent per year ($600 ÷ $10,000). The custom of expressing inter- est as a percentage rate is an established business practice.2 In fact, business managers make investing and borrowing decisions on the basis of the rate of interest involved, rather than on the actual dollar amount of interest to be received or paid.

How is the interest rate determined? One important factor is the level of credit risk (risk of nonpayment) involved. Other factors being equal, the higher the credit risk, the higher the interest rate. Low-risk borrowers like Microsoft or Intel can probably obtain a loan at or slightly below the going market rate of interest. However, a bank would prob- ably charge the neighborhood delicatessen several percentage points above the market rate, if granting the loan at all.

The amount of interest involved in any financing transaction is a function of the fol- lowing three variables.

6. BUSINESS COMBINATIONS. Determining the value of receivables, payables, liabili- ties, accruals, and commitments acquired or assumed in a “purchase.”

7. DISCLOSURES. Measuring the value of future cash fl ows from oil and gas reserves for disclosure in supplementary information.

8. ENVIRONMENTAL LIABILITIES. Determining the fair value of future obligations for asset retirements.

2Federal law requires the disclosure of interest rates on an annual basis in all contracts. That is, instead of stating the rate as “1% per month,” contracts must state the rate as “12% per year” if it is simple interest or “12.68% per year” if it is compounded monthly.

1. PRINCIPAL. The amount borrowed or invested.

2. INTEREST RATE. A percentage of the outstanding principal.

3. TIME. The number of years or fractional portion of a year that the principal is outstanding.

VARIABLES IN INTEREST COMPUTATION

Thus, the following three relationships apply:

• The larger the principal amount, the larger the dollar amount of interest. • The higher the interest rate, the larger the dollar amount of interest. • The longer the time period, the larger the dollar amount of interest.

270 Chapter 6 Accounting and the Time Value of Money

Simple Interest Companies compute simple interest on the amount of the principal only. It is the return on (or growth of) the principal for one time period. The following equation expresses simple interest.3

Interest = p × i × n where

p = principal i = rate of interest for a single period

n = number of periods

To illustrate, Barstow Electric Inc. borrows $10,000 for 3 years with a simple interest rate of 8% per year. It computes the total interest it will pay as follows.

Interest = p × i × n = $10,000 × .08 × 3 = $2,400

If Barstow borrows $10,000 for 3 months at 8%, the interest is $200, computed as follows.

Interest = $10,000 × .08 × 3/12 = $200

Compound Interest John Maynard Keynes, the legendary English economist, supposedly called it magic. Mayer Rothschild, the founder of the famous European banking firm, proclaimed it the eighth wonder of the world. Today, people continue to extol its wonder and its power. The object of their affection? Compound interest.

We compute compound interest on principal and on any interest earned that has not been paid or withdrawn. It is the return on (or growth of) the principal for two or more time periods. Compounding computes interest not only on the principal but also on the interest earned to date on that principal, assuming the interest is left on deposit.

To illustrate the difference between simple and compound interest, assume that Vasquez Company deposits $10,000 in the Last National Bank, where it will earn simple interest of 9% per year. It deposits another $10,000 in the First State Bank, where it will earn compound interest of 9% per year compounded annually. In both cases, Vasquez will not withdraw any interest until 3 years from the date of deposit. Illustration 6-1 shows the computation of interest Vasquez will receive, as well as its accumulated year-end balance.

3Business mathematics and business finance textbooks traditionally state simple interest as I (interest) = P (principal) × R (rate) × T (time).

Simple Interest Calculation

Simple Interest

Last National Bank

Year 1 $10,000.00 × 9% 900.00 $10,900.00

Accumulated Year-End Balance

Year 2 $10,000.00 × 9%

Year 3 $10,000.00 × 9% $2,700.00

Compound Interest Calculation

Compound Interest

First State Bank

Year 1 $10,000.00 × 9% $ 900.00 $10,900.00

Accumulated Year-End Balance

Year 2 $10,900.00 × 9% 981.00

Year 3 $11,881.00 × 9% 1,069.29 $2,950.29

$11,881.00

$12,950.29

$11,800.00

$12,700.00

900.00

$250.29 Difference $250.29

Difference

ILLUSTRATION 6-1 Simple vs. Compound Interest

Basic Time Value Concepts 271

Note in Illustration 6-1 that simple interest uses the initial principal of $10,000 to compute the interest in all 3 years. Compound interest uses the accumulated balance (principal plus interest to date) at each year-end to compute interest in the succeeding year. This explains the larger balance in the compound interest account.

Obviously, any rational investor would choose compound interest, if available, over simple interest. In the example above, compounding provides $250.29 of additional inter- est revenue. For practical purposes, compounding assumes that unpaid interest earned becomes a part of the principal. Furthermore, the accumulated balance at the end of each year becomes the new principal sum on which interest is earned during the next year.

Compound interest is the typical interest computation applied in business situa- tions. This occurs particularly in our economy, where companies use and finance large amounts of long-lived assets over long periods of time. Financial managers view and evaluate their investment opportunities in terms of a series of periodic returns, each of which they can reinvest to yield additional returns. Simple interest usually applies only to short-term investments and debts that involve a time span of one year or less.

The continuing debate on Social Security reform provides a great context to illustrate the power of compounding. One proposed idea is for the government to give $1,000 to every citizen at birth. This gift would be deposited in an account that would earn interest tax-free until the citizen retires. Assuming the account earns a modest 5% annual return until retirement at age 65, the $1,000 would grow to $23,839. With monthly compounding, the $1,000 deposited at birth would grow to $25,617.

Why start so early? If the government waited until age 18 to deposit the money, it would grow to only $9,906 with annual compounding. That is, reducing the time invested by a third results in more than a 50% reduction in retirement money. This example illustrates the importance of starting early when the power of compounding is involved.

WHAT DO THE NUMBERS MEAN? A PRETTY GOOD START

Compound Interest Tables (see pages 314–323) We present five different types of compound interest tables at the end of this chapter. These tables should help you study this chapter as well as solve other problems involv- ing interest.

1. FUTURE VALUE OF 1 TABLE. Contains the amounts to which 1 will accumulate if deposited now at a specifi ed rate and left for a specifi ed number of periods (Table 6-1).

2. PRESENT VALUE OF 1 TABLE. Contains the amounts that must be deposited now at a specifi ed rate of interest to equal 1 at the end of a specifi ed number of periods (Table 6-2).

3. FUTURE VALUE OF AN ORDINARY ANNUITY OF 1 TABLE. Contains the amounts to which periodic rents of 1 will accumulate if the payments (rents) are invested at the end of each period at a specifi ed rate of interest for a specifi ed number of periods (Table 6-3).

4. PRESENT VALUE OF AN ORDINARY ANNUITY OF 1 TABLE. Contains the amounts that must be deposited now at a specifi ed rate of interest to permit withdrawals of 1 at the end of regular periodic intervals for the specifi ed number of periods (Table 6-4).

5. PRESENT VALUE OF AN ANNUITY DUE OF 1 TABLE. Contains the amounts that must be deposited now at a specifi ed rate of interest to permit withdrawals of 1 at the beginning of regular periodic intervals for the specifi ed number of periods (Table 6-5).

INTEREST TABLES AND THEIR CONTENTS

272 Chapter 6 Accounting and the Time Value of Money

Illustration 6-2 lists the general format and content of these tables. It shows how much principal plus interest a dollar accumulates to at the end of each of five periods, at three different rates of compound interest.

ILLUSTRATION 6-2 Excerpt from Table 6-1

FUTURE VALUE OF 1 AT COMPOUND INTEREST (EXCERPT FROM TABLE 6-1, PAGE 314)

Period 4% 5% 6%

1 1.04000 1.05000 1.06000 2 1.08160 1.10250 1.12360 3 1.12486 1.15763 1.19102 4 1.16986 1.21551 1.26248 5 1.21665 1.27628 1.33823

The compound tables rely on basic formulas. For example, the formula to determine the future value factor (FVF) for 1 is:

FVFn,i = (1 + i)n

where

FVFn,i = future value factor for n periods at i interest n = number of periods i = rate of interest for a single period

Financial calculators include preprogrammed FVFn,i and other time value of money formulas.

To illustrate the use of interest tables to calculate compound amounts, assume an interest rate of 5%. Illustration 6-3 shows the future value to which 1 accumulates (the future value factor).

ILLUSTRATION 6-3 Accumulation of Compound Amounts

Beginning-of- Multiplier End-of-Period Formula Period Period Amount × (1 + i ) = Amount* (1 + i )n

1 1.00000 1.05 1.05000 (1.05)1

2 1.05000 1.05 1.10250 (1.05)2

3 1.10250 1.05 1.15763 (1.05)3

*Note that these amounts appear in Table 6-1 in the 5% column.

Throughout our discussion of compound interest tables, note the intentional use of the term periods instead of years. Interest is generally expressed in terms of an annual rate. However, many business circumstances dictate a compounding period of less than one year. In such circumstances, a company must convert the annual interest rate to cor- respond to the length of the period. To convert the “annual interest rate” into the “com- pounding period interest rate,” a company divides the annual rate by the number of compounding periods per year.

In addition, companies determine the number of periods by multiplying the number of years involved by the number of compounding periods per year. To illustrate, assume an investment of $1 for 6 years at 8% annual interest compounded quarterly. Using Table 6-1 (page 314), read the factor that appears in the 2% (8% ÷ 4) column on the 24th row—6 years × 4 compounding periods per year, namely 1.60844,

Basic Time Value Concepts 273

or approximately $1.61. Thus, all compound interest tables use the term periods, not years, to express the quantity of n. Illustration 6-4 shows how to determine (1) the interest rate per compounding period and (2) the number of compounding periods in four situations of differing compounding frequency.4

4Because interest is theoretically earned (accruing) every second of every day, it is possible to calculate interest that is compounded continuously. Using the natural, or Napierian, system of logarithms facilitates computations involving continuous compounding. As a practical matter, however, most business transactions assume interest to be compounded no more frequently than daily. 5The formula for calculating the effective rate, in situations where the compounding frequency (n) is greater than once a year, is as follows.

Effective rate = (1 + i)n − 1

To illustrate, if the stated annual rate is 8% compounded quarterly (or 2% per quarter), the effective annual rate is:

Effective rate = (1 + .02)4 − 1 = (1.02)4 − 1 = 1.0824 − 1 = .0824 = 8.24%

ILLUSTRATION 6-4 Frequency of Compounding

12% Annual Interest Rate Interest Rate per Number of over 5 Years Compounded Compounding Period Compounding Periods

Annually (1) .12 ÷ 1 = .12 5 years × 1 compounding per year = 5 periods

Semiannually (2) .12 ÷ 2 = .06 5 years × 2 compoundings per year = 10 periods

Quarterly (4) .12 ÷ 4 = .03 5 years × 4 compoundings per year = 20 periods

Monthly (12) .12 ÷ 12 = .01 5 years × 12 compoundings per year = 60 periods

ILLUSTRATION 6-5 Comparison of Different Compounding Periods

Compounding Periods

Interest Rate Annually Semiannually Quarterly Monthly Daily

8% 8.00% 8.16% 8.24% 8.30% 8.33% $800 $816 $824 $830 $833

9% 9.00% 9.20% 9.31% 9.38% 9.42% $900 $920 $931 $938 $942

10% 10.00% 10.25% 10.38% 10.47% 10.52% $1,000 $1,025 $1,038 $1,047 $1,052

How often interest is compounded can substantially affect the rate of return. For example, a 9% annual interest compounded daily provides a 9.42% yield, or a difference of 0.42%. The 9.42% is the effective yield.5 The annual interest rate (9%) is the stated, nominal, or face rate. When the compounding frequency is greater than once a year, the effective-interest rate will always exceed the stated rate.

Illustration 6-5 shows how compounding for five different time periods affects the effective yield and the amount earned by an investment of $10,000 for one year.

274 Chapter 6 Accounting and the Time Value of Money

Fundamental Variables The following four variables are fundamental to all compound interest problems.

1. RATE OF INTEREST. Unless otherwise stated, an annual rate that must be adjusted to refl ect the length of the compounding period if less than a year.

2. NUMBER OF TIME PERIODS. The number of compounding periods. (A period may be equal to or less than a year.)

3. FUTURE VALUE. The value at a future date of a given sum or sums invested assuming compound interest.

4. PRESENT VALUE. The value now (present time) of a future sum or sums discounted assuming compound interest.

FUNDAMENTAL VARIABLES

Illustration 6-6 depicts the relationship of these four fundamental variables in a time diagram.

Present Value

Future Value

4 Number of Periods

Interest Rate

510 3

ILLUSTRATION 6-6 Basic Time Diagram

In some cases, all four of these variables are known. However, at least one variable is unknown in many business situations. To better understand and solve the problems in this chapter, we encourage you to sketch compound interest problems in the form of the preceding time diagram.

SINGLE-SUM PROBLEMS Many business and investment decisions involve a single amount of money that either exists now or will in the future. Single-sum problems are generally classified into one of the following two categories.

1. Computing the unknown future value of a known single sum of money that is invested now for a certain number of periods at a certain interest rate.

2. Computing the unknown present value of a known single sum of money in the future that is discounted for a certain number of periods at a certain interest rate.

When analyzing the information provided, determine first whether the problem involves a future value or a present value. Then apply the following general rules, depending on the situation:

• If solving for a future value, accumulate all cash flows to a future point. In this in- stance, interest increases the amounts or values over time so that the future value exceeds the present value.

LEARNING OBJECTIVE 2 Solve future and present value of 1 problems.

Single-Sum Problems 275

• If solving for a present value, discount all cash flows from the future to the present. In this case, discounting reduces the amounts or values, so that the present value is less than the future amount.

Preparation of time diagrams aids in identifying the unknown as an item in the future or the present. Sometimes the problem involves neither a future value nor a present value. Instead, the unknown is the interest or discount rate, or the number of com- pounding or discounting periods.

Future Value of a Single Sum To determine the future value of a single sum, multiply the future value factor by its present value (principal), as follows.

FV = PV (FVFn,i)

where

FV = future value PV = present value (principal or single sum) FVFn,i = future value factor for n periods at i interest

To illustrate, Bruegger Co. wants to determine the future value of $50,000 invested for 5 years compounded annually at an interest rate of 6%. Illustration 6-7 shows this investment situation in time-diagram form.

Present Value PV = $50,000

540 2 3 Number of Periods

n = 5

Interest Rate i = 6%

Future Value FV = ? = ?FV

ILLUSTRATION 6-7 Future Value Time Diagram (n = 5, i = 6%)

Using the future value formula, Bruegger solves this investment problem as follows.

Future value = PV (FVFn,i) = $50,000 (FVF5,6%) = $50,000 (1 + .06)5

= $50,000 (1.33823) = $66,912

To determine the future value factor of 1.33823 in the formula above, Bruegger uses a financial calculator or reads the appropriate table, in this case Table 6-1 (6% column and the 5-period row).

Companies can apply this time diagram and formula approach to routine business situations. To illustrate, assume that Commonwealth Edison Company deposited $250 million in an escrow account with Northern Trust Company at the beginning of 2017 as a commitment toward a power plant to be completed December 31, 2020. How much will the company have on deposit at the end of 4 years if interest is 10%, compounded semiannually?

With a known present value of $250 million, a total of 8 compounding periods (4 × 2), and an interest rate of 5% per compounding period (10% ÷ 2), the company

276 Chapter 6 Accounting and the Time Value of Money

can time-diagram this problem and determine the future value as shown in Illustra- tion 6-8.

ILLUSTRATION 6-8 Future Value Time Diagram (n = 8, i = 5%)

54 6

PV = $250,000,000

n = 8 0 1 2 3 87

i = 5% FV = ?FV = ?

Future value = $250,000,000 (FVF8,5%) = $250,000,000 (1 + .05)8

= $250,000,000 (1.47746) = $369,365,000

Using a future value factor found in Table 6-1 (5% column, 8-period row), we find that the deposit of $250 million will accumulate to $369,365,000 by December 31, 2020.

Present Value of a Single Sum The Bruegger example on page 275 showed that $50,000 invested at an annually com- pounded interest rate of 6% will equal $66,912 at the end of 5 years. It follows, then, that $66,912, 5 years in the future, is worth $50,000 now. That is, $50,000 is the present value of $66,912. The present value is the amount needed to invest now, to produce a known future value.

The present value is always a smaller amount than the known future value, due to earned and accumulated interest. In determining the future value, a company moves forward in time using a process of accumulation. In determining present value, it moves backward in time using a process of discounting.

As indicated earlier, a “present value of 1 table” appears at the end of this chapter as Table 6-2. Illustration 6-9 demonstrates the nature of such a table. It shows the present value of 1 for five different periods at three different rates of interest.

PRESENT VALUE OF 1 AT COMPOUND INTEREST (EXCERPT FROM TABLE 6-2, PAGE 316)

Period 4% 5% 6%

1 .96154 .95238 .94340 2 .92456 .90703 .89000 3 .88900 .86384 .83962 4 .85480 .82270 .79209 5 .82193 .78353 .74726

ILLUSTRATION 6-9 Excerpt from Table 6-2

The following formula is used to determine the present value of 1 (present value factor):

PVFn,i = 1

(1 + i)n

where PVFn,i = present value factor for n periods at i interest

Single-Sum Problems 277

To illustrate, assuming an interest rate of 5%, the present value of 1 discounted for three different periods is as shown in Illustration 6-10.

ILLUSTRATION 6-10 Present Value of $1 Discounted at 5% for Three Periods

Discount Formula Periods 1 ÷ (1 + i)n = Present Value* 1/(1 + i )n

1 1.00000 1.05 .95238 1/(1.05)1

2 1.00000 (1.05)2 .90703 1/(1.05)2

3 1.00000 (1.05)3 .86384 1/(1.05)3

*Note that these amounts appear in Table 6-2 in the 5% column.

Future Value

$73,466

0 1 2 3 4 5

Interest Rate i = 8%

Number of Periods n = 5

PV = ?

Present Value

PV = ?

ILLUSTRATION 6-11 Present Value Time Diagram (n = 5, i = 8%)

The present value of any single sum (future value), then, is as follows.

PV = FV (PVFn,i) where

PV = present value FV = future value PVFn,i = present value factor for n periods at i interest

To illustrate, what is the present value of $73,466 to be received or paid in 5 years discounted at 8% compounded annually? Illustration 6-11 shows this problem as a time diagram.

Using the formula, we solve this problem as follows.

Present value = FV (PVFn,i) = $73,466 (PVF5,8%)

= $73,466 ( 1(1 + .08)5 ) = $73,466 (.68058) = $50,000 (rounded by $.51)

To determine the present value factor of 0.68058, use a financial calculator or read the present value of a single sum in Table 6-2 (8% column, 5-period row).

The time diagram and formula approach can be applied in a variety of situations. For example, assume that your rich uncle decides to give you $2,000 for a trip to Europe when you graduate from college 3 years from now. He proposes to finance the trip by investing a sum of money now at 8% compound interest that will provide you with $2,000 upon your graduation. The only conditions are that you graduate and that you tell him how much to invest now.

278 Chapter 6 Accounting and the Time Value of Money

To impress your uncle, you set up the time diagram in Illustration 6-12 and solve this problem as follows.

FV = $2,000i = 8%

0 1 2 3 n = 3

PV = ?PV = ?

ILLUSTRATION 6-12 Present Value Time Diagram (n = 3, i = 8%)

ILLUSTRATION 6-13 Time Diagram to Solve for Unknown Number of Periods i = 10%PV = $47,811 FV = $70,000

n = ? n = ?

Present value = $2,000 (PVF3,8%)

= $2,000 ( 1(1 + .08)3 ) = $2,000 (.79383)

= $1,587.66

Advise your uncle to invest $1,587.66 now to provide you with $2,000 upon graduation. To satisfy your uncle’s other condition, you must pass this course (and many more).

Solving for Other Unknowns in Single-Sum Problems In computing either the future value or the present value in the previous single-sum illustrations, both the number of periods and the interest rate were known. In many business situations, both the future value and the present value are known, but the number of periods or the interest rate is unknown. The following two examples are single-sum problems (future value and present value) with either an unknown number of periods (n) or an unknown interest rate (i). These examples, and the accompanying solutions, demonstrate that knowing any three of the four values (future value, FV; present value, PV; number of periods, n; interest rate, i) allows you to derive the remain- ing unknown variable.

Example—Computation of the Number of Periods The Village of Somonauk wants to accumulate $70,000 for the construction of a veterans monument in the town square. At the beginning of the current year, the Village depos- ited $47,811 in a memorial fund that earns 10% interest compounded annually. How many years will it take to accumulate $70,000 in the memorial fund?

In this illustration, the Village knows both the present value ($47,811) and the future value ($70,000), along with the interest rate of 10%. Illustration 6-13 depicts this invest- ment problem as a time diagram.

Annuities (Future Value) 279

Knowing both the present value and the future value allows the Village to solve for the unknown number of periods. It may use either the future value or the present value formulas, as shown in Illustration 6-14.

Future Value Approach Present Value Approach

FV = PV (FVFn,10%) PV = FV (PVFn,10%) $70,000 = $47,811 (FVFn,10%) $47,811 = $70,000 (PVFn,10%)

FVFn,10% = = 1.46410 PVFn,10% = = .68301 $70,000 $47,811

$47,811 $70,000

ILLUSTRATION 6-14 Solving for Unknown Number of periods

Using the future value factor of 1.46410, refer to Table 6-1 and read down the 10% column to find that factor in the 4-period row. Thus, it will take 4 years for the $47,811 to accumulate to $70,000 if invested at 10% interest compounded annually. Or, using the present value factor of 0.68301, refer to Table 6-2 and read down the 10% column to find that factor in the 4-period row.

Example—Computation of the Interest Rate Advanced Design, Inc. needs $1,070,584 for basic research 5 years from now. The com- pany currently has $800,000 to invest for that purpose. At what rate of interest must it invest the $800,000 to fund basic research projects of $1,070,584, 5 years from now?

The time diagram in Illustration 6-15 depicts this investment situation.

ILLUSTRATION 6-15 Time Diagram to Solve for Unknown Interest Rate

PV = $800,000

FV = $1,070,584

43210 n = 5

i = ?i = ?

Advanced Design may determine the unknown interest rate from either the future value approach or the present value approach, as Illustration 6-16 shows.

Using the future value factor of 1.33823, refer to Table 6-1 and read across the 5-period row to find that factor in the 6% column. Thus, the company must invest the $800,000 at 6% to accumulate to $1,070,584 in 5 years. Or, using the present value factor of .74726 and Table 6-2, again find that factor at the juncture of the 5-period row and the 6% column.

ANNUITIES (FUTURE VALUE) The preceding discussion involved only the accumulation or discounting of a single principal sum. However, many situations arise in which a series of dollar amounts are paid or received periodically, such as installment loans or sales; regular, partially recov- ered invested funds; or a series of realized cost savings.

Future Value Approach Present Value Approach

FV = PV (FVF5,i) PV = FV (PVF5,i) $1,070,584 = $800,000 (FVF5,i) $800,000 = $1,070,584 (PVF5,i)

FVF5,i = = 1.33823 PVF5,i = = .74726

ILLUSTRATION 6-16 Solving for Unknown Interest Rate

$1,070,584 $800,000

$800,000 $1,070,584

LEARNING OBJECTIVE 3 Solve future value of ordinary and annuity due problems.

280 Chapter 6 Accounting and the Time Value of Money

For example, a life insurance contract involves a series of equal payments made at equal intervals of time. Such a process of periodic payment represents the accumulation of a sum of money through an annuity. An annuity, by definition, requires the follow- ing: (1) periodic payments or receipts (called rents) of the same amount, (2) the same- length interval between such rents, and (3) compounding of interest once each interval. The future value of an annuity is the sum of all the rents plus the accumulated com- pound interest on them.

Note that the rents may occur at either the beginning or the end of the periods. If the rents occur at the end of each period, an annuity is classified as an ordinary annuity. If the rents occur at the beginning of each period, an annuity is classified as an annuity due.

Future Value of an Ordinary Annuity One approach to determining the future value of an annuity computes the value to which each of the rents in the series will accumulate, and then totals their individual future values.

For example, assume that $1 is deposited at the end of each of 5 years (an ordinary annuity) and earns 5% interest compounded annually. Illustration 6-17 shows the com- putation of the future value, using the “future value of 1” table (Table 6-1 on pages 314–315) for each of the five $1 rents.

ILLUSTRATION 6-17 Solving for the Future Value of an Ordinary Annuity

END OF PERIOD IN WHICH $1.00 IS TO BE INVESTED

Value at End Present 1 2 3 4 5 of Year 5

$1.00 $1.21551 $1.00 1.15762 $1.00 1.10250 $1.00 1.05000 $1.00 1.00000

Total (future value of an ordinary annuity of $1.00 for 5 periods at 5%) $5.52563

Because an ordinary annuity consists of rents deposited at the end of the period, those rents earn no interest during the period in which they are deposited. For example, the third rent earns interest for only two periods (periods four and five). It earns no interest for the third period since it is not deposited until the end of the third period. When computing the future value of an ordinary annuity, the number of compounding periods will always be one less than the number of rents.

The foregoing procedure for computing the future value of an ordinary annuity always produces the correct answer. However, it can become cumbersome if the num- ber of rents is large. A formula provides a more efficient way of expressing the future value of an ordinary annuity of 1. This formula sums the individual rents plus the com- pound interest, as follows.

FVF-OAn,i = (1 + i)n − 1

i where

FVF-OAn,i = future value factor of an ordinary annuity i = rate of interest per period n = number of compounding periods

For example, FVF-OA5,5% refers to the value to which an ordinary annuity of 1 will accu- mulate in 5 periods at 5% interest.

Annuities (Future Value) 281

Interpreting the table, if $1 is invested at the end of each year for 4 years at 5% inter- est compounded annually, the value of the annuity at the end of the fourth year is $4.31 (4.31013 × $1.00). Now, multiply the factor from the appropriate line and column of the table by the dollar amount of one rent involved in an ordinary annuity. The result: the accumulated sum of the rents and the compound interest to the date of the last rent.

The following formula computes the future value of an ordinary annuity.

Future value of an ordinary annuity = R (FVF-OAn,i)

where R = periodic rent

FVF-OAn,i = future value of an ordinary annuity factor for n periods at i interest

To illustrate, what is the future value of five $5,000 deposits made at the end of each of the next 5 years, earning interest of 6%? Illustration 6-19 depicts this problem as a time diagram.

ILLUSTRATION 6-18 Excerpt from Table 6-3

FUTURE VALUE OF AN ORDINARY ANNUITY OF 1 (EXCERPT FROM TABLE 6-3, PAGE 318)

Period 4% 5% 6%

1 1.00000 1.00000 1.00000 2 2.04000 2.05000 2.06000 3 3.12160 3.15250 3.18360 4 4.24646 4.31013 4.37462 5 5.41632 5.52563* 5.63709

*Note that this annuity table factor is the same as the sum of the future values of 1 factors shown in Illustration 6-17.

Using the formula above has resulted in the development of tables, similar to those used for the “future value of 1” and the “present value of 1” for both an ordinary annu- ity and an annuity due. Illustration 6-18 provides an excerpt from the “future value of an ordinary annuity of 1” table.

0 1 2 3 4 5 n = 5

R = $5,000 $5,000 Present Value

i = 6% $5,000 $5,000

FV-OA = ? Future Value FV-OA = ?

$5,000

ILLUSTRATION 6-19 Time Diagram for Future Value of Ordinary Annuity (n = 5, i = 6%)

Use of the formula solves this investment problem as follows.

Future value of an ordinary annuity = R (FVF-OAn,i) = 5,000 (FVF-OA5,6%)

= $5,000 ((1 + .06) 5 − 1

0.6 ) = $5,000 (5.63709) = $28,185.45

282 Chapter 6 Accounting and the Time Value of Money

To determine the future value of an ordinary annuity factor of 5.63709 in the formula on page 281, use a financial calculator or read the appropriate table, in this case, Table 6-3 (6% column and the 5-period row).

To illustrate these computations in a business situation, assume that Hightown Electronics deposits $75,000 at the end of each 6-month period for the next 3 years, to accumulate enough money to meet debts that mature in 3 years. What is the future value that the company will have on deposit at the end of 3 years if the annual interest rate is 10%? The time diagram in Illustration 6-20 depicts this situation.

i = 5% $75,000

0 1 2 3 4 5 6

$75,000$75,000$75,000

n = 6

R = $75,000 FV-OA = ? Future Value FV-OA = ? $75,000

ILLUSTRATION 6-20 Time Diagram for Future Value of Ordinary Annuity (n = 6, i = 5%)

The formula solution for the Hightown Electronics situation is as follows.

Future value of an ordinary annuity = R (FVF-OAn,i) = $75,000 (FVF-OA6,5%)

= $75,000 ((1 + .05) 6 − 1

.05 ) = $75,000 (6.80191) = $510,143.25

Thus, six 6-month deposits of $75,000 earning 5% per period will grow to $510,143.25.

Future Value of an Annuity Due The preceding analysis of an ordinary annuity assumed that the periodic rents occur at the end of each period. Recall that an annuity due assumes periodic rents occur at the beginning of each period. This means an annuity due will accumulate interest during the first period (in contrast to an ordinary annuity rent, which will not). In other words, the two types of annuities differ in the number of interest accumulation periods involved even though the same number of rents occur.

If rents occur at the end of a period (ordinary annuity), in determining the future value of an annuity there will be one less interest period than if the rents occur at the beginning of the period (annuity due). Illustration 6-21 shows this distinction.

In this example, the cash flows from the annuity due come exactly one period earlier than for an ordinary annuity. As a result, the future value of the annuity due factor is exactly 12% higher than the ordinary annuity factor. For example, the value of an ordi- nary annuity factor at the end of period one at 12% is 1.00000, whereas for an annuity due it is 1.12000.

Annuities (Future Value) 283

To find the future value of an annuity due factor, multiply the future value of an ordinary annuity factor by 1 plus the interest rate. For example, to determine the future value of an annuity due interest factor for 5 periods at 12% compound interest, simply multiply the future value of an ordinary annuity interest factor for 5 periods (6.35285), by one plus the interest rate (1 + .12), to arrive at 7.11519 (6.35285 × 1.12).

To illustrate the use of the ordinary annuity tables in converting to an annuity due, assume that Sue Lotadough plans to deposit $800 a year on each birthday of her son Howard. She makes the first deposit on his tenth birthday, at 6% interest compounded annually. Sue wants to know the amount she will have accumulated for college expenses by her son’s eighteenth birthday.

If the first deposit occurs on Howard’s tenth birthday, Sue will make a total of 8 deposits over the life of the annuity (assume no deposit on the eighteenth birthday), as shown in Illustration 6-22. Because all the deposits are made at the beginning of the periods, they represent an annuity due.

ILLUSTRATION 6-21 Comparison of the Future Value of an Ordinary Annuity with an Annuity Due

Future Value of an Annuity of 1 at 12%

Future value of an ordinary annuity (per Table 6-3)

Period 1 Period 2 Period 3 Period 4 Period 5

Period 1 Period 4 Period 5

No interest Interest Interest Interest Interest

Interest Interest Interest Interest Interest Period 2 Period 3

First deposit at end of period

(No table provided)

Ordinary annuity

Annuity due

1.00000 2.12000 3.37440 4.77933 6.35285

7.115195.352853.779332.374401.120001.00000

First deposit at beginning of period

Ordinary annuity

Annuity due

i = 6%

n = 8

R = $800 $800 $800$800 $800 $800 $800 $800

FV-AD = Future value of an annuity due

0 1 2 3 5 6 7 8

FV-AD = ?

Future Value

FV-AD = ?

ILLUSTRATION 6-22 Annuity Due Time Diagram

Referring to the “future value of an ordinary annuity of 1” table for 8 periods at 6%, Sue finds a factor of 9.89747. She then multiplies this factor by (1 + .06) to arrive at the future value of an annuity due factor. As a result, the accumulated value on Howard’s eigh- teenth birthday is $8,393.06, as calculated in Illustration 6-23 (on page 284).

284 Chapter 6 Accounting and the Time Value of Money

ILLUSTRATION 6-23 Computation of Accumulated Value of Annuity Due

1. Future value of an ordinary annuity of 1 for 8 periods at 6% (Table 6-3) 9.89747 2. Factor (1 + .06) × 1.06 3. Future value of an annuity due of 1 for 8 periods at 6% 10.49132 4. Periodic deposit (rent) × $800 5. Accumulated value on son’s 18th birthday $8,393.06

WHAT DO THE NUMBERS MEAN? DON’T WAIT TO MAKE THAT CONTRIBUTION! There is great power in compounding of interest, and there is no better illustration of this maxim than the case of retirement savings, especially for young adults. Under current tax rules for individual retirement accounts (IRAs), you can contribute up to $5,500 in an investment fund, which will grow tax-free until you reach retirement age. What’s more, you get a tax deduction for the amount contributed in the current year. Financial planners encourage young adults to take advantage of the tax benefi ts of IRAs. Indeed, one type of IRA—a Roth—is tax-free when you receive payments in retirement. By starting early, you can use the power of compounding to grow a pretty good nest egg. As shown in the adjacent chart, starting earlier can have a big impact on the value of your retirement fund.

As shown, by setting aside $1,000 each year, beginning when you are 25 and assuming a rate of return of 6%, your retirement account at age 65 will have a tidy balance of $154,762 [$1,000 × 154.76197 (FVF-OA40,6%)]. That’s the power of compounding. Not too bad you say, but hey, there are a lot of things you might want to spend that $1,000 on (clothes, a trip to Vegas or Europe, new golf clubs). However, if you delay starting those contributions until age 30, your

0 25 Age when contributions begin

20,000 40,000 60,000 80,000

100,000 120,000 140,000 160,000

$180,000

Value of retirement fund at age 65 with $1,000 per year contributions with a 6% annual return

retirement fund will grow only to a value of $111,435 ($1,000 × 111.43478 (FVF-OA35,6%)). That is quite a haircut—about 28%. That is, by delaying or missing contributions, you miss out on the power of compounding and put a dent in your projected nest egg.

Source: Adapted from T. Rowe Price, “A Roadmap to Financial Security for Young Adults,” Invest with Confidence (troweprice.com).

Depending on the college he chooses, Howard may have enough to finance only part of his first year of school.

Examples of Future Value of Annuity Problems The foregoing annuity examples relied on three known values—amount of each rent, interest rate, and number of periods. Using these values enables us to determine the unknown fourth value, future value.

The first two future value problems we present illustrate the computations of (1) the amount of the rents and (2) the number of rents. The third problem illustrates the com- putation of the future value of an annuity due.

Computation of Rent Assume that you plan to accumulate $14,000 for a down payment on a condominium apartment 5 years from now. For the next 5 years, you earn an annual return of 8% com- pounded semiannually. How much should you deposit at the end of each 6-month period?

The $14,000 is the future value of 10 (5 × 2) semiannual end-of-period payments of an unknown amount, at an interest rate of 4% (8% ÷ 2). Illustration 6-24 depicts this problem as a time diagram.

Annuities (Future Value) 285

Future Value

FV-OA = $14,000i = 4%

n = 10 FV-OA = Future value of an ordinary annuity

0 1 2 3 4 5 6 7 8 9 10

? ???? ? ? ? ?R = ? ???? ? ? ? ? ??R =

ILLUSTRATION 6-24 Future Value of Ordinary Annuity Time Diagram (n = 10, i = 4%)

0 1 2

R = $20,000

Future Value

FV-OA = $117,332$20,000 $20,000

i = 8%

3 n = ?n = ?

ILLUSTRATION 6-25 Future Value of Ordinary Annuity Time Diagram, to Solve for Unknown Number of Periods

Using the formula for the future value of an ordinary annuity, you determine the amount of each rent as follows.

Future value of an ordinary annuity = R (FVF-OAn,i) $14,000 = R (FVF-OA10,4%) $14,000 = R (12.00611) R = $1,166.07

Thus, you must make 10 semiannual deposits of $1,166.07 each in order to accumulate $14,000 for your down payment.

Computation of the Number of Periodic Rents Suppose that a company’s goal is to accumulate $117,332 by making periodic deposits of $20,000 at the end of each year, which will earn 8% compounded annually while accu- mulating. How many deposits must it make?

The $117,332 represents the future value of n(?) $20,000 deposits, at an 8% annual rate of interest. Illustration 6-25 depicts this problem in a time diagram.

Using the future value of an ordinary annuity formula, the company obtains the following factor.

Future value of an ordinary annuity = R (FVF-OAn,i) $117,332 = $20,000 (FVF-OAn,8%)

FVF-OAn,8% = $117,332

$20,000 = 5.86660

Use Table 6-3 and read down the 8% column to find 5.86660 in the 5-period row. Thus, the company must make five deposits of $20,000 each.

Computation of the Future Value To create his retirement fund, Walter Goodwrench, a mechanic, now works weekends. Mr. Goodwrench deposits $2,500 today in a savings account that earns 9% interest. He

286 Chapter 6 Accounting and the Time Value of Money

plans to deposit $2,500 every year for a total of 30 years. How much cash will Mr. Goodwrench accumulate in his retirement savings account, when he retires in 30 years? Illustration 6-26 depicts this problem in a time diagram.

Using the “future value of an ordinary annuity of 1” table, Mr. Goodwrench computes the solution as shown in Illustration 6-27.

ILLUSTRATION 6-26 Future Value Annuity Due Time Diagram (n = 30, i = 9%)

$2,500 i = 9%

0 1 2 29 30

R = $2,500 $2,500 $2,500

n = 30

FV-AD = ?

Future Value

FV-AD = ?

ILLUSTRATION 6-27 Computation of Accumulated Value of an Annuity Due

1. Future value of an ordinary annuity of 1 for 30 periods at 9% 136.30754 2. Factor (1 + .09) × 1.09 3. Future value of an annuity due of 1 for 30 periods at 9% 148.57522 4. Periodic rent × $2,500 5. Accumulated value at end of 30 years $371,438

Present Value at Beg. of Year 1 1 2 3 4 5

$0.95238 $1.00 .90703 $1.00 .86384 $1.00 .82270 $1.00 .78353 $1.00

$4.32948 Total (present value of an ordinary annuity of $1.00 for five periods at 5%)

END OF PERIOD IN WHICH $1.00 IS TO BE RECEIVED ILLUSTRATION 6-28 Solving for the Present Value of an Ordinary Annuity

ANNUITIES (PRESENT VALUE) The present value of an annuity is the single sum that, if invested at compound interest now, would provide for an annuity (a series of withdrawals) for a certain number of future periods.

Present Value of an Ordinary Annuity The present value of an ordinary annuity is the present value of a series of equal rents, to be withdrawn at equal intervals at the end of the period.

One approach to finding the present value of an annuity determines the present value of each of the rents in the series and then totals their individual present values. For example, we may view an annuity of $1, to be received at the end of each of 5 periods, as separate amounts. We then compute each present value using the table of present values (see Table 6-2 on pages 316–317), assuming an interest rate of 5%. Illustration 6-28 shows this approach.

LEARNING OBJECTIVE 4 Solve present value of ordinary and annuity due problems.

Annuities (Present Value) 287

This computation tells us that if we invest the single sum of $4.33 today at 5% inter- est for 5 periods, we will be able to withdraw $1 at the end of each period for 5 periods. We can summarize this cumbersome procedure by the following formula.

PVF-OAn,i =

The expression PVF-OAn,i refers to the present value of an ordinary annuity of 1 factor for n periods at i interest. Ordinary annuity tables base present values on this formula. Illustration 6-29 shows an excerpt from such a table.

1 (1 + i)n

1 −

ILLUSTRATION 6-29 Excerpt from Table 6-4

PRESENT VALUE OF AN ORDINARY ANNUITY OF 1 (EXCERPT FROM TABLE 6-4, PAGE 320)

Period 4% 5% 6%

1 .96154 .95238 .94340 2 1.88609 1.85941 1.83339 3 2.77509 2.72325 2.67301 4 3.62990 3.54595 3.46511 5 4.45182 4.32948* 4.21236

*Note that this annuity table factor is equal to the sum of the present value of 1 factors shown in Illustration 6-28.

The general formula for the present value of any ordinary annuity is as follows.

Present value of an ordinary annuity = R (PVF-OAn,i)

where

R = periodic rent (ordinary annuity) PVF-OAn,i = present value of an ordinary annuity of 1

for n periods at i interest

To illustrate with an example, what is the present value of rental receipts of $6,000 each, to be received at the end of each of the next 5 years when discounted at 6%? This problem may be time-diagrammed and solved as shown in Illustration 6-30.

0 1 2 3 4 5 n = 5

R = $6,000 $6,000 $6,000 $6,000 i = 6%

$6,000PV-OA = ?

Present Value

PV-OA = ?

ILLUSTRATION 6-30 Present Value of Ordinary Annuity Time Diagram

The formula for this calculation is as shown below.

Present value of an ordinary annuity = R (PVF-OAn,i) = $6,000 (PVF-OA5,6%) = $6,000 (4.21236) = $25,274.16 The present value of the 5 ordinary annuity rental receipts of $6,000 each is $25,274.16. To determine the present value of the ordinary annuity factor 4.21236, use a financial calcu- lator or read the appropriate table, in this case Table 6-4 (6% column and 5-period row).

288 Chapter 6 Accounting and the Time Value of Money

Present Value of an Annuity Due In our discussion of the present value of an ordinary annuity, we discounted the final rent based on the number of rent periods. In determining the present value of an annu- ity due, there is always one fewer discount period. Illustration 6-31 shows this distinction.

Time value of money concepts also can be relevant to public policy debates. For example, several states had to determine how to receive the payments from tobacco companies as set- tlement for a national lawsuit against the companies for the healthcare costs of smoking.

The State of Wisconsin was due to collect 25 years of payments totaling $5.6 billion. The state could wait to collect the payments, or it could sell the payments to an investment bank (a process called securitization). If it were to sell the payments, it would receive a lump-sum payment today of $1.26 billion. Is this a good deal for the state? Assuming a discount rate of 8% and that the payments will be received in equal amounts (e.g., an annuity), the present value of the tobacco payment is:

$ 5.6 billion ÷ 25 = $224 million $224 million × 10.67478* = $2.39 billion

*PV-OA (i = 8%, n = 25)

Why would some in the state be willing to take just $1.26 billion today for an annuity whose present value is almost twice that amount? One reason is that Wisconsin was facing a hole in its budget that could be plugged in part by the lump-sum payment. Also, some believed that the risk of not getting paid by the tobacco companies in the future makes it prudent to get the money earlier.

If this latter reason has merit, then the present value com- putation above should have been based on a higher interest rate. Assuming a discount rate of 15%, the present value of the annuity is $1.448 billion ($5.6 billion ÷ 25 = $224 million; $224 million × 6.46415), which is much closer to the lump- sum payment offered to the State of Wisconsin.

WHAT DO THE NUMBERS MEAN? UP IN SMOKE

Because each cash flow comes exactly one period sooner in the present value of the annuity due, the present value of the cash flows is exactly 12% higher than the present value of an ordinary annuity. Thus, to find the present value of an annuity due factor, multiply the present value of an ordinary annuity factor by 1 plus the interest rate (that is, 1 + i).

Present Value of an Annuity of 1 at 12%

Present value of an ordinary annuity (per Table 6-4)

Present value of annuity due (per Table 6-5)

Period 1 Period 2 Period 3 Period 4 Period 5

Period 1 Period 4 Period 5

Discount

.89286 1.69005 3.037352.40183 3.60478

Period 2 Period 3

Discount Discount Discount Discount

Discount Discount DiscountNo discount

Rent at beginning of period

Rent at end of period

Annuity due

Ordinary annuity

1.00000 4.037353.401832.690051.89286

Annuity due

Ordinary annuity

ILLUSTRATION 6-31 Comparison of Present Value of an Ordinary Annuity with an Annuity Due

Annuities (Present Value) 289

To determine the present value of an annuity due interest factor for 5 periods at 12% interest, take the present value of an ordinary annuity for 5 periods at 12% inter- est (3.60478) and multiply it by 1.12 to arrive at the present value of an annuity due, 4.03735 (3.60478 × 1.12). We provide present value of annuity due factors in Table 6-5 (pages 322–323).

To illustrate, Space Odyssey, Inc., rents a communications satellite for 4 years with annual rental payments of $4.8 million to be made at the beginning of each year. If the relevant annual interest rate is 5%, what is the present value of the rental obligations? Illustration 6-32 shows the company’s time diagram for this problem.

$4.8M i = 5%

n = 4 PV-AD = the present value of an annuity due

0 1 2 3 4

$4.8M $4.8M PV-AD = ?

Present Value PV-AD = ? R = $4.8M

ILLUSTRATION 6-32 Present Value of Annuity Due Time Diagram (n = 4, i = 5%)

Illustration 6-33 shows the computations to solve this problem.

ILLUSTRATION 6-33 Computation of Present Value of an Annuity Due

1. Present value of an ordinary annuity of 1 for 4 periods at 5% (Table 6-4) 3.54595 2. Factor (1 + .05) × 1.05 3. Present value of an annuity due of 1 for 4 periods at 5% 3.72325 4. Periodic deposit (rent) × $4,800,000 5. Present value of payments $17,871,600

Using Table 6-5 also locates the desired factor 3.72325 and computes the present value of the lease payments to be $17,871,600.

Examples of Present Value of Annuity Problems In the following three examples, we demonstrate the computation of (1) the present value, (2) the interest rate, and (3) the amount of each rent.

Computation of the Present Value of an Ordinary Annuity You have just won a lottery totaling $4,000,000. You learn that you will receive a check in the amount of $200,000 at the end of each of the next 20 years. What amount have you really won? That is, what is the present value of the $200,000 checks you will receive over the next 20 years? Illustration 6-34 (page 290) shows a time diagram of this enviable situation (assuming an appropriate interest rate of 10%).

You calculate the present value as follows.

Present value of an ordinary annuity = R (PVF-OAn,i) = $200,000 (PVF-OA20,10%) = $200,000 (8.51356) = $1,702,712

290 Chapter 6 Accounting and the Time Value of Money

As a result, if the state deposits $1,702,712 now and earns 10% interest, it can withdraw $200,000 a year for 20 years to pay you the $4,000,000.

Computation of the Interest Rate Many shoppers use credit cards to make purchases. When you receive the statement for payment, you may pay the total amount due or you may pay the balance in a certain number of payments. For example, assume you receive a statement from MasterCard with a balance due of $528.77. You may pay it off in 12 equal monthly payments of $50 each, with the first payment due one month from now. What rate of interest would you be paying?

The $528.77 represents the present value of the 12 payments of $50 each at an unknown rate of interest. The time diagram in Illustration 6-35 depicts this situation.

$200,000

0 1 2 19 20

R = $200,000 $200,000 $200,000 i = 10%

n = 20

PV-OA = ?PV-OA = ?

ILLUSTRATION 6-34 Time Diagram to Solve for Present Value of Lottery Payments

n = 12

Present Value PV-OA = $528.77

R = $50

10 2 3 4 5 6 7 8 9 10 11 12

$50 $50 $50 $50 $50 $50 $50 $50 $50 $50 $50 i = ?i = ?

ILLUSTRATION 6-35 Time Diagram to Solve for Effective-Interest Rate on Loan

You calculate the rate as follows.

Present value of an ordinary annuity = R (PVF-OAn,i) $528.77 = $50 (PVF-OA12,i)

(PVFOA12,i) = = 10.57540

Referring to Table 6-4 and reading across the 12-period row, you find 10.57534 in the 2% column. Since 2% is a monthly rate, the nominal annual rate of interest is 24% (12 × 2%). The effective annual rate is 26.82423% [(1 + .02)12 − 1]. Obviously, you are better off pay- ing the entire bill now if possible.

Computation of a Periodic Rent Norm and Jackie Remmers have saved $36,000 to finance their daughter Dawna’s col- lege education. They deposited the money in the Bloomington Savings and Loan Asso- ciation, where it earns 4% interest compounded semiannually. What equal amounts can their daughter withdraw at the end of every 6 months during her 4 college years, with- out exhausting the fund? Illustration 6-36 shows a time diagram of this situation.

$528.77 $50

Other Time Value of Money Issues 291

Determining the answer by simply dividing $36,000 by 8 withdrawals is wrong. Why? Because that ignores the interest earned on the money remaining on deposit. Dawna must consider that interest is compounded semiannually at 2% (4% ÷ 2) for 8 periods (4 years × 2). Thus, using the same present value of an ordinary annuity for- mula, she determines the amount of each withdrawal that she can make as follows.

Present value of an ordinary annuity = R (PVF-OAn,i) $36,000 = R (PVF-OA8,2%) $36,000 = R (7.32548) R = $4,914.35

OTHER TIME VALUE OF MONEY ISSUES Solving time value problems often requires using more than one table. For example, a business problem may need computations of both present value of a single sum and present value of an annuity. In addition, GAAP may require the use of expected cash flows in determining present value. In this section, we examine:

1. Deferred annuities. 2. Bond problems. 3. Present value measurement.

Deferred Annuities A deferred annuity is an annuity in which the rents begin after a specified number of periods. A deferred annuity does not begin to produce rents until two or more periods have expired. For example, “an ordinary annuity of six annual rents deferred 4 years” means that no rents will occur during the first 4 years and that the first of the six rents will occur at the end of the fifth year. “An annuity due of six annual rents deferred 4 years” means that no rents will occur during the first 4 years and that the first of six rents will occur at the beginning of the fifth year.

Future Value of a Deferred Annuity Computing the future value of a deferred annuity is relatively straightforward. Because there is no accumulation or investment on which interest may accrue, the future value of a deferred annuity is the same as the future value of an annuity not deferred. That is, computing the future value simply ignores the deferred period.

To illustrate, assume that Sutton Corporation plans to purchase a land site in 6 years for the construction of its new corporate headquarters. Because of cash flow problems, Sut- ton budgets deposits of $80,000 on which it expects to earn 5% annually, only at the end of the fourth, fifth, and sixth periods. What future value will Sutton have accumulated at the end of the sixth year? Illustration 6-37 (page 292) shows a time diagram of this situation.

R = ? ? ? ? ? ? ? ?

n = 8

i = 2%

0 1 2 3 4 5 6 7 8

Present Value PV-OA = $36,000 ? ? ? ? ? ? ?R = ?

ILLUSTRATION 6-36 Time Diagram for Ordinary Annuity for a College Fund

LEARNING OBJECTIVE 5 Solve present value prob- lems related to deferred annuities, bonds, and expected cash flows.

292 Chapter 6 Accounting and the Time Value of Money

i = 5% R = $80,000 $80,000

n = 3 (first 3 periods are ignored)

0 1 2 3 4 5 6

FV-OA = ? Future Value FV-OA = ? $80,000

ILLUSTRATION 6-37 Time Diagram for Future Value of Deferred Annuity

Sutton determines the value accumulated by using the standard formula for the future value of an ordinary annuity:

Future value of an ordinary annuity = R (FVF-OAn,i) = $80,000 (FVF-OA3,5%) = $80,000 (3.15250) = $252,200

Present Value of a Deferred Annuity Computing the present value of a deferred annuity must recognize the interest that accrues on the original investment during the deferral period.

To compute the present value of a deferred annuity, we compute the present value of an ordinary annuity of 1 as if the rents had occurred for the entire period. We then subtract the present value of rents that were not received during the deferral period. We are left with the present value of the rents actually received subsequent to the deferral period.

To illustrate, Bob Boyd has developed and copyrighted tutorial software for stu- dents in advanced accounting. He agrees to sell the copyright to Campus Micro Systems for 6 annual payments of $5,000 each. The payments will begin 5 years from today. Given an annual interest rate of 8%, what is the present value of the 6 payments?

This situation is an ordinary annuity of 6 payments deferred 4 periods. The time diagram in Illustration 6-38 depicts this sales agreement.

ILLUSTRATION 6-38 Time Diagram for Present Value of Deferred Annuity

i = 8%

n = 6

$5,000 $5,000 $5,000 $5,000 $5,000

0 1 2 3 4 7 8 9 105 6 n = 4

R = $5,000PV = ?PV = ?

Two options are available to solve this problem. The first is to use only Table 6-4, as shown in Illustration 6-39.

ILLUSTRATION 6-39 Computation of the Present Value of a Deferred Annuity

1. Each periodic rent $5,000 2. Present value of an ordinary annuity of 1 for total periods (10)

[number of rents (6) plus number of deferred periods (4)] at 8% 6.71008 3. Less: Present value of an ordinary annuity of 1 for the number of

deferred periods (4) at 8% 3.31213 4. Difference × 3.39795 5. Present value of 6 rents of $5,000 deferred 4 periods $16,989.75

Other Time Value of Money Issues 293

The subtraction of the present value of an annuity of 1 for the deferred periods eliminates the nonexistent rents during the deferral period. It converts the present value of an ordinary annuity of $1.00 for 10 periods to the present value of 6 rents of $1.00, deferred 4 periods.

Alternatively, Boyd can use both Table 6-2 and Table 6-4 to compute the present value of the 6 rents. He can first discount the annuity 6 periods. However, because the annuity is deferred 4 periods, he must treat the present value of the annuity as a future amount to be discounted another 4 periods. The time diagram in Illustration 6-40 depicts this two-step process.

ILLUSTRATION 6-40 Time Diagram for Present Value of Deferred Annuity (2-Step Process)

$5,000$5,000 $5,000$5,000$5,000

FV (PVFn,i) R (PVF-OAn,i) 1 2 3 4 5 6 7 8 9 100

$5,000PV = ? PV-OA = ?PV = ? PV-OA = ?

Calculation using formulas would be done in two steps, as follows.

Step 1: Present value of an ordinary annuity = R (PVF-OAn,i)

= $5,000 (PVF-OA6,8%) = $5,000 (4.62288) (Table 6-4, Present value of an ordinary annuity) = $23,114.40

Step 2: Present value of a single sum = FV (PVFn,i)

= $23,114.40 (PVF4,8%) = $23,114.40 (.73503) (Table 6-2, Present value of a single sum) = $16,989.78

The present value of $16,989.78 is the same as in Illustration 6-39 although computed differently. (The $0.03 difference is due to rounding.)

Valuation of Long-Term Bonds A long-term bond produces two cash flows: (1) periodic interest payments during the life of the bond, and (2) the principal (face value) paid at maturity. At the date of issue, bond buyers determine the present value of these two cash flows using the market rate of interest.

The periodic interest payments represent an annuity. The principal represents a single-sum problem. The current market value of the bonds is the combined present values of the interest annuity and the principal amount.

To illustrate, Alltech Corporation on January 1, 2017, issues $100,000 of 5% bonds due in 5 years with interest payable annually at year-end. The current mar- ket rate of interest for bonds of similar risk is 6%. What will the buyers pay for this bond issue?

294 Chapter 6 Accounting and the Time Value of Money

The time diagram in Illustration 6-41 depicts both cash flows.

4 n = 5

i = 6%

2 3 50 1

$5,000$5,000 $5,000 $5,000 $5,000 Interest

$100,000 PrincipalPV

PV-OA

Alltech computes the present value of the two cash flows by discounting at 6% as follows.

ILLUSTRATION 6-41 Time Diagram to Solve for Bond Valuation

LLUSTRATION 6-42 Computation of the Present Value of an Interest-Bearing Bond

1. Present value of the principal: FV (PVF5,6%) = $100,000 (.74726) $74,726.00 2. Present value of the interest payments: R (PVF-OA5,6%) = $5,000 (4.21236) 21,061.80 3. Combined present value (market price)—carrying value of bonds $95,787.80

By paying $95,787.80 at date of issue, the buyers of the bonds will realize an effec- tive yield of 6% over the 5-year term of the bonds. This is true because Alltech dis- counted the cash flows at 6%.

Effective-Interest Method of Amortization of Bond Discount or Premium In the previous example (Illustration 6-42), Alltech Corporation issued bonds at a dis- count, computed as follows.

ILLUSTRATION 6-43 Computation of Bond Discount

Maturity value (face amount) of bonds $100,000.00 Present value of the principal $74,726.00 Present value of the interest 21,061.80

Proceeds (present value and cash received) (95,787.80)

Discount on bonds issued $ 4,212.20

Alltech amortizes (writes off to interest expense) the amount of this discount over the life of the bond issue.

The preferred procedure for amortization of a discount or premium is the effective- interest method. Under the effective-interest method:

1. The company issuing the bond fi rst computes bond interest expense by multiply- ing the carrying value of the bonds at the beginning of the period by the effective- interest rate.

2. The company then determines the bond discount or premium amortization by com- paring the bond interest expense with the interest to be paid.

Other Time Value of Money Issues 295

Illustration 6-44 depicts the computation of bond amortization.

ILLUSTRATION 6-44 Amortization Computation Bond Interest Expense Bond Interest Paid

Carrying Value Effective- Face Amount

Stated Amortization of Bonds at × Interest −

of Bonds × Interest = Amount

Beginning of Period Rate Rate( ) ( )

We use the amortization schedule illustrated above for note and bond transactions in Chapters 7 and 14.

Present Value Measurement In the past, most accounting calculations of present value relied on the most likely cash flow amount. Concepts Statement No. 7 introduces an expected cash flow approach.6 It uses a range of cash flows and incorporates the probabilities of those cash flows to pro- vide a more relevant measurement of present value.

To illustrate the expected cash flow model, assume that there is a 30% probability that future cash flows will be $100, a 50% probability that they will be $200, and a 20% probability that they will be $300. In this case, the expected cash flow would be $190 [($100 × 0.3) + ($200 × 0.5) + ($300 × 0.2)]. Traditional present value approaches would use the most likely estimate ($200). However, that estimate fails to consider the different probabilities of the possible cash flows.

6“Using Cash Flow Information and Present Value in Accounting Measurements,” Statement of Financial Accounting Concepts No. 7 (Norwalk, Conn.: FASB, 2000).

SCHEDULE OF BOND DISCOUNT AMORTIZATION 5-YEAR, 5% BONDS SOLD TO YIELD 6%

Cash Bond Carrying Interest Interest Discount Value Date Paid Expense Amortization of Bonds

1/1/15 $ 95,787.80 12/31/15 $ 5,000.00a $ 5,747.27b $ 747.27c 96,535.07d

12/31/16 5,000.00 5,792.10 792.10 97,327.17 12/31/17 5,000.00 5,839.63 839.63 98,166.80 12/31/18 5,000.00 5,890.01 890.01 99,056.81 12/31/19 5,000.00 5,943.19e 943.19 100,000.00

$25,000.00 $29,212.20 $4,212.20

a$100,000 × 5% = $5,000 d$95,787.80 + $747.27 = $96,535.07 b$95,787.80 × 6% = $5,747.27 e$0.22 difference due to rounding. c$5,747.27 − $5,000 = $747.27

ILLUSTRATION 6-45 Effective-Interest Amortization Schedule

The effective-interest method produces a periodic interest expense equal to a con- stant percentage of the carrying value of the bonds. Since the percentage used is the effective rate of interest incurred by the borrower at the time of issuance, the effective- interest method results in matching expenses with revenues.

We can use the data from the Alltech Corporation example to illustrate the effective- interest method of amortization. Alltech issued $100,000 face value of bonds at a dis- count of $4,212.20, resulting in a carrying value of $95,787.80. Illustration 6-45 shows the effective-interest amortization schedule for Alltech’s bonds.

296 Chapter 6 Accounting and the Time Value of Money

Choosing an Appropriate Interest Rate After determining expected cash flows, a company must then use the proper interest rate to discount the cash flows. The interest rate used for this purpose has the following three components.

Cash Flow Probability Expected Estimate × Assessment = Cash Flow 2017 $3,800 20% $ 760 6,300 50% 3,150 7,500 30% 2,250

Total $6,160

2018 $5,400 30% $1,620 7,200 50% 3,600 8,400 20% 1,680

Total $6,900

ILLUSTRATION 6-46 Expected Cash Outfl ows—Warranties

1. PURE RATE OF INTEREST (2%–4%). The amount a lender would charge if there were no possibilities of default and no expectation of infl ation.

2. EXPECTED INFLATION RATE OF INTEREST (0%–?). Lenders recognize that in an infl ationary economy, they are being paid back with less valuable dollars. As a result, they increase their interest rate to compensate for this loss in purchasing power. When infl ationary expectations are high, interest rates are high.

3. CREDIT RISK RATE OF INTEREST (0%–5%). The government has little or no credit risk (i.e., risk of nonpayment) when it issues bonds. A business enterprise, however, depending upon its fi nancial stability, profi tability, etc., can have a low or a high credit risk.

THREE COMPONENTS OF INTEREST

The FASB takes the position that after computing the expected cash flows, a com- pany should discount those cash flows by the risk-free rate of return. That rate is defined as the pure rate of return plus the expected inflation rate. The Board notes that the expected cash flow framework adjusts for credit risk because it incorporates the probability of receipt or payment into the computation of expected cash flows. There- fore, the rate used to discount the expected cash flows should consider only the pure rate of interest and the inflation rate.

Example of Expected Cash Flow To illustrate, assume that Al’s Appliance Outlet offers a 2-year warranty on all products sold. In 2017, Al’s Appliance sold $250,000 of a particular type of clothes dryer. Al’s Appliance entered into an agreement with Ralph’s Repair to provide all warranty ser- vice on the dryers sold in 2017. To determine the warranty expense to record in 2017 and the amount of warranty liability to record on the December 31, 2017, balance sheet, Al’s Appliance must measure the fair value of the agreement. Since there is not a ready mar- ket for these warranty contracts, Al’s Appliance uses expected cash flow techniques to value the warranty obligation.

Based on prior warranty experience, Al’s Appliance estimates the expected cash outflows associated with the dryers sold in 2017, as shown in Illustration 6-46.

Review and Practice 297

ILLUSTRATION 6-47 Present Value of Cash Flows

Expected PV Factor, Present Year Cash Flow × i = 5% = Value 2017 $6,160 0.95238 $ 5,866.66 2018 6,900 0.90703 6,258.51

Total $12,125.17

Applying expected cash flow concepts to these data, Al’s Appliance estimates war- ranty cash outflows of $6,160 in 2017 and $6,900 in 2018.

Illustration 6-47 shows the present value of these cash flows, assuming a risk-free rate of 5% and cash flows occurring at the end of the year.

Management of the level of interest rates is an important policy tool of the Federal Reserve Bank and its chair, Janet Yellen. Through a number of policy options, the Fed has the ability to move interest rates up or down, and these rate changes can affect the wealth of all market participants. For example, if the Fed wants to raise rates (because the overall economy is get- ting overheated), it can raise the discount rate, which is the rate banks pay to borrow money from the Fed. This rate increase will factor into the rates banks and other creditors use to lend money. As a result, companies will think twice about borrowing money to expand their businesses. The result will be a slowing economy. A rate cut does just the opposite. It makes borrow- ing cheaper, and it can help the economy expand as more companies borrow to expand their operations.

Keeping rates low had been the Fed’s policy in the early 2000s. The low rates did help keep the economy humming. But these same low rates may have also resulted in too much

real estate lending and the growth of a real estate bubble, as the price of housing was fueled by cheaper low-interest mort- gage loans. But, as the old saying goes, “What goes up, must come down.” That is what real estate prices did, triggering massive loan write-offs, a seizing up of credit markets, and a slowing economy.

So just when a rate cut might have helped the economy, the Fed’s rate-cutting toolbox was empty. In response, the Fed began repurchasing long-term government bonds—referred to as “quantitative easing.” These repurchases put money into the market and reduce long-term Interest rates. After three rounds of quantitative easing, it now appears that the Fed was able to spur the economy out of its persistent funk. More recently, Fed watchers are trying to predict how far the Fed will allow rates to rise (after a small rate increase in December 2015), with many concerned that a rate increase could disrupt the economy’s fragile recovery.

WHAT DO THE NUMBERS MEAN? HOW LOW CAN THEY GO?

Sources: Adam Shell, “Five Investments to Consider if the Fed Uncorks QE3,” USA TODAY (September 1, 2012); and M. Crutsinger, “Yellen Reiterates Fed’s Patience in Raising Rates,” Associated Press (February 24, 2015).

REVIEW AND PRACTICE KEY TERMS REVIEW

annuity, 280 annuity due, 280 compound interest, 270 deferred annuity, 291 discounting, 275 effective-interest method,

294

effective yield, 273 expected cash flow

approach, 295 face rate, 273 future value, 274 future value of an

annuity, 280

interest, 269 nominal rate, 273 ordinary annuity, 280 present value, 274 principal, 269 risk-free rate of return,

296

simple interest, 270 stated rate, 273 time value of money, 268

298 Chapter 6 Accounting and the Time Value of Money

1. SIMPLE INTEREST. Interest on principal only, regardless of interest that may have accrued in the past.

2. COMPOUND INTEREST. Interest accrues on the unpaid interest of past periods as well as on the principal.

3. RATE OF INTEREST. Interest is usually expressed as an annual rate, but when the compounding period is shorter than one year, the interest rate for the shorter period must be determined.

4. ANNUITY. A series of payments or receipts (called rents) that occur at equal intervals of time. Types of annuities: (a) Ordinary Annuity. Each rent is payable (receivable) at the end of the period. (b) Annuity Due. Each rent is payable (receivable) at the beginning of the period.

5. FUTURE VALUE. Value at a later date of a single sum that is invested at compound-interest. (a) Future Value of 1 (or value of a single sum). The future value of $1 (or a single given sum), FV, at the end of n pe-

riods at i compound interest rate (Table 6-1). (b) Future Value of an Annuity. The future value of a series of rents invested at compound interest. In other words,

the accumulated total that results from a series of equal deposits at regular intervals invested at compound interest. Both deposits and interest increase the accumulation.

(1) Future Value of an Ordinary Annuity. The future value on the date of the last rent (Table 6-3). (2) Future Value of an Annuity Due. The future value one period after the date of the last rent. When an annuity

due table is not available, use Table 6-3 with the following formula.

FUNDAMENTAL CONCEPTS

LEARNING OBJECTIVES REVIEW 1 Describe the fundamental concepts related to the time value of money. Some of the applications of present value–

based measurements to accounting topics are (1) notes, (2) leases, (3) pensions and other postretirement benefits, (4) long- term assets, (5) sinking funds, (6) business combinations, (7) disclosures, and (8) installment contracts. See items 1 and 2 in the Fundamental Concepts below for the distinctions between simple and compound interest.

In order to identify which of the five compound interest tables to use, determine whether you are solving for (1) the future value of a single sum, (2) the present value of a single sum, (3) the future value of a series of sums (an annuity), or (4) the present value of a series of sums (an annuity). In addition, when a series of sums (an annuity) is involved, identify whether these sums are received or paid (1) at the beginning of each period (annuity due) or (2) at the end of each period (ordinary annuity).

The following four variables are fundamental to all compound interest problems. (1) Rate of interest: unless otherwise stated, an annual rate, adjusted to reflect the length of the compounding period if less than a year. (2) Number of time periods: the number of compounding periods (a period may be equal to or less than a year). (3) Future value: the value at a future date of a given sum or sums invested assuming compound interest. (4) Present value: the value now (present time) of a future sum or sums discounted assuming compound interest.

2 Solve future and present value of 1 problems. See items 5(a) and 6(a) in the Fundamental Concepts on page 299.

3 Solve future value of ordinary and annuity due problems. See item 5(b) in the Fundamental Concepts on page 299.

4 Solve present value of ordinary and annuity due problems. See item 6(b) in the Fundamental Concepts on page 299.

5 Solve present value problems related to deferred annuities, bonds, and expected cash flows. Deferred annui- ties are annuities in which rents begin after a specified number of periods. The future value of a deferred annuity is computed the same as the future value of an annuity not deferred. To find the present value of a deferred annuity, compute the present value of an ordinary annuity of 1 as if the rents had occurred for the entire period, and then subtract the present value of rents not received during the deferral period. The current market price of bonds combines the present values of the interest annuity and the principal amount. The expected cash flow approach uses a range of cash flows and the probabilities of those cash flows to provide the most likely estimate of expected cash flows. The proper interest rate used to discount the cash flows is the risk-free rate of return.

Value of annuity due of 1 =

(Value of ordinary annuity for for n rents n rents) × (1 + interest rate)

6. PRESENT VALUE. The value at an earlier date (usually now) of a given future sum discounted at compound interest.

(a) Present Value of 1 (or present value of a single sum). The present value (worth) of $1 (or a given sum), due n periods hence, discounted at i compound interest (Table 6-2).

(b) Present Value of an Annuity. The present value (worth) of a series of rents discounted at compound interest. In other words, it is the sum when invested at compound interest that will permit a series of equal withdrawals at regular intervals.

(1) Present Value of an Ordinary Annuity. The value now of $1 to be received or paid at the end of each period (rents) for n periods, discounted at i compound interest (Table 6-4).

(2) Present Value of an Annuity Due. The value now of $1 to be received or paid at the beginning of each period (rents) for n periods, discounted at i compound interest (Table 6-5). To use Table 6-4 for an annuity due, apply this formula.

(Present value of an Present value of annuity due of 1

= ordinary annuity of n rents) for n rents

× (1 + interest rate)

ENHANCED REVIEW AND PRACTICE Go online for multiple-choice questions with solutions, review exercises with solutions, and a full glossary of all key terms.

PRACTICE PROBLEM

Messier Company is a manufacturer of cycling equipment. It is facing several decisions involving time value of money consid- erations.

Instructions Provide the requested information for (a)–(d) below. (Round all answers to the nearest dollar.)

(a) Messier recently signed a lease for a new office building for a lease period of 10 years. Under the lease agreement, a security deposit of $12,000 is made, with the deposit to be returned at the expiration of the lease, with interest com- pounded at 10% per year. What amount will the company receive at the time the lease expires?

(b) Recently, the vice president of operations of the company has requested construction of a new plant to meet the increas- ing demand for the company’s bikes. After a careful evaluation of the request, the board of directors has decided to raise funds for the new plant by issuing $3,000,000 of 11% term corporate bonds on March 1, 2017, due on March 1, 2032, with interest payable each March 1 and September 1. At the time of issuance, the market interest rate for similar financial instruments is 10%. Determine the selling price of the bonds.

(c) The company, having issued the bonds in part (b), is committed to make annual sinking fund deposits of $90,000. The deposits are made on the last day of each year and yield a return of 10%. Will the fund at the end of 15 years be sufficient to retire the bonds? If not, what will the deficiency be?

(d) Messier has 50 employees. Recently, after a long negotiation with the local labor union, the company decided to initi- ate a pension plan as a part of its employee compensation plan. The plan will start on January 1, 2017. Each employee

Practice Problem 299

covered by the plan is entitled to a pension payment each year after retirement. As required by accounting standards, the controller of the company needs to report the pension obligation (liability). The following estimates have been collected.

Average length of time to retirement 15 years Expected life duration after retirement 10 years Total pension payment expected each year after retirement for all employees $800,000 per year

On the basis of the information above, determine the present value of the pension liability. Assume payment made at the end of the year and the interest rate to be used is 8%.

300 Chapter 6 Accounting and the Time Value of Money

SOLUTION

(a) Future value of $12,000 at 10% for 10 years ($12,000 × 2.59374) = $ 31,125

(b) Formula for the interest payments: PV-OA = R (PVF-OAn,i) PV-OA = $165,000 (PVF-OA30,5%) PV-OA = $165,000 (15.37245) PV-OA = $2,536,454

Formula for the principal: PV = FV (PVFn,i) PV = $3,000,000 (PVF30,5%) PV = $3,000,000 (0.23138) PV = $694,140

The selling price of the bonds = $2,536,454 + $694,140 = $3,230,594.

Deficiency ($3,000,000 − $2,859,523) $ 140,477

(d) Compute the value of the deferred annuity and then discount that amount to the present.

(i) Present value of the expected annual pension payments at the end of the tenth year: PV-OA = R (PVF-OAn,i) PV-OA = $800,000 (PVF-OA10,8%) PV-OA = $800,000 (6.71008) PV-OA = $5,368,064

(ii) Present value of the expected annual pension payments at the beginning of the current year: PV = FV (PVFn,i) PV = $5,368,064 (PVF15,8%) PV = $5,368,064 (0.31524) PV = $1,692,228

The company’s pension obligation (liability) is $1,692,228.

Exercises, Problems, Problem Solution Walkthrough Videos, and many more assessment tools and resources are available for practice in WileyPLUS.

1. What is the time value of money? Why should accoun- tants have an understanding of compound interest, annuities, and present value concepts?

2. Identify three situations in which accounting measures are based on present values. Do these present value applications involve single sums or annuities, or both single sums and annuities? Explain.

3. What is the nature of interest? Distinguish between “sim- ple interest” and “compound interest.”

4. What are the components of an interest rate? Why is it important for accountants to understand these components?

5. The following are a number of values taken from com- pound interest tables involving the same number of peri- ods and the same rate of interest. Indicate what each of these four values represents.

(a) 6.71008. (c) .46319.

(b) 2.15892. (d) 14.48656. 6. Jose Oliva is considering two investment options for a

$1,500 gift he received for graduation. Both investments have 8% annual interest rates. One offers quarterly com- pounding; the other compounds on a semiannual basis. Which investment should he choose? Why?

7. Regina Henry deposited $20,000 in a money market cer- tificate that provides interest of 10% compounded quar- terly if the amount is maintained for 3 years. How much will Regina have at the end of 3 years?

8. Will Smith will receive $80,000 5 years from now, from a trust fund established by his father. Assuming the appro- priate interest rate for discounting is 12% (compounded semiannually), what is the present value of this amount today?

9. What are the primary characteristics of an annuity? Differentiate between an “ordinary annuity” and an “annuity due.”

10. Kehoe, Inc. owes $40,000 to Ritter Company. How much would Kehoe have to pay each year if the debt is retired through four equal payments (made at the end of the year), given an interest rate on the debt of 12%? (Round to two decimal places.)

11. The Kellys are planning for a retirement home. They estimate they will need $200,000 4 years from now to pur- chase this home. Assuming an interest rate of 10%, what amount must be deposited at the end of each of the 4 years to fund the home price? (Round to two decimal places.)

12. Assume the same situation as in Question 11, except that the four equal amounts are deposited at the beginning of the period rather than at the end. In this case, what amount must be deposited at the beginning of each period? (Round to two decimals.)

13. Explain how the future value of an ordinary annuity interest table is converted to the future value of an annu- ity due interest table.

14. Explain how the present value of an ordinary annuity interest table is converted to the present value of an annuity due interest table.

15. In a book named Treasure, the reader has to figure out where a 2.2 pound, 24 kt gold horse has been buried. If the horse is found, a prize of $25,000 a year for 20 years is provided. The actual cost to the publisher to pur- chase an annuity to pay for the prize is $245,000. What interest rate (to the nearest percent) was used to deter- mine the amount of the annuity? (Assume end-of-year payments.)

16. Alexander Enterprises leases property to Hamilton, Inc. Because Hamilton is experiencing financial diffi- culty, Alexander agrees to receive five rents of $20,000 at the end of each year, with the rents deferred 3 years. What is the present value of the five rents discounted at 12%?

17. Answer the following questions.

(a) On May 1, 2017, Goldberg Company sold some ma- chinery to Newlin Company on an installment con- tract basis. The contract required five equal annual payments, with the first payment due on May 1, 2017. What present value concept is appropriate for this situation?

(b) On June 1, 2017, Seymour Inc. purchased a new ma- chine that it does not have to pay for until June 1, 2019. The total payment on June 1, 2019, will include both principal and interest. Assuming interest at a 12% rate, the cost of the machine would be the total payment multiplied by what time value of money concept?

(c) Costner Inc. wishes to know how much money it will have available in 5 years if five equal amounts of $35,000 are invested, with the first amount invested immediately. What interest table is appropriate for this situation?

(d) Megan Hoffman invests in a “jumbo” $200,000, 3-year certificate of deposit at First Wisconsin Bank. What table would be used to determine the amount accumulated at the end of 3 years?

18. Recently, Glenda Estes was interested in purchasing a Honda Acura. The salesperson indicated that the price of the car was either $27,600 cash or $6,900 at the end of each of 5 years. Compute the effective-interest rate to the nearest percent that Glenda would pay if she chooses to make the five annual payments.

19. Property/casualty insurance companies have been crit- icized because they reserve for the total loss as much as 5 years before it may happen. The IRS has joined the debate because it says the full reserve is unfair from a taxation viewpoint. What do you believe is the IRS position?

QUESTIONS

Questions 301

302 Chapter 6 Accounting and the Time Value of Money

BRIEF EXERCISES

(Unless instructed otherwise, round answers to the nearest dollar.)

BE6-1 (L02) Chris Spear invested $15,000 today in a fund that earns 8% compounded annually. To what amount will the investment grow in 3 years? To what amount would the investment grow in 3 years if the fund earns 8% annual interest com- pounded semiannually?

BE6-2 (L02) Tony Bautista needs $25,000 in 4 years. What amount must he invest today if his investment earns 12% com- pounded annually? What amount must he invest if his investment earns 12% annual interest compounded quarterly?

BE6-3 (L02) Candice Willis will invest $30,000 today. She needs $150,000 in 21 years. What annual interest rate must she earn?

BE6-4 (L02) Bo Newman will invest $10,000 today in a fund that earns 5% annual interest. How many years will it take for the fund to grow to $17,100?

BE6-5 (L03) Sally Medavoy will invest $8,000 a year for 20 years in a fund that will earn 6% annual interest. If the first pay- ment into the fund occurs today, what amount will be in the fund in 20 years? If the first payment occurs at year-end, what amount will be in the fund in 20 years?

BE6-6 (L03) Steve Madison needs $250,000 in 10 years. How much must he invest at the end of each year, at 5% interest, to meet his needs?

BE6-7 (L02) John Fillmore’s lifelong dream is to own his own fishing boat to use in his retirement. John has recently come into an inheritance of $400,000. He estimates that the boat he wants will cost $300,000 when he retires in 5 years. How much of his inheritance must he invest at an annual rate of 8% (compounded annually) to buy the boat at retirement?

BE6-8 (L02) Refer to the data in BE6-7. Assuming quarterly compounding of amounts invested at 8%, how much of John Fillmore’s inheritance must be invested to have enough at retirement to buy the boat?

BE6-9 (L03) Morgan Freeman is investing $9,069 at the end of each year in a fund that earns 5% interest. In how many years will the fund be at $100,000?

BE6-10 (L04) Henry Quincy wants to withdraw $30,000 each year for 10 years from a fund that earns 8% interest. How much must he invest today if the first withdrawal is at year-end? How much must he invest today if the first withdrawal takes place immediately?

BE6-11 (L04) Leon Tyler’s VISA balance is $793.15. He may pay it off in 12 equal end-of-month payments of $75 each. What interest rate is Leon paying?

BE6-12 (L04) Maria Alvarez is investing $300,000 in a fund that earns 4% interest compounded annually. What equal amounts can Maria withdraw at the end of each of the next 20 years?

BE6-13 (L03) Adams Inc. will deposit $30,000 in a 6% fund at the end of each year for 8 years beginning December 31, 2017. What amount will be in the fund immediately after the last deposit?

BE6-14 (L04) Amy Monroe wants to create a fund today that will enable her to withdraw $25,000 per year for 8 years, with the first withdrawal to take place 5 years from today. If the fund earns 8% interest, how much must Amy invest today?

BE6-15 (L05) Clancey Inc. issues $2,000,000 of 7% bonds due in 10 years with interest payable at year-end. The current mar- ket rate of interest for bonds of similar risk is 8%. What amount will Clancey receive when it issues the bonds?

BE6-16 (L04) Zach Taylor is settling a $20,000 loan due today by making 6 equal annual payments of $4,727.53. Determine the interest rate on this loan, if the payments begin one year after the loan is signed.

BE6-17 (L04) Consider the loan in BE6-16. What payments must Zach Taylor make to settle the loan at the same interest rate but with the 6 payments beginning on the day the loan is signed?

EXERCISES

(Unless instructed otherwise, round answers to the nearest dollar. Interest rates are per annum unless otherwise indicated.)

E6-1 (L01) (Using Interest Tables) For each of the following cases, indicate (a) to what rate columns, and (b) to what number of periods you would refer in looking up the interest factor.

Exercises 303

E6-2 (L01,2) EXCEL (Simple and Compound Interest Computations) Alan Jackson invests $20,000 at 8% annual interest, leaving the money invested without withdrawing any of the interest for 8 years. At the end of the 8 years, Alan withdraws the accumulated amount of money.

Instructions (a) Compute the amount Alan would withdraw assuming the investment earns simple interest. (b) Compute the amount Alan would withdraw assuming the investment earns interest compounded annually. (c) Compute the amount Alan would withdraw assuming the investment earns interest compounded semiannually.

E6-3 (L02,3,4) EXCEL (Computation of Future Values and Present Values) Using the appropriate interest table, answer each of the following questions. (Each case is independent of the others.)

(a) What is the future value of $7,000 at the end of 5 periods at 8% compounded interest? (b) What is the present value of $7,000 due 8 periods hence, discounted at 6%? (c) What is the future value of 15 periodic payments of $7,000 each made at the end of each period and compounded at 10%? (d) What is the present value of $7,000 to be received at the end of each of 20 periods, discounted at 5% compound interest?

E6-4 (L03,4) (Computation of Future Values and Present Values) Using the appropriate interest table, answer the following questions. (Each case is independent of the others).

(a) What is the future value of 20 periodic payments of $4,000 each made at the beginning of each period and compounded at 8%? (b) What is the present value of $2,500 to be received at the beginning of each of 30 periods, discounted at 5% compound interest? (c) What is the future value of 15 deposits of $2,000 each made at the beginning of each period and compounded at 10%?

(Future value as of the end of the fifteenth period.) (d) What is the present value of six receipts of $1,000 each received at the beginning of each period, discounted at 9% com-

pounded interest?

E6-5 (L04) (Computation of Present Value) Using the appropriate interest table, compute the present values of the following periodic amounts due at the end of the designated periods.

(a) $30,000 receivable at the end of each period for 8 periods compounded at 12%. (b) $30,000 payments to be made at the end of each period for 16 periods at 9%. (c) $30,000 payable at the end of the seventh, eighth, ninth, and tenth periods at 12%.

E6-6 (L02,3,4) (Future Value and Present Value Problems) Presented below are three unrelated situations. (a) Dwayne Wade Company recently signed a lease for a new office building, for a lease period of 10 years. Under the lease

agreement, a security deposit of $12,000 is made, with the deposit to be returned at the expiration of the lease, with interest compounded at 5% per year. What amount will the company receive at the time the lease expires?

(b) Serena Williams Corporation, having recently issued a $20 million, 15-year bond issue, is committed to make annual sinking fund deposits of $600,000. The deposits are made on the last day of each year and yield a return of 10%. Will the fund at the end of 15 years be sufficient to retire the bonds? If not, what will the deficiency be?

(c) Under the terms of his salary agreement, president Rex Walters has an option of receiving either an immediate bonus of $55,000, or a deferred bonus of $70,000 payable in 10 years. Ignoring tax considerations and assuming a relevant interest rate of 4%, which form of settlement should Walters accept?

1. In a future value of 1 table

Annual Number of Rate Years Invested Compounded

a. 9% 9 Annually b. 12% 5 Quarterly c. 10% 15 Semiannually

2. In a present value of an annuity of 1 table

Annual Number of Number of Frequency of Rate Years Involved Rents Involved Rents

a. 9% 25 25 Annually b. 10% 15 30 Semiannually c. 12% 7 28 Quarterly

304 Chapter 6 Accounting and the Time Value of Money

E6-7 (L05) (Computation of Bond Prices) What would you pay for a $100,000 debenture bond that matures in 15 years and pays $5,000 a year in interest if you wanted to earn a yield of:

(a) 4%? (b) 5%? (c) 6%?

E6-8 (L05) (Computations for a Retirement Fund) Clarence Weatherspoon, a super salesman contemplating retirement on his fifty-fifth birthday, decides to create a fund on an 8% basis that will enable him to withdraw $20,000 per year on June 30, beginning in 2021 and continuing through 2024. To develop this fund, Clarence intends to make equal contributions on June 30 of each of the years 2017–2020.

Instructions (a) How much must the balance of the fund equal on June 30, 2020, in order for Clarence to satisfy his objective? (b) What are each of Clarence’s contributions to the fund?

E6-9 (L02) (Unknown Rate) LEW Company purchased a machine at a price of $100,000 by signing a note payable, which requires a single payment of $123,210 in 2 years. Assuming annual compounding of interest, what rate of interest is being paid on the loan?

E6-10 (L02) (Unknown Periods and Unknown Interest Rate) Consider the following independent situations. (a) Mike Finley wishes to become a millionaire. His money market fund has a balance of $92,296 and has a guaranteed

interest rate of 10%. How many years must Mike leave that balance in the fund in order to get his desired $1,000,000? (b) Assume that Sally Williams desires to accumulate $1 million in 15 years using her money market fund balance of

$182,696. At what interest rate must Sally’s investment compound annually?

E6-11 (L04) (Evaluation of Purchase Options) Sosa Excavating Inc. is purchasing a bulldozer. The equipment has a price of $100,000. The manufacturer has offered a payment plan that would allow Sosa to make 10 equal annual payments of $16,274.53, with the first payment due one year after the purchase.

Instructions (a) How much total interest will Sosa pay on this payment plan? (b) Sosa could borrow $100,000 from its bank to finance the purchase at an annual rate of 9%. Should Sosa borrow from the

bank or use the manufacturer’s payment plan to pay for the equipment?

E6-12 (L04) (Analysis of Alternatives) The Black Knights Inc., a manufacturer of low-sugar, low-sodium, low-cholesterol TV dinners, would like to increase its market share in the Sunbelt. In order to do so, Black Knights has decided to locate a new factory in the Panama City area. Black Knights will either buy or lease a site depending upon which is more advantageous. The site loca- tion committee has narrowed down the available sites to the following three very similar buildings that will meet their needs.

Building A: Purchase for a cash price of $600,000, useful life 25 years. Building B: Lease for 25 years with annual lease payments of $69,000 being made at the beginning of the year. Building C: Purchase for $650,000 cash. This building is larger than needed; however, the excess space can be sublet for 25 years at a net annual rental of $7,000. Rental payments will be received at the end of each year. The Black Knights Inc. has no aversion to being a landlord.

Instructions In which building would you recommend that The Black Knights Inc. locate, assuming a 12% cost of funds?

E6-13 (L05) (Computation of Bond Liability) Hincapie Inc. manufactures cycling equipment. Recently, the vice president of operations of the company has requested construction of a new plant to meet the increasing demand for the company’s bikes. After a careful evaluation of the request, the board of directors has decided to raise funds for the new plant by issuing $2,000,000 of 11% term corporate bonds on March 1, 2017, due on March 1, 2032, with interest payable each March 1 and September 1. At the time of issuance, the market interest rate for similar financial instruments is 10%.

Instructions As the controller of the company, determine the selling price of the bonds. E6-14 (L05) (Computation of Pension Liability) Nerwin, Inc. is a furniture manufacturing company with 50 employees. Recently, after a long negotiation with the local labor union, the company decided to initiate a pension plan as a part of its com- pensation plan. The plan will start on January 1, 2017. Each employee covered by the plan is entitled to a pension payment each year after retirement. As required by accounting standards, the controller of the company needs to report the pension obligation (liability). On the basis of a discussion with the supervisor of the Personnel Department and an actuary from an insurance com- pany, the controller develops the following information related to the pension plan.

Average length of time to retirement 15 years Expected life duration after retirement 10 years Total pension payment expected each year after retirement for all employees. Payment made at the end of the year. $700,000 per year

The interest rate to be used is 8%.

Instructions On the basis of the information above, determine the present value of the pension obligation (liability).

E6-15 (L02,3) (Investment Decision) Andrew Bogut just received a signing bonus of $1,000,000. His plan is to invest this payment in a fund that will earn 8%, compounded annually.

Instructions (a) If Bogut plans to establish the AB Foundation once the fund grows to $1,999,000, how many years until he can establish

the foundation? (b) Instead of investing the entire $1,000,000, Bogut invests $300,000 today and plans to make 9 equal annual investments

into the fund beginning one year from today. What amount should the payments be if Bogut plans to establish the $1,999,000 foundation at the end of 9 years?

E6-16 (L03) (Retirement of Debt) Ricky Fowler borrowed $70,000 on March 1, 2015. This amount plus accrued interest at 6% compounded semiannually is to be repaid March 1, 2025. To retire this debt, Ricky plans to contribute to a debt retirement fund five equal amounts starting on March 1, 2020, and for the next 4 years. The fund is expected to earn 5% per annum.

Instructions How much must be contributed each year by Ricky Fowler to provide a fund sufficient to retire the debt on March 1, 2025?

E6-17 (L04) (Computation of Amount of Rentals) Your client, Keith Moreland Leasing Company, is preparing a contract to lease a machine to Souvenirs Corporation for a period of 25 years. Moreland has an investment cost of $365,755 in the machine, which has a useful life of 25 years and no salvage value at the end of that time. Your client is interested in earning an 11% return on its investment and has agreed to accept 25 equal rental payments at the end of each of the next 25 years.

Instructions You are requested to provide Moreland with the amount of each of the 25 rental payments that will yield an 11% return on investment.

E6-18 (L04) (Least Costly Payoff) Assume that Sonic Foundry Corporation has a contractual debt outstanding. Sonic has available two means of settlement. It can either make immediate payment of $2,600,000, or it can make annual payments of $300,000 for 15 years, each payment due on the last day of the year.

Instructions Which method of payment do you recommend, assuming an expected effective interest rate of 8% during the future period?

E6-19 (L04) (Least Costly Payoff) Assuming the same facts as those in E6-18 except that the payments must begin now and be made on the first day of each of the 15 years, what payment method would you recommend?

E6-20 (L05) (Expected Cash Flows) For each of the following, determine the expected cash flows. Cash Flow Probability Estimate Assessment

(a) $ 4,800 20% 6,300 50% 7,500 30%

(b) $ 5,400 30% 7,200 50% 8,400 20%

E6-21 (L05) (Expected Cash Flows and Present Value) Keith Bowie is trying to determine the amount to set aside so that he will have enough money on hand in 2 years to overhaul the engine on his vintage used car. While there is some uncertainty about the cost of engine overhauls in 2 years, by conducting some research online, Keith has developed the following estimates.

Engine Overhaul Probability Estimated Cash Outfl ow Assessment

$200 10% 450 30% 600 50% 750 10%

Exercises 305

306 Chapter 6 Accounting and the Time Value of Money

Instructions How much should Keith Bowie deposit today in an account earning 6%, compounded annually, so that he will have enough money on hand in 2 years to pay for the overhaul?

E6-22 (L05) (Fair Value Estimate) Killroy Company owns a trade name that was purchased in an acquisition of McClellan Company. The trade name has a book value of $3,500,000, but according to GAAP, it is assessed for impairment on an annual basis. To perform this impairment test, Killroy must estimate the fair value of the trade name. (You will learn more about intangible asset impairments in Chapter 12.) It has developed the following cash flow estimates related to the trade name based on internal information. Each cash flow estimate reflects Killroy’s estimate of annual cash flows over the next 8 years. The trade name is assumed to have no salvage value after the 8 years. (Assume the cash flows occur at the end of each year.)

Probability Cash Flow Estimate Assessment

$380,000 20% 630,000 50% 750,000 30%

Instructions (a) What is the estimated fair value of the trade name? Killroy determines that the appropriate discount rate for this estima-

tion is 8%. (b) Is the estimate developed for part (a) a Level 1 or Level 3 fair value estimate? Explain.

PROBLEMS

(Unless instructed otherwise, round answers to the nearest dollar. Interest rates are per annum unless otherwise indicated.)

P6-1 (L02,4) GROUPWORK (Various Time Value Situations) Answer each of these unrelated questions. (a) On January 1, 2017, Fishbone Corporation sold a building that cost $250,000 and that had accumulated depreciation of

$100,000 on the date of sale. Fishbone received as consideration a $240,000 non-interest-bearing note due on January 1, 2020. There was no established exchange price for the building, and the note had no ready market. The prevailing rate of interest for a note of this type on January 1, 2017, was 9%. At what amount should the gain from the sale of the building be reported?

(b) On January 1, 2017, Fishbone Corporation purchased 300 of the $1,000 face value, 9%, 10-year bonds of Walters Inc. The bonds mature on January 1, 2027, and pay interest annually beginning January 1, 2018. Fishbone purchased the bonds to yield 11%. How much did Fishbone pay for the bonds?

(c) Fishbone Corporation bought a new machine and agreed to pay for it in equal annual installments of $4,000 at the end of each of the next 10 years. Assuming that a prevailing interest rate of 8% applies to this contract, how much should Fishbone record as the cost of the machine?

(d) Fishbone Corporation purchased a special tractor on December 31, 2017. The purchase agreement stipulated that Fish- bone should pay $20,000 at the time of purchase and $5,000 at the end of each of the next 8 years. The tractor should be recorded on December 31, 2017, at what amount, assuming an appropriate interest rate of 12%?

(e) Fishbone Corporation wants to withdraw $120,000 (including principal) from an investment fund at the end of each year for 9 years. What should be the required initial investment at the beginning of the first year if the fund earns 11%?

P6-2 (L02,3,4) GROUPWORK EXCEL (Various Time Value Situations) Using the appropriate interest table, provide the solution to each of the following four questions by computing the unknowns.

(a) What is the amount of the payments that Ned Winslow must make at the end of each of 8 years to accumulate a fund of $90,000 by the end of the eighth year, if the fund earns 8% interest, compounded annually?

(b) Robert Hitchcock is 40 years old today and he wishes to accumulate $500,000 by his sixty-fifth birthday so he can retire to his summer place on Lake Hopatcong. He wishes to accumulate this amount by making equal deposits on his fortieth through his sixty-fourth birthdays. What annual deposit must Robert make if the fund will earn 8% interest com- pounded annually?

(c) Diane Ross has $20,000 to invest today at 9% to pay a debt of $47,347. How many years will it take her to accumulate enough to liquidate the debt?

(d) Cindy Houston has a $27,600 debt that she wishes to repay 4 years from today; she has $19,553 that she intends to invest for the 4 years. What rate of interest will she need to earn annually in order to accumulate enough to pay the debt?

P6-3 (L02,4) (Analysis of Alternatives) Assume that Wal-Mart Stores, Inc. has decided to surface and maintain for 10 years a vacant lot next to one of its stores to serve as a parking lot for customers. Management is considering the following bids involv- ing two different qualities of surfacing for a parking area of 12,000 square yards.

Bid A: A surface that costs $5.75 per square yard to install. This surface will have to be replaced at the end of 5 years. The annual maintenance cost on this surface is estimated at 25 cents per square yard for each year except the last year of its service. The replacement surface will be similar to the initial surface. Bid B: A surface that costs $10.50 per square yard to install. This surface has a probable useful life of 10 years and will require annual maintenance in each year except the last year, at an estimated cost of 9 cents per square yard.

Instructions Prepare computations showing which bid should be accepted by Wal-Mart. You may assume that the cost of capital is 9%, that the annual maintenance expenditures are incurred at the end of each year, and that prices are not expected to change during the next 10 years.

P6-4 (L04) EXCEL (Evaluating Payment Alternatives) Howie Long has just learned he has won a $500,000 prize in the lot- tery. The lottery has given him two options for receiving the payments. (1) If Howie takes all the money today, the state and federal governments will deduct taxes at a rate of 46% immediately. (2) Alternatively, the lottery offers Howie a payout of 20 equal payments of $36,000 with the first payment occurring when Howie turns in the winning ticket. Howie will be taxed on each of these payments at a rate of 25%.

Instructions Assuming Howie can earn an 8% rate of return (compounded annually) on any money invested during this period, which pay- out option should he choose?

P6-5 (L02,4) (Analysis of Alternatives) Julia Baker died, leaving to her husband Brent an insurance policy contract that provides that the beneficiary (Brent) can choose any one of the following four options.

(a) $55,000 immediate cash. (b) $4,000 every 3 months payable at the end of each quarter for 5 years. (c) $18,000 immediate cash and $1,800 every 3 months for 10 years, payable at the beginning of each 3-month period. (d) $4,000 every 3 months for 3 years and $1,500 each quarter for the following 25 quarters, all payments payable at the end

of each quarter.

Instructions If money is worth 2½% per quarter, compounded quarterly, which option would you recommend that Brent exercise?

P6-6 (L05) (Purchase Price of a Business) During the past year, Stacy McGill planted a new vineyard on 150 acres of land that she leases for $30,000 a year. She has asked you, as her accountant, to assist her in determining the value of her vineyard operation.

The vineyard will bear no grapes for the first 5 years (1–5). In the next 5 years (6–10), Stacy estimates that the vines will bear grapes that can be sold for $60,000 each year. For the next 20 years (11–30), she expects the harvest will provide annual revenues of $110,000. But during the last 10 years (31–40) of the vineyard’s life, she estimates that revenues will decline to $80,000 per year.

During the first 5 years, the annual cost of pruning, fertilizing, and caring for the vineyard is estimated at $9,000; during the years of production, 6–40, these costs will rise to $12,000 per year. The relevant market rate of interest for the entire period is 6%. Assume that all receipts and payments are made at the end of each year.

Instructions Dick Button has offered to buy Stacy’s vineyard business by assuming the 40-year lease. On the basis of the current value of the business, what is the minimum price Stacy should accept?

P6-7 (L02,3,4) (Time Value Concepts Applied to Solve Business Problems) Answer the following questions related to Dubois Inc.

Problems 307

308 Chapter 6 Accounting and the Time Value of Money

(a) Dubois Inc. has $600,000 to invest. The company is trying to decide between two alternative uses of the funds. One alternative provides $80,000 at the end of each year for 12 years, and the other is to receive a single lump-sum payment of $1,900,000 at the end of the 12 years. Which alternative should Dubois select? Assume the interest rate is constant over the entire investment.

(b) Dubois Inc. has completed the purchase of new Dell computers. The fair value of the equipment is $824,150. The purchase agreement specifies an immediate down payment of $200,000 and semiannual payments of $76,952 begin- ning at the end of 6 months for 5 years. What is the interest rate, to the nearest percent, used in discounting this purchase transaction?

(c) Dubois Inc. loans money to John Kruk Corporation in the amount of $800,000. Dubois accepts an 8% note due in 7 years with interest payable semiannually. After 2 years (and receipt of interest for 2 years), Dubois needs money and therefore sells the note to Chicago National Bank, which demands interest on the note of 10% compounded semiannually. What is the amount Dubois will receive on the sale of the note?

(d) Dubois Inc. wishes to accumulate $1,300,000 by December 31, 2027, to retire bonds outstanding. The company deposits $200,000 on December 31, 2017, which will earn interest at 10% compounded quarterly, to help in the retirement of this debt. In addition, the company wants to know how much should be deposited at the end of each quarter for 10 years to ensure that $1,300,000 is available at the end of 2027. (The quarterly deposits will also earn at a rate of 10%, com- pounded quarterly.) (Round to even dollars.)

P6-8 (L04) (Analysis of Alternatives) Ellison Inc., a manufacturer of steel school lockers, plans to purchase a new punch press for use in its manufacturing process. After contacting the appropriate vendors, the purchasing department received differ- ing terms and options from each vendor. The Engineering Department has determined that each vendor’s punch press is sub- stantially identical and each has a useful life of 20 years. In addition, Engineering has estimated that required year-end mainte- nance costs will be $1,000 per year for the first 5 years, $2,000 per year for the next 10 years, and $3,000 per year for the last 5 years. Following is each vendor’s sales package.

Vendor A: $55,000 cash at time of delivery and 10 year-end payments of $18,000 each. Vendor A offers all its custom- ers the right to purchase at the time of sale a separate 20-year maintenance service contract, under which Vendor A will perform all year-end maintenance at a one-time initial cost of $10,000. Vendor B: Forty semiannual payments of $9,500 each, with the fi rst installment due upon delivery. Vendor B will per- form all year-end maintenance for the next 20 years at no extra charge. Vendor C: Full cash price of $150,000 will be due upon delivery.

Instructions Assuming that both Vendors A and B will be able to perform the required year-end maintenance, that Ellison’s cost of funds is 10%, and the machine will be purchased on January 1, from which vendor should the press be purchased?

P6-9 (L02,4) (Analysis of Business Problems) James Kirk is a financial executive with McDowell Enterprises. Although James Kirk has not had any formal training in finance or accounting, he has a “good sense” for numbers and has helped the company grow from a very small company ($500,000 sales) to a large operation ($45 million in sales). With the business growing steadily, however, the company needs to make a number of difficult financial decisions in which James Kirk feels a little “over his head.” He therefore has decided to hire a new employee with “numbers” expertise to help him. As a basis for determining whom to employ, he has decided to ask each prospective employee to prepare answers to questions relating to the following situations he has encountered recently. Here are the questions.

(a) In 2016, McDowell Enterprises negotiated and closed a long-term lease contract for newly constructed truck terminals and freight storage facilities. The buildings were constructed on land owned by the company. On January 1, 2017, McDowell took possession of the leased property. The 20-year lease is effective for the period January 1, 2017, through December 31, 2036. Advance rental payments of $800,000 are payable to the lessor (owner of facilities) on January 1 of each of the first 10 years of the lease term. Advance payments of $400,000 are due on January 1 for each of the last 10 years of the lease term. McDowell has an option to purchase all the leased facilities for $1 on December 31, 2036. At the time the lease was negotiated, the fair value of the truck terminals and freight storage facilities was approximately $7,200,000. If the company had borrowed the money to purchase the facilities, it would have had to pay 10% interest. Should the company have purchased rather than leased the facilities?

(b) Last year the company exchanged a piece of land for a non-interest-bearing note. The note is to be paid at the rate of $15,000 per year for 9 years, beginning one year from the date of disposal of the land. An appropriate rate of interest for the note was 11%. At the time the land was originally purchased, it cost $90,000. What is the fair value of the note?

(c) The company has always followed the policy to take any cash discounts on goods purchased. Recently, the company purchased a large amount of raw materials at a price of $800,000 with terms 1/10, n/30 on which it took the discount.

McDowell has recently estimated its cost of funds at 10%. Should McDowell continue this policy of always taking the cash discount?

P6-10 (L02,4) (Analysis of Lease vs. Purchase) Dunn Inc. owns and operates a number of hardware stores in the New Eng- land region. Recently, the company has decided to locate another store in a rapidly growing area of Maryland. The company is trying to decide whether to purchase or lease the building and related facilities.

Purchase: The company can purchase the site, construct the building, and purchase all store fi xtures. The cost would be $1,850,000. An immediate down payment of $400,000 is required, and the remaining $1,450,000 would be paid off over 5 years at $350,000 per year (including interest payments made at end of year). The property is expected to have a useful life of 12 years, and then it will be sold for $500,000. As the owner of the property, the company will have the following out- of-pocket expenses each period.

Property taxes (to be paid at the end of each year) $40,000 Insurance (to be paid at the beginning of each year) 27,000 Other (primarily maintenance which occurs at the end of each year) 16,000

$83,000

Lease: First National Bank has agreed to purchase the site, construct the building, and install the appropriate fi xtures for Dunn Inc. if Dunn will lease the completed facility for 12 years. The annual costs for the lease would be $270,000. Dunn would have no responsibility related to the facility over the 12 years. The terms of the lease are that Dunn would be required to make 12 annual payments (the fi rst payment to be made at the time the store opens and then each following year). In addition, a deposit of $100,000 is required when the store is opened. This deposit will be returned at the end of the twelfth year, assuming no unusual damage to the building structure or fi xtures.

Instructions Which of the two approaches should Dunn Inc. follow? (Currently, the cost of funds for Dunn Inc. is 10%.)

P6-11 (L05) (Pension Funding) You have been hired as a benefit consultant by Jean Honore, the owner of Attic Angels. She wants to establish a retirement plan for herself and her three employees. Jean has provided the following information. The retire- ment plan is to be based upon annual salary for the last year before retirement and is to provide 50% of Jean’s last-year annual salary and 40% of the last-year annual salary for each employee. The plan will make annual payments at the beginning of each year for 20 years from the date of retirement. Jean wishes to fund the plan by making 15 annual deposits beginning January 1, 2017. Invested funds will earn 12% compounded annually. Information about plan participants as of January 1, 2017, is as follows.

Jean Honore, owner: Current annual salary of $48,000; estimated retirement date January 1, 2042. Colin Davis, fl ower arranger: Current annual salary of $36,000; estimated retirement date January 1, 2047. Anita Baker, sales clerk: Current annual salary of $18,000; estimated retirement date January 1, 2037. Gavin Bryars, part-time bookkeeper: Current annual salary of $15,000; estimated retirement date January 1, 2032.

In the past, Jean has given herself and each employee a year-end salary increase of 4%. Jean plans to continue this policy in the future.

Instructions (a) Based upon the above information, what will be the annual retirement benefit for each plan participant? (Round to the

nearest dollar.) (Hint: Jean will receive raises for 24 years.) (b) What amount must be on deposit at the end of 15 years to ensure that all benefits will be paid? (Round to the nearest dollar.) (c) What is the amount of each annual deposit Jean must make to the retirement plan?

P6-12 (L05) ETHICS (Pension Funding) Craig Brokaw, newly appointed controller of STL, is considering ways to reduce his company’s expenditures on annual pension costs. One way to do this is to switch STL’s pension fund assets from First Secu- rity to NET Life. STL is a very well-respected computer manufacturer that recently has experienced a sharp decline in its finan- cial performance for the first time in its 25-year history. Despite financial problems, STL still is committed to providing its employees with good pension and postretirement health benefits.

Under its present plan with First Security, STL is obligated to pay $43 million to meet the expected value of future pension benefits that are payable to employees as an annuity upon their retirement from the company. On the other hand, NET Life requires STL to pay only $35 million for identical future pension benefits. First Security is one of the oldest and most reputable insurance companies in North America. NET Life has a much weaker reputation in the insurance industry. In pondering the significant difference in annual pension costs, Brokaw asks himself, “Is this too good to be true?”

Problems 309

310 Chapter 6 Accounting and the Time Value of Money

Instructions Answer the following questions.

(a) Why might NET Life’s pension cost requirement be $8 million less than First Security’s requirement for the same future value?

(b) What ethical issues should Craig Brokaw consider before switching STL’s pension fund assets? (c) Who are the stakeholders that could be affected by Brokaw’s decision?

P6-13 (L04,5) (Expected Cash Flows and Present Value) Danny’s Lawn Equipment sells high-quality lawn mowers and offers a 3-year warranty on all new lawn mowers sold. In 2017, Danny sold $300,000 of new specialty mowers for golf greens for which Danny’s service department does not have the equipment to do the service. Danny has entered into an agreement with Mower Mavens to provide all warranty service on the special mowers sold in 2017. Danny wishes to measure the fair value of the agreement to determine the warranty liability for sales made in 2017. The controller for Danny’s Lawn Equipment estimates the following expected warranty cash outflows associated with the mowers sold in 2017.

Cash Flow Probability Year Estimate Assessment

2018 $2,500 20% 4,000 60% 5,000 20%

2019 $3,000 30% 5,000 50% 6,000 20%

2020 $4,000 30% 6,000 40% 7,000 30%

Net Cash Flow Probability Year Estimate Assessment

2018 $6,000 40% 9,000 60%

2019 $ (500) 20% 2,000 60% 4,000 20%

Scrap Value

2019 $ 500 50% 900 50%

Instructions Using expected cash flow and present value techniques, determine the value of the warranty liability for the 2017 sales. Use an annual discount rate of 5%. Assume all cash flows occur at the end of the year.

P6-14 (L04,5) (Expected Cash Flows and Present Value) At the end of 2017, Sawyer Company is conducting an impair- ment test and needs to develop a fair value estimate for machinery used in its manufacturing operations. Given the nature of Sawyer’s production process, the equipment is for special use. (No secondhand market values are available.) The equip- ment will be obsolete in 2 years, and Sawyer’s accountants have developed the following cash flow information for the equipment.

Instructions Using expected cash flow and present value techniques, determine the fair value of the machinery at the end of 2017. Use a 6% discount rate. Assume all cash flows occur at the end of the year.

Using Your Judgment 311

P6-15 (L05) (Fair Value Estimate) Murphy Mining Company recently purchased a quartz mine that it intends to work for the next 10 years. According to state environmental laws, Murphy must restore the mine site to its original natural prairie state after it ceases mining operations at the site. To properly account for the mine, Murphy must estimate the fair value of this asset retire- ment obligation. This amount will be recorded as a liability and added to the value of the mine on Murphy’s books. (You will learn more about these asset retirement obligations in Chapters 10 and 13.)

There is no active market for retirement obligations such as these, but Murphy has developed the following cash flow estimates based on its prior experience in mining-site restoration. It will take 3 years to restore the mine site when mining operations cease in 10 years. Each estimated cash outflow reflects an annual payment at the end of each year of the 3-year res- toration period.

Restoration Estimated Probability Cash Outflow Assessment

$15,000 10% 22,000 30% 25,000 50% 30,000 10%

Instructions (a) What is the estimated fair value of Murphy’s asset retirement obligation? Murphy determines that the appropriate

discount rate for this estimation is 5%. Round calculations to the nearest dollar. (b) Is the estimate developed for part (a) a Level 1 or Level 3 fair value estimate? Explain.

USING YOUR JUDGMENT

Instructions

(a) Examining each item in P&G’s balance sheet, identify those items that require present value, discounting, or inter- est computations in establishing the amount reported. (The accompanying notes are an additional source for this information.)

(b) (1) What interest rates are disclosed by P&G as being used to compute interest and present values? (2) Why are there so many different interest rates applied to P&G’s financial statement elements (assets, liabilities, revenues, and expenses)?

Financial Statement Analysis Case Consolidated Natural Gas Company Consolidated Natural Gas Company (CNG), with corporate headquarters in Pittsburgh, Pennsylvania, is one of the largest producers, transporters, distributors, and marketers of natural gas in North America. Periodically, the company experiences a decrease in the value of its gas- and oil-producing properties, and a special charge to income was recorded in order to reduce the carrying value of those assets. Assume the following information. In 2016, CNG estimated the cash inflows from its oil- and gas-producing properties to be $375,000 per year. During 2017, the write-downs described above caused the estimate to be decreased to $275,000 per year. Production costs (cash outflows) associated with all these properties were estimated to be $125,000 per year in 2016, but this amount was revised to $155,000 per year in 2017.

Instructions (Assume that all cash flows occur at the end of the year.)

(a) Calculate the present value of net cash flows for 2016–2018 (three years), using the 2016 estimates and a 10% discount factor.

(b) Calculate the present value of net cash flows for 2017–2019 (three years), using the 2017 estimates and a 10% discount factor.

312 Chapter 6 Accounting and the Time Value of Money

(c) Compare the results using the two estimates. Is information on future cash flows from oil- and gas-producing proper- ties useful, considering that the estimates must be revised each year? Explain.

Accounting, Analysis, and Principles Johnson Co. accepts a note receivable from a customer in exchange for some damaged inventory. The note requires the customer make semiannual installments of $50,000 each for 10 years. The first installment begins six months from the date the customer takes delivery of the damaged inventory. Johnson’s management estimates that the fair value of the damaged inventory is $679,517.

Accounting

(a) What interest rate is Johnson implicitly charging the customer? Express the rate as an annual rate but assume semian- nual compounding.

(b) At what dollar amount do you think Johnson should record the note receivable on the day the customer takes delivery of the damaged inventory?

Analysis Assume the note receivable for damaged inventory makes up a significant portion of Johnson’s assets. If interest rates increase, what happens to the fair value of the receivable? Briefly explain why.

Principles The Financial Accounting Standards Board has issued an accounting standard that allows companies to report assets such as notes receivable at fair value. Discuss how fair value versus historical cost potentially involves a trade-off of one desired quality of accounting information against another.

FASB Codifi cation References [1] FASB ASC 820-10. [Predecessor literature: “Fair Value Measurement,” Statement of Financial Accounting Standards No. 157

(Norwalk, Conn.: FASB, September 2006).] [2] FASB ASC 310-10. [Predecessor literature: “Accounting by Creditors for Impairment of a Loan,” FASB Statement No. 114

(Norwalk, Conn.: FASB, May 1993).] [3] FASB ASC 840-30-30. [Predecessor literature: “Accounting for Leases,” FASB Statement No. 13 as amended and interpreted

through May 1980 (Stamford, Conn.: FASB, 1980).] [4] FASB ASC 715-30-35. [Predecessor literature: “Employers’ Accounting for Pension Plans,” Statement of Financial Accounting

Standards No. 87 (Stamford, Conn.: FASB, 1985).] [5] FASB ASC 360-10-35. [Predecessor literature: “Accounting for the Impairment or Disposal of Long-Lived Assets,” Statement

of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001).] [6] FASB ASC 718-10-10. [Predecessor literature: “Accounting for Stock-Based Compensation,” Statement of Financial Account-

ing Standards No. 123 (Norwalk, Conn: FASB, 1995); and “Share-Based Payment,” Statement of Financial Accounting Standard No. 123(R) (Norwalk, Conn.: FASB, 2004).]

Codifi cation Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE6-1 Access the glossary (“Master Glossary”) to answer the following.

(a) What is the definition of present value? (b) Briefly describe the term “discount rate adjustment technique.”

CE6-2 In addition to the list of topics identified in footnote 1 on page 268, identify the specific Codification guidance related to the use of present value in goodwill impairment. CE6-3 What is interest cost? Briefly describe imputation of interest.

BRIDGE TO THE PROFESSION

Bridge to the Profession 313

Codifi cation Research Case At a recent meeting of the accounting staff in your company, the controller raised the issue of using present value techniques to conduct impairment tests for some of the company’s fixed assets. Some of the more senior members of the staff admitted having little knowledge of present value concepts in this context, but they had heard about a FASB Concepts Statement that may be relevant. As the junior staff in the department, you have been asked to conduct some research of the authoritative literature on this topic and report back at the staff meeting next week.

Instructions If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and access the FASB State- ments of Financial Accounting Concepts. When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following items. (Provide paragraph citations.)

(a) Identify the concept statement that addresses present value measurement in accounting. (b) What are some of the contexts in which present value concepts are applied in accounting measurement? (c) Provide definitions for the following terms:

(1) Best estimate. (2) Estimated cash flow (contrasted to expected cash flow). (3) Fresh-start measurement. (4) Interest methods of allocation.

ADDITIONAL PROFESSIONAL RESOURCES Go to WileyPLUS for other career-readiness resources, such as career coaching, internship opportunities, and CPAexcel prep.

314 Chapter 6 Accounting and the Time Value of Money

Future Value of 1 315

316 Chapter 6 Accounting and the Time Value of Money

Present Value of 1 317

318 Chapter 6 Accounting and the Time Value of Money

Future Value of an Ordinary Annuity of 1 319

320 Chapter 6 Accounting and the Time Value of Money

Present Value of an Ordinary Annuity of 1 321

322 Chapter 6 Accounting and the Time Value of Money

Present Value of an Annuity Due of 1 323

LUCK OF THE IRISH At one time, Apple executives explained what they were planning to do with their $98 billion in cash (pay a $2.65 dividend and buy back some of their shares). However, what they were really talking about was not the full $98 billion but the $34 billion the company has here in the United States. The other $64 billion is sitting in overseas subsidiaries and may never find its way back to the United States. The reason: U.S. tax laws allow companies to defer taxes on their profits from international operations until they bring the cash back into the country.

So what do many companies do? Either the cash just sits there in foreign bank accounts or is reinvested in factories and acquisitions overseas. After all, why should a company send its cash back to the United States when it can reinvest this cash overseas without any tax payments? As a result, companies have the incentive to move as much of their earnings overseas to low-tax jurisdictions such as a country like Ireland. As one expert noted, it cannot be the luck of the Irish that explains the extraordinary and systematic profitability of Irish sub- sidiaries of U.S. companies.

So when investors analyze an annual report and find a company reporting a large cash balance, they may believe that this cash is available for increased dividends or for acquisitions in the United States. But that is not necessarily so—much of the cash may be overseas and may never return. Unfortunately, the problem is getting bigger, not smaller. Untaxed foreign earnings are now growing at a much faster rate than earnings generated in the United States. For example, in a recent five-year period, the accumulated untaxed foreign earnings have reached over $2 trillion. A majority of these earnings are concentrated in three sectors: health care, technology, and industrials. The table below presents the top eight companies in terms of cash parked overseas as a percent- age of market value.

Overseas Cash as a Percentage of Market Cap Cash Parked Overseas

Amount ($ in millions)

As a % of Market Cap

NetApp $ 4,300 36% Cisco Systems 47,400 31 Hewlett-Packard 15,133 24 First Solar 1,400 23 General Electric 61,100 23 NVIDIA 2,610 22 Amgen 25,700 21 Microsoft 77,100 11

Cash and Receivables7 1 Indicate how to report cash and related items. 2 Define receivables and understand

accounting issues related to their recognition.

3 Explain accounting issues related to valuation of accounts receivable.

4 Explain accounting issues related to recognition and valuation of notes receivable.

5 Explain the fair value option. 6 Explain accounting issues related to

disposition of accounts and notes receivable.

7 Describe how to report and analyze receivables.

LEARNING OBJECTIVES After studying this chapter, you should be able to:

325

What this tells us is that the U.S. taxpayer is presently holding the bag because many of these companies may never be taxed as the cash from these earnings will not be invested in the United States. At a minimum, investors need more information about foreign earnings, the amount of cash in foreign deposits, and cash gen- erated from foreign operations where untaxed foreign earnings were reported. Capital markets are well served when good information is provided. You would think that cash is cash and the amount is certain, but unfortu- nately some cash is better than other cash.

Sources: J. Ciesielski, “Growing, Glowing Earnings: S&P 500’s 2011 Untaxed Income,” The Analyst’s Accounting Observer (March 26, 2012); and D. Zion, R. Gomatam, and R. Graziano, “Parking A-Lot Overseas: At least $600 Billion in Cash and Over $2 Trillion in Earnings,” Credit Suisse Equity Research (March 17, 2015).

This chapter also includes numerous conceptual and international discussions that are integral to the topics presented here.

PREVIEW OF CHAPTER 7 As our opening story indicates, investors and creditors need to keep an eye on cash balances and how companies manage these cash balances. This highlights the importance of good information on cash to help investors assess liquidity and financial flexibility. In this chapter, we discuss cash and receivables—two current assets important to the liquidity of companies like Apple, Cisco, and General Electric. The content and organization of the chapter are as follows.

CASH AND RECEIVABLES

CASH

• Reporting cash • Summary of cash-

related items

RECEIVABLES

• Recognition of accounts receivable

• Valuation of accounts receivable

NOTES RECEIVABLE

• Recognition of notes receivable

• Valuation of notes receivable

SPECIAL ISSUES

• Fair value option • Disposition of accounts

and notes receivable • Presentation and

analysis

326 Chapter 7 Cash and Receivables

CASH Cash, the most liquid of assets, is the standard medium of exchange and the basis for measuring and accounting for all other items. Companies generally classify cash as a current asset. Cash consists of coin, currency, and available funds on deposit at the bank. Negotiable instruments such as money orders, certified checks, cashier’s checks, per- sonal checks, and bank drafts are also viewed as cash. What about savings accounts? Banks do have the legal right to demand notice before withdrawal. But, because banks rarely demand prior notice, savings accounts nevertheless are considered cash.

Some negotiable instruments provide small investors with an opportunity to earn interest. These items, more appropriately classified as temporary investments than as cash, include money market funds, money market savings certificates, certificates of deposit (CDs), and similar types of deposits and “short-term paper.”1 These securities usually contain restrictions or penalties on their conversion to cash. Money market funds that provide checking account privileges, however, are usually classified as cash.

Certain items present classification problems: Companies treat postdated checks and I.O.U.s as receivables. They also treat travel advances as receivables if collected from employees or deducted from their salaries. Otherwise, companies classify the travel advance as a prepaid expense. Postage stamps on hand are classified as part of office supplies inventory or as a prepaid expense. Because petty cash funds and change funds are used to meet current operating expenses and liquidate current liabilities, companies include these funds in current assets as cash.

Reporting Cash Although the reporting of cash is relatively straightforward, a number of issues merit special attention. These issues relate to the reporting of:

1. Cash equivalents. 2. Restricted cash. 3. Bank overdrafts.

Cash Equivalents A current classification that has become popular is “Cash and cash equivalents.”2 Cash equivalents are short-term, highly liquid investments that are both (a) readily convert- ible to known amounts of cash, and (b) so near their maturity that they present insignifi- cant risk of changes in value because of changes in interest rates. Generally, only invest- ments with original maturities of three months or less qualify under these definitions. Examples of cash equivalents are Treasury bills, commercial paper, and money market

LEARNING OBJECTIVE 1 Indicate how to report cash and related items.

1A variety of “short-term paper” is available for investment. For example, certificates of deposit (CDs) represent formal evidence of indebtedness, issued by a bank, subject to withdrawal under the specific terms of the instrument. Issued in various denominations, they have maturities anywhere from 7 days to 10 years and generally pay interest at the short-term interest rate in effect at the date of issuance. In money-market funds, a variation of the mutual fund, the mix of Treasury bills and commercial paper making up the fund’s portfolio determines the yield. Most money-market funds require an initial minimum investment of $1,000; many allow withdrawal by check or wire transfer. Treasury bills are U.S. government obligations generally issued with 4-, 13-, and 26-week maturities; they are sold at weekly government auctions in denominations of $1,000 up to a maximum purchase of $5 million. Commercial paper is a short-term note issued by corporations with good credit ratings. Often issued in $5,000 and $10,000 denominations, these notes generally yield a higher rate than Treasury bills. 2Accounting Trends and Techniques recently indicated that approximately 2 percent of the companies surveyed use the caption “Cash,” 89 percent use “Cash and cash equivalents,” and 2 percent use a caption such as “Cash and marketable securities” or similar terminology.

Cash 327

funds. Some companies combine cash with temporary investments on the balance sheet. In these cases, they describe the amount of the temporary investments either parentheti- cally or in the notes.

Most individuals think of cash equivalents as cash. Unfortunately, that is not always the case. Companies like Kohl’s and ADC Telecommunications learned the hard way and took sizable write-downs on cash equivalents. Their losses resulted because they purchased auction-rate notes that declined in value. These notes carry interest rates that usually reset weekly and often have long-maturity dates (as long as 30 years). Compa- nies argued that such notes should be classified as cash equivalents because they can be routinely traded at auction on a daily basis. (In short, they are liquid and risk-free.) Auditors agreed and permitted cash-equivalent treatment even though maturities extended well beyond three months. But when the credit crunch hit, the auctions stopped, and the value of these securities dropped because no market existed. In retro- spect, the cash-equivalent classification was misleading.

The FASB has studied whether to eliminate the cash-equivalent classification from financial statement presentations altogether. One idea would have companies report only cash. If an asset is not cash and is short-term in nature, it should be reported as a temporary investment. An interesting moral to this story is that when times are good, some careless accounting may work. But in bad times, it quickly becomes apparent that sloppy accounting can lead to misleading and harmful effects for users of the financial statements.

Restricted Cash Petty cash, payroll, and dividend funds are examples of cash set aside for a particular purpose. In most situations, these fund balances are not material. Therefore, companies do not segregate them from cash in the financial statements. When material in amount, companies segregate restricted cash from “regular” cash for reporting purposes. Com- panies classify restricted cash either in the current assets or in the long-term assets sec- tion, depending on the date of availability or disbursement. Classification in the current section is appropriate if using the cash for payment of existing or maturing obligations (within a year or the operating cycle, whichever is longer). On the other hand, compa- nies show the restricted cash in the long-term section of the balance sheet if holding the cash for a longer period of time. Among other potential restrictions, companies need to determine whether any of the cash in accounts outside the United States is restricted by regulations against exportation of currency.

Cash classified in the long-term section is frequently set aside for plant expansion, retirement of long-term debt, or, in the case of International Thoroughbred Breeders, for entry fee deposits.

International Thoroughbred Breeders

Restricted cash and investments (See Note) $3,730,000

Note: Restricted Cash. At year-end, the Company had approximately $3,730,000, which was classified as restricted cash and investments. These funds are primarily cash received from horsemen for nomination and entry fees to be applied to upcoming racing meets, purse winnings held in trust for horsemen, and amounts held for unclaimed ticketholder winnings.

ILLUSTRATION 7-1 Disclosure of Restricted Cash

Banks and other lending institutions often require customers to maintain minimum cash balances in checking or savings accounts. The SEC defines these minimum bal- ances, called compensating balances, as “that portion of any demand deposit (or any time deposit or certificate of deposit) maintained by a corporation which constitutes support for existing borrowing arrangements of the corporation with a lending institu- tion. Such arrangements would include both outstanding borrowings and the assurance of future credit availability.” [1]

See the FASB Codifi cation References (page 382).

328 Chapter 7 Cash and Receivables

To avoid misleading investors about the amount of cash available to meet recurring obligations, the SEC recommends that companies state separately legally restricted deposits held as compensating balances against short-term borrowing arrangements among the “Cash and cash equivalent items” in current assets. Companies should clas- sify separately restricted deposits held as compensating balances against long-term bor- rowing arrangements as noncurrent assets in either the investments or other assets sec- tions, using a caption such as “Cash on deposit maintained as compensating balance.” In cases where compensating balance arrangements exist without agreements that restrict the use of cash amounts shown on the balance sheet, companies should describe the arrangements and the amounts involved in the notes.

Bank Overdrafts Bank overdrafts occur when a company writes a check for more than the amount in its cash account. Companies should report bank overdrafts in the current liabilities section, adding them to the amount reported as accounts payable. If material, companies should disclose these items separately, either on the face of the balance sheet or in the related notes.3

Bank overdrafts are generally not offset against the cash account. A major exception is when available cash is present in another account in the same bank on which the over- draft occurred. Offsetting in this case is required.

Summary of Cash-Related Items Cash and cash equivalents include the medium of exchange and most negotiable instru- ments. If the item cannot be quickly converted to coin or currency, a company separately classifies it as an investment, receivable, or prepaid expense. Companies segregate and classify cash that is unavailable for payment of currently maturing liabilities in the long- term assets section. Illustration 7-2 summarizes the classification of cash-related items.

3Bank overdrafts usually occur because of a simple oversight by the company writing the check. Banks often expect companies to have overdrafts from time to time and therefore negotiate a fee as payment for this possible occurrence. However, at one time, E. F. Hutton (a large brokerage firm) began intentionally overdrawing its accounts by astronomical amounts—on some days exceeding $1 billion—thus obtaining interest-free loans that it could invest. Because the amounts were so large and fees were not negotiated in advance, E. F. Hutton came under criminal investigation for its actions.

ILLUSTRATION 7-2 Classifi cation of Cash- Related Items

Classification of Cash, Cash Equivalents, and Noncash Items

Item Classification Comment

Cash Cash If unrestricted, report as cash. If restricted, identify and classify as current and noncurrent assets. Petty cash and Cash Report as cash. change funds Short-term paper Cash equivalents Investments with maturity of less than 3 months, often combined with cash. Short-term paper Temporary investments Investments with maturity of 3 to 12 months. Postdated checks Receivables Assumed to be collectible. and I.O.U.s Travel advances Receivables Assumed to be collected from employees or deducted from their salaries. Postage on hand Prepaid expenses May also be classified as office supplies (as stamps or in inventory. postage meters) Bank overdrafts Current liability If right of offset exists, reduce cash. Compensating Cash separately classified Classify as current or noncurrent in the balances as a deposit maintained balance sheet. Disclose separately in as compensating balance notes details of the arrangement.

Receivables 329

RECEIVABLES Like cash, receivables are also financial assets. Receivables (often referred to as loans and receivables) are claims held against customers and others for money, goods, or services. An example of a loan is a financial institution like Wells Fargo providing funds to Tesla. An example of a receivable is a company like GoPro recording an account receivable when it sells a camera on account to one of its retailers. For pur- poses of discussion, we will simply use the term receivables to mean loans and receivables.

For financial statement purposes, companies classify receivables as either current (short-term) or noncurrent (long-term). Companies expect to collect current receivables within a year or during the current operating cycle, whichever is longer. They classify all other receivables as noncurrent. Receivables are further classified in the balance sheet as either trade or nontrade receivables.

Customers often owe a company amounts for goods bought or services rendered. A company may subclassify these trade receivables, usually the most significant item it possesses, into accounts receivable and notes receivable. Accounts receivable are oral promises of the purchaser to pay for goods and services sold. They represent “open accounts” resulting from short-term extensions of credit. A company normally collects them within 30 to 60 days. Notes receivable are written promises to pay a certain sum of money on a specified future date. They may arise from sales, financing, or other transactions. Notes may be short-term or long-term.

Nontrade receivables arise from a variety of transactions. Some examples of non- trade receivables are:

1. Advances to offi cers and employees. 2. Advances to subsidiaries. 3. Deposits paid to cover potential damages or losses. 4. Deposits paid as a guarantee of performance or payment. 5. Dividends and interest receivable.

LEARNING OBJECTIVE 2 Define receivables and understand accounting issues related to their recognition.

WHAT DO THE NUMBERS MEAN? WHERE DID I PARK MY CASH? We have learned that companies report both cash and cash equivalents as cash on their balance sheets. But where do they park cash that is not used to pay for inventory, employees, or other expenses? As shown in the chart to the right, compa- nies plow the largest portion of their cash holdings into corpo- rate debt.

As indicated, corporate debt is the parking place of choice, followed by U.S. Treasury and agency debt. Surveyed corporate treasurers say that high-grade corporate bonds are preferred because they are reasonably safe while providing a greater yield premium relative to Treasurys. Seems like a good strategy as long as the corporate issuers can make their pay- ments. However, if the economy takes a downturn, similar to investments in auction-rate notes, these investments may not be true cash equivalents.

Source: J. Willhite, “Companies Park Cash in Corporate Debt,” Wall Street Journal (December 4, 2012).

16%

25%

32%

13%

Money Management

Other

Municipal bonds

Commercial paper

Agency bonds

Government debt (U.S.)

Corporate debt

330 Chapter 7 Cash and Receivables

6. Claims against: (a) Insurance companies for casualties sustained. (b) Defendants under suit. (c) Governmental bodies for tax refunds. (d) Common carriers for damaged or lost goods. (e) Creditors for returned, damaged, or lost goods. (f) Customers for returnable items (crates, containers, etc.).

Because of the peculiar nature of nontrade receivables, companies generally report them as separate items in the balance sheet. Illustration 7-3 shows the reporting of trade and nontrade receivables in the balance sheets of Molson Coors Brewing Company and Seaboard Corporation.

The basic issues in accounting for accounts and notes receivable are the same: rec- ognition, valuation, and disposition. We discuss these basic issues for accounts and notes receivable next.

Recognition of Accounts Receivable As indicated, accounts receivable generally arise as part of a revenue arrangement. For example, if Lululemon sells a yoga outfit to Jennifer Burian for $100 on account, when does Lululemon recognize revenue (the sale) and the related accounts receivable? As indicated in Chapter 2, the revenue recognition principle indicates that Lululemon should recognize revenue when it satisfies its performance obligation by transferring the good or service to the customer. It follows that in the Lululemon situation, the yoga outfit is transferred when Jennifer obtains control of this outfit.

When this change in control occurs, Lululemon should recognize an account receiv- able and sales revenue. Lululemon makes the following entry, assuming that $100 is the amount it expects to receive from Jennifer.

Accounts Receivable 100 Sales Revenue 100

The concept of change of control is the deciding factor in determining when a perfor- mance obligation is satisfied and an account receivable recognized. Here are some key

Molson Coors Brewing Company (in thousands)

Current assets

Cash and cash equivalents $ 377,023 Accounts and notes receivable Trade, less allowance for doubtful accounts of $8,827 758,526 Current notes receivable and other receivables, less allowance for doubtful accounts of $3,181 112,626 Inventories 369,521 Maintenance and operating supplies, less allowance for obsolete supplies of $10,556 34,782 Other current assets, less allowance for advertising supplies of $948 124,336 Total current assets $1,776,814

Seaboard Corporation (in thousands)

Current assets

Cash and cash equivalents $ 47,346 Short-term investments 286,660 Receivables Trade $251,005 Due from foreign affiliates 90,019 Other 26,349 367,373 Allowance for doubtful accounts (8,060)

Net receivables 359,313 Inventories 392,946 Deferred income taxes 19,558 Other current assets 77,710

Total current assets $1,183,533

ILLUSTRATION 7-3 Receivables Balance Sheet Presentations

Receivables 331

indicators to determine that Lululemon has transferred and that Jennifer has obtained control of the yoga outfit.

1. Lululemon has the right to payment from the customer. If Jennifer is obligated to pay, it indicates that control has passed to the customer.

2. Lululemon has passed legal title to the customer. If Jennifer has legal title to the goods, it indicates that control has passed to the customer.

3. Lululemon has transferred physical possession of the goods. If Jennifer has physical possession, it indicates that control has passed to the customer.

4. Lululemon no longer has signifi cant risks and rewards of ownership of the goods. If Jennifer now has the signifi cant risks and rewards of ownership, it indicates that control has passed to the customer.

5. Jennifer has accepted the asset.

Measurement of the Transaction Price The transaction price is the amount of consideration that a company expects to receive from a customer in exchange for transferring goods or services. In the Lululemon case, the transaction price is easily determined because Jennifer Burian agrees to pay a fixed amount to Lululemon over a short period of time. However in other situations, compa- nies must consider items such as variable consideration which may affect the accounts receivable balance.

Variable Consideration In some cases the price of a good or service is dependent on future events. These future events often include such items as discounts, returns and allowances, rebates, and perfor- mance bonuses. Here are four items that affect the transaction price and thus the accounts receivable balance.

Trade Discounts. Prices may be subject to a trade or quantity discount. Companies use such trade discounts to avoid frequent changes in catalogs, to alter prices for different quantities purchased, or to hide the true invoice price from competitors.

Trade discounts are commonly quoted in percentages. For example, say your cell phone has a list price of $90, and the manufacturer sells it to Best Buy for list less a 40 percent trade discount. The manufacturer then records the receivable at $54 per phone. The manufacturer, per normal practice, simply deducts the trade discount from the list price and bills the customer net. As another example, assume Ryobi sells a cordless drill with a suggested retail price of $99.99 to a retailer like Home Depot for $70, a trade discount of approximately 30 percent. Home Depot in turn sells the drill for $99.99. Ryobi records the accounts receivable and related sales revenue at $70, not $99.99.

Cash Discounts (Sales Discounts). Companies offer cash discounts (sales discounts) to induce prompt payment. Cash discounts are generally presented in terms such as 2/10, n/30 (2 percent if paid within 10 days, gross amount due in 30 days), or 2/10, E.O.M., net 30, E.O.M. (2 percent if paid any time by the tenth day of the following month, with full payment due by the thirtieth of the following month).

Customers usually take sales discounts unless their cash is severely limited. Why? A customer that receives a 1 percent reduction in the sales price for payment within 10 days, total payment due within 30 days, effectively earns 18.25 percent [.01 ÷ (20/365)], or at least avoids that rate of interest cost.

Companies should record accounts receivable and related revenue at the amount of consideration expected to be received from a customer. [2] For example, assume that Han- ley Company sells goods for $10,000 to Murdoch Inc. with terms 2/10, net 30, and Hanley expects that the discount will be taken. As a result, Hanley records the accounts receivable and related sales revenue at its net price of $9,800. This approach is often referred to as the net method as it attempts to value the receivable at its net realizable value.

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If Murdoch fails to take the discount, then Hanley debits the discount not taken to accounts receivable and credits Sales Discounted Forfeited. Sales Discounts Forfeited is shown in the “Other revenue and gains” section of the income statement.4 Theoretically, the net method is correct because the receivable is stated at net realizable value (assum- ing estimates are correct) and the net sales measures the revenue recognized from the sale. However, many companies continue to use what is referred to as the gross method in recording the receivable and related sales.

If Hanley uses the gross method, it records the accounts receivable and related sales revenue at $10,000, not $9,800. Under the gross method, Hanley recognizes sales discounts when it receives payment within the discount period. Hanley’s income state- ment then shows sales discounts as a deduction from sales to arrive at net sales. The entries in Illustration 7-4 show the difference between the gross method and net method.

4To the extent that discounts not taken reflect short-term financing, some argue that companies could use an interest revenue account to record these amounts.

Gross Method Net Method

Sales of $10,000, terms 2/10, n/30

Accounts Receivable 10,000 Accounts Receivable 9,800 Sales Revenue 10,000 Sales Revenue 9,800

Payment on $4,000 of sales received within discount period

Cash 3,920 Cash 3,920 Sales Discounts 80 Accounts Receivable 3,920 Accounts Receivable 4,000

Payment on $6,000 of sales received after discount period

Cash 6,000 Cash 6,000 Accounts Receivable 6,000 Accounts Receivable 5,880 Sales Discounts Forfeited 120

ILLUSTRATION 7-4 Entries under Gross and Net Methods of Recording Cash (Sales) Discounts

We present the gross method because companies may not use the net method for practicability reasons. That is, the net method requires additional analysis and book- keeping to record sales discounts forfeited on accounts receivable that have passed the discount period. If collection periods are relatively short, using either the gross or the net method results in the same amounts for revenues and receivables equal to the trans- action price. Any differences that arise are likely to be immaterial.

Sales Returns and Allowances. Another form of variable consideration relates to sales returns and allowances. For example, assume that Max Glass sells hurricane glass to Oliver Builders. As part of the sales agreement, Max includes a provision that if Oliver is dissatis- fied with the product, Max will grant an allowance on the sales price or agree to take the product back. As a result, similar to a sales discount, Max should record the accounts receivable and related revenue at the amount of consideration expected to be received.

To illustrate, assume on January 4, 2017, Max sells $5,000 of hurricane glass to Oliver on account. Max records the sale on account as follows.

January 4, 2017 Accounts Receivable 5,000 Sales Revenue 5,000

On January 16, 2017, Max grants an allowance of $300 to Oliver because some of the hurricane glass is defective. The entry to record this transaction is as follows.

Receivables 333

January 15, 2017 Sales Returns and Allowances 300 Accounts Receivable 300

Sales Returns and Allowances is a contra revenue account to Sales Revenue and offsets sales revenue on the income statement.

On January 31, 2017, before preparing financial statements, Max estimates that an additional $100 in sales returns and allowances will result from the sale to Oliver on January 4, 2017. An adjusting entry to record this additional allowance is as follows.

January 31, 2017 Sales Returns and Allowances 100 Allowance for Sales Returns and Allowances 100

Allowance for Sales Returns and Allowances is a contra asset account to Accounts Receiv- able and offsets accounts receivable on the balance sheet. This allowance account shows the estimated amount of claims Max expects to pay in the future. Max does not credit Accounts Receivable on January 31 because it does not know precisely the amount of accounts receivable that will be subject to an allowance. In addition, assuming that Max has many different customers, it may not know which customers will receive an allow- ance. The allowance account will absorb any additional write-offs that occur in the future.

As a result of these transactions, Max reports net sales revenue on the income statement of $4,600 ($5,000 − $300 − $100), which is the amount Max expects to receive from Oliver from the sale of the glass. In addition, Max reports on its balance sheet the estimated net realizable value of its accounts receivable from Oliver of $4,600 ($5,000 − $300 − $100).

The use of both Sales Returns and Allowances, and Allowance for Sales Return and Allowances accounts is helpful to management because they help identify potential problems associated with inferior merchandise, inefficiencies in filling orders, or deliv- ery or shipment mistakes.5

Time Value of Money. Another variable consideration issue relates to the time value of money. Ideally, a company should measure receivables in terms of their present value, that is, the discounted value of the cash to be received in the future. When expected cash receipts require a waiting period, the receivable face amount is not worth the amount that the com- pany ultimately receives.

To illustrate, assume that Best Buy makes a sale on account for $1,000 with payment due in four months. The applicable annual rate of interest is 12 percent, and payment is made at the end of four months. The present value of that receivable is not $1,000 but $961.54 ($1,000 × .96154). In other words, the $1,000 Best Buy receives four months from now is not the same as the $1,000 received today.

Theoretically, any revenue after the period of sale is interest revenue. In practice, companies ignore interest revenue related to accounts receivable because the amount of the discount is not usually material in relation to the net income for the period. The profession specifically excludes from present value considerations “receivables arising from transactions with customers in the normal course of business which are due in customary trade terms not exceeding approximately one year.” [3]

5As indicated, at the date of sale, both sales revenue and accounts receivable are recorded at their gross amounts without consideration of sales returns and allowances. Then, at the end of the reporting period, adjusting entries are made, resulting in both sales revenues and accounts receivable being reported at net amounts and which reflect actual and estimated returns and allowances. Most companies follow this adjusting entry approach because estimating net sales at the date of sale is often difficult and time- consuming. In addition, recording accounts receivables net at the sale date may lead to a lack of correspondence between the control account and the subsidiary ledger related to accounts receivable. By waiting to make the necessary adjusting entries at the end of the reporting period, information related to actual sales returns and allowances is available, and a company still achieves the FASB’s objective of reflecting accounts receivable and sales revenue at the amount the company is entitled to receive. If Oliver returns the product, Max also accounts for the returned inventory and adjusts Cost of Goods Sold for the cost of the product. We provide expanded discussion related to sales returns and allowances in Chapters 8 and 18.

UNDERLYING CONCEPTS

Materiality means it must make a difference to a decision-maker. The FASB believes that present value concepts can be ignored for short-term receivables.

334 Chapter 7 Cash and Receivables

Valuation of Accounts Receivable As one revered accountant aptly noted, the credit manager’s idea of heaven probably would be a place where everyone (eventually) paid his or her debts.6 Unfortunately, this situation often does not occur. For example, a customer may not be able to pay because of a decline in its sales revenue due to a downturn in the economy. Similarly, individuals may be laid off from their jobs or faced with unexpected hospital bills. Companies record credit losses as debits to Bad Debt Expense (or Uncollectible Accounts Expense). Such losses are a normal and necessary risk of doing business on a credit basis.

Two methods are used in accounting for uncollectible accounts: (1) the direct write-off method and (2) the allowance method. The following sections explain these methods.

Direct Write-Off Method for Uncollectible Accounts Under the direct write-off method, when a company determines a particular account to be uncollectible, it charges the loss to Bad Debt Expense. Assume, for example, that on December 10 Cruz Co. writes off as uncollectible Yusado’s $8,000 balance. The entry is:

December 10

Bad Debt Expense 8,000

Accounts Receivable (Yusado) 8,000

(To record write-off of Yusado account)

Under this method, Bad Debt Expense will show only actual losses from uncollectibles. The company will report accounts receivable at its gross amount.

Supporters of the direct write-off-method (which is often used for tax purposes) con- tend that it records facts, not estimates. It assumes that a good account receivable resulted from each sale, and that later events revealed certain accounts to be uncollectible and worthless. From a practical standpoint, this method is simple and convenient to apply. But the direct write-off method is theoretically deficient. It usually fails to record expenses in the same period as associated revenues. Nor does it result in receivables being stated at net realizable value on the balance sheet. As a result, using the direct write-off method is not considered appropriate, except when the amount uncollectible is immaterial.

Allowance Method for Uncollectible Accounts The allowance method of accounting for bad debts involves estimating uncollectible accounts at the end of each period. This ensures that companies state receivables on the balance sheet at their net realizable value. Net realizable value is the net amount the company expects to receive in cash. At each financial statement date, companies estimate uncollectible accounts and net realizable value using information about past and current events as well as forecasts of future collectibility. As a result, the balance sheet reflects the current estimate of expected uncollectible account losses at the reporting date, and the income statement reflects the effects of credit deterioration (or improvement) that has taken place during the period. Many companies set their credit policies to provide for a certain percentage of uncollectible accounts. (In fact, many feel that failure to reach that percentage means that they are losing sales due to overly restrictive credit policies.) Thus, the FASB requires the allowance method for financial reporting purposes when bad debts are material in amount. This method has three essential features:

1. Companies estimate uncollectible accounts receivable and compare the new esti- mate to the current balance in the allowance account.

2. Companies debit estimated increases in uncollectibles to Bad Debt Expense and credit them to Allowance for Doubtful Accounts (a contra asset account) through an adjusting entry at the end of each period.

6William J. Vatter, Managerial Accounting (Englewood Cliffs, N.J.: Prentice-Hall, 1950), p. 60.

LEARNING OBJECTIVE 3 Explain accounting issues related to valuation of accounts receivable.

Receivables 335

3. When companies write off a specifi c account, they debit actual uncollectibles to Allowance for Doubtful Accounts and credit that amount to Accounts Receivable.

Recording Estimated Uncollectibles. To illustrate the allowance method, assume that Brown Furniture in 2017, its first year of operations, has credit sales of $1,800,000. Of this amount, $150,000 remains uncollected at December 31. The credit manager estimates that $10,000 of these sales will be uncollectible. The adjusting entry to record the esti- mated uncollectibles (assuming a zero balance in the allowance account) is:

December 31, 2017

Bad Debt Expense 10,000

Allowance for Doubtful Accounts 10,000

(To record estimate of uncollectible accounts)

Brown reports Bad Debt Expense in the income statement as an operating expense. Thus, Brown records the increased estimated uncollectibles as bad debt expense in the period of credit deterioration.

As Illustration 7-5 shows, the company deducts the allowance account from accounts receivable in the current assets section of the balance sheet.

BROWN FURNITURE BALANCE SHEET (PARTIAL)

Current assets Cash $ 15,000 Accounts receivable $150,000 Less: Allowance for doubtful accounts 10,000 140,000 Inventory 300,000 Prepaid insurance 25,000

Total current assets $480,000

ILLUSTRATION 7-5 Presentation of Allowance for Doubtful Accounts

Allowance for Doubtful Accounts shows the estimated amount of claims on custom- ers that the company expects it will not collect in the future.7 Companies use a contra account instead of a direct credit to Accounts Receivable because they do not know which customers will not pay. The credit balance in the allowance account will absorb the specific write-offs when they occur. The amount of $140,000 in Illustration 7-5 represents the net realizable value of the accounts receivable at the statement date. Companies do not close Allowance for Doubtful Accounts at the end of the fiscal year.

Recording the Write-Off of an Uncollectible Account. When companies have exhausted all means of collecting a past-due account and collection appears impossible, the com- pany should write off the account. In the credit card industry, for example, it is standard practice to write off accounts that are 210 days past due.

To illustrate a receivables write-off, assume that the financial vice president of Brown Furniture authorizes a write-off of the $1,000 balance owed by Randall Co. on March 1, 2018. The entry to record the write-off is:

March 1, 2018

Allowance for Doubtful Accounts 1,000 Accounts Receivable (Randall Co.) 1,000 (Write-off of Randall Co. account)

7The account description employed for the allowance account is usually Allowance for Doubtful Accounts or simply Allowance. Accounting Trends and Techniques recently indicated that approximately 83 percent of the companies surveyed used “allowance” in their description.

336 Chapter 7 Cash and Receivables

Bad Debt Expense does not increase when the write-off occurs. Under the allowance method, companies debit every bad debt write-off to the allowance account rather than to Bad Debt Expense. A debit to Bad Debt Expense would be incorrect because the company has already recognized the expense when it made the adjusting entry for esti- mated bad debts. Instead, the entry to record the write-off of an uncollectible account reduces both Accounts Receivable and Allowance for Doubtful Accounts.

Recovery of an Uncollectible Account. Occasionally, a company collects from a customer after it has written off the account as uncollectible. The company makes two entries to record the recovery of a bad debt: (1) It reverses the entry made in writing off the account. This reinstates the customer’s account. (2) It journalizes the collection in the usual manner.

To illustrate, assume that on July 1, 2018, Randall Co. pays the $1,000 amount that Brown had written off on March 1. These are the entries:

July 1, 2018

Accounts Receivable (Randall Co.) 1,000 Allowance for Doubtful Accounts 1,000 (To reverse write-off of account)

Cash 1,000 Accounts Receivable (Randall Co.) 1,000 (Collection of account)

Note that the recovery of a bad debt, like the write-off of a bad debt, affects only balance sheet accounts. The net effect of the two entries above is a debit to Cash and a credit to Allowance for Doubtful Accounts for $1,000.8

Estimating the Allowance. To simplify the preceding explanation, we assumed we knew the amount of the expected uncollectibles. In “real life,” companies must estimate that amount when they use the allowance method. As indicated, expected uncollectible accounts are estimated based on information about past events (loss experience), adjusted for current conditions and reasonable forecasts of factors that would affect uncollectible accounts. While much judgment is involved, the goal is to develop the best estimate of expected uncollectible receivables.9

For example, a company can estimate the percentage of its outstanding receivables that will become uncollectible, without identifying specific accounts. This procedure provides a reasonably accurate estimate of the receivables’ realizable value. Hence, it is referred to as the percentage-of-receivables approach.10

Companies may apply this method using one composite rate that reflects an esti- mate of the uncollectible receivables. Or, companies may set up an aging schedule of accounts receivable, which applies a different percentage based on past experience to the various age categories. An aging schedule also identifies which accounts require special attention by indicating the extent to which certain accounts are past due. The schedule of Wilson & Co. in Illustration 7-6 is an example.

8If using the direct write-off approach, the company debits the amount collected to Cash and credits a revenue account entitled Uncollectible Amounts Recovered, with proper notation in the customer’s account. 9In contrast to prior impairment rules, which recorded bad debts only when a loss had occurred, companies must adjust estimates for the possibility that expectations about losses may not be reflected in historical data. That is, companies are required to estimate credit losses over the entire contractual term of the receivables. [4] 10In general, estimating bad debt expense with a focus on the income statement (e.g., percentage-of-sales) is not appropriate. That is, the goal is to arrive at an estimate in the allowance, which reduces the receivables amount to net realizable value (i.e., the amount of receivables expected to be collected). While a percentage- of-sales approach may provide a better “matching” of bad debt expense to sales, the balance in the allow- ance likely will not provide a representationally faithful estimate of net realizable value.

Receivables 337

11The expected loss model does not specify a recognition threshold (e.g., probable and estimable) to record an allowance for uncollectible accounts. As a result, companies must measure expected uncollectible accounts and record bad debt expense on all receivables, even those with a low risk of loss (e.g., receivables that are not past due). Thus, in the Wilson example, an estimate for uncollectible accounts is developed for balances that are under 30 days past due.

Wilson reports bad debt expense of $26,610 for this year, assuming that no balance existed in the allowance account.11

To change the illustration slightly, assume that the allowance account had a credit balance of $800 before adjustment. In this case, Wilson adds $25,810 ($26,610 − $800) to the allowance account and makes the following entry.

Bad Debt Expense 25,810 Allowance for Doubtful Accounts 25,810

Wilson therefore states the balance in the allowance account at $26,610. If the Allow- ance for Doubtful Accounts balance before adjustment had a debit balance of $200, then Wilson records bad debt expense of $26,810 ($26,610 desired balance + $200 debit balance). In the percentage-of-receivables method, Wilson cannot ignore the balance in the allowance account because the percentage is related to a real account (Accounts Receivable).

Companies do not prepare an aging schedule only to determine bad debt expense. They often prepare it as a control device to determine the composition of receivables and to identify delinquent accounts. In the Wilson example, the aging analysis was used to classify receivables according to a risk factor (days past due) that is related to the collect- ibility of the receivables. Other approaches are acceptable as long as the estimation tech- niques are applied consistently over time with the objective of faithfully estimating expected uncollectible accounts. [5] For example, a company may use historical loss ratios for customers with different credit ratings as a basis for estimating uncollectible accounts. Or, a company may utilize a probability-weighted discounted cash flow model (as illustrated in Chapter 6) to estimate expected credit losses. The discounted cash flow approach is generally appropriate when analyzing an individual loan or receivable (we present a comprehensive example of this approach in Appendix 7B).

ILLUSTRATION 7-6 Accounts Receivable Aging Schedule

* Estimates are based on historical loss rates, taking into consideration whether and, if so, how the historical loss rates differ from what is currently expected over the life of the trade receivables (on the basis of current conditions and reasonable and supportable forecasts about the future).

WILSON & CO. AGING SCHEDULE

Balance Under 30–60 61–90 91–120 Over Name of Customer Dec. 31 30 days days days days 120 days

Western Stainless Steel Corp. $ 98,000 $ 15,000 $ 65,000 $18,000 Brockway Steel Company 320,000 280,000 40,000 Freeport Sheet & Tube Co. 55,000 $55,000 Allegheny Iron Works 74,000 50,000 10,000 $14,000

$547,000 $345,000 $115,000 $18,000 $14,000 $55,000

Percentage Estimated to Be Required Balance

Age Amount Uncollectible* in Allowance

Under 30 days $345,000 0.8% $ 2,760 30-60 days 115,000 4.0 4,600 61–90 days 18,000 15.0 2,700 91–120 days 14,000 20.0 2,800 Over 120 days 55,000 25.0 13,750

Year-end balance of allowance for doubtful accounts $26,610

338 Chapter 7 Cash and Receivables

In summary, the primary objective for financial statement purposes is to report receivables in the balance sheet at net realizable value. The allowance for doubtful accounts as a percentage of receivables will vary, depending on the industry and the economic climate. Companies such as Eastman Kodak, General Electric, and Mon- santo have recorded allowances ranging from $3 to $6 per $100 of accounts receivable. Other large companies, such as CPC International ($1.48), Texaco ($1.23), and USX Corp. ($0.78), have had bad debt allowances of less than $1.50 per $100. At the other extreme are hospitals that allow for $15 to $20 per $100 of accounts receivable.

Regardless of the estimation approach used, determining the expense associated with uncollectible accounts requires a large degree of judgment. Recent concern exists that some banks use this judgment to manage earnings. By overestimating the amounts of uncollectible loans in a good earnings year, the bank can “save for a rainy day” in a future period. In future (less-profitable) periods, banks can reduce the overly conserva- tive allowance for loan loss account to increase earnings.12

NOTES RECEIVABLE A note receivable is supported by a formal promissory note, a written promise to pay a certain sum of money at a specific future date. Such a note is a negotiable instrument that a maker signs in favor of a designated payee who may legally and readily sell or otherwise transfer the note to others. Although all notes contain an interest element because of the time value of money, companies classify them as interest-bearing or non- interest-bearing. Interest-bearing notes have a stated rate of interest. Zero-interest- bearing notes (non-interest-bearing) include interest as part of their face amount. Notes receivable are considered fairly liquid, even if long-term, because companies may easily convert them to cash (although they might pay a fee to do so).

Companies frequently accept notes receivable from customers who need to extend the payment period of an outstanding receivable. Or they require notes from high-risk or new customers. In addition, companies often use notes in loans to employees and subsidiaries, and in the sales of property, plant, and equipment. In some industries (e.g., the pleasure and sport boat industry), notes support all credit sales. The majority of notes, however, originate from lending transactions. The basic issues in accounting for notes receivable are the same as those for accounts receivable: recognition, valuation, and disposition.

Recognition of Notes Receivable Companies record and report long-term notes receivable at the present value of the cash they expect to collect. When the interest stated on an interest-bearing note equals the effective (market) rate of interest, the note sells at face value.13 When the stated rate differs from the market rate, the cash exchanged (present value) differs from the face value of the note. Companies then record this difference, either a discount or a pre- mium, and amortize it over the life of a note to approximate the effective (market) inter- est rate. This illustrates one of the many situations in which time value of money con- cepts are applied to accounting measurement.

Note Issued at Face Value To illustrate the discounting of a note issued at face value, assume that Bigelow Corp. lends Scandinavian Imports $10,000 in exchange for a $10,000, three-year note bearing interest at 10 percent annually. The market rate of interest for a note of similar risk is also 10 percent. We show the time diagram depicting both cash flows in Illustration 7-7.

12The SEC brought action against Suntrust Banks, requiring a reversal of $100 million of bad debt expense. This reversal increased after-tax profit by $61 million. Recall from our earnings management discussion in Chapter 4 that increasing or decreasing income through management manipulation can reduce the quality of financial reports. 13The stated interest rate, also referred to as the face rate or the coupon rate, is the rate contracted as part of the note. The effective-interest rate, also referred to as the market rate or the effective yield, is the rate used in the market to determine the value of the note—that is, the discount rate used to determine present value.

LEARNING OBJECTIVE 4 Explain accounting issues related to recogni- tion and valuation of notes receivable.

Notes Receivable 339

n = 3

i = 10%

2 30 1

$1,000 Interest

$10,000 Principal

PV-OA $1,000$1,000PV-OA

Present Value ILLUSTRATION 7-7 Time Diagram for Note Issued at Face Value

Face value of the note $10,000 Present value of the principal: $10,000 (PVF3,10%) = $10,000 × .75132 $7,513 Present value of the interest: $1,000 (PVF-OA3,10%) = $1,000 × 2.48685 2,487 Present value of the note (10,000)

Difference $ –0–

ILLUSTRATION 7-8 Present Value of Note— Stated and Market Rates the Same

You can use a financial calculator to solve this problem.

Calculator Solution for Present Value of Note Receivable

Inputs

I 10

PV ?

PMT 1,000

FV 10,000

–10,000

Answer

Bigelow computes the present value or exchange price of the note as follows.

In this case, the present value of the note equals its face value because the effective and stated rates of interest are also the same. Bigelow records the receipt of the note as follows.

Notes Receivable 10,000 Cash 10,000

Bigelow recognizes the interest earned each year as follows.

Cash 1,000 Interest Revenue 1,000

Note Not Issued at Face Value Zero-Interest-Bearing Notes. If a company receives a zero-interest-bearing note, its present value is the cash paid to the issuer. Because the company knows both the future amount and the present value of the note, it can compute the interest rate. This rate is often referred to as the implicit interest rate. Companies record the difference between the future (face) amount and the present value (cash paid) as a discount and amortize it to interest revenue over the life of the note.

To illustrate, Jeremiah Company receives a three-year, $10,000 zero-interest-bearing note, the present value of which is $7,721.80. The implicit rate that equates the total cash to be received ($10,000 at maturity) to the present value of the future cash flows ($7,721.80) is 9 percent (the present value of 1 for three periods at 9 percent is .77218). We show the time diagram depicting the one cash flow in Illustration 7-9.

n = 3

i = 9%

2 30 1

$0 Interest

$10,000 Principal

PV-OA $0$0PV-OA

Present Value ILLUSTRATION 7-9 Time Diagram for Zero- Interest-Bearing Note

340 Chapter 7 Cash and Receivables

SCHEDULE OF NOTE DISCOUNT AMORTIZATION EFFECTIVE-INTEREST METHOD 0% NOTE DISCOUNTED AT 9%

Carrying Cash Interest Discount Amount Received Revenue Amortized of Note

Date of issue $ 7,721.80 End of year 1 $ –0– $ 694.96a $ 694.96b 8,416.76c

End of year 2 –0– 757.51 757.51 9,174.27 End of year 3 –0– 825.73d 825.73 10,000.00

$ –0– $2,278.20 $2,278.20

a$7,721.80 × .09 = $694.96 c$7,721.80 + $694.96 = $8,416.76 b$694.96 − $0 = $694.96 d5¢ adjustment to compensate for rounding

ILLUSTRATION 7-10 Discount Amortization Schedule—Effective- Interest Method

Inputs Answer

N 3

I 9

PMT 0

FV 10,000

–7,721.80

Calculator Solution for Effective-Interest Rate on Note

Jeremiah records the transaction as follows.

Notes Receivable 10,000.00 Discount on Notes Receivable ($10,000 − $7,721.80) 2,278.20 Cash 7,721.80

Discount on Notes Receivable is a valuation account. Companies report it on the balance sheet as a contra asset account to notes receivable. They then amortize the dis- count, and recognize interest revenue annually using the effective-interest method. Illustration 7-10 shows the three-year discount amortization and interest revenue schedule.

Jeremiah records interest revenue at the end of the first year using the effective- interest method as follows.

Discount on Notes Receivable 694.96 Interest Revenue ($7,721.80 × 9%) 694.96

The amount of the discount, $2,278.20 in this case, represents the interest revenue Jere- miah will receive from the note over the three years.

Interest-Bearing Notes. Often the stated rate and the effective rate differ. The zero- interest-bearing note is one example.

To illustrate a more common situation, assume that Morgan Corp. makes a loan to Marie Co. and receives in exchange a three-year, $10,000 note bearing interest at 10 per- cent annually. The market rate of interest for a note of similar risk is 12 percent. We show the time diagram depicting both cash flows in Illustration 7-11.

n = 3

i = 12%

2 30 1

$1,000 Interest

$10,000 Principal

$1,000$1,000

Present Value

PV-OAPV-OA

ILLUSTRATION 7-11 Time Diagram for Interest-Bearing Note

Notes Receivable 341

Morgan computes the present value of the two cash flows as follows.

In this case, because the effective rate of interest (12 percent) exceeds the stated rate (10 percent), the present value of the note is less than the face value. That is, Morgan exchanged the note at a discount. Morgan records the receipt of the note at a discount as follows.

Notes Receivable 10,000 Discount on Notes Receivable 480 Cash 9,520

Morgan then amortizes the discount and recognizes interest revenue annually using the effective-interest method. Illustration 7-13 shows the three-year discount amortiza- tion and interest revenue schedule.

SCHEDULE OF NOTE DISCOUNT AMORTIZATION EFFECTIVE-INTEREST METHOD

10% NOTE DISCOUNTED AT 12%

Carrying Cash Interest Discount Amount Received Revenue Amortized of Note

Date of issue $ 9,520 End of year 1 $1,000a $1,142b $142c 9,662d

End of year 2 1,000 1,159 159 9,821 End of year 3 1,000 1,179 179 10,000

$3,000 $3,480 $480

a$10,000 × 10% = $1,000 c$1,142 − $1,000 = $142 b$9,520 × 12% = $1,142 d$9,520 + $142 = $9,662

ILLUSTRATION 7-13 Discount Amortization Schedule—Effective- Interest Method

On the date of issue, the note has a present value of $9,520. Its unamortized discount—additional interest revenue spread over the three-year life of the note— is $480.

At the end of year 1, Morgan receives $1,000 in cash. But its interest revenue is $1,142 ($9,520 × 12%). The difference between $1,000 and $1,142 is the amortized discount, $142. Morgan records receipt of the annual interest and amortization of the discount for the first year as follows (amounts per amortization schedule).

Cash 1,000 Discount on Notes Receivable 142 Interest Revenue 1,142

The carrying amount of the note is now $9,662 ($9,520 + $142). Morgan repeats this process until the end of year 3.

When the present value exceeds the face value, the note is exchanged at a premium. Companies record the premium on a note receivable as a debit and amortize it using the effective-interest method over the life of the note as annual reductions in the amount of interest revenue recognized.

Face value of the note $10,000 Present value of the principal: $10,000 (PVF3,12%) = $10,000 × .71178 $7,118 Present value of the interest: $1,000 (PVF-OA3,12%) = $1,000 × 2.40183 2,402 Present value of the note (9,520)

Difference (Discount) $ 480

ILLUSTRATION 7-12 Computation of Present Value—Effective Rate Different from Stated Rate

342 Chapter 7 Cash and Receivables

Notes Received for Property, Goods, or Services. When a note is received in exchange for property, goods, or services in a bargained transaction entered into at arm’s length, the stated interest rate is presumed to be fair unless:

1. No interest rate is stated, or 2. The stated interest rate is unreasonable, or 3. The face amount of the note is materially different from the current cash sales price for

the same or similar items or from the current fair value of the debt instrument. [6]

In these circumstances, the company measures the present value of the note by the fair value of the property, goods, or services or by an amount that reasonably approxi- mates the fair value of the note.

To illustrate, Oasis Development Co. sold a corner lot to Rusty Pelican as a restau- rant site. Oasis accepted in exchange a five-year note having a maturity value of $35,247 and no stated interest rate. The land originally cost Oasis $14,000. At the date of sale, the land had a fair value of $20,000. Given the criterion above, Oasis uses the fair value of the land, $20,000, as the present value of the note. Oasis therefore records the sale as:

Notes Receivable 35,247 Discount on Notes Receivable ($35,247 − $20,000) 15,247 Land 14,000 Gain on Disposal of Land ($20,000 − $14,000) 6,000

Oasis amortizes the discount to interest revenue over the five-year life of the note using the effective-interest method.

Choice of Interest Rate In note transactions, other factors involved in the exchange, such as the fair value of the property, goods, or services, determine the effective or real interest rate. But, if a company cannot determine that fair value and if the note has no ready market, deter- mining the present value of the note is more difficult. To estimate the present value of a note under such circumstances, the company must approximate an applicable inter- est rate that may differ from the stated interest rate. This process of interest-rate approximation is called imputation. The resulting interest rate is called an imputed interest rate.

The prevailing rates for similar instruments, from issuers with similar credit ratings, affect the choice of a rate. Restrictive covenants, collateral, payment schedule, and the existing prime interest rate also impact the choice. A company determines the imputed interest rate when it receives the note. It ignores any subsequent changes in prevailing interest rates.

Valuation of Notes Receivable Like accounts receivable, companies record and report short-term notes receivable at their net realizable value—that is, at their face amount less all necessary allowances. The primary notes receivable allowance account is Allowance for Doubtful Accounts. The computations and estimations involved in valuing short-term notes receivable and in recording bad debt expense and the related allowance exactly parallel that for trade accounts receivable. Companies estimate the amount of uncollectibles by an analysis of the receivables.

Long-term notes receivable involve additional estimation problems. For example, the value of a note receivable can change significantly over time from its original cost. That is, with the passage of time, historical numbers become less and less relevant. As discussed earlier (in Chapters 2, 5, and 6), the FASB requires that for financial instru- ments such as receivables, companies disclose not only their cost but also their fair value in the notes to the financial statements.

Inputs Answer

N 5

I ?

PV –20,000

PMT 0

FV 35,247

Calculator Solution for Effective-Interest Rate on Note

Special Issues 343

SPECIAL ISSUES Three additional special issues for accounting and reporting of receivables relate to the following.

1. Fair value option. 2. Disposition of receivables. 3. Presentation and disclosure.

WHAT DO THE NUMBERS MEAN? PLEASE RELEASE ME?

Sources: S. Kapner, “Citi Shines, but Investors Shrug,” Wall Street Journal (October 18, 2011), p. C1; M. Rapoport, “Banks Depleting Earnings Back- stop: Days Numbered for Using Reserves to Increase Profit,” Wall Street Journal (February 8, 2012), p. C1; and Associated Press, “Legal Costs Weigh Down U.S. Banks Earnings,” The New York Times (February 24, 2015).

As the economy climbed out of the great recession of 2008, several U.S. banks reported increases in net income compared to the same quarter in the previous year. How did the market greet this news? With a resounding “blah.” For example, Wells Fargo’s report led to a share price decline of 8.4 percent, and Citigroup saw a 1.7 percent drop in its share price when it announced earn- ings. What gives?

It seems that the source of earnings increase matters to the market. And in the case of banks, a signifi cant portion of

these earnings increases were the result of decreases in the banks’ bad debt expense, not increased revenues on loans and investments. These decreases happened when the banks’ reserves that had accumulated in the allowance for loan losses were judged to be too high. How big was the effect? As shown in the chart below, of the $14.3 billion in earnings reported by the top 10 U.S. banks, $3.5 billion came from releasing loan loss reserves. For Citi, without the reserve release, it would have reported a loss.

*After-tax reserve releases based on pretax releases and effective tax rate for period.Sources: The companies; WSJ research

10 Biggest Banks: Loan-loss reserves at year-end 2011

$127.2b reserves

$26.7b 2011 releases before taxes

Earnings: $14.3b

After-Tax Reserve Release:*

$3.5b

Loan-Loss Reserve Releases at Big Banks

Earnings: $1.2b

After-Tax Reserve Release: $1.3b

Citigroup: 4Q 2011 Results

10 Biggest Banks: 4Q 2011 Results

As shown in the left side of the chart, the 10 largest banks had $127.2 billion in the allowance for loan losses at the end of 2011, and $26.7 billion was drawn down (released) in that same year.

So is this a problem? Supposedly, reserves should be released when there is a decline in the likelihood that loans will not be paid. However, some market-watchers doubt that banks can afford to keep up the pace of reserve releases. Low- ering reserves could increase pressure on profi ts that are being hit by slow economic growth, low interest rates, and other costs. For example, in a recent quarter, U.S. banks experi- enced an earnings decline of 7.3 percent compared to the same quarter from a year earlier. The culprit? Big banks expe- rienced increased costs to settle legal cases related to sales of

risky mortgage securities before the fi nancial crisis. Three of the biggest United States banks—JPMorgan Chase, Bank of America, and Citigroup—together posted $4.4 billion in legal costs during the quarter. According to one analyst, “The releases are masking some horrible operating performance. . . . The bottom line is your earnings power is decreasing.”

To be fair, analysts often criticize banks when they increase the allowance for loan losses during profi table periods. In some cases, the banks are accused of managing earnings. That is, in good times they increase loan loss reserves, which reduces (or smoothes) earnings. Then in bad times, the reserves can be released, thereby increasing earnings. The SEC has repri- manded some banks for this alleged earnings management— in not only the tough times, but the good times as well.

344 Chapter 7 Cash and Receivables

Fair Value Option Companies have the option to use fair value as the basis of measurement in the financial statements. [7] The Board believes that fair value measurement for financial instruments provides more relevant and understandable information than historical cost. It considers fair value to be more relevant because it reflects the current cash equivalent value of finan- cial instruments. As a result, companies now have the option to record fair value in their accounts for most financial instruments, including receivables.

If companies choose the fair value option, the receivables are recorded at fair value, with unrealized holding gains or losses reported as part of net income. An unrealized holding gain or loss is the net change in the fair value of the receivable from one period to another, exclusive of interest revenue. As a result, the company reports the receivable at fair value each reporting date. In addition, it reports the change in value as part of net income.

Companies may elect to use the fair value option at the time the financial instru- ment is originally recognized or when some event triggers a new basis of accounting (such as when a business acquisition occurs). If a company elects the fair value option for a financial instrument, it must continue to use fair value measurement for that instrument until the company no longer owns this instrument. If the company does not elect the fair value option for a given financial instrument at the date of recogni- tion, it may not use this option on that specific instrument in subsequent periods.

Recording Fair Value Option Assume that Escobar Company receives a note receivable from one of its customers for $620,000 on December 31, 2016. Therefore, at December 31, 2016, the fair value and car- rying value of the notes receivable is $620,000. Escobar decides to use the fair value option for this receivable. Having elected to use the fair value option, Escobar must value these receivables at fair value in all subsequent periods in which it holds these receivables. Similarly, if Escobar elects not to use the fair value option, it must use its carrying amount for all future periods.

On December 31, 2017, the notes receivable has a carrying value of $620,000 and a fair value of $810,000. Because Escobar has elected the fair value option, it reports the receivable at fair value, with any unrealized holding gains and losses reported as part of net income. The unrealized holding gain is the difference between the fair value and the carrying amount at December 31, 2017, which for Escobar is $190,000 ($810,000 − $620,000). Escobar makes an adjusting entry to record the increase in value of notes receivable and to record the unrealized holding gain, as follows.

December 31, 2017

Notes Receivable 190,000 Unrealized Holding Gain or Loss—Income 190,000

Escobar adds the difference between fair value and the cost of the notes receivable to arrive at the fair value reported on the balance sheet. In subsequent periods, the com- pany will report any change in fair value as an unrealized holding gain or loss. For example, if at December 31, 2018, the fair value of the notes receivable is $800,000, Esco- bar recognizes an unrealized holding loss of $10,000 ($810,000 − $800,000) and reduces the Notes Receivable account.

Disposition of Accounts and Notes Receivable In the normal course of events, companies collect accounts and notes receivable when due and then remove them from the books. However, the growing size and significance of credit sales and receivables has led to changes in this “normal course of events.” In order to accelerate the receipt of cash from receivables, the owner may transfer accounts or notes receivables to another company for cash.

LEARNING OBJECTIVE 6 Explain accounting issues related to disposition of accounts and notes receivable.

LEARNING OBJECTIVE 5 Explain the fair value option.

INTERNATIONAL PERSPECTIVE

IFRS also has the fair value option.

Special Issues 345

There are various reasons for this early transfer. First, for competitive reasons, provid- ing sales financing for customers is virtually mandatory in many industries. In the sale of durable goods, such as automobiles, trucks, industrial and farm equipment, computers, and appliances, most sales are on an installment contract basis. Many major companies in these industries have created wholly owned subsidiaries specializing in receivables financ- ing. For example, Ford has Ford Motor Credit, and John Deere has John Deere Credit.

Second, the holder may sell receivables because money is tight and access to normal credit is unavailable or too expensive. Also, a firm may sell its receivables, instead of borrowing, to avoid violating existing lending agreements.

Finally, billing and collection of receivables are often time-consuming and costly. Credit card companies such as MasterCard, Visa, American Express, Diners Club, Discover, and others take over the collection process and provide merchants with immediate cash.14

The transfer of receivables to a third party for cash happens in one of two ways:

1. Sales of receivables. 2. Secured borrowing.

Sales of Receivables Sales of receivables have increased substantially in recent years. A common type is a sale to a factor. Factors are finance companies or banks that buy receivables from businesses for a fee and then collect the remittances directly from the customers. Factoring receiv- ables is traditionally associated with the textile, apparel, footwear, furniture, and home furnishing industries.15 Illustration 7-14 shows a typical factoring arrangement.

14Some purchasers of receivables buy them to obtain the legal protection of ownership rights afforded a purchaser of assets versus the lesser rights afforded a secured creditor. In addition, banks and other lending institutions may need to purchase receivables because of legal lending limits. That is, they cannot make any additional loans but they can buy receivables and charge a fee for this service. 15Credit cards like MasterCard and Visa are a type of factoring arrangement. Typically, the purchaser of the receivable charges a ¾–1½ percent commission of the receivables purchased (the commission is 4–5 percent for credit card factoring). 16Recourse is the right of a transferee of receivables to receive payment from the transferor of those receivables for (1) failure of the debtors to pay when due, (2) the effects of prepayments, or (3) adjustments resulting from defects in the eligibility of the transferred receivables. [8]

(5) Advances cash

(6) Makes payment (2) Requests credit review

(1) Places order

(4) Ships goods Retailer

or Wholesaler

CUSTOMER

Manufacturer or

Distributor

COMPANY

(3) Approves credit

FACTOR

ILLUSTRATION 7-14 Basic Procedures in Factoring

In a factoring or a securitization transaction, a company sells receivables on either a without recourse or a with recourse basis.16

346 Chapter 7 Cash and Receivables

Sale without Recourse. For receivables sold without recourse (nonrecourse), the seller of the receivable assumes no responsibility for any credit losses associated with the transferred receivables. The transfer of accounts receivable in a nonrecourse trans- action is therefore an outright sale of the receivables both in form (transfer of title) and substance (transfer of control). In nonrecourse transactions (as in any sale of assets), the seller:

1. Debits Cash for the proceeds and credits Accounts Receivable for the face value of the receivables.

2. Recognizes the difference, reduced by any provision for probable adjustments (dis- counts, returns, allowances, etc.), as Loss on Sale of Receivables.

3. Uses a Due from Factor account (reported as a receivable) to account for the proceeds retained by the factor to cover probable sales discounts, sales returns, and sales allowances.

To illustrate, Crest Textiles, Inc. factors $500,000 of accounts receivable with Com- mercial Factors, Inc., on a without recourse basis. Crest Textiles transfers the receivable records to Commercial Factors, which will receive the collections. Commercial Factors assesses a finance charge of 3 percent of the amount of accounts receivable and retains an amount equal to 5 percent of the accounts receivable (for probable adjustments). Crest Textiles and Commercial Factors make the following journal entries for the receiv- ables transferred without recourse.

ILLUSTRATION 7-15 Entries for Sale of Receivables without Recourse

Crest Textiles, Inc. Commercial Factors, Inc.

Cash 460,000 Accounts (Notes) Receivable 500,000 Due from Factor 25,000* Due to Customer (Crest Textiles) 25,000 Loss on Sale of Receivables 15,000** Interest Revenue 15,000 Accounts (Notes) Receivable 500,000 Cash 460,000

*(5% × $500,000) **(3% × $500,000)

Cash received $460,000 Due from factor 25,000 $485,000

Less: Recourse liability 6,000

Net proceeds $479,000

ILLUSTRATION 7-16 Net Proceeds Computation

In recognition of the sale of receivables, Crest Textiles records a loss of $15,000. The factor’s net income will be the difference between the financing revenue of $15,000 and the amount of any uncollectible receivables.

Sale with Recourse. For receivables sold with recourse, the seller guarantees pay- ment to the purchaser in the event the debtor fails to pay. To record this type of trans- action, the seller uses a financial components approach because the seller has a con- tinuing involvement with the receivable. Values are now assigned to such components as the recourse provision, servicing rights, and agreement to reacquire. In this approach, each party to the sale only recognizes the assets and liabilities that it con- trols after the sale.

To illustrate, assume the same information as in Illustration 7-15 for Crest Textiles and for Commercial Factors, except that Crest Textiles sold the receivables on a with recourse basis. Crest Textiles determines that this recourse liability has a fair value of $6,000. To determine the loss on the sale of the receivables, Crest Textiles computes the net proceeds from the sale as follows.

Special Issues 347

Net proceeds are cash or other assets received in a sale less any liabilities incurred. Crest Textiles then computes the loss as follows.

17If a company transfers the receivables for custodial purposes, the custodial arrangement is often referred to as a pledge. 18What happens if Citizens Bank collected the transferred accounts receivable rather than Howat Mills? Citizens Bank would simply remit the cash proceeds to Howat Mills, and Howat Mills would make the same entries shown in Illustration 7-19, according to the payment schedule in the secured borrowing agreement. As a result, Howat Mills reports these “collaterized” receivables as an asset on the balance sheet.

Illustration 7-18 shows the journal entries for both Crest Textiles and Commercial Factors for the receivables sold with recourse.

Carrying (book) value $500,000 Net proceeds 479,000

Loss on sale of receivables $ 21,000

ILLUSTRATION 7-17 Loss on Sale Computation

Crest Textiles, Inc. Commercial Factors, Inc.

Cash 460,000 Accounts Receivable 500,000 Due from Factor 25,000 Due to Customer Loss on Sale of (Crest Textiles) 25,000 Receivables 21,000 Interest Revenue 15,000 Accounts (Notes) Cash 460,000 Receivable 500,000 Recourse Liability 6,000

ILLUSTRATION 7-18 Entries for Sale of Receivables with Recourse

In this case, Crest Textiles recognizes a loss of $21,000. In addition, it records a liabil- ity of $6,000 to indicate the probable payment to Commercial Factors for uncollectible receivables. If Commercial Factors collects all the receivables, Crest Textiles eliminates its recourse liability and increases income. Commercial Factors’ net income is the inter- est revenue of $15,000. It will have no bad debts related to these receivables.

Secured Borrowing A company like Scotts Miracle-Gro often uses receivables as collateral in a borrowing transaction. In fact, a creditor like U.S. Bank often requires that the debtor designate (assign) or pledge17 receivables as security for the loan. If the loan is not paid when due, the creditor can convert the collateral to cash—that is, collect the receivables.

To illustrate, on March 1, 2017, Howat Mills, Inc. provides (assigns) $700,000 of its accounts receivable to Citizens Bank as collateral for a $500,000 note. Here is what hap- pens under this arrangement:

• Howat Mills continues to collect the accounts receivable; the account debtors are not notified of the arrangement.

• Citizens Bank assesses a finance charge of 1 percent of the accounts receivable and interest on the note of 12 percent.

• Howat Mills makes monthly payments to the bank for all cash it collects on the receivables.

Illustration 7-19 (on page 348) shows the entries for the secured borrowing for Howat Mills and Citizens Bank.

In addition to recording the collection of receivables, Howat Mills must recognize all discounts, returns and allowances, and bad debts. Each month Howat Mills uses the proceeds from the collection of the accounts receivable to retire the note obligation. In addition, it pays interest on the note.18

348 Chapter 7 Cash and Receivables

Secured Borrowing versus Sale As discussed previously, the FASB concluded that a sale occurs only if the seller surrenders control of the receivables to the buyer. The following three conditions must be met before a company can record a sale:

1. The transferred asset has been isolated from the transferor (put beyond reach of the transferor and its creditors).

2. The transferees have obtained the right to pledge or exchange either the transferred assets or benefi cial interests in the transferred assets.

3. The transferor does not maintain effective control over the transferred assets through an agreement to repurchase or redeem them before their maturity.

If the three conditions are met, a sale occurs. Otherwise, the transferor should record the transfer as a secured borrowing. For example, Crest Textiles makes the following entry if the sale of receivables does not meet the sale conditions.

Cash 475,000 Due from Factor 25,000 Notes Payable 500,000

If sale accounting is appropriate, a company must still consider assets obtained and liabilities incurred in the transaction. Illustration 7-20 shows the rules of accounting for transfers of receivables.

Howat Mills, Inc. Citizens Bank

Transfer of accounts receivable and issuance of note on March 1, 2017

Cash 493,000 Notes Receivable 500,000 Interest Expense 7,000* Interest Revenue 7,000* Notes Payable 500,000 Cash 493,000 *(1% × $700,000)

Collection in March of $440,000 of accounts less cash discounts of $6,000 plus receipt of $14,000 sales returns

Cash 434,000 Sales Discounts 6,000 Sales Returns and Allowances 14,000 (No entry) Accounts Receivable 454,000* *($440,000 + $14,000)

Remitted March collections plus accrued interest to the bank on April 1, 2017

Interest Expense 5,000* Cash 439,000 Notes Payable 434,000 Interest Revenue 5,000* Cash 439,000 Notes Receivable 434,000 *($500,000 × .12 × 1/12)

Collection in April of the balance of accounts less $2,000 written off as uncollectible

Cash 244,000 Allowance for Doubtful Accounts 2,000 (No entry) Accounts Receivable 246,000* *($700,000 − $454,000)

Remitted the balance due of $66,000 ($500,000 − $434,000) on the note plus interest on May 1, 2017

Interest Expense 660* Cash 66,660 Notes Payable 66,000 Interest Revenue 660* Cash 66,660 Notes Receivable 66,000 *($66,000 × .12 × 1/12)

ILLUSTRATION 7-19 Entries for Transfer of Receivables—Secured Borrowing

Special Issues 349

Record as a sale: 1. Reduce receivables. 2. Recognize assets obtained and liabilities incurred. 3. Record gain or loss.

Yes

Transfer of Receivables

1. Transferred assets isolated from transferor. 2. Transferee has right to pledge or sell assets. 3. Transferor does not maintain control through repurchase agreement.

Is there continuing involvement? Record as secured borrowing: 1. Record liability. 2. Record interest expense.

Record as a sale: 1. Reduce receivables. 2. Record gain or loss.

Does it meet three conditions?

ILLUSTRATION 7-20 Accounting for Transfers of Receivables

As indicated, if there is continuing involvement in a sale transaction, a company must record the assets obtained and liabilities incurred.19

19In response to the financial crisis, which was partly caused by securitizations gone bad (see the “What Do the Numbers Mean?” box on this page), the FASB issued new accounting rules that, in general, will result in reduced sale treatment for transfers of receivables. First, rules were issued to limit the types of trusts that can be used in a securitization. [9] Second, the FASB issued enhanced guidance on transfers of assets in repurchase agreements. These arrangements were used by some financial institutions during the financial crisis (e.g., Lehman Brothers’ Repo 105) to “window-dress” their balance sheets and show lower leverage. The new rules tighten the requirements for meeting the control criterion, which raises the bar for companies to be able to assert sale accounting in a repurchase agreement. [10]

INTERNATIONAL PERSPECTIVE

With recent changes in U.S. GAAP, the ac- counting guidance for transfers is substantially converged.

WHAT DO THE NUMBERS MEAN? SECURITIZATIONS—GOOD OR BAD?

Sources: M. Hudson, “How Wall Street Stoked the Mortgage Meltdown,” Wall Street Journal (June 27, 2007), p. A10; and Associated Press, “Legal Costs Weigh Down US Banks Earnings,” The New York Times (February 24, 2015).

A popular form of sale (transfer) of receivables is securitization. Securitization takes a pool of assets, such as credit card receivables, mortgage receivables, or car loan receivables, and sells shares in these pools of interest and principal payments. This, in effect, creates securities backed by these pools of assets. Virtually every asset with a payment stream and a long- term payment history is a candidate for securitization. What are the differences between factoring and securitization? Factoring usually involves sale to only one company, fees are high, the quality of the receivables is low, and the seller afterward does not service the receivables. In a securitization, many investors are involved, margins are tight, the receivables are of generally higher quality, and the seller usually continues to service the receivables.

Securitizations got a black eye in the booming mortgage market leading up to the fi nancial crisis of 2008. In that setting, mortgage loans to high-risk (subprime) borrowers were securi- tized with lenders selling the loans to investment banks or trusts

(special purpose entities) at a gain. Investors in the securities issued by the trusts were happy because they earned a return that they believed was excellent, given the risk they took. How- ever, due to lax regulatory oversight of the mortgage lending process, many of the securitizations resulted in lenders having to take back the loans when subprime borrowers could not make the payments when the economy and the housing market slowed. The costs of these bad securitizations are still being felt by banks several years after the mortgage market meltdown.

The moral of the story is that accounting matters. Lenders had strong incentives to want to report upfront gains on sales of loans. But in most cases, these gains should never have been booked. The FASB has since issued new rules to tighten up “gain-on-sale” accounting for securitizations and loan losses. With these new rules, lenders have to keep the loans on their balance sheets. Under these conditions, lenders would be much less likely to lend so much money to individuals with poor credit ratings.

350 Chapter 7 Cash and Receivables

Presentation and Analysis Presentation of Receivables The general rules in classifying receivables are:

1. Segregate the different types of receivables that a company possesses, if material. 2. Appropriately offset the valuation accounts against the proper receivable

accounts. 3. Determine that receivables classifi ed in the current assets section will be converted

into cash within the year or the operating cycle, whichever is longer. 4. Disclose any loss contingencies that exist on the receivables. 5. Disclose any receivables designated or pledged as collateral. 6. Disclose the nature of credit risk inherent in the receivables, how that risk is ana-

lyzed and assessed in arriving at the allowance for credit losses, and the changes and reasons for those changes in the allowance for credit losses.

With respect to additional disclosures, companies are required to disaggregate based on type of receivable. In response to demands for additional information about credit risk, the FASB recently issued rules for companies to provide the following disclosures about its receivables on a disaggregated basis: (1) a roll-forward sched- ule of the allowance for doubtful accounts from the beginning of the reporting period to the end of the reporting period, (2) the nonaccrual status of receivables by class of receivables, and (3) impaired receivables by type of receivable. In addi- tion, companies should disclose credit quality indicators and the aging of past due receivables. [11]

Companies must disclose concentrations of credit risk for all financial instru- ments (including receivables). Concentrations of credit risk exist when receivables have common characteristics that may affect their collection. These common charac- teristics might be companies in the same industry or same region of the country. For example, Quantum Corporation reported that sales of its disk drives to its top five customers (including Hewlett-Packard) represented nearly 40 percent of its revenues in a recent year. Financial statement users want to know if a substantial amount of receivables from such sales are to customers facing uncertain economic conditions. No numerical guidelines are provided as to what is meant by a “concentration of credit risk.”20

The assets sections of Colton Corporation’s balance sheet in Illustration 7-21 show many of the disclosures required for receivables.

Analysis of Receivables Accounts Receivable Turnover. Analysts frequently compute financial ratios to evalu- ate the liquidity of a company’s accounts receivable. To assess the liquidity of the receiv- ables, they use the accounts receivable turnover. This ratio measures the number of times, on average, a company collects receivables during the period. The ratio is com- puted by dividing net sales by average (net) accounts receivable outstanding during the year. Theoretically, the numerator should include only net credit sales, but this informa- tion is frequently unavailable. However, if the relative amounts of credit and cash sales remain fairly constant, the trend indicated by the ratio will still be valid. Barring signifi- cant seasonal factors, average receivables outstanding can be computed from the begin- ning and ending balances of net trade receivables.

LEARNING OBJECTIVE 7 Describe how to report and analyze receivables.

20Three items should be disclosed with an identified concentration: (1) information on the characteristic that determines the concentration, (2) the amount of loss that could occur upon nonperformance, and (3) information on any collateral related to the receivable. [12]

INTERNATIONAL PERSPECTIVE

Holding receivables that it will receive in a foreign currency represents risk that the exchange rate may move against the company. This results in a decrease in the amount collected in terms of U.S. dollars. Companies engaged in cross-border trans- actions often “hedge” these receivables by buying contracts to exchange currencies at specifi ed amounts at future dates.

Special Issues 351

21Several figures other than 365 could be used. A common alternative is 360 days because it is divisible by 30 (days) and 12 (months). Use 365 days in any homework computations.

ILLUSTRATION 7-21 Disclosure of Receivables

COLTON CORPORATION BALANCE SHEET (PARTIAL) AS OF DECEMBER 31, 2017

Current assets Cash and cash equivalents $ 1,870,250 Accounts and notes receivable (Note 2) $10,509,673 Less: Allowance for doubtful accounts 500,226

10,009,447 Advances to subsidiaries due 9/30/18 2,090,000 Federal income taxes refundable 146,704 Dividends and interest receivable 75,500 Other receivables and claims (including debit balances in accounts payable) 174,620 12,496,271

Total current assets $14,366,521 Noncurrent receivables Notes receivable from officers and key employees 376,090 Claims receivable (litigation settlement to be collected over four years) 585,000

Note 2: Accounts and Notes Receivable. All noncurrent receivables are due within five years from the balance sheet date. Trade receivables that are less than three months past due are not considered impaired. At December 31, the aging analysis of receivables is as follows.

Neither Past Past Due but Not Impaired

Amounts Due or <30 30–60 60–90 90–120 >120 ($000) Total Impaired days days days days days

2017 10,510 5,115 2,791 1,582 570 360 92

As at December 31, 2017, trade receivables at initial value of $109 were impaired and fully provided for. The following table summarises movements in the provision for impairment of receivables.

Total $000

At January 1, 2017 98 Expense for the year 26 Written off (9) Recoveries (6)

At December 31, 2017 109

Certain subsidiaries transferred receivable balances amounting to $1,014 to a bank in exchange for cash during the year ended December 31, 2017. The transaction has been accounted for as a secured borrowing. In case of default under the loan agreement, the borrower has the right to receive the cash flows from the receivables transferred. Without default, the subsidiaries will collect the receivables and assign new receivables as collateral.

Segregate different types of receivables

Disclose aging of receivables

Presentation of impaired receivables

Disclose collateral arrangements

UNDERLYING CONCEPTS

Information that helps users assess a compa- ny’s current liquidity and prospective cash fl ows is a primary objective of accounting.

ILLUSTRATION 7-22 Computation of Accounts Receivable Turnover

Net Sales Accounts Receivable Average Net Accounts Receivable

= Turnover

$40,339 = 31.2 times, or every 11.7 days (365 ÷ 31.2) ($1,280 + $1,308)/2

To illustrate, Best Buy reported 2014 net sales of $40,339 million, its beginning and ending accounts receivable balances were $1,280 million and $1,308 million, respec- tively. Illustration 7-22 shows the computation of its accounts receivable turnover.

This information21 shows how successful the company is in collecting its outstanding receivables. If possible, an aging schedule should also be prepared to help determine how long receivables have been outstanding. A satisfactory accounts receivable turnover may

352 Chapter 7 Cash and Receivables

have resulted because certain receivables were collected quickly though others have been outstanding for a relatively long period. An aging schedule would reveal such patterns.

Average Days to Collect Receivables Often the accounts receivable turnover is trans- formed to days to collect accounts receivable or days outstanding—an average collection period. In this case, 31.2 is divided into 365 days, resulting in 11.7 days. Companies fre- quently use the average collection period to assess the effectiveness of a company’s credit and collection policies. The general rule is that the average collection period should not greatly exceed the credit term period. That is, if customers are given a 60-day period for payment, then the average collection period should not be too much in excess of 60 days.

LEARNING OBJECTIVE *8 Explain common techniques employed to control cash.

APPENDIX 7A CASH CONTROLS

Cash is the asset most susceptible to improper diversion and use. Management faces two problems in accounting for cash transactions: (1) to establish proper controls to prevent any unauthorized transactions by officers or employees, and (2) to provide

YOU WILL WANT TO READ THE

IFRS INSIGHTS ON PAGES 383–385 For discussion of IFRS related to cash and receivables.

Small companies many times fi nd themselves in a bind when the economy turns south. Their suppliers demand payment earlier, and their customers (represented by their accounts receivable) take longer to pay. That means companies with the least clout get squeezed the hardest. As one company execu- tive noted, “The slowdown of currency, of money, the exchange, puts us in a very precarious position.”

The average time small companies took to collect accounts receivable recently increased to 27 days from about 23 days in the previous four-year period. Many small compa- nies are seeing their payments from larger customers stretch from 30 days to 60 and even 90 days after an invoice is issued. Wal-Mart Stores, Inc., for example, took 29.5 days to pay its bills in the fi rst quarter of 2010, up from 27 days a year earlier. Apple took 52 days, up from 43 days a year earlier. As one individual stated, “If you are working with one of these large companies, as your only customer, they have the power. They can go to somebody else, but you can't go anywhere.”

The chart on the right indicates that, overall, companies increased their payment times past the due date regardless of their size. For example, in the fi rst quarter of 2012, companies paid their bills an average of 7.6 days past due, a 14.1 percent increase from the same period the previous period. The very small companies and the large companies generally have delayed payment the most.

Clearly, the recession of 2008 took its toll. And as the economy emerged from the great recession, the working capi- tal cycle did improve steadily from 2009 to 2013, based on a

global survey by PricewaterhouseCoopers. However, these improvements may be hitting the wall—just 9 percent of sur- veyed companies reported working capital improvements three years in a row. As companies get squeezed between late payments and tighter credit terms, nonpayments often result. Therefore, much judgment must be exercised in determining the proper percentage to record for bad debts.

WHAT DO THE NUMBERS MEAN? I'M STILL WAITING

Source: Experian-Moody’s Q1 2012 benchmark report. March 2012 March 2011

2 4 6 8 Days

27.8 Over 1000

14.6 500 to 999

7.1 250 to 499

5.8 100 to 249

6.9 50 to 99

8.0 20 to 49

11.8 10 to 19

14.0 5 to 9

10.5% 1 to 4 Employees

Company Size Past Due Payments Percentage Change

Sources: Anonymous, “A Cash-Flow Crisis Is the Recession’s Legacy,” Bloomberg Businessweek (March 28–April 3, 2011), pp. 59–60; A. Loten, “Small Firms’ Big Customers Are Slow to Pay,” Wall Street Journal (June 7, 2012), p. B7; and E. Chasen, “The Big Number: 38.2—Average Days of Working Capital at Global Companies,” Wall Street Journal (August 5, 2014).

information necessary to properly manage cash on hand and cash transactions. Yet even with sophisticated control devices, errors can and do happen. For example, the Wall Street Journal ran a story entitled “A $7.8 Million Error Has a Happy Ending for a Horri- fied Bank.” The story described how Manufacturers Hanover Trust Co. mistakenly overpaid about $7.8 million in cash dividends to its stockholders. (As implied in the headline, most stockholders returned the monies.)

To safeguard cash and to ensure the accuracy of the accounting records for cash, companies need effective internal control over cash. Provisions of the Sarbanes- Oxley Act call for enhanced efforts to increase the quality of internal control (for cash and other assets). Such efforts are expected to result in improved financial reporting. In this appendix, we discuss some of the basic control issues related to cash.

USING BANK ACCOUNTS To obtain desired control objectives, a company can vary the number and location of banks and the types of bank accounts. For large companies operating in multiple locations, the location of bank accounts can be important. Establishing collection accounts in strategic locations can accelerate the flow of cash into the company by shortening the time between a customer’s mailing of a payment and the company’s use of the cash. Multiple collection centers generally reduce the size of a company’s collection float. This is the difference between the amount on deposit according to the company’s records and the amount of collected cash according to the bank record.

Large, multilocation companies frequently use lockbox accounts to collect in cit- ies with heavy customer billing. The company rents a local post office box and autho- rizes a local bank to pick up the remittances mailed to that box number. The bank empties the box at least once a day and immediately credits the company’s account for collections. The greatest advantage of a lockbox is that it accelerates the availability of collected cash. Generally, in a lockbox arrangement the bank microfilms the checks for record purposes and provides the company with a deposit slip, a list of collections, and any customer correspondence. Thus, a lockbox system improves the control over cash and accelerates collection of cash. If the income generated from accelerating the receipt of funds exceeds the cost of the lockbox system, then it is a worthwhile undertaking.

The general checking account is the principal bank account in most companies and frequently the only bank account in small businesses. A company deposits in and dis- burses cash from this account. A company cycles all transactions through it. For exam- ple, a company deposits from and disburses to all other bank accounts through the general checking account.

Companies use imprest bank accounts to make a specific amount of cash available for a limited purpose. The account acts as a clearing account for a large volume of checks or for a specific type of check. To clear a specific and intended amount through the imprest account, a company transfers that amount from the general checking account or other source. Companies often use imprest bank accounts for disbursing payroll checks, dividends, commissions, bonuses, confidential expenses (e.g., officers’ salaries), and travel expenses.

THE IMPREST PETTY CASH SYSTEM Almost every company finds it necessary to pay small amounts for miscellaneous expenses such as taxi fares, minor office supplies, and employees’ lunches. Disburse- ments by check for such items is often impractical, yet some control over them is

INTERNATIONAL PERSPECTIVE

Multinational corpora- tions often have cash accounts in more than one currency. For fi nan- cial statement purpos- es, these corporations typically translate these currencies into U.S. dol- lars, using the exchange rate in effect at the bal- ance sheet date.

Appendix 7A: Cash Controls 353

354 Chapter 7 Cash and Receivables

important. A simple method of obtaining reasonable control, while adhering to the rule of disbursement by check, is the imprest system for petty cash disbursements. This is how the system works:

1. The company designates a petty cash custodian, and gives the custodian a small amount of currency from which to make payments. It records transfer of funds to petty cash as:

Petty Cash 300 Cash 300

2. The petty cash custodian obtains signed receipts from each individual to whom he or she pays cash, attaching evidence of the disbursement to the petty cash receipt. Petty cash transactions are not recorded until the fund is reimbursed; someone other than the petty cash custodian records those entries.

3. When the supply of cash runs low, the custodian presents to the controller or accounts payable cashier a request for reimbursement supported by the petty cash receipts and other disbursement evidence. The custodian receives a company check to replenish the fund. At this point, the company records transactions based on petty cash receipts.

Supplies Expense 42 Postage Expense 53 Miscellaneous Expense 76 Cash Over and Short 2 Cash 173

4. If the company decides that the amount of cash in the petty cash fund is excessive, it lowers the fund balance as follows.

Cash 50 Petty Cash 50

Subsequent to establishment, a company makes entries to the Petty Cash account only to increase or decrease the size of the fund.

A company uses a Cash Over and Short account when the petty cash fund fails to prove out. That is, an error occurs such as incorrect change, overpayment of expense, or lost receipt. If cash proves out short (i.e., the sum of the receipts and cash in the fund is less than the imprest amount), the company debits the shortage to the Cash Over and Short account. If cash proves out over, it credits the overage to Cash Over and Short. The company closes Cash Over and Short only at the end of the year. It generally shows Cash Over and Short on the income statement as an “Other expense or revenue.”

There are usually expense items in the fund except immediately after reimburse- ment. Therefore, to maintain accurate financial statements, a company must reimburse the funds at the end of each accounting period and also when nearly depleted.

Under the imprest system, the petty cash custodian is responsible at all times for the amount of the fund on hand either as cash or in the form of signed receipts. These receipts provide the evidence required by the disbursing officer to issue a reimburse- ment check. Further, a company follows two additional procedures to obtain more com- plete control over the petty cash fund:

1. A superior of the petty cash custodian makes surprise counts of the fund from time to time to determine that a satisfactory accounting of the fund has occurred.

2. The company cancels or mutilates petty cash receipts after they have been submitted for reimbursement, so that they cannot be used to secure a second reimbursement.

PHYSICAL PROTECTION OF CASH BALANCES Not only must a company safeguard cash receipts and cash disbursements through internal control measures, but it must also protect the cash on hand and in banks. Because receipts become cash on hand and disbursements are made from cash in banks, adequate control of receipts and disbursements is part of the protection of cash bal- ances, along with certain other procedures.

Physical protection of cash is so elementary a necessity that it requires little discus- sion. A company should make every effort to minimize the cash on hand in the office. It should only have on hand a petty cash fund, the current day’s receipts, and perhaps funds for making change. Insofar as possible, it should keep these funds in a vault, safe, or locked cash drawer. The company should transmit intact each day’s receipts to the bank as soon as practicable. Accurately stating the amount of available cash both in internal management reports and in external financial statements is also extremely important.

Every company has a record of cash received, disbursed, and the balance. Because of the many cash transactions, however, errors or omissions may occur in keeping this record. Therefore, a company must periodically prove the balance shown in the general ledger. It can count cash actually present in the office—petty cash, change funds, and undeposited receipts—for comparison with the company records. For cash on deposit, a company prepares a bank reconciliation—a reconciliation of the company’s record and the bank’s record of the company’s cash.

RECONCILIATION OF BANK BALANCES At the end of each calendar month the bank supplies each customer with a bank state- ment (a copy of the bank’s account with the customer) together with the customer’s checks that the bank paid during the month.22 If neither the bank nor the customer made any errors, if all deposits made and all checks drawn by the customer reached the bank within the same month, and if no unusual transactions occurred that affected either the company’s or the bank’s record of cash, the balance of cash reported by the bank to the customer equals that shown in the customer’s own records. This condition seldom occurs due to one or more of the reconciling items presented below.

22As we mentioned in Chapter 7, paper checks continue to be used as a means of payment. However, ready availability of desktop publishing software and hardware has created new opportunities for check fraud in the form of duplicate, altered, and forged checks. At the same time, new fraud-fighting technologies, such as ultraviolet imaging, high-capacity barcodes, and biometrics, are being developed. These technologies convert paper documents into electronically processed document files, thereby reducing the risk of fraud.

Appendix 7A: Cash Controls 355

1. DEPOSITS IN TRANSIT. End-of-month deposits of cash recorded on the depositor’s books in one month are received and recorded by the bank in the following month.

2. OUTSTANDING CHECKS. Checks written by the depositor are recorded when writ- ten but may not be recorded by (may not “clear”) the bank until the next month.

3. BANK CHARGES. Charges recorded by the bank against the depositor’s balance for such items as bank services, printing checks, not-suffi cient-funds (NSF) checks, and safe-deposit box rentals. The depositor may not be aware of these charges until the re- ceipt of the bank statement.

4. BANK CREDITS. Collections or deposits by the bank for the benefi t of the depositor that may be unknown to the depositor until receipt of the bank statement. Examples are note collection for the depositor and interest earned on interest-bearing checking accounts.

RECONCILING ITEMS

356 Chapter 7 Cash and Receivables

Hence, a company expects differences between its record of cash and the bank’s record. Therefore, it must reconcile the two to determine the nature of the differences between the two amounts.

A bank reconciliation is a schedule explaining any differences between the bank’s and the company’s records of cash. If the difference results only from transactions not yet recorded by the bank, the company’s record of cash is considered correct. But, if some part of the difference arises from other items, either the bank or the company must adjust its records.

A company may prepare two forms of a bank reconciliation. One form reconciles from the bank statement balance to the book balance or vice versa. The other form recon- ciles both the bank balance and the book balance to a correct cash balance. Most compa- nies use this latter form. Illustration 7A-1 shows a sample of that form and its common reconciling items.

This form of reconciliation consists of two sections: (1) “Balance per bank state- ment” and (2) “Balance per depositor’s books.” Both sections end with the same “Cor- rect cash balance.” The correct cash balance is the amount to which the books must be adjusted and is the amount reported on the balance sheet. Companies prepare adjust- ing journal entries for all the addition and deduction items appearing in the “Balance per depositor’s books” section. Companies should immediately call to the bank’s atten- tion any errors attributable to it.

To illustrate, Nugget Mining Company’s books show a cash balance at the Denver National Bank on November 30, 2017, of $20,502. The bank statement covering the month of November shows an ending balance of $22,190. An examination of Nugget’s account- ing records and November bank statement identified the following reconciling items.

1. A deposit of $3,680 that Nugget mailed November 30 does not appear on the bank statement.

2. Checks written in November but not charged to the November bank statement are:

Check #7327 $ 150 #7348 4,820 #7349 31

5. BANK OR DEPOSITOR ERRORS. Errors on either the part of the bank or the part of the depositor cause the bank balance to disagree with the depositor’s book balance.

Balance per bank statement (end of period) $$$ Add: Deposits in transit $$ Undeposited receipts (cash on hand) $$ Bank errors that understate the bank statement balance $$ $$

$$$

Deduct: Outstanding checks $$ Bank errors that overstate the bank statement balance $$ $$

Correct cash balance $$$

Balance per depositor’s books $$$ Add: Bank credits and collections not yet recorded in the books $$ Book errors that understate the book balance $$ $$

$$$ Deduct: Bank charges not yet recorded in the books $$ Book errors that overstate the book balance $$ $$

Correct cash balance $$$

ILLUSTRATION 7A-1 Bank Reconciliation Form and Content

3. Nugget has not yet recorded the $600 of interest collected by the bank November 20 on Sequoia Co. bonds held by the bank for Nugget.

4. Bank service charges of $18 are not yet recorded on Nugget’s books. 5. The bank returned one of Nugget’s customer’s checks for $220 with the bank state-

ment, marked “NSF.” The bank treated this bad check as a disbursement. 6. Nugget discovered that it incorrectly recorded check #7322, written in November

for $131 in payment of an account payable, as $311. 7. A check for Nugent Oil Co. in the amount of $175 that the bank incorrectly charged

to Nugget accompanied the statement.

Nugget reconciled the bank and book balances to the correct cash balance of $21,044 as shown in Illustration 7A-2.

NUGGET MINING COMPANY BANK RECONCILIATION

DENVER NATIONAL BANK, NOVEMBER 30, 2017

Balance per bank statement (end of period) $22,190 Add: Deposit in transit (1) $3,680 Bank error—incorrect check charged to account by bank (7) 175 3,855

26,045 Deduct: Outstanding checks (2) 5,001

Correct cash balance $21,044

Balance per books $20,502 Add: Interest collected by the bank (3) $ 600 Error in recording check #7322 (6) 180 780

21,282 Deduct: Bank service charges (4) 18 NSF check returned (5) 220 238

Correct cash balance $21,044

ILLUSTRATION 7A-2 Sample Bank Reconciliation

The journal entries required to adjust and correct Nugget’s books in early Decem- ber 2017 are taken from the items in the “Balance per books” section and are as follows.

Cash 600 Interest Revenue 600 (To record interest on Sequoia Co. bonds, collected by bank)

Cash 180 Accounts Payable 180 (To correct error in recording amount of check #7322)

Office Expense (bank charges) 18 Cash 18 (To record bank service charges for November)

Accounts Receivable 220 Cash 220 (To record customer’s check returned NSF)

After posting the entries, Nugget’s cash account will have a balance of $21,044. Nugget should return the Nugent Oil Co. check to Denver National Bank, informing the bank of the error.

Appendix 7A: Cash Controls 357

358 Chapter 7 Cash and Receivables

APPENDIX 7B COLLECTIBILITY ASSESSMENT BASED ON EXPECTED CASH FLOWS

Companies continually evaluate their receivables to determine their ultimate collect- ibility. As discussed in the chapter, many companies start with historical loss rates and modify these rates for changes in economic conditions that could affect a borrower’s ability to repay the loan. The discussion in the chapter assumed use of this approach to determine the amount of bad debts to be recorded for a period.

Companies commonly evaluate loans (long-term notes receivable) for collectibility based on an analysis of the expected contractual cash flows. They then apply discounted expected cash flow methods (as discussed in Chapter 6) to measure the allowance and to report the loan at net realizable value.

MEASUREMENT OF COLLECTIBILITY The allowance for doubtful accounts and related bad debt expense on a loan or note receivable can be estimated as the difference between the investment in the loan (gener- ally the principal plus accrued interest or amortized cost) and the expected future cash flows discounted at the loan’s historical effective-interest rate.23

When using the historical effective loan rate, the value of the investment will change only if some of the legally contracted cash flows are reduced. A company recognizes a loss in this case because the expected future cash flows are now lower. The company ignores interest rate changes caused by current economic events that affect the fair value of the loan. As indicated in the chapter, in estimating future cash flows, the creditor should use reasonable and supportable assumptions and projections.

Example At December 31, 2016, Ogden Bank recorded an investment of $100,000 in a loan to Carl King. The loan has an historical effective-interest rate of 10 percent, the principal is due in full at maturity in three years, and interest is due annually. The loan officer performs a review of the loan’s expected future cash flows and utilizes the present value method for measuring the collectibility of the loan. Unfortunately, King is experiencing financial difficulty and thinks he will have a difficult time making full payment. Illustration 7B-1 shows the cash flow schedule prepared by the loan officer.

LEARNING OBJECTIVE *9 Describe the estimation of the allowance based on expected cash flows.

23The creditor may also, for the sake of expediency, use the market price of the loan (if such a price is available) or the fair value of the collateral if it is a collateralized loan. [13] Note that the collectibility analysis shown in this appendix only applies to credit risk inherent in a loan or receivable. However, if the loans are bundled into a security (e.g., mortgage-backed securities), the impairment test is different. Impairments of securities are measured based on fair value. We discuss this accounting in Chapter 17.

ILLUSTRATION 7B-1 Collectibility Analysis of Loan

Contractual Expected Loss of Dec. 31 Cash Flow Cash Flow Cash Flow

2017 $ 10,000 $ 5,000 $ 5,000 2018 10,000 5,000 5,000 2019 $110,000 105,000 5,000

Total cash flows $130,000 $115,000 $15,000

As indicated, this loan is impaired. The expected cash flows of $115,000 are less than the contractual cash flows, including principal and interest, of $130,000. The amount of the impairment to be recorded equals the difference between the recorded investment of $100,000 and the present value of the expected cash flows, as shown in Illustration 7B-2.

The impairment is $12,434. Why isn’t it $15,000 ($130,000 − $115,000)? Because Ogden Bank must measure the loss at a present-value amount, not at an undiscounted amount, when it records the loss.

Recording Bad Debts Ogden Bank (the creditor) recognizes an impairment $12,434 by debiting Bad Debt Expense for the expected loss. At the same time, it reduces the overall value of the receivable by crediting Allowance for Doubtful Accounts. The journal entry to record the loss is therefore as follows.24

Bad Debt Expense 12,434 Allowance for Doubtful Accounts 12,434

What entry does Carl King (the debtor) make? The debtor makes no entry because he still legally owes $100,000.

In some cases, debtors like King negotiate a modification in the terms of the loan agreement. In such cases, the accounting entries from Ogden Bank are the same as the situation in which the loan officer must estimate the future cash flows—except that the calculation for the amount of the loss becomes more reliable (because the revised expected cash flow amounts are contractually specified in the loan agreement).25 The entries related to the debtor in this case often change; they are discussed in Appendix 14A.

Recorded investment $100,000 Less: Present value of $100,000 due in 3 years at 10% (Table 6-2); FV (PVF3,10%); ($100,000 × .75132) $75,132 Present value of $5,000 interest payable annually for 3 years at 10% R (PVF-OA3,10%); ($5,000 × 2.48685) 12,434 87,566 Impairment $ 12,434

ILLUSTRATION 7B-2 Computation of Impairment Loss

24In the event of a loan write-off, the company charges the loss against the allowance. In subsequent periods, if revising estimated expected cash flows based on new information, the company adjusts the allowance account and bad debt expense account (either increased or decreased depending on whether conditions improved or worsened) in the same fashion as the original impairment. We use the terms “loss” and “bad debt expense” interchangeably throughout this discussion. Companies should charge losses related to receivables transactions to Bad Debt Expense or the related Allowance for Doubtful Accounts because they use these accounts to recognize changes in values affecting receivables. 25Many alternatives are permitted to recognize income by Ogden Bank in subsequent periods. [14]

Review and Practice 359

REVIEW AND PRACTICE KEY TERMS REVIEW

accounts receivable, 329 accounts receivable

turnover, 350 aging schedule, 336 allowance method, 334 bank overdrafts, 328 *bank reconciliation, 356 cash, 326 cash discounts, 331 cash equivalents, 326

compensating balances, 327

direct write-off method, 334

factoring receivables, 345 fair value option, 344 financial components

approach, 346 *imprest system for petty

cash, 354

imputed interest rate, 342 net realizable value, 334 nontrade receivables, 329 notes receivable, 329 *not-sufficient-funds (NSF)

checks, 355 promissory note, 338 receivables, 329 restricted cash, 327 sales discounts, 331

trade discounts, 331 trade receivables, 329 transaction price, 331 unrealized holding gain or

loss, 344 without recourse, 346 with recourse, 346 zero-interest-bearing notes,

338

360 Chapter 7 Cash and Receivables

LEARNING OBJECTIVES REVIEW 1 Indicate how to report cash and related items. To be reported as “cash,” an asset must be readily available for the

payment of current obligations and free from contractual restrictions that limit its use in satisfying debts. Cash consists of coin, currency, and available funds on deposit at the bank. Negotiable instruments such as money orders, certified checks, cashier’s checks, personal checks, and bank drafts are also viewed as cash. Savings accounts are usually classified as cash.

Companies report cash as a current asset in the balance sheet. The reporting of other related items are as follows. (1) Restricted cash: The SEC recommends that companies state separately legally restricted deposits held as compensating

balances against short-term borrowing among the “Cash and cash equivalent items” in current assets. Restricted depos- its held against long-term borrowing arrangements should be separately classified as noncurrent assets in either the investments or other assets sections.

(2) Bank overdrafts: Companies should report overdrafts in the current liabilities section and usually add them to the amount reported as accounts payable. If material, these items should be separately disclosed either on the face of the balance sheet or in the related notes.

(3) Cash equivalents: Companies often report this item together with cash as “Cash and cash equivalents.”

2 Define receivables and understand issues related to their recognition. Receivables are claims held against cus- tomers and others for money, goods, or services. The receivables are classified into three types: (1) current or noncurrent, (2) trade or nontrade, and (3) accounts receivable or notes receivable. Two issues that may complicate the measurement of accounts receivable are (1) the availability of discounts (trade and cash discounts), and (2) the length of time between the sale and the payment due dates (the interest element).

Ideally, companies should measure receivables in terms of their present value—that is, the discounted value of the cash to be received in the future. The profession specifically excludes from the present value considerations receivables arising from normal business transactions that are due in customary trade terms within approximately one year.

3 Explain accounting issues related to valuation of accounts receivable. Companies value and report short-term receivables at net realizable value—the net amount expected to be received in cash, which is not necessarily the amount legally receivable. Determining net realizable value requires estimating uncollectible receivables.

4 Explain accounting issues related to recognition and valuation of notes receivable. Companies record short- term notes at face value and long-term notes receivable at the present value of the cash they expect to collect. When the inter- est stated on an interest-bearing note equals the effective (market) rate of interest, the note sells at face value. When the stated rate differs from the effective rate, a company records either a discount or premium. Like accounts receivable, companies record and report short-term notes receivable at their net realizable value. The same is also true of long-term receivables.

5 Explain the fair value option. Companies have the option to record receivables at fair value. Once the fair value option is chosen, the receivable is reported on the balance sheet at fair value, with the change in fair value recorded in income.

6 Explain accounting issues related to disposition of accounts and notes receivable. To accelerate the receipt of cash from receivables, the owner may transfer the receivables to another company for cash in one of two ways. (1) Sales ( factoring) of receivables: Factors are finance companies or banks that buy receivables from businesses and then collect the remittances directly from the customers. In many cases, transferors may have some continuing involvement with the receivable sold. Companies use a financial components approach to record this type of transaction. (2) Secured borrowing: A creditor often requires that the debtor designate or pledge receivables as security for the loan.

7 Describe how to report and analyze receivables. Companies should report receivables with appropriate offset of valu- ation accounts against receivables, classify receivables as current or noncurrent, identify pledged or designated receivables, and disclose the credit risk inherent in the receivables. Analysts assess receivables based on turnover and the days outstanding.

*8 Explain common techniques employed to control cash. The common techniques employed to control cash are as fol- lows. (1) Using bank accounts: A company can vary the number and location of banks and the types of accounts to obtain desired control objectives. (2) The imprest petty cash system: It may be impractical to require small amounts of various expenses be paid by check, yet some control over them is important. (3) Physical protection of cash balances: Adequate control of receipts and disburse- ments is a part of the protection of cash balances. Every effort should be made to minimize the cash on hand in the office. (4) Reconciliation of bank balances: Cash on deposit is not available for count and is proved by preparing a bank reconciliation.

*9 Describe the estimation of the allowance based on expected cash flows. Companies commonly evaluate the col- lectability of loans (long-term notes receivable) based on an analysis of the expected contractual cash flows. The allowance for doubtful accounts and related bad debt expense on a loan or note receivable can be estimated as the difference between the investment in the loan and expected future cash flows discounted at the loan’s historical effective-interest rate.

PRACTICE PROBLEM

The trial balance before adjustment for Slamar Company shows the following balances.

Debit Credit

Net sales $860,000 Accounts receivable 338,000 Allowance for doubtful accounts $4,240

Consider the following independent situations:

1. To obtain additional cash, Slamar factors without recourse $50,000 of accounts receivable with Pierce Finance. The finance charge is 11% of the amount factored.

2. To obtain a 1-year loan of $75,000, Slamar assigns $80,000 of specific receivable accounts to Milo Financial. The finance charge is 9% of the loan; the cash is received and the accounts turned over to Milo Financial.

3. The company wants to maintain Allowance for Doubtful Accounts at 6% of gross accounts receivable.

Instructions (a) Using the data above, give the journal entries required to record situations 1–3. (b) Discuss how analysis based on the current ratio and the accounts receivable turnover would be affected if Slamar had

transferred the receivables in situation 1 using a secured borrowing.

ENHANCED REVIEW AND PRACTICE Go online for multiple-choice questions with solutions, review exercises with solutions, and a full glossary of all key terms.

Practice Problem 361

SOLUTION

(a) 1. Cash 44,500 Loss on Sale of Receivables ($50,000 × 11%) 5,500 Accounts Receivable 50,000

2. Cash 68,250 Interest Expense ($75,000 × 9%) 6,750 Notes Payable 75,000

3. Bad Debt Expense 16,040 Allowance for Doubtful Accounts [($338,000 × 6%) − $4,240] 16,040

(b) With a secured borrowing, the receivables would stay on Slamar’s books, and Slamar would record a note payable. This would reduce the current ratio and accounts receivable turnover.

Exercises, Problems, Problem Solution Walkthrough Videos, and many more assessment tools and resources are available for practice in WileyPLUS.

362 Chapter 7 Cash and Receivables

1. What may be included under the heading of “cash”? 2. In what accounts should the following items be

classified? (a) Coins and currency. (b) U.S. Treasury (government) bonds. (c) Certificate of deposit (matures in 5 months). (d) Cash in a bank that is in receivership. (e) NSF check (returned with bank statement). (f) Deposit in foreign bank (exchangeability limited). (g) Postdated checks. (h) Cash to be used for retirement of long-term bonds. (i) Deposits in transit. (j) 100 shares of HP stock (intention is to sell in one

year or less). (k) Savings and checking accounts. (l) Petty cash. (m) Stamps. (n) Travel advances. 3. Define a “compensating balance.” How should a com-

pensating balance be reported?

4. Springsteen Inc. reported in a recent annual report “Restricted cash for debt redemption.” What section of the balance sheet would report this item?

5. What are the reasons that a company gives trade dis- counts? Why are trade discounts not recorded in the accounts like cash discounts?

6. What are two methods of recording accounts receivable transactions when a cash discount situation is involved? Which is more theoretically correct? Which is used in practice more of the time? Why?

7. Discuss the accounting for sales allowances and how they relate to the concept of variable consideration.

8. What are the basic problems that occur in the valuation of accounts receivable?

9. What is the theoretical justification of the allowance method as contrasted with the direct write-off method of accounting for bad debts?

10. Indicate how the percentage-of-receivables method, based on an aging schedule, accomplishes the objectives of the allowance method of accounting for bad debts. What other methods, besides an aging analysis, can be used for estimating uncollectible accounts?

11. Of what merit is the contention that the allowance method lacks the objectivity of the direct write-off method? Dis- cuss in terms of accounting’s measurement function.

12. Explain how the accounting for bad debts can be used for earnings management.

13. Because of calamitous earthquake losses, Bernstein Company, one of your client’s oldest and largest cus- tomers, suddenly and unexpectedly became bankrupt.

Approximately 30% of your client’s total sales have been made to Bernstein Company during each of the past sev- eral years. The amount due from Bernstein Company— none of which is collectible—equals 22% of total accounts receivable, an amount that is considerably in excess of what was determined to be an adequate provision for doubtful accounts at the close of the preceding year. How would your client record the write-off of the Bernstein Company receivable if it is using the allowance method of account- ing for bad debts? Justify your suggested treatment.

14. What is the normal procedure for handling the collec- tion of accounts receivable previously written off using the direct write-off method? The allowance method?

15. On January 1, 2017, Lombard Co. sells property for which it had paid $690,000 to Sargent Company, receiv- ing in return Sargent’s zero-interest-bearing note for $1,000,000 payable in 5 years. What entry would Lom- bard make to record the sale, assuming that Lombard frequently sells similar items of property for a cash sales price of $640,000?

16. What is “imputed interest”? In what situations is it nec- essary to impute an interest rate for notes receivable? What are the considerations in imputing an appropriate interest rate?

17. What is the fair value option? Where do companies that elect the fair value option report unrealized holding gains and losses?

18. Indicate three reasons why a company might sell its receivables to another company.

19. When is the financial components approach to recording the transfers of receivables used? When should a trans- fer of receivables be recorded as a sale?

20. Moon Hardware is planning to factor some of its receiv- ables. The cash received will be used to pay for inven- tory purchases. The factor has indicated that it will require “recourse” on the sold receivables. Explain to the controller of Moon Hardware what “recourse” is and how the recourse will be reflected in Moon’s finan- cial statements after the sale of the receivables.

21. Horizon Outfitters Company includes in its trial balance for December 31 an item for Accounts Receivable $789,000. This balance consists of the following items:

Due from regular customers $523,000 Refund receivable on prior year’s income taxes (an established claim) 15,500 Travel advance to employees 22,000 Loan to wholly owned subsidiary 45,500 Advances to creditors for goods ordered 61,000 Accounts receivable assigned as security for loans payable 75,000 Notes receivable past due plus interest on these notes 47,000

Total $789,000

QUESTIONS

Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter.

Illustrate how these items should be shown in the bal- ance sheet as of December 31.

22. What is the accounts receivable turnover, and what type of information does it provide?

23. You are evaluating Woodlawn Racetrack for a potential loan. An examination of the notes to the financial state- ments indicates restricted cash at year-end amounts to $100,000. Explain how you would use this information in evaluating Woodlawn’s liquidity.

*24. Distinguish among the following: (1) a general checking account, (2) an imprest bank account, and (3) a lockbox account.

*25. What are the general rules for measuring and recogniz- ing gain or loss by both the debtor and the creditor in an impairment?

*26. Describe the estimation of the allowance, based on expected cash flows.

BRIEF EXERCISES

BE7-1 (L01) Kraft Enterprises owns the following assets at December 31, 2017.

Cash in bank—savings account 68,000 Checking account balance 17,000 Cash on hand 9,300 Postdated checks 750 Cash refund due from IRS 31,400 Certifi cates of deposit (180-day) 90,000

What amount should be reported as cash? BE7-2 (L02) Restin Co. uses the gross method to record sales made on credit. On June 1, 2017, it made sales of $50,000 with terms 3/15, n/45. On June 12, 2017, Restin received full payment for the June 1 sale. Prepare the required journal entries for Restin Co. BE7-3 (L02) Use the information from BE7-2, assuming Restin Co. uses the net method to account for cash discounts. Prepare the required journal entries for Restin Co. BE7-4 (L02) Roeher Company sold $9,000 of its specialty shelving to Elkins Office Supply Co. on account. Prepare the entries when (a) Roeher makes the sale, (b) Roeher grants an allowance of $700 when some of the shelving does not meet exact specifica- tions but still could be sold by Elkins, and (c) at year-end; Roeher estimates that an additional $200 in allowances will be granted to Elkins.

BE7-5 (L03) Wilton, Inc. had net sales in 2017 of $1,400,000. At December 31, 2017, before adjusting entries, the balances in selected accounts were Accounts Receivable $250,000 debit, and Allowance for Doubtful Accounts $2,400 credit. If Wilton esti- mates that 8% of its receivables will prove to be uncollectible, prepare the December 31, 2017, journal entry to record bad debt expense.

BE7-6 (L03) Use the information presented in BE7-5 for Wilton, Inc.

(a) Instead of an Allowance for Doubtful Accounts Balance of $2,400 credit, the balance was $1,900 debit. Assume that 10% of accounts receivable will prove to be uncollectible. Prepare the entry to record bad debt expense.

(b) Instead of estimating uncollectibles based on a percentage of receivables, assume Wilton prepares an aging schedule that estimates total uncollectible accounts at $24,600. (Assume an allowance of $2,400 credit.) Prepare the entry to re- cord bad debt expense.

BE7-7 (L04) Milner Family Importers sold goods to Tung Decorators for $30,000 on November 1, 2017, accepting Tung’s $30,000, 6-month, 6% note. Prepare Milner’s November 1 entry, December 31 annual adjusting entry, and May 1 entry for the collection of the note and interest.

BE7-8 (L04) Dold Acrobats lent $16,529 to Donaldson, Inc., accepting Donaldson’s 2-year, $20,000, zero-interest-bearing note. The implied interest rate is 10%. Prepare Dold’s journal entries for the initial transaction, recognition of interest each year, and the collection of $20,000 at maturity.

BE7-9 (L06) On October 1, 2017, Chung, Inc. assigns $1,000,000 of its accounts receivable to Seneca National Bank as collateral for a $750,000 note. The bank assesses a finance charge of 2% of the receivables assigned and interest on the note of 9%. Prepare the October 1 journal entries for both Chung and Seneca.

BE7-10 (L06) Wood Incorporated factored $150,000 of accounts receivable with Engram Factors Inc. on a without-recourse basis. Engram assesses a 2% finance charge of the amount of accounts receivable and retains an amount equal to 6% of accounts receivable for possible adjustments. Prepare the journal entry for Wood Incorporated and Engram Factors to record the factoring of the accounts receivable to Engram.

BE7-11 (L06) Use the information in BE7-10 for Wood. Assume that the receivables are sold with recourse. Prepare the journal entry for Wood to record the sale, assuming that the recourse liability has a fair value of $7,500.

Brief Exercises 363

364 Chapter 7 Cash and Receivables

BE7-12 (L06) Arness Woodcrafters sells $250,000 of receivables to Commercial Factors, Inc. on a with recourse basis. Com- mercial assesses a finance charge of 5% and retains an amount equal to 4% of accounts receivable. Arness estimates the fair value of the recourse liability to be $8,000. Prepare the journal entry for Arness to record the sale.

BE7-13 (L06) Use the information presented in BE7-12 for Arness Woodcrafters but assume that the recourse liability has a fair value of $4,000, instead of $8,000. Prepare the journal entry and discuss the effects of this change in the value of the recourse liability on Arness’s financial statements.

BE7-14 (L07) Recent financial statements of General Mills, Inc. report net sales of $12,442,000,000. Accounts receivable are $912,000,000 at the beginning of the year and $953,000,000 at the end of the year. Compute General Mills’ accounts receivable turnover. Compute General Mills’ average collection period for accounts receivable in days.

*BE7-15 (L08) Finman Company designated Jill Holland as petty cash custodian and established a petty cash fund of $200. The fund is reimbursed when the cash in the fund is at $15, which it is. Petty cash receipts indicate funds were disbursed for office supplies $94 and miscellaneous expense $87. Prepare journal entries for the establishment of the fund and the reimbursement.

*BE7-16 (L08) Horton Corporation is preparing a bank reconciliation and has identified the following potential reconciling items. For each item, indicate if it is (1) added to balance per bank statement, (2) deducted from balance per bank statement, (3) added to balance per books, or (4) deducted from balance per books.

(a) Deposit in transit $5,500. (d) Outstanding checks $7,422. (b) Bank service charges $25. (e) NSF check returned $377. (c) Interest credited to Horton’s account $31.

*BE7-17 (L08) Use the information presented in BE7-16 for Horton Corporation. Prepare any entries necessary to make Horton’s accounting records correct and complete.

*BE7-18 (L09) Assume that Toni Braxton Company has recently fallen into financial difficulties. By reviewing all available evidence on December 31, 2017, one of Toni Braxton’s creditors, the National American Bank, determined that Toni Braxton would pay back only 65% of the principal at maturity. As a result, the bank decided that the loan was impaired. If the loss is estimated to be $225,000, what entry(ies) should National American Bank make to record this loss?

EXERCISES

E7-1 (L01) EXCEL (Determining Cash Balance) The controller for Clint Eastwood Co. is attempting to determine the amount of cash to be reported on its December 31, 2017, balance sheet. The following information is provided.

1. Commercial savings account of $600,000 and a commercial checking account balance of $900,000 are held at First National Bank of Yojimbo.

2. Money market fund account held at Volonte Co. (a mutual fund organization) permits Eastwood to write checks on this balance, $5,000,000.

3. Travel advances of $180,000 for executive travel for the first quarter of next year (employee to reimburse through salary reduction). 4. A separate cash fund in the amount of $1,500,000 is restricted for the retirement of long-term debt. 5. Petty cash fund of $1,000. 6. An I.O.U. from Marianne Koch, a company customer, in the amount of $190,000. 7. A bank overdraft of $110,000 has occurred at one of the banks the company uses to deposit its cash receipts. At the present

time, the company has no deposits at this bank. 8. The company has two certificates of deposit, each totaling $500,000. These CDs have a maturity of 120 days. 9. Eastwood has received a check that is dated January 12, 2018, in the amount of $125,000. 10. Eastwood has agreed to maintain a cash balance of $500,000 at all times at First National Bank of Yojimbo to ensure future

credit availability. 11. Eastwood has purchased $2,100,000 of commercial paper of Sergio Leone Co. which is due in 60 days. 12. Currency and coin on hand amounted to $7,700.

Instructions (a) Compute the amount of cash to be reported on Eastwood Co.’s balance sheet at December 31, 2017. (b) Indicate the proper reporting for items that are not reported as cash on the December 31, 2017, balance sheet.

E7-2 (L01) (Determining Cash Balance) Presented below are a number of independent situations.

Instructions For each individual situation, determine the amount that should be reported as cash. If the item(s) is not reported as cash, explain the rationale.

1. Checking account balance $925,000; certificate of deposit $1,400,000; cash advance to subsidiary of $980,000; utility deposit paid to gas company $180.

2. Checking account balance $600,000; an overdraft in special checking account at same bank as normal checking account of $17,000; cash held in a bond sinking fund $200,000; petty cash fund $300; coins and currency on hand $1,350.

3. Checking account balance $590,000; postdated check from customer $11,000; cash restricted due to maintaining compen- sating balance requirement of $100,000; certified check from customer $9,800; postage stamps on hand $620.

4. Checking account balance at bank $37,000; money market balance at mutual fund (has checking privileges) $48,000; NSF check received from customer $800.

5. Checking account balance $700,000; cash restricted for future plant expansion $500,000; short-term Treasury bills $180,000; cash advance received from customer $900 (not included in checking account balance); cash advance of $7,000 to company executive, payable on demand; refundable deposit of $26,000 paid to federal government to guarantee performance on construction contract.

E7-3 (L02) (Financial Statement Presentation of Receivables) Jim Carrie Company shows a balance of $181,140 in the Accounts Receivable account on December 31, 2017. The balance consists of the following.

Installment accounts due in 2018 $23,000 Installment accounts due after 2018 34,000 Overpayments to vendors 2,640 Due from regular customers, of which $40,000 represents

accounts pledged as security for a bank loan 79,000 Advances to employees 1,500 Advance to subsidiary company (due in 2018) 81,000

Instructions Illustrate how the information above should be shown on the balance sheet of Jim Carrie Company on December 31, 2017.

E7-4 (L02) (Determining Ending Accounts Receivable) Your accounts receivable clerk, Mitra Adams, to whom you pay a salary of $1,500 per month, has just purchased a new Acura. You decide to test the accuracy of the accounts receivable balance of $82,000 as shown in the ledger.

The following information is available for your first year in business.

(1) Collections from customers $198,000 (2) Merchandise purchased 320,000 (3) Ending merchandise inventory 90,000 (4) Goods are marked to sell at 40% above cost

Instructions Compute an estimate of the ending balance of accounts receivable from customers that should appear in the ledger and any apparent shortages. Assume that all sales are made on account.

E7-5 (L02) EXCEL (Recording Sales Gross and Net) On June 3, Arnold Company sold to Chester Company merchandise having a sale price of $3,000 with terms of 2/10, n/60, f.o.b. shipping point. An invoice totaling $90, terms n/30, was received by Chester on June 8 from John Booth Transport Service for the freight cost. On June 12, the company received a check for the balance due from Chester Company.

Instructions (a) Prepare journal entries on the Arnold Company books to record all the events noted above under each of the following

bases. (1) Sales and receivables are entered at gross selling price. (2) Sales and receivables are entered at net of cash discounts. (b) Prepare the journal entry under basis 2, assuming that Chester Company did not remit payment until July 29.

E7-6 (L02) (Recording Sales Transactions) Presented below is information from Perez Computers Incorporated.

July 1 Sold $20,000 of computers to Robertson Company with terms 3/15, n/60. Perez uses the gross method to record cash discounts. Perez estimates allowances of $1,300 will be honored on these sales.

10 Perez received payment from Robertson for the full amount owed from the July transactions. 17 Sold $200,000 in computers and peripherals to The Clark Store with terms of 2/10, n/30. 30 The Clark Store paid Perez for its purchase of July 17.

Instructions Prepare the necessary journal entries for Perez Computers.

Exercises 365

366 Chapter 7 Cash and Receivables

E7-7 (L03) (Recording Bad Debts) Duncan Company reports the following financial information before adjustments. Dr. Cr.

Accounts Receivable $100,000 Allowance for Doubtful Accounts $ 2,000 Sales Revenue (all on credit) 900,000 Sales Returns and Allowances 50,000

Instructions Prepare the journal entry to record Bad Debt Expense assuming Duncan Company estimates bad debts at (a) 5% of accounts receivable and (b) 5% of accounts receivable but Allowance for Doubtful Accounts had a $1,500 debit balance.

E7-8 (L03) (Recording Bad Debts) At the end of 2017, Aramis Company has accounts receivable of $800,000 and an allow- ance for doubtful accounts of $40,000. On January 16, 2018, Aramis Company determined that its receivable from Ramirez Company of $6,000 will not be collected, and management authorized its write-off.

Instructions (a) Prepare the journal entry for Aramis Company to write off the Ramirez receivable. (b) What is the net realizable value of Aramis Company’s accounts receivable before the write-off of the Ramirez receivable? (c) What is the net realizable value of Aramis Company’s accounts receivable after the write-off of the Ramirez receivable?

E7-9 (L03) (Computing Bad Debts and Preparing Journal Entries) The trial balance before adjustment of Taylor Swift Inc. shows the following balances.

Dr. Cr.

Accounts Receivable $90,000 Allowance for Doubtful Accounts 1,750 Sales Revenue (all on credit) $680,000

Instructions Give the entry for estimated bad debts assuming that the allowance is to provide for doubtful accounts on the basis of (a) 4% of gross accounts receivable and (b) 5% of gross accounts receivable and Allowance for Doubtful Accounts has a $1,700 credit balance.

E7-10 (L03) (Bad-Debt Reporting) The chief accountant for Dickinson Corporation provides you with the following list of accounts receivable written off in the current year.

Date Customer Amount

March 31 E. L. Masters Company $7,800 June 30 Stephen Crane Associates 6,700 September 30 Amy Lowell’s Dress Shop 7,000 December 31 R. Frost, Inc. 9,830

Dickinson follows the policy of debiting Bad Debt Expense as accounts are written off. The chief accountant maintains that this procedure is appropriate for financial statement purposes because the Internal Revenue Service will not accept other meth- ods for recognizing bad debts.

All of Dickinson’s sales are on a 30-day credit basis. Sales for the current year total $2,200,000. The balance in Accounts Receivable at year-end is $77,000 and an analysis of customer risk and charge-off experience indicates that 12% of receivables will be uncollectible (assume a zero balance in the allowance).

Instructions (a) Do you agree or disagree with Dickinson’s policy concerning recognition of bad debt expense? Why or why not? (b) By what amount would net income differ if bad debt expense was computed using the percentage-of-receivables

approach?

E7-11 (L03) (Bad Debts—Aging) Danica Patrick, Inc. includes the following account among its trade receivables.

Hopkins Co.

1/1 Balance forward 700 1/28 Cash (#1710) 1,100 1/20 Invoice #1710 1,100 4/2 Cash (#2116) 1,350 3/14 Invoice #2116 1,350 4/10 Cash (1/1 Balance) 155 4/12 Invoice #2412 1,710 4/30 Cash (#2412) 1,000 9/5 Invoice #3614 490 9/20 Cash (#3614 and 10/17 Invoice #4912 860 part of #2412) 790 11/18 Invoice #5681 2,000 10/31 Cash (#4912) 860 12/20 Invoice #6347 800 12/1 Cash (#5681) 1,250 12/29 Cash (#6347) 800

Instructions Age the balance and specify any items that apparently require particular attention at year-end.

E7-12 (L02,3,6) (Journalizing Various Receivable Transactions) Presented below is information related to James Garfield Corp., which sells merchandise with terms 2/10, net 60. Garfield records its sales and receivables net.

July 1 James Garfield Corp. sold to Warren Harding Co. merchandise having a sales price of $8,000. 5 Accounts receivable of $9,000 (gross) are factored with Andrew Jackson Credit Corp. without recourse at a financing

charge of 9%. Cash is received for the proceeds; collections are handled by the finance company. (These accounts were all past the discount period.)

9 Specific accounts receivable of $9,000 (gross) are pledged to Alf Landon Credit Corp. as security for a loan of $6,000 at a finance charge of 6% of the amount of the loan. The finance company will make the collections. (All the accounts receiv- able are past the discount period.)

Dec. 29 Warren Harding Co. notifies Garfield that it is bankrupt and will pay only 10% of its account. Give the entry to write off the uncollectible balance using the allowance method. (Note: First record the increase in the receivable on July 11 when the discount period passed.)

Instructions Prepare all necessary entries in general journal form for Garfield Corp.

E7-13 (L04) (Note Transactions at Unrealistic Interest Rates) On July 1, 2017, Agincourt Inc. made two sales.

1. It sold land having a fair value of $700,000 in exchange for a 4-year zero-interest-bearing promissory note in the face amount of $1,101,460. The land is carried on Agincourt’s books at a cost of $590,000.

2. It rendered services in exchange for a 3%, 8-year promissory note having a face value of $400,000 (interest payable annually).

Agincourt Inc. recently had to pay 8% interest for money that it borrowed from British National Bank. The customers in these two transactions have credit ratings that require them to borrow money at 12% interest.

Instructions Record the two journal entries that should be recorded by Agincourt Inc. for the sales transactions above that took place on July 1, 2017.

E7-14 (L04,6) (Notes Receivable with Unrealistic Interest Rate) On December 31, 2015, Ed Abbey Co. performed environ- mental consulting services for Hayduke Co. Hayduke was short of cash, and Abbey Co. agreed to accept a $200,000 zero-inter- est-bearing note due December 31, 2017, as payment in full. Hayduke is somewhat of a credit risk and typically borrows funds at a rate of 10%. Abbey is much more creditworthy and has various lines of credit at 6%.

Instructions (a) Prepare the journal entry to record the transaction of December 31, 2015, for the Ed Abbey Co. (b) Assuming Ed Abbey Co.’s fiscal year-end is December 31, prepare the journal entry for December 31, 2016. (c) Assuming Ed Abbey Co.’s fiscal year-end is December 31, prepare the journal entry for December 31, 2017.

E7-15 (L06) (Assigning Accounts Receivable) On April 1, 2017, Rasheed Company assigns $400,000 of its accounts receiv- able to the Third National Bank as collateral for a $200,000 loan due July 1, 2017. The assignment agreement calls for Rasheed to continue to collect the receivables. Third National Bank assesses a finance charge of 2% of the accounts receivable, and interest on the loan is 10% (a realistic rate of interest for a note of this type).

Instructions (a) Prepare the April 1, 2017, journal entry for Rasheed Company. (b) Prepare the journal entry for Rasheed’s collection of $350,000 of the accounts receivable during the period from April 1,

2017, through June 30, 2017. (c) On July 1, 2017, Rasheed paid Third National all that was due from the loan it secured on April 1, 2017. Prepare the

journal entry to record this payment.

E7-16 (L02,3,6) (Journalizing Various Receivable Transactions) The trial balance before adjustment for Phil Collins Com- pany shows the following balances.

Dr. Cr.

Accounts Receivable $82,000 Allowance for Doubtful Accounts 2,120 Sales Revenue $430,000

Exercises 367

368 Chapter 7 Cash and Receivables

Instructions Using the data above, give the journal entries required to record each of the following cases. (Each situation is independent.)

1. To obtain additional cash, Collins factors without recourse $25,000 of accounts receivable with Stills Finance. The finance charge is 10% of the amount factored.

2. To obtain a 1-year loan of $55,000, Collins pledges $65,000 of specific receivable accounts to Crosby Financial. The finance charge is 8% of the loan; the cash is received and the accounts turned over to Crosby Financial.

3. The company wants to maintain the Allowance for Doubtful Accounts at 5% of gross accounts receivable. 4. Based on an aging analysis, an allowance of $5,800 should be reported. Assume the allowance has a credit balance of

$1,100.

E7-17 (L06) (Transfer of Receivables with Recourse) Ames Quartet Inc. factors receivables with a carrying amount of $200,000 to Joffrey Company for $160,000 on a with recourse basis.

Instructions The recourse provision has a fair value of $1,000. This transaction should be recorded as a sale. Prepare the appropriate journal entry to record this transaction on the books of Ames Quartet Inc.

E7-18 (L06) (Transfer of Receivables with Recourse) Beyoncé Corporation factors $175,000 of accounts receivable with Kathleen Battle Financing, Inc. on a with recourse basis. Kathleen Battle Financing will collect the receivables. The receivables records are transferred to Kathleen Battle Financing on August 15, 2017. Kathleen Battle Financing assesses a finance charge of 2% of the amount of accounts receivable and also reserves an amount equal to 4% of accounts receivable to cover probable adjustments.

Instructions (a) What conditions must be met for a transfer of receivables with recourse to be accounted for as a sale? (b) Assume the conditions from part (a) are met. Prepare the journal entry on August 15, 2017, for Beyoncé to record the

sale of receivables, assuming the recourse obligation has a fair value of $2,000.

E7-19 (L06) (Transfer of Receivables without Recourse) JFK Corp. factors $300,000 of accounts receivable with LBJ Finance Corporation on a without recourse basis on July 1, 2017. The receivables records are transferred to LBJ Finance, which will receive the collections. LBJ Finance assesses a finance charge of 1½% of the amount of accounts receivable and retains an amount equal to 4% of accounts receivable to cover sales discounts, returns, and allowances. The transaction is to be recorded as a sale.

Instructions (a) Prepare the journal entry on July 1, 2017, for JFK Corp. to record the sale of receivables without recourse. (b) Prepare the journal entry on July 1, 2017, for LBJ Finance Corporation to record the purchase of receivables without

recourse.

E7-20 (L07) (Analysis of Receivables) Presented below is information for Jones Company.

1. Beginning-of-the-year Accounts Receivable balance was $15,000. 2. Net sales (all on account) for the year were $100,000. Jones does not offer cash discounts. 3. Collections on accounts receivable during the year were $70,000.

Instructions (a) Prepare (summary) journal entries to record the items noted above. (b) Compute Jones’s accounts receivable turnover and days to collect receivables for the year. The company does not

believe it will have any bad debts. (c) Use the turnover ratio computed in (b) to analyze Jones’s liquidity. The turnover ratio last year was 6.0.

E7-21 (L06,7) (Transfer of Receivables) Use the information for Jones Company as presented in E7-20. Jones is planning to factor some accounts receivable at the end of the year. Accounts totaling $25,000 will be transferred to Credit Factors, Inc. with recourse. Credit Factors will retain 5% of the balances for probable adjustments and assesses a finance charge of 4%. The fair value of the recourse obligation is $1,200.

Instructions (a) Prepare the journal entry to record the sale of the receivables. (b) Compute Jones’s accounts receivable turnover for the year, assuming the receivables are sold, and discuss how factor-

ing of receivables affects the turnover ratio.

*E7-22 (L08) (Petty Cash) Carolyn Keene, Inc. decided to establish a petty cash fund to help ensure internal control over its small cash expenditures. The following information is available for the month of April.

1. On April 1, it established a petty cash fund in the amount of $200. 2. A summary of the petty cash expenditures made by the petty cash custodian as of April 10 is as follows.

Delivery charges paid on merchandise purchased $60.00 Supplies purchased and used 25.00 Postage expense 33.00 I.O.U. from employees 17.00 Miscellaneous expense 36.00

The petty cash fund was replenished on April 10. The balance in the fund was $27. 3. The petty cash fund balance was increased $100 to $300 on April 20.

Instructions Prepare the journal entries to record transactions related to petty cash for the month of April.

*E7-23 (L08) (Petty Cash) The petty cash fund of Fonzarelli’s Auto Repair Service, a sole proprietorship, contains the following.

1. Coins and currency $ 15.20 2. Postage stamps 2.90 3. An I.O.U. from Richie Cunningham, an employee, for cash advance 40.00 4. Check payable to Fonzarelli’s Auto Repair from Pottsie Weber, an employee, marked NSF 34.00 5. Vouchers for the following: Stamps $ 20.00 Two Rose Bowl tickets for Nick Fonzarelli 170.00 Printer cartridge 14.35 204.35

$296.45

The general ledger account Petty Cash has a balance of $300.

Instructions Prepare the journal entry to record the reimbursement of the petty cash fund.

*E7-24 (L08) (Bank Reconciliation and Adjusting Entries) Angela Lansbury Company deposits all receipts and makes all payments by check. The following information is available from the cash records.

June 30 Bank Reconciliation

Balance per bank $ 7,000 Add: Deposits in transit 1,540 Deduct: Outstanding checks (2,000)

Balance per books $ 6,540

Month of July Results

Per Bank Per Books

Balance July 31 $8,650 $9,250 July deposits 5,000 5,810 July checks 4,000 3,100 July note collected (not included in July deposits) 1,000 — July bank service charge 15 — July NSF check from a customer, returned by the bank 335 — (recorded by bank as a charge)

Instructions (a) Prepare a bank reconciliation going from balance per bank and balance per book to correct cash balance. (b) Prepare the general journal entry or entries to correct the Cash account.

Exercises 369

370 Chapter 7 Cash and Receivables

*E7-25 (L08) (Bank Reconciliation and Adjusting Entries) Logan Bruno Company has just received the August 31, 2017, bank statement, which is summarized below.

County National Bank Disbursements Receipts Balance

Balance, August 1 $ 9,369 Deposits during August $32,200 41,569 Note collected for depositor, including $40 interest 1,040 42,609 Checks cleared during August $34,500 8,109 Bank service charges 20 8,089 Balance, August 31 8,089

The general ledger Cash account contained the following entries for the month of August.

Deposits in transit at August 31 are $3,800, and checks outstanding at August 31 total $1,050. Cash on hand at August 31 is $310. The bookkeeper improperly entered one check in the books at $146.50 which was written for $164.50 for supplies (expense); it cleared the bank during the month of August.

Instructions (a) Prepare a bank reconciliation dated August 31, 2017, proceeding to a correct balance. (b) Prepare any entries necessary to make the books correct and complete. (c) What amount of cash should be reported in the August 31 balance sheet?

*E7-26 (L09) (Expected Cash Flows) On December 31, 2017, Iva Majoli Company borrowed $62,092 from Paris Bank, signing a 5-year, $100,000 zero-interest-bearing note. The note was issued to yield 10% interest. Unfortunately, during 2019, Majoli began to experience financial difficulty. As a result, at December 31, 2019, Paris Bank determined that it was probable that it would receive back only $75,000 at maturity. The market rate of interest on loans of this nature is now 11%.

Instructions (a) Prepare the entry to record the issuance of the loan by Paris Bank on December 31, 2017. (b) Prepare the entry, if any, to record the impairment of the loan on December 31, 2019, by Paris Bank.

*E7-27 (L09) (Expected Cash Flows) On December 31, 2017, Conchita Martinez Company signed a $1,000,000 note to Sauk City Bank. The market interest rate at that time was 12%. The stated interest rate on the note was 10%, payable annually. The note matures in 5 years. Unfortunately, because of lower sales, Conchita Martinez’s financial situation worsened. On December 31, 2019, Sauk City Bank determined that it was probable that the company would pay back only $600,000 of the principal at matu- rity. However, it was considered likely that interest would continue to be paid, based on the $1,000,000 loan.

Instructions (a) Determine the amount of cash Conchita Martinez received from the loan on December 31, 2017. (b) Prepare a note amortization schedule for Sauk City Bank up to December 31, 2019. (c) Determine the loss on impairment that Sauk City Bank should recognize on December 31, 2019.

PROBLEMS

P7-1 (L01) EXCEL (Determine Proper Cash Balance) Francis Equipment Co. closes its books regularly on December 31, but at the end of 2017 it held its cash book open so that a more favorable balance sheet could be prepared for credit purposes. Cash receipts and disbursements for the first 10 days of January were recorded as December transactions. The information is given below.

1. January cash receipts recorded in the December cash book totaled $45,640, of which $28,000 represents cash sales, and $17,640 represents collections on account for which cash discounts of $360 were given.

2. January cash disbursements recorded in the December check register liquidated accounts payable of $22,450 on which discounts of $250 were taken.

3. The ledger has not been closed for 2017. 4. The amount shown as inventory was determined by physical count on December 31, 2017.

The company uses the periodic method of inventory.

Instructions (a) Prepare any entries you consider necessary to correct Francis’s accounts at December 31. (b) To what extent was Francis Equipment Co. able to show a more favorable balance sheet at December 31 by holding its

cash book open? (Compute working capital and the current ratio.) Assume that the balance sheet that was prepared by the company showed the following amounts:

Cash

Balance, August 1 10,050 Disbursements in August 34,903 Receipts during August 35,000

Dr. Cr.

Cash $39,000 Accounts receivable 42,000 Inventory 67,000 Accounts payable $45,000 Other current liabilities 14,200

P7-2 (L03) GROUPWORK (Bad-Debt Reporting) The following are a series of unrelated situations.

1. Halen Company’s unadjusted trial balance at December 31, 2017, included the following accounts.

Debit Credit

Accounts receivable $53,000 Allowance for doubtful accounts 4,000 Net sales $1,200,000

Halen Company estimates its bad debt expense to be 7% of gross accounts receivable. Determine its bad debt expense for 2017.

2. An analysis and aging of Stuart Corp. accounts receivable at December 31, 2017, disclosed the following.

Amounts estimated to be uncollectible $ 180,000 Accounts receivable 1,750,000 Allowance for doubtful accounts (per books) 125,000

What is the net realizable value of Stuart’s receivables at December 31, 2017?

3. Shore Co. provides for doubtful accounts based on 4% of gross accounts receivable, The following data are available for 2017.

Credit sales during 2017 $4,400,000 Bad debt expense 57,000 Allowance for doubtful accounts 1/1/17 17,000 Collection of accounts written off in prior years

(customer credit was reestablished) 8,000 Customer accounts written off as uncollectible during 2017 30,000

What is the balance in Allowance for Doubtful Accounts at December 31, 2017?

4. At the end of its first year of operations, December 31, 2017, Darden Inc. reported the following information.

Accounts receivable, net of allowance for doubtful accounts $950,000 Customer accounts written off as uncollectible during 2017 24,000 Bad debt expense for 2017 84,000

What should be the balance in accounts receivable at December 31, 2017, before subtracting the allowance for doubtful accounts?

5. The following accounts were taken from Bullock Inc.’s trial balance at December 31, 2017.

Debit Credit

Net credit sales $750,000 Allowance for doubtful accounts $ 14,000 Accounts receivable 310,000

If doubtful accounts are 3% of accounts receivable, determine the bad debt expense to be reported for 2017.

Instructions Answer the questions relating to each of the five independent situations as requested.

P7-3 (L03) EXCEL (Bad-Debt Reporting—Aging) Manilow Corporation operates in an industry that has a high rate of bad debts. Before any year-end adjustments, the balance in Manilow’s Accounts Receivable account was $555,000 and Allowance for Doubtful Accounts had a credit balance of $40,000. The year-end balance reported in the balance sheet for Allowance for Doubtful Accounts will be based on the aging schedule shown below.

Probability of Days Account Outstanding Amount Collection

Less than 16 days $300,000 .98 Between 16 and 30 days 100,000 .90 Between 31 and 45 days 80,000 .85 Between 46 and 60 days 40,000 .80 Between 61 and 75 days 20,000 .55 Over 75 days 15,000 .00

Problems 371

372 Chapter 7 Cash and Receivables

Instructions (a) What is the appropriate balance for Allowance for Doubtful Accounts at year-end? (b) Show how accounts receivable would be presented on the balance sheet. (c) What is the dollar effect of the year-end bad debt adjustment on the before-tax income? (CMA adapted)

P7-4 (L03) (Bad-Debt Reporting) From inception of operations to December 31, 2017, Fortner Corporation provided for uncollectible accounts receivable under the allowance method. The provisions are recorded, based on analyses of customers with different risk characteristics. Bad debts written off were charged to the allowance account; recoveries of bad debts previ- ously written off were credited to the allowance account, and no year-end adjustments to the allowance account were made. Fortner’s usual credit terms are net 30 days.

The balance in Allowance for Doubtful Accounts was $130,000 at January 1, 2017. During 2017, credit sales totaled $9,000,000, the provision for doubtful accounts was determined to be $180,000, $90,000 of bad debts were written off, and recoveries of accounts previously written off amounted to $15,000. Fortner installed a computer system in November 2017, and an aging of accounts receivable was prepared for the first time as of December 31, 2017. A summary of the aging is as follows.

Classifi cation by Balance in Estimated % Month of Sale Each Category Uncollectible

November–December 2017 $1,080,000 2% July–October 650,000 10% January–June 420,000 25% Prior to 1/1/17 150,000 80%

$2,300,000

Based on the review of collectibility of the account balances in the “prior to 1/1/17” aging category, additional receivables totaling $60,000 were written off as of December 31, 2017. The 80% uncollectible estimate applies to the remaining $90,000 in the category. Effective with the year ended December 31, 2017, Fortner adopted a different method for estimating the allowance for doubtful accounts at the amount indicated by the year-end aging analysis of accounts receivable.

Instructions (a) Prepare a schedule analyzing the changes in Allowance for Doubtful Accounts for the year ended December 31, 2017.

Show supporting computations in good form. (Hint: In computing the 12/31/17 allowance, subtract the $60,000 write-off.) (b) Prepare the journal entry for the year-end adjustment to Allowance for Doubtful Accounts balance as of December 31, 2017. (AICPA adapted)

P7-5 (L03) (Bad-Debt Reporting) Presented below is information related to the Accounts Receivable accounts of Gulistan Inc. during the current year 2017.

1. An aging schedule of the accounts receivable as of December 31, 2017, is as follows. % to Be Applied after Age Net Debit Balance Correction Is Made

Under 60 days $172,342 1% 60–90 days 136,490 3% 91–120 days 39,924* 6% Over 120 days 23,644 $3,700 defi nitely uncollectible; $372,400 estimated remainder uncollectible is 25%

*The $3,240 write-off of receivables is related to the 91-to-120 day category.

2. The Accounts Receivable control account has a debit balance of $372,400 on December 31, 2017. 3. Two entries were made in the Bad Debt Expense account during the year: (1) a debit on December 31 for the amount cred-

ited to Allowance for Doubtful Accounts, and (2) a credit for $3,240 on November 3, 2017, and a debit to Allowance for Doubtful Accounts because of a bankruptcy.

4. Allowance for Doubtful Accounts is as follows for 2017.

Allowance for Doubtful Accounts

Nov. 3 Uncollectible accounts Jan. 1 Beginning balance 8,750 written off 3,240 Dec. 31 5% of $372,400 18,620

5. A credit balance exists in Accounts Receivable (60–90 days) of $4,840, which represents an advance on a sales contract.

Instructions Assuming that the books have not been closed for 2017, make the necessary correcting entries.

P7-6 (L02,3) (Journalize Various Accounts Receivable Transactions) The balance sheet of Starsky Company at December 31, 2016, includes the following.

Notes receivable $ 36,000 Accounts receivable 182,100 Less: Allowance for doubtful accounts 17,300 $200,800

Transactions in 2017 include the following.

1. Accounts receivable of $138,000 were collected including accounts of $60,000 on which 2% sales discounts were allowed. 2. $5,300 was received in payment of an account which was written off the books as worthless in 2016. 3. Customer accounts of $17,500 were written off during the year. 4. At year-end, Allowance for Doubtful Accounts was estimated to need a balance of $20,000. This estimate is based on an

analysis of aged accounts receivable.

Instructions Prepare all journal entries necessary to reflect the transactions above.

P7-7 (L04) (Notes Receivable with Realistic Interest Rate) On October 1, 2017, Arden Farm Equipment Company sold a pecan-harvesting machine to Valco Brothers Farm, Inc. In lieu of a cash payment Valco Brothers Farm gave Arden a 2-year, $120,000, 8% note (a realistic rate of interest for a note of this type). The note required interest to be paid annually on October 1. Arden’s financial statements are prepared on a calendar-year basis.

Instructions Assuming Valco Brothers Farm fulfills all the terms of the note, prepare the necessary journal entries for Arden Farm Equipment Company for the entire term of the note.

P7-8 (L04) (Notes Receivable Journal Entries) On December 31, 2017, Oakbrook Inc. rendered services to Beghun Corpora- tion at an agreed price of $102,049, accepting $40,000 down and agreeing to accept the balance in four equal installments of $20,000 receivable each December 31. An assumed interest rate of 11% is imputed.

Instructions Prepare the entries that would be recorded by Oakbrook Inc. for the sale and for the receipts and interest on the following dates (prepare an amortization schedule). (Assume that the effective-interest method is used for amortization purposes.)

(a) December 31, 2017. (c) December 31, 2019. (e) December 31, 2021. (b) December 31, 2018. (d) December 31, 2020.

P7-9 (L04) (Comprehensive Receivables Problem) Braddock Inc. had the following long-term receivable account balances at December 31, 2016.

Note receivable from sale of division $1,500,000 Note receivable from offi cer 400,000

Transactions during 2017 and other information relating to Braddock’s long-term receivables were as follows.

1. The $1,500,000 note receivable is dated May 1, 2016, bears interest at 9%, and represents the balance of the consideration received from the sale of Braddock’s electronics division to New York Company. Principal payments of $500,000 plus ap- propriate interest are due on May 1, 2017, 2018, and 2019. The first principal and interest payment was made on May 1, 2017. Collection of the note installments is reasonably assured.

2. The $400,000 note receivable is dated December 31, 2016, bears interest at 8%, and is due on December 31, 2019. The note is due from Sean May, president of Braddock Inc. and is collateralized by 10,000 shares of Braddock’s common stock. Inter- est is payable annually on December 31, and all interest payments were paid on their due dates through December 31, 2017. The quoted market price of Braddock’s common stock was $45 per share on December 31, 2017.

3. On April 1, 2017, Braddock sold a patent to Pennsylvania Company in exchange for a $100,000 zero-interest-bearing note due on April 1, 2019. There was no established exchange price for the patent, and the note had no ready market. The prevail- ing rate of interest for a note of this type at April 1, 2017, was 12%. The present value of $1 for two periods at 12% is 0.797 (use this factor). The patent had a carrying value of $40,000 at January 1, 2017, and the amortization for the year ended December 31, 2017, would have been $8,000. The collection of the note receivable from Pennsylvania is reasonably assured.

4. On July 1, 2017, Braddock sold a parcel of land to Splinter Company for $200,000 under an installment sale contract. Splin- ter made a $60,000 cash down payment on July 1, 2017, and signed a 4-year 11% note for the $140,000 balance. The equal annual payments of principal and interest on the note will be $45,125 payable on July 1, 2018, through July 1, 2021. The land could have been sold at an established cash price of $200,000. The cost of the land to Braddock was $150,000. Circum- stances are such that the collection of the installments on the note is reasonably assured.

Problems 373

374 Chapter 7 Cash and Receivables

Instructions (a) Prepare the long-term receivables section of Braddock’s balance sheet at December 31, 2017. (b) Prepare a schedule showing the current portion of the long-term receivables and accrued interest receivable that would

appear in Braddock’s balance sheet at December 31, 2017. (c) Prepare a schedule showing interest revenue from the long-term receivables that would appear on Braddock’s income

statement for the year ended December 31, 2017.

P7-10 (L06) (Assigned Accounts Receivable—Journal Entries) Salen Company finances some of its current operations by assigning accounts receivable to a finance company. On July 1, 2017, it assigned, under guarantee, specific accounts amounting to $150,000. The finance company advanced to Salen 80% of the accounts assigned (20% of the total to be withheld until the finance company has made its full recovery), less a finance charge of ½% of the total accounts assigned.

On July 31, Salen Company received a statement that the finance company had collected $80,000 of these accounts and had made an additional charge of ½% of the total accounts outstanding as of July 31. This charge is to be deducted at the time of the first remit- tance due Salen Company from the finance company. (Hint: Make entries at this time.) On August 31, 2017, Salen Company received a second statement from the finance company, together with a check for the amount due. The statement indicated that the finance company had collected an additional $50,000 and had made a further charge of ½% of the balance outstanding as of August 31.

Instructions Make all entries on the books of Salen Company that are involved in the transactions above. (AICPA adapted) P7-11 (L06,7) GROUPWORK (Income Effects of Receivables Transactions) Sandburg Company requires additional cash for its business. Sandburg has decided to use its accounts receivable to raise the additional cash and has asked you to determine the income statement effects of the following contemplated transactions.

1. On July 1, 2017, Sandburg assigned $400,000 of accounts receivable to Keller Finance Company. Sandburg received an advance from Keller of 80% of the assigned accounts receivable less a commission of 3% on the advance. Prior to Decem- ber 31, 2017, Sandburg collected $220,000 on the assigned accounts receivable, and remitted $232,720 to Keller, $12,720 of which represented interest on the advance from Keller.

2. On December 1, 2017, Sandburg sold $300,000 of net accounts receivable to Wunsch Company for $270,000. The receiv- ables were sold outright on a without recourse basis.

3. On December 31, 2017, an advance of $120,000 was received from First Bank by pledging $160,000 of Sandburg’s accounts receivable. Sandburg’s first payment to First Bank is due on January 30, 2018.

Instructions Prepare a schedule showing the income statement effects for the year ended December 31, 2017, as a result of the above facts.

*P7-12 (L08) (Petty Cash, Bank Reconciliation) Bill Jovi is reviewing the cash accounting for Nottleman, Inc., a local mailing service. Jovi’s review will focus on the petty cash account and the bank reconciliation for the month ended May 31, 2017. He has collected the following information from Nottleman’s bookkeeper for this task.

Petty Cash

1. The petty cash fund was established on May 10, 2017, in the amount of $250. 2. Expenditures from the fund by the custodian as of May 31, 2017, were evidenced by approved receipts for the following.

Postage expense $33.00 Mailing labels and other supplies 65.00 I.O.U. from employees 30.00 Shipping charges (to customer) 57.45 Newspaper advertising 22.80 Miscellaneous expense 15.35

On May 31, 2017, the petty cash fund was replenished and increased to $300; currency and coin in the fund at that time totaled $26.40.

Bank Reconciliation

THIRD NATIONAL BANK BANK STATEMENT

Disbursements Receipts Balance

Balance, May 1, 2017 $8,769 Deposits $28,000 Note payment direct from customer (interest of $30) 930 Checks cleared during May $31,150 Bank service charges 27 Balance, May 31, 2017 6,522

Nottleman’s Cash Account

Balance, May 1, 2017 $ 8,850 Deposits during May 2017 31,000 Checks written during May 2017 (31,835)

Deposits in transit are determined to be $3,000, and checks outstanding at May 31 total $850. Cash on hand (besides petty cash) at May 31, 2017, is $246.

Instructions (a) Prepare the journal entries to record the transactions related to the petty cash fund for May. (b) Prepare a bank reconciliation dated May 31, 2017, proceeding to a correct cash balance, and prepare the journal entries

necessary to make the books correct and complete. (c) What amount of cash should be reported in the May 31, 2017, balance sheet?

*P7-13 (L08) (Bank Reconciliation and Adjusting Entries) The cash account of Aguilar Co. showed a ledger balance of $3,969.85 on June 30, 2017. The bank statement as of that date showed a balance of $4,150. Upon comparing the statement with the cash records, the following facts were determined.

1. There were bank service charges for June of $25. 2. A bank memo stated that Bao Dai’s note for $1,200 and interest of $36 had been collected on June 29, and the bank had

made a charge of $5.50 on the collection. (No entry had been made on Aguilar’s books when Bao Dai’s note was sent to the bank for collection.)

3. Receipts for June 30 for $3,390 were not deposited until July 2. 4. Checks outstanding on June 30 totaled $2,136.05. 5. The bank had charged the Aguilar Co.’s account for a customer’s uncollectible check amounting to $253.20 on June 29. 6. A customer’s check for $90 (as payment on the customer’s Accounts Receivable) had been entered as $60 in the cash

receipts journal by Aguilar on June 15. 7. Check no. 742 in the amount of $491 had been entered in the cash journal as $419, and check no. 747 in the amount of

$58.20 had been entered as $582. Both checks had been issued to pay for purchases and were payments on Aguilar’s Accounts Payable.

Instructions (a) Prepare a bank reconciliation dated June 30, 2017, proceeding to a correct cash balance. (b) Prepare any entries necessary to make the books correct and complete.

*P7-14 (L08) (Bank Reconciliation and Adjusting Entries) Presented below is information related to Haselhof Inc. Balance per books at October 31, $41,847.85; receipts $173,523.91; disbursements $164,893.54. Balance per bank statement

November 30, $56,274.20. The following checks were outstanding at November 30.

1224 $1,635.29 1230 2,468.30 1232 2,125.15 1233 482.17

Included with the November bank statement and not recorded by the company were a bank debit memo for $27.40 covering bank charges for the month, a debit memo for $372.13 for a customer’s check returned and marked NSF, and a credit memo for $1,400 representing bond interest collected by the bank in the name of Haselhof Inc. Cash on hand at November 30 recorded and awaiting deposit amounted to $1,915.40.

Instructions (a) Prepare a bank reconciliation (to the correct balance) at November 30, for Haselhof Inc. from the information above. (b) Prepare any journal entries required to adjust the cash account at November 30.

*P7-15 (L09) (Expected Cash Flows) On January 1, 2017, Botosan Company issued a $1,200,000, 5-year, zero-interest- bearing note to National Organization Bank. The note was issued to yield 8% annual interest. Unfortunately, during 2018 Botosan fell into financial trouble due to increased competition. After reviewing all available evidence on December 31, 2018, National Organization Bank decided that the loan was impaired. Botosan will probably pay back only $800,000 of the principal at maturity.

Instructions (a) Prepare journal entries for both Botosan Company and National Organization Bank to record the issuance of the note

on January 1, 2017. (Round to the nearest $10.)

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376 Chapter 7 Cash and Receivables

(b) Assuming that both Botosan Company and National Organization Bank use the effective-interest method to amortize the discount, prepare the amortization schedule for the note.

(c) Under what circumstances can National Organization Bank consider Botosan’s note to be impaired? (d) Compute the loss National Organization Bank will suffer from Botosan’s financial distress on December 31, 2018. What

journal entries should be made to record this loss?

CONCEPTS FOR ANALYSIS

CA7-1 (Bad-Debt Accounting) Simms Company has significant amounts of trade accounts receivable. Simms uses the allowance method to estimate bad debts instead of the direct write-off method. During the year, some specific accounts were written off as uncollectible, and some that were previously written off as uncollectible were collected.

Instructions (a) What are the deficiencies of the direct write-off method? (b) Briefly describe the allowance method to estimate bad debts and the theoretical justification for its use? (c) How should Simms account for the collection of the specific accounts previously written off as uncollectible?

CA7-2 (Various Receivable Accounting Issues) Kimmel Company uses the net method of accounting for sales discounts. Kim- mel also offers trade discounts to various groups of buyers.

On August 1, 2017, Kimmel sold some accounts receivable on a without recourse basis. Kimmel incurred a finance charge. Kimmel also has some notes receivable bearing an appropriate rate of interest. The principal and total interest are due at

maturity. The notes were received on October 1, 2017, and mature on September 30, 2019. Kimmel’s operating cycle is less than one year.

Instructions (a) (1) Using the net method, how should Kimmel account for the sales discounts at the date of sale? What is the rationale

for the amount recorded as sales under the net method? (2) Using the net method, what is the effect on Kimmel’s sales revenues and net income when customers do not take

the sales discounts? (b) What is the effect of trade discounts on sales revenues and accounts receivable? Why? (c) How should Kimmel account for the accounts receivable factored on August 1, 2017? Why? (d) How should Kimmel account for the note receivable and the related interest on December 31, 2017? Why?

CA7-3 WRITING (Bad-Debt Reporting Issues) Clark Pierce conducts a wholesale merchandising business that sells approxi- mately 5,000 items per month with a total monthly average sales value of $250,000. Its annual bad debt rate has been approximately 1½% of sales. In recent discussions with his bookkeeper, Mr. Pierce has become confused by all the alternatives apparently available in handling the Allowance for Doubtful Accounts balance. The following information has been presented to Pierce.

1. An allowance can be set up (a) on the basis of a percentage of receivables or (b) on the basis of a valuation of all past due or otherwise questionable accounts receivable. Those considered uncollectible can be charged to such allowance at the close of the accounting period, or specific items can be charged off directly against (1) Gross Sales or to (2) Bad Debt Ex- pense in the year in which they are determined to be uncollectible.

2. Collection agency and legal fees, and so on, incurred in connection with the attempted recovery of bad debts can be charged to (a) Bad Debt Expense, (b) Allowance for Doubtful Accounts, (c) Legal Expense, or (d) Administrative Expense.

3. Debts previously written off in whole or in part but currently recovered can be credited to (a) Other Revenue, (b) Bad Debt Expense, or (c) Allowance for Doubtful Accounts.

Instructions Which of the foregoing methods would you recommend to Mr. Pierce in regard to (1) allowances and charge-offs, (2) collection expenses, and (3) recoveries? State briefly and clearly the reasons supporting your recommendations.

CA7-4 WRITING (Basic Note and Accounts Receivable Transactions)

Part 1: On July 1, 2017, Wallace Company, a calendar-year company, sold special-order merchandise on credit and received in return an interest-bearing note receivable from the customer. Wallace Company will receive interest at the prevailing rate for a note of this type. Both the principal and interest are due in one lump sum on June 30, 2018.

Instructions When should Wallace Company report interest revenue from the note receivable? Discuss the rationale for your answer.

Part 2: On December 31, 2017, Wallace Company had significant amounts of accounts receivable as a result of credit sales to its customers. Wallace uses the allowance method based on credit sales to estimate bad debts. Past experience indicates a reliable estimate of uncollectible accounts can be developed based on an aging analysis of receivable balances. This pattern is expected to continue.

Instructions (a) Discuss the rationale for using the allowance method based on the balance in the trade receivables accounts. (b) How should Wallace Company report the allowance for doubtful accounts on its balance sheet at December 31, 2017?

Also, describe the alternatives, if any, for presentation of bad debt expense in Wallace Company’s 2017 income statement.

(AICPA adapted)

CA7-5 (Sale of Notes Receivable) Corrs Wholesalers Co. sells industrial equipment for a standard 3-year note receivable. Rev- enue is recognized at time of sale. Each note is secured by a lien on the equipment and has a face amount equal to the equipment’s list price. Each note’s stated interest rate is below the customer’s market rate at date of sale. All notes are to be collected in three equal annual installments beginning one year after sale. Some of the notes are subsequently sold to a bank with recourse, some are subsequently sold without recourse, and some are retained by Corrs. At year end, Corrs evaluates all outstanding notes receivable and provides for estimated losses arising from defaults.

Instructions (a) What is the appropriate valuation basis for Corrs’s notes receivable at the date it sells equipment? (b) How should Corrs account for the sale, without recourse, of a February 1, 2017, note receivable sold on May 1, 2017?

Why is it appropriate to account for it in this way? (c) At December 31, 2017, how should Corrs measure and account for the impact of estimated losses resulting from notes

receivable that it (1) Retained and did not sell? (2) Sold to bank with recourse?

(AICPA adapted)

CA7-6 (Zero-Interest-Bearing Note Receivable) On September 30, 2016, Rolen Machinery Co. sold a machine and accepted the customer’s zero-interest-bearing note. Rolen normally makes sales on a cash basis. Since the machine was unique, its sales price was not determinable using Rolen’s normal pricing practices.

After receiving the first of two equal annual installments on September 30, 2017, Rolen immediately sold the note with re- course. On October 9, 2018, Rolen received notice that the note was dishonored, and it paid all amounts due. At all times prior to default, the note was reasonably expected to be paid in full.

Instructions (a) (1) How should Rolen determine the sales price of the machine? (2) How should Rolen report the effects of the zero-interest-bearing note on its income statement for the year ended

December 31, 2016? Why is this accounting presentation appropriate? (b) What are the effects of the sale of the note receivable with recourse on Rolen’s income statement for the year ended

December 31, 2017, and its balance sheet at December 31, 2017? (c) How should Rolen account for the effects of the note being dishonored?

CA7-7 GROUPWORK (Reporting of Notes Receivable, Interest, and Sale of Receivables) On July 1, 2017, Moresan Company sold special-order merchandise on credit and received in return an interest-bearing note receivable from the customer. Moresan will receive interest at the prevailing rate for a note of this type. Both the principal and interest are due in one lump sum on June 30, 2018.

On September 1, 2017, Moresan sold special-order merchandise on credit and received in return a zero-interest-bearing note receivable from the customer. The prevailing rate of interest for a note of this type is determinable. The note receivable is due in one lump sum on August 31, 2019.

Moresan also has significant amounts of trade accounts receivable as a result of credit sales to its customers. On October 1, 2017, some trade accounts receivable were assigned to Indigo Finance Company on a non-notification (Moresan handles collec- tions) basis for an advance of 75% of their amount at an interest charge of 8% on the balance outstanding.

On November 1, 2017, other trade accounts receivable were sold on a without recourse basis. The factor withheld 5% of the trade accounts receivable factored as protection against sales returns and allowances and charged a finance charge of 3%.

Instructions (a) How should Moresan determine the interest revenue for 2017 on the: (1) Interest-bearing note receivable? Why? (2) Zero-interest-bearing note receivable? Why?

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378 Chapter 7 Cash and Receivables

(b) How should Moresan report the interest-bearing note receivable and the zero-interest-bearing note receivable on its balance sheet at December 31, 2017?

(c) How should Moresan account for subsequent collections on the trade accounts receivable assigned on October 1, 2017, and the payments to Indigo Finance? Why?

(d) How should Moresan account for the trade accounts receivable factored on November 1, 2017? Why? (AICPA adapted)

CA7-8 WRITING (Accounting for Zero-Interest-Bearing Note) Soon after beginning the year-end audit work on March 10 at Engone Company, the auditor has the following conversation with the controller.

Controller: The year ended March 31st should be our most profitable in history and, as a consequence, the board of directors has just awarded the officers generous bonuses.

Auditor: I thought profits were down this year in the industry, according to your latest interim report. Controller: Well, they were down, but 10 days ago we closed a deal that will give us a substantial increase for the year. Auditor: Oh, what was it? Controller: Well, you remember a few years ago our former president bought stock in Henderson Enterprises because he

had those grandiose ideas about becoming a conglomerate. For 6 years we have not been able to sell this stock, which cost us $3,000,000 and has not paid a nickel in dividends. Thursday we sold this stock to Bimini Inc. for $4,000,000. So, we will have a gain of $700,000 ($1,000,000 pretax) which will increase our net income for the year to $4,000,000, compared with last year’s $3,800,000. As far as I know, we’ll be the only company in the industry to register an increase in net income this year. That should help the market value of the stock!

Auditor: Do you expect to receive the $4,000,000 in cash by March 31st, your fiscal year-end? Controller: No. Although Bimini Inc. is an excellent company, they are a little tight for cash because of their rapid growth.

Consequently, they are going to give us a $4,000,000 zero-interest-bearing note with payments of $400,000 per year for the next 10 years. The first payment is due on March 31 of next year.

Auditor: Why is the note zero-interest-bearing? Controller: Because that’s what everybody agreed to. Since we don’t have any interest-bearing debt, the funds invested in the

note do not cost us anything and besides, we were not getting any dividends on the Henderson Enterprises stock.

Instructions Do you agree with the way the controller has accounted for the transaction? If not, how should the transaction be accounted for?

CA7-9 WRITING (Receivables Management) As the manager of the accounts receivable department for Beavis Leather Goods, Ltd., you recently noticed that Kelly Collins, your accounts receivable clerk who is paid $1,200 per month, has been wearing unusually tasteful and expensive clothing. (This is Beavis’s first year in business.) This morning, Collins drove up to work in a brand new Lexus.

Naturally suspicious by nature, you decide to test the accuracy of the accounts receivable balance of $192,000 as shown in the ledger. The following information is available for your first year (precisely 9 months ended September 30, 2017) in business.

(1) Collections from customers $188,000 (2) Merchandise purchased 360,000 (3) Ending merchandise inventory 90,000 (4) Goods are marked to sell at 40% above cost.

Instructions Assuming all sales were made on account, compute the ending accounts receivable balance that should appear in the ledger, not- ing any apparent shortage. Then, draft a memo dated October 3, 2017, to Mark Price, the branch manager, explaining the facts in this situation. Remember that this problem is serious, and you do not want to make hasty accusations.

CA7-10 ETHICS (Bad-Debt Reporting) Marvin Company is a subsidiary of Hughes Corp. The controller believes that the yearly allowance for doubtful accounts for Marvin should be 8% of gross accounts receivable. Given the recession and the high interest rate environment, the president, nervous that the parent company might expect the subsidiary to sustain its 10% growth rate, suggests that the controller increase the allowance for doubtful accounts to 9%. The president thinks that the lower net income, which reflects a 6% growth rate, will be a more sustainable rate for Marvin Company.

Instructions (a) In a recessionary environment with tight credit and high interest rates: (1) Identify steps Marvin Company might consider to improve the accounts receivable situation. (2) Then evaluate each step identified in terms of the risks and costs involved. (b) Should the controller be concerned with Marvin Company’s growth rate in estimating the allowance? Explain your answer. (c) Does the president’s request pose an ethical dilemma for the controller? Give your reasons.

USING YOUR JUDGMENT

Financial Reporting The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix B. The company’s complete annual report, including the notes to the financial statements, is available online.

Instructions Refer to P&G’s financial statements and the accompanying notes to answer the following questions.

(a) What criteria does P&G use to classify “Cash and cash equivalents” as reported in its balance sheet? (b) As of June 30, 2014, what balances did P&G have in cash and cash equivalents? What were the major uses of cash during

the year? (c) P&G reports no allowance for doubtful accounts, suggesting that bad debt expense is not material for this company. Is

it reasonable that a company like P&G would not have material bad debt expense? Explain.

Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. The financial statements of Coca-Cola and PepsiCo are presented in Appendices C and D, respectively. The companies’ com- plete annual reports, including the notes to the financial statements, are available online.

Instructions Use the companies’ financial information to answer the following questions.

(a) What were the cash and cash equivalents reported by Coca-Cola and PepsiCo at the end of 2014? What does each com- pany classify as cash equivalents?

(b) What were the accounts receivable (net) for Coca-Cola and PepsiCo at the end of 2014? Which company reports the greater allowance for doubtful accounts (amount and percentage of gross receivable) at the end of 2014?

(c) Assuming that all “net operating revenues” (Coca-Cola) and all “net revenues” (PepsiCo) were net credit sales, compute the accounts receivable turnover for 2014 for Coca-Cola and PepsiCo; also compute the days outstanding for receiv- ables. What is your evaluation of the difference?

Financial Statement Analysis Cases Case 1: Occidental Petroleum Corporation Occidental Petroleum Corporation reported the following information in a recent annual report.

Occidental Petroleum Corporation Consolidated Balance Sheets (in millions)

Current Prior Assets at December 31, year year

Current assets Cash and cash equivalents $ 683 $ 146 Trade receivables, net of allowances 804 608 Receivables from joint ventures, partnerships, and other 330 321 Inventories 510 491 Prepaid expenses and other 147 307

Total current assets 2,474 1,873

Long-term receivables, net 264 275

Notes to Consolidated Financial Statements Cash and Cash Equivalents. Cash equivalents consist of highly liquid investments. Cash equivalents totaled approximately $661 million and $116 million at current and prior year-ends, respectively.

Trade Receivables. Occidental has agreement to sell, under a revolving sale program, an undivided percentage ownership interest in a designated pool of non-interest-bearing receivables. Under this program, Occidental serves as the collection agent with respect to the receivables sold. An interest in new receivables is sold as collections are made from customers. The balance sold at current year-end was $360 million.

Using Your Judgment 379

380 Chapter 7 Cash and Receivables

Instructions

(a) What items other than coin and currency may be included in “cash”? (b) What items may be included in “cash equivalents”? (c) What are compensating balance arrangements, and how should they be reported in financial statements? (d) What are the possible differences between cash equivalents and short-term (temporary) investments? (e) Assuming that the sale agreement meets the criteria for sale accounting, cash proceeds were $345 million, the carrying

value of the receivables sold was $360 million, and the fair value of the recourse liability was $15 million, what was the effect on income from the sale of receivables?

(f) Briefly discuss the impact of the transaction in (e) on Occidental’s liquidity.

Case 2: Microsoft Corporation Microsoft is the leading developer of software in the world. To continue to be successful Microsoft must generate new products, which requires significant amounts of cash. The following is the current asset and current liability information from Microsoft’s current balance sheets (in millions). Following the Microsoft data is the current asset and current liability information from Oracle’s current balance sheets (in millions). Oracle is another major software developer.

Microsoft Corporation Balance Sheets (partial) As of June 30 (in millions)

Current assets 2014 2013

Cash and cash equivalents $ 8,669 $ 3,804 Short-term investments 77,040 73,218 Accounts receivable, net 19,544 17,486 Inventories 2,660 1,938 Other 6,333 5,020

Total current assets $114,246 $101,466

Total current liabilities $ 45,625 $ 37,417

Oracle Balance Sheets (partial) As of May 31 (in millions)

Current assets 2014 2013

Cash and cash equivalents $17,769 $14,613 Marketable securities 21,050 17,603 Accounts receivable, net 6,087 6,049 Inventories 189 240 Other current assets 3,043 3,187

Total current assets $48,138 $41,692

Total current liabilities $14,389 $12,872

Part 1 (Cash and Cash Equivalents) Instructions

(a) What is the definition of a cash equivalent? Give some examples of cash equivalents. How do cash equivalents differ from other types of short-term investments?

(b) Calculate (1) the current ratio and (2) working capital for each company for 2014 and discuss your results. (c) Is it possible to have too many liquid assets?

Part 2 (Accounts Receivable) Microsoft provided the following disclosure related to its accounts receivable.

Allowance for Doubtful Accounts. The allowance for doubtful accounts refl ects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, histori- cal experience, and other currently available evidence. Activity in the allowance for doubtful accounts is as follows:

(in millions)

Balance at Charged to beginning of costs Balance at Year Ended June 30 period and expenses Write-offs end of period

2012 $333 $115 $(59) $389 2013 389 4 (57) 336 2014 336 16 (51) 301

Instructions (a) Compute Microsoft’s accounts receivable turnover for 2014 and discuss your results. Microsoft had sales revenue of

$69,943 million in 2014. (b) Reconstruct the summary journal entries for 2014 based on the information in the disclosure. (c) Briefly discuss how the accounting for bad debts affects the analysis in Part 2 (a).

Accounting, Analysis, and Principles The Flatiron Pub provides catering services to local businesses. The following information was available for The Flatiron Pub for the years ended December 31, 2016 and 2017.

December December 31, 2016 31, 2017

Cash $ 2,000 $ 1,685 Accounts receivable 46,000 ? Allowance for doubtful accounts 550 ? Other current assets 8,500 7,925 Current liabilities 37,000 44,600 Total credit sales 205,000 255,000 Collections on accounts receivable 190,000 228,000

Flatiron management is preparing for a meeting with its bank concerning renewal of a loan and has collected the following in- formation related to the above balances.

1. The cash reported at December 31, 2017, reflects the following items: petty cash $1,575 and postage stamps $110. The other current assets balance at December 31, 2017, includes the checking account balance of $4,000.

2. On November 30, 2017, Flatiron agreed to accept a 6-month, $5,000 note bearing 12% interest, payable at maturity, from a major client in settlement of a $5,000 bill. The above balances do not reflect this transaction.

3. Flatiron factored some accounts receivable at the end of 2017. It transferred accounts totaling $10,000 to Final Factor, Inc. with recourse. Final Factor will receive the collections from Flatiron’s customers and will retain 2% of the balances. Final Factor assesses Flatiron a finance charge of 3% on this transfer. The fair value of the recourse liability is $400. However, management has determined that the amount due from the factor and the fair value of the resource obligation have not been recorded, and neither are included in the balances above.

4. Flatiron charged off uncollectible accounts with balances of $1,600. On the basis of the latest available information, the 2017 provision for bad debts is estimated to be 2.5% of accounts receivable.

Accounting

(a) Based on the above transactions, determine the balance for (1) Accounts Receivable and (2) Allowance for Doubtful Accounts at December 31, 2017.

(b) Prepare the current assets section of The Flatiron Pub’s balance sheet at December 31, 2017.

Analysis

(a) Compute Flatiron’s current ratio and accounts receivable turnover for December 31, 2017. Use these measures to ana- lyze Flatiron’s liquidity. The accounts receivable turnover in 2016 was 4.37.

(b) Discuss how the analysis you did above of Flatiron’s liquidity would be affected if Flatiron had transferred the receiv- ables in a secured borrowing transaction.

Principles What is the conceptual basis for recording bad debt expense based on the percentage-of-receivables approach at December 31, 2017?

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382 Chapter 7 Cash and Receivables

FASB Codifi cation References [1] FASB ASC 210-10-S99-1. [Predecessor literature: “Amendments to Regulations S-X and Related Interpretations and Guide-

lines Regarding the Disclosure of Compensating Balances and Short-Term Borrowing Arrangements,” Accounting Series Release No. 148, Securities and Exchange Commission (November 13, 1973).]

[2] FASB ASC 606-10-32-2 to 4. [Predecessor literature: None.] [3] FASB ASC 835-30-15-3. [Predecessor literature: “Interest on Receivables and Payables,” Opinions of the Accounting Principles

Board No. 21 (New York: AICPA, 1971), par. 3(a).] [4] FASB ASC 825-15-25-3 [Predecessor literature: None.] [5] FASB ASC 825-15-55-2 [Predecessor literature: None.] [6] FASB ASC 835-30-05. [Predecessor literature: “Interest on Receivables and Payables,” Opinions of the Accounting Principles

Board No. 21 (New York: AICPA, 1971), par. 3(a).] [7] FASB ASC 825-10-25. [Predecessor literature: “The Fair Value Option for Financial Assets and Liabilities—Including an

Amendment to FASB No. 115,” Statement of Financial Accounting Standards No. 159 (Norwalk, Conn.: FASB, 2007).] [8] FASB ASC 860-40 and FASB ASC 860-10-5-15. [Predecessor literature: “Accounting for Transfers and Servicing of Financial Assets

and Extinguishments of Liabilities,” Statement of Financial Accounting Standards No. 140 (Stamford, Conn.: FASB, 2000), p. 155.] [9] FASB ASC 860-10-40. [Predecessor literature: None.] [10] FASB ASC 860. [Predecessor literature: “Transfers and Servicing,” Accounting Standards Update 2011–03 (April 2011).] [11] FASB ASC 310-10-50 and 825-15-50. [Predecessor literature: None.] [12] FASB ASC 825-10-50-20 through 22. [Predecessor literature: “Disclosures about Fair Value of Financial Instruments,” State-

ment of Financial Accounting Standards No. 107 (Norwalk, Conn.: FASB, 1991), par. 15.] [13] FASB ASC 825-15-55-6. [Predecessor literature: “Accounting by Creditors for Impairment of a Loan,” FASB Statement No.

114 (Norwalk, Conn.: FASB, May 1993), par. 13.] [14] FASB ASC 825-15-25-8. [Predecessor literature: “Accounting by Creditors for Impairment of a Loan—Income Recognition

and Disclosures,” FASB Statement No. 118 (Norwalk, Conn.: FASB, October 1994).]

Codifi cation Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE7-1 Access the glossary (“Master Glossary”) to answer the following.

(a) What is the definition of cash? (b) What is the definition of securitization? (c) What are the three contexts that give rise to recourse?

CE7-2 Carrie Underwood believes that by establishing an allowance for uncollectible receivables, a company recognizes losses that have occurred in the past. What does the authoritative literature say about this belief? CE7-3 In addition to securitizations, what are the other types of transfers of financial assets identified in the Codification? CE7-4 The controller for Nesheim Construction Company believes that it is appropriate to offset a note payable to Oregon Bank against an account receivable from Oregon Bank related to remodeling services provided to the bank. What is the authoritative guidance concerning the criteria to be met to allow such offsetting?

Codifi cation Research Case As the new staff person in your company’s treasury department, you have been asked to conduct research related to a proposed transfer of receivables. Your supervisor wants the authoritative sources for the following items that are discussed in the securi- tization agreement.

(a) Identify relevant Codification section that addresses transfers of receivables. (b) Provide definitions for the following: (1) Transfer. (2) Recourse. (3) Collateral. (c) Provide other examples (besides recourse and collateral) that qualify as continuing involvement.

BRIDGE TO THE PROFESSION

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LEARNING OBJECTIVE 10 Compare the accounting procedures for cash and receivables under GAAP and IFRS.

IFRS Insights The basic accounting and reporting issues related to recognition and measurement of receivables, such as the use of allowance accounts, how to record discounts, use of the allowance method to account for bad debts, and factoring, are similar for both IFRS and GAAP. IAS 1 (“Presentation of Financial Statements”) is the only standard that discusses issues specifically related to cash. IFRS 7 (“Financial Instruments: Disclosure”) and IFRS 9 (“Financial Instruments") are the two international standards that address issues related to financial instruments and more specifically receivables.

RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to cash and receivables.

Similarities • The accounting and reporting related to cash is essentially the same under both IFRS and

GAAP. In addition, the defi nition used for cash equivalents is the same. • Like GAAP, cash and receivables are generally reported in the current assets section of the

statement of fi nancial position under IFRS. • Like GAAP, for trade and other accounts receivable without a signifi cant fi nancing component,

an allowance for uncollectible accounts should be recorded to result in receivables reported at net realizable value. The estimation approach used is similar to that under GAAP.

• Similar to GAAP, IFRS requires that loans and receivables be accounted for at amortized cost, adjusted for allowances for doubtful accounts. IFRS sometimes refers to these allowances as provisions. The entry to record the allowance would be as follows.

Bad Debt Expense xxxxxx Provision for Doubtful Accounts xxxxxx

Differences • Under IFRS, companies may report cash and receivables as the last items in current assets

under IFRS. Under GAAP, these items are reported in order of liquidity. • While IFRS implies that receivables with different characteristics should be reported separately,

there is no standard that mandates this segregation. GAAP has explicit guidance in the area. • Unlike GAAP, IFRS has a different approach to estimating uncollectible accounts on receivables

with a signifi cant fi nancing component (e.g., notes receivable). For long-term receivables that have not experienced a deterioration in credit quality after origination, uncollectible accounts are estimated based on expected losses over the next 12 months. For long-term receivables that experience a credit quality decline, uncollectible accounts are estimated based on lifetime expected losses (which is the model used under GAAP for all receivables).

• The fair value option is similar under GAAP and IFRS but not identical. The international stan- dard related to the fair value option is subject to certain qualifying criteria not in the U.S. stan- dard. In addition, there are some differences in the fi nancial instruments covered.

• Under IFRS, bank overdrafts are generally reported as cash. Under GAAP, such balances are reported as liabilities.

• IFRS and GAAP differ in the criteria used to account for transfers of receivables. IFRS is a combi- nation of an approach focused on risks and rewards and loss of control. GAAP uses loss of control as the primary criterion. In addition, IFRS generally permits partial transfers; GAAP does not.

IFRS Insights 383

384 Chapter 7 Cash and Receivables

ABOUT THE NUMBERS The accounting for loan impairments is similar between GAAP and IFRS. Subsequent to record- ing an impairment, events or economic conditions may change such that the extent of the impair- ment loss decreases (e.g., due to an impairment in the debtor’s credit rating). Under IFRS, some or all of the previously recognized impairment loss shall be reversed either directly, with a debit to Accounts Receivable, or by debiting the allowance account and crediting Bad Debt Expense. Such reversals of impairment losses are not allowed under GAAP. To illustrate, recall the Ogden Bank impairment example (on page 359). In that situation, Ogden Bank (the creditor) recognized an impairment loss of $12,434 by debiting Bad Debt Expense for the expected loss. At the same time, it reduced the overall value of the receivable by crediting Allowance for Doubtful Accounts. Ogden made the following entry to record the loss.

Bad Debt Expense 12,434 Allowance for Doubtful Accounts 12,434

Now, assume that in the year following the impairment recorded by Ogden, Carl King (the borrower) has worked his way out of financial difficulty. Ogden now expects to receive all pay- ments on the loan according to the original loan terms. Based on this new information, the present value of the expected payments is $100,000. Thus, Ogden makes the following entry to reverse the previously recorded impairment.

Allowance for Doubtful Accounts 12,434 Bad Debt Expense 12,434

Note that the reversal of impairment losses shall not result in carrying amount of the receivable that exceeds the amortized cost that would have been reported had the impairment not been rec- ognized. Under GAAP, reversal of an impairment is not permitted. Rather, the balance of the loan after the impairment becomes the new basis for the loan.

ON THE HORIZON The question of recording fair values for financial instruments will continue to be an important issue to resolve as the Boards work toward convergence. Both the IASB and the FASB have indi- cated that they believe that financial statements would be more transparent and understandable if companies recorded and reported all financial instruments at fair value. That said, in IFRS 9 the IASB created a split model, where some financial instruments are recorded at fair value but other financial assets, such as loans and receivables, can be accounted for at amortized cost if certain criteria are met. While the FASB has adopted a similar approach to classifications, there remain differences in the accounting for impairments on financial instruments with a significant financing component (just about all notes receivable). As indicated, the IASB approach estimates uncollect- ible accounts over shorter future periods, compared to the FASB model. Critics say that this can result in a delayed recognition of impairments under IFRS as well as situations in which two com- panies with identical securities account for those securities in different ways. Most believe that both Boards’ approaches to estimating uncollectible accounts represent improvements and address the weakness in previous bad debt accounting that was highlighted by the financial crisis. Time will tell if one model or the other provides more useful information to investors and creditors.

1. Under IFRS, cash and cash equivalents are reported: (a) the same as GAAP. (b) as separate items. (c) similar to GAAP, except for the reporting of bank

overdrafts. (d) always as the first items in the current assets section.

2. Under IFRS, receivables are to be reported on the balance sheet at:

(a) amortized cost. (b) amortized cost adjusted for estimated loss provisions. (c) historical cost. (d) replacement cost.

3. Which of the following statements is false? (a) Receivables include equity securities purchased by

the company. (b) Receivables include credit card receivables. (c) Receivables include amounts owed by employees as

result of company loans to employees. (d) Receivables include amounts resulting from transac-

tions with customers.

4. Under IFRS: (a) the entry to record estimated uncollected accounts is

the same as GAAP.

IFRS SELF-TEST QUESTIONS

(b) loans and receivables should only be tested for impairment as a group.

(d) all financial instruments are recorded at fair value.

5. Which of the following statements is true? (a) The fair value option requires that some types of

financial instruments be recorded at fair value.

(b) The fair value option requires that all noncurrent financial instruments be recorded at amortized cost.

(c) The fair value option allows, but does not require, that some types of financial instruments be recorded at fair value.

(d) The FASB and IASB would like to reduce the reli- ance on fair value accounting for financial instru- ments in the future.

IFRS CONCEPTS AND APPLICATION

IFRS7-1 What are some steps taken by both the FASB and IASB to move to fair value measurement for financial instruments? In what ways have some of the approaches differed?

IFRS7-2 On December 31, 2017, Firth Company borrowed $62,092 from Paris Bank, signing a 5-year, $100,000 zero-interest-rate note. The note was issued to yield 10% interest. Unfortunately, during 2019, Firth began to experience financial difficulty. As a result, at December 31, 2019, Paris Bank determined that it was probable that it would collect only $75,000 at maturity. The mar- ket rate of interest on loans of this nature is now 11%.

Instructions (a) Prepare the entry (if any) to record the impairment of the loan on December 31, 2019, by Paris Bank. (b) Prepare the entry on March 31, 2020, if Paris learns that Firth will be able to repay the loan under the original terms.

Professional Research IFRS7-3 As the new staff person in your company’s treasury department, you have been asked to conduct research related to a proposed transfer of receivables. Your supervisor wants the authoritative sources for the following items that are discussed in the receivables transfer agreement.

Instructions Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to pre- pare responses to the following items. (a) Identify relevant IFRSs that address transfers (derecognition) of receivables. (b) What are the criteria for a transfer of a financial asset to qualify for derecognition? (c) Provide the definition for “Amortized cost.”

IFRS Insights 385

International Financial Reporting Problem Marks and Spencer plc (M&S)

IFRS7-4 The financial statements of M&S are presented in Appendix E. The company’s complete annual report, includ- ing the notes to the financial statements, is available online.

Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions.

(a) What criteria does M&S use to classify “Cash and cash equivalents” as reported in its statement of fi nancial position? (b) As of 28 March 2015, what balances did M&S have in cash and cash equivalents? What were the major uses of cash

during the year? (c) What amounts related to trade receivables does M&S report? Does M&S have any past due but not impaired

receivables?

ANSWERS TO IFRS SELF-TEST QUESTIONS

1. c 2. b 3. a 4. a 5. c

TO SWITCH OR NOT TO SWITCH Many companies use the last-in, first-out (LIFO) cost flow assumption in the accounting for inventories. LIFO has a lot going for it in terms of tax savings and providing an income number that better reflects the gross profit associated with inventories with different historical costs. However, in the wake of international convergence discussions (LIFO is not permitted under IFRS) and tax policy debates (LIFO is one of a num- ber of “tax loopholes” that if closed could help address our budget and deficit challenges), more companies are seriously considering the switch from LIFO to first-in, first-out (FIFO) or average-cost inventory methods. For example, of the 449 large public companies recently surveyed by the AICPA, just 163 indicated LIFO use ( a 25% decline relative to 11 years earlier). Here are some of the reasons to support the switch from LIFO.

• While many believe that LIFO provides a more useful income measure, other methods, such as FIFO and average-cost, better reflect the current value of inventory on the balance sheet.

• Many companies discontinued LIFO use to support uniformity of inventory valuation across operations. That is, companies were using LIFO in their U.S. operations but FIFO and/or average-cost in international units. The switch from LIFO simplifies the external reporting for these multinational companies.

• There is also a “bandwagon” effect—when some companies make the switch, their peers likely follow suit to enhance comparability for financial statement users.

• The recent periods of low inflation have resulted in less significant tax benefits associated with LIFO use. That is, in times of rising costs, by expensing the most recently purchased items, cost of goods sold is higher (compared to FIFO or average-cost) and taxable income is lower. A number of companies do not believe the smaller tax benefits of LIFO offset the costs. For example, Kraft Foods switched from LIFO to average- cost, noting that in the recent stable price environment, its cost of goods sold was $95 million higher under average-cost.

• Finally, the companies most resistant to make the switch from LIFO are those with large inventory bal- ances. That is, the higher the inventory balance, the higher the additional tax payment will be upon the switch to FIFO. However, a growing number of companies have implemented just-in-time (JIT) or other

8 Valuation of Inventories: A Cost-Basis Approach 1 Understand inventory classifications and

different inventory systems.

2 Determine the goods and costs included in inventory.

3 Describe and compare the cost flow assumptions used to account for inventories.

4 Identify special issues related to LIFO. 5 Determine the effects of inventory errors

on the financial statements.

LEARNING OBJECTIVES After studying this chapter, you should be able to:

387

lean manufacturing techniques, under which much lower inventories are kept on hand. In the extreme, JIT leads to zero inventory and no LIFO effect relative to other methods. For example, JCPenney recently switched from LIFO to FIFO in the same period that it rolled out its “Door-to-Floor” lean inventory strategy. As a result, the accounting effect of the change to FIFO was immaterial.

The merits of LIFO use (about which you will learn more in this chapter) are many. However, these benefits appear to be waning. We expect more companies to consider a voluntary switch away from LIFO in the future.

Source: Adapted from L. Hughes, J. Livingstone, and D. Upton, “Switching from LIFO: Strategies for Change,” The CPA Journal (April 2011), pp. 26–29.

PREVIEW OF CHAPTER 8 As our opening story indicates, the accounting choice related to inventory is affected by operating strategies, tax consequences, and is important for providing information that is useful for predicting financial performance. In this chapter, we discuss the basic issues related to accounting and reporting for inventory. The content and organization of the chapter are as follows.

VALUATION OF INVENTORIES: A COST-BASIS APPROACH

INVENTORY ISSUES

• Classification • Cost flow • Control • Cost of goods

sold

GOODS AND COSTS INCLUDED IN INVENTORY

• Goods included • Costs included

COST FLOW ASSUMPTIONS

• Specific identification

• Average-cost • FIFO • LIFO

LIFO: SPECIAL ISSUES

• LIFO reserve • LIFO liquidation • Dollar-value LIFO • Comparison of

LIFO approaches • Advantages and

disadvantages • Basis for selection

EFFECT OF INVENTORY ERRORS

• Ending inventory misstated

• Purchases and inventory misstated

This chapter also includes numerous conceptual and international discussions that are integral to the topics presented here. IFRS Insights related to inventory are presented in Chapter 9.

388 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

INVENTORY ISSUES Classifi cation Inventories are asset items that a company holds for sale in the ordinary course of busi- ness, or goods that it will use or consume in the production of goods to be sold. The description and measurement of inventory require careful attention. The investment in inventories is frequently the largest current asset of merchandising (retail) and manu- facturing businesses.

A merchandising concern, such as Wal-Mart Stores, Inc., usually purchases its merchandise in a form ready for sale. It reports the cost assigned to unsold units left on hand as merchandise inventory. Only one inventory account, Inventory, appears in the financial statements.

Manufacturing concerns, on the other hand, produce goods to sell to merchandis- ing firms. Many of the largest U.S. businesses are manufacturers, such as Boeing, IBM, ExxonMobil, Procter & Gamble, Ford, and Motorola. Although the products they pro- duce may differ, manufacturers normally have three inventory accounts—Raw Materi- als, Work in Process, and Finished Goods.

A company reports the cost assigned to goods and materials on hand but not yet placed into production as raw materials inventory. Raw materials include the wood to make a baseball bat or the steel to make a car. These materials can be traced directly to the end product.

At any point in a continuous production process, some units are only partially proc- essed. The cost of the raw material for these unfinished units, plus the direct labor cost applied specifically to this material and a ratable share of manufacturing overhead costs, constitute the work in process inventory.

Companies report the costs identified with the completed but unsold units on hand at the end of the fiscal period as finished goods inventory. Illustration 8-1 contrasts the financial statement presentation of inventories of Wal-Mart Stores, Inc. (a merchandis- ing company) with those of Sherwin-Williams Company (a manufacturing company.) The remainder of the balance sheet is essentially similar for the two types of companies.

LEARNING OBJECTIVE 1 Understand inventory classifications and different inventory systems.

Merchandising Company Wal-Mart Stores, Inc.

Balance Sheet

January 31, 2015

Current assets (in millions) Cash and cash equivalents $ 9,135 Receivables, net 6,778 Inventories 45,141 Prepaid expenses and other 2,224

Total current assets $63,278

Manufacturing Company Sherwin-Williams Company

Balance Sheet

December 31, 2014

Current assets (in thousands) Cash and cash equivalents $ 40,732 Accounts receivable, less allowance 1,130,565 Inventories: Finished goods $841,784 Work in process and raw materials 191,743 1,033,527

Deferred income taxes 109,087 Other current assets 252,869

Total current assets $2,566,780

ILLUSTRATION 8-1 Comparison of Presentation of Current Assets for Merchandising and Manufacturing Companies

A manufacturing company like Sherwin-Williams also might include a Manufactur- ing or Factory Supplies Inventory account. In it, Sherwin-Williams would include such items as machine oils, nails, cleaning material, and the like—supplies that are used in production but are not the primary materials being processed.

Inventory Issues 389

Illustration 8-2 shows the differences in the flow of costs through a merchandising company and a manufacturing company.

Actual materials cost

Materials used

Raw Materials

Actual labor cost

Labor applied

Labor

Actual overhead cost

Overhead applied

Overhead

MANUFACTURING COMPANY

MERCHANDISING COMPANY

Cost of goods purchased

Cost of goods sold

Inventory

Cost of goods manufactured

Work in Process

Cost of Goods Sold

Finished Goods

Cost of goods sold

ILLUSTRATION 8-2 Flow of Costs through Manufacturing and Merchandising Companies

Inventory Cost Flow Companies that sell or produce goods report inventory and cost of goods sold at the end of each accounting period. The flow of costs for a company is as follows. Beginning inventory plus the cost of goods purchased or manufactured is the cost of goods avail- able for sale. As goods are sold, they are assigned to cost of goods sold. Those goods that are not sold by the end of the accounting period represent ending inventory. Illustration 8-3 describes these relationships.

Companies use one of two types of systems for maintaining accurate inventory records for these costs—the perpetual system or the periodic system.

Beginning Inventory

Cost of Goods Purchased

Ending Inventory

Cost of Goods Sold

Cost of Goods Available for Sale

ILLUSTRATION 8-3 Inventory Cost Flow

390 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

Perpetual System A perpetual inventory system continuously tracks changes in the Inventory account. That is, a company records all purchases and sales (issues) of goods directly in the Inventory account as they occur. The accounting features of a perpetual inventory sys- tem are as follows.

1. Purchases of merchandise for resale or raw materials for production are debited to Inventory rather than to Purchases.

2. Freight-in is debited to Inventory, not Purchases. Purchase returns and allowances and purchase discounts are credited to Inventory rather than to separate accounts.

3. Cost of goods sold is recorded at the time of each sale by debiting Cost of Goods Sold and crediting Inventory.

4. A subsidiary ledger of individual inventory records is maintained as a control mea- sure. The subsidiary records show the quantity and cost of each type of inventory on hand.

The perpetual inventory system provides a continuous record of the balances in both the Inventory account and the Cost of Goods Sold account.

Periodic System Under a periodic inventory system, a company determines the quantity of inventory on hand only periodically, as the name implies. To do so, a company does the following. (1) It records all acquisitions of inventory during the accounting period by debiting the Purchases account. (2) A company then adds the total in the Purchases account at the end of the accounting period to the cost of the inventory on hand at the beginning of the period. This sum determines the total cost of the goods available for sale during the period. (3) To compute the cost of goods sold, the company then subtracts the ending inventory from the cost of goods available for sale. Note that under a periodic inventory system, the cost of goods sold is a residual amount that depends on a physical count of ending inventory. This process is referred to as “taking a physical inventory.” Companies that use the periodic system take a physical inventory at least once a year.

Comparing Perpetual and Periodic Systems To illustrate the difference between a perpetual and a periodic system, assume that Fes- mire Company had the following transactions during the current year.

Beginning inventory 100 units at $6 = $ 600 Purchases 900 units at $6 = $5,400 Sales 600 units at $12 = $7,200 Ending inventory 400 units at $6 = $2,400

Fesmire records these transactions during the current year as shown in Illustration 8-4. When a company uses a perpetual inventory system and a difference exists between

the perpetual inventory balance and the physical inventory count, it needs a separate entry to adjust the perpetual inventory account. To illustrate, assume that at the end of the reporting period, the perpetual inventory account reported an inventory balance of $4,000. However, a physical count indicates inventory of $3,800 is actually on hand. The entry to record the necessary write-down is as follows.

Inventory Over and Short 200 Inventory 200

Perpetual inventory overages and shortages generally represent a misstatement of cost of goods sold. The difference results from normal and expected shrinkage,

Inventory Issues 391

breakage, shoplifting, incorrect recordkeeping, and the like. Inventory Over and Short therefore adjusts Cost of Goods Sold. In practice, companies sometimes report Inven- tory Over and Short in the “Other revenues and gains” or “Other expenses and losses” section of the income statement.

Note that a company using the periodic inventory system does not report the account Inventory Over and Short. The reason: The periodic method does not have accounting records against which to compare the physical count. As a result, a company buries inventory overages and shortages in cost of goods sold.

Inventory Control For various reasons, management is vitally interested in inventory planning and con- trol. Whether a company manufactures or merchandises goods, it needs an accurate accounting system with up-to-date records. It may lose sales and customers if it does not stock products in the desired style, quality, and quantity. Further, companies must mon- itor inventory levels carefully to limit the financing costs of carrying large amounts of inventory.

In a perfect world, companies would like a continuous record of both their inventory levels and their cost of goods sold. The popularity and affordability of accounting software makes the perpetual system cost-effective for many kinds of businesses. Companies like Target, Best Buy, and Sears Holdings now incorporate the recording of sales with optical scanners at the cash register into perpetual inven- tory systems.

However, many companies cannot afford a complete perpetual system. But, most of these companies need current information regarding their inventory levels, to pro- tect against stock-outs or overpurchasing, and to aid in preparation of monthly or quarterly financial data. As a result, these companies use a modified perpetual inventory system. This system provides detailed inventory records of increases and decreases in quantities only—not dollar amounts. It is merely a memorandum device outside the double-entry system, which helps in determining the level of inventory at any point in time.

ILLUSTRATION 8-4 Comparative Entries— Perpetual vs. Periodic

Perpetual Inventory System Periodic Inventory System

Beginning inventory, 100 units at $6

The Inventory account shows the inventory The Inventory account shows the inventory on hand at $600. on hand at $600.

Purchase 900 units at $6

Inventory 5,400 Purchases 5,400 Accounts Payable 5,400 Accounts Payable 5,400

Sale of 600 units at $12

Accounts Receivable 7,200 Accounts Receivable 7,200 Sales Revenue 7,200 Sales Revenue 7,200 Cost of Goods Sold 3,600 (No entry) (600 at $6) Inventory 3,600

End-of-period entries for inventory accounts, 400 units at $6

No entry necessary. Inventory (ending, by count) 2,400 The Inventory account shows the ending Cost of Goods Sold 3,600 balance of $2,400 ($600 + $5,400 − $3,600). Purchases 5,400 Inventory (beginning) 600

392 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

Whether a company maintains a complete perpetual inventory in quantities and dollars or a modified perpetual inventory system, it probably takes a physical inventory once a year. No matter what type of inventory records companies use, they all face the danger of loss and error. Waste, breakage, theft, improper entry, failure to prepare or record requisitions, and other similar possibilities may cause the inventory records to differ from the actual inventory on hand. Thus, all companies need periodic verification of the inventory records by actual count, weight, or measurement, with the counts com- pared with the detailed inventory records. As indicated earlier, a company corrects the records to agree with the quantities actually on hand.

Insofar as possible, companies should take the physical inventory near the end of their fiscal year, to properly report inventory quantities in their annual accounting reports. Because this is not always possible, physical inventories taken within two or three months of the year’s end are satisfactory if a company maintains detailed inven- tory records with a fair degree of accuracy.1

1Some companies have developed methods of determining inventories, including statistical sampling, that are sufficiently reliable to make unnecessary an annual physical count of each item of inventory.

WHAT DO THE NUMBERS MEAN? STAYING LEAN When you drop by a Walmart store, you are witnessing one of history’s greatest logistical and operational successes. As one article noted, the retail giant stocks products in more than 70 countries and at any given time operates more than 11,000 stores in 27 countries around the world. It manages an average of $32 billion in inventory.

With these kinds of numbers, having an effective and effi - cient supply chain management system and a sound internal control system is imperative. For example, Wal-Mart Stores, Inc. uses its buying power in the supply chain to purchase an increasing proportion of its goods directly from manufacturers and on a combined basis across geographic borders. Wal- Mart estimates that it saves 5–15% across its supply chain by implementing direct purchasing on a combined basis for the

15 countries in which it operates. Thus, Wal-Mart has a good handle on what products it needs to stock, and it gets the best prices when it purchases.

Wal-Mart also provides a classic example of the use of tight inventory controls. Department managers use a scan- ner that when placed over the bar code corresponding to a particular item, will tell them how many of the items the store sold yesterday, last week, and over the same period last year. It will tell them how many of those items are in stock, how many are on the way, and how many the neighboring Walmart stores are carrying (in case one store runs out). Wal-Mart’s inventory management practices have helped it become one of the top-ranked companies on the Fortune 500 in terms of sales.

Sources: J. Birchall, “Walmart Aims to Cut Supply Chain Cost,” Financial Times (January 4, 2010); and http://www.tradegecko.com/blog/incredibly- successful-supply-chain-management-walmart.

Determining Cost of Goods Sold Goods sold (or used) during an accounting period seldom correspond exactly to the goods bought (or produced) during that period. As a result, inventories either increase or decrease during the period. Companies must then allocate the cost of all the goods available for sale (or use) between the goods that were sold or used and those that are still on hand. The cost of goods available for sale or use is the sum of (1) the cost of the goods on hand at the beginning of the period, and (2) the cost of the goods acquired or produced during the period. The cost of goods sold is the difference between (1) the cost of goods available for sale during the period, and (2) the cost of goods on hand at the end of the period. Illustration 8-5 shows these calculations.

ILLUSTRATION 8-5 Computation of Cost of Goods Sold

Beginning inventory, Jan. 1 $100,000 Cost of goods acquired or produced during the year 800,000

Total cost of goods available for sale 900,000 Ending inventory, Dec. 31 (200,000)

Cost of goods sold during the year $700,000

Goods and Costs Included in Inventory 393

GOODS AND COSTS INCLUDED IN INVENTORY Goods Included in Inventory A company recognizes inventory and accounts payable at the time it controls the asset. For example, when Verizon purchases Apple watches for resale, Verizon records these watches as inventory at the time control passes to Verizon. Control is therefore the key factor in determining when purchases and sales of a product are recognized.2

The FASB indicates that Verizon controls the Apple watches when it has the ability to direct the use of and obtain substantially all the benefits from these watches. Control also includes Verizon’s ability to prevent other companies from directing the use of or receiving the benefits from these watches. As noted in Chapter 7, companies then look to various indicators to determine whether control has passed.

One of these indicators, passage of title, is often used to determine control because the rights and obligations are established legally. For example, when Verizon purchases the Apple watches, legal title belongs to Verizon until the watches are sold to customers. However in some limited cases, other indicators must be considered because legal title and passage of control do not match.

Goods in Transit Often, a company like Walgreens purchases merchandise that remains in transit—not yet received—at the end of a fiscal period. The accounting for these shipped goods depends on who controls the merchandise. In these situations, companies generally determine control based on who has legal title to the goods by applying the “passage of title” rule. If a supplier ships goods to Walgreens f.o.b. shipping point, title passes to Walgreens when the supplier delivers the goods to the common carrier, who acts as an agent for Walgreens. (The abbreviation f.o.b. stands for free on board.) If the supplier ships the goods f.o.b. destination, title passes to Walgreens only when it receives the goods from the common carrier. “Shipping point” and “destination” are often desig- nated by a particular location, for example, f.o.b. Denver.

When Walgreens obtains legal title to goods, it must record them as purchases in that fiscal period, assuming a periodic inventory system. Thus, goods shipped to Wal- greens f.o.b. shipping point, but in transit at the end of the period, belong to Walgreens. It should show the purchase in its records because legal title to these goods passed to Walgreens upon shipment of the goods. To disregard such purchases results in under- stating inventories and accounts payable in the balance sheet, and understating pur- chases and ending inventories in the income statement.

Consigned Goods Companies market certain products through a consignment shipment. Under this arrangement, a company like Williams Art Gallery (the consignor) ships various art merchandise to Sotheby’s Holdings (the consignee), who acts as Williams’ agent in selling the consigned goods. Sotheby’s agrees to accept the goods without any liabil- ity, except to exercise due care and reasonable protection from loss or damage, until it sells the goods to a third party. When Sotheby’s sells the goods, it remits the revenue, less a selling commission and expenses incurred in accomplishing the sale, to Williams.

Goods out on consignment remain the property of the consignor (Williams in the example above). Although Sotheby’s has physical possession of the goods, it does not have control because legal title and the risks and rewards of ownership remain with Williams. Williams thus includes the goods in its inventory at purchase price or produc- tion cost. Occasionally, and only for a significant amount, the consignor shows the inventory out on consignment as a separate item. Sometimes a consignor reports the

2As indicated in Chapter 7, Lululemon recognized accounts receivable and sales revenue when it transferred control of its yoga outfit to its customer, Jennifer Burian.

LEARNING OBJECTIVE 2 Determine the goods and costs included in inventory.

INTERNATIONAL PERSPECTIVE

Who owns the goods, as well as the costs to include in inventory, are essentially accounted for the same under IFRS and GAAP.

394 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

inventory on consignment in the notes to the financial statements. For example, Eagle Clothes, Inc. reported the following related to consigned goods: “Inventories consist of finished goods shipped on consignment to customers of the Company’s subsidiary April-Marcus, Inc.”

The consignee makes no entry to the inventory account for goods received. Remem- ber, these goods remain the property of the consignor until sold. In fact, the consignee should be extremely careful not to include any of the goods consigned as a part of inven- tory. Additional discussion related to consignments is provided in Chapter 18.

Special Sales Agreements As we indicated earlier, transfer of legal title is the general guideline used to determine whether a company should include an item in inventory. Unfortunately, transfer of legal title and the underlying substance of the transaction sometimes do not match. For exam- ple, legal title may have passed to the purchaser, but the seller of the goods retains con- trol of the inventory.

Two special sales situations are illustrated here to indicate the types of problems companies encounter in practice:

1. Sales with repurchase agreement. 2. Sales with high rates of return.

Sales with Repurchase Agreement. Sometimes a company finances its inventory with- out reporting either a liability or the inventory on its balance sheet. This approach, often referred to as a repurchase (or product financing) agreement, usually involves a transfer (sale) with either an implicit or explicit repurchase agreement.

To illustrate, Hill Enterprises transfers (“sells”) inventory to Chase, Inc. and simul- taneously agrees to repurchase this merchandise at a specified price over a specified period of time. Chase then uses the inventory as collateral and borrows against it. Chase uses the loan proceeds to pay Hill, which repurchases the inventory in the future. Chase employs the proceeds from repayment to meet its loan obligation.

The essence of this transaction is that Hill is financing its inventory—and retaining control—even though it transferred to Chase technical legal title to the merchandise. By structuring a transaction in this manner, Hill avoids personal property taxes in certain states. Other advantages of this transaction for Hill are the removal of the current liabil- ity from its balance sheet and the ability to manipulate income. For Chase, the purchase of the goods may solve a LIFO liquidation problem (discussed later), or Chase may enter into a similar reciprocal agreement at a later date.

These arrangements are often described in practice as “parking transactions.” In this situation, Hill simply parks the inventory on Chase’s balance sheet for a short period of time. Generally, when a repurchase agreement exists, Hill should report the inventory and related liability on its books. [1] The reason? Hill has retained control of the asset; that is, Hill still owns the asset.

Sales with High Rates of Return. In industries such as publishing, music, toys, and sporting goods, formal or informal agreements often exist that permit purchasers to return inventory for a full or partial refund.

To illustrate, Quality Publishing Company sells textbooks to Campus Book- stores with an agreement that Campus may return for full credit any books not sold. Historically, Campus Bookstores returned approximately 25 percent of the textbooks from Quality Publishing. How should Quality Publishing report its sales transactions?

The key question to determine whether a sale occurs is: Has Quality Publishing transferred control of these goods to Campus Bookstore? Because Campus Bookstore now has the ability to direct the use of and obtain substantially all the benefits from these textbooks, these transactions are normally recorded as a sale by Quality

See the FASB Codifi cation References (page 441).

UNDERLYING CONCEPTS

Recognizing revenue at the time the inventory is “parked” violates the revenue recognition principle. That is, a performance obliga- tion is not met because control has not been transferred to the buyer.

Goods and Costs Included in Inventory 395

Publishing. In addition, the normal indicators for transfer of control, such as passage of legal title, loss of physical control, and transfer of risks and rewards of ownership, appear to have occurred. However, Quality Publishing must also recognize that only partial control has transferred to Campus Bookstore. Therefore, Quality Publishing does the following:

1. Record sales revenue at the amount it expects to receive from the transaction. This transaction involves variable consideration and therefore the transaction price is adjusted to recognize that a portion of these textbooks will be returned.

2. Establish an estimated inventory return account to recognize that some of its text- books will be returned. The reason for recording estimated inventory is that control over a signifi cant number of the textbooks has not passed to Campus Bookstore.

In other words, control does pass from seller to buyer for a majority of the textbooks but not all of them. Quality Publishing therefore records an estimated inventory return amount to recognize that fact. If returns are unpredictable and uncertain, Quality Pub- lishing should not consider the textbooks sold and should not remove the goods from its inventory. This example illustrates that difficulty of determining when control has passed in situations where substantial returns are involved. [2] We provide expanded discussion of special sales agreements and returns in Chapter 18.

WHAT DO THE NUMBERS MEAN? NO PARKING! In one of the more elaborate accounting frauds, employees at Kurzweil Applied Intelligence Inc. booked millions of dollars in phony inventory sales during a two-year period that straddled two audits and an initial public stock offering. They dummied up phony shipping documents and logbooks to support bogus sales trans- actions. Then they shipped high-tech equipment, not to custom- ers, but to a public warehouse for “temporary” storage, where some of it sat for 17 months. (Kurzweil still had ownership.)

To foil auditors’ attempts to verify the existence of the inventory, Kurzweil employees moved the goods from ware- house to warehouse. To cover the fraudulently recorded sales transactions as auditors closed in, the employees brought back the still-hidden goods, under the pretense that the goods

were returned by customers. When auditors uncovered the fraud, the bottom dropped out of Kurzweil’s stock.

Similar inventory shenanigans occurred at Delphi, which used side-deals with third parties to get inventory off its books and to record sales. The overstatement in income eventually led to a bankruptcy fi ling for Delphi.

More recently and with an international twist, concerns about inventory shenanigans are surfacing in China. Following years of torrid growth, the global economic slowdown has resulted in a huge buildup of unsold goods that is cluttering shop fl oors, clogging car dealerships, and fi lling factory warehouses. The large inventory overhang is raising alarms about phantom profi ts and suspect economic data coming out of China.

Sources: Adapted from “Anatomy of a Fraud,” BusinessWeek (September 16, 1996), pp. 90–94; J. McCracken, “Delphi Executives Named in Suit over Inventory Practices,” Wall Street Journal (May 5, 2005), p. A3; and K. Bradsher, “China Confronts Mounting Piles of Unsold Goods,” The New York Times (August 23, 2012).

Costs Included in Inventory One of the most important problems in dealing with inventory concerns the dollar amount at which to carry the inventory in the accounts. Companies generally account for the acquisition of inventories, like other assets, on a cost basis.

Product Costs Product costs are those costs that “attach” to the inventory. As a result, a company records product costs in the inventory account. These costs are directly connected with bringing the goods to the buyer’s place of business and converting such goods to a

396 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

salable condition. Such charges include freight charges on goods purchased, other direct costs of acquisition, and labor and other production costs incurred in processing the goods up to the time of sale.

It seems proper also to allocate to inventories a share of any buying costs or expenses of a purchasing department, storage costs, and other costs incurred in storing or han- dling the goods before their sale. However, because of the practical difficulties involved in allocating such costs and expenses, companies usually exclude these items in valuing inventories.

A manufacturing company’s costs include direct materials, direct labor, and manu- facturing overhead costs. Manufacturing overhead costs include indirect materials, indirect labor, and various costs, such as depreciation, taxes, insurance, and utilities.

Period Costs Period costs are those costs that are indirectly related to the acquisition or produc- tion of goods. Period costs such as selling expenses and, under ordinary circum- stances, general and administrative expenses are therefore not included as part of inventory cost.

Yet, conceptually, these expenses are as much a cost of the product as the initial purchase price and related freight charges attached to the product. Why then do compa- nies exclude these costs from inventoriable items? Because companies generally con- sider selling expenses as more directly related to the cost of goods sold than to the unsold inventory. In addition, period costs, especially administrative expenses, are so unrelated or indirectly related to the immediate production process that any allocation is purely arbitrary.3

Interest is another period cost. Companies usually expense interest costs associated with getting inventories ready for sale. Supporters of this approach argue that interest costs are really a cost of financing. Others contend that interest costs incurred to finance activities associated with readying inventories for sale are as much a cost of the asset as materials, labor, and overhead. Therefore, they reason, companies should capitalize interest costs.

The FASB ruled that companies should capitalize interest costs related to assets constructed for internal use or assets produced as discrete projects (such as ships or real estate projects) for sale or lease [4].4 The FASB emphasized that these discrete projects should take considerable time, entail substantial expenditures, and be likely to involve significant amounts of interest cost. A company should not capi- talize interest costs for inventories that it routinely manufactures or otherwise pro- duces in large quantities on a repetitive basis. In this case, the informational benefit does not justify the cost.

Treatment of Purchase Discounts The use of a Purchase Discounts account in a periodic inventory system indicates that the company is reporting its purchases and accounts payable at the gross amount. If a company uses this gross method, it reports purchase discounts as a deduction from purchases on the income statement.

Another approach is to record the purchases and accounts payable at an amount net of the cash discounts. In this approach, the company records failure to take a purchase

3Companies should not record abnormal freight, handling costs, and amounts of wasted materials (spoilage) as inventory costs. If the costs associated with the actual level of spoilage or product defects are greater than the costs associated with normal spoilage or defects, the company should charge the excess as an expense in the current period. [3] 4The reporting rules related to interest cost capitalization have their greatest impact in accounting for long-term assets. We therefore discuss them in Chapter 10.

INTERNATIONAL PERSPECTIVE

GAAP has more detailed rules related to the accounting for inventories, compared to IFRS.

Goods and Costs Included in Inventory 397

discount within the discount period in a Purchase Discounts Lost account. If a company uses this net method, it considers purchase discounts lost as a financial expense and reports it in the “Other expenses and losses” section of the income statement. This treat- ment is considered better for two reasons. (1) It provides a correct reporting of the cost of the asset and related liability. (2) It can measure management inefficiency by holding management responsible for discounts not taken.

To illustrate the difference between the gross and net methods, assume the follow- ing transactions.

ILLUSTRATION 8-6 Entries under Gross and Net Methods

Gross Method Net Method

Purchase cost $10,000, terms 2/10, net 30

Purchases 10,000 Purchases 9,800 Accounts Payable 10,000 Accounts Payable 9,800

Invoices of $4,000 are paid within discount period

Accounts Payable 4,000 Accounts Payable 3,920 Purchase Discounts 80 Cash 3,920 Cash 3,920

Invoices of $6,000 are paid after discount period

Accounts Payable 6,000 Accounts Payable 5,880 Cash 6,000 Purchase Discounts Lost 120

Cash 6,000

Many believe that the somewhat more complicated net method is not justified by the resulting benefits. This could account for the widespread use of the less logical but simpler gross method. In addition, some contend that management is reluctant to report in the financial statements the amount of purchase discounts lost. Use the gross method to record purchase discounts for homework problems unless specified otherwise.

WHAT DO THE NUMBERS MEAN? YOU MAY NEED A MAP Does it really matter where a company reports certain costs in its income statement as long as it includes them all as expenses in computing income?

For e-tailers, such as Amazon.com or Drugstore.com, where they report certain selling costs does appear to be impor- tant. Contrary to well-established retailer practices, these com- panies insist on reporting some selling costs—fulfi llment costs related to inventory shipping and warehousing—as part of administrative expenses, instead of as cost of goods sold. This practice is allowable within GAAP, if applied consistently and adequately disclosed. Although the practice doesn’t affect the bottom line, it does make the e-tailers’ gross margins look better. For example, at one time Amazon reported $265 million of these costs in one quarter. Some experts thought Amazon should

Source: Adapted from P. Elstrom, “The End of Fuzzy Math?” BusinessWeek, e.Biz—Net Worth (December 11, 2000). According to GAAP [5], compa- nies must disclose the accounting policy for classifying these selling costs in income.

UNDERLYING CONCEPTS

Not using the net method because of resultant diffi culties is an example of the application of the cost constraint.

include those charges in costs of goods sold, which would sub- stantially lower its gross profi t, as shown below (in millions).

E-Tailer Reporting Traditional Reporting

Sales $2,795 $2,795 Cost of goods sold 2,132 2,397 Gross profit $ 663 $ 398 Gross margin % 24% 14%

Similarly, if Drugstore.com and eToys.com made similar adjust- ments, their gross margins would go from positive to negative.

Thus, if you want to be able to compare the operating results of e-tailers to other traditional retailers, it might be a good idea to have a good accounting map in order to navigate their income statements and how they report certain selling costs.

398 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

WHICH COST FLOW ASSUMPTION TO ADOPT? During any given fiscal period, companies typically purchase merchandise at several different prices. If a company prices inventories at cost and it made numerous pur- chases at different unit costs, which cost price should it use? Conceptually, a specific identification of the given items sold and unsold seems optimal. But this measure often proves both expensive and impossible to achieve. Consequently, companies use one of several systematic inventory cost flow assumptions.

Indeed, the actual physical flow of goods and the cost flow assumption often greatly dif- fer. There is no requirement that the cost flow assumption adopted be consistent with the physical movement of goods. A company’s major objective in selecting a method should be to choose the one that, under the circumstances, most clearly reflects periodic income. [6]

To illustrate, assume that Call-Mart Inc. had the following transactions in its first month of operations.

LEARNING OBJECTIVE 3 Describe and compare the cost flow assumptions used to account for inventories.

Date Purchased Sold or Issued Balance

March 2 2,000 @ $4.00 2,000 units March 15 6,000 @ $4.40 8,000 units March 19 4,000 units 4,000 units March 30 2,000 @ $4.75 6,000 units

From this information, Call-Mart computes the ending inventory of 6,000 units and the cost of goods available for sale (beginning inventory + purchases) of $43,900 [(2,000 at $4.00) + (6,000 at $4.40) + (2,000 at $4.75)]. The question is, which price or prices should it assign to the 6,000 units of ending inventory? The answer depends on which cost flow assumption it uses.

Specifi c Identifi cation Specific identification calls for identifying each item sold and each item in inventory. A company includes in cost of goods sold the costs of the specific items sold. It includes in inventory the costs of the specific items on hand. This method may be used only in instances where it is practical to separate physically the different purchases made. As a result, most companies only use this method when handling a relatively small number of costly, easily distinguishable items. In the retail trade, this includes some types of jewelry, fur coats, automobiles, and some furniture. In manufacturing, it includes spe- cial orders and many products manufactured under a job cost system.

To illustrate, assume that Call-Mart Inc.’s 6,000 units of inventory consists of 1,000 units from the March 2 purchase, 3,000 from the March 15 purchase, and 2,000 from the March 30 purchase. Illustration 8-7 shows how Call-Mart computes the ending inven- tory and cost of goods sold.

Date No. of Units Unit Cost Total Cost

March 2 1,000 $4.00 $ 4,000 March 15 3,000 4.40 13,200 March 30 2,000 4.75 9,500

Ending inventory 6,000 $26,700

Cost of goods available for sale (computed in previous section) $43,900 Deduct: Ending inventory 26,700

Cost of goods sold $17,200

ILLUSTRATION 8-7 Specifi c Identifi cation Method

Which Cost Flow Assumption to Adopt? 399

This method appears ideal. Specific identification matches actual costs against actual revenue. Thus, a company reports ending inventory at actual cost. In other words, under specific identification the cost flow matches the physical flow of the goods. On closer observation, however, this method has certain deficiencies.

Some argue that specific identification allows a company to manipulate net income. For example, assume that a wholesaler purchases identical plywood early in the year at three different prices. When it sells the plywood, the wholesaler can select either the lowest or the highest price to charge to expense. It simply selects the plywood from a specific lot for delivery to the customer. A business manager, therefore, can manipulate net income by delivering to the customer the higher- or lower-priced item, depending on whether the company seeks lower or higher reported earnings for the period.

Another problem relates to the arbitrary allocation of costs that sometimes occurs with specific inventory items. For example, a company often faces difficulty in relating shipping charges, storage costs, and discounts directly to a given inventory item. This results in allocating these costs somewhat arbitrarily, leading to a “breakdown” in the precision of the specific identification method.5

Average-Cost As the name implies, the average-cost method prices items in the inventory on the basis of the average cost of all similar goods available during the period. To illustrate use of the periodic inventory method (amount of inventory computed at the end of the period), Call-Mart computes the ending inventory and cost of goods sold using a weighted- average method as follows.

5The film industry provides a good illustration of the cost allocation problem. Often actors receive a percentage of net income for a given movie or television program. Some actors, however, have alleged that their programs have been extremely profitable to the film studios but they themselves have received little in the way of profit-sharing. Actors contend that the studios allocate additional costs to successful projects to avoid sharing profits.

ILLUSTRATION 8-8 Weighted-Average Method—Periodic Inventory

Date of Invoice No. Units Unit Cost Total Cost

March 2 2,000 $4.00 $ 8,000 March 15 6,000 4.40 26,400 March 30 2,000 4.75 9,500

Total goods available 10,000 $43,900

Weighted-average cost per unit $43,900 = $4.39 10,000

Inventory in units 6,000 units Ending inventory 6,000 × $4.39 = $26,340

Cost of goods available for sale $43,900 Deduct: Ending inventory 26,340

Cost of goods sold $17,560

In computing the average cost per unit, Call-Mart includes the beginning inventory, if any, both in the total units available and in the total cost of goods available.

Companies use the moving-average method with perpetual inventory records. Illustration 8-9 (on page 400) shows the application of the average-cost method for perpetual records.

INTERNATIONAL PERSPECTIVE

IFRS indicates specifi c identifi cation is the preferred inventory method, unless it is impracticable to use.

400 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

ILLUSTRATION 8-9 Moving-Average Method— Perpetual Inventory

Date Purchased Sold or Issued Balance

March 2 (2,000 @ $4.00) $ 8,000 (2,000 @ $4.00) $ 8,000 March 15 (6,000 @ 4.40) 26,400 (8,000 @ 4.30) 34,400 March 19 (4,000 @ $4.30) $17,200 (4,000 @ 4.30) 17,200 March 30 (2,000 @ 4.75) 9,500 (6,000 @ 4.45) 26,700

In this method, Call-Mart computes a new average unit cost each time it makes a purchase. For example, on March 15, after purchasing 6,000 units for $26,400, Call-Mart has 8,000 units costing $34,400 ($8,000 plus $26,400) on hand. The average unit cost is $34,400 divided by 8,000, or $4.30. Call-Mart uses this unit cost in costing withdrawals until it makes another purchase. At that point, Call-Mart computes a new average unit cost. Accordingly, the company shows the cost of the 4,000 units withdrawn on March 19 at $4.30, for a total cost of goods sold of $17,200. On March 30, following the purchase of 2,000 units for $9,500, Call-Mart determines a new unit cost of $4.45 ($26,700 ÷ 6,000) and ending inventory of $26,700.

Companies often use average-cost methods for practical rather than conceptual reasons. These methods are both simple to apply and objective. They are not as subject to income manipulation as some of the other inventory costing methods. In addition, proponents of the average-cost methods reason that measuring a specific physical flow of inventory is often impossible. Therefore, it is better to cost items on an aver- age-price basis. This argument is particularly persuasive when dealing with similar inventory items.

First-In, First-Out (FIFO) The first-in, first-out (FIFO) method assumes that a company uses goods in the order in which it purchases them. In other words, the FIFO method assumes that the first goods purchased are the first used (in a manufacturing concern) or the first sold (in a merchandising concern). The inventory remaining must therefore represent the most recent purchases.

To illustrate, assume that Call-Mart uses the periodic inventory system. It deter- mines its cost of the ending inventory by taking the cost of the most recent purchase and working back until it accounts for all units in the inventory. Call-Mart determines its ending inventory and cost of goods sold as shown in Illustration 8-10.

ILLUSTRATION 8-10 FIFO Method—Periodic Inventory

Date No. Units Unit Cost Total Cost

March 30 2,000 $4.75 $ 9,500 March 15 4,000 4.40 17,600

Ending inventory 6,000 $27,100

Cost of goods available for sale $43,900 Deduct: Ending inventory 27,100

Cost of goods sold $16,800

If Call-Mart instead uses a perpetual inventory system in quantities and dol- lars, it attaches a cost figure to each withdrawal. Then the cost of the 4,000 units removed on March 19 consists of the cost of the items purchased on March 2 and March 15. Illustration 8-11 shows the inventory on a FIFO basis perpetual system for Call-Mart.

Which Cost Flow Assumption to Adopt? 401

Here, the ending inventory is $27,100, and the cost of goods sold is $16,800 [(2,000 @ $4.00) + (2,000 @ $4.40)].

Notice that in these two FIFO examples, the cost of goods sold ($16,800) and end- ing inventory ($27,100) are the same. In all cases where FIFO is used, the inventory and cost of goods sold would be the same at the end of the month whether a per- petual or periodic system is used. Why? Because the same costs will always be first in and, therefore, first out. This is true whether a company computes cost of goods sold as it sells goods throughout the accounting period (the perpetual system) or as a residual at the end of the accounting period (the periodic system).

One objective of FIFO is to approximate the physical flow of goods. When the physi- cal flow of goods is actually first-in, first-out, the FIFO method closely approximates specific identification. At the same time, it prevents manipulation of income. With FIFO, a company cannot pick a certain cost item to charge to expense.

Another advantage of the FIFO method is that the ending inventory is close to cur- rent cost. Because the first goods in are the first goods out, the ending inventory amount consists of the most recent purchases. This is particularly true with rapid inventory turnover. This approach generally approximates replacement cost on the balance sheet when price changes have not occurred since the most recent purchases.

However, the FIFO method fails to match current costs against current revenues on the income statement. A company charges the oldest costs against the more current rev- enue, possibly distorting gross profit and net income.

Last-In, First-Out (LIFO) The last-in, first-out (LIFO) method matches the cost of the last goods purchased against revenue. If Call-Mart Inc. uses a periodic inventory system, it assumes that the cost of the total quantity sold or issued during the month comes from the most recent purchases. Call-Mart prices the ending inventory by using the total units as a basis of computation and disregards the exact dates of sales or issuances. For example, Call- Mart would assume that the cost of the 4,000 units withdrawn absorbed the 2,000 units purchased on March 30 and 2,000 of the 6,000 units purchased on March 15. Illustration 8-12 shows how Call-Mart computes the inventory and related cost of goods sold, using the periodic inventory method.

ILLUSTRATION 8-11 FIFO Method—Perpetual Inventory

Date Purchased Sold or Issued Balance

March 2 (2,000 @ $4.00) $ 8,000 2,000 @ $4.00 $ 8,000 March 15 (6,000 @ 4.40) 26,400 2,000 @ 4.00

34,400 6,000 @ 4.40 March 19 2,000 @ $4.00

4,000 @ 4.40

17,600 2,000 @ 4.40

($16,800) March 30 (2,000 @ 4.75) 9,500 4,000 @ 4.40

27,100 2,000 @ 4.75

} }

}

Date of Invoice No. Units Unit Cost Total Cost

March 2 2,000 $4.00 $ 8,000 March 15 4,000 4.40 17,600

Ending inventory 6,000 $25,600

Goods available for sale $43,900 Deduct: Ending inventory 25,600

Cost of goods sold $18,300

ILLUSTRATION 8-12 LIFO Method—Periodic Inventory

INTERNATIONAL PERSPECTIVE

IFRS does not permit LIFO.

402 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

If Call-Mart keeps a perpetual inventory record in quantities and dollars, use of the LIFO method results in different ending inventory and cost of goods sold amounts than the amounts calculated under the periodic method. Illustration 8-13 shows these differences under the perpetual method.

ILLUSTRATION 8-13 LIFO Method—Perpetual Inventory

The month-end periodic inventory computation presented in Illustration 8-12 (inventory $25,600 and cost of goods sold $18,300) shows a different amount from the perpetual inventory computation (inventory $26,300 and cost of goods sold $17,600). The periodic system matches the total withdrawals for the month with the total pur- chases for the month in applying the last-in, first-out method. In contrast, the perpetual system matches each withdrawal with the immediately preceding purchases. In effect, the periodic computation assumed that Call-Mart included the cost of the goods that it purchased on March 30 in the sale or issue on March 19.

SPECIAL ISSUES RELATED TO LIFO LIFO Reserve Many companies use LIFO for tax and external reporting purposes. However, they maintain a FIFO, average-cost, or standard cost system for internal reporting purposes. There are several reasons to do so. (1) Companies often base their pricing decisions on a FIFO, average-cost, or standard-cost assumption, rather than on a LIFO basis. (2) Recordkeeping on some other basis is easier because the LIFO assumption usually does not approximate the physical flow of the product. (3) Profit-sharing and other bonus arrangements often depend on a non-LIFO inventory assumption. (4) The use of a pure LIFO system is troublesome for interim periods, which require estimates of year-end quantities and prices.

The difference between the inventory method used for internal reporting purposes and LIFO is the Allowance to Reduce Inventory to LIFO account or the LIFO reserve. The change in the allowance balance from one period to the next is the LIFO effect. The LIFO effect is the adjustment that companies must make to the accounting records in a given year.

To illustrate, assume that Acme Boot Company uses the FIFO method for internal reporting purposes and LIFO for external reporting purposes. At January 1, 2017, the Allowance to Reduce Inventory to LIFO balance is $20,000. At December 31, 2017, the balance should be $50,000. As a result, Acme Boot realizes a LIFO effect of $30,000 and makes the following entry at year-end.

Cost of Goods Sold 30,000 Allowance to Reduce Inventory to LIFO 30,000

Acme Boot deducts Allowance to Reduce Inventory to LIFO from inventory to ensure that it states the inventory on a LIFO basis at year-end.

Companies should disclose either the LIFO reserve or the replacement cost of the inventory, as shown in Illustration 8-14. [7]

LEARNING OBJECTIVE 4 Identify special issues related to LIFO.

Date Purchased Sold or Issued Balance

March 2 (2,000 @ $4.00) $ 8,000 2,000 @ $4.00 $ 8,000 March 15 (6,000 @ 4.40) 26,400 2,000 @ 4.00

34,400 6,000 @ 4.40 March 19 (4,000 @ $4.40) 2,000 @ 4.00 $17,600 2,000 @ 4.40

16,800

March 30 (2,000 @ 4.75) 9,500 2,000 @ 4.00 2,000 @ 4.40 26,300 2,000 @ 4.75

} } }

Special Issues Related to LIFO 403

American Maize-Products Company

Inventories (Note 3) $80,320,000

Note 3: Inventories. At December 31, $31,516,000 of inventories were valued using the LIFO method. This amount is less than the corresponding replacement value by $3,765,000.

ILLUSTRATION 8-14 Note Disclosures of LIFO Reserve

Brown Shoe Company, Inc. (in thousands)

Current Year Previous Year

Inventories, (Note 1) $365,989 $362,274

Note 1 (partial): Inventories. Inventories are valued at the lower of cost or market determined principally by the last-in, first-out (LIFO) method. If the first-in, first-out (FIFO) cost method had been used, inventories would have been $11,709 higher in the current year and $13,424 higher in the previous year.

WHAT DO THE NUMBERS MEAN? COMPARING APPLES TO APPLES a company using FIFO. It would be like comparing apples to oranges since the two companies measure inventory (and cost of goods sold) differently.

To make the current ratio comparable on an apples-to- apples basis, analysts use the LIFO reserve. The following adjustments should do the trick:

Investors commonly use the current ratio to evaluate a com- pany’s liquidity. They compute the current ratio as current assets divided by current liabilities. A higher current ratio indi- cates that a company is better able to meet its current obliga- tions when they come due. However, it is not meaningful to compare the current ratio for a company using LIFO to one for

Inventory Adjustment: LIFO inventory + LIFO reserve = FIFO inventory

(For cost of goods sold, deduct the change in the LIFO reserve from LIFO cost of goods sold to yield the comparable FIFO amount.)

For Brown Shoe, Inc. (see Illustration 8-14), with current assets of $487.8 million and current liabilities of $217.8 million,

the current ratio using LIFO is $487.8 ÷ $217.8 = 2.2. After adjusting for the LIFO effect, Brown Shoe’s current ratio under FIFO would be ($487.8 + $11.7) ÷ $217.8 = 2.3.

Thus, without the LIFO adjustment, the Brown Shoe current ratio is understated.

LIFO Liquidation Up to this point, we have emphasized a specific-goods approach to costing LIFO inven- tories (also called traditional LIFO or unit LIFO). This approach is often unrealistic for two reasons:

1. When a company has many different inventory items, the accounting cost of track- ing each inventory item is expensive.

2. Erosion of the LIFO inventory can easily occur. Referred to as LIFO liquidation, this often distorts net income and leads to substantial tax payments.

To understand the LIFO liquidation problem, assume that Basler Co. has 30,000 pounds of steel in its inventory on December 31, 2017, with cost determined on a spe- cific-goods LIFO approach.

404 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

As indicated, the ending 2017 inventory for Basler comprises costs from past peri- ods. These costs are called layers (increases from period to period). The first layer is identified as the base layer. Illustration 8-15 shows the layers for Basler.

Ending Inventory (2017)

Pounds Unit Cost LIFO Cost

2014 8,000 $ 4 $ 32,000 2015 10,000 6 60,000 2016 7,000 9 63,000 2017 5,000 10 50,000

30,000 $205,000

2016 Layer

2017 Layer

2015 Layer

2014 Base layer

$63,000 (7,000 $9)

$60,000 (10,000 $6)

$32,000 (8,000 $4)

$50,000 (5,000 $10)

ILLUSTRATION 8-15 Layers of LIFO Inventory

Note the increased price of steel over the four-year period. In 2018, due to metal shortages, Basler had to liquidate much of its inventory (a LIFO liquidation). At the end of 2018, only 6,000 pounds of steel remained in inventory. Because the company uses LIFO, Basler liquidates the most recent layer, 2017, first, followed by the 2016 layer, and so on. The result: Basler matches costs from preceding periods against sales revenues reported in current dollars. As Illustration 8-16 shows, this leads to a

ILLUSTRATION 8-16 LIFO Liquidation

(6,000 lbs. remaining)

Sold

$50,000 (5,000 $10)

$63,000 (7,000 $9)

$60,000 (10,000 $6)

$32,000 (8,000 $4)

Sales Revenue (All Current Prices)

Cost of Goods Sold (Some Current, Some

Old Prices)

= Higher income and probably higher tax bill

Result

7,000 lbs.

5,000 lbs.

2,000 lbs.

10,000 lbs.

Special Issues Related to LIFO 405

distortion in net income and increased taxable income in the current period. Unfor- tunately, LIFO liquidations can occur frequently when using a specific-goods LIFO approach.

To alleviate the LIFO liquidation problems and to simplify the accounting, compa- nies can combine goods into pools. A pool groups items of a similar nature. Thus, instead of only identical units, a company combines, and counts as a group, a number of similar units or products. This method, the specific-goods pooled LIFO approach, usually results in fewer LIFO liquidations. Why? Because the reduction of one quantity in the pool may be offset by an increase in another.

The specific-goods pooled LIFO approach eliminates some of the disadvantages of the specific-goods (traditional) accounting for LIFO inventories. This pooled approach, using quantities as its measurement basis, however, creates other problems.

First, most companies continually change the mix of their products, materials, and production methods. As a result, in employing a pooled approach using quantities, companies must continually redefine the pools. This can be time-consuming and costly. Second, even when practical, the approach often results in an erosion (“LIFO liquida- tion”) of the layers, thereby losing much of the LIFO costing benefit. Erosion of the lay- ers occurs when a specific good or material in the pool is replaced with another good or material. The new item may not be similar enough to be treated as part of the old pool. Therefore, a company may need to recognize any inflationary profit deferred on the old goods as it replaces them.

Dollar-Value LIFO The dollar-value LIFO method overcomes the problems of redefining pools and eroding layers. The dollar-value LIFO method determines and measures any increases and decreases in a pool in terms of total dollar value, not the physical quantity of the goods in the inventory pool.

Such an approach has two important advantages over the specific-goods pooled approach. First, companies may include a broader range of goods in a dollar-value LIFO pool. Second, a dollar-value LIFO pool permits replacement of goods that are similar items, similar in use, or interchangeable. (In contrast, a specific-goods LIFO pool only allows replacement of items that are substantially identical.)

Thus, dollar-value LIFO techniques help protect LIFO layers from erosion. Because of this advantage, companies frequently use the dollar-value LIFO method in practice.6 Companies use the more traditional LIFO approaches only when dealing with few goods and expecting little change in product mix.

Under the dollar-value LIFO method, one pool may contain the entire inventory. However, companies generally use several pools.7 In general, the more goods included in a pool, the more likely that increases in the quantities of some goods will offset decreases in other goods in the same pool. Thus, companies avoid liquidation of the LIFO layers. It follows that having fewer pools means less cost and less chance of a reduction of a LIFO layer.8

6A study by James M. Reeve and Keith G. Stanga disclosed that the vast majority of respondent companies applying LIFO use the dollar-value method or the dollar-value retail method to apply LIFO. Only a small minority of companies use the specific-goods (unit LIFO) approach or the specific-goods pooling approach. See J.M. Reeve and K.G. Stanga, “The LIFO Pooling Decision,” Accounting Horizons (June 1987), p. 27. 7The Reeve and Stanga study (ibid.) reports that most companies have only a few pools—the median is six for retailers and three for nonretailers. But the distributions are highly skewed; some companies have 100 or more pools. Retailers that use LIFO have significantly more pools than nonretailers. About a third of the nonretailers (mostly manufacturers) use a single pool for their entire LIFO inventory. 8One study shows that when quantities are increasing, multiple pools over a period of time may produce (under rather general conditions) significantly higher cost of goods sold deductions than a single-pool approach. When a stock-out occurs, a single-pool approach may lessen the layer liquidation for that year, but it may not erase the cumulative cost of goods sold advantage accruing to the use of multiple pools built up over the preceding years. See William R. Coon and Randall B. Hayes, “The Dollar Value LIFO Pooling Decision: The Conventional Wisdom Is Too General,” Accounting Horizons (December 1989), pp. 57–70.

406 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

Dollar-Value LIFO Example To illustrate how the dollar-value LIFO method works, assume that Enrico Company first adopts dollar-value LIFO on December 31, 2016 (base period). The inventory at cur- rent prices on that date was $20,000. The inventory on December 31, 2017, at current prices is $26,400.

Can we conclude that Enrico’s inventory quantities increased 32 percent during the year ($26,400 ÷ $20,000 = 132%)? First, we need to ask: What is the value of the ending inventory in terms of beginning-of-the-year prices? Assuming that prices have increased 20 percent during the year, the ending inventory at beginning-of-the-year prices amounts to $22,000 ($26,400 ÷ 120%). Therefore, the inventory quantity has increased only 10 percent, or from $20,000 to $22,000 in terms of beginning-of-the-year prices.

The next step is to price this real-dollar quantity increase. This real-dollar quantity increase of $2,000 valued at year-end prices is $2,400 (120% × $2,000). This increment (layer) of $2,400, when added to the beginning inventory of $20,000, totals $22,400 for the December 31, 2017, inventory, as shown below.

First layer—(beginning inventory) in terms of 100 $20,000 Second layer—(2017 increase) in terms of 120 2,400

Dollar-value LIFO inventory, December 31, 2017 $22,400

Note that a layer forms only when the ending inventory at base-year prices exceeds the beginning inventory at base-year prices. And only when a new layer forms must Enrico compute a new index.

Comprehensive Dollar-Value LIFO Example To illustrate the use of the dollar-value LIFO method in a more complex situation, assume that Bismark Company develops the following information.

At December 31, 2014, Bismark computes the ending inventory under dollar-value LIFO as $200,000, as Illustration 8-17 shows.

End-of-Year Inventory at

÷ Price Index

= Inventory at

December 31 End-of-Year Prices (percentage) Base-Year Prices

(Base year) 2014 $200,000 100 $200,000 2015 299,000 115 260,000 2016 300,000 120 250,000 2017 351,000 130 270,000

ILLUSTRATION 8-17 Computation of 2014 Inventory at LIFO Cost

Ending Inventory Layer at Ending Inventory at Base-Year Price Index at Base-Year Prices Prices (percentage) LIFO Cost

$200,000 $200,000 × 100 = $200,000

At December 31, 2015, a comparison of the ending inventory at base-year prices ($260,000) with the beginning inventory at base-year prices ($200,000) indicates that the quantity of goods (in base-year prices) increased $60,000 ($260,000 − $200,000). Bismark

Special Issues Related to LIFO 407

At December 31, 2016, a comparison of the ending inventory at base-year prices ($250,000) with the beginning inventory at base-year prices ($260,000) indicates a decrease in the quantity of goods of $10,000 ($250,000 − $260,000). If the ending in- ventory at base-year prices is less than the beginning inventory at base-year prices, a company must subtract the decrease from the most recently added layer. When a decrease occurs, the company “peels off” previous layers at the prices in existence when it added the layers. In Bismark’s situation, this means that it removes $10,000 in base-year prices from the 2015 layer of $60,000 at base-year prices. It values the balance of $50,000 ($60,000 − $10,000) at base-year prices at the 2015 price index of 115 percent. As a result, it now values this 2015 layer at $57,500 ($50,000 × 115%). Therefore, Bismark computes the ending inventory at $257,500, consisting of the beginning inventory of $200,000 and the second layer of $57,500. Illustration 8-19 shows the computations for 2016.

ILLUSTRATION 8-18 Computation of 2015 Inventory at LIFO Cost

Ending Inventory Layers Ending Inventory at at Price Index at Base-Year Prices Base-Year Prices (percentage) LIFO Cost

$260,000 2014 $200,000 × 100 = $200,000 2015 60,000 × 115 = 69,000 $260,000 $269,000

Note that if Bismark eliminates a layer or base (or portion thereof), it cannot rebuild it in future periods. That is, the layer is gone forever.

At December 31, 2017, a comparison of the ending inventory at base-year prices ($270,000) with the beginning inventory at base-year prices ($250,000) indicates an increase in the quantity of goods (in base-year prices) of $20,000 ($270,000 − $250,000). After converting the $20,000 increase, using the 2017 price index, the ending inventory is $283,500, composed of the beginning layer of $200,000, a 2015 layer of $57,500, and a 2017 layer of $26,000 ($20,000 × 130%). Illustration 8-20 shows this computation.

Ending Inventory Layers Ending Inventory at at Price Index at Base-Year Prices Base-Year Prices (percentage) LIFO Cost

$250,000 2014 $200,000 × 100 = $200,000 2015 50,000 × 115 = 57,500 $250,000 $257,500

ILLUSTRATION 8-19 Computation of 2016 Inventory at LIFO Cost

ILLUSTRATION 8-20 Computation of 2017 Inventory at LIFO Cost

Ending Inventory Layers Ending Inventory at at Price Index at Base-Year Prices Base-Year Prices (percentage) LIFO Cost

$270,000 2014 $200,000 × 100 = $200,000 2015 50,000 × 115 = 57,500 2017 20,000 × 130 = 26,000 $270,000 $283,500

prices this increment (layer) at the 2015 index of 115 percent to arrive at a new layer of $69,000. Ending inventory for 2015 is $269,000, composed of the beginning inventory of $200,000 and the new layer of $69,000. Illustration 8-18 shows the computations.

408 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

The ending inventory at base-year prices must always equal the total of the layers at base-year prices. Checking that this situation exists will help to ensure correct dollar- value computations.

Selecting a Price Index Obviously, price changes are critical in dollar-value LIFO. How do companies determine the price indexes? Many companies use the general price-level index that the federal government prepares and publishes each month. The most popular general external price-level index is the Consumer Price Index for Urban Consumers (CPI-U).9 Com- panies also use more-specific external price indexes. For instance, various organiza- tions compute and publish daily indexes for most commodities (gold, silver, other metals, corn, wheat, and other farm products). Many trade associations prepare indexes for specific product lines or industries. Any of these indexes may be used for dollar-value LIFO purposes.

When a relevant specific external price index is not readily available, a company may compute its own specific internal price index. The desired approach is to price end- ing inventory at the most current cost. Therefore, a company that chose to compute its own specific internal price index would ordinarily determine current cost by referring to the actual cost of the goods it most recently had purchased. The price index provides a measure of the change in price or cost levels between the base year and the current year. The company then computes the index for each year after the base year. The gen- eral formula for computing the index is as follows.

9Indexes may be general (composed of several commodities, goods, or services) or specific (for one commodity, good, or service). Additionally, they may be external (computed by an outside party, such as the government, commodity exchange, or trade association) or internal (computed by the enterprise for its own product or service).

ILLUSTRATION 8-21 Formula for Computing a Price Index

Ending Inventory for the Period at Current Cost Ending Inventory for the Period at Base-Year Cost

= Price Index for Current Year

Items Quantity Cost per Unit Total Cost

A 1,000 $ 6 $ 6,000 B 2,000 20 40,000

January 1, 2017, inventory at base-year costs $46,000

Examination of the ending inventory indicates that the company holds 3,000 units of Item A and 6,000 units of Item B on December 31, 2017. The most recent actual purchases related to these items were as follows.

This approach is generally referred to as the double-extension method. As its name implies, the value of the units in inventory is extended at both base-year prices and current-year prices.

To illustrate this computation, assume that Toledo Company’s base-year inventory (January 1, 2017) consisted of the following.

Special Issues Related to LIFO 409

Quantity Items Purchase Date Purchased Cost per Unit

A December 1, 2017 4,000 $ 7 B December 15, 2017 5,000 25 B November 16, 2017 1,000 22

10To simplify the analysis, companies may use another approach, initially sanctioned by the Internal Revenue Service for tax purposes. Under this method, a company obtains an index from an outside source or by double-extending only a sample portion of the inventory. For example, the IRS allows all companies to use as their inflation rate for a LIFO pool 80 percent of the inflation rate reported by the appropriate consumer or producer price indexes prepared by the Bureau of Labor Statistics (BLS). Once the company obtains the index, it divides the ending inventory at current cost by the index to find the base-year cost. Using generally available external indexes greatly simplifies LIFO computations, and frees companies from having to compute internal indexes.

ILLUSTRATION 8-22 Double-Extension Method of Determining a Price Index

12/31/17 Inventory at 12/31/17 Inventory at Base-Year Costs Current-Year Costs

Base-Year Current-Year Cost Cost Items Units per Unit Total Units per Unit Total

A 3,000 $ 6 $ 18,000 3,000 $ 7 $ 21,000 B 6,000 20 120,000 5,000 25 125,000 B 1,000 22 22,000

$138,000 $168,000

Toledo double-extends the inventory as shown in Illustration 8-22.

After the inventories are double-extended, Toledo uses the formula in Illustration 8-21 to develop the index for the current year (2017), as follows.

Toledo then applies this index (121.74%) to the layer added in 2017. Note in this illustration that Toledo used the most recent actual purchases to determine current cost. Alternatively, it could have used other approaches such as FIFO and average-cost. Whichever flow assumption is adopted, a company must use it consistently from one period to another.

Use of the double-extension method is time-consuming and difficult where sub- stantial technological change has occurred or where many items are involved. That is, as time passes, the company must determine a new base-year cost for new products, and must keep a base-year cost for each inventory item.10

ILLUSTRATION 8-23 Computation of 2017 Index

Ending Inventory for the Period at Current Cost $168,000 Ending Inventory for the Period at Base-Year Cost

= $138,000

= 121.74%

410 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

Comparison of LIFO Approaches We present three different approaches to computing LIFO inventories in this chapter— specific-goods LIFO, specific-goods pooled LIFO, and dollar-value LIFO. As we indi- cated earlier, the use of the specific-goods LIFO is unrealistic. Most companies have numerous goods in inventory at the end of a period. Costing (pricing) them on a unit basis is extremely expensive and time-consuming.

The specific-goods pooled LIFO approach reduces recordkeeping and clerical costs. In addition, it is more difficult to erode the layers because the reduction of one quantity in the pool may be offset by an increase in another. Nonetheless, the pooled approach using quantities as its measurement basis can lead to untimely LIFO liquidations.

As a result, most companies using a LIFO system employ dollar-value LIFO. Although the approach appears complex, the logic and the computations are actually quite simple, after determining an appropriate index.

However, problems do exist with the dollar-value LIFO method. The selection of the items to be put in a pool can be subjective.11 Such a determination, however, is extremely important because manipulation of the items in a pool without conceptual justification can affect reported net income. For example, the SEC noted that some com- panies have set up pools that are easy to liquidate. As a result, to increase income, a company simply decreases inventory, thereby matching low-cost inventory items to current revenues.

WHAT DO THE NUMBERS MEAN? QUITE A DIFFERENCE As indicated, consistent with LIFO costing in times of ris-

ing prices, the dollar-value LIFO inventory amount is less than inventory stated at end-of-year prices. The company did not add layers at the 2017 prices. This is because the increase in inventory at end-of-year (current) prices was due to higher prices. Also, establishing the LIFO layers based on price- adjusted dollars relative to base-year layers reduces the likeli- hood of a LIFO liquidation.

As indicated, signifi cant differences can arise in inventory mea- sured according to current cost and dollar-value LIFO. Let’s look at an additional summary example.

Truman Company uses the dollar-value LIFO method of computing its inventory. Inventory for the last three years is as shown below.

Year Ended Inventory at Price December 31 Current-Year Cost Index

2015 $60,000 100 2016 84,000 105 2017 87,000 116

The values of the 2015, 2016, and 2017 inventories using the dollar-value LIFO method are presented in the table below.

Inventory at Inventory at Layers at Price-Index Dollar-Value End-of-Year Base-Year Base-Year × Layers at LIFO Year Prices Prices Prices LIFO Cost Inventory

2015 $60,000 $60,000 ÷ 100 = $60,000 2015 $60,000 × 100 = $60,000 $60,000 2016 84,000 $84,000 ÷ 105 = $80,000 2015 $60,000 × 100 = $60,000 2016 20,000 × 105 = $21,000 $81,000 2017 87,000 $87,000 ÷ 116 = $75,000 2015 $60,000 × 100 = $60,000 2016 15,000 × 105 = $15,750 $75,750

11It is suggested that companies analyze how inventory purchases are affected by price changes, how goods are stocked, how goods are used, and if future liquidations are likely. See William R. Cron and Randall Hayes, ibid., p. 57.

Special Issues Related to LIFO 411

To curb this practice, the SEC has taken a much harder line on the number of pools that companies may establish. In a well-publicized case, Stauffer Chemical Company increased the number of LIFO pools from 8 to 280, boosting its net income by $16,515,000 or approximately 13 percent. Stauffer justified the change in its annual report on the basis of “achieving a better matching of cost and revenue.” The SEC required Stauffer to reduce the number of its inventory pools, contending that some pools were inappropri- ate and alleging income manipulation.

Major Advantages of LIFO One obvious advantage of LIFO approaches is that the LIFO cost flow may approximate the physical flow of the goods in and out of inventory. For instance, in a coal pile, the last coal in is the first coal out because it is on the top of the pile. The coal remover is not going to take the coal from the bottom of the pile! The coal taken first is the coal placed on the pile last.

However, this is one of only a few situations where the actual physical flow corre- sponds to LIFO. Therefore, most adherents of LIFO use other arguments for its wide- spread use, as follows.

Matching LIFO matches the more recent costs against current revenues to provide a better mea- sure of current earnings. During periods of inflation, many challenge the quality of non- LIFO earnings, noting that failing to match current costs against current revenues creates transitory or “paper” profits (“inventory profits”). Inventory profits occur when the inventory costs matched against sales are less than the inventory replacement cost. This results in understating the cost of goods sold and overstating profit. Using LIFO (rather than a method such as FIFO) matches current costs against revenues, thereby reducing inventory profits.

Tax Benefi ts/Improved Cash Flow LIFO’s popularity mainly stems from its tax benefits. As long as the price level increases and inventory quantities do not decrease, a deferral of income tax occurs. Why? Because a company matches the items it most recently purchased (at the higher price level) against revenues. For example, when Fuqua Industries switched to LIFO, it realized a tax savings of about $4 million. Even if the price level decreases later, the company still temporarily deferred its income taxes. Thus, use of LIFO in such situations improves a company’s cash flow.12

The tax law requires that if a company uses LIFO for tax purposes, it must also use LIFO for financial accounting purposes13 (although neither tax law nor GAAP requires a company to pool its inventories in the same manner for book and tax purposes). This requirement is often referred to as the LIFO conformity rule. Other inventory valuation methods do not have this requirement.

Future Earnings Hedge With LIFO, future price declines will not substantially affect a company’s future reported earnings. The reason: Since the company records the most recent inventory as sold first, there is not much ending inventory at high prices vulnerable to a price decline. Thus

12In periods of rising prices, the use of fewer pools will translate into greater income tax benefits through the use of LIFO. The use of fewer pools allows companies to offset inventory reductions on some items and inventory increases in others. In contrast, the use of more pools increases the likelihood of liquidating old, low-cost inventory layers and incurring negative tax consequences. See Reeve and Stanga, ibid., pp. 28–29. 13Management often selects an accounting procedure because a lower tax results from its use, instead of an accounting method that is conceptually more appealing. Throughout this textbook, we identify accounting procedures that provide income tax benefits to the user.

412 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

LIFO eliminates or substantially minimizes write-downs to market as a result of price decreases. In contrast, inventory costed under FIFO is more vulnerable to price declines, which can reduce net income substantially.

Major Disadvantages of LIFO Despite its advantages, LIFO has the following drawbacks.

Reduced Earnings Many corporate managers view the lower profits reported under the LIFO method in inflationary times as a distinct disadvantage. They would rather have higher reported profits than lower taxes. Some fear that investors may misunderstand an accounting change to LIFO, and that the lower profits may cause the price of the company’s stock to fall.

Inventory Understated LIFO may have a distorting effect on a company’s balance sheet. The inventory valu- ation is normally outdated because the oldest costs remain in inventory. This under- statement makes the working capital position of the company appear worse than it really is. A good example is Walgreens, which uses LIFO costing for most of its inven- tory, valued at $6.1 billion at fiscal year-end 2014. Under FIFO costing, Walgreens’ inventories have a value of $8.4 billion—approximately 38 percent higher than the LIFO amount.

The magnitude and direction of this variation between the carrying amount of inventory and its current price depend on the degree and direction of the price changes and the amount of inventory turnover. The combined effect of rising product prices and avoidance of inventory liquidations increases the difference between the inventory car- rying value at LIFO and current prices of that inventory. This magnifies the balance sheet distortion attributed to the use of LIFO.

Physical Flow LIFO does not approximate the physical flow of the items except in specific situations (such as the coal pile discussed earlier). Originally, companies could use LIFO only in certain circumstances. This situation has changed over the years. Now, physical flow characteristics no longer determine whether a company may employ LIFO.

Involuntary Liquidation/Poor Buying Habits If a company eliminates the base or layers of old costs, it may match old, irrelevant costs against current revenues. A distortion in reported income for a given period may result, as well as detrimental income tax consequences. For example, Caterpillar at one time experienced a LIFO liquidation, resulting in an increased tax bill of $60 million.14

Because of the liquidation problem, LIFO may cause poor buying habits. A com- pany may simply purchase more goods and match these goods against revenue to avoid charging the old costs to expense. Furthermore, recall that with LIFO, a company may attempt to manipulate its net income at the end of the year simply by altering its pattern of purchases.15

One survey uncovered the following reasons why companies reject LIFO (as shown in Illustration 8-24).16

14Companies should disclose the effects on income of LIFO inventory liquidations in the notes to the financial statements. [8] 15For example, General Tire and Rubber accelerated raw material purchases at the end of the year to minimize the book profit from a liquidation of LIFO inventories and to minimize income taxes for the year. 16Michael H. Granof and Daniel Short, “Why Do Companies Reject LIFO?” Journal of Accounting, Auditing, and Finance (Summer 1984), pp. 323–333 and Table 1, p. 327.

Special Issues Related to LIFO 413

Basis for Selection of Inventory Method How does a company choose among the various inventory methods? Although no absolute rules can be stated, preferability for LIFO usually occurs in either of the follow- ing circumstances: (1) if selling prices and revenues have been increasing faster than costs, thereby distorting income, and (2) in situations where LIFO has been traditional, such as department stores and industries where a fairly constant “base stock” is present (such as refining, chemicals, and glass).17

Conversely, LIFO is probably inappropriate in the following circumstances: (1) where prices tend to lag behind costs; (2) in situations where specific identification is traditional, such as in the sale of automobiles, farm equipment, art, and antique jewelry; or (3) where unit costs tend to decrease as production increases, thereby nullifying the tax benefit that LIFO might provide.18

Tax consequences are another consideration. Switching from FIFO to LIFO usu- ally results in an immediate tax benefit. However, switching from LIFO to FIFO can result in a substantial tax burden. For example, when Chrysler changed from LIFO to FIFO, it became responsible for an additional $53 million in taxes that the company had deferred over 14 years of LIFO inventory valuation. Why, then, would Chrysler, and other companies, change to FIFO? The major reason was the profit crunch of that era. Although Chrysler showed a loss of $7.6 million after the switch, the loss would have been $20 million more if the company had not changed its inventory valuation from LIFO to FIFO.

It is questionable whether companies should switch from LIFO to FIFO for the sole purpose of increasing reported earnings. Intuitively, we would assume that companies with higher reported earnings would have a higher share valuation (common stock price). However, some studies have indicated that the users of financial data exhibit a

ILLUSTRATION 8-24 Why Do Companies Reject LIFO? Summary of Responses

Reasons to Reject LIFO Number % of Total*

No expected tax benefits No required tax payment 34 16% Declining prices 31 15 Rapid inventory turnover 30 14 Immaterial inventory 26 12 Miscellaneous tax related 38 17

159 74% Regulatory or other restrictions 26 12% Excessive cost High administrative costs 29 14% LIFO liquidation–related costs 12 6

41 20% Other adverse consequences Lower reported earnings 18 8% Bad accounting 7 3

25 11%

*Percentage totals more than 100% as some companies offered more than one explanation.

17Accounting Trends and Techniques recently reported that of 669 inventory method disclosures, 163 used LIFO, 312 used FIFO, 133 used average-cost, and 56 used other methods. As discussed in the opening story, because of steady or falling raw materials costs and costs savings from electronic data interchange and just-in-time technologies in recent years, many businesses using LIFO no longer experience substantial tax benefits. Even some companies for which LIFO is creating a benefit are finding that the administrative costs associated with LIFO are higher than the LIFO benefit obtained. As a result, some companies are moving to FIFO or average-cost. 18See Barry E. Cushing and Marc J. LeClere, “Evidence on the Determinants of Inventory Accounting Policy Choice,” The Accounting Review (April 1992), pp. 355–366 and Table 4, p. 363, for a list of factors hypoth- esized to affect FIFO–LIFO choices.

414 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

much higher sophistication than might be expected. Share prices are the same and, in some cases, even higher under LIFO in spite of lower reported earnings.19

The concern about reduced income resulting from adoption of LIFO has even less substance now because the IRS has also relaxed the LIFO conformity rule which requires a company employing LIFO for tax purposes to use it for book purposes as well. The IRS has also relaxed restrictions against providing non-LIFO income numbers as supple- mentary information. As a result, companies now provide supplemental non-LIFO dis- closures. While not intended to override the basic LIFO method adopted for financial reporting, these disclosures may be useful in comparing operating income and working capital with companies not on LIFO.

For example, Sherwin-Williams Company, a LIFO user, presented the information in its annual report as shown in Illustration 8-25.

19See, for example, Shyam Sunder, “Relationship Between Accounting Changes and Stock Prices: Problems of Measurement and Some Empirical Evidence,” Empirical Research in Accounting: Selected Studies, 1973 (Chicago: University of Chicago), pp. 1–40. But see Robert Moren Brown, “Short-Range Market Reaction to Changes to LIFO Accounting Using Preliminary Earnings Announcement Dates,” The Journal of Accounting Research (Spring 1980), which found that companies that do change to LIFO suffer a short-run decline in the price of their stock. 20Note that a company can use one variation of LIFO for financial reporting purposes and another for tax without violating the LIFO conformity rule. Such a relaxation has caused many problems because the general approach to accounting for LIFO has been “whatever is good for tax is good for financial reporting.” 21For an interesting discussion of the reasons for and against the use of FIFO and average-cost, see Michael H. Granof and Daniel G. Short, “For Some Companies, FIFO Accounting Makes Sense,” Wall Street Journal (August 30, 1982); and the subsequent rebuttal by Gary C. Biddle, “Taking Stock of Inventory Accounting Choices,” Wall Street Journal (September 15, 1982).

INTERNATIONAL PERSPECTIVE

Many U.S. companies that have international operations use LIFO for U.S. purposes but use FIFO for their foreign subsidiaries.

Sherwin-Williams Company

Inventories were stated at the lower of cost or market with cost determined principally on the last-in, first-out (LIFO) method. The following presents the effect on inventories, net income and net income per common share had the Company used the first-in, first-out (FIFO) inventory valuation method adjusted for income taxes at the statutory rate and assuming no other adjustments.

Current Year Previous Year

Percentage of total inventories on LIFO 77% 76% Excess of FIFO over LIFO $378,986 $277,164 (Decrease) increase in net income due to LIFO (62,636) (16,394) (Decrease) increase in net income per common share due to LIFO (.59) (.15)

ILLUSTRATION 8-25 Supplemental Non-LIFO Disclosure

Relaxation of the LIFO conformity rule has led some companies to select LIFO as their inventory valuation method because they will be able to disclose FIFO income numbers in the financial reports if they so desire.20

Companies often combine inventory methods. For example, John Deere uses LIFO for most of its inventories, and prices the remainder using FIFO. The Hershey Company follows the same practice. One reason for these practices is that certain product lines can be highly susceptible to deflation instead of inflation. In addition, if the level of inventory is unstable, unwanted involuntary liquidations may result in certain product lines if using LIFO. Finally, for high inventory turnover in certain product lines, a company cannot justify LIFO’s additional recordkeeping and expense. In such cases, a company often uses average-cost because it is easy to compute.21

Although a company may use a variety of inventory methods to assist in accurate computation of net income, once it selects a costing method, it must apply it consistently

Special Issues Related to LIFO 415

thereafter. If conditions indicate that the inventory costing method in use is unsuitable, the company must seriously consider all other possibilities before selecting another method. It should clearly explain any change and disclose its effect in the financial statements.

In some situations, use of LIFO can result in signifi cant tax sav- ings for companies. For example, Sherwin-Williams Com- pany estimates its tax bill would increase by $16 million if it were to change from LIFO to FIFO. The option to use LIFO to reduce taxes has become a political issue because of the growing federal defi cit. Some are proposing elimination of

LIFO (and other tax law changes) to help reduce the 2016 fi s- cal year budget defi cit. Why pick on LIFO? Well, one estimate indicates that repeal of LIFO would help plug the budget defi cit with over $76 billion in additional tax collections over 10 years. In addition, since IFRS does not permit LIFO, its repeal will contribute to international accounting convergence.

Sources: R. Bloom and W. Cenker, “The Death of LIFO?” Journal of Accountancy (January 2009), pp. 44–49; and A. Lundeen, “Proposed Tax Changes in President Obama’s Fiscal Year 2016 Budget,” http://taxfoundation.org/blog/proposed-tax-changes-president-obama-s-fiscal-year-2016-budget (February 11, 2015).

EVOLVING ISSUE REPEAL LIFO!

Inventory Valuation Methods—Summary Analysis The preceding sections of this chapter described a number of inventory valuation meth- ods. Here we present a brief summary of the three major inventory methods to show the effects these valuation methods have on the financial statements. This comparison assumes periodic inventory procedures and the following selected data.

Illustration 8-26 shows the comparative results on net income of the use of average- cost, FIFO, and LIFO. Notice that gross profit and net income are lowest under LIFO, highest under FIFO, and somewhere in the middle under average-cost.

Selected Data

Beginning cash balance $ 7,000 Beginning retained earnings $10,000 Beginning inventory: 4,000 units @ $3 $12,000 Purchases: 6,000 units @ $4 $24,000 Sales: 5,000 units @ $12 $60,000 Operating expenses $10,000 Income tax rate 40%

ILLUSTRATION 8-26 Comparative Results of Average-Cost, FIFO, and LIFO Methods

Average- Cost FIFO LIFO

Sales $60,000 $60,000 $60,000 Cost of goods sold 18,000a 16,000b 20,000c

Gross profit 42,000 44,000 40,000 Operating expenses 10,000 10,000 10,000

Income before taxes 32,000 34,000 30,000 Income taxes (40%) 12,800 13,600 12,000

Net income $19,200 $20,400 $18,000

a4,000 @ $3 = $12,000 b4,000 @ $3 = $12,000 c5,000 @ $4 = $20,000 6,000 @ $4 = 24,000 1,000 @ $4 = 4,000

$36,000 $16,000

$36,000 ÷ 10,000 = $3.60 $3.60 × 5,000 = $18,000

416 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

Illustration 8-27 shows the final balances of selected items at the end of the period.

ILLUSTRATION 8-27 Balances of Selected Items under Alternative Inventory Valuation Methods

Gross Net Retained Inventory Profit Taxes Income Earnings Cash

Average- $18,000 $42,000 $12,800 $19,200

$29,200 $20,200a Cost (5,000 × $3.60) ($10,000 + $19,200)

FIFO $20,000

$44,000 $13,600 $20,400 $30,400

$19,400a (5,000 × $4) ($10,000 + $20,400)

$16,000 LIFO (4,000 × $3) $40,000 $12,000 $18,000 $28,000 $21,000a

(1,000 × $4) ($10,000 + $18,000)

aCash at year-end = Beg. Balance + Sales − Purchases − Operating expenses − Taxes Average-cost—$20,200 = $7,000 + $60,000 − $24,000 − $10,000 − $12,800 FIFO—$19,400 = $7,000 + $60,000 − $24,000 − $10,000 − $13,600 LIFO—$21,000 = $7,000 + $60,000 − $24,000 − $10,000 − $12,000

LIFO results in the highest cash balance at year-end (because taxes are lower). This exam- ple assumes that prices are rising. The opposite result occurs if prices are declining.

EFFECT OF INVENTORY ERRORS Items incorrectly included or excluded in determining cost of goods sold through inven- tory misstatements will result in errors in the financial statements. We next look at two cases, assuming a periodic inventory system.

Ending Inventory Misstated What would happen if IBM correctly records its beginning inventory and purchases, but fails to include some items in ending inventory? In this situation, we would have the following effects on the financial statements at the end of the period.

LEARNING OBJECTIVE 5 Determine the effects of inventory errors on the financial statements.

ILLUSTRATION 8-28 Financial Statement Effects of Misstated Ending Inventory

Balance Sheet Income Statement

Inventory Understated Cost of goods sold Overstated Retained earnings Understated Working capital Understated Net income Understated Current ratio Understated

If ending inventory is understated, working capital (current assets less current liabili- ties) and the current ratio (current assets divided by current liabilities) are understated. If cost of goods sold is overstated, then net income is understated.

To illustrate the effect on net income over a two-year period (2016–2017), assume that Jay Weiseman Corp. understates its ending inventory by $10,000 in 2016; all other items are correctly stated. The effect of this error is to decrease net income in 2016 and to increase net income in 2017. The error is counterbalanced (offset) in 2017 because begin- ning inventory is understated and net income is overstated. As Illustration 8-29 shows, the income statement misstates the net income figures for both 2016 and 2017 although the total for the two years is correct.

Effect of Inventory Errors 417

If Weiseman overstates ending inventory in 2016, the reverse effect occurs. Inventory, working capital, current ratio, and net income are overstated, and cost of goods sold is understated. The effect of the error on net income will be counterbalanced in 2017, but the income statement misstates both years’ net income figures.

Purchases and Inventory Misstated Suppose that Bishop Company does not record as a purchase certain goods that it owns and does not count them in ending inventory. The effect on the financial statements (assuming this is a purchase on account) is as follows.

Balance Sheet Income Statement

Inventory Understated Purchases Understated Retained earnings No effect Cost of goods sold No effect Accounts payable Understated Net income No effect Working capital No effect Inventory (ending) Understated Current ratio Overstated

ILLUSTRATION 8-30 Financial Statement Effects of Misstated Purchases and Inventory

Omission of goods from purchases and inventory results in an understatement of inventory and accounts payable in the balance sheet. It also results in an understate- ment of purchases and ending inventory in the income statement. However, the omis- sion of such goods does not affect net income for the period. Why not? Because Bishop understates both purchases and ending inventory by the same amount—the error is thereby offset in cost of goods sold. Total working capital is unchanged, but the current ratio is overstated because of the omission of equal amounts from inventory and accounts payable.

To illustrate the effect on the current ratio, assume that Bishop understated accounts payable and ending inventory by $40,000. Illustration 8-31 (on page 418) shows the understated and correct data.

}

ILLUSTRATION 8-29 Effect of Ending Inventory Error on Two Periods

}

JAY WEISEMAN CORP. (All Figures Assumed)

Incorrect Recording Correct Recording

2016 2017 2016 2017

Revenues $100,000 $100,000 $100,000 $100,000

Cost of goods sold Beginning inventory 25,000 20,000 25,000 30,000 Purchased or produced 45,000 60,000 45,000 60,000

Goods available for sale 70,000 80,000 70,000 90,000 Less: Ending inventory 20,000* 40,000 30,000 40,000

Cost of goods sold 50,000 40,000 40,000 50,000

Gross profit 50,000 60,000 60,000 50,000 Administrative and selling

expenses 40,000 40,000 40,000 40,000

Net income $ 10,000 $ 20,000 $ 20,000 $ 10,000

Total income Total income for two years = $30,000 for two years = $30,000

*Ending inventory understated by $10,000 in 2016.

418 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

The understated data indicate a current ratio of 3 to 1, whereas the correct ratio is 2 to 1. Thus, understatement of accounts payable and ending inventory can lead to a “window- dressing” of the current ratio. That is, Bishop can make the current ratio appear better than it is.

If Bishop overstates both purchases (on account) and ending inventory, then the effects on the balance sheet are exactly the reverse. The financial statements overstate inventory and accounts payable, and understate the current ratio. The overstatement does not affect cost of goods sold and net income because the errors offset one another. Similarly, working capital is not affected.

We cannot overemphasize the importance of proper inventory measurement in presenting accurate financial statements. For example, Leslie Fay, a women’s apparel maker, had accounting irregularities that wiped out one year’s net income and caused a restatement of the prior year’s earnings. One reason: It inflated inventory and deflated cost of goods sold. Anixter Bros. Inc. had to restate its income by $1.7 million because an accountant in the antenna manufacturing division overstated the ending inventory, thereby reducing its cost of sales. Similarly, AM International allegedly recorded as sold products that were only being rented. As a result, inaccurate inventory and sales figures inappropriately added $7.9 million to pretax income.

UNDERLYING CONCEPTS

When inventory is mis- stated, its presentation is not representationally faithful.

REVIEW AND PRACTICE KEY TERMS REVIEW

LEARNING OBJECTIVES REVIEW 1 Understand inventory classifications and different inventory systems. Only one inventory account, Inventory,

appears in the financial statements of a merchandising concern. A manufacturer normally has three inventory accounts: Raw Materials, Work in Process, and Finished Goods. Companies report the cost assigned to goods and materials on hand but not yet placed into production as raw materials inventory. They report the cost of the raw materials on which production has been started but not completed, plus the direct labor cost applied specifically to this material and a ratable share of manufacturing overhead costs, as work in process inventory. Finally, they report the costs identified with the completed but unsold units on hand at the end of the fiscal period as finished goods inventory.

average-cost method, 399 consigned goods, 393 cost of goods available for

sale or use, 392 cost of goods sold, 392 cost flow assumptions, 398 dollar-value LIFO, 405 double-extension method,

408 finished goods

inventory, 388

first-in, first-out (FIFO) method, 400

f.o.b. destination, 393 f.o.b. shipping point, 393 gross method, 396 inventories, 388 last-in, first-out (LIFO)

method, 401 LIFO effect, 402 LIFO liquidation, 403 LIFO reserve, 402

merchandise inventory, 388 modified perpetual

inventory system, 391 moving-average

method, 399 net method, 397 net of the cash

discounts, 396 period costs, 396 periodic inventory

system, 390

perpetual inventory system, 390

product costs, 395 Purchase Discounts, 396 raw materials inventory, 388 specific-goods pooled LIFO

approach, 405 specific identification, 398 weighted-average

method, 399 work in process inventory, 388

ILLUSTRATION 8-31 Effects of Purchases and Ending Inventory Errors

Purchases and Ending Purchases and Ending Inventory Understated Inventory Correct

Current assets $120,000 Current assets $160,000 Current liabilities $ 40,000 Current liabilities $ 80,000 Current ratio 3 to 1 Current ratio 2 to 1

A perpetual inventory system maintains a continuous record of inventory changes in the Inventory account. That is, a company records all purchases and sales (issues) of goods directly in the Inventory account as they occur. Under a periodic inventory system, companies determine the quantity of inventory on hand only periodically. A company debits a Purchases account, but the Inventory account remains the same. It determines cost of goods sold at the end of the period by subtracting ending inventory from cost of goods available for sale. A company ascertains ending inventory by physical count.

2 Determine the goods and costs included in inventory. Companies record purchases of inventory when they obtain legal title to the goods (generally when they receive the goods). Shipping terms must be evaluated to determine when legal title passes, and careful consideration must be made for cost of goods sold on consignment and sales with repurchase agree- ments and high rates of return.

Product costs are those costs that attach to the inventory and are recorded in the Inventory account. Such charges include freight charges on goods purchased, other direct costs of acquisition, and labor and other production costs incurred in processing the goods up to the time of sale. Period costs are those costs that are indirectly related to the acquisition or production of goods. These changes, such as selling expense and general and administrative expenses, are therefore not included as part of inventory cost.

3 Describe and compare the cost flow assumptions used to account for inventories. (1) Average-cost prices items in the inventory on the basis of the average cost of all similar goods available during the period. (2) First-in, first-out (FIFO) assumes that a company uses goods in the order in which it purchases them. The inventory remaining must there- fore represent the most recent purchases. (3) Last-in, first-out (LIFO) matches the cost of the last goods purchased against revenue.

4 Identify special issues related to LIFO. The difference between the inventory method used for internal reporting pur- poses and LIFO is referred to as Allowance to Reduce Inventory to LIFO, or the LIFO reserve. The change in LIFO reserve is referred to as the LIFO effect. Companies should disclose either the LIFO reserve or the replacement cost of the inventory in the financial statements.

LIFO liquidations match costs from preceding periods against sales revenues reported in current dollars. This distorts net income and results in increased taxable income in the current period. LIFO liquidations can occur frequently when using a specific-goods LIFO approach.

For the dollar-value LIFO method, companies determine and measure increases and decreases in a pool in terms of total dollar value, not the physical quantity of the goods in the inventory pool.

The major advantages of LIFO are the following. (1) It matches recent costs against current revenues to provide a better measure of current earnings. (2) As long as the price level increases and inventory quantities do not decrease, a deferral of income tax occurs in LIFO. (3) Because of the deferral of income tax, cash flow improves. Major disadvantages are (1) reduced earnings, (2) understated inventory, (3) does not approximate physical flow of the items except in peculiar situations, and (4) involuntary liquidation issues.

Companies ordinarily prefer LIFO in the following circumstances: (1) if selling prices and revenues have been increasing faster than costs and (2) if a company has a fairly constant “base stock.” Conversely, LIFO would probably not be appropriate in the following circumstances: (1) if sale prices tend to lag behind costs, (2) if specific identification is traditional, and (3) when unit costs tend to decrease as production increases, thereby nullifying the tax benefit that LIFO might provide.

5 Determine the effects of inventory errors on the financial statements. If the company misstates ending inventory: (1) In the balance sheet, the inventory and retained earnings will be misstated, which will lead to miscalculation of the working capital and current ratio, and (2) in the income statement, the cost of goods sold and net income will be misstated. If the company misstates purchases (and related accounts payable) and inventory: (1) In the balance sheet, the inventory and accounts payable will be misstated, which will lead to miscalculation of the current ratio, and (2) in the income statement, purchases and ending inventory will be misstated.

Review and Practice 419

ENHANCED REVIEW AND PRACTICE Go online for multiple-choice questions with solutions, review exercises with solutions, and a full glossary of all key terms.

420 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

PRACTICE PROBLEM

Clinton Company makes specialty cases for smart phones and other handheld devices. The company has experienced strong growth, and you are especially interested in how well Clinton is managing its inventory balances. You have collected the following information for the current year.

Inventory at the beginning of year $ 1,555 million Inventory at the end of year, before any adjustments $ 1,267 million Total cost of goods sold, before any adjustments $17,844 million

The company values inventory using the LIFO cost fl ow assumption.

Instructions Prepare a schedule (a computer worksheet would serve well) showing the impact of the following items on Clinton’s inventory turnover.

(a) Shipping contracts changed 2 months ago from f.o.b. shipping point to f.o.b. destination. At the end of the year, $5 million of products are en route to China (and will not arrive until after financial statements are released). Current inventory bal- ances do not reflect this change in policy.

(b) During the year, Clinton recorded sales and costs of goods sold on $2 million of units shipped to various wholesalers on consignment. At year-end, none of these units have been sold by wholesalers.

(c) To be more consistent with industry inventory valuation practices, Clinton changed from perpetual LIFO to FIFO for its inventory of iPad cases. This inventory is currently carried at $724 million. Data for this item of inventory for the year are as follows.

Month Units Purchased Inventory Sold Price per Unit Units Balance

January 1 100 $3.10 100 April 15 150 3.20 250 October 25 130 120 November 10 250 3.50 370 December 20 150 220

(d) Explain to Clinton management the advantages of using the LIFO cost flow assumption. Are there any drawbacks? Explain.

Formulas Data Review ViewPage LayoutInsert

A P18 fx

E FB C D

Home

Unadjusted Balance Adjustment (a) Adjustment (b) Adjustment (c) Adjusted Balance

Beginning inventory Ending inventory Average inventory Cost of goods sold Inventory turnover

Explanation

(in millions)

Goods officially change hands at the point of destination.

Clinton should include the goods on consignment to other sellers.

Ending inventory under FIFO would be $770 (220 @ $3.50), which is $46 ($770 - $724) higher than LIFO.

$(5.00)

$ 5.00 –

–

$ 46.00

$(46.00)

$ 2.00

$(2.00)

$ 1,555.00 1,320.00 1,437.50

17,791.00 12.38

$ 1,555.00 1,267.00

1,411.00 17,844.00 12.65

–

Clinton.xlsClinton.xls

SOLUTION

(a)–(c)

Questions 421

Exercises, Problems, Problem Solution Walkthrough Videos, and many more assessment tools and resources are available for practice in WileyPLUS.

1. In what ways are the inventory accounts of a retailing com- pany different from those of a manufacturing company?

2. Why should inventories be included in (a) a statement of financial position and (b) the computation of net income?

3. What is the difference between a perpetual inventory and a physical inventory? If a company maintains a per- petual inventory, should its physical inventory at any date be equal to the amount indicated by the perpetual inventory records? Why?

4. Mishima, Inc. indicated in a recent annual report that approximately $19 million of merchandise was received on consignment. Should Mishima, Inc. report this amount on its balance sheet? Explain.

5. What is a repurchase agreement (product financing) arrangement? How should a product repurchase agree- ment be reported in the financial statements?

6. Where, if at all, should the following items be classified on a balance sheet? (a) Goods out on approval to customers. (b) Goods in transit that were recently purchased f.o.b.

destination. (c) Land held by a realty firm for sale. (d) Raw materials. (e) Goods received on consignment. (f) Manufacturing supplies.

7. Define “cost” as applied to the valuation of inventories. 8. Distinguish between product costs and period costs as

they relate to inventory. 9. Ford Motor Co. is considering alternate methods of

accounting for the cash discounts it takes when paying suppliers promptly. One method suggested was to report these discounts as financial income when payments are made. Comment on the propriety of this approach.

10. Zonker Inc. purchases 500 units of an item at an invoice cost of $30,000. What is the cost per unit? If the goods are shipped f.o.b. shipping point and the freight bill was

$1,500, what is the cost per unit if Zonker Inc. pays the freight charges? If these items were bought on 2/10, n/30 terms and the invoice and the freight bill were paid within the 10-day period, what would be the cost per unit?

11. Specific identification is sometimes said to be the ideal method of assigning cost to inventory and to cost of goods sold. Briefly indicate the arguments for and against this method of inventory valuation.

12. FIFO, average-cost, and LIFO methods are often used instead of specific identification for inventory valuation purposes. Compare these methods with the specific identi- fication method, discussing the theoretical propriety of each method in the determination of income and asset valuation.

13. How might a company obtain a price index in order to apply dollar-value LIFO?

14. Describe the LIFO double-extension method. Using the following information, compute the index at December 31, 2017, applying the double-extension method to a LIFO pool consisting of 25,500 units of product A and 10,350 units of product B. The base-year cost of product A is $10.20 and of product B is $37.00. The price at December 31, 2017, for product A is $21.00 and for product B is $45.60. (Round to two decimal places.)

15. As compared with the FIFO method of costing invento- ries, does the LIFO method result in a larger or smaller net income in a period of rising prices? What is the com- parative effect on net income in a period of falling prices?

16. What is the dollar-value method of LIFO inventory valu- ation? What advantage does the dollar-value method have over the specific goods approach of LIFO inventory valuation? Why will the traditional LIFO inventory cost- ing method and the dollar-value LIFO inventory costing method produce different inventory valuations if the composition of the inventory base changes?

17. Explain the following terms. (a) LIFO layer. (b) LIFO reserve. (c) LIFO effect.

QUESTIONS

(d) The major advantages of the LIFO inventory method include better matching of costs with revenues, deferral of income taxes, improved cash flow, and minimization of the impact of future price declines on future earnings. Better matching arises in the use of LIFO because the most recent costs are matched with current revenues. In times of rising prices, this matching will result in lower taxable income, which in turn will reduce current taxes. The deferral of taxes under LIFO contributes to a higher cash flow. As illustrated in the analysis above, the switch to FIFO resulted in a higher ending inventory, which leads to a lower cost of goods sold and higher income. Thus, Clinton’s reported income will be higher but so will its taxes. Note that under LIFO, future taxes may be higher when lower cost items of inventory are sold in future periods and matched with higher sales prices.

422 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

18. On December 31, 2016, the inventory of Powhattan Com- pany amounts to $800,000. During 2017, the company decides to use the dollar-value LIFO method of costing inventories. On December 31, 2017, the inventory is $1,053,000 at December 31, 2017, prices. Using the December 31, 2016, price level of 100 and the December 31, 2017, price level of 108, compute the inventory value at December 31, 2017, under the dollar-value LIFO method.

19. In an article that appeared in the Wall Street Journal, the phrases “phantom (paper) profits” and “high LIFO profits”

through involuntary liquidation were used. Explain these phrases.

20. At the balance sheet date, Clarkson Company held title to goods in transit amounting to $214,000. This amount was omitted from the purchases figure for the year and also from the ending inventory. What is the effect of this omission on the net income for the year as calculated when the books are closed? What is the effect on the com- pany’s financial position as shown in its balance sheet? Is materiality a factor in determining whether an adjust- ment for this item should be made?

BRIEF EXERCISES

BE8-1 (L01) Included in the December 31 trial balance of Rivera Company are the following assets.

Cash $ 190,000 Work in process $200,000 Equipment (net) 1,100,000 Accounts receivable (net) 400,000 Prepaid insurance 41,000 Patents 110,000 Raw materials 335,000 Finished goods 170,000

Prepare the current assets section of the December 31 balance sheet.

BE8-2 (L01) Matlock Company uses a perpetual inventory system. Its beginning inventory consists of 50 units that cost $34 each. During June, the company purchased 150 units at $34 each, returned 6 units for credit, and sold 125 units at $50 each. Journalize the June transactions.

BE8-3 (L02) Stallman Company took a physical inventory on December 31 and determined that goods costing $200,000 were on hand. Not included in the physical count were $25,000 of goods purchased from Pelzer Corporation, f.o.b. shipping point, and $22,000 of goods sold to Alvarez Company for $30,000, f.o.b. destination. Both the Pelzer purchase and the Alvarez sale were in transit at year-end. What amount should Stallman report as its December 31 inventory?

BE8-4 (L03) Amsterdam Company uses a periodic inventory system. For April, when the company sold 600 units, the follow- ing information is available.

Units Unit Cost Total Cost

April 1 inventory 250 $10 $ 2,500 April 15 purchase 400 12 4,800 April 23 purchase 350 13 4,550

1,000 $11,850

Compute the April 30 inventory and the April cost of goods sold using the average-cost method.

BE8-5 (L03) Data for Amsterdam Company are presented in BE8-4. Compute the April 30 inventory and the April cost of goods sold using the FIFO method.

BE8-6 (L03) Data for Amsterdam Company are presented in BE8-4. Compute the April 30 inventory and the April cost of goods sold using the LIFO method.

BE8-7 (L04) Trout Company uses the LIFO method for financial reporting purposes but FIFO for internal reporting purposes. At January 1, 2017, the LIFO reserve has a credit balance of $1,300,000. At December 31, 2017, Trout’s internal reports indicated that the FIFO inventory balance was $2,900,000 and for external reporting purposes the LIFO inventory balance was $1,500,000. What is the amount of the LIFO reserve and the LIFO effect related to 2017? What is the journal entry needed to record the LIFO effect at December 31, 2017?

BE8-8 (L04) Midori Company had ending inventory at end-of-year prices of $100,000 at December 31, 2016; $119,900 at December 31, 2017; and $134,560 at December 31, 2018. The year-end price indexes were 100 at 12/31/16, 110 at 12/31/17, and 116 at 12/31/18. Compute the ending inventory for Midori Company for 2016 through 2018 using the dollar-value LIFO method.

Compute the value of the 2017 and 2018 inventories using the dollar-value LIFO method.

BE8-10 (L05) Bienvenu Enterprises reported cost of goods sold for 2017 of $1,400,000 and retained earnings of $5,200,000 at December 31, 2017. Bienvenu later discovered that its ending inventories at December 31, 2016 and 2017, were overstated by $110,000 and $35,000, respectively. Determine the corrected amounts for 2017 cost of goods sold and December 31, 2017, retained earnings.

EXERCISES

E8-1 (L02) (Inventoriable Goods and Costs) Presented below is a list of items that may or may not be reported as inventory in a company’s December 31 balance sheet.

1. Goods out on consignment at another company’s store. 2. Goods sold on an installment basis (bad debts can be reasonably estimated). 3. Goods purchased f.o.b. shipping point that are in transit at December 31. 4. Goods purchased f.o.b. destination that are in transit at December 31. 5. Goods sold to another company, for which our company has signed an agreement to repurchase at a set price that covers

all costs related to the inventory. 6. Goods sold where large returns are predictable. 7. Goods sold f.o.b. shipping point that are in transit at December 31. 8. Freight charges on goods purchased. 9. Interest costs incurred for inventories that are routinely manufactured. 10. Costs incurred to advertise goods held for resale. 11. Materials on hand not yet placed into production by a manufacturing firm. 12. Office supplies. 13. Raw materials on which a manufacturing firm has started production but which are not completely processed. 14. Factory supplies. 15. Goods held on consignment from another company. 16. Costs identified with units completed by a manufacturing firm but not yet sold. 17. Goods sold f.o.b. destination that are in transit at December 31. 18. Short-term investments in stocks and bonds that will be resold in the near future.

Instructions Indicate which of these items would typically be reported as inventory in the financial statements. If an item should not be reported as inventory, indicate how it should be reported in the financial statements.

E8-2 (L02) EXCEL (Inventoriable Goods and Costs) In your audit of Jose Oliva Company, you find that a physical inven- tory on December 31, 2017, showed merchandise with a cost of $441,000 was on hand at that date. You also discover the follow- ing items were all excluded from the $441,000.

1. Merchandise of $61,000 which is held by Oliva on consignment. The consignor is the Max Suzuki Company. 2. Merchandise costing $38,000 which was shipped by Oliva f.o.b. destination to a customer on December 31, 2017. The cus-

tomer was expected to receive the merchandise on January 6, 2018. 3. Merchandise costing $46,000 which was shipped by Oliva f.o.b. shipping point to a customer on December 29, 2017. The

customer was scheduled to receive the merchandise on January 2, 2018. 4. Merchandise costing $83,000 shipped by a vendor f.o.b. destination on December 30, 2017, and received by Oliva on Janu-

ary 4, 2018. 5. Merchandise costing $51,000 shipped by a vendor f.o.b. shipping point on December 31, 2017, and received by Oliva on

January 5, 2018.

Exercises 423

Year Ended December 31 Inventory at Current-Year Cost Price Index

2016 $19,750 100 2017 22,140 108 2018 25,935 114

BE8-9 (L04) Arna, Inc. uses the dollar-value LIFO method of computing its inventory. Data for the past 3 years follow.

424 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

Instructions Based on the above information, calculate the amount that should appear on Oliva’s balance sheet at December 31, 2017, for inventory.

E8-3 (L02) (Inventoriable Goods and Costs) Assume that in an annual audit of Harlowe Inc. at December 31, 2017, you find the following transactions near the closing date.

1. A special machine, fabricated to order for a customer, was finished and specifically segregated in the back part of the ship- ping room on December 31, 2017. The customer was billed on that date and the machine excluded from inventory although it was shipped on January 4, 2018.

2. Merchandise costing $2,800 was received on January 3, 2018, and the related purchase invoice recorded January 5. The invoice showed the shipment was made on December 29, 2017, f.o.b. destination.

3. A packing case containing a product costing $3,400 was standing in the shipping room when the physical inventory was taken. It was not included in the inventory because it was marked “Hold for shipping instructions.” Your investigation revealed that the customer’s order was dated December 18, 2017, but that the case was shipped and the customer billed on January 10, 2018. The product was a stock item of your client.

4. Merchandise received on January 6, 2018, costing $680 was entered in the purchase journal on January 7, 2018. The invoice showed shipment was made f.o.b. supplier’s warehouse on December 31, 2017. Because it was not on hand at December 31, it was not included in inventory.

5. Merchandise costing $720 was received on December 28, 2017, and the invoice was not recorded. You located it in the hands of the purchasing agent; it was marked “on consignment.”

Instructions Assuming that each of the amounts is material, state whether the merchandise should be included in the client’s inventory, and give your reason for your decision on each item.

E8-4 (L02) (Inventoriable Goods and Costs—Perpetual) Colin Davis Machine Company maintains a general ledger account for each class of inventory, debiting such accounts for increases during the period and crediting them for decreases. The transac- tions below relate to the Raw Materials inventory account, which is debited for materials purchased and credited for materials requisitioned for use.

1. An invoice for $8,100, terms f.o.b. destination, was received and entered January 2, 2017. The receiving report shows that the materials were received December 28, 2016.

2. Materials costing $28,000, shipped f.o.b. destination, were not entered by December 31, 2016, “because they were in a railroad car on the company’s siding on that date and had not been unloaded.”

3. Materials costing $7,300 were returned to the supplier on December 29, 2016, and were shipped f.o.b. shipping point. The return was entered on that date, even though the materials are not expected to reach the supplier’s place of business until January 6, 2017.

4. An invoice for $7,500, terms f.o.b. shipping point, was received and entered December 30, 2016. The receiving report shows that the materials were received January 4, 2017, and the bill of lading shows that they were shipped January 2, 2017.

5. Materials costing $19,800 were received December 30, 2016, but no entry was made for them because “they were ordered with a specified delivery of no earlier than January 10, 2017.”

Instructions Prepare correcting general journal entries required at December 31, 2016, assuming that the books have not been closed.

E8-5 (L02) (Inventoriable Goods and Costs—Error Adjustments) Craig Company asks you to review its December 31, 2017, inventory values and prepare the necessary adjustments to the books. The following information is given to you.

1. Craig uses the periodic method of recording inventory. A physical count reveals $234,890 of inventory on hand at Decem- ber 31, 2017.

2. Not included in the physical count of inventory is $13,420 of merchandise purchased on December 15 from Browser. This merchandise was shipped f.o.b. shipping point on December 29 and arrived in January. The invoice arrived and was recorded on December 31.

3. Included in inventory is merchandise sold to Champy on December 30, f.o.b. destination. This merchandise was shipped after it was counted. The invoice was prepared and recorded as a sale on account for $12,800 on December 31. The mer- chandise cost $7,350, and Champy received it on January 3.

4. Included in inventory was merchandise received from Dudley on December 31 with an invoice price of $15,630. The mer- chandise was shipped f.o.b. destination. The invoice, which has not yet arrived, has not been recorded.

5. Not included in inventory is $8,540 of merchandise purchased from Glowser Industries. This merchandise was received on December 31 after the inventory had been counted. The invoice was received and recorded on December 30.

6. Included in inventory was $10,438 of inventory held by Craig on consignment from Jackel Industries. 7. Included in inventory is merchandise sold to Kemp f.o.b. shipping point. This merchandise was shipped on December 31

after it was counted. The invoice was prepared and recorded as a sale for $18,900 on December 31. The cost of this mer- chandise was $10,520, and Kemp received the merchandise on January 5.

8. Excluded from inventory was a carton labeled “Please accept for credit.” This carton contains merchandise costing $1,500 which had been sold to a customer for $2,600. No entry had been made to the books to reflect the return, but none of the returned merchandise seemed damaged; Craig will honor the return.

Instructions (a) Determine the proper inventory balance for Craig Company at December 31, 2017. (b) Prepare any correcting entries to adjust inventory to its proper amount at December 31, 2017. Assume the books have

not been closed.

E8-6 (L02) (Determining Merchandise Amounts—Periodic) Two or more items are omitted in each of the following tabula- tions of income statement data. Fill in the amounts that are missing.

Exercises 425

2016 2017 2018

Sales revenue $290,000 $ ? $410,000 Sales returns and allowances 11,000 13,000 ? Net sales ? 347,000 ? Beginning inventory 20,000 32,000 ? Ending inventory ? ? ? Purchases ? 260,000 298,000 Purchase returns and allowances 5,000 8,000 10,000 Freight-in 8,000 9,000 12,000 Cost of goods sold 233,000 ? 293,000 Gross profi t on sales 46,000 91,000 97,000

E8-7 (L02) (Purchases Recorded Net) Presented below are transactions related to Tom Brokaw, Inc.

May 10 Purchased goods billed at $15,000 subject to cash discount terms of 2/10, n/60. 11 Purchased goods billed at $13,200 subject to terms of 1/15, n/30. 19 Paid invoice of May 10. 24 Purchased goods billed at $11,500 subject to cash discount terms of 2/10, n/30.

Instructions (a) Prepare general journal entries for the transactions above under the assumption that purchases are to be recorded at net

amounts after cash discounts and that discounts lost are to be treated as financial expense. (b) Assuming no purchase or payment transactions other than those given above, prepare the adjusting entry required on

May 31 if financial statements are to be prepared as of that date.

E8-8 (L02) (Purchases Recorded, Gross Method) Cruise Industries purchased $10,800 of merchandise on February 1, 2017, subject to a trade discount of 10% and with credit terms of 3/15, n/60. It returned $2,500 (gross price before trade or cash dis- count) on February 4. The invoice was paid on February 13.

Instructions (a) Assuming that Cruise uses the perpetual method for recording merchandise transactions, record the purchase, return,

and payment using the gross method. (b) Assuming that Cruise uses the periodic method for recording merchandise transactions, record the purchase, return,

and payment using the gross method. (c) At what amount would the purchase on February 1 be recorded if the net method were used?

E8-9 (L03) EXCEL (Periodic versus Perpetual Entries) Fong Sai-Yuk Company sells one product. Presented below is infor- mation for January for Fong Sai-Yuk Company.

Jan. 1 Inventory 100 units at $5 each 4 Sale 80 units at $8 each 11 Purchase 150 units at $6 each 13 Sale 120 units at $8.75 each 20 Purchase 160 units at $7 each 27 Sale 100 units at $9 each

Fong Sai-Yuk uses the FIFO cost flow assumption. All purchases and sales are on account.

426 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

Instructions (a) Assume Fong Sai-Yuk uses a periodic system. Prepare all necessary journal entries, including the end-of-month closing

entry to record cost of goods sold. A physical count indicates that the ending inventory for January is 110 units. (b) Compute gross profit using the periodic system. (c) Assume Fong Sai-Yuk uses a perpetual system. Prepare all necessary journal entries. (d) Compute gross profit using the perpetual system.

E8-10 (L03) (FIFO and LIFO—Periodic and Perpetual) Inventory information for Part 311 of Monique Aaron Corp. dis- closes the following information for the month of June.

June 1 Balance 300 units @ $10 June 10 Sold 200 units @ $24 11 Purchased 800 units @ $12 15 Sold 500 units @ $25 20 Purchased 500 units @ $13 27 Sold 300 units @ $27

Instructions (a) Assuming that the periodic inventory method is used, compute the cost of goods sold and ending inventory under

(1) LIFO and (2) FIFO. (b) Assuming that the perpetual inventory method is used and costs are computed at the time of each withdrawal, what is

the value of the ending inventory at LIFO? (c) Assuming that the perpetual inventory method is used and costs are computed at the time of each withdrawal, what is

the gross profit if the inventory is valued at FIFO? (d) Why is it stated that LIFO usually produces a lower gross profit than FIFO?

E8-11 (L03) (FIFO, LIFO and Average-Cost Determination) John Adams Company’s record of transactions for the month of April was as follows.

Instructions (a) Assuming that periodic inventory records are kept in units only, compute the inventory at April 30 using (1) LIFO and

(2) average-cost. (b) Assuming that perpetual inventory records are kept in dollars, determine the inventory using (1) FIFO and (2) LIFO. (c) Compute cost of goods sold assuming periodic inventory procedures and inventory priced at FIFO. (d) In an inflationary period, which inventory method—FIFO, LIFO, average-cost—will show the highest net income?

E8-12 (L03) (FIFO, LIFO, Average-Cost Inventory) Shania Twain Company was formed on December 1, 2016. The following information is available from Twain’s inventory records for Product BAP.

Purchases Sales

April 1 (balance on hand) 600 @ $ 6.00 April 3 500 @ $10.00 4 1,500 @ 6.08 9 1,400 @ 10.00 8 800 @ 6.40 11 600 @ 11.00 13 1,200 @ 6.50 23 1,200 @ 11.00 21 700 @ 6.60 27 900 @ 12.00

29 500 @ 6.79 4,600 5,300

Units Unit Cost

January 1, 2017 (beginning inventory) 600 $ 8.00 Purchases: January 5, 2017 1,200 9.00 January 25, 2017 1,300 10.00 February 16, 2017 800 11.00 March 26, 2017 600 12.00

A physical inventory on March 31, 2017, shows 1,600 units on hand.

Instructions Prepare schedules to compute the ending inventory at March 31, 2017, under each of the following inventory methods.

(a) FIFO (b) LIFO. (c) Weighted-average (round unit costs to two decimal places).

Units Unit Units Selling Date Transaction In Cost Total Sold Price Total

July 1 Balance 100 $4.10 $ 410 6 Purchase 800 4.20 3,360 7 Sale 300 $7.00 $ 2,100 10 Sale 300 7.30 2,190 12 Purchase 400 4.50 1,800 15 Sale 200 7.40 1,480 18 Purchase 300 4.60 1,380 22 Sale 400 7.40 2,960 25 Purchase 500 4.58 2,290 30 Sale 200 7.50 1,500

Totals 2,100 $9,240 1,400 $10,230

Exercises 427

Instructions (a) Assuming that the periodic inventory method is used, compute the inventory cost at July 31 under each of the following

cost flow assumptions. (1) FIFO. (2) LIFO. (3) Weighted-average.

(b) Answer the following questions. (1) Which of the methods used above will yield the lowest figure for gross profit for the income statement? Explain why. (2) Which of the methods used above will yield the lowest figure for ending inventory for the balance sheet? Explain

why.

E8-14 (L03) (FIFO and LIFO—Periodic and Perpetual) The following is a record of Pervis Ellison Company’s transactions for Boston Teapots for the month of May 2017.

May 1 Balance 400 units @ $20 May 10 Sale 300 units @ $38 12 Purchase 600 units @ $25 20 Sale 540 units @ $38 28 Purchase 400 units @ $30

Instructions (a) Assuming that perpetual inventories are not maintained and that a physical count at the end of the month shows 560

units on hand, what is the cost of the ending inventory using (1) FIFO and (2) LIFO? (b) Assuming that perpetual records are maintained and they tie into the general ledger, calculate the ending inventory

using (1) FIFO and (2) LIFO.

E8-15 (L03) (FIFO and LIFO; Income Statement Presentation) The board of directors of Ichiro Corporation is considering whether or not it should instruct the accounting department to shift from a first-in, first-out (FIFO) basis of pricing inventories to a last-in, first-out (LIFO) basis. The following information is available.

Sales 21,000 units @ $50 Inventory, January 1 6,000 units @ 20 Purchases 6,000 units @ 22 10,000 units @ 25 7,000 units @ 30 Inventory, December 31 8,000 units @ ? Operating expenses $200,000

Instructions Prepare a condensed income statement for the year on both bases for comparative purposes. E8-16 (L03) (FIFO and LIFO Effects) You are the vice president of finance of Sandy Alomar Corporation, a retail com- pany that prepared two different schedules of gross margin for the first quarter ended March 31, 2017. These schedules appear below.

Sales Cost of Gross ($5 per unit) Goods Sold Margin

Schedule 1 $150,000 $124,900 $25,100 Schedule 2 150,000 129,400 20,600

E8-13 (L03) (Compute FIFO, LIFO, Average-Cost—Periodic) Presented below is information related to Blowfish radios for the Hootie Company for the month of July.

428 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

Jane Torville, the president of the corporation, cannot understand how two different gross margins can be computed from the same set of data. As the vice president of finance, you have explained to Ms. Torville that the two schedules are based on differ- ent assumptions concerning the flow of inventory costs, i.e., FIFO and LIFO. Schedules 1 and 2 were not necessarily prepared in this sequence of cost flow assumptions.

Instructions Prepare two separate schedules computing cost of goods sold and supporting schedules showing the composition of the ending inventory under both cost flow assumptions. E8-17 (L03) (FIFO and LIFO—Periodic) Johnny Football Shop began operations on January 2, 2017. The following stock record card for footballs was taken from the records at the end of the year.

Cost Total Units per Unit Cost

Beginning inventory, January 1 10,000 $4.00 $40,000 Purchase, January 10 8,000 4.20 33,600 Purchase, January 30 6,000 4.25 25,500 Purchase, February 11 9,000 4.30 38,700 Purchase, March 17 11,000 4.40 48,400

Units Unit Invoice Gross Invoice Date Voucher Terms Received Cost Amount

1/15 10624 Net 30 50 $20 $1,000 3/15 11437 1/5, net 30 65 16 1,040 6/20 21332 1/10, net 30 90 15 1,350 9/12 27644 1/10, net 30 84 12 1,008 11/24 31269 1/10, net 30 76 11 836

Totals 365 $5,234

A physical inventory on December 31, 2017, reveals that 100 footballs were in stock. The bookkeeper informs you that all the discounts were taken. Assume that Johnny Football Shop uses the invoice price less discount for recording purchases.

Instructions (a) Compute the December 31, 2017, inventory using the FIFO method. (b) Compute the 2017 cost of goods sold using the LIFO method. (c) What method would you recommend to the owner to minimize income taxes in 2017, using the inventory information

for footballs as a guide?

E8-18 (L04) (LIFO Effect) The following example was provided to encourage the use of the LIFO method. In a nutshell, LIFO subtracts inflation from inventory costs, deducts it from taxable income, and records it in a LIFO reserve account on the books. The LIFO benefit grows as inflation widens the gap between current-year and past-year (minus inflation) inventory costs. This gap is:

With LIFO Without LIFO

Revenues $3,200,000 $3,200,000 Cost of goods sold 2,800,000 2,800,000 Operating expenses 150,000 150,000

Operating income 250,000 250,000 LIFO adjustment 40,000 0

Taxable income $ 210,000 $ 250,000

Income taxes @ 36% $ 75,600 $ 90,000

Cash fl ow $ 174,400 $ 160,000

Extra cash $ 14,400 0

Increased cash fl ow 9% 0%

Instructions (a) Explain what is meant by the LIFO reserve account. (b) How does LIFO subtract inflation from inventory costs? (c) Explain how the cash flow of $174,400 in this example was computed. Explain why this amount may not be correct. (d) Why does a company that uses LIFO have extra cash? Explain whether this situation will always exist.

The computation of cost of goods sold in each schedule is based on the following data.

E8-19 (L03,4) (Alternative Inventory Methods—Comprehensive) Tori Amos Corporation began operations on December 1, 2016. The only inventory transaction in 2016 was the purchase of inventory on December 10, 2016, at a cost of $20 per unit. None of this inventory was sold in 2016. Relevant information is as follows.

The company uses the periodic inventory method.

Instructions (a) Determine ending inventory under (1) specific identification, (2) FIFO, (3) LIFO, and (4) average-cost. (b) Determine ending inventory using dollar-value LIFO. Assume that the December 2, 2017, purchase cost is the current

cost of inventory. (Hint: The beginning inventory is the base layer priced at $20 per unit.)

E8-20 (L04) (Dollar-Value LIFO) Oasis Company has used the dollar-value LIFO method for inventory cost determination for many years. The following data were extracted from Oasis’ records.

Ending inventory units December 31, 2016 100 December 31, 2017, by purchase date December 2, 2017 100 July 20, 2017 50 150

During the year, the following purchases and sales were made.

Purchases Sales

March 15 300 units at $24 April 10 200 July 20 300 units at 25 August 20 300 September 4 200 units at 28 November 18 150 December 2 100 units at 30 December 12 200

Instructions Calculate the index used for 2018 that yielded the above results.

E8-21 (L04) (Dollar-Value LIFO) The dollar-value LIFO method was adopted by Enya Corp. on January 1, 2017. Its inven- tory on that date was $160,000. On December 31, 2017, the inventory at prices existing on that date amounted to $140,000. The price level at January 1, 2017, was 100, and the price level at December 31, 2017, was 112.

Instructions (a) Compute the amount of the inventory at December 31, 2017, under the dollar-value LIFO method. (b) On December 31, 2018, the inventory at prices existing on that date was $172,500, and the price level was 115. Compute

the inventory on that date under the dollar-value LIFO method.

E8-22 (L04) (Dollar-Value LIFO) Presented below is information related to Dino Radja Company.

Price Ending Inventory Ending Inventory Date Index at Base Prices at Dollar-Value LIFO

December 31, 2017 105 $92,000 $92,600 December 31, 2018 ? 97,000 98,350

Instructions Compute the ending inventory for Dino Radja Company for 2014 through 2019 using the dollar-value LIFO method.

E8-23 (L04) (Dollar-Value LIFO) The following information relates to the Jimmy Johnson Company.

Ending Inventory Price Date (End-of-Year Prices) Index

December 31, 2014 $ 80,000 100 December 31, 2015 115,500 105 December 31, 2016 108,000 120 December 31, 2017 122,200 130 December 31, 2018 154,000 140 December 31, 2019 176,900 145

Exercises 429

Ending Inventory Price Date (End-of-Year Prices) Index

December 31, 2013 $ 70,000 100 December 31, 2014 90,300 105 December 31, 2015 95,120 116 December 31, 2016 105,600 120 December 31, 2017 100,000 125

430 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

Instructions Use the dollar-value LIFO method to compute the ending inventory for Johnson Company for 2013 through 2017.

E8-24 (L05) (Inventory Errors—Periodic) Ann M. Martin Company makes the following errors during the current year. (Evaluate each case independently and assume ending inventory in the following year is correctly stated.)

1. Ending inventory is overstated, but purchases and related accounts payable are recorded correctly. 2. Both ending inventory and purchases and related accounts payable are understated. (Assume this purchase was recorded

and paid for in the following year.) 3. Ending inventory is correct, but a purchase on account was not recorded. (Assume this purchase was recorded and paid

for in the following year.)

Instructions Indicate the effect of each of these errors on working capital, current ratio (assume that the current ratio is greater than 1), retained earnings, and net income for the current year and the subsequent year.

E8-25 (L05) (Inventory Errors) At December 31, 2016, Stacy McGill Corporation reported current assets of $370,000 and cur- rent liabilities of $200,000. The following items may have been recorded incorrectly.

1. Goods purchased costing $22,000 were shipped f.o.b. shipping point by a supplier on December 28. McGill received and recorded the invoice on December 29, 2016, but the goods were not included in McGill’s physical count of inventory because they were not received until January 4, 2017.

2. Goods purchased costing $15,000 were shipped f.o.b. destination by a supplier on December 26. McGill received and recorded the invoice on December 31, but the goods were not included in McGill’s 2016 physical count of inventory because they were not received until January 2, 2017.

3. Goods held on consignment from Claudia Kishi Company were included in McGill’s December 31, 2016, physical count of inventory at $13,000.

4. Freight-in of $3,000 was debited to advertising expense on December 28, 2016.

Instructions (a) Compute the current ratio based on McGill’s balance sheet. (b) Recompute the current ratio after corrections are made. (c) By what amount will income (before taxes) be adjusted up or down as a result of the corrections?

E8-26 (L05) (Inventory Errors) The net income per books of Linda Patrick Company was determined without knowledge of the errors indicated.

Net Income Error in Ending Year per Books Inventory

2012 $50,000 Overstated $ 3,000 2013 52,000 Overstated 9,000 2014 54,000 Understated 11,000 2015 56,000 No error 2016 58,000 Understated 2,000 2017 60,000 Overstated 8,000

Instructions Prepare a worksheet to show the adjusted net income figure for each of the 6 years after taking into account the inventory errors.

PROBLEMS

P8-1 (L02,3,4) GROUPWORK (Various Inventory Issues) The following independent situations relate to inventory accounting.

1. Kim Co. purchased goods with a list price of $175,000, subject to trade discounts of 20% and 10%, with no cash discounts allowable. How much should Kim Co. record as the cost of these goods?

2. Keillor Company’s inventory of $1,100,000 at December 31, 2017, was based on a physical count of goods priced at cost and before any year-end adjustments relating to the following items. (a) Goods shipped from a vendor f.o.b. shipping point on December 24, 2017, at an invoice cost of $69,000 to Keillor Com-

pany were received on January 4, 2018. (b) The physical count included $29,000 of goods billed to Sakic Corp. f.o.b. shipping point on December 31, 2017. The

carrier picked up these goods on January 3, 2018. What amount should Keillor report as inventory on its balance sheet?

Problems 431

Computing an internal price index and using the dollar-value LIFO method, at what amount should the inventory be re- ported at December 31, 2018?

5. Donovan Inc., a retail store chain, had the following information in its general ledger for the year 2018.

Merchandise purchased for resale $909,400 Interest on notes payable to vendors 8,700 Purchase returns 16,500 Freight-in 22,000 Freight-out (delivery expense) 17,100 Cash discounts on purchases 6,800

What is Donovan’s inventoriable cost for 2018?

Instructions Answer each of the preceding questions about inventories, and explain your answers.

P8-2 (L02) GROUPWORK (Inventory Adjustments) Dimitri Company, a manufacturer of small tools, provided the following information from its accounting records for the year ended December 31, 2017.

Inventory at December 31, 2017 (based on physical count of goods in Dimitri’s plant, at cost, on December 31, 2017) $1,520,000 Accounts payable at December 31, 2017 1,200,000 Net sales (sales less sales returns) 8,150,000

Additional information is as follows.

1. Included in the physical count were tools billed to a customer f.o.b. shipping point on December 31, 2017. These tools had a cost of $31,000 and were billed at $40,000. The shipment was on Dimitri’s loading dock waiting to be picked up by the common carrier.

2. Goods were in transit from a vendor to Dimitri on December 31, 2017. The invoice cost was $76,000, and the goods were shipped f.o.b. shipping point on December 29, 2017.

3. Work in process inventory costing $30,000 was sent to an outside processor for plating on December 30, 2017. 4. Tools returned by customers and held pending inspection in the returned goods area on December 31, 2017, were not in-

cluded in the physical count. On January 8, 2018, the tools costing $32,000 were inspected and returned to inventory. Credit memos totaling $47,000 were issued to the customers on the same date.

5. Tools shipped to a customer f.o.b. destination on December 26, 2017, were in transit at December 31, 2017, and had a cost of $26,000. Upon notification of receipt by the customer on January 2, 2018, Dimitri issued a sales invoice for $42,000.

6. Goods, with an invoice cost of $27,000, received from a vendor at 5:00 p.m. on December 31, 2017, were recorded on a re- ceiving report dated January 2, 2018. The goods were not included in the physical count, but the invoice was included in accounts payable at December 31, 2017.

7. Goods received from a vendor on December 26, 2017, were included in the physical count. However, the related $56,000 vendor invoice was not included in accounts payable at December 31, 2017, because the accounts payable copy of the re- ceiving report was lost.

At Base- At Current- Inventory Year Cost Year Cost

1/1/17 $200,000 $200,000 12/31/17 240,000 264,000 12/31/18 256,000 286,720

3. Zimmerman Corp. had 1,500 units of part M.O. on hand May 1, 2017, costing $21 each. Purchases of part M.O. during May were as follows.

Units Unit Cost

May 9 2,000 $22.00 17 3,500 23.00 26 1,000 24.00

A physical count on May 31, 2017, shows 2,000 units of part M.O. on hand. Using the FIFO method, what is the cost of part M.O. inventory at May 31, 2017? Using the LIFO method, what is the inventory cost? Using the average-cost method, what is the inventory cost?

4. Ashbrook Company adopted the dollar-value LIFO method on January 1, 2017 (using internal price indexes and multiple pools). The following data are available for inventory pool A for the 2 years following adoption of LIFO.

432 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

8. On January 3, 2018, a monthly freight bill in the amount of $8,000 was received. The bill specifically related to merchandise purchased in December 2017, one-half of which was still in the inventory at December 31, 2017. The freight charges were not included in either the inventory or in accounts payable at December 31, 2017.

Instructions Using the format shown below, prepare a schedule of adjustments as of December 31, 2017, to the initial amounts per Dimitri’s accounting records. Show separately the effect, if any, of each of the eight transactions on the December 31, 2017, amounts. If the transactions would have no effect on the initial amount shown, enter NONE.

Accounts Net Inventory Payable Sales

Initial amounts $1,520,000 $1,200,000 $8,150,000

Adjustments—increase (decrease) 1 2 3 4 5 6 7 8

Total adjustments

Adjusted amounts $ $ $

(AICPA adapted)

P8-3 (L02) EXCEL (Purchases Recorded Gross and Net) Some of the transactions of Torres Company during August are listed below. Torres uses the periodic inventory method.

August 10 Purchased merchandise on account, $12,000, terms 2/10, n/30. 13 Returned part of the purchase of August 10, $1,200, and received credit on account. 15 Purchased merchandise on account, $16,000, terms 1/10, n/60. 25 Purchased merchandise on account, $20,000, terms 2/10, n/30. 28 Paid invoice of August 15 in full.

Instructions (a) Assuming that purchases are recorded at gross amounts and that discounts are to be recorded when taken: (1) Prepare general journal entries to record the transactions. (2) Describe how the various items would be shown in the financial statements. (b) Assuming that purchases are recorded at net amounts and that discounts lost are treated as financial expenses: (1) Prepare general journal entries to enter the transactions. (2) Prepare the adjusting entry necessary on August 31 if financial statements are to be prepared at that time. (3) Describe how the various items would be shown in the financial statements. (c) Which of the two methods do you prefer and why?

P8-4 (L03) EXCEL (Compute FIFO, LIFO, and Average-Cost) Hull Company’s record of transactions concerning part X for the month of April was as follows.

Purchases Sales

April 1 (balance on hand) 100 @ $5.00 April 5 300 4 400 @ 5.10 12 200 11 300 @ 5.30 27 800 18 200 @ 5.35 28 150 26 600 @ 5.60 30 200 @ 5.80

Instructions (a) Compute the inventory at April 30 on each of the following bases. Assume that perpetual inventory records are kept in

units only. Carry unit costs to the nearest cent. (1) First-in, first-out (FIFO). (2) Last-in, first-out (LIFO). (3) Average-cost.

(b) If the perpetual inventory record is kept in dollars, and costs are computed at the time of each withdrawal, what amount would be shown as ending inventory in (1), (2), and (3) above? (Carry average unit costs to four decimal places.)

P8-5 (L03) (Compute FIFO, LIFO, and Average-Cost) Some of the information found on a detail inventory card for Slatkin Inc. for the first month of operations is as follows.

Received Issued, Balance, Date No. of Units Unit Cost No. of Units No. of Units

January 2 1,200 $3.00 1,200 7 700 500 10 600 3.20 1,100 13 500 600 18 1,000 3.30 300 1,300 20 1,100 200 23 1,300 3.40 1,500 26 800 700 28 1,600 3.50 2,300 31 1,300 1,000

Instructions (a) From these data compute the ending inventory on each of the following bases. Assume that perpetual inventory records

are kept in units only. (Carry unit costs to the nearest cent and ending inventory to the nearest dollar.) (1) First-in, first-out (FIFO). (2) Last-in, first-out (LIFO). (3) Average-cost. (b) If the perpetual inventory record is kept in dollars, and costs are computed at the time of each withdrawal, would the

amounts shown as ending inventory in (1), (2), and (3) above be the same? Explain and compute. (Round average unit costs to four decimal places.)

P8-6 (L03) GROUPWORK (Compute FIFO, LIFO, Average-Cost—Periodic and Perpetual) Ehlo Company is a multiprod- uct firm. Presented below is information concerning one of its products, the Hawkeye.

Instructions Compute cost of goods sold, assuming Ehlo uses:

(a) Periodic system, FIFO cost flow. (d) Perpetual system, LIFO cost flow. (b) Perpetual system, FIFO cost flow. (e) Periodic system, weighted-average cost flow. (c) Periodic system, LIFO cost flow. (f) Perpetual system, moving-average cost flow.

P8-7 (L03) GROUPWORK (Financial Statement Effects of FIFO and LIFO) The management of Tritt Company has asked its accounting department to describe the effect upon the company’s financial position and its income statements of accounting for invento- ries on the LIFO rather than the FIFO basis during 2017 and 2018. The accounting department is to assume that the change to LIFO would have been effective on January 1, 2017, and that the initial LIFO base would have been the inventory value on December 31, 2016. The following are the company’s financial statements and other data for the years 2017 and 2018 when the FIFO method was employed.

Date Transaction Quantity Price/Cost

1/1 Beginning inventory 1,000 $12 2/4 Purchase 2,000 18 2/20 Sale 2,500 30 4/2 Purchase 3,000 23 11/4 Sale 2,200 33

Problems 433

Financial Position as of

12/31/16 12/31/17 12/31/18

Cash $ 90,000 $130,000 $154,000 Accounts receivable 80,000 100,000 120,000 Inventory 120,000 140,000 176,000 Other assets 160,000 170,000 200,000

Total assets $450,000 $540,000 $650,000

Accounts payable $ 40,000 $ 60,000 $ 80,000 Other liabilities 70,000 80,000 110,000 Common stock 200,000 200,000 200,000 Retained earnings 140,000 200,000 260,000

Total liabilities and equity $450,000 $540,000 $650,000

434 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

Other data:

1. Inventory on hand at December 31, 2016, consisted of 40,000 units valued at $3.00 each. 2. Sales (all units sold at the same price in a given year):

2017—150,000 units @ $6.00 each 2018—180,000 units @ $7.50 each

3. Purchases (all units purchased at the same price in given year):

2017—150,000 units @ $3.50 each 2018—180,000 units @ $4.40 each

4. Income taxes at the effective rate of 40% are paid on December 31 each year.

Instructions Name the account(s) presented in the financial statements that would have different amounts for 2018 if LIFO rather than FIFO had been used, and state the new amount for each account that is named. Show computations. (CMA adapted)

P8-8 (L04) (Dollar-Value LIFO) Norman’s Televisions produces television sets in three categories: portable, midsize, and flat-screen. On January 1, 2017, Norman adopted dollar-value LIFO and decided to use a single inventory pool. The company’s January 1 inventory consists of:

Income for Years Ended

12/31/17 12/31/18

Sales revenue $900,000 $1,350,000

Less: Cost of goods sold 505,000 756,000 Other expenses 205,000 304,000

710,000 1,060,000

Income before income taxes 190,000 290,000 Income taxes (40%) 76,000 116,000

Net income $114,000 $ 174,000

Category Quantity Cost per Unit Total Cost

Portable 6,000 $100 $ 600,000 Midsize 8,000 250 2,000,000 Flat-screen 3,000 400 1,200,000

17,000 $3,800,000

During 2017, the company had the following purchases and sales.

Quantity Quantity Selling Price Category Purchased Cost per Unit Sold per Unit

Portable 15,000 $110 14,000 $150 Midsize 20,000 300 24,000 405 Flat-screen 10,000 500 6,000 600

45,000 44,000

Instructions (Round to four decimals.)

(a) Compute ending inventory, cost of goods sold, and gross profit. (b) Assume the company uses three inventory pools instead of one. Repeat instruction (a).

P8-9 (L04) GROUPWORK (Internal Indexes—Dollar-Value LIFO) On January 1, 2017, Bonanza Wholesalers Inc. adopted the dollar-value LIFO inventory method for income tax and external financial reporting purposes. However, Bonanza continued to use the FIFO inventory method for internal accounting and management purposes. In applying the LIFO method, Bonanza uses internal conversion price indexes and the multiple pools approach under which substantially identical inventory items are grouped into LIFO inventory pools. The following data were available for inventory pool no. 1, which comprises products A and B, for the 2 years following the adoption of LIFO.

Problems 435

Instructions (a) Prepare a schedule to compute the internal conversion price indexes for 2017 and 2018. Round indexes to two decimal places. (b) Prepare a schedule to compute the inventory amounts at December 31, 2017 and 2018, using the dollar-value LIFO

inventory method. (AICPA adapted)

P8-10 (L04) (Internal Indexes—Dollar-Value LIFO) Presented below is information related to Kaisson Corporation for the last 3 years.

FIFO Basis per Records

Unit Total Units Cost Cost

Inventory, 1/1/17 Product A 10,000 $30 $300,000 Product B 9,000 25 225,000

$525,000

Inventory, 12/31/17 Product A 17,000 36 $612,000 Product B 9,000 26 234,000

$846,000

Inventory, 12/31/18 Product A 13,000 40 $520,000 Product B 10,000 32 320,000

$840,000

Quantities Base-Year Cost Current-Year Cost in Ending Item Inventories Unit Cost Amount Unit Cost Amount

December 31, 2016

A 9,000 $2.00 $18,000 $2.20 $19,800 B 6,000 3.00 18,000 3.55 21,300 C 4,000 5.00 20,000 5.40 21,600

Totals $56,000 $62,700

December 31, 2017

A 9,000 $2.00 $18,000 $2.60 $23,400 B 6,800 3.00 20,400 3.75 25,500 C 6,000 5.00 30,000 6.40 38,400

Totals $68,400 $87,300

December 31, 2018

A 8,000 $2.00 $16,000 $2.70 $21,600 B 8,000 3.00 24,000 4.00 32,000 C 6,000 5.00 30,000 6.20 37,200

Totals $70,000 $90,800

Instructions Compute the ending inventories under the dollar-value LIFO method for 2016, 2017, and 2018. The base period is January 1, 2016, and the beginning inventory cost at that date was $45,000. Compute indexes to two decimal places.

P8-11 (L04) WRITING (Dollar-Value LIFO) Richardson Company cans a variety of vegetable-type soups. Recently, the company decided to value its inventories using dollar-value LIFO pools. The clerk who accounts for inventories does not understand how to value the inventory pools using this new method, so, as a private consultant, you have been asked to teach him how this new method works.

He has provided you with the following information about purchases made over a 6-year period. Ending Inventory Date (End-of-Year Prices) Price Index

Dec. 31, 2013 $ 80,000 100 Dec. 31, 2014 111,300 105 Dec. 31, 2015 108,000 120 Dec. 31, 2016 128,700 130 Dec. 31, 2017 147,000 140 Dec. 31, 2018 174,000 145

You have already explained to him how this inventory method is maintained, but he would feel better about it if you were to leave him detailed instructions explaining how these calculations are done and why he needs to put all inventories at a base-year value.

436 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

Instructions (a) Compute the ending inventory for Richardson Company for 2013 through 2018 using dollar-value LIFO. (b) Using your computation schedules as your illustration, write a step-by-step set of instructions explaining how the cal-

culations are done. Begin your explanation by briefly explaining the theory behind this inventory method, including the purpose of putting all amounts into base-year price levels.

CONCEPTS FOR ANALYSIS

CA8-1 (Inventoriable Goods and Costs) You are asked to travel to Milwaukee to observe and verify the inventory of the Milwaukee branch of one of your clients. You arrive on Thursday, December 30, and find that the inventory procedures have just been started. You spot a railway car on the sidetrack at the unloading door and ask the warehouse superintendent, Buck Rogers, how he plans to inventory the contents of the car. He responds, “We are not going to include the contents in the inventory.”

Later in the day, you ask the bookkeeper for the invoice on the carload and the related freight bill. The invoice lists the vari- ous items, prices, and extensions of the goods in the car. You note that the carload was shipped December 24 from Albuquerque, f.o.b. Albuquerque, and that the total invoice price of the goods in the car was $35,300. The freight bill called for a payment of $1,500. Terms were net 30 days. The bookkeeper affirms the fact that this invoice is to be held for recording in January.

Instructions (a) Does your client have a liability that should be recorded at December 31? Discuss. (b) Prepare a journal entry(ies), if required, to reflect any accounting adjustment required. Assume a perpetual inventory

system is used by your client. (c) For what possible reason(s) might your client wish to postpone recording the transaction?

CA8-2 (Inventoriable Goods and Costs) Clay Mattews, an inventory control specialist, is interested in better understanding the accounting for inventories. Although Clay understands the more sophisticated computer inventory control systems, he has little knowledge of how inventory cost is determined. In studying the records of Strider Enterprises, which sells normal brand-name goods from its own store and on consignment through Chavez Inc., he asks you to answer the following questions.

Instructions (a) Should Strider Enterprises include in its inventory normal brand-name goods purchased from its suppliers but not yet

received if the terms of purchase are f.o.b. shipping point (manufacturer’s plant)? Why? (b) Should Strider Enterprises include freight-in expenditures as an inventory cost? Why? (c) If Strider Enterprises purchases its goods on terms 2/10, net 30, should the purchases be recorded gross or net? Why? (d) What are products on consignment? How should they be reported in the financial statements? (AICPA adapted)

CA8-3 (Inventoriable Goods and Costs) George Solti, the controller for Garrison Lumber Company, has recently hired you as assistant controller. He wishes to determine your expertise in the area of inventory accounting and therefore asks you to answer the following unrelated questions.

(a) A company is involved in the wholesaling and retailing of automobile tires for foreign cars. Most of the inventory is imported, and it is valued on the company’s records at the actual inventory cost plus freight-in. At year-end, the warehousing costs are prorated over cost of goods sold and ending inventory. Are warehousing costs considered a product cost or a period cost?

(b) A certain portion of a company’s “inventory” is composed of obsolete items. Should obsolete items that are not cur- rently consumed in the production of “goods or services to be available for sale” be classified as part of inventory?

(c) A company purchases airplanes for sale to others. However, until they are sold, the company charters and services the planes. What is the proper way to report these airplanes in the company’s financial statements?

(d) A company wants to buy coal deposits but does not want the financing for the purchase to be reported on its financial statements. The company therefore establishes a trust to acquire the coal deposits. The company agrees to buy the coal over a certain period of time at specified prices. The trust is able to finance the coal purchase and pay off the loan as it is paid by the company for the minerals. How should this transaction be reported?

CA8-4 (Accounting Treatment of Purchase Discounts) Shawnee Corp., a household appliances dealer, purchases its inventories from various suppliers. Shawnee has consistently stated its inventories at FIFO cost.

Instructions Shawnee is considering alternate methods of accounting for the cash discounts it takes when paying its suppliers promptly. From a theoretical standpoint, discuss the acceptability of each of the following methods.

(a) Financial income when payments are made. (b) Reduction of cost of goods sold for the period when payments are made. (c) Direct reduction of purchase cost. (AICPA adapted)

CA8-5 (General Inventory Issues) In January 2017, Susquehanna Inc. requested and secured permission from the commissioner of the Internal Revenue Service to compute inventories under the last-in, first-out (LIFO) method and elected to determine

inventory cost under the dollar-value LIFO method. Susquehanna Inc. satisfied the commissioner that cost could be accurately determined by use of an index number computed from a representative sample selected from the company’s single inventory pool.

Instructions (a) Why should inventories be included in (1) a balance sheet and (2) the computation of net income? (b) The Internal Revenue Code allows some accountable events to be considered differently for income tax reporting pur-

poses and financial accounting purposes, while other accountable events must be reported the same for both purposes. Discuss why it might be desirable to report some accountable events differently for financial accounting purposes than for income tax reporting purposes.

(c) Discuss the ways and conditions under which the FIFO and LIFO inventory costing methods produce different inven- tory valuations. Do not discuss procedures for computing inventory cost.

(AICPA adapted)

CA8-6 (LIFO Inventory Advantages) Jane Yoakam, president of Estefan Co., recently read an article that claimed that at least 100 of the country’s largest 500 companies were either adopting or considering adopting the last-in, first-out (LIFO) method for valuing inventories. The article stated that the firms were switching to LIFO to (1) neutralize the effect of inflation in their financial state- ments, (2) eliminate inventory profits, and (3) reduce income taxes. Ms. Yoakam wonders if the switch would benefit her company.

Estefan currently uses the first-in, first-out (FIFO) method of inventory valuation in its periodic inventory system. The com- pany has a high inventory turnover rate, and inventories represent a significant proportion of the assets.

Ms. Yoakam has been told that the LIFO system is more costly to operate and will provide little benefit to companies with high turnover. She intends to use the inventory method that is best for the company in the long run rather than selecting a method just because it is the current fad.

Instructions (a) Explain to Ms. Yoakam what “inventory profits” are and how the LIFO method of inventory valuation could reduce them. (b) Explain to Ms. Yoakam the conditions that must exist for Estefan Co. to receive tax benefits from a switch to the LIFO method.

CA8-7 WRITING (Average-Cost, FIFO, and LIFO) Prepare a memorandum containing responses to the following items.

(a) Describe the cost flow assumptions used in average-cost, FIFO, and LIFO methods of inventory valuation. (b) Distinguish between weighted-average-cost and moving-average-cost for inventory costing purposes. (c) Identify the effects on both the balance sheet and the income statement of using the LIFO method instead of the FIFO

method for inventory costing purposes over a substantial time period when purchase prices of inventoriable items are rising. State why these effects take place.

CA8-8 WRITING (LIFO Application and Advantages) Geddes Corporation is a medium-sized manufacturing company with two divisions and three subsidiaries, all located in the United States. The Metallic Division manufactures metal castings for the automotive industry, and the Plastic Division produces small plastic items for electrical products and other uses. The three subsid- iaries manufacture various products for other industrial users.

Geddes Corporation plans to change from the lower of first-in, first-out (FIFO)-cost-or market method of inventory valua- tion to the last-in, first-out (LIFO) method of inventory valuation to obtain tax benefits. To make the method acceptable for tax purposes, the change also will be made for its annual financial statements.

Instructions (a) Describe the establishment of and subsequent pricing procedures for each of the following LIFO inventory methods. (1) LIFO applied to units of product when the periodic inventory system is used.

(2) Application of the dollar-value method to LIFO units of product. (b) Discuss the specific advantages and disadvantages of using the dollar-value LIFO application as compared to specific

goods LIFO (unit LIFO). (Ignore income tax considerations.) (c) Discuss the general advantages and disadvantages claimed for LIFO methods.

CA8-9 WRITING (Dollar-Value LIFO Issues) Arruza Co. is considering switching from the specific-goods LIFO approach to the dollar-value LIFO approach. Because the financial personnel at Arruza know very little about dollar-value LIFO, they ask you to answer the following questions.

(a) What is a LIFO pool? (b) Is it possible to use a LIFO pool concept and not use dollar-value LIFO? Explain. (c) What is a LIFO liquidation? (d) How are price indexes used in the dollar-value LIFO method? (e) What are the advantages of dollar-value LIFO over specific-goods LIFO?

CA8-10 WRITING (FIFO and LIFO) Harrisburg Company is considering changing its inventory valuation method from FIFO to LIFO because of the potential tax savings. However, management wishes to consider all of the effects on the company, including its reported performance, before making the final decision.

The inventory account, currently valued on the FIFO basis, consists of 1,000,000 units at $8 per unit on January 1, 2017. There are 1,000,000 shares of common stock outstanding as of January 1, 2017, and the cash balance is $400,000.

Concepts for Analysis 437

438 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

The company has made the following forecasts for the period 2017–2019.

Instructions (a) Prepare a schedule that illustrates and compares the following data for Harrisburg Company under the FIFO and the

LIFO inventory method for 2017–2019. Assume the company would begin LIFO at the beginning of 2017. (1) Year-end inventory balances. (3) Earnings per share. (2) Annual net income after taxes. (4) Cash balance.

Assume all sales are collected in the year of sale and all purchases, operating expenses, and taxes are paid during the year incurred.

(b) Using the data above, your answer to (a), and any additional issues you believe need to be considered, prepare a report that recommends whether or not Harrisburg Company should change to the LIFO inventory method. Support your conclusions with appropriate arguments.

(CMA adapted)

CA8-11 ETHICS (LIFO Choices) Wilkens Company uses the LIFO method for inventory costing. In an effort to lower net income, company president Mike Wilkens tells the plant accountant to take the unusual step of recommending to the purchasing department a large purchase of inventory at year-end. The price of the item to be purchased has nearly doubled during the year, and the item represents a major portion of inventory value.

Instructions Answer the following questions.

(a) Identify the major stakeholders. If the plant accountant recommends the purchase, what are the consequences? (b) If Wilkens Company were using the FIFO method of inventory costing, would Mike Wilkens give the same order? Why

or why not?

USING YOUR JUDGMENT

Financial Statement Analysis Cases Case 1: T J International T J International was founded in 1969 as Trus Joist International. The firm, a manufacturer of specialty building products, has its headquarters in Boise, Idaho. The company, through its partnership in the Trus Joist MacMillan joint venture, develops and manufactures engineered lumber. This product is a high-quality substitute for structural lumber and uses lower-grade wood and materials formerly considered waste. The company also is majority owner of the Outlook Window Partnership, which is a consortium of three wood and vinyl window manufacturers.

Following is T J International’s adapted income statement and information concerning inventories from its annual report.

2017 2018 2019

Unit sales (in millions of units) 1.1 1.0 1.3 Sales price per unit $10 $12 $12 Unit purchases (in millions of units) 1.0 1.1 1.2 Purchase price per unit $8 $9 $10 Annual depreciation (in thousands of dollars) $300 $300 $300 Cash dividends per share $0.15 $0.15 $0.15 Cash payments for additions to and replacement of plant and equipment (in thousands of dollars) $350 $350 $350 Income tax rate 40% 40% 40% Operating expenses (exclusive of depreciation) as a percent of sales 15% 15% 15% Common shares outstanding (in millions) 1 1 1

T J International Sales $618,876,000 Cost of goods sold 475,476,000

Gross profit 143,400,000 Selling and administrative expenses 102,112,000

Income from operations 41,288,000 Other expense 24,712,000

Income before income tax 16,576,000 Income taxes 7,728,000

Net income $ 8,848,000

Using Your Judgment 439

Instructions

(a) How much would income before taxes have been if FIFO costing had been used to value all inventories? (b) If the income tax rate is 46.6%, what would income tax have been if FIFO costing had been used to value all inventories?

In your opinion, is this difference in net income between the two methods material? Explain. (c) Does the use of a different costing system for different types of inventory mean that there is a different physical flow of

goods among the different types of inventory? Explain.

Case 2: Noven Pharmaceuticals, Inc. Noven Pharmaceuticals, Inc., headquartered in Miami, Florida, describes itself in a recent annual report as follows.

Noven also reported in its annual report that its activities to date have consisted of product development efforts, some of which have been independent and some of which have been completed in conjunction with Rhone-Poulenc Rorer (RPR) and Ciba-Geigy. The revenues so far have consisted of money received from licensing fees, “milestone” payments (payments made under licensing agreements when certain stages of the development of a certain product have been completed), and interest on its investments. The company expects that it will have significant revenue in the upcoming fiscal year from the launch of its first product, a transdermal estrogen delivery system. The current assets portion of Noven’s balance sheet follows.

Inventories. Inventories are valued at the lower of cost or market and include material, labor, and produc- tion overhead costs. Inventories consisted of the following:

Current Year Prior Year

Finished goods $27,512,000 $23,830,000 Raw materials and work-in-progress 34,363,000 33,244,000

61,875,000 57,074,000 Reduction to LIFO cost (5,263,000) (3,993,000)

$56,612,000 $53,081,000

The last-in, first-out (LIFO) method is used for determining the cost of lumber, veneer, Microllam lumber, TJI joists, and open web joists. Approximately 35 percent of total inventories at the end of the current year were valued using the LIFO method. The first-in, first-out (FIFO) method is used to determine the cost of all other inventories.

Cash and cash equivalents $12,070,272 Securities held to maturity 23,445,070 Inventory of supplies 1,264,553 Prepaid and other current assets 825,159

Total current assets $37,605,054

Inventory of supplies is recorded at the lower-of-cost (first-in, first-out)-or-net realizable value and consists mainly of supplies for research and development.

Instructions

(a) What would you expect the physical flow of goods for a pharmaceutical manufacturer to be most like: FIFO, LIFO, or random (flow of goods does not follow a set pattern)? Explain.

(b) What are some of the factors that Noven should consider as it selects an inventory measurement method? (c) Suppose that Noven had $49,000 in an inventory of transdermal estrogen delivery patches. These patches are from an

initial production run and will be sold during the coming year. Why do you think that this amount is not shown in a separate inventory account? In which of the accounts shown is the inventory likely to be? At what point will the inven- tory be transferred to a separate inventory account?

Noven Pharmaceuticals, Inc. Noven is a place of ideas—a company where scientific excellence and state-of-the-art manufacturing com- bine to create new answers to human needs. Our transdermal delivery systems speed drugs painlessly and effortlessly into the bloodstream by means of a simple skin patch. This technology has proven applications in estrogen replacement, but at Noven we are developing a variety of systems incorporating bestselling drugs that fight everything from asthma, anxiety and dental pain to cancer, heart disease and neurological illness. Our research portfolio also includes new technologies, such as iontophoresis, in which drugs are delivered through the skin by means of electrical currents, as well as products that could satisfy broad consumer needs, such as our anti-microbial mouthrinse.

440 Chapter 8 Valuation of Inventories: A Cost-Basis Approach

Instructions

(a) Compute Kroger’s inventory turnovers for fiscal years ending January 31, 2015, and February 1, 2014, using: (1) Cost of sales and LIFO inventory. (2) Cost of sales and FIFO inventory. (b) Some firms calculate inventory turnover using sales rather than cost of goods sold in the numerator. Calculate Kroger’s

fiscal years ending January 31, 2015, and February 1, 2014, turnover, using: (1) Sales and LIFO inventory. (2) Sales and FIFO inventory. (c) State which method you would choose to evaluate Kroger’s performance. Justify your choice.

Accounting, Analysis, and Principles Englehart Company sells two types of pumps. One is large and is for commercial use. The other is smaller and is used in resi- dential swimming pools. The following inventory data is available for the month of March.

January 31, February 1, February 2, 2015 2014 2013

Net sales $108,465 $98,375 $96,619 Cost of sales (using LIFO) 85,512 78,138 76,726 Year-end inventories using FIFO 6,933 6,801 6,244 Year-end inventories using LIFO 5,688 5,651 5,146

Price per Units Unit Total

Residential Pumps Inventory at Feb. 28: 200 $ 400 $ 80,000 Purchases: March 10 500 $ 450 $225,000 March 20 400 $ 475 $190,000 March 30 300 $ 500 $150,000 Sales: March 15 500 $ 540 $270,000 March 25 400 $ 570 $228,000 Inventory at March 31: 500

Commercial Pumps Inventory at Feb. 28: 600 $ 800 $480,000 Purchases: March 3 600 $ 900 $540,000 March 12 300 $ 950 $285,000 March 21 500 $1,000 $500,000 Sales: March 18 900 $1,080 $972,000 March 29 600 $1,140 $684,000 Inventory at March 31: 500

Accounting

(a) Assuming Englehart uses a periodic inventory system, determine the cost of inventory on hand at March 31 and the cost of goods sold for March under first-in, first-out (FIFO).

(b) Assume Englehart uses dollar-value LIFO and one pool, consisting of the combination of residential and commercial pumps. Determine the cost of inventory on hand at March 31 and the cost of goods sold for March. Assume Englehart’s initial adoption of LIFO is on March 1. Use the double-extension method to determine the appropriate price indices. (Hint: The price index for February 28/March 1 should be 1.00.) (Round the index to three decimal places.)

Analysis (a) Assume you need to compute a current ratio for Englehart. Which inventory method (FIFO or dollar-value LIFO) do

you think would give you a more meaningful current ratio? (b) Some of Englehart’s competitors use LIFO inventory costing and some use FIFO. How can an analyst compare the

results of companies in an industry, when some use LIFO and others use FIFO?

Case 3: The Kroger Company The Kroger Company reported the following data in its annual report (in millions).

Bridge to the Profession 441

BRIDGE TO THE PROFESSION

FASB Codifi cation References [1] FASB ASC 470-40-05. [Predecessor literature: “Accounting for Product Financing Arrangements,” Statement of Financial

Accounting Standards No. 49 (Stamford, Conn.: FASB, 1981).] [2] FASB ASC 606-10-32-11 to 13 and 606-10-55-66 to 78. [Predecessor literature: “Revenue Recognition When Right of Return

Exists,” Statement of Financial Accounting Standards No. 48 (Stamford, Conn.: FASB, 1981).] [3] FASB ASC 330-10-30-7. [Predecessor literature: “Inventory Costs: An Amendment of ARB No. 43, Chapter 4,” Statement of

Financial Accounting Standards No. 151 (Norwalk, Conn.: FASB 2004).] [4] FASB ASC 835-20-05. [Predecessor literature: “Capitalization of Interest Cost,” Statement of Financial Accounting Standards

No. 34 (Stamford, Conn.: FASB, 1979).] [5] FASB ASC 605-45-50-2 and 605-45-S99. [Predecessor literature: “Accounting for Shipping and Handling Fees and Costs,” EITF

No. 00–10 (2000).] [6] FASB ASC 330-10-30. [Predecessor literature: “Restatement and Revision of Accounting Research Bulletins,” Accounting

Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4, Statement 4.] [7] FASB ASC 330-10-S99-1. [Predecessor literature: “AICPA Task Force on LIFO Inventory Problems, Issues Paper (New York:

AICPA, November 30, 1984), pp. 2–24.] [8] FASB ASC 330-10-S99-3. [Predecessor literature: “AICPA Task Force on LIFO Inventory Problems, Issues Paper (New York:

AICPA, November 30, 1984), pp. 36–37.]

Codifi cation Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE8-1 Access the glossary (“Master Glossary”) to answer the following.

(a) What is the definition provided for inventory? (b) What is a customer? (c) Under what conditions is a distributor considered a customer? (d) What is a product financing arrangement?

CE8-2 Due to rising fuel costs, your client, Overstock.com, is considering adding a charge for shipping and handling costs on products sold through its website. What is the authoritative guidance for reporting these costs? CE8-3 What guidance does the Codification provide concerning reporting inventories above cost? CE8-4 What is the nature of the SEC guidance concerning the reporting of LIFO liquidations?

Codifi cation Research Case In conducting year-end inventory counts, your audit team is debating the impact of the client’s right of return policy both on inventory valuation and revenue recognition. The assistant controller argues that there is no need to worry about the return policies since they have not changed in a while. The audit senior wants a more authoritative answer and has asked you to con- duct some research of the authoritative literature before she presses the point with the client.

(a) What is the authoritative guidance for revenue recognition when right of return exists? (b) When is this guidance important for a company? (c) Sales with high rates of return can ultimately cause inventory to be misstated. Why are returns allowed? Should differ-

ent industries be able to make different types of return policies? (d) In what situations would a reasonable estimate of returns be difficult to make?

ADDITIONAL PROFESSIONAL RESOURCES Go to WileyPLUS for other career-readiness resources, such as career coaching, internship opportunities, and CPAexcel prep.

Principles Can companies change from one inventory accounting method to another? If a company changes to an inventory accounting method used by most of its competitors, what are the trade-offs in terms of the conceptual framework discussed in Chapter 2 of the textbook?

NOT WHAT IT SEEMS TO BE Investors need comparable information about inventory when evaluating a retailer’s financial statements. To do so, investors need to determine what inventory method a retailer is using (FIFO, LIFO, average-cost, or a combination of methods) and then adjust the company’s results to a common method. That is a good start. What investors often then do is compute relevant information about the company such as inventory turnover, number of days sales in inventory, gross profit rate, and liquidity measures such as the acid-test ratio (using adjusted numbers).

These calculations are critical. Inventory is a significant component of working capital, and the gross profit resulting from sales of inventory is often viewed as the most important income component in measuring a retailer’s success. For example, consider the financial statements of Best Buy shown in the following table. Inventory com- prises over 44 percent of current assets, and gross profit represents over 22 percent of sales revenue.

9 1 Understand and apply the lower-of-

cost-or-net realizable value rule.

2 Understand and apply the lower-of- cost-or-market rule.

3 Understand other inventory valuation issues.

4 Determine ending inventory by applying the gross profit method.

5 Determine ending inventory by applying the retail inventory method.

6 Explain how to report and analyze inventory.

Inventories: Additional Valuation Issues LEARNING OBJECTIVES After studying this chapter, you should be able to:

Analysis is based on these numbers. However, there often are questions about the reliability of the information reported in the financial statements. That is, subjective estimates are involved because of possible decline in the value of the inventory. For example, Best Buy provides disclosures related to inventory in its annual report, shown on the next page.

As indicated in the following Best Buy disclosures, subjective estimates concerning the measurement of inventory (related to markdowns and inventory losses) could have a significant impact on an investor’s ability to compare inventory levels (and their impact on gross profit) at the company relative to other retailers. Thus, inventory balances may not be what they seem, not only due to the cost flow assumptions (e.g., LIFO/

BEST BUY ($ in millions)

Consolidated Balance Sheets

Current Assets Cash and cash equivalents $ 2,432 Short-term investments 1,456 Receivables 1,280 Merchandise inventory 5,174 Other current assets 1,387

Total current assets $11,729

Consolidated Statements of Earnings

Revenue $40,339 Cost of goods sold 31,292 Gross profit $ 9,047

Net income (loss) $ 1,233

443

FIFO) you learned about in Chapter 8 but also due to significant markdowns and losses that you will learn about in this chapter.

PREVIEW OF CHAPTER 9 As our opening story indicates, information on inventories is important to investors. In this chapter, we discuss some of the valuation and estimation concepts that companies use to develop relevant inventory information. The content and organization of the chapter are as follows.

This chapter also includes numerous conceptual and international discussions that are integral to the topics presented here.

INVENTORIES: ADDITIONAL VALUATION ISSUES

LOWER-OF- COST-OR-NET REALIZABLE VALUE

• Definition • Illustration • Methods of

applying • Recording • Use of

allowance • Multiple

periods

OTHER VALUATION APPROACHES

• Net realizable value

• Relative sales value

• Purchase commitments

LOWER-OF- COST-OR- MARKET

• How LCM works

• Methods • Evaluation of

LCNRV and LCM rules

GROSS PROFIT METHOD

• Gross profit percentage

• Evaluation of method

PRESENTATION AND ANALYSIS

• Presentation • Analysis

RETAIL INVENTORY METHOD

• Concepts • Conventional

method • Special items • Evaluation of

method

Critical Accounting Estimates in Preparation of the Financial Statements: Inventory

We value our inventory at the lower of cost or market through the establishment of markdown and inventory loss adjustments.

Our inventory valuation reflects markdowns for the excess of the cost over the amount we expect to realize from the ultimate sale or other disposal of the inventory. Markdowns establish a new cost basis for our inventory. Subsequent changes in facts or circumstances do not result in the reversal of previously recorded markdowns or an increase in that newly established cost basis.

Our inventory valuation also reflects adjustments for anticipated physical inventory losses (e.g., theft) that have occurred since the last physical inventory. Physical inventory counts are taken on a regular basis to ensure that the inventory reported in our consoli- dated financial statements is properly stated.

Judgments and Uncertainties

Our markdown adjustment contains uncertainties because the cal- culation requires management to make assumptions and to apply judgment regarding inventory aging, forecast consumer demand, the promotional environment and technological obsolescence.

Our inventory loss adjustment contains uncertainties because the calculation requires management to make assumptions and to apply judgment regarding a number of factors, including historical results and current inventory loss trends.

} }

444 Chapter 9 Inventories: Additional Valuation Issues

LOWER-OF-COST-OR-NET REALIZABLE VALUE Inventories are recorded at their cost. However, if inventory declines in value below its original cost, a major departure from the historical cost principle occurs. Whatever the reason for a decline—damage, physical deterioration, obsolescence, changes in price levels, or other causes—a company should write down the inventory to net realizable value to report this loss. A company abandons the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost.

Defi nition of Net Realizable Value Recall that cost is the acquisition price of inventory computed using one of the historical cost-based methods—specific identification, average-cost, FIFO, or LIFO. The term net realizable value (NRV) refers to the net amount that a company expects to realize from the sale of inventory. Specifically, net realizable value is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. [1]

To illustrate, assume that Mander Corp. has unfinished inventory with a cost of $950, a sales value of $1,000, estimated cost of completion of $50, and estimated selling costs of $200. Mander’s net realizable value is computed as follows.

LEARNING OBJECTIVE 1 Understand and apply the lower-of-cost-or-net realizable value rule.

See the FASB Codifi cation References (page 493).

Mander reports inventory on its balance sheet at $750. In its income statement, Mander reports a Loss Due to Decline of Inventory to NRV of $200 ($950 − $750). A departure from cost is justified because inventories should not be reported at amounts higher than their expected realization from sale or use. In addition, a company like Mander should charge the loss of utility against revenues in the period in which the loss occurs, not in the period of sale.

Companies therefore report their inventories at the lower-of-cost-or-net realizable value (LCNRV) at each reporting date. [2] Illustration 9-2 shows how Kesa Electricals indicate measurement at LCNRV.

Illustration of LCNRV As indicated, a company values inventory at LCNRV. A company estimates net realiz- able value based on the most predictable evidence of the inventories’ realizable amounts (expected selling price, expected costs of completion, disposal, and transportation). To illustrate, Regner Foods computes its inventory at LCNRV, as shown in Illustration 9-3 (amounts in thousands).

ILLUSTRATION 9-2 LCNRV Disclosures Kesa Electricals

Inventories are stated at the lower-of-cost-or-net realisable value. Cost is determined using the weighted average method. Net realisable value represents the estimated selling price in the ordinary course of business, less applicable variable selling expenses.

ILLUSTRATION 9-1 Computation of Net Realizable Value

Inventory value—unfinished $1,000 Less: Estimated cost of completion $ 50 Estimated cost to sell 200 250

Net realizable value $ 750

Lower-of-Cost-or-Net Realizable Value 445

As indicated, the final inventory value of $384,000 equals the sum of the LCNRV for each of the inventory items. That is, Regner applies the LCNRV rule to each individual type of food.

Methods of Applying LCNRV In the Regner Foods illustration, we assumed that the company applied the lower-of- cost-or-net realizable value to each individual type of food. However, companies may apply the LCNRV rule either directly to each item, to each category, or to the total of the inventory. If a company follows a major categories or total inventory approach in apply- ing the LCNRV rule, increases in selling prices tend to offset decreases in selling prices. To illustrate, assume that Regner Foods separates its food products into two major categories, frozen and canned, as shown in Illustration 9-4.

If Regner Foods applied the LCNRV rule to individual items, the amount of inven- tory is $384,000. If applying the rule to major categories, it jumps to $394,000. If applying LCNRV to the total inventory, it totals $415,000. Why this difference? When a company uses a major categories or total inventory approach, selling prices higher than cost offset selling prices lower than cost. For Regner Foods, using the major categories approach partially offsets the high selling price for spinach. Using the total inventory approach totally offsets the high selling price for spinach.

Net Final Realizable Inventory Food Cost Value Value

Spinach $ 80,000 $120,000 $ 80,000 Carrots 100,000 100,000 100,000 Cut beans 50,000 40,000 40,000 Peas 90,000 72,000 72,000 Mixed vegetables 95,000 92,000 92,000

$384,000

Final Inventory Value:

Spinach Cost ($80,000) is selected because it is lower than net realizable value. Carrots Cost ($100,000) is the same as net realizable value. Cut beans Net realizable value ($40,000) is selected because it is lower than cost. Peas Net realizable value ($72,000) is selected because it is lower than cost. Mixed vegetables Net realizable value ($92,000) is selected because it is lower than cost.

ILLUSTRATION 9-3 Determining Final Inventory Value

Lower-of-Cost-or-Net Realizable Value by:

Individual Major Total Cost NRV Items Categories Inventory

Frozen Spinach $ 80,000 $120,000 $ 80,000 Carrots 100,000 100,000 100,000 Cut beans 50,000 40,000 40,000

Total frozen 230,000 260,000 $230,000

Canned Peas 90,000 72,000 72,000 Mixed vegetables 95,000 92,000 92,000

Total canned 185,000 164,000 164,000

Total $415,000 $424,000 $384,000 $394,000 $415,000

ILLUSTRATION 9-4 Alternative Applications of LCNRV

UNDERLYING CONCEPTS

The inconsistency in the presentation of inven- tory is an example of the trade-off between relevance and faithful representation. Net realizable value is more relevant than cost, and cost is more rep- resentationally faithful than NRV.

446 Chapter 9 Inventories: Additional Valuation Issues

Companies usually value inventory on an item-by-item basis. In fact, tax rules require that companies use an individual-item basis barring practical difficulties. In addition, the individual-item approach gives the most conservative valuation for bal- ance sheet purposes. Often, a company values inventory on a total-inventory basis when it offers only one end product (comprised of many different raw materials). If it produces several end products, a company might use a category approach instead. The method selected should be the one that most clearly reflects income. Whichever method a com- pany selects, it should apply the method consistently from one period to another.

Recording NRV Instead of Cost One of two methods may be used to record the income effect of valuing inventory at NRV. One method, referred to as the cost-of-goods-sold method, debits cost of goods sold for the write-down of the inventory to NRV. As a result, the company does not report a loss in the income statement because the cost of goods sold already includes the amount of the loss. The second method, referred to as the loss method, debits a loss account for the write-down of the inventory to NRV. We use the following inventory data for Ricardo Company to illustrate entries under both methods.

Cost of goods sold (before adjustment to NRV) $108,000 Ending inventory (cost) 82,000 Ending inventory (at NRV) 70,000

Illustration 9-5 shows the entries for both the cost-of-goods-sold and loss methods, assuming the use of a perpetual inventory system.

Illustration 9-6 contrasts the differing amounts reported in the income statement under the two approaches, using data from the Ricardo example.

ILLUSTRATION 9-6 Income Statement Presentation—Cost-of- Goods-Sold and Loss Methods of Reducing Inventory to NRV

Cost-of-Goods-Sold Method Sales revenue $200,000 Cost of goods sold (after adjustment to NRV*) 120,000

Gross profit on sales $ 80,000

*Cost of goods sold (before adjustment to NRV) $108,000 Difference between inventory at cost and NRV

($82,000 − $70,000) 12,000

Cost of goods sold (after adjustment to NRV) $120,000

Loss Method

Sales revenue $200,000 Cost of goods sold 108,000

Gross profit on sales 92,000 Loss due to decline of inventory to NRV 12,000

$ 80,000

Cost-of-Goods-Sold Method Loss Method

To reduce inventory from cost to NRV

Cost of Goods Sold 12,000 Loss Due to Decline of Inventory to NRV 12,000 Inventory 12,000 Inventory 12,000

ILLUSTRATION 9-5 Accounting for the Reduction of Inventory to NRV—Perpetual Inventory System

Lower-of-Cost-or-Net Realizable Value 447

GAAP does not specify a particular account to debit for the write-down. We believe the loss method presentation is preferable because it clearly discloses the loss resulting from a decline in inventory to NRV.

Use of an Allowance Instead of crediting the Inventory account for market adjustments, companies generally use an allowance account, often referred to as Allowance to Reduce Inventory to NRV. For example, using an allowance account under the loss method, Ricardo Company makes the following entry to record the inventory write-down to NRV.

Loss Due to Decline of Inventory to NRV 12,000 Allowance to Reduce Inventory to NRV 12,000

Use of the allowance account results in reporting both the cost and the NRV of the inventory. Ricardo reports inventory in the balance sheet as follows.

ILLUSTRATION 9-7 Presentation of Inventory Using an Allowance Account

Inventory (at cost) $ 82,000 Allowance to reduce inventory to NRV (12,000)

Inventory (at NRV) $ 70,000

The use of the allowance under the cost-of-goods-sold or loss method permits the bal- ance sheet to reflect inventory measured at $82,000, although the balance sheet shows a net amount of $70,000. It also keeps subsidiary inventory ledgers and records in cor- respondence with the control account without changing prices. For homework purposes, use an allowance account to record net realizable value adjustments, unless instructed otherwise.

With respect to accounting for the allowance in the subsequent period, if the company still has on hand the merchandise in question, it should retain the allowance account. If it does not keep that account, the company will overstate beginning inven- tory and cost of goods. However, if the company has sold the goods, then it should close the account. It then establishes a “new allowance account” for any decline in inventory value that takes place in the current year.

Use of an Allowance—Multiple Periods In general, accountants leave the allowance account on the books. They merely adjust the balance at the next year-end to agree with the discrepancy between cost and the LCNRV at that balance sheet date. Thus, if prices are falling, the company records an additional write-down. If prices are rising, the company records an increase in income, as shown in Illustration 9-8.

ILLUSTRATION 9-8 Effect on Net Income of Reducing Inventory to NRV

Amount Adjustment Required in of Valuation Effect Inventory Inventory Valuation Account on Net Date at Cost at NRV Account Balance Income

Dec. 31, 2016 $188,000 $176,000 $12,000 $12,000 inc. Decrease Dec. 31, 2017 194,000 187,000 7,000 5,000 dec. Increase Dec. 31, 2018 173,000 174,000 0 7,000 dec. Increase Dec. 31, 2019 182,000 180,000 2,000 2,000 inc. Decrease

UNDERLYING CONCEPTS

The income statement under the cost-of- goods-sold method presentation lacks rep- resentational faithfulness. The cost-of-goods-sold method does not indicate what it purports to represent. However, allowing this presenta- tion illustrates the concept of materiality.

We can think of the net increase in income as the excess of the credit effect of clos- ing the beginning allowance balance over the debit effect of setting up the current year-end allowance account. Recognizing the increases and decreases has the same effect on net income as closing the allowance balance to beginning inventory or to cost of goods sold.

448 Chapter 9 Inventories: Additional Valuation Issues

LOWER-OF-COST-OR-MARKET The use of the lower-of-cost-or-net realizable value method works well to measure the decline in value of a company’s inventory for most companies. The recent introduction of the LCNRV approach was designed to simplify and reduce the cost and complexity of inventory measurement under GAAP. However, the Board learned that for compa- nies using LIFO or the retail inventory methods, the change to LCNRV would result in potentially significant costs, particularly upon transition, and would not simplify their subsequent measurement of inventory.1

As a consequence, the FASB decided to grant an exception to the LCNRV approach for companies that use the LIFO or retail inventory methods. Rather than comparing cost to net realizable value, under the alternative approach, companies compare a “designated market value” of the inventory to cost. The approach is commonly referred to as lower-of- cost-or-market (LCM). This approach begins with replacement cost, then applies two addi- tional limitations to value ending inventory—net realizable value and net realizable value less a normal profit margin. As discussed earlier, net realizable value (NRV) is the estimated selling price in the ordinary course of business, less reasonably predictable costs of comple- tion and disposal (often referred to as net selling price). A normal profit margin is sub- tracted from that amount to arrive at net realizable value less a normal profit margin.

To illustrate, assume that Parker Corp. has unfinished inventory with a sales value of $1,000, estimated cost of completion and disposal of $300, and a normal profit margin of 10 percent of sales. Parker determines the following net realizable value.

LEARNING OBJECTIVE 2 Understand and apply the lower-of-cost-or-market rule.

1Specifically, as was discussed in Chapter 8, in times of rising prices, LIFO costing generally results in inventory stated at lower historical cost amounts. However, applying LCNRV to already lower-stated LIFO inventory amounts (in a period when prices decline) results in an increase in income. This leads to distortions in income, significant costs to track changes in the LIFO reserve, and is inconsistent with the goal of LCNRV. In addition, as we discuss later in the chapter, the use of the retail inventory method based on cost-to-retail price ratios provides a reliable estimate of inventory cost. Moreover, implementation of the conventional retail inventory method results in a reasonable approximation for LCNRV in many situations, without the additional cost to estimate net realizable value. The Board did not want LIFO and retail inventory method companies to incur these costs, given the change to LCNRV might not simplify the accounting nor improve the information reported to users for these companies. See FASB Accounting Standards Update 2015-11, Inventory (Topic 330): “Simplifying the Measurement of Inventory” (July 2015), paras. BC5–BC9.

ILLUSTRATION 9-9 Computation of Net Realizable Value

Inventory—sales value $1,000 Less: Estimated cost of completion and disposal 300

Net realizable value 700 Less: Allowance for normal profit margin (10% of sales) 100

Net realizable value less a normal profit margin $ 600

The general lower-of-cost-or-market rule is: A company values inventory at the lower-of-cost-or-market, with market limited to an amount that is not more than net realizable value or less than net realizable value less a normal profit margin. [3]

The upper limit (ceiling) is the net realizable value of inventory. The lower limit (floor) is the net realizable value less a normal profit margin. What is the rationale for these two limitations? Establishing these limits for the value of the inventory prevents companies from over- or understating inventory.

The maximum limitation, not to exceed the net realizable value (ceiling), prevents overstatement of the value of obsolete, damaged, or shopworn inventories. That is, if the replacement cost of an item exceeds its net realizable value, a company should not report inventory at replacement cost. The company can receive only the selling price less cost of disposal. To report the inventory at replacement cost would result in an over- statement of inventory and understatement of the loss in the current period.

To illustrate, assume that Staples paid $1,000 for a color laser printer that it can now replace for $900. The printer’s net realizable value is $700. At what amount should Staples report the laser printer in its financial statements? To report the replacement cost

Lower-of-Cost-or-Market 449

of $900 overstates the ending inventory and understates the loss for the period. There- fore, Staples should report the printer at $700.

The minimum limitation (floor) is not to be less than net realizable value reduced by an allowance for an approximately normal profit margin. The floor establishes a value below which a company should not price inventory, regardless of replacement cost. It makes no sense to price inventory below net realizable value less a normal mar- gin. This minimum amount (floor) measures what the company can receive for the inventory and still earn a normal profit. Use of a floor deters understatement of inven- tory and overstatement of the loss in the current period.

Illustration 9-10 graphically presents the guidelines for valuing inventory at the lower-of-cost-or-market.

ILLUSTRATION 9-10 Inventory Valuation— Lower-of-Cost-or-Market

Cost Market

GAAP

NRV

Not More Than

Replacement Cost

NRV Less Normal Profit

Margin

Not Less Than

Ceiling

Floor

Lower-of-Cost- or-Market

How Lower-of-Cost-or-Market Works The designated market value is the amount that a company compares to cost. It is always the middle value of three amounts: replacement cost, net realizable value, and net realizable value less a normal profit margin. To illustrate how to compute desig- nated market value, let us return to the inventory data for Regner Foods, as shown in Illustration 9-11. Assume now that Regner uses the LIFO method.

ILLUSTRATION 9-11 Computation of Designated Market Value

Net Realizable Net Value Less a Realizable Normal Profit Designated Replacement Value Margin Market Food Cost (Ceiling) (Floor) Value

Spinach $ 88,000 $120,000 $104,000 $104,000 Carrots 90,000 100,000 70,000 90,000 Cut beans 45,000 40,000 27,500 40,000 Peas 36,000 72,000 48,000 48,000 Mixed vegetables 105,000 92,000 80,000 92,000

Designated Market Value Decision:

Spinach Net realizable value less a normal profit margin is selected because it is the middle value.

Carrots Replacement cost is selected because it is the middle value. Cut beans Net realizable value is selected because it is the middle value. Peas Net realizable value less a normal profit margin is selected because it is the middle

value. Mixed vegetables Net realizable value is selected because it is the middle value.

INTERNATIONAL PERSPECTIVE

IFRS requires all companies to apply LCNRV. Thus, IFRS does not use a ceiling or floor to determine market.

450 Chapter 9 Inventories: Additional Valuation Issues

As with the LCNRV approach, the application of the lower-of-cost-or-market rule incorporates only losses in value that occur in the normal course of business. Regner makes the following entry (using the loss method) to record the decline in value.

Loss Due to Decline of Inventory to Market ($415,000 − $350,000) 65,000 Allowance to Reduce Inventory to Market 65,000

Methods of Applying Lower-of-Cost-or-Market In the Regner Foods illustration, we assumed that the company applied the lower-of- cost-or-market rule to each individual type of food. As in the application of LCNRV, companies may apply the lower-of-cost-or-market rule either directly to each item, to each category, or to the total of the inventory. To illustrate, assume that Regner Foods separates its food products into two major categories, frozen and canned, as shown in Illustration 9-13.

Lower-of-Cost-or-Market by:

Designated Individual Major Total Cost Market Items Categories Inventory Frozen Spinach $ 80,000 $104,000 $ 80,000 Carrots 100,000 90,000 90,000 Cut beans 50,000 40,000 40,000

Total frozen 230,000 234,000 $230,000

Canned Peas 90,000 48,000 48,000 Mixed vegetables 95,000 92,000 92,000

Total canned 185,000 140,000 140,000

Total $415,000 $374,000 $350,000 $370,000 $374,000

ILLUSTRATION 9-13 Alternative Applications of Lower-of-Cost-or-Market

Regner Foods then compares designated market value to cost to determine the lower- of-cost-or-market. It determines the final inventory value as shown in Illustration 9-12.

ILLUSTRATION 9-12 Determining Final Inventory Value

Net Realizable Net Value Less a Realizable Normal Profit Designated Final Replacement Value Margin Market Inventory Food Cost Cost (Ceiling) (Floor) Value Value

Spinach $ 80,000 $ 88,000 $120,000 $104,000 $104,000 $ 80,000 Carrots 100,000 90,000 100,000 70,000 90,000 90,000 Cut beans 50,000 45,000 40,000 27,500 40,000 40,000 Peas 90,000 36,000 72,000 48,000 48,000 48,000 Mixed vegetables 95,000 105,000 92,000 80,000 92,000 92,000

$415,000 $350,000

Final Inventory Value:

Spinach Cost ($80,000) is selected because it is lower than designated market value (net realizable value less a normal profit margin).

Carrots Designated market value (replacement cost, $90,000) is selected because it is lower than cost.

Cut beans Designated market value (net realizable value, $40,000) is selected because it is lower than cost.

Peas Designated market value (net realizable value less a normal profit margin, $48,000) is selected because it is lower than cost.

Mixed vegetables Designated market value (net realizable value, $92,000) is selected because it is lower than cost.

Lower-of-Cost-or-Market 451

If Regner Foods applied the lower-of-cost-or-market rule to individual items, the amount of inventory is $350,000. If applying the rule to major categories, it jumps to $370,000. If applying lower-of-cost-or-market to the total inventory, it totals $374,000. Why this difference? When a company uses a major categories or total inventory approach, market values higher than cost offset market values lower than cost. For Regner Foods, using the major categories approach partially offsets the high market value for spinach. Using the total inventory approach totally offsets the high market value for spinach.

Recall that companies usually value inventory on an item-by-item basis and this approach gives the most conservative valuation for balance sheet purposes. The method selected should be the one that most clearly reflects income. Whichever method a com- pany selects, it should apply the method consistently from one period to another.

Evaluation of the LCNRV and Lower-of-Cost-or-Market Rules The LCNRV and lower-of-cost-or-market rules suffer some conceptual deficiencies:

1. A company recognizes decreases in the value of the asset and the charge to expense in the period in which the loss in utility occurs—not in the period of sale. On the other hand, it recognizes increases in the value of the asset only at the point of sale. This inconsistent treatment can distort income data.

2. Application of the rules results in inconsistency because a company may value the inventory at cost in one year and at market in the next year.

3. These approaches value the inventory in the balance sheet conservatively, but their effect on the income statement may or may not be conservative. Net income for the year in which a company takes the loss is defi nitely lower. Net income of the subse- quent period may be higher than normal if the expected reductions in sales price do not materialize.

WHAT DO THE NUMBERS MEAN? “PUT IT IN REVERSE”

Source: S. E. Ante, “The Secret Behind Those Profit Jumps,” BusinessWeek Online (December 8, 2003).

The lower-of-cost-or-net-realizable value (market) rule is designed to provide timely information about the decline in the value of inventory. When the value of inventory declines, income takes a hit in the period of the write-down.

What happens in the periods after the write-down? For some companies, gross margins and bottom lines get a boost when they sell inventory that had been written down in a previous period. For example, as the table below shows, Vishay Intertechnology, Transwitch, and Cisco Systems reported gains from selling inventory that had previously been written down. The table also evaluates how clearly these companies disclosed the effects of the reversal of inventory write-downs.

For Transwitch, the reversal of fortunes amounted to 23 percent of net income. The problem is that the $600,000 credit had little to do with the company’s ongoing operations, and the company did not do a good job disclosing the effect of the reversal on current-year profi tability.

Even when companies do disclose a reversal, it is some- times hard to determine the impact on income. For example, Intel disclosed that it had sold inventory that had been written down in prior periods but did not specify how much reserved inventory was sold.

Transparency of fi nancial reporting should be a top priority. With better disclosure of the reversals that boost profi ts in the current period, fi nancial transparency would also get a boost.

Gain from Company Reversal Disclosure

Vishay Not available Poor—The semiconductor company did not mention the gain in its earnings announcement. Intertechnology Two weeks later in an SEC fi ling, Vishay disclosed the gain on the inventory that it had written

down. Transwitch $600,000 Poor—The company did not mention the gain in its earnings announcement. Three weeks later

in an SEC fi ling, the company disclosed the gain on the inventory that it had written down. Cisco Systems $525 million Good—The networking giant detailed in its earnings release and in SEC fi lings the gains from

selling inventory it had previously written off.

452 Chapter 9 Inventories: Additional Valuation Issues

4. Application of these rules uses “normal profi t” or “ordinary” costs to sell or dispose in determining inventory values. Since companies develop these estimates based on past experience (which they may not attain in the future), this subjective measure presents an opportunity for income manipulation.

Many financial statement users appreciate the LCNRV and lower-of-cost-or-market rules because they at least know that these rules prevent overstatement of inventory. In addition, recognizing all losses but anticipating no gains generally avoids overstating income.

OTHER VALUATION APPOACHES

Valuation at Net Realizable Value As indicated in the prior section, companies record inventory at cost or at the LCNRV or lower-of-cost-or-market.2 Under limited circumstances, support exists for recording inventory at net realizable value, even if that amount is above cost. GAAP permits this exception to the normal recognition rule under the following conditions:

1. When there is a controlled market with a quoted price applicable to all quantities, 2. When no signifi cant costs of disposal are involved, and 3. The product is available for immediate delivery.

Until items of inventory meet the three NRV conditions, they are accounted for based on accumulated historical costs.3 For example, mining companies ordinarily report inven- tories of certain minerals (rare metals, especially) at selling prices because there is often a controlled market without significant costs of disposal. Similar treatment is given agri- cultural products (such as harvested crops or animals held-for-sale) that are immedi- ately marketable at quoted prices.

Another situation in which valuation at net realizable value is allowed is when it is difficult to obtain cost figures. For example, the accounting for inventory in a meat-packing plant presents a costing challenge. The “raw material” consists of cattle, each unit of which the company purchases as a whole and then divides into parts that are the products. Instead of one product out of many raw materials or parts, the meat-packing company makes many products from one “unit” of raw material. To allocate the cost of the animal “on the hoof” into the cost of ribs, chuck, and shoulders is a practical impossibility.

This costing situation is in stark contrast to a manufacturing plant, where the com- pany combines various raw materials and purchased parts to create a finished product. The manufacturer can use the cost basis to account for various items in inventory because it knows the cost of each individual component part. Because of a peculiarity of the industry, meat-packing companies sometimes carry inventories at sales price less distribution costs. That is, it is much easier and more useful for the company to determine the market price of the various products and value them in the inventory at selling price less the various costs necessary to get them to market (costs such as ship- ping and handling).

LEARNING OBJECTIVE 3 Understand other inven- tory valuation issues.

2Manufacturing companies frequently employ a standardized cost system that predetermines the unit costs for material, labor, and manufacturing overhead and values raw materials, work in process, and finished goods inventories at their standard costs. For financial reporting purposes, it is acceptable to price inventories at standard costs if there is no significant difference between the actual costs and standard costs. If there is a significant difference, companies should adjust the inventory amounts to actual cost. In Accounting Research and Terminology Bulletin, Final Edition, the profession notes that “standard costs are acceptable if adjusted at reasonable intervals to reflect current conditions.” Burlington Industries and Hewlett-Packard use standard costs for valuing at least a portion of their inventories. 3Companies that meet the three conditions for valuation at net realizable value (NRV) have an option to use either NRV or LCNRV. [4]

INTERNATIONAL PERSPECTIVE

Similar to GAAP, certain agricultural products and mineral products can be reported at net realizable value using IFRS.

Other Valuation Appoaches 453

Valuation Using Relative Sales Value A special problem arises when a company buys a group of varying units in a single lump-sum purchase, also called a basket purchase. To illustrate, assume that Woodland Developers purchases land for $1 million that it will subdivide into 400 lots. These lots are of different sizes and shapes but can be roughly sorted into three groups graded A, B, and C. As Woodland sells the lots, it apportions the purchase cost of $1 million among the lots sold and the lots remaining on hand.

You might wonder why Woodland would not simply divide the total cost of $1 mil- lion by 400 lots, to get a cost of $2,500 for each lot. This approach would not recognize that the lots vary in size, shape, and attractiveness. Therefore, to accurately value each unit, the common and most logical practice is to allocate the total among the various units on the basis of their relative sales value.

Illustration 9-14 shows the allocation of relative sales value for the Woodland Devel- opers example.

4One study noted that about 30 percent of public companies have purchase commitments outstanding, with an estimated value of $725 billion (“SEC Staff Report on Off-Balance Sheet Arrangements, Special Purpose Entities, and Related Issues,” http://www.sec.gov/news/studies/soxoffbalancerpt.pdf, June 2005). Purchase commitments are popular because the buyer can secure a supply of inventory at a known price. The seller also benefits in these arrangements by knowing how much to produce.

ILLUSTRATION 9-14 Allocation of Costs, Using Relative Sales Value

Number Sales Total Relative Cost Cost of Price Sales Sales Total Allocated per Lots Lots per Lot Price Price Cost to Lots Lot

A 100 $10,000 $1,000,000 100/250 $1,000,000 $ 400,000 $4,000 B 100 6,000 600,000 60/250 1,000,000 240,000 2,400 C 200 4,500 900,000 90/250 1,000,000 360,000 1,800

$2,500,000 $1,000,000

Woodland determines the cost of lots sold and the gross profit, using the amounts given in the “Cost per Lot” column, as follows.

The ending inventory is therefore $320,000 ($1,000,000 − $680,000). Woodland also can compute this inventory amount another way. The ratio of cost to

selling price for all the lots is $1 million divided by $2,500,000, or 40 percent. Accord- ingly, if the total sales price of lots sold is, say $1,700,000, then the cost of the lots sold is 40 percent of $1,700,000, or $680,000. The inventory of lots on hand is then $1 million less $680,000, or $320,000.

The petroleum industry widely uses the relative sales value method to value (at cost) the many products and by-products obtained from a barrel of crude oil.

Purchase Commitments—A Special Problem In many lines of business, a company’s survival and continued profitability depends on its having a sufficient stock of merchandise to meet customer demand. Consequently, it is quite common for a company to make purchase commitments, which are agreements to buy inventory weeks, months, or even years in advance. Generally, the seller retains title to the merchandise or materials covered in the purchase commitments. Indeed, the goods may exist only as natural resources as unplanted seed (in the case of agricultural commodities) or as work in process (in the case of a product).4

ILLUSTRATION 9-15 Determination of Gross Profi t, Using Relative Sales Value

Number of Cost per Cost of Lots Lots Sold Lot Lots Sold Sales Gross Profit

A 77 $4,000 $308,000 $ 770,000 $ 462,000 B 80 2,400 192,000 480,000 288,000 C 100 1,800 180,000 450,000 270,000

$680,000 $1,700,000 $1,020,000

454 Chapter 9 Inventories: Additional Valuation Issues

Usually, it is not necessary for the buyer to make any entries to reflect commitments for purchases of goods that the seller has not shipped. Ordinary orders, for which the buyer and seller will determine prices at the time of shipment and which are subject to cancellation, do not represent either an asset or a liability to the buyer. Therefore, the buyer need not record such purchase commitments or report them in the financial statements.

What happens, though, if a buyer enters into a formal, noncancelable purchase con- tract? Even then, the buyer recognizes no asset or liability at the date of inception, because the contract is “executory” in nature: Neither party has fulfilled its part of the contract. However, if material, the buyer should disclose such contract details in a note to its financial statements. Illustration 9-16 shows an example of a purchase commit- ment disclosure.

5There is a long-standing controversy on the accounting in this area. See, for example, Yuji Ijiri, Recognition of Contractual Rights and Obligations, Research Report (Stamford, Conn.: FASB, 1980), who argues that companies should capitalize firm purchase commitments. “Firm” means that it is unlikely that companies can avoid performance under the contract without a severe penalty.

Also, see Mahendra R. Gujarathi and Stanley F. Biggs, “Accounting for Purchase Commitments: Some Issues and Recommendations,” Accounting Horizons (September 1988), pp. 75–78. They conclude, “Recording an asset and liability on the date of inception for the noncancelable purchase commitments is suggested as the first significant step towards alleviating the accounting problems associated with the issue. At year-end, the potential gains and losses should be treated as contingencies which provide a coherent structure for the reporting of such gains and losses.”

In the disclosure in Illustration 9-16, the contract price was less than the market price at the balance sheet date. If the contract price is greater than the market price and the buyer expects that losses will occur when the purchase is effected, the buyer should recognize losses in the period during which such declines in market prices take place. [5]5

As an example, at one time many Northwest forest-product companies such as Boise Cascade, Georgia-Pacific, and Weyerhaeuser at one time signed long-term timber-cutting contracts with the U.S. Forest Service. These contracts required that the companies pay $310 per thousand board feet for timber-cutting rights. Unfortunately, the market price for timber-cutting rights in the latter part of that year dropped to $80 per thousand board feet. As a result, a number of these companies had long-term con- tracts that, if fulfilled, would result in substantial future losses.

To illustrate the accounting problem, assume that St. Regis Paper Co. signed timber- cutting contracts to be executed in 2018 at a price of $10,000,000. Assume further that the market price of the timber cutting rights on December 31, 2017, dropped to $7,000,000. St. Regis would make the following entry on December 31, 2017.

Unrealized Holding Gain or Loss—Income (Purchase Commitments) 3,000,000 Estimated Liability on Purchase Commitments 3,000,000

St. Regis would report this unrealized holding loss in the income statement under “Other expenses and losses.” And because the contract is to be executed within the next fiscal year, St. Regis would report the Estimated Liability on Purchase Commitments in the current liabilities section on the balance sheet. When St. Regis cuts the timber at a cost of $10 million, it would make the following entry.

Purchases (Inventory) 7,000,000 Estimated Liability on Purchase Commitments 3,000,000 Cash 10,000,000

ILLUSTRATION 9-16 Disclosure of Purchase Commitment

Note 1: Contracts for the purchase of raw materials in 2017 have been executed in the amount of $600,000. The market price of such raw materials on December 31, 2016, is $640,000.

UNDERLYING CONCEPTS

Reporting the loss is conservative. However, reporting the decline in market price is debat- able because no asset is recorded. This area demonstrates the need for good defi nitions of assets and liabilities.

The Gross Profi t Method of Estimating Inventory 455

The result of the purchase commitment was that St. Regis paid $10 million for a contract worth only $7 million. It recorded the loss in the previous period—when the price actually declined.

If St. Regis can partially or fully recover the contract price before it cuts the timber, it reduces the Estimated Liability on Purchase Commitments. In that case, it then reports in the period of the price increase a resulting gain for the amount of the partial or full recov- ery. For example, Congress permitted some of the forest-products companies to buy out of their contracts at reduced prices in order to avoid potential bankruptcies. To illustrate, assume that Congress permitted St. Regis to reduce its contract price and therefore its commitment by $1,000,000. The entry to record this transaction is as follows.

Estimated Liability on Purchase Commitments 1,000,000 Unrealized Holding Gain or Loss—Income (Purchase Commitments) 1,000,000

If the market price at the time St. Regis cuts the timber is more than $2,000,000 below the contract price, St. Regis will have to recognize an additional loss in the period of cutting and record the purchase at the lower-of-cost-or-market.

Are purchasers at the mercy of market price declines? Not totally. Purchasers can protect themselves against the possibility of market price declines of goods under con- tract by hedging. In hedging, the purchaser in the purchase commitment simultane- ously enters into a contract in which it agrees to sell in the future the same quantity of the same (or similar) goods at a fixed price. Thus the company holds a buy position in a purchase commitment and a sell position in a futures contract in the same commodity. The purpose of the hedge is to offset the price risk of the buy and sell positions. The company will be better off under one contract by approximately (maybe exactly) the same amount by which it is worse off under the other contract.

For example, St. Regis Paper Co. could have hedged its purchase commitment con- tract with a futures contract for timber rights of the same amount. In that case, its loss of $3,000,000 on the purchase commitment could have been offset by a $3,000,000 gain on the futures contract.6

As easy as this makes it sound, accounting for purchase commitments is still unset- tled and controversial. Some argue that companies should report purchase commit- ments as assets and liabilities at the time they sign the contract. Others believe that the present recognition at the delivery date is more appropriate. FASB Concepts Statement No. 6 states, “a purchase commitment involves both an item that might be recorded as an asset and an item that might be recorded as a liability. That is, it involves both a right to receive assets and an obligation to pay. . . . If both the right to receive assets and the obligation to pay were recorded at the time of the purchase commitment, the nature of the loss and the valuation account that records it when the price falls would be clearly seen.” Although the discussion in Concepts Statement No. 6 does not exclude the possibil- ity of recording assets and liabilities for purchase commitments, it contains no conclu- sions or implications about whether companies should record them.7

THE GROSS PROFIT METHOD OF ESTIMATING INVENTORY Companies take a physical inventory to verify the accuracy of the perpetual inventory records or, if no records exist, to arrive at an inventory amount. Sometimes, however, taking a physical inventory is impractical. In such cases, companies use substitute mea- sures to approximate inventory on hand.

6Appendix 17A provides a complete discussion of hedging and the use of derivatives such as futures. 7“Elements of Financial Statements,” Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, 1985), paras. 251–253.

LEARNING OBJECTIVE 4 Determine ending inven- tory by applying the gross profit method.

456 Chapter 9 Inventories: Additional Valuation Issues

One substitute method of verifying or determining the inventory amount is the gross profit method (also called the gross margin method). Auditors widely use this method in situations where they need only an estimate of the company’s inventory (e.g., interim reports). Companies also use this method when fire or other catastrophe destroys either inventory or inventory records. The gross profit method relies on three assumptions:

1. The beginning inventory plus purchases equal total goods to be accounted for. 2. Goods not sold must be on hand. 3. The sales, reduced to cost, deducted from the sum of the opening inventory plus pur-

chases, equal ending inventory.

To illustrate, assume that Cetus Corp. has a beginning inventory of $60,000 and purchases of $200,000, both at cost. Sales at selling price amount to $280,000. The gross profit on selling price is 30 percent.

Cetus applies the gross profit method as follows.

8An alternative method of estimating inventory using the gross profit percentage is considered by some to be less complicated than the traditional method. This alternative method uses the standard income statement format as follows. (Assume the same data as in the Cetus example above.)

ILLUSTRATION 9-17 Application of Gross Profi t Method

Beginning inventory (at cost) $ 60,000 Purchases (at cost) 200,000

Goods available (at cost) 260,000 Sales (at selling price) $280,000 Less: Gross profit (30% of $280,000) 84,000

Sales (at cost) 196,000

Approximate inventory (at cost) $ 64,000

The current period’s records contain all the information Cetus needs to compute inventory at cost, except for the gross profit percentage. Cetus determines the gross profit percentage by reviewing company policies or prior period records. In some cases, companies must adjust this percentage if they consider prior periods unrepresentative of the current period.8

Computation of Gross Profi t Percentage In most situations, the gross profit percentage is stated as a percentage of selling price. The previous illustration, for example, used a 30 percent gross profit on sales. Gross profit on selling price is the common method for quoting the profit for several reasons. (1) Most companies state goods on a retail basis, not a cost basis. (2) A profit quoted on selling

Relationships Solution

Sales revenue $280,000 $280,000 Cost of sales Beginning inventory $ 60,000 $ 60,000 Purchases 200,000 200,000

Goods available for sale 260,000 260,000 Ending inventory (3) ? (3) 64,000 Est.

Cost of goods sold (2) ? (2)196,000 Est.

Gross profi t on sales (30%) (1) ? (1) 84,000 Est.

Compute the unknowns as follows: first the gross profit amount, then cost of goods sold, and finally the ending inventory, as shown below.

(1) $280,000 × 30% = $84,000 (gross profit on sales). (2) $280,000 − $84,000 = $196,000 (cost of goods sold). (3) $260,000 − $196,000 = $64,000 (ending inventory).

The Gross Profi t Method of Estimating Inventory 457

price is lower than one based on cost. This lower rate gives a favorable impression to the consumer. (3) The gross profit based on selling price can never exceed 100 percent.9

In Illustration 9-17, the gross profit was a given. But how did Cetus derive that fig- ure? To see how to compute a gross profit percentage, assume that an article cost $15 and sells for $20, a gross profit of $5. As shown in the computations in Illustration 9-18, this markup is ¼ or 25 percent of retail, and 1/3 or, 331/3 percent of cost.

ILLUSTRATION 9-18 Computation of Gross Profi t Percentage

9The terms gross margin percentage, rate of gross profit, and percentage markup are synonymous, although companies more commonly use markup in reference to cost and gross profit in reference to sales.

Although companies normally compute the gross profit on the basis of selling price, you should understand the basic relationship between markup on cost and markup on sell- ing price. For example, assume that a company marks up a given item by 25 percent. What, then, is the gross profit on selling price? To find the answer, assume that the item sells for $1. In this case, the following formula applies.

Cost + Gross profi t = Selling price C + .25C = SP (1 + .25)C = SP 1.25C = $1.00 C = $0.80 The gross profit equals $0.20 ($1.00 − $0.80). The rate of gross profit on selling price is therefore 20 percent ($0.20/$1.00).

Conversely, assume that the gross profit on selling price is 20 percent. What is the markup on cost? To find the answer, again assume that the item sells for $1. Again, the same formula holds:

Cost + Gross profi t = Selling price C + .20SP = SP C = (1 − .20)SP C = .80SP C = .80($1.00) C = $0.80 As in the previous example, the markup equals $0.20 ($1.00 − $0.80). The markup on cost is 25 percent ($0.20/$0.80).

Retailers use the following formulas to express these relationships:

ILLUSTRATION 9-19 Formulas Relating to Gross Profi t

1. Gross Profit on Selling Price = Percentage Markup on Cost 100% + Percentage Markup on Cost

2. Percentage Markup on Cost = Gross Profit on Selling Price 100% − Gross Profit on Selling Price

To understand how to use these formulas, consider their application in the follow- ing calculations.

ILLUSTRATION 9-20 Application of Gross Profi t Formulas

Gross Profit on Selling Price Percentage Markup on Cost

Given: 20% .20

1.00 − .20 = 25%

Given: 25% .25

1.00 − .25 = 33 1/3%

.25

1.00 +.25 = 20% Given: 25%

.50

1.00 + .50 = 33 1/3% Given: 50%

Markup Retail

$5 $20

= == 25% at retail Markup

Cost $5 $15

= 331/3% on cost

458 Chapter 9 Inventories: Additional Valuation Issues

Because selling price exceeds cost and with the gross profit amount being the same for both, gross profit on selling price will always be less than the related percentage based on cost. Note that companies do not multiply sales by a cost-based markup percentage. Instead, they must convert the gross profit percentage to a percentage based on selling price.

Evaluation of Gross Profi t Method Illustration 9-21 summarizes the three main disadvantages of the gross profi t method.

Major Disadvantage Result

1. It is an estimate. Companies must take a physical inventory once a year to verify the inventory.

2. It generally relies on past percentages in determining the markup.

Although the past often provides answers to the future, a current rate is more appropriate. Note that whenever signifi cant fl uctuations occur, companies should adjust the percentage as appropriate.

3. Care must be exercised when applying a blanket gross profi t rate when there are varying gross profi ts.

Frequently, a store or department handles merchandise with widely varying rates of gross profi t. In these situations, the company may need to apply the gross profi t method by subsections, lines of merchandise, or a similar basis that classifi es merchandise according to their respective rates of gross profi t.

ILLUSTRATION 9-21 Disadvantages of Gross Profi t Method

The gross profit method is normally unacceptable for financial reporting purposes because it provides only an estimate. GAAP requires a physical inventory as additional verification of the inventory indicated in the records. Nevertheless, GAAP permits the gross profit method to determine ending inventory for interim (generally quarterly) reporting purposes, provided a company discloses the use of this method. Note that the gross profit method will follow closely the inventory method used (FIFO, LIFO, average- cost) because it relies on historical records.

WHAT DO THE NUMBERS MEAN? THE SQUEEZE

Sources: Trefis, “Nike’s Earnings Reiterate Gross Margin Pressure,” http://seekingalpha.com (March 23, 2011); D. Kardous, “Higher Pricing Helps Boost Dr. Pepper Snapple’s Net,” Wall Street Journal Online (June 5, 2008); and D. Sparks, “Will Apple Inc.’s Profit Margin Continue Upward?” The Motley Fool (December 4, 2014).

Managers and analysts closely follow gross profi ts. A small change in the gross profi t rate can signifi cantly affect the bottom line. At one time, Apple suffered a textbook case of shrinking gross profi ts. In response to pricing wars in the personal com- puter market, Apple had to reduce prices more quickly than it could reduce its costs. As a result, gross profi t declined and so did its stock price. However, times are now changing. Apple’s stock price is increasing, and one of the key drivers behind the high stock valuations is Apple’s improved gross profi t. Perhaps this is not so surprising when you consider the success of its iPhone 6, its upgrades, and now the Apple watch!

Here are two other examples of how gross profi t and stock price are very much correlated. Nike—the largest global manufacturer of athletic footwear—at one time reported earn- ings that indicated falling gross profi t, leading market analysts to adjust Nike’s stock price downward. The cause—continuing downward pressure on its gross profi t. On the positive side, an increase in the gross profi t rate provides a positive signal to the market. For example, just a 1 percent boost in Dr. Pepper’s gross profi t rate cheered the market, indicating the company was able to avoid the squeeze of increased commodity costs by raising its prices.

LEARNING OBJECTIVE 5 Determine ending inven- tory by applying the retail inventory method.

RETAIL INVENTORY METHOD Accounting for inventory in a retail operation presents several challenges. Retailers with certain types of inventory may use the specific identification method to value their inventories. Such an approach makes sense when a retailer holds significant individual inventory units, such as automobiles, pianos, or fur coats. However, imagine attempting to use such an approach at Target, Home Depot, Sears Holdings, or Bloomingdale’s— high-volume retailers that have many different types of merchandise. It would be extremely difficult to determine the cost of each sale, to enter cost codes on the tickets,

Retail Inventory Method 459

to change the codes to reflect declines in value of the merchandise, to allocate costs such as transportation, and so on.

An alternative is to compile the inventories at retail prices. For most retailers, an observable pattern between cost and price exists. The retailer can then use a formula to convert retail prices to cost. This method is called the retail inventory method. It requires that the retailer keep a record of (1) the total cost and retail value of goods purchased, (2) the total cost and retail value of the goods available for sale, and (3) the sales for the period. Use of the retail inventory method is very common. For example, Safeway supermarkets, Target, Wal-Mart, and Best Buy use the retail inventory method.

Here is how it works at a company like Best Buy. Beginning with the retail value of the goods available for sale, Best Buy deducts the sales revenue for the period. This cal- culation determines an estimated inventory (goods on hand) at retail. It next computes the cost-to-retail ratio for all goods. The formula for this computation is to divide the total goods available for sale at cost by the total goods available at retail price. Finally, to obtain ending inventory at cost, Best Buy applies the cost-to-retail ratio to the ending inventory valued at retail. Illustration 9-22 shows the retail inventory method calcula- tions for Best Buy (assumed data).

ILLUSTRATION 9-22 Retail Inventory MethodBEST BUY(current period)

Cost Retail

Beginning inventory $14,000 $ 20,000 Purchases 63,000 90,000

Goods available for sale $77,000 110,000

Deduct: Sales revenue 85,000

Ending inventory, at retail $ 25,000

Cost-to-retail ratio ($77,000 × $110,000) = 70% Ending inventory at cost (70% of $25,000) = $17,500

There are different versions of the retail inventory method. These include the con- ventional method (based on lower-of-average-cost-or-market), the cost method, the LIFO retail method, and the dollar-value LIFO retail method. Regardless of which ver- sion a company uses, the IRS, various retail associations, and the accounting profession all sanction use of the retail inventory method. One of its advantages is that a company like Best Buy can approximate the inventory balance without a physical count. How- ever, to avoid a potential overstatement of the inventory, Target makes periodic inven- tory counts. Such counts are especially important in retail operations where loss due to shoplifting or breakage is common.

The retail inventory method is particularly useful for any type of interim report because such reports usually need a fairly quick and reliable measure of the inventory. Also, similar to use of the gross profit method, insurance adjusters often use this method to estimate losses from fire, flood, or other type of casualty. This method also acts as a control device because a company will have to explain any deviations from a physical count at the end of the year. Finally, the retail method expedites the physical inventory count at the end of the year. The crew taking the physical inventory need record only the retail price of each item. The crew does not need to look up each item’s invoice cost, thereby saving time and expense.

Retail-Method Concepts The amounts shown in the “Retail” column of Illustration 9-22 above represent the orig- inal retail prices, assuming no price changes. In practice, though, retailers frequently mark up or mark down the prices they charge buyers.

For retailers, the term markup means an additional markup of the original retail price. (In another context, such as the gross profit discussion on pages 455–458, we often

460 Chapter 9 Inventories: Additional Valuation Issues

think of markup on the basis of cost.) Markup cancellations are decreases in prices of merchandise that the retailer had marked up above the original retail price.

In a competitive market, retailers often need to use markdowns, which are decreases in the original sales prices. Such cuts in sales prices may be necessary because of a decrease in the general level of prices, special sales, soiled or damaged goods, over- stocking, and market competition. Markdowns are common in retailing these days. Markdown cancellations occur when the markdowns are later offset by increases in the prices of goods that the retailer had marked down—such as after a one-day sale, for example. Neither a markup cancellation nor a markdown cancellation can exceed the original markup or markdown.

To illustrate these concepts, assume that Designer Clothing Store recently purchased 100 dress shirts from Marroway, Inc. The cost for these shirts was $1,500, or $15 a shirt. Designer Clothing established the selling price on these shirts at $30 a shirt. The shirts were selling quickly in anticipation of Father’s Day, so the manager added a markup of $5 per shirt. This markup made the price too high for customers, and sales slowed. The manager then reduced the price to $32. At this point we would say that the shirts at Designer Clothing have had a markup of $5 and a markup cancellation of $3.

Right after Father’s Day, the manager marked down the remaining shirts to a sale price of $23. At this point, an additional markup cancellation of $2 has taken place, and a $7 markdown has occurred. If the manager later increases the price of the shirts to $24, a markdown cancellation of $1 would occur.

Retail Inventory Method with Markups and Markdowns—Conventional Method Retailers use markup and markdown concepts in developing the proper inventory val- uation at the end of the accounting period. To obtain the appropriate inventory figures, companies must give proper treatment to markups, markup cancellations, markdowns, and markdown cancellations.

To illustrate the different possibilities, consider the data for In-Fusion Inc., shown in Illustration 9-23. In-Fusion can calculate its ending inventory at cost under two assump- tions, A and B. (We’ll explain the reasons for the two later.)

Assumption A: Computes a cost ratio after markups (and markup cancellations) but before markdowns. Assumption B: Computes a cost ratio after both markups and markdowns (and cancellations).

The computations for In-Fusion are:

Ending inventory at retail × Cost ratio = Value of ending inventory Assumption A: $12,500 × 53.9% = $6,737.50 Assumption B: $12,500 × 54.7% = $6,837.50

The question becomes: Which assumption and which percentage should In-Fusion use to compute the ending inventory valuation? The answer depends on which retail inventory method In-Fusion chooses.

One approach uses only assumption A (a cost ratio using markups but not mark- downs). It approximates the lower-of-average-cost-or-market. We will refer to this approach as the conventional retail inventory method or the lower-of-cost-or-market approach.10

To understand why this method considers only the markups, not the markdowns, in the cost percentage, you must understand how a retail business operates. A markup normally indicates an increase in the market value of the item. On the other hand, a

10This explains part of the rationale for the previously discussed exception to LCNRV for companies that use the retail inventory method.

Retail Inventory Method 461

markdown means a decline in the utility of that item. Therefore, to approximate the lower-of-cost-or-market, we would consider markdowns a current loss and so would not include them in calculating the cost-to-retail ratio. Omitting the markdowns would make the cost-to-retail ratio lower, which leads to an approximate lower-of-cost- or-market.

An example will make the distinction between the two methods clear. In-Fusion purchased two items for $5 apiece; the original sales price was $10 each. One item was subsequently written down to $2. Assuming no sales for the period, if markdowns are considered in the cost-to-retail ratio (assumption B—the cost method), we compute the ending inventory in the following way.

ILLUSTRATION 9-23 Retail Inventory Method with Markups and Markdowns

Cost Retail

Beginning inventory $ 500 $ 1,000 Purchases (net) 20,000 35,000 Markups 3,000 Markup cancellations 1,000 Markdowns 2,500 Markdown cancellations 2,000 Sales (net) 25,000

IN-FUSION INC.

Cost Retail

Beginning inventory $ 500 $ 1,000 Purchases (net) 20,000 35,000

Merchandise available for sale 20,500 36,000 Add: Markups $3,000 Less: Markup cancellations 1,000 Net markups 2,000

20,500 38,000

(A) Cost-to-retail ratio = $20,500 $38,000

= 53.9%

Deduct: Markdowns 2,500 Markdown cancellations (2,000)

Net markdowns 500

$20,500 37,500

(B) Cost-to-retail ratio = $20,500 $37,500

= 54.7%

Deduct: Sales (net) 25,000

Ending inventory at retail $12,500

ILLUSTRATION 9-24 Retail Inventory Method Including Markdowns— Cost Method

Markdowns Included in Cost-to-Retail Ratio

Cost Retail

Purchases $10 $20 Deduct: Markdowns 8

Ending inventory, at retail $12

Cost-to-retail ratio = $10 $12

= 83.3%

Ending inventory at cost ($12 × .833) = $10

This approach (the cost method) reflects an average cost of the two items of the com- modity without considering the loss on the one item. It values ending inventory at $10.

462 Chapter 9 Inventories: Additional Valuation Issues

If markdowns are not considered in the cost-to-retail ratio (assumption A—the conventional retail method), we compute the ending inventory as follows.

ILLUSTRATION 9-25 Retail Inventory Method Excluding Markdowns— Conventional Method (LCM)

Markdowns Not Included in Cost-to-Retail Ratio

Cost Retail

Purchases $10 $20

Cost-to-retail ratio = $10 $20

= 50%

Deduct: Markdowns 8

Ending inventory, at retail $12

Ending inventory at cost ($12 × .50) = $6

Under this approach (the conventional retail method, in which markdowns are not considered), ending inventory would be $6. The inventory valuation of $6 reflects two inventory items, one inventoried at $5 and the other at $1. It reflects the fact that In- Fusion reduced the sales price from $10 to $2, and reduced the cost from $5 to $1.11

To approximate the lower-of-cost-or-market, In-Fusion must establish the cost-to- retail ratio. It does this by dividing the cost of goods available for sale by the sum of the original retail price of these goods plus the net markups. This calculation excludes markdowns and markdown cancellations. Illustration 9-26 shows the basic format for the retail inventory method using the lower-of-cost-or-market approach along with the In-Fusion Inc. information.

ILLUSTRATION 9-26 Comprehensive Conventional Retail Inventory Method Format

IN-FUSION INC.

Cost Retail

Beginning inventory $ 500 $ 1,000 Purchases (net) 20,000 35,000

Totals 20,500 36,000 Add: Net markups Markups $3,000 Markup cancellations 1,000 2,000

Totals $20,500 38,000 Deduct: Net markdowns Markdowns 2,500 Markdown cancellations 2,000 500

Sales price of goods available 37,500 Deduct: Sales (net) 25,000

Ending inventory, at retail $12,500

Cost-to-retail ratio = Cost of goods available Original retail price of goods available, plus net markups

= $20,500 $38,000

= 53.9%

Ending inventory at lower-of-cost-or-market (53.9% × $12,500) = $6,737.50

11This figure is not really market (replacement cost), but it is net realizable value less the normal margin that is allowed. In other words, the sale price of the goods written down is $2, but subtracting a normal margin of 50 percent ($5 cost, $10 price), the figure becomes $1.

Because an averaging effect occurs, an exact lower-of-cost-or-market inventory val- uation is ordinarily not obtained, but an adequate approximation can be achieved. In contrast, adding net markups and deducting net markdowns yields approximate cost.

Retail Inventory Method 463

Special Items Relating to Retail Method The retail inventory method becomes more complicated when we consider such items as freight-in, purchase returns and allowances, and purchase discounts. In the retail method, we treat such items as follows.

• Freight costs are part of the purchase cost. • Purchase returns are ordinarily considered as a reduction of the price at both cost

and retail. • Purchase discounts and allowances usually are considered as a reduction of the

cost of purchases.

In short, the treatment for the items affecting the cost column of the retail inventory approach follows the computation for cost of goods available for sale.12

Note also that sales returns and allowances are considered as proper adjustments to gross sales. However, when sales are recorded gross, companies do not recognize sales discounts. To adjust for the sales discount account in such a situation would pro- vide an ending inventory figure at retail that would be overvalued.

In addition, a number of special items require careful analysis:

• Transfers-in from another department are reported in the same way as purchases from an outside company.

• Normal shortages (breakage, damage, theft, shrinkage) should reduce the retail col- umn because these goods are no longer available for sale. Such costs are reflected in the selling price because a certain amount of shortage is considered normal in a re- tail enterprise. As a result, companies do not consider this amount in computing the cost-to-retail percentage. Rather, to arrive at ending inventory at retail, they show normal shortages as a deduction similar to sales.

• Abnormal shortages, on the other hand, are deducted from both the cost and retail columns and reported as a special inventory amount or as a loss. To do otherwise distorts the cost-to-retail ratio and overstates ending inventory.

• Employee discounts (given to employees to encourage loyalty, better performance, and so on) are deducted from the retail column in the same way as sales. These dis- counts should not be considered in the cost-to-retail percentage because they do not reflect an overall change in the selling price.13

WHAT DO THE NUMBERS MEAN? PRICE FIXING

Source: Anonymous, “Stores Try Fixed Prices That Aren’t So Fixed,” Businessweek (August 2, 2015), p. 22.

Markups, markdowns, cancellations… how can retailers keep up? Well, it can be pretty tough, but it may be getting more manageable with some innovative technology. It used to be that a company like Nebraska Furniture Mart would have to dispatch an army of employees each morning to update printed price labels throughout its stores, to maintain its pledge to offer the lowest prices on televisions, dishwashers, sofas, and fl ooring. But after a major investment in digital price dis- plays, a single worker can now quickly update the prices for thousands of products at multiple locations. This helps Nebraska match price changes at competitors, like Home

Depot and Sears. At present, Nebraska resets prices at the beginning of each day, so the investment in inventory technol- ogy may not be as effective in competing with online retailers, such as eBay and Amazon.com, which commonly change prices throughout the day (Nebraska does not want the price of a product to change as a customer is walking up to the checkout). Nonetheless, digital price displays help Nebraska (and other brick-and-mortar retailers) stay competitive and should reduce the cost of implementing the retail inventory method in its accounting system.

12When the purchase allowance is not reflected by a reduction in the selling price, no adjustment is made to the retail column. 13Note that if employee sales are recorded gross, no adjustment is necessary for employee discounts in the retail column.

464 Chapter 9 Inventories: Additional Valuation Issues

Illustration 9-27 shows some of these concepts. The company, Extreme Sport Apparel, determines its inventory using the conventional retail inventory method.

ILLUSTRATION 9-27 Conventional Retail Inventory Method— Special Items Included

EXTREME SPORT APPAREL

Cost Retail

Beginning inventory $ 1,000 $ 1,800 Purchases 30,000 60,000 Freight-in 600 — Purchase returns (1,500) (3,000)

Totals 30,100 58,800 Net markups 9,000 Abnormal shortage (1,200) (2,000)

Totals $28,900 65,800

Deduct: Net markdowns 1,400 Sales revenue $36,000 Sales returns (900) 35,100

Employee discounts 800 Normal shortage 1,300

$27,200

Cost-to-retail ratio = $28,900 $65,800

= 43.9%

Ending inventory at lower-of-cost-or-market (43.9% × $27,200) = $11,940.80

Evaluation of Retail Inventory Method Companies like Gap Inc., Home Depot, or your local department store use the retail inventory method of computing inventory for the following reasons: (1) to permit the computation of net income without a physical count of inventory, (2) as a control mea- sure in determining inventory shortages, (3) in regulating quantities of merchandise on hand, and (4) for insurance information.

One characteristic of the retail inventory method is that it has an averaging effect on varying rates of gross profit. This can be problematic when companies apply the method to an entire business, where rates of gross profit vary among departments. There is no allowance for possible distortion of results because of such differences. Companies refine the retail method under such conditions by computing inventory separately by departments or by classes of merchandise with similar gross profits. In addition, the reliability of this method assumes that the distribution of items in inven- tory is similar to the “mix” in the total goods available for sale.

PRESENTATION AND ANALYSIS Presentation of Inventories Accounting standards require financial statement disclosure of the composition of the inventory, inventory financing arrangements, and the inventory costing methods employed. The standards also require the consistent application of costing methods from one period to another.

Manufacturers should report the inventory composition either in the balance sheet or in a separate schedule in the notes. The relative mix of raw materials, work in process, and finished goods helps in assessing liquidity and in computing the stage of inventory completion.

Significant or unusual financing arrangements relating to inventories may require note disclosure. Examples include transactions with related parties, product financing

LEARNING OBJECTIVE 6 Explain how to report and analyze inventory.

Presentation and Analysis 465

arrangements, firm purchase commitments, involuntary liquidation of LIFO inventories, and pledging of inventories as collateral. Companies should present inventories pledged as collateral for a loan in the current assets section rather than as an offset to the liability.

A company should also report the basis on which it states inventory amounts (e.g., lower-of-cost-or-market) and the method used in determining cost (LIFO, FIFO, aver- age-cost, etc.). For example, the annual report (adapted) of Mumford of Wyoming con- tains the following disclosures.

ILLUSTRATION 9-28 Disclosure of Inventory Methods

Mumford of Wyoming

Note A: Significant Accounting Policies

Live feeder cattle and feed—last-in, first-out (LIFO) cost, which is below approximate market $854,800

Live range cattle—lower of principally identified cost or market $1,240,500 Live sheep and supplies—lower of first-in, first-out (FIFO) cost

or net realizable value $674,000 Dressed meat and by-products—principally at market less

allowances for distribution and selling expenses $362,630

Illustration 9-28 shows that a company can use different costing methods for differ- ent elements of its inventory. If Mumford changes the method of costing any of its inventory elements, it must report a change in accounting principle. For example, if Mumford changes its method of accounting for live sheep from FIFO to average-cost, it should separately report this change, along with the effect on income, in the current and prior periods. Changes in accounting principle require an explanatory paragraph in the auditor’s report describing the change in method.

Fortune Brands, Inc. reported its inventories in its annual report (adapted) as follows (note the “trade practice” followed in classifying inventories among the current assets).

ILLUSTRATION 9-29 Disclosure of Trade Practice in Valuing Inventories

Fortune Brands, Inc. Current assets

(in millions) December 31

Inventories Maturing spirits $1,243.0 Other raw materials, supplies and work in process 322.7 Finished products 450.9

Total inventories $2,016.6

Significant Accounting Policies (in part)

Inventories The first-in, first-out (FIFO) inventory method is our principal inventory method across all segments. In accordance with generally recognized trade practice, maturing spirits inventories are classi- fied as current assets, although the majority of these inventories ordinarily will not be sold within one year, due to the duration of aging processes. Inventory provisions are recorded to reduce inventory to the lower of cost or net realizable value for obsolete or slow moving inventory based on assumptions about fu- ture demand and marketability of products, the impact of new product introductions, inventory turns, product spoilage and specific identification of items, such as product discontinuance or engineering/ material changes.

Analysis of Inventories As our opening story illustrates, the amount of inventory that a company carries can have significant economic consequences. As a result, companies must manage inven- tories. But, inventory management is a double-edged sword. It requires constant atten- tion. On the one hand, management wants to stock a great variety and quantity of items. Doing so will provide customers with the greatest selection. However, such an

466 Chapter 9 Inventories: Additional Valuation Issues

inventory policy may incur excessive carrying costs (e.g., investment, storage, insur- ance, taxes, obsolescence, and damage). On the other hand, low inventory levels lead to stockouts, lost sales, and disgruntled customers.

Using financial ratios helps companies to chart a middle course between these two dangers. Common ratios used in the management and evaluation of inventory levels are inventory turnover and a related measure, average days to sell inventory.

Inventory Turnover The inventory turnover measures the number of times on average a company sells the inventory during the period. It measures the liquidity of the inventory. To compute inventory turnover, divide the cost of goods sold by the average inventory on hand dur- ing the period.

Barring seasonal factors, analysts compute average inventory from beginning and ending inventory balances. For example, in its 2014 annual report Kellogg Company reported a beginning inventory of $1,248 million, an ending inventory of $1,279 million, and cost of goods sold of $9,517 million for the year. Illustration 9-30 shows the inven- tory turnover formula and Kellogg Company’s 2014 ratio computation below.

ILLUSTRATION 9-30 Inventory Turnover Inventory Turnover = Cost of Goods SoldAverage Inventory =

$9,517 ($1,279 + $1,248)/2 = 7.53 times

Average Days to Sell Inventory A variant of the inventory turnover is the average days to sell inventory. This measure represents the average number of days’ sales for which a company has inventory on hand. For example, the inventory turnover for Kellogg Company of 7.53 times divided into 365 is approximately 48.5 days.

There are typical levels of inventory in every industry. However, companies that keep their inventory at lower levels with higher turnovers than those of their competi- tors, and that still can satisfy customer needs, are the most successful.

APPENDIX 9A LIFO RETAIL METHODS

A number of retail establishments have changed from the more conventional treatment to a LIFO retail method. For example, the world’s largest retailer, Wal-Mart Stores, Inc., uses the LIFO retail method. The primary reason to do so is for the tax advantages asso- ciated with valuing inventories on a LIFO basis. In addition, adoption of LIFO results in a better matching of costs and revenues.

The use of LIFO retail is made under two assumptions: (1) stable prices and (2) fluc- tuating prices.

STABLE PRICES—LIFO RETAIL METHOD It is much more complex to compute the final inventory balance using a LIFO flow than using the conventional retail method. Under the LIFO retail method, companies like Wal-Mart or Target consider both markups and markdowns in obtaining the proper cost-to-retail percentage. Furthermore, since the LIFO method is concerned only with the additional layer, or the amount that should be subtracted from the previous layer, the beginning inventory is excluded from the cost-to-retail percentage.

A major assumption of the LIFO retail method is that the markups and mark- downs apply only to the goods purchased during the current period and not to the

LEARNING OBJECTIVE *7 Determine ending inven- tory by applying the LIFO retail methods.

YOU WILL WANT TO READ THE

IFRS INSIGHTS ON PAGES 494–501 For discussion of IFRS related to inventories.

Appendix 9A: LIFO Retail Methods 467

beginning inventory. This assumption is debatable and may explain why some compa- nies do not adopt this method.

Illustration 9A-1 presents the major concepts involved in the LIFO retail method applied to the Hernandez Company. Note that, to simplify the accounting, we have assumed that the price level has remained unchanged.

ILLUSTRATION 9A-1 LIFO Retail Method— Stable Prices

Cost Retail

Beginning inventory—2017 $ 27,000 $ 45,000

Net purchases during the period 346,500 480,000 Net markups 20,000 Net markdowns . (5,000)

Total (excluding beginning inventory) 346,500 495,000

Total (including beginning inventory) $373,500 540,000

Net sales during the period (484,000)

Ending inventory at retail $ 56,000

Establishment of cost-to-retail percentage under assumptions of LIFO retail ($346,500 ÷ $495,000) = 70%

Illustration 9A-2 indicates that the inventory is composed of two layers: the beginning inventory and the additional increase that occurred in the inventory this period (2017). When we start the next period (2018), the beginning inventory will be composed of those two layers. If an increase in inventory occurs again, an additional layer will be added.

ILLUSTRATION 9A-2 Ending Inventory at LIFO Cost, 2017—Stable Prices

Ending Inventory at

Retail Prices—2017

Layers at

Retail Prices Cost-to-Retail (Percentage)

Ending Inventory at

LIFO Cost

$56,000 2016 $45,000 × 60%* = $27,000 2017 11,000 × 70 = 7,700

$56,000 $34,700

*$27,000 (prior year’s cost-to-retail)

$45,000

However, if the final inventory figure is below the beginning inventory, Hernandez must reduce the beginning inventory starting with the most recent layer. For example, assume that the ending inventory for 2018 at retail is $50,000. Illustration 9A-3 shows the computation of the ending inventory at cost. Notice that the 2017 layer is reduced from $11,000 to $5,000.

ILLUSTRATION 9A-3 Ending Inventory at LIFO Cost, 2018—Stable Prices

Ending Inventory at

Retail Prices—2018

Layers at

Retail Prices Cost-to-Retail (Percentage)

Ending Inventory at

LIFO Cost

$50,000 2016 $45,000 × 60% = $27,000 2017 5,000 × 70 = 3,500

$50,000 $30,500

FLUCTUATING PRICES—DOLLAR-VALUE LIFO RETAIL METHOD The previous example simplified the LIFO retail method by ignoring changes in the sell- ing price of the inventory. Let us now assume that a change in the price level of the inventories occurs (as is usual). If the price level does change, the company must

468 Chapter 9 Inventories: Additional Valuation Issues

eliminate the price change so as to measure the real increase in inventory, not the dollar increase. This approach is referred to as the dollar-value LIFO retail method.

To illustrate, assume that the beginning inventory had a retail market value of $10,000 and the ending inventory had a retail market value of $15,000. Assume further that the price level has risen from 100 to 125. It is inappropriate to suggest that a real increase in inventory of $5,000 has occurred. Instead, the company must deflate the end- ing inventory at retail, as the computation in Illustration 9A-4 shows.

ILLUSTRATION 9A-4 Ending Inventory at Retail— Defl ated and Restated

Ending inventory at retail (deflated) $15,000 ÷ 1.25* $12,000 Beginning inventory at retail 10,000

Real increase in inventory at retail $ 2,000

Ending inventory at retail on LIFO basis: First layer $10,000 Second layer ($2,000 × 1.25) 2,500 $12,500

*1.25 = 125 ÷ 100

ILLUSTRATION 9A-5 Dollar-Value LIFO Retail Method—Fluctuating Prices

Cost Retail

Beginning inventory—2017 $ 27,000 $ 45,000

Net purchases during the period 346,500 480,000 Net markups 20,000 Net markdowns . (5,000)

Total (excluding beginning inventory) 346,500 495,000

Total (including beginning inventory) $373,500 540,000

Net sales during the period at retail (484,000)

Ending inventory at retail $ 56,000

Establishment of cost-to-retail percentage under assumptions of LIFO retail ($346,500 ÷ $495,000) = 70%

A. Ending inventory at retail prices deflated to base-year prices ($56,000 ÷ 1.12) $50,000 B. Beginning inventory (retail) at base-year prices 45,000

C. Inventory increase (retail) from beginning of period $ 5,000

This approach is essentially the dollar-value LIFO method discussed in Chapter 8. In computing the LIFO inventory under a dollar-value LIFO approach, the company finds the dollar increase in inventory and deflates it to beginning-of-the-year prices. This indicates whether actual increases or decreases in quantity have occurred. If an increase in quantities occurs, the company prices this increase at the new index, in order to compute the value of the new layer. If a decrease in quantities happens, the company subtracts the decrease from the most recent layers to the extent necessary.

The following computations, based on those in Illustration 9A-1 for Hernandez Company, illustrate the differences between the dollar-value LIFO retail method and the regular LIFO retail approach. Assume that the current 2017 price index is 112 (prior year = 100) and that the inventory ($56,000) has remained unchanged. In comparing Illustrations 9A-1 and 9A-5 (see below), note that the computations involved in find- ing the cost-to-retail percentage are exactly the same. However, the dollar-value method determines the increase that has occurred in the inventory in terms of base- year prices.

Appendix 9A: LIFO Retail Methods 469

From this information, we compute the inventory amount at cost:

ILLUSTRATION 9A-6 Ending Inventory at LIFO Cost, 2017—Fluctuating Prices

Ending Inventory at Base-Year

Retail Prices—2017

Layers at Base-Year Retail Prices

Price Index (percentage)

Cost-to-Retail (percentage)

Ending Inventory at LIFO Cost

$50,000 2016 $45,000 × 100% × 60% = $27,000 2017 5,000 × 112 × 70 = 3,920

$50,000 $30,920

ILLUSTRATION 9A-7 Comparison of Effect of Price Assumptions

LIFO (stable prices) LIFO (fluctuating prices)

Beginning inventory $27,000 $27,000 Increment 7,700 3,920

Ending inventory $34,700 $30,920

ILLUSTRATION 9A-8 Ending Inventory at LIFO Cost, 2018—Fluctuating Prices

Ending Inventory at Base-Year

Retail Prices—2018

Layers at Base-Year Retail Prices

Price Index (percentage)

Cost-to-Retail (percentage)

Ending Inventory at LIFO Cost

$54,000 2016 $45,000 × 100% × 60% = $27,000 2017 5,000 × 112 × 70 = 3,920 2018 4,000 × 120 × 75 = 3,600

$54,000 $34,520

As Illustration 9A-6 shows, before the conversion to cost takes place, Hernandez must restate layers of a particular year to the prices in effect in the year when the layer was added.

Note the difference between the LIFO approach (stable prices) and the dollar-value LIFO method as indicated below.

The difference of $3,780 ($34,700 − $30,920) results from an increase in the price of goods, not from an increase in the quantity of goods.

SUBSEQUENT ADJUSTMENTS UNDER DOLLAR-VALUE LIFO RETAIL The dollar-value LIFO retail method follows the same procedures in subsequent periods as the traditional dollar-value method discussed in Chapter 8. That is, when a real increase in inventory occurs, Hernandez adds a new layer.

To illustrate, using the data from the previous example, assume that the retail value of the 2018 ending inventory at current prices is $64,800, the 2018 price index is 120 per- cent of base-year, and the cost-to-retail percentage is 75 percent. In base-year dollars, the ending inventory is therefore $54,000 ($64,800/120%). Illustration 9A-8 shows the com- putation of the ending inventory at LIFO cost.

Conversely, when a real decrease in inventory develops, Hernandez “peels off” pre- vious layers at prices in existence when the layers were added. To illustrate, assume that

470 Chapter 9 Inventories: Additional Valuation Issues

in 2018 the ending inventory in base-year prices is $48,000. The computation of the LIFO inventory is as follows.

ILLUSTRATION 9A-9 Ending Inventory at LIFO Cost, 2018—Fluctuating Prices

Ending Inventory at Base-Year

Retail Prices—2018

Layers at Base-Year Retail Prices

Price Index (percentage)

Cost-to-Retail (percentage)

Ending Inventory at LIFO Cost

$48,000 2016 $45,000 × 100% × 60% = $27,000 2017 3,000 × 112 × 70 = 2,352

$48,000 $29,352

At Cost At Retail

Inventory, January 1, 2017 $ 5,210 $ 15,000 Net purchases in 2017 47,250 100,000 Net markups in 2017 7,000 Net markdowns in 2017 2,000 Sales revenue in 2017 95,000

The advantages and disadvantages of the lower-of-cost-or-market method (conven- tional retail) versus LIFO retail are the same for retail operations as for non-retail opera- tions. As a practical matter, a company’s selection of which retail inventory method to use often involves determining which method provides a lower taxable income. It might appear that retail LIFO will provide the lower taxable income in a period of rising prices. But this is not always the case. LIFO will provide an approximate current cost matching, but it states ending inventory at cost. The conventional retail method may have a large write-off because of the use of the lower-of-cost-or-market approach, which may offset the LIFO current cost matching.

CHANGING FROM CONVENTIONAL RETAIL TO LIFO Because conventional retail is a lower-of-cost-or-market approach, the company must restate beginning inventory to a cost basis when changing from the conventional retail to the LIFO method.14 The usual approach is to compute the cost basis from the pur- chases of the prior year, adjusted for both markups and markdowns.15

To illustrate, assume that Hakeman Clothing Store employs the conventional retail method but wishes to change to the LIFO retail method beginning in 2018. The amounts shown on the company’s books are as follows.

14Changing from the conventional retail method to LIFO retail represents a change in accounting principle. We provide an expanded discussion of accounting principle changes in Chapter 22. 15A logical question to ask is, “Why are only the purchases from the prior period considered and not also the beginning inventory?” Apparently, the IRS believes that “the purchases-only approach” provides a more reasonable cost basis. The IRS position is debatable. However, for our purposes, it seems appropriate to use the purchases-only approach.

Illustration 9A-10 shows the computation of ending inventory under the conven- tional retail method for 2017.

Review and Practice 471

Hakeman Clothing can then quickly approximate the ending inventory for 2017 under the LIFO retail method, as shown in Illustration 9A-11.

ILLUSTRATION 9A-10 Conventional Retail Inventory Method

Cost Retail

Inventory January 1, 2017 $ 5,210 $ 15,000 Net purchases 47,250 100,000 Net additional markups . 7,000

$52,460 122,000

Net markdowns (2,000) Sales revenue (95,000)

Ending inventory at retail $ 25,000

Establishment of cost-to-retail percentage ($52,460 ÷ $122,000) = 43% December 31, 2017, inventory at cost Inventory at retail $ 25,000 Cost-to-retail ratio × 43% Inventory at cost under conventional retail $ 10,750

ILLUSTRATION 9A-11 Conversion to LIFO Retail Inventory Method

December 31, 2017, Inventory at LIFO Cost

Ending inventory = Retail

$25,000 × Ratio

45%* = LIFO

$11,250

*The cost-to-retail ratio was computed as follows.

Net purchases at cost Net purchases at retail plus

= $47,250$100,000 + $7,000 − $2,000 =

45%

markups less markdowns

The difference of $500 ($11,250 − $10,750) between the LIFO retail method and the conventional retail method in the ending inventory for 2017 is the amount by which the company must adjust beginning inventory for 2018. The entry to adjust the inventory to a cost basis is as follows.

Inventory 500 Adjustment to Record Inventory at Cost 500

REVIEW AND PRACTICE KEY TERMS REVIEW

average days to sell inventory, 466

conventional retail inventory method, 460

cost-of-goods-sold method, 446

cost-to-retail ratio, 459 designated market value, 449 *dollar-value LIFO retail

method, 468

gross profit method, 456 gross profit percentage, 456 hedging, 455 inventory turnover, 466 *LIFO retail method, 466 loss method, 446 lower limit (floor), 448 lower-of-cost-or-market

(LCM), 448

lower-of-cost-or-net realizable value (LCNRV), 444

lump-sum (basket) purchase, 453

markdown, 460 markdown cancellations, 460 markup, 459 markup cancellations, 460

net realizable value (NRV), 444

net realizable value less a normal profit margin, 448

purchase commitments, 453 retail inventory method, 459 upper limit (ceiling), 448

LEARNING OBJECTIVES REVIEW 1 Understand and apply the lower-of-cost-or-net realizable value rule. If inventory declines in value below its origi-

nal cost, for whatever reason, a company should write down the inventory to reflect this loss. The general rule is to abandon the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost. In these situations, companies write down inventory to net realizable value to record this loss.

2 Understand and apply the lower-of-cost-or-market rule. For companies that use the LIFO or the retail inventory methods of costing inventory, a better measure for reporting the decline in value of inventories is to use replacement cost subject to certain constraints. Rather than comparing cost to net realizable value, under the lower-of-cost-or-market approach, companies compare a “designated market value” of the inventory to cost. Under this exception to the general rule, companies write inventory down to the designated market value to record the loss.

3 Understand other inventory valuation issues. Companies value inventory at net realizable value when (1) there is a controlled market with a quoted price applicable to all quantities, (2) no significant costs of disposal are involved, and (3) the cost figures are too difficult to obtain.

When a company purchases a group of varying units at a single lump-sum price—a so-called basket purchase—the company may allocate the total purchase price to the individual items on the basis of relative sales value.

Accounting for purchase commitments is controversial. Some argue that companies should report purchase commitment contracts as assets and liabilities at the time the contract is signed. Others believe that recognition at the delivery date is most appropriate. The FASB neither excludes nor recommends the recording of assets and liabilities for purchase commitments. However, companies record losses when market prices fall relative to the commitment price.

4 Determine ending inventory by applying the gross profit method. Companies follow these steps to determine end- ing inventory by the gross profit method. (1) Compute the gross profit percentage on selling price. (2) Compute gross profit by multiplying net sales by the gross profit percentage. (3) Compute cost of goods sold by subtracting gross profit from net sales. (4) Compute ending inventory by subtracting cost of goods sold from total goods available for sale.

5 Determine ending inventory by applying the retail inventory method. Companies follow these steps to determine ending inventory by the conventional retail method. (1) To estimate inventory at retail, deduct the sales for the period from the retail value of the goods available for sale. (2) To find the cost-to-retail ratio for all goods passing through a department or firm, divide the total goods available for sale at cost by the total goods available at retail. (3) Convert the inventory valued at retail to approximate cost by applying the cost-to-retail ratio.

6 Explain how to report and analyze inventory. Accounting standards require financial statement disclosure of (1) the composition of the inventory (in the balance sheet or a separate schedule in the notes), (2) significant or unusual inventory financing arrangements, and (3) inventory costing methods employed (which may differ for different elements of inventory). Accounting standards also require the consistent application of costing methods from one period to another. Common ratios used in the management and evaluation of inventory levels are inventory turnover and average days to sell inventory.

*7 Determine ending inventory by applying the LIFO retail methods. The application of LIFO retail is made under two assumptions: stable prices and fluctuating prices.

Procedures under stable prices: (a) Because the LIFO method is a cost method, both markups and markdowns must be considered in obtaining the proper cost-to-retail percentage. (b) Since the LIFO method is concerned only with the additional layer, or the amount that should be subtracted from the previous layer, the beginning inventory is excluded from the cost- to-retail percentage. (c) The markups and markdowns apply only to the goods purchased during the current period and not to the beginning inventory.

Procedures under fluctuating prices: The steps are the same as for stable prices except that in computing the LIFO inventory under a dollar-value LIFO approach, the dollar increase in inventory is found and deflated to beginning-of-the- year prices. Doing so will determine whether actual increases or decreases in quantity have occurred. If quantities increase, this increase is priced at the new index to compute the new layer. If quantities decrease, the decrease is subtracted from the most recent layers to the extent necessary.

ENHANCED REVIEW AND PRACTICE Go online for multiple-choice questions with solutions, review exercises with solutions, and a full glossary of all key terms.

472 Chapter 9 Inventories: Additional Valuation Issues

Questions 473

PRACTICE PROBLEM

Norwood Company makes miniature circuit boards that are components of wireless phones and personal organizers. The com- pany has experienced strong growth, and you are especially interested in how well Norwood is managing its inventory balanc- es. You have collected the following information for the current year.

Inventory at the beginning of year $ 1,026,000 Inventory at the end of year, before any adjustments 1,007,000 Total cost of goods sold, before any adjustments 11,776,000

The company values inventory at lower-of-cost (using LIFO cost fl ow assumption)-or-market; use the cost-of-goods-sold method.

Instructions (a) Compute Norwood’s inventory turnover before any adjustment. (b) Recompute the inventory turnover after adjusting Norwood’s inventory information for the following items.

1. During the year, Norwood recorded sales and costs of goods sold on $22,000 of units shipped to various wholesalers on consignment. At year-end, none of these units have been sold by wholesalers.

2. Shipping contracts changed 2 months ago from f.o.b. shipping point to f.o.b. destination point. At the end of the year, $25,000 of products are en route to China and will not arrive until after financial statements are released. Current in- ventory balances do not reflect this change in policy.

3. At the end of the year, Norwood determined that a certain section of inventory with an historical cost of $112,000 has a replacement cost of $100,800, net realizable value of $101,000 and net realizable value less a normal profit margin of $90,400. There is no need to make a lower-of-cost-or-market adjustment to other inventory.

SOLUTION

(a) $11,776,000 ($1,026,000 + $1,007,000)/2 = 11.6 times

(b) Adjustments to ending inventory

Item

Adjustment to Ending Inventory Explanation

1. Consigned goods $22,000 Norwood should count the goods it has consigned in other stores.

2. Goods in transit $25,000 Goods offi cially change hands at the point of destination. Norwood should still show these goods in inventory (not cost of goods sold), until they reach the destination.

3. Lower-of-cost-or- market

$(11,200) ($112,000 − $100,800). The correct valuation is $100,800 since the market designation of $100,800 is less than the original cost.

Adjusted inventory turnover = $11,740,200 a

($1,026,000 + $1,042,800b)/2 = 11.4 times aCost of goods sold: $11,776,000 − $22,000 − $25,000 + $11,200 = $11,740,200 bEnding inventory: $1,007,000 + $22,000 + $25,000 − $11,200 = $1,042,800

Exercises, Problems, Problem Solution Walkthrough Videos, and many more assessment tools and resources are available for practice in WileyPLUS.

Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.

1. Where there is evidence that the utility of inventory goods, as part of their disposal in the ordinary course of business, will be less than cost, what is the proper accounting treatment?

2. Why are inventories valued at the lower-of-cost-or-net realizable value (LCNRV)? What are the arguments against the use of the LCNRV method of valuing inven- tories?

QUESTIONS

474 Chapter 9 Inventories: Additional Valuation Issues

3. What approaches may be employed in applying the LCNRV procedure? Which approach is normally used and why?

4. In some instances, accounting principles require a depar- ture from valuing inventories at cost alone. Determine the proper unit inventory price in the following cases using LCNRV.

Cases

1 2 3 4 5

Cost $15.90 $16.10 $15.90 $15.90 $15.90 Sales value 14.80 19.20 15.20 10.40 17.80 Estimated cost to complete 1.50 1.90 1.65 .80 1.00 Estimated cost to sell .50 .70 .55 .40 .60

5. What method(s) might be used in the accounts to record a loss due to a price decline in the inventories? Discuss.

6. Explain the rationale for the ceiling and floor in the lower-of-cost-or-market method of valuing inventories.

7. In some instances, accounting principles require a depar- ture from valuing inventories at cost alone. Determine the proper unit inventory price in the following cases, under the lower-of-cost-or-market rule.

Cases

1 2 3 4 5

Cost $15.90 $16.10 $15.90 $15.90 $15.90 Net realizable value 14.50 19.20 15.20 10.40 16.40 Net realizable value less normal profit 12.80 17.60 13.75 8.80 14.80 Market (replacement cost) 14.80 17.20 12.80 9.70 16.80

8. What factors might call for inventory valuation at sales prices (net realizable value or market price)?

9. Under what circumstances is relative sales value an appropriate basis for determining the price assigned to inventory?

10. At December 31, 2017, Ashley Co. has outstanding pur- chase commitments for 150,000 gallons, at $6.20 per gallon, of a raw material to be used in its manufacturing process. The company prices its raw material inventory at cost or market, whichever is lower. Assuming that the market price as of December 31, 2017, is $5.90, how would you treat this situation in the accounts?

11. What are the major uses of the gross profit method? 12. Distinguish between gross profit as a percentage of cost

and gross profit as a percentage of sales price. Convert the following gross profit percentages based on cost to

gross profit percentages based on sales price: 25% and 331/3%. Convert the following gross profit percentages based on sales price to gross profit percentages based on cost: 331/3% and 60%.

13. Adriana Co., with annual net sales of $5 million, main- tains a markup of 25% based on cost. Adriana’s expenses average 15% of net sales. What is Adriana’s gross profit and net profit in dollars?

14. A fire destroys all of the merchandise of Assante Com- pany on February 10, 2017. Presented below is informa- tion compiled up to the date of the fire.

Inventory, January 1, 2017 $ 400,000 Sales revenue to February 10, 2017 1,950,000 Purchases to February 10, 2017 1,140,000 Freight-in to February 10, 2017 60,000 Rate of gross profi t on selling price 40%

What is the approximate inventory on February 10, 2017? 15. What conditions must exist for the retail inventory

method to provide valid results? 16. The conventional retail inventory method yields results

that are essentially the same as those yielded by the lower-of-cost-or-market method. Explain. Prepare an illustration of how the retail inventory method reduces inventory to market.

17. (a) Determine the ending inventory under the conven- tional retail method for the furniture department of Mayron Department Stores from the following data.

Cost Retail

Inventory, Jan. 1 $ 149,000 $ 283,500 Purchases 1,400,000 2,160,000 Freight-in 70,000 Markups, net 92,000 Markdowns, net 48,000 Sales revenue 2,175,000

(b) If the results of a physical inventory indicated an in- ventory at retail of $295,000, what inferences would you draw?

18. Deere and Company reported inventory in its balance sheet as follows.

Inventories $1,999,100,000

What additional disclosures might be necessary to present the inventory fairly?

19. Of what significance is inventory turnover to a retail store? *20. What modifications to the conventional retail method are

necessary to approximate a LIFO retail flow?

BRIEF EXERCISES

BE9-1 (L01) Presented below is information related to Rembrandt Inc.’s inventory. (per unit) Skis Boots Parkas

Historical cost $190.00 $106.00 $53.00 Selling price 212.00 145.00 73.75 Cost to sell 19.00 8.00 2.50 Cost to complete 32.00 29.00 21.25

Determine the following: (a) the net realizable value for each item, and (b) the carrying value of each item under LCNRV.

BE9-2 (L01) Floyd Corporation has the following four items in its ending inventory.

Item Cost Net Realizable Value (NRV)

Jokers $2,000 $2,100 Penguins 5,000 4,950 Riddlers 4,400 4,625 Scarecrows 3,200 3,830

Determine the following: (a) the LCNRV for each item, and (b) the amount of write-down, if any, using (1) an item-by-item LCNRV evaluation and (2) a total category LCNRV evaluation. BE9-3 (L01) Kumar Inc. uses a perpetual inventory system. At January 1, 2017, inventory was $214,000,000 at both cost and net realizable value. At December 31, 2017, the inventory was $286,000,000 at cost and $265,000,000 at net realizable value. Pre- pare the entry under (a) the cost-of-goods-sold method and (b) the loss method. BE9-4 (L02) Presented below is information related to Rembrandt Inc.’s inventory, assuming Rembrandt uses lower-of-LIFO cost-or-market.

(per unit) Skis Boots Parkas

Historical cost $190.00 $106.00 $53.00 Selling price 212.00 145.00 73.75 Cost to distribute 19.00 8.00 2.50 Current replacement cost 203.00 105.00 51.00 Normal profi t margin 32.00 29.00 21.25

Determine the following: (a) the two limits to market value (i.e., the ceiling and the floor) that should be used in the lower-of- cost-or-market computation for skis, (b) the cost amount that should be used in the lower-of-cost-or-market comparison of boots, and (c) the market amount that should be used to value parkas on the basis of the lower-of-cost-or-market. BE9-5 (L02) Kumar Inc. uses LIFO inventory costing. At January 1, 2017, inventory was $214,000 at both cost and market value. At December 31, 2017, the inventory was $286,000 at cost and $265,000 at market value. Prepare the necessary December 31 entry under (a) the cost-of-goods-sold method and (b) the loss method. BE9-6 (L03) Bell, Inc. buys 1,000 computer game CDs from a distributor who is discontinuing those games. The purchase price for the lot is $8,000. Bell will group the CDs into three price categories for resale, as indicated below.

Group No. of CDs Price per CD

1 100 $ 5 2 800 10 3 100 15

Determine the cost per CD for each group, using the relative sales value method. BE9-7 (L03) Kemper Company signed a long-term noncancelable purchase commitment with a major supplier to purchase raw materials in 2018 at a cost of $1,000,000. At December 31, 2017, the raw materials to be purchased have a market value of $950,000. Prepare any necessary December 31, 2017, entry. BE9-8 (L03) Use the information for Kemper Company from BE9-7. In 2018, Kemper paid $1,000,000 to obtain the raw mate- rials which were worth $950,000. Prepare the entry to record the purchase. BE9-9 (L04) Fosbre Corporation’s April 30 inventory was destroyed by fire. January 1 inventory was $150,000, and pur- chases for January through April totaled $500,000. Sales revenue for the same period was $700,000. Fosbre’s normal gross profit percentage is 35% on sales. Using the gross profit method, estimate Fosbre’s April 30 inventory that was destroyed by fire. BE9-10 (L05) Boyne Inc. had beginning inventory of $12,000 at cost and $20,000 at retail. Net purchases were $120,000 at cost and $170,000 at retail. Net markups were $10,000, net markdowns were $7,000, and sales revenue was $147,000. Compute ending inventory at cost using the conventional retail method. BE9-11 (L06) In its 2015 annual report, Gap Inc. reported inventory of $1,889 million on January 31, 2015, and $1,928 million on February 1, 2014, cost of goods sold of $10,146 million for 2015, and net sales of $16,435 million. Compute Gap’s inventory turnover and the average days to sell inventory for the fiscal year 2015. *BE9-12 (L07) Use the information for Boyne Inc. from BE9-10. Compute ending inventory at cost using the LIFO retail method. *BE9-13 (L07) Use the information for Boyne Inc. from BE9-10, and assume the price level increased from 100 at the beginning of the year to 115 at year-end. Compute ending inventory at cost using the dollar-value LIFO retail method.

Brief Exercises 475

476 Chapter 9 Inventories: Additional Valuation Issues

EXERCISES

E9-1 (L01) EXCEL (LCNRV) The inventory of Oheto Company on December 31, 2017, consists of the following items.

Part Quantity Cost per Unit Net Realizable Value

110 600 $ 95 $100 111 1,000 60 52 112 500 80 76 113 200 170 180 120 400 205 208

121a 1,600 16 1 122 300 240 235

aPart No. 121 is obsolete and has a realizable value of $1 each as scrap.

Instructions 1. Determine the inventory as of December 31, 2017, by the LCNRV method, applying this method to each item. 2. Determine the inventory by the LCNRV method, applying the method to the total of the inventory.

E9-2 (L01) (LCNRV) Riegel Company uses the LCNRV method, on an individual-item basis, in pricing its inventory items. The inventory at December 31, 2017, consists of products D, E, F, G, H, and I. Relevant per unit data for these products appear below.

Item

D E F G H I

Estimated selling price $120 $110 $95 $90 $110 $90 Cost 75 80 80 80 50 36 Cost to complete 30 30 25 35 30 30 Selling costs 10 18 10 20 10 20

Instructions Using the LCNRV rule, determine the proper unit value for balance sheet reporting purposes at December 31, 2017, for each of the inventory items above. E9-3 (L01) (LCNRV) Sedato Company follows the practice of pricing its inventory at LCNRV, on an individual-item basis.

Item No. Quantity Cost

per Unit Estimated

Selling Price Cost to Complete

and Sell

1320 1,200 $3.20 $4.50 $1.60 1333 900 2.70 3.40 1.00 1426 800 4.50 5.00 1.40 1437 1,000 3.60 3.20 1.35 1510 700 2.25 3.25 1.40 1522 500 3.00 3.90 0.80 1573 3,000 1.80 2.50 1.20 1626 1,000 4.70 6.00 1.50

Instructions From the information above, determine the amount of Sedato Company inventory. E9-4 (L01) (LCNRV—Journal Entries) Dover Company began operations in 2017 and determined its ending inventory at cost and at LCNRV at December 31, 2017, and December 31, 2018. This information is presented below.

Cost Net Realizable Value

12/31/17 $346,000 $322,000 12/31/18 410,000 390,000

Instructions (a) Prepare the journal entries required at December 31, 2017, and December 31, 2018, assuming inventory is recorded at

LCNRV and a perpetual inventory system using the cost-of-goods-sold method. (b) Prepare journal entries required at December 31, 2017, and December 31, 2018, assuming inventory is recorded at

LCNRV and a perpetual system using the loss method. (c) Which of the two methods above provides the higher net income in each year?

E9-5 (L01) (LCNRV—Valuation Account) Presented below is information related to Knight Enterprises.

Jan. 31 Feb. 28 Mar. 31 Apr. 30

Inventory at cost $15,000 $15,100 $17,000 $14,000 Inventory at LCNRV 14,500 12,600 15,600 13,300 Purchases for the month 17,000 24,000 26,500 Sales for the month 29,000 35,000 40,000

Instructions (a) From the information, prepare (as far as the data permit) monthly income statements in columnar form for February,

March, and April. The inventory is to be shown in the statement at cost; the gain or loss due to market fluctuations is to be shown separately (using a valuation account).

(b) Prepare the journal entry required to establish the valuation account at January 31 and entries to adjust it monthly thereafter.

E9-6 (L01) (LCNRV—Error Effect) LaGreca Company uses the LCNRV method, on an individual-item basis, in pricing its inventory items. The inventory at December 31, 2017, included product X. Relevant per-unit data for product X are as follows.

Estimated selling price $50 Cost 40 Estimated selling costs 14 Normal profi t 9

There were 1,000 units of product X on hand at December 31, 2017. Product X was incorrectly valued at $38 per unit for reporting purposes. All 1,000 units were sold in 2018.

Instructions Compute the effect of this error on net income for 2017 and the effect on net income for 2018, and indicate the direction of the misstatement for each year.

E9-7 (L02) (Lower-of-Cost-or-Market) Referring to the inventory data for Sedato Company in E9-3, assume that Sedato fol- lows the practice of pricing its inventory at the lower-of-cost-or-market, on an individual-item basis.

Item No. Quantity Cost

per Unit Cost

to Replace Estimated

Selling Price Cost of Completion

and Disposal Normal Profi t

1320 1,200 $3.20 $3.00 $4.50 $0.35 $1.25 1333 900 2.70 2.30 3.50 0.50 0.50 1426 800 4.50 3.70 5.00 0.40 1.00 1437 1,000 3.60 3.10 3.20 0.25 0.90 1510 700 2.25 2.00 3.25 0.80 0.60 1522 500 3.00 2.70 3.80 0.40 0.50 1573 3,000 1.80 1.60 2.50 0.75 0.50 1626 1,000 4.70 5.20 6.00 0.50 1.00

Instructions From the information above, determine the amount of Sedato Company inventory.

E9-8 (L02) (Lower-of-Cost-or-Market—Journal Entries) Corrs Company began operations in 2016 and determined its end- ing inventory at cost and at lower-of-LIFO cost-or-market at December 31, 2016, and December 31, 2017. This information is presented below.

Cost Lower-of-Cost-or-Market 12/31/16 $356,000 $327,000 12/31/17 420,000 395,000

Instructions (a) Prepare the journal entries required at December 31, 2016, and December 31, 2017, assuming that the inventory is

recorded at market, and a perpetual inventory system (cost-of-goods-sold method) is used. (b) Prepare journal entries required at December 31, 2016, and December 31, 2017, assuming that the inventory is recorded

at market under a perpetual system (loss method is used). (c) Which of the two methods above provides the higher net income in each year?

Exercises 477

478 Chapter 9 Inventories: Additional Valuation Issues

E9-9 (L03) EXCEL (Relative Sales Value Method) Phil Collins Realty Corporation purchased a tract of unimproved land for $55,000. This land was improved and subdivided into building lots at an additional cost of $34,460. These building lots were all of the same size but owing to differences in location were offered for sale at different prices as follows.

Group No. of Lots Price per Lot

1 9 $3,000 2 15 4,000 3 17 2,400

Operating expenses for the year allocated to this project total $18,200. Lots unsold at the year-end were as follows.

Group 1 5 lots Group 2 7 lots Group 3 2 lots

Instructions At the end of the fiscal year Phil Collins Realty Corporation instructs you to arrive at the net income realized on this operation to date.

E9-10 (L03) (Relative Sales Value Method) During 2017, Pretenders Furniture Company purchases a carload of wicker chairs. The manufacturer sells the chairs to Pretenders for a lump sum of $59,850 because it is discontinuing manufacturing operations and wishes to dispose of its entire stock. Three types of chairs are included in the carload. The three types and the estimated selling price for each are listed below.

Type No. of Chairs Estimated Selling Price Each

Lounge chairs 400 $90 Armchairs 300 80 Straight chairs 700 50

During 2017, Pretenders sells 200 lounge chairs, 100 armchairs, and 120 straight chairs.

Instructions What is the amount of gross profit realized during 2017? What is the amount of inventory of unsold straight chairs on December 31, 2017?

E9-11 (L03) (Purchase Commitments) Marvin Gaye Company has been having difficulty obtaining key raw materials for its manufacturing process. The company therefore signed a long-term noncancelable purchase commitment with its largest sup- plier of this raw material on November 30, 2017, at an agreed price of $400,000. At December 31, 2017, the raw material had declined in price to $365,000.

Instructions What entry would you make on December 31, 2017, to recognize these facts?

E9-12 (L03) (Purchase Commitments) At December 31, 2017, Indigo Girls Company has outstanding noncancelable pur- chase commitments for 36,000 gallons, at $3.00 per gallon, of raw material to be used in its manufacturing process. The company prices its raw material inventory at cost or market, whichever is lower.

Instructions (a) Assuming that the market price as of December 31, 2017, is $3.30, how would this matter be treated in the accounts and

statements? Explain. (b) Assuming that the market price as of December 31, 2017, is $2.70, instead of $3.30, how would you treat this situation

in the accounts and statements? (c) Give the entry in January 2018, when the 36,000-gallon shipment is received, assuming that the situation given in (b)

above existed at December 31, 2017, and that the market price in January 2018 was $2.70 per gallon. Give an explanation of your treatment.

E9-13 (L04) (Gross Profit Method) Each of the following gross profit percentages is expressed in terms of cost.

1. 20%. 3. 331/3%. 2. 25%. 4. 50%.

Instructions Indicate the gross profit percentage in terms of sales for each of the above.

E9-14 (L04) (Gross Profit Method) Mark Price Company uses the gross profit method to estimate inventory for monthly reporting purposes. Presented below is information for the month of May.

Inventory, May 1 $ 160,000 Purchases (gross) 640,000 Freight-in 30,000 Sales revenue 1,000,000 Sales returns 70,000 Purchase discounts 12,000

Instructions (a) Compute the estimated inventory at May 31, assuming that the gross profit is 30% of sales. (b) Compute the estimated inventory at May 31, assuming that the gross profit is 30% of cost.

E9-15 (L04) (Gross Profit Method) Tim Legler requires an estimate of the cost of goods lost by fire on March 9. Merchandise on hand on January 1 was $38,000. Purchases since January 1 were $72,000; freight-in, $3,400; purchase returns and allowances, $2,400. Sales are made at 331/3% above cost and totaled $100,000 to March 9. Goods costing $10,900 were left undamaged by the fire; remaining goods were destroyed.

Instructions (a) Compute the cost of goods destroyed. (b) Compute the cost of goods destroyed, assuming that the gross profit is 331/3% of sales.

E9-16 (L04) (Gross Profit Method) Wallace Company lost most of its inventory in a fire in December just before the year-end physical inventory was taken. The corporation’s books disclosed the following.

Beginning inventory $170,000 Sales revenue $650,000 Purchases for the year 390,000 Sales returns 24,000 Purchase returns 30,000 Rate of gross profi t on net sales 40%

Merchandise with a selling price of $21,000 remained undamaged after the fire. Damaged merchandise with an original selling price of $15,000 had a net realizable value of $5,300.

Instructions Compute the amount of the loss as a result of the fire, assuming that the corporation had no insurance coverage.

E9-17 (L04) (Gross Profit Method) You are called by Tim Duncan of Spurs Co. on July 16 and asked to prepare a claim for insurance as a result of a theft that took place the night before. You suggest that an inventory be taken immediately. The follow- ing data are available.

Inventory, July 1 $ 38,000 Purchases—goods placed in stock July 1–15 85,000 Sales revenue—goods delivered to customers (gross) 116,000 Sales returns—goods returned to stock 4,000

Your client reports that the goods on hand on July 16 cost $30,500, but you determine that this figure includes goods of $6,000 received on a consignment basis. Your past records show that sales are made at approximately 40% over cost. Duncan’s insur- ance covers only goods owned.

Instructions Compute the claim against the insurance company.

E9-18 (L04) (Gross Profit Method) Gheorghe Moresan Lumber Company handles three principal lines of merchandise with these varying rates of gross profit on cost.

Lumber 25% Millwork 30% Hardware and fi ttings 40%

On August 18, a fire destroyed the office, lumber shed, and a considerable portion of the lumber stacked in the yard. To file a report of loss for insurance purposes, the company must know what the inventories were immediately preceding the fire. No detail or perpetual inventory records of any kind were maintained. The only pertinent information you are able to obtain are the following facts from the general ledger, which was kept in a fireproof vault and thus escaped destruction.

Lumber Millwork Hardware

Inventory, Jan. 1, 2017 $ 250,000 $ 90,000 $ 45,000 Purchases to Aug. 18, 2017 1,500,000 375,000 160,000 Sales revenue to Aug. 18, 2017 2,080,000 533,000 210,000

Exercises 479

480 Chapter 9 Inventories: Additional Valuation Issues

Instructions Submit your estimate of the inventory amounts immediately preceding the fire.

E9-19 (L04) (Gross Profit Method) Presented below is information related to Aaron Rodgers Corporation for the current year.

Beginning inventory $ 600,000 Purchases 1,500,000 Total goods available for sale $2,100,000 Sales revenue 2,500,000

Instructions Compute the ending inventory, assuming that (a) gross profit is 45% of sales, (b) gross profit is 60% of cost, (c) gross profit is 35% of sales, and (d) gross profit is 25% of cost.

E9-20 (L05) (Retail Inventory Method) Presented below is information related to Bobby Engram Company.

Cost Retail

Beginning inventory $ 58,000 $100,000 Purchases (net) 122,000 200,000 Net markups 10,345 Net markdowns 26,135 Sales revenue 186,000

Instructions (a) Compute the ending inventory at retail. (b) Compute a cost-to-retail percentage (round to two decimals) under the following conditions.

(1) Excluding both markups and markdowns. (2) Excluding markups but including markdowns. (3) Excluding markdowns but including markups. (4) Including both markdowns and markups.

(c) Which of the methods in (b) above (1, 2, 3, or 4) does the following? (1) Provides the most conservative estimate of ending inventory. (2) Provides an approximation of lower-of-cost-or-market. (3) Is used in the conventional retail method.

(d) Compute ending inventory at lower-of-cost-or-market (round to nearest dollar). (e) Compute cost of goods sold based on (d). (f) Compute gross margin based on (d).

E9-21 (L05) (Retail Inventory Method) Presented below is information related to Ricky Henderson Company.

Cost Retail

Beginning inventory $ 200,000 $ 280,000 Purchases 1,375,000 2,140,000 Markups 95,000 Markup cancellations 15,000 Markdowns 35,000 Markdown cancellations 5,000 Sales revenue 2,200,000

Instructions Compute the inventory by the conventional retail inventory method.

E9-22 (L05) (Retail Inventory Method) The records of Ellen’s Boutique report the following data for the month of April.

Sales revenue $99,000 Purchases (at cost) $48,000 Sales returns 2,000 Purchases (at sales price) 88,000 Markups 10,000 Purchase returns (at cost) 2,000 Markup cancellations 1,500 Purchase returns (at sales price) 3,000 Markdowns 9,300 Beginning inventory (at cost) 30,000 Markdown cancellations 2,800 Beginning inventory (at sales price) 46,500 Freight on purchases 2,400

Exercises 481

Instructions Compute ConAgra’s (a) inventory turnover and (b) the average days to sell inventory for 2014 and 2013.

*E9-24 (L07) (Retail Inventory Method—Conventional and LIFO) Keller Company began operations on January 1, 2016, adopting the conventional retail inventory system. None of the company’s merchandise was marked down in 2016 and, because there was no beginning inventory, its ending inventory for 2016 of $38,100 would have been the same under either the conven- tional retail system or the LIFO retail system.

On December 31, 2017, the store management considers adopting the LIFO retail system and desires to know how the December 31, 2017, inventory would appear under both systems. All pertinent data regarding purchases, sales, markups, and markdowns are shown below. There has been no change in the price level.

Cost Retail

Inventory, Jan. 1, 2017 $ 38,100 $ 60,000 Markdowns (net) 13,000 Markups (net) 22,000 Purchases (net) 130,900 178,000 Sales (net) 167,000

Instructions Determine the cost of the 2017 ending inventory under both (a) the conventional retail method and (b) the LIFO retail method.

*E9-25 (L07) (Retail Inventory Method—Conventional and LIFO) Leonard Company began operations late in 2016 and adopted the conventional retail inventory method. Because there was no beginning inventory for 2016 and no markdowns dur- ing 2016, the ending inventory for 2016 was $14,000 under both the conventional retail method and the LIFO retail method. At the end of 2017, management wants to compare the results of applying the conventional and LIFO retail methods. There was no change in the price level during 2017. The following data are available for computations.

Cost Retail

Inventory, January 1, 2017 $14,000 $20,000 Sales revenue 80,000 Net markups 9,000 Net markdowns 1,600 Purchases 58,800 81,000 Freight-in 7,500 Estimated theft 2,000

Instructions Compute the cost of the 2017 ending inventory under both (a) the conventional retail method and (b) the LIFO retail method.

*E9-26 (L07) (Dollar-Value LIFO Retail) You assemble the following information for Seneca Department Store, which com- putes its inventory under the dollar-value LIFO method.

Cost Retail

Inventory on January 1, 2017 $216,000 $300,000 Purchases 364,800 480,000 Increase in price level for year 9%

Instructions Compute the cost of the inventory on December 31, 2017, assuming that the inventory at retail is (a) $294,300 and (b) $365,150.

Instructions Compute the ending inventory by the conventional retail inventory method.

E9-23 (L06) (Analysis of Inventories) The financial statements of ConAgra Foods, Inc.’s 2014 annual report disclose the fol- lowing information.

(in millions) 2014 2013 2012

Year-end inventories $2,201 $2,077 $2,341

Fiscal Year

2014 2013

Net sales $17,703 $15,427 Cost of goods sold 13,980 11,864 Net income 315 786

482 Chapter 9 Inventories: Additional Valuation Issues

*E9-27 (L07) (Dollar-Value LIFO Retail) Presented below is information related to Langston Hughes Corporation.

Price LIFO Index Cost Retail

Inventory on December 31, 2017, when dollar-value LIFO is adopted 100 $36,000 $ 74,500 Inventory, December 31, 2018 110 ? 100,100

Instructions Compute the ending inventory under the dollar-value LIFO method at December 31, 2018. The cost-to-retail ratio for 2018 was 60%.

*E9-28 (L07) (Conventional Retail and Dollar-Value LIFO Retail) Amiras Corporation began operations on January 1, 2017, with a beginning inventory of $30,100 at cost and $50,000 at retail. The following information relates to 2017.

Retail

Net purchases ($108,500 at cost) $150,000 Net markups 10,000 Net markdowns 5,000 Sales revenue 126,900

Instructions (a) Assume Amiras decided to adopt the conventional retail method. Compute the ending inventory to be reported in the

balance sheet. (b) Assume instead that Amiras decides to adopt the dollar-value LIFO retail method. The appropriate price indexes are

100 at January 1 and 110 at December 31. Compute the ending inventory to be reported in the balance sheet. (c) On the basis of the information in part (b), compute cost of goods sold.

*E9-29 (L07) (Dollar-Value LIFO Retail) Connie Chung Corporation adopted the dollar-value LIFO retail inventory method on January 1, 2016. At that time the inventory had a cost of $54,000 and a retail price of $100,000. The following information is available.

Year-End Current Year Year-End Inventory at Retail Cost—Retail % Price Index

2016 $118,720 57% 106 2017 138,750 60% 111 2018 125,350 61% 115 2019 162,500 58% 125

The price index at January 1, 2016, is 100.

Instructions Compute the ending inventory at December 31 of the years 2016–2019. (Round to the nearest dollar.)

*E9-30 (L07) (Change to LIFO Retail) John Olerud Ltd., a local retailing concern in the Bronx, New York, has decided to change from the conventional retail inventory method to the LIFO retail method starting on January 1, 2018. The company recomputed its ending inventory for 2017 in accordance with the procedures necessary to switch to LIFO retail. The inventory computed was $212,600.

Instructions Assuming that John Olerud Ltd.’s ending inventory for 2017 under the conventional retail inventory method was $205,000, prepare the appropriate journal entry on January 1, 2018.

PROBLEMS

P9-1 (L01) (LCNRV) Remmers Company manufactures desks. Most of the company’s desks are standard models and are sold on the basis of catalog prices. At December 31, 2017, the following finished desks (10 desks in each category) appear in the company’s inventory.

Finished Desks A B C D

2017 catalog selling price $45 $48 $90 $105 FIFO cost per inventory list 12/31/17 47 45 83 96 Estimated cost to complete and sell 5 11 26 20 2018 catalog selling price 50 54 90 120

The 2017 catalog was in effect through November 2017, and the 2018 catalog is effective as of December 1; catalog prices are net of the usual discounts.

Instructions At what amount should each of the four desks appear in the company’s December 31, 2017, inventory, assuming that the company has adopted a lower-of-FIFO-cost-or-net realizable value (LCNRV) approach for valuation of inventories on an individual-item basis?

P9-2 (L01) (LCNRV) Garcia Home Improvement Company installs replacement siding, windows, and louvered glass doors for single-family homes and condominium complexes. The company is in the process of preparing its annual financial statements for the fiscal year ended May 31, 2017. Jim Alcide, controller for Garcia, has gathered the following data concerning inventory.

At May 31, 2017, the balance in Garcia’s Raw Materials Inventory account was $408,000, and Allowance to Reduce Inventory to NRV had a credit balance of $27,500. Alcide summarized the relevant inventory cost and market data at May 31, 2017, in the schedule below.

Alcide assigned Patricia Devereaux, an intern from a local college, the task of calculating the amount that should appear on Garcia’s May 31, 2017, financial statements for inventory under the LCNRV rule as applied to each item in inventory. Devereaux expressed concern over departing from the historical cost principle.

Net Realizable Cost Sales Price Value

Aluminum siding $ 70,000 $ 64,000 $ 56,000 Cedar shake siding 86,000 94,000 84,800 Louvered glass doors 112,000 186,400 168,300 Thermal windows 140,000 154,800 140,000

Total $408,000 $499,200 $449,100

Instructions (a) Determine the proper balance in Allowance to Reduce Inventory to NRV at May 31, 2017. (b) For the fiscal year ended May 31, 2017, determine the amount of the gain or loss that would be recorded (using the loss

method) due to the change in Allowance to Reduce Inventory to NRV. (c) Explain the rationale for the use of the LCNRV rule as it applies to inventories.

P9-3 (L01) (LCNRV—Cost-of-Goods-Sold and Loss) Malone Company determined its ending inventory at cost and at LCNRV at December 31, 2017, December 31, 2018, and December 31, 2019, as shown below.

Cost NRV

12/31/17 $650,000 $650,000 12/31/18 780,000 712,000 12/31/19 905,000 830,000

Instructions (a) Prepare the journal entries required at December 31, 2018, and at December 31, 2019, assuming that a perpetual inven-

tory system and the cost-of-goods-sold method of adjusting to LCNRV is used. (b) Prepare the journal entries required at December 31, 2018, and at December 31, 2019, assuming that a perpetual inven-

tory is recorded at cost and reduced to LCNRV using the loss method.

P9-4 (L02) EXCEL GROUPWORK (Lower-of-Cost-or-Market) Referring to the situation in P9-2 for Garcia Home Improve- ment Company, consider the following expanded data at May 31, 2017. Assume Garcia uses LIFO inventory costing.

Problems 483

Replacement Sales Net Realizable Normal Cost Cost Price Value Profi t

Aluminum siding $ 70,000 $ 62,500 $ 64,000 $ 56,000 $ 5,100 Cedar shake siding 86,000 79,400 94,000 84,800 7,400 Louvered glass doors 112,000 124,000 186,400 168,300 18,500 Thermal windows 140,000 126,000 154,800 140,000 15,400

Total $408,000 $391,900 $499,200 $449,100 $46,400

Instructions (a) (1) Determine the proper balance in Allowance to Reduce Inventory to Market at May 31, 2017. (2) For the fiscal year ended May 31, 2017, determine the amount of the gain or loss that would be recorded due to the

change in Allowance to Reduce Inventory to Market. (b) Explain the rationale for the use of the lower-of-cost-or-market rule as it applies to inventories.

(CMA adapted)

484 Chapter 9 Inventories: Additional Valuation Issues

Merchandise with a selling price of $30,000 remained undamaged after the fire, and damaged merchandise has a net realizable value of $8,150. The company does not carry fire insurance on its inventory.

Instructions Prepare a formal labeled schedule computing the fire loss incurred. (Do not use the retail inventory method.)

P9-7 (L04) GROUPWORK (Gross Profit Method) On April 15, 2018, fire damaged the office and warehouse of Stanislaw Corporation. The only accounting record saved was the general ledger, from which the balance sheet data below was prepared.

P9-5 (L02) WRITING (Lower-of-Cost-or-Market) Fiedler Co. follows the practice of valuing its inventory at the lower-of- cost-or-market. The following information is available from the company’s inventory records as of December 31, 2017.

Instructions Greg Forda is an accounting clerk in the accounting department of Fiedler Co., and he cannot understand why the market value keeps changing from replacement cost to net realizable value to something that he cannot even figure out. Greg is very confused, and he is the one who records inventory purchases and calculates ending inventory. You are the manager of the department and an accountant.

(a) Calculate the lower-of-cost-or-market using the individual-item approach. (b) Show the journal entry he will need to make in order to write down the ending inventory from cost to market. (c) Write a memo to Greg explaining what designated market value is as well as how it is computed. Use your calculations

to aid in your explanation.

P9-6 (L04) (Gross Profit Method) Eastman Company lost most of its inventory in a fire in December just before the year-end physical inventory was taken. Corporate records disclose the following.

Item Quantity Unit Cost

Replacement Cost/Unit

Estimated Selling

Price/Unit

Completion & Disposal Cost/Unit

Normal Profit

Margin/Unit

A 1,100 $7.50 $8.40 $10.50 $1.50 $1.80 B 800 8.20 7.90 9.40 0.90 1.20 C 1,000 5.60 5.40 7.20 1.15 0.60 D 1,000 3.80 4.20 6.30 0.80 1.50 E 1,400 6.40 6.30 6.70 0.70 1.00

Inventory (beginning) $ 80,000 Sales revenue $415,000 Purchases 290,000 Sales returns 21,000 Purchase returns 28,000 Gross profi t % based on

net selling price 35%

STANISLAW CORPORATION MARCH 31, 2018

Dr. Cr.

Cash $ 20,000 Accounts receivable 40,000 Inventory, December 31, 2017 75,000 Land 35,000 Buildings 110,000 Accumulated depreciation $ 41,300 Equipment 3,600 Accounts payable 23,700 Other accrued expenses 10,200 Common stock 100,000 Retained earnings 52,000 Sales revenue 135,000 Purchases 52,000 Miscellaneous expense 26,600 .

$362,200 $362,200

Problems 485

The following data and information have been gathered. 1. The fiscal year of the corporation ends on December 31. 2. An examination of the April bank statement and canceled checks revealed that checks written during the period April

1–15 totaled $13,000: $5,700 paid to accounts payable as of March 31, $3,400 for April merchandise shipments, and $3,900 paid for other expenses. Deposits during the same period amounted to $12,950, which consisted of receipts on account from customers with the exception of a $950 refund from a vendor for merchandise returned in April.

3. Correspondence with suppliers revealed unrecorded obligations at April 15 of $15,600 for April merchandise shipments, including $2,300 for shipments in transit (f.o.b. shipping point) on that date.

4. Customers acknowledged indebtedness of $46,000 at April 15, 2018. It was also estimated that customers owed another $8,000 that will never be acknowledged or recovered. Of the acknowledged indebtedness, $600 will probably be uncollectible.

5. The companies insuring the inventory agreed that the corporation’s fire-loss claim should be based on the assumption that the overall gross profit rate for the past 2 years was in effect during the current year. The corporation’s audited financial statements disclosed this information:

Year Ended December 31

2017 2016

Net sales $530,000 $390,000 Net purchases 280,000 235,000 Beginning inventory 50,000 66,000 Ending inventory 75,000 50,000

6. Inventory with a cost of $7,000 was salvaged and sold for $3,500. The balance of the inventory was a total loss.

Instructions Prepare a schedule computing the amount of inventory fire loss. The supporting schedule of the computation of the gross profit should be in good form.

(AICPA adapted)

P9-8 (L05) EXCEL (Retail Inventory Method) The records for the Clothing Department of Sharapova’s Discount Store are summarized below for the month of January.

Inventory, January 1: at retail $25,000; at cost $17,000 Purchases in January: at retail $137,000; at cost $82,500 Freight-in: $7,000 Purchase returns: at retail $3,000; at cost $2,300 Transfers in from suburban branch: at retail $13,000; at cost $9,200 Net markups: $8,000 Net markdowns: $4,000 Inventory losses due to normal breakage, etc.: at retail $400 Sales revenue at retail: $95,000 Sales returns: $2,400

Instructions (a) Compute the inventory for this department as of January 31, at retail prices. (b) Compute the ending inventory using lower-of-average-cost-or-market.

P9-9 (L05) (Retail Inventory Method) Presented below is information related to Waveland Inc.

Cost Retail

Inventory, 12/31/17 $250,000 $ 390,000 Purchases 914,500 1,460,000 Purchase returns 60,000 80,000 Purchase discounts 18,000 — Gross sales revenue (after employee discounts) — 1,410,000 Sales returns — 97,500 Markups — 120,000 Markup cancellations — 40,000 Markdowns — 45,000 Markdown cancellations — 20,000 Freight-in 42,000 — Employee discounts granted — 8,000 Loss from breakage (normal) — 4,500

486 Chapter 9 Inventories: Additional Valuation Issues

Instructions Assuming that Waveland Inc. uses the conventional retail inventory method, compute the cost of its ending inventory at Decem- ber 31, 2018.

P9-10 (L05) GROUPWORK (Retail Inventory Method) Fuque Inc. uses the retail inventory method to estimate ending inventory for its monthly financial statements. The following data pertain to a single department for the month of October 2018.

Inventory, October 1, 2018 At cost $ 52,000 At retail 78,000 Purchases (exclusive of freight and returns) At cost 272,000 At retail 423,000 Freight-in 16,600 Purchase returns At cost 5,600 At retail 8,000 Markups 9,000 Markup cancellations 2,000 Markdowns (net) 3,600 Normal spoilage and breakage 10,000 Sales revenue 390,000

Instructions (a) Using the conventional retail method, prepare a schedule computing estimated lower-of-cost-or-market inventory for

October 31, 2018. (b) A department store using the conventional retail inventory method estimates the cost of its ending inventory as $60,000.

An accurate physical count reveals only $47,000 of inventory at lower-of-cost-or-market. List the factors that may have caused the difference between the computed inventory and the physical count.

P9-11 (L01,3,6) (Statement and Note Disclosure, LCNRV, and Purchase Commitment) Maddox Specialty Company, a division of Lost World Inc., manufactures three models of gear shift components for bicycles that are sold to bicycle manufactur- ers, retailers, and catalog outlets. Since beginning operations in 1993, Maddox has used normal absorption costing and has assumed a first-in, first-out cost flow in its perpetual inventory system. The balances of the inventory accounts at the end of Maddox’s fiscal year, November 30, 2017, are shown below. The inventories are stated at cost before any year-end adjustments.

Finished goods $647,000 Work in process 112,500 Raw materials 264,000 Factory supplies 69,000

The following information relates to Maddox’s inventory and operations.

1. The finished goods inventory consists of the items analyzed below.

Cost NRV

Down tube shifter

Standard model $ 67,500 $ 67,000 Click adjustment model 94,500 89,000 Deluxe model 108,000 110,000

Total down tube shifters 270,000 266,000

Bar end shifter

Standard model 83,000 90,050 Click adjustment model 99,000 97,550

Total bar end shifters 182,000 187,600

Head tube shifter

Standard model 78,000 77,650 Click adjustment model 117,000 119,300

Total head tube shifters 195,000 196,950

Total fi nished goods $647,000 $650,550

2. One-half of the head tube shifter finished goods inventory is held by catalog outlets on consignment. 3. Three-quarters of the bar end shifter finished goods inventory has been pledged as collateral for a bank loan. 4. One-half of the raw materials balance represents derailleurs acquired at a contracted price 20% above the current market

price. The NRV of the rest of the raw materials is $127,400.

5. The total NRV of the work in process inventory is $108,700. 6. Included in the cost of factory supplies are obsolete items with an historical cost of $4,200. The market value of the remain-

ing factory supplies is $65,900. 7. Maddox applies the LCNRV method to each of the three types of shifters in finished goods inventory. For each of the other

three inventory accounts, Maddox applies the LCNRV method to the total of each inventory account. 8. Consider all amounts presented above to be material in relation to Maddox’s financial statements taken as a whole.

Instructions (a) Prepare the inventory section of Maddox’s balance sheet as of November 30, 2017, including any required note(s).

(b) Without prejudice to your answer to (a), assume that the NRV of Maddox’s inventories is less than cost. Explain how this decline would be presented in Maddox’s income statement for the fiscal year ended November 30, 2017.

(c) Assume that Maddox has a firm purchase commitment for the same type of derailleur included in the raw materials inven- tory as of November 30, 2017, and that the purchase commitment is at a contracted price 15% greater than the current market price. These derailleurs are to be delivered to Maddox after November 30, 2017. Discuss the impact, if any, that this purchase commitment would have on Maddox’s financial statements prepared for the fiscal year ended November 30, 2017.

(CMA adapted)

*P9-12 (L07) (Conventional and Dollar-Value LIFO Retail) As of January 1, 2017, Aristotle Inc. adopted the retail method of accounting for its merchandise inventory. To prepare the store’s financial statements at June 30, 2017, you obtain the following data.

Cost Selling Price

Inventory, January 1 $ 30,000 $ 43,000 Markdowns 10,500 Markups 9,200 Markdown cancellations 6,500 Markup cancellations 3,200 Purchases 104,800 155,000 Sales revenue 154,000 Purchase returns 2,800 4,000 Sales returns and allowances 8,000

Instructions (a) Prepare a schedule to compute Aristotle’s June 30, 2017, inventory under the conventional retail method of accounting

for inventories. (b) Without prejudice to your solution to part (a), assume that you computed the June 30, 2017, inventory to be $59,400 at

retail and the ratio of cost to retail to be 70%. The general price level has increased from 100 at January 1, 2017, to 108 at June 30, 2017. Prepare a schedule to compute the June 30, 2017, inventory at the June 30 price level under the dollar- value LIFO retail method.

(AICPA adapted)

*P9-13 (L07) GROUPWORK (Retail, LIFO Retail, and Inventory Shortage) Late in 2014, Joan Seceda and four other inves- tors took the chain of Becker Department Stores private, and the company has just completed its third year of operations under the ownership of the investment group. Andrea Selig, controller of Becker Department Stores, is in the process of preparing the year-end financial statements. Based on the preliminary financial statements, Seceda has expressed concern over inventory shortages, and she has asked Selig to determine whether an abnormal amount of theft and breakage has occurred. The account- ing records of Becker Department Stores contain the following amounts on November 30, 2017, the end of the fiscal year.

Cost Retail

Beginning inventory $ 68,000 $100,000 Purchases 255,000 400,000 Net markups 50,000 Net markdowns 110,000 Sales revenue 320,000

According to the November 30, 2017, physical inventory, the actual inventory at retail is $115,000.

Instructions (a) Describe the circumstances under which the retail inventory method would be applied and the advantages of using the

retail inventory method. (b) Assuming that prices have been stable, calculate the value, at cost, of Becker Department Stores’ ending inventory

using the last-in, first-out (LIFO) retail method. Be sure to furnish supporting calculations.

Problems 487

488 Chapter 9 Inventories: Additional Valuation Issues

(c) Estimate the amount of shortage, at retail, that has occurred at Becker Department Stores during the year ended November 30, 2017.

(d) Complications in the retail method can be caused by such items as (1) freight-in costs, (2) purchase returns and allow- ances, (3) sales returns and allowances, and (4) employee discounts. Explain how each of these four special items is handled in the retail inventory method.

(CMA adapted)

*P9-14 (L07) (Change to LIFO Retail) Diderot Stores Inc., which uses the conventional retail inventory method, wishes to change to the LIFO retail method beginning with the accounting year ending December 31, 2017. Amounts as shown below appear on the store’s books before adjustment.

Cost Retail

Inventory, January 1, 2017 $ 15,800 $ 24,000 Purchases in 2017 116,200 184,000 Markups in 2017 12,000 Markdowns in 2017 5,500 Sales revenue in 2017 175,000

You are to assume that all markups and markdowns apply to 2017 purchases, and that it is appropriate to treat the entire inven- tory as a single department.

Instructions Compute the inventory at December 31, 2017, under the following methods.

(a) The conventional retail method. (b) The last-in, first-out retail method, effecting the change in method as of January 1, 2017. Assume that the cost-to-retail

percentage for 2016 was recomputed correctly in accordance with procedures necessary to change to LIFO. This ratio was 59%.

(AICPA adapted)

*P9-15 (L07) (Change to LIFO Retail; Dollar-Value LIFO Retail) Davenport Department Store converted from the con- ventional retail method to the LIFO retail method on January 1, 2017, and is now considering converting to the dollar-value LIFO inventory method. During your examination of the financial statements for the year ended December 31, 2018, man- agement requested that you furnish a summary showing certain computations of inventory cost for the past 3 years.

Here is the available information.

1. The inventory at January 1, 2016, had a retail value of $56,000 and cost of $29,800 based on the conventional retail method. 2. Transactions during 2016 were as follows.

Cost Retail

Purchases $311,000 $554,000 Purchase returns 5,200 10,000 Purchase discounts 6,000 Gross sales revenue (after employee discounts) 551,000 Sales returns 9,000 Employee discounts 3,000 Freight-in 17,600 Net markups 20,000 Net markdowns 12,000

3. The retail value of the December 31, 2017, inventory was $75,600, the cost ratio for 2017 under the LIFO retail method was 61%, and the regional price index was 105% of the January 1, 2017, price level.

4. The retail value of the December 31, 2018, inventory was $62,640, the cost ratio for 2018 under the LIFO retail method was 60%, and the regional price index was 108% of the January 1, 2017, price level.

Instructions (a) Prepare a schedule showing the computation of the cost of inventory on hand at December 31, 2016, based on the con-

ventional retail method. (b) Prepare a schedule showing the recomputation of the inventory to be reported on December 31, 2016, in accordance

with procedures necessary to convert from the conventional retail method to the LIFO retail method beginning January 1, 2017. Assume that the retail value of the December 31, 2016, inventory was $60,000.

(c) Without prejudice to your solution to part (b), assume that you computed the December 31, 2016, inventory (retail value $60,000) under the LIFO retail method at a cost of $33,300. Prepare a schedule showing the computations of the cost of the store’s 2017 and 2018 year-end inventories under the dollar-value LIFO method.

(AICPA adapted)

Concepts for Analysis 489

CONCEPTS FOR ANALYSIS

CA9-1 (LCNRV) You have been asked by the financial vice president to develop a short presentation on the LCNRV method for inventory purposes. The financial VP needs to explain this method to the president because it appears that a portion of the com- pany’s inventory has declined in value.

Instructions The financial vice president asks you to answer the following questions.

(a) What is the purpose of the LCNRV method? (b) What is meant by “net realizable value”? (c) Do you apply the LCNRV method to each individual item, to a category, or to the total of the inventory? Explain. (d) What are the potential disadvantages of the LCNRV method?

CA9-2 ETHICS (LCNRV) The net realizable value of Lake Corporation’s inventory has declined below its cost. Allyn Conan, the controller, wants to use the loss method to write down inventory because it more clearly discloses the decline in the net realizable value and does not distort the cost of goods sold. His supervisor, financial vice president Bill Ortiz, prefers the cost- of-goods-sold method to write down inventory because it does not call attention to the decline in net realizable value.

Instructions Answer the following questions.

(a) What, if any, is the ethical issue involved? (b) Is any stakeholder harmed if Bill Ortiz’s preference is used? (c) What should Allyn Conan do?

CA9-3 (LCNRV) Ogala Corporation purchased a significant amount of raw materials inventory for a new product that it is manu- facturing. Ogala uses the LCNRV rule for these raw materials. The net realizable value of the raw materials is below the original cost.

Ogala uses the FIFO inventory method for these raw materials. In the last 2 years, each purchase has been at a lower price than the previous purchase, and the ending inventory quantity for each period has been higher than the beginning inventory quantity for that period.

Instructions (a) At which amount should Ogala’s raw materials inventory be reported on the balance sheet? Why? (b) In general, why is the LCNRV rule used to report inventory? (c) What would have been the effect on ending inventory and cost of goods sold had Ogala used the average-cost inven-

tory method instead of the FIFO inventory method for the raw materials? Why?

CA9-4 (LCNRV) Steele Corporation purchased a significant amount of raw materials inventory for a new product that it is manufacturing. Steele uses the lower-of-average-cost-or-net realizable value (LCNRV) rule for these raw materials. The net realiz- able value of the raw materials is below the original cost.

In the last 2 years, each purchase has been at a lower price than the previous purchase, and the ending inventory quantity for each period has been higher than the beginning inventory quantity for that period.

Instructions (a) (1) At which amount should Steele’s raw materials inventory be reported on the balance sheet? Why? (2) In general, why is the LCNRV rule used to report inventory? (b) What would have been the effect on ending inventory and cost of goods sold had Steele used the LIFO inventory

method instead of the average-cost inventory method for the raw materials? Why?

CA9-5 WRITING (Retail Inventory Method) Saurez Company, your client, manufactures paint. The company’s president, Maria Saurez, has decided to open a retail store to sell Saurez paint as well as wallpaper and other supplies that would be purchased from other suppliers. She has asked you for information about the conventional retail method of pricing inventories at the retail store.

Instructions Prepare a report to the president explaining the retail method of pricing inventories. Your report should include the following points.

(a) Description and accounting features of the method. (b) The conditions that may distort the results under the method. (c) A comparison of the advantages of using the retail method with those of using cost methods of inventory pricing. (d) The accounting theory underlying the treatment of net markdowns and net markups under the method.

(AICPA adapted)

490 Chapter 9 Inventories: Additional Valuation Issues

CA9-6 (Cost Determination, LCM, Retail Method) Olson Corporation, a retailer and wholesaler of national brand-name house- hold lighting fixtures, purchases its inventories from various suppliers.

Instructions (a) (1) What criteria should be used to determine which of Olson’s costs are inventoriable? (2) Are Olson’s administrative costs inventoriable? Defend your answer. (b) (1) Olson uses the lower-of-cost-or-market rule for its wholesale inventories. What are the theoretical arguments for

that rule? (2) The replacement cost of the inventories is below the net realizable value less a normal profit margin, which, in turn,

is below the original cost. What amount should be used to value the inventories? Why? (c) Olson calculates the estimated cost of its ending inventories held for sale at retail using the conventional retail inven-

tory method. How would Olson treat the beginning inventories and net markdowns in calculating the cost ratio used to determine its ending inventories? Why?

(AICPA adapted)

CA9-7 ETHICS (Purchase Commitments) Prophet Company signed a long-term purchase contract to buy timber from the U.S. Forest Service at $300 per thousand board feet. Under these terms, Prophet must cut and pay $6,000,000 for this timber during the next year. Currently, the market value is $250 per thousand board feet. At this rate, the market price is $5,000,000. Jerry Herman, the controller, wants to recognize the loss in value on the year-end financial statements, but the financial vice president, Billie Hands, argues that the loss is temporary and should be ignored. Herman notes that market value has remained near $250 for many months, and he sees no sign of significant change.

Instructions (a) What are the ethical issues, if any? (b) Is any particular stakeholder harmed by the financial vice president’s decision? (c) What should the controller do?

USING YOUR JUDGMENT

Instructions Refer to P&G’s financial statements and the accompanying notes to answer the following questions.

(a) How does P&G value its inventories? Which inventory costing method does P&G use as a basis for reporting its inventories?

(b) How does P&G report its inventories in the balance sheet? In the notes to its financial statements, what three descrip- tions are used to classify its inventories?

(c) What costs does P&G include in Inventory and Cost of Products Sold? (d) What was P&G’s inventory turnover in 2014? What is its gross profit percentage? Evaluate P&G’s inventory turnover

and its gross profit percentage.

Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. The financial statements of Coca-Cola and PepsiCo are presented in Appendices C and D, respectively. The companies’ com- plete annual reports, including the notes to the financial statements, are available online.

Instructions Use the companies’ financial information to answer the following questions.

(a) What is the amount of inventory reported by Coca-Cola at December 31, 2014, and by PepsiCo at December 31, 2014? What percent of total assets is invested in inventory by each company?

(b) What inventory costing methods are used by Coca-Cola and PepsiCo? How does each company value its inventories?

(d) Compute and compare the inventory turnovers and days to sell inventory for Coca-Cola and PepsiCo for 2014. Indicate why there might be a significant difference between the two companies.

Financial Statement Analysis Cases Case 1: Robots, Inc. Robots, Inc. reported the following information regarding 2016–2017 inventory.

Robots, Inc. 2017 2016 Current assets Cash $ 153,010 $ 538,489 Accounts receivable, net of allowance for doubtful accounts

of $46,000 in 2017 and $160,000 in 2016 1,627,980 2,596,291 Inventories (Note 2) 1,340,494 1,734,873 Other current assets 123,388 90,592 Assets of discontinued operations — 32,815

Total current assets 3,244,872 4,993,060

Notes to Consolidated Financial Statements

Note 1 (in part): Nature of Business and Significant Accounting Policies

Inventories—Inventories are stated at the lower-of-cost-or-market. Cost is determined by the last-in, first-out (LIFO) method.

Note 2: Inventories

Inventories consist of the following. 2017 2016

Raw materials $1,264,646 $2,321,178 Work in process 240,988 171,222 Finished goods and display units 129,406 711,252

Total inventories 1,635,040 3,203,652 Less: Amount classified as long-term 294,546 1,468,779

Current portion $1,340,494 $1,734,873

Inventories are stated at the lower of cost determined by the LIFO method or market for Robots, Inc. If the FIFO method had been used for the entire consolidated group, inventories after an adjustment to the lower-of-cost-or- market would have been approximately $2,000,000 and $3,800,000 at October 31, 2017 and 2016, respectively.

Inventory has been written down to estimated net realizable value, and results of operations for 2017, 2016, and 2015 include a corresponding charge of approximately $868,000, $960,000, and $273,000, respectively, which repre- sents the excess of LIFO cost over market.

Inventory of $294,546 and $1,468,779 at October 31, 2017 and 2016, respectively, shown on the balance sheet as a noncurrent asset represents that portion of the inventory that is not expected to be sold currently.

Reduction in inventory quantities during the years ended October 31, 2017, 2016, and 2015 resulted in liquidation of LIFO inventory quantities carried at a lower cost prevailing in prior years as compared with the cost of fiscal 2014 purchases. The effect of these reductions was to decrease the net loss by approximately $24,000, $157,000, and $90,000 at October 31, 2017, 2016, and 2015, respectively.

Instructions

(a) Comment on why Robots, Inc., might disclose how its LIFO inventories would be valued under FIFO. (b) Why does the LIFO liquidation reduce operating costs? (c) Comment on whether Robots, Inc. would report more or less income if it had been on a FIFO basis for all its inventory.

Case 2: Barrick Gold Corporation Barrick Gold Corporation, with headquarters in Toronto, Canada, is the world’s most profitable and largest gold mining com- pany outside South Africa. Part of the key to Barrick’s success has been due to its ability to maintain cash flow while improving production and increasing its reserves of gold-containing property. In the most recent year, Barrick achieved record growth in cash flow, production, and reserves. The company maintains an aggressive policy of developing previously identified target areas that have the possibility of a large amount of gold ore, and that have not been previously developed. Barrick limits the riskiness of this development by choosing only properties that are located in politically stable regions, and by the company’s use of internally generated funds, rather than debt, to finance growth.

Using Your Judgment 491

492 Chapter 9 Inventories: Additional Valuation Issues

Barrick’s inventories are as follows.

Barrick Gold Corporation

Inventories (in millions, US dollars)

Current Gold in process $133 Mine operating supplies 82

$215

Non-current (included in Other assets) Ore in stockpiles $65

Instructions

(a) Why do you think that there are no finished goods inventories? Why do you think the raw material, ore in stockpiles, is considered to be a non-current asset?

(b) Consider that Barrick has no finished goods inventories. What journal entries are made to record a sale? (c) Suppose that gold bullion that cost $1.8 million to produce was sold for $2.4 million. The journal entry was made to

record the sale, but no entry was made to remove the gold from the gold in process inventory. How would this error affect the following?

Balance Sheet Income Statement Inventory ? Cost of goods sold ? Retained earnings ? Net income ? Accounts payable ? Working capital ? Current ratio ?

Units Price per

Unit Total Residential Pumps Inventory at Feb. 28: 200 $ 400 $ 80,000 Purchases:

March 10 500 $ 450 $225,000 March 20 400 $ 475 $190,000 March 30 300 $ 500 $150,000

Sales: March 15 500 $ 540 $270,000 March 25 400 $ 570 $228,000 Inventory at March 31: 500

Commercial Pumps Inventory at Feb. 28: 600 $ 800 $480,000

Purchases: March 3 600 $ 900 $540,000 March 12 300 $ 950 $285,000 March 21 500 $1,000 $500,000

Sales: March 18 900 $1,080 $972,000 March 29 600 $1,140 $684,000 Inventory at March 31: 500

In addition to the above information, due to a downturn in the economy that has hit Englehart’s commercial customers espe- cially hard, Englehart expects commercial pump prices from March 31 onward to be considerably different (and lower) than at the beginning of and during March. Englehart has developed the following additional information.

Commercial Pumps Residential Pumps

Net realizable value (per unit) $900 $580

The normal profit margin is 16.67% of cost. Englehart uses the FIFO accounting method.

Accounting

(a) Determine the dollar amount that Englehart should report on its March 31 balance sheet for inventory. Assume Englehart applies lower-of-cost-or-net realizable value at the individual product level.

(b) Repeat part (a) but assume Englehart applies lower-of-cost-or-net realizable value at the major categories level. Englehart places both commercial and residential pumps into the same (and only) category.

Analysis Which of the two approaches above (individual product level or major categories) for applying LCNRV do you think gives the financial statement reader better information?

Principles Assume that during April, the net realizable value of commercial pumps rebounds to $1,050.

(a) Briefly describe how Englehart will report in its April financial statements the inventory remaining from March 31. (b) Briefly describe the conceptual trade-offs inherent in the accounting in part (a).

BRIDGE TO THE PROFESSION

FASB Codifi cation References [1] FASB ASC Master Glossary. [Predecessor literature: “Restatement and Revision of Accounting Research Bulletins,” Account-

ing Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4, par. 8.] [2] FASB ASC 330-10-35-1B. [Predecessor literature: “Restatement and Revision of Accounting Research Bulletins,” Accounting

Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4, par. 8.] [3] FASB ASC 330-10-35-1C. [Predecessor literature: “Restatement and Revision of Accounting Research Bulletins,” Accounting

Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4, par. 8.] [4] FASB ASC 905-330-35-3. [Predecessor literature: “Restatement and Revision of Accounting Research Bulletins,” Accounting

Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4.] [5] FASB ASC 330-10-35-16 through 18. [Predecessor literature: “Restatement and Revision of Accounting Research Bulletins,”

Accounting Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4.]

Codifi cation Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE9-1 Access the glossary (“Master Glossary”) to answer the following.

(a) What is the definition of inventory? (b) What is the definition of market as it relates to inventory? (c) What is the definition of net realizable value?

CE9-2 Based on increased competition for one of its key products, Tutaj Company is concerned that it will not be able to sell its products at a price that would cover its costs. Since the company is already having a bad year, the sales manager proposes writ- ing down the inventory to the lowest level possible, so that all the bad news will be in the current year. Explain to the sales manager the rationale for lower-of-cost-or-net realizable value adjustments, according to GAAP. CE9-3 What are the provisions for subsequent measurement of inventory in the context of a hedging transaction? CE9-4 What is the nature of the SEC guidance concerning inventory disclosures?

Codifi cation Research Case Jones Co. is in a technology-intensive industry. Recently, one of its competitors introduced a new product with technology that might render obsolete some of Jones’s inventory. The accounting staff wants to follow the appropriate authoritative literature in determining the accounting for this significant market event.

Instructions If your school has a subscription to the FASB Codification, go to http://aaahg.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.

(a) Identify the primary authoritative guidance for the accounting for inventories. What is the predecessor literature?

Bridge to the Profession 493

494 Chapter 9 Inventories: Additional Valuation Issues

(b) List three types of goods that are classified as inventory. What characteristic will automatically exclude an item from being classified as inventory?

(c) Define “market” as used in the phrase “lower-of-cost-or-market.” (d) Explain when it is acceptable to state inventory above cost and which industries allow this practice.

IFRS Insights The major IFRS requirements related to accounting and reporting for inventories are found in IAS 2 (“Inventories”), and IAS 41 (“Agriculture”). In most cases, IFRS and GAAP are the same. The major differences are that IFRS prohibits the use of the LIFO cost flow assumption and does not have an exception to LCNRV.

RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to inventories.

Similarities • IFRS and GAAP account for inventory acquisitions at historical cost and evaluate inventory for

LCNRV subsequent to acquisition. • Who owns the goods—goods in transit, consigned goods, special sales agreements—as well as

the costs to include in inventory are essentially accounted for the same under IFRS and GAAP.

Differences • The requirements for accounting for and reporting inventories are more principles-based under

IFRS. That is, GAAP provides more detailed guidelines in inventory accounting. • A major difference between IFRS and GAAP relates to the LIFO cost fl ow assumption. GAAP

permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost fl ow assumptions permitted under IFRS. Both sets of standards permit specifi c identifi cation where appropriate.

• IFRS does not have an exception to the LCNRV rule for the LIFO/retail inventory methods (IFRS does not allow LIFO). GAAP, on the other hand, for LIFO/retail inventory method com- panies, defi nes market as replacement cost subject to the constraints of net realizable value (the ceiling) and net realizable value less a normal markup (the fl oor). IFRS does not use a ceiling or a fl oor to determine lower-of-cost-or-market.

• Under GAAP, if inventory is written down under the LCNRV or lower-of-cost-or-market valu- ation, the new basis is now considered its cost. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement. IFRS accounting for lower-of-cost-or-market is discussed more fully in the About the Numbers section below.

• IFRS requires both biological assets and agricultural produce at the point of harvest to be reported at net realizable value. GAAP does not require companies to account for all biological assets in the same way. Furthermore, these assets generally are not reported at net realizable value. Disclosure requirements also differ between the two sets of standards. IFRS accounting for agriculture and biological assets is discussed more fully in the About the Numbers section.

LEARNING OBJECTIVE 8 Compare the accounting procedures related to valuation of inventories under GAAP and IFRS.

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ABOUT THE NUMBERS

Lower-of-Cost-or-Net Realizable Value (LCNRV) Inventories are recorded at their cost. However, if inventory declines in value below its original cost, a major departure from the historical cost principle occurs. Whatever the reason for a decline—obsolescence, price-level changes, or damaged goods—a company should write down the inventory to net realizable value to report this loss. A company abandons the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost.

Net Realizable Value Recall that cost is the acquisition price of inventory computed using one of the historical cost- based methods—specific identification, average-cost, or FIFO. The term net realizable value (NRV) refers to the net amount that a company expects to realize from the sale of inventory. Spe- cifically, net realizable value is the estimated selling price in the normal course of business less estimated costs to complete and estimated costs to make a sale. To illustrate, assume that Mander Corp. has unfinished inventory with a cost of $950, a sales value of $1,000, estimated cost of completion of $50, and estimated selling costs of $200. Mander’s net realizable value is computed as follows.

Inventory value—unfinished $1,000 Less: Estimated cost of completion $ 50 Estimated cost to sell 200 250

Net realizable value $ 750

Mander reports inventory on its statement of financial position (balance sheet) at $750. In its income statement, Mander reports a Loss on Inventory Write-Down of $200 ($950 − $750). A departure from cost is justified because inventories should not be reported at amounts higher than their expected realization from sale or use. In addition, a company like Mander should charge the loss of utility against revenues in the period in which the loss occurs, not in the period of sale. Companies therefore report their inventories at the lower-of-cost-or-net realizable value (LCNRV) at each reporting date.

Illustration of LCNRV As indicated, a company values inventory at LCNRV. A company estimates net realizable value based on the most reliable evidence of the inventories’ realizable amounts (expected selling price, expected costs to completion, and expected costs to sell). To illustrate, Regner Foods computes its inventory at LCNRV, as shown in Illustration IFRS9-1.

IFRS Insights 495

Food Cost

Net Realizable

Value

Final Inventory

Value

Spinach $ 80,000 $120,000 $ 80,000 Carrots 100,000 110,000 100,000 Cut beans 50,000 40,000 40,000 Peas 90,000 72,000 72,000 Mixed vegetables 95,000 92,000 92,000

$384,000

Final Inventory Value: Spinach Cost ($80,000) is selected because it is lower than net realizable value. Carrots Cost ($100,000) is selected because it is lower than net realizable value. Cut beans Net realizable value ($40,000) is selected because it is lower than cost. Peas Net realizable value ($72,000) is selected because it is lower than cost. Mixed vegetables Net realizable value ($92,000) is selected because it is lower than cost.

ILLUSTRATION IFRS9-1 LCNRV Data

496 Chapter 9 Inventories: Additional Valuation Issues

As indicated, the final inventory value of $384,000 equals the sum of the LCNRV for each of the inventory items. That is, Regner Foods applies the LCNRV rule to each individual type of food. Similar to GAAP, under IFRS, companies may apply the LCNRV rule to a group of similar or related items, or to the total of the inventory. If a company follows a group-of-similar-or-related- items or total-inventory approach in determining LCNRV, increases in market prices tend to offset decreases in market prices. In most situations, companies price inventory on an item-by-item basis. In fact, tax rules in some countries require that companies use an individual-item basis, bar- ring practical difficulties. In addition, the individual-item approach gives the lowest valuation for statement of finan- cial position purposes. In some cases, a company prices inventory on a total-inventory basis when it offers only one end product (comprised of many different raw materials). If it produces several end products, a company might use a similar-or-related approach instead. Whichever method a company selects, it should apply the method consistently from one period to another.

Recording Net Realizable Value Instead of Cost Similar to GAAP, one of two methods may be used to record the income effect of valuing inven- tory at net realizable value. One method, referred to as the cost-of-goods-sold method, debits cost of goods sold for the write-down of the inventory to net realizable value. As a result, the company does not report a loss in the income statement because the cost of goods sold already includes the amount of the loss. The second method, referred to as the loss method, debits a loss account for the write-down of the inventory to net realizable value. We use the following inventory data for Ricardo Company to illustrate entries under both methods.

Cost of goods sold (before adjustment to NRV) $108,000 Ending inventory (cost) 82,000 Ending inventory (at NRV) 70,000

Illustration IFRS9-2 shows the entries for both the cost-of-goods-sold and loss methods, assuming the use of a perpetual inventory system.

ILLUSTRATION IFRS9-3 Income Statement Reporting—LCNRV

Cost-of-Goods-Sold Method

Sales revenue $200,000 Cost of goods sold (after adjustment to NRV*) 120,000

Gross profit on sales $ 80,000

*Cost of goods sold (before adjustment to NRV) $108,000 Difference between inventory at cost and NRV ($82,000 − $70,000) 12,000

Cost of goods sold (after adjustment to NRV) $120,000

Loss Method Sales revenue $200,000 Cost of goods sold 108,000

Gross profit on sales 92,000 Loss due to decline of inventory to NRV 12,000

$ 80,000

ILLUSTRATION IFRS9-2 LCNRV Entries

Cost-of-Goods-Sold Method Loss Method

To reduce inventory from cost to net realizable value

Cost of Goods Sold Inventory

12,000 12,000

Loss Due to Decline of Inventory to NRV 12,000 Inventory 12,000

The cost-of-goods-sold method buries the loss in the Cost of Goods Sold account. The loss method, by identifying the loss due to the write-down, shows the loss separate from Cost of Goods Sold in the income statement. Illustration IFRS9-3 contrasts the differing amounts reported in the income statement under the two approaches, using data from the Ricardo example.

IFRS does not specify a particular account to debit for the write-down. We believe the loss method presentation is preferable because it clearly discloses the loss resulting from a decline in inventory net realizable values.

Use of an Allowance Instead of crediting the Inventory account for net realizable value adjustments, companies gener- ally use an allowance account, often referred to as Allowance to Reduce Inventory to NRV. For example, using an allowance account under the loss method, Ricardo Company makes the fol- lowing entry to record the inventory write-down to net realizable value.

Loss Due to Decline of Inventory to NRV 12,000 Allowance to Reduce Inventory to NRV 12,000

Use of the allowance account results in reporting both the cost and the net realizable value of the inventory. Ricardo reports inventory in the statement of financial position as follows.

ILLUSTRATION IFRS9-4 Presentation of Inventory Using an Allowance Account

Inventory (at cost) $82,000 Allowance to reduce inventory to NRV (12,000)

Inventory (at net realizable value) $70,000

The use of the allowance under the cost-of-goods-sold or loss method permits both the income statement and the statement of financial position to reflect inventory measured at $82,000, although the statement of financial position shows a net amount of $70,000. It also keeps subsid- iary inventory ledgers and records in correspondence with the control account without changing prices. For homework purposes, use an allowance account to record net realizable value adjustments, unless instructed otherwise.

Recovery of Inventory Loss In periods following the write-down, economic conditions may change such that the net realiz- able value of inventories previously written down may be greater than cost or there is clear evi- dence of an increase in the net realizable value. In this situation, the amount of the write-down is reversed, with the reversal limited to the amount of the original write-down.

Continuing the Ricardo example, assume that in the subsequent period, market conditions change, such that the net realizable value increases to $74,000 (an increase of $4,000). As a result, only $8,000 is needed in the allowance. Ricardo makes the following entry, using the loss method.

Allowance to Reduce Inventory to NRV 4,000 Recovery of Inventory Loss ($74,000 − $70,000) 4,000

Valuation Bases For the most part, companies record inventory at LCNRV. However, there are some situations in which companies depart from the LCNRV rule. Such treatment may be justified in situations when cost is difficult to determine, the items are readily marketable at quoted market prices, and units of product are interchangeable. In this section, we discuss agricultural assets (including biological assets and agricultural produce), for which net realizable value is the general rule for valuing inventory.

Agricultural Inventory Under IFRS, net realizable value measurement is used for inventory when the inventory is related to agricultural activity. In general, agricultural activity results in two types of agricultural assets: (1) biological assets or (2) agricultural produce at the point of harvest.

A biological asset (classified as a non-current asset) is a living animal or plant, such as sheep, cows, fruit trees, or cotton plants. Agricultural produce is the harvested product of a biological asset, such as wool from a sheep, milk from a dairy cow, picked fruit from a fruit tree, or cotton from a cotton plant.

Biological assets are measured on initial recognition and at the end of each reporting period at fair value less costs to sell (net realizable value). Companies record a gain or loss due to changes in the net realizable value of biological assets in income when it arises. For example, a gain may arise on initial recognition of a biological asset, such as when a calf is born. A gain or loss may arise on initial recognition of agricultural produce as a result of harvesting. Losses may arise on initial recognition for agricultural assets because costs to sell are deducted in determining fair value less costs to sell.

IFRS Insights 497

498 Chapter 9 Inventories: Additional Valuation Issues

Agricultural produce (which are harvested from biological assets) are measured at fair value less costs to sell (net realizable value) at the point of harvest. Once harvested, the net realizable value of the agricultural produce becomes its cost, and this asset is accounted for similar to other inventories held for sale in the normal course of business. Measurement at fair value or selling price less point-of-sale costs corresponds to the net realizable value measure in the LCNRV test (selling price less estimated costs to complete and sell) since at harvest, the agricultural product is complete and is ready for sale.

Illustration of Agricultural Accounting at Net Realizable Value To illustrate the accounting at net realizable value for agricultural assets, assume that Bancroft Dairy produces milk for sale to local cheese-makers. Bancroft began operations on January 1, 2017, by purchasing 420 milking cows for $460,000. Bancroft provides the following information related to the milking cows.

Milking cows Carrying value, January 1, 2017* $460,000 Change in fair value due to growth and price changes $35,000 Decrease in fair value due to harvest (1,200) Change in carrying value 33,800

Carrying value, January 31, 2017 $493,800 Milk harvested during January** $ 36,000

*The carrying value is measured at fair value less costs to sell (net realizable value). The fair value of milking cows is determined based on market prices of livestock of similar age, breed, and genetic merit. **Milk is initially measured at its fair value less costs to sell (net realizable value) at the time of milking. The fair value of milk is determined based on market prices in the local area.

ILLUSTRATION IFRS9-5 Agricultural Assets— Bancroft Dairy

As indicated, the carrying value of the milking cows increased during the month. Part of the change is due to changes in market prices (less costs to sell) for milking cows. The change in mar- ket price may also be affected by growth—the increase in value as the cows mature and develop increased milking capacity. At the same time, as mature cows are milked, their milking capacity declines (fair value decrease due to harvest). For example, changes in fair value arising from growth and harvesting from mature cows can be estimated based on changes in market prices of different age cows in the herd.

Bancroft makes the following entry to record the change in carrying value of the milking cows.

Biological Asset—Milking Cows ($493,800 − $460,000) 33,800 Unrealized Holding Gain or Loss—Income 33,800

As a result of this entry, Bancroft’s statement of financial position reports Biological Asset—Milk- ing Cows as a non-current asset at fair value less costs to sell (net realizable value). In addition, the unrealized gains and losses are reported as other income and expense on the income state- ment. In subsequent periods at each reporting date, Bancroft continues to report Biological Asset—Milking Cows at net realizable value and records any related unrealized gains or losses in income. Because there is a ready market for the biological assets (milking cows), valuation at net realizable value provides more relevant information about these assets.

In addition to recording the change in the biological asset, Bancroft makes the following sum- mary entry to record the milk harvested for the month of January.

Milk Inventory 36,000 Unrealized Holding Gain or Loss—Income 36,000

The milk inventory is recorded at net realizable value at the time it is harvested, and Unrealized Holding Gain or Loss—Income is recognized in income. As with the biological assets, net realizable value is considered the most relevant for purposes of valuation at harvest. What happens to the milk inventory that Bancroft recorded upon harvesting the milk from the cows? Assuming the milk har- vested in January was sold to a local cheese-maker for $38,500, Bancroft records the sale as follows.

Cash 38,500 Cost of Goods Sold 36,000 Milk Inventory 36,000 Sales Revenue 38,500

IFRS Insights 499

Thus, once harvested, the net realizable value of the harvested milk becomes its cost, and the milk is accounted for similar to other inventories held for sale in the normal course of business.

A final note: Some animals or plants may not be considered biological assets but would be classified and accounted for as other types of assets (not at net realizable value). For example, a pet shop may hold an inventory of dogs purchased from breeders that it then sells. Because the pet shop is not breeding the dogs, these dogs are not considered biological assets. As a result, the dogs are accounted for as inventory held for sale (at LCNRV).

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

1. All of the following are key similarities between GAAP and IFRS with respect to accounting for inventories except:

(a) costs to include in inventories are similar. (b) LIFO cost flow assumption where appropriate is

used by both sets of standards. (c) fair value valuation of inventories is prohibited by

both sets of standards. (d) guidelines on ownership of goods are similar.

2. All of the following are key differences between GAAP and IFRS with respect to accounting for inventories except the:

(a) definition of the lower-of-cost-or-market test for inventory valuation differs between GAAP and IFRS.

(b) average-cost method is prohibited under IFRS. (c) inventory basis determination for write-downs dif-

fers between GAAP and IFRS. (d) guidelines are more principles-based under IFRS

than they are under GAAP. 3. Starfish Company (a company using GAAP and the LIFO inventory method) is considering changing to IFRS and the FIFO inventory method. How would a comparison of these methods affect Starfish’s financials?

(a) During a period of inflation, working capital would decrease when IFRS and the FIFO inventory method are used as compared to GAAP and LIFO.

(b) During a period of inflation, the taxes will decrease when IFRS and the FIFO inventory method are used as compared to GAAP and LIFO.

(c) During a period of inflation, net income would be greater if IFRS and the FIFO inventory method are used as compared to GAAP and LIFO.

(d) During a period of inflation, the current ratio would decrease when IFRS and the FIFO inventory method are used as compared to GAAP and LIFO.

4. Assume that Darcy Industries had the following inventory values.

Inventory cost (on December 31, 2017) $1,500 Inventory market (on December 31, 2017) $1,350 Inventory net realizable value (on December 31, 2017) $1,320

Under IFRS, what is the inventory carrying value on December 31, 2017?

(a) $1,500. (b) $1,570. (c) $1,560. (d) $1,320.

5. Under IFRS, agricultural activity results in which of the following types of assets?

I. Agricultural produce II. Biological assets (a) I only. (b) II only. (c) I and II. (d) Neither I nor II.

IFRS SELF-TEST QUESTIONS

IFRS CONCEPTS AND APPLICATION

IFRS9-1 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to the accounting for inventories.

IFRS9-2 LaTour Inc. is based in France and prepares its financial statements in accordance with IFRS. In 2017, it reported cost of goods sold of $578 million and average inventory of $154 million. Briefly discuss how analysis of LaTour’s inventory turnover (and comparisons to a company using GAAP) might be affected by differences in inventory accounting between IFRS and GAAP.

IFRS9-3 Reed Pentak, a finance major, has been following globalization and made the following observation concerning accounting convergence: “I do not see many obstacles concerning development of a single accounting standard for inventories.” Prepare a response to Reed to explain the main obstacle to achieving convergence in the area of inventory accounting.

500 Chapter 9 Inventories: Additional Valuation Issues

IFRS9-4 Briefly describe the valuation of (a) biological assets and (b) agricultural produce.

IFRS9-5 In some instances, accounting principles require a departure from valuing inventories at cost alone. Determine the proper unit inventory price in the following cases.

Cases

1 2 3 4 5

Cost $15.90 $16.10 $15.90 $15.90 $15.90 Sales price 14.80 19.20 15.20 10.40 17.80 Estimated cost to complete 1.50 1.90 1.65 .80 1.00 Estimated cost to sell

.50 .70 .55 .40 .60

IFRS9-6 Riegel Company uses the LCNRV method, on an individual-item basis, in pricing its inventory items. The inventory at December 31, 2017, consists of products D, E, F, G, H, and I. Relevant per unit data for these products appear below.

Using the LCNRV rule, determine the proper unit value for statement of financial position reporting purposes at December 31, 2017, for each of the inventory items above.

IFRS9-7 Dover Company began operations in 2017 and determined its ending inventory at cost and at LCNRV at December 31, 2017, and December 31, 2018. This information is presented below.

Items

D E F G H I

Estimated selling price $120 $110 $95 $90 $110 $90 Cost 75 80 80 80 50 36 Cost to complete 30 30 25 35 30 30 Selling costs 10 18 10 20 10 20

(a) Prepare the journal entries required at December 31, 2017, and December 31, 2018, assuming that the inventory is recorded at LCNRV and a perpetual inventory system using the cost-of-goods-sold method is used.

(b) Prepare journal entries required at December 31, 2017, and December 31, 2018, assuming that the inventory is recorded at cost and a perpetual system using the loss method is used.

IFRS9-8 Keyser’s Fleece Inc. holds a drove of sheep. Keyser shears the sheep on a semiannual basis and then sells the har- vested wool into the specialty knitting market. Keyser has the following information related to the shearing sheep at January 1, 2017, and during the first six months of 2017. Shearing Sheep

Carrying value (equal to net realizable value), January 1, 2017 $74,000 Change in fair value due to growth and price changes 4,700 Change in fair value due to harvest (575) Wool harvested during the fi rst 6 months (at NRV) 9,000

Prepare the journal entry(ies) for Keyser’s biological asset (shearing sheep) for the first six months of 2017.

IFRS9-9 Refer to the data in IFRS9-8 for Keyser’s Fleece Inc. Prepare the journal entries for (a) the wool harvested in the first six months of 2017, and (b) the wool harvested that is sold for $10,500 in July 2017.

Professional Research IFRS9-10 Jones Co. is in a technology-intensive industry. Recently, one of its competitors introduced a new product with tech- nology that might render obsolete some of Jones’s inventory. The accounting staff wants to follow the appropriate authoritative literature in determining the accounting for this significant market event.

Cost Net Realizable Value

12/31/17 $346,000 $322,000 12/31/18 410,000 390,000

IFRS Insights 501

International Financial Reporting Problem

Marks and Spencer plc (M&S)

IFRS9-11 The financial statements of M&S are presented in Appendix E. The company’s complete annual report, including the notes to the financial statements, is available online.

Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions.

(a) How does M&S value its inventories? Which inventory costing method does M&S use as a basis for reporting its inventories?

(b) How does M&S report its inventories in the statement of fi nancial position? (c) What costs does M&S include in Inventory and Cost of Sales? (d) What was M&S’s inventory turnover in 2015? What is its gross profi t percentage? Evaluate M&S’s inventory

turnover and its gross profi t percentage.

ANSWERS TO IFRS SELF-TEST QUESTIONS

1. b 2. b 3. c 4. d 5. c

(a) Identify the authoritative literature addressing inventory pricing. (b) List three types of goods that are classifi ed as inventory. What characteristic will automatically exclude an item from

being classifi ed as inventory? (c) Defi ne “net realizable value” as used in the phrase “lower-of-cost-or-net realizable value.” (d) Explain when it is acceptable to state inventory above cost and which industries allow this practice.

WATCH YOUR SPENDING Investments in long-lived assets, such as property, plant, and equipment, are important elements in many com- panies’ balance sheets. Along with research and development, these investments are the driving force in gener- ating cash flows. To provide some insight into the magnitude of these expenditures, the following graph shows how capital expenditures on structures and equipment (whether new or used) are starting to grow again after the effects of the 2008 financial crisis.

Acquisition and Disposition of Property, Plant, and Equipment10 1 Understand property, plant, and

equipment and its related costs.

2 Describe the accounting problems associated with self-constructed assets.

3 Describe the accounting problems associated with interest capitalization.

4 Understand accounting issues related to acquiring and valuing plant assets.

5 Describe the accounting treatment for costs subsequent to acquisition.

6 Describe the accounting treatment for the disposal of property, plant, and equipment.

LEARNING OBJECTIVES After studying this chapter, you should be able to:

300

600

900

1,200

$1,500

358.5

639.4

2002 2003 2004 2005

Structures Equipment

2006 2007 2008 2009 2010 2011

630.4 673.4

Year

Cu rr

en t D

ol la

rs (i

n bi

lli on

743.1 821.2 829.5 811.8 641.1 676.1 770.9

344.6 368.7 401.7

488.7 525.3 562.4

449.5 429.6 454.7

On an even more positive note, spending on capital projects (including research and development) is on the uptrend in just about all industries, as shown in the following table.

Capital expenditures are significant for many companies. For example, at Jet Blue Airways, plant assets are 69 percent of its total assets. For Wal-Mart Stores, Inc., it’s 56 percent. Conversely, Microsoft’s percentage is just 8 percent. Amounts for companies’ capital expenditures are reported on a company’s balance sheet and directly affect such items as total assets, depreciation expense, cash flows, and net income. Companies that overspend in this area find that income is reduced as depreciation increases without corresponding increases in revenues. As a result, these companies often lose financial flexibility. That is, they find themselves in a cash bind as their cash flows from operations can no longer meet their obligations.

A good example is Baker Hughes, Inc. (an oilfield-services company), which in the first half of 2012 reported cash flow from operations of $24 million but capital expenditures of $1,442 million. Although the company is presently stable, the unfavorable relationship of cash flow from operations to capital expenditures was a cause for concern.

Companies can also affect income by reducing capital expenditures. For example, Cintas (a uniform-rental business) cut back on capital expenditures in recent years. Subsequently, depreciation expense declined to $152 million from $158 million in the prior year. That lifted its earnings per share by seven cents. Similarly, Norfolk Southern added eight cents per share to its bottom line through lower depreciation charges.

Thus, not only do companies have to be careful in planning the proper amount of capital expenditures, but users must understand the impact of these expenditures on measures of financial performance. As illustrated by the exam- ples above, the level of capital expenditures, depreciation expense, cash flow from operations, and net income all play a role in assessing a company’s ability to generate future cash flows.

Sources: Adapted from L. Strauss, “Depreciation: An Appreciation,” Barrons Online (April 30, 2011); D. Phelps, “Top 100 Capi- tal Spending Report: Greek Yogurt Plants Are Stacking Up,” www.FoodProcessing.com (April 9, 2012); and T. Francis, "Big Firms Finally Start to Ramp Up Spending," Wall Street Journal (March 4, 2015).

PREVIEW OF CHAPTER 10 As we indicate in the opening story, a company like Jet Blue Airways has a substantial investment in property, plant, and equipment. Con- versely, other companies, such as Microsoft, have a minor investment in these types of as- sets. In this chapter, we discuss the proper accounting for the acquisition, use, and disposition of property, plant, and equipment. The content and organization of the chapter are as follows.

ACQUISITION AND DISPOSITION OF PROPERTY, PLANT, AND EQUIPMENT

ACQUISITION

• Acquisition costs: land, buildings, equipment

• Self-constructed assets

• Interest costs • Observations

DISPOSITION

• Sale • Involuntary

conversion • Miscellaneous

problems

This chapter also includes numerous conceptual and international discussions that are integral to the topics presented here. IFRS Insights related to PPE are presented in Chapter 11.

VALUATION

• Cash discounts • Deferred-payment contracts • Lump-sum purchases • Stock issuance • Nonmonetary exchanges • Contributions • Other valuation methods

COSTS SUBSEQUENT TO ACQUISITION

• Additions • Improvements and

replacements • Rearrangement and

reinstallation • Repairs • Summary

Capital Expense (in billions)

Industry 2013 2014 Change

Retail $ 17.5 $ 18.6 6% Services 29.4 33.5 14 Finance, insurance, and real estate 32.7 38.8 19 Mining 91.7 90.9 −1 Transportation and utilities 162.1 166.3 3 Manufacturing 224.3 224.3 0

503

504 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

PROPERTY, PLANT, AND EQUIPMENT Companies like Boeing, Target, and Starbucks use assets of a durable nature. Such assets are called property, plant, and equipment. Other terms commonly used are plant assets and fixed assets. We use these terms interchangeably. Property, plant, and equip- ment include land, building structures (offices, factories, warehouses), and equipment (machinery, computers, vehicles, furniture, tools). The major characteristics of property, plant, and equipment are as follows.

1. They are acquired for use in operations and not for resale. Only assets used in nor- mal business operations are classifi ed as property, plant, and equipment. For exam- ple, an idle building is more appropriately classifi ed separately as an investment. Land developers or subdividers classify land as inventory.

2. They are long-term in nature and usually depreciated. Property, plant, and equip- ment yield services over a number of years. Companies allocate the cost of the investment in these assets to future periods through periodic depreciation charges. The exception is land, which is depreciated only if a material decrease in value occurs, such as a loss in fertility of agricultural land because of poor crop rotation, drought, or soil erosion.

3. They possess physical substance. Property, plant, and equipment are tangible assets characterized by physical existence or substance. This differentiates them from intangible assets, such as patents or goodwill. Unlike raw material, however, property, plant, and equipment do not physically become part of a product held for resale.

Acquisition of Property, Plant, and Equipment Most companies use historical cost as the basis for valuing property, plant, and equip- ment. Historical cost measures the cash or cash equivalent price of obtaining the asset and bringing it to the location and condition necessary for its intended use. For exam- ple, companies like Kellogg Co. consider the purchase price, freight costs, sales taxes, and installation costs of a productive asset as part of the asset’s cost. It then allocates these costs to future periods through depreciation. Further, Kellogg adds to the asset’s original cost any related costs incurred after the asset’s acquisition, such as additions, improvements, or replacements, if they provide future service potential. Otherwise, Kellogg expenses these costs immediately.1

Subsequent to acquisition, companies should not write up property, plant, and equipment to reflect fair value when it is above cost. The main reasons for this position are as follows.

1. Historical cost involves actual, not hypothetical, transactions and so is the most reliable.

2. Companies should not anticipate gains and losses but should recognize gains and losses only when the asset is sold.

Even those who favor fair value measurement for inventory and financial instru- ments often take the position that property, plant, and equipment should not be reval- ued. The major concern is the difficulty of developing a reliable fair value for these types

LEARNING OBJECTIVE 1 Understand property, plant, and equipment and its related costs.

INTERNATIONAL PERSPECTIVE

Under international accounting standards, historical cost is the benchmark (preferred) treatment for property, plant, and equipment. However, companies may also use revalued amounts. When using revaluation, companies must revalue the class of assets regularly.

1Additional costs to be included in the cost of property, plant, and equipment are those related to asset retirement obligations (AROs). These costs, such as those related to decommissioning nuclear facilities or reclamation or restoration of a mining facility, reflect a legal requirement to retire the asset at the end of its useful life. The expected costs are recorded in the asset cost and depreciated over the useful life (see an expanded discussion of AROs in Chapter 13).

UNDERLYING CONCEPTS

Fair value is relevant to inventory but less so for property, plant, and equipment which, con- sistent with the going concern assumption, are held for use in the business, not for sale like inventory.

Property, Plant, and Equipment 505

of assets. For example, how does one value a General Motors automobile manufactur- ing plant or a nuclear power plant owned by Consolidated Edison?

However, if the fair value of the property, plant, and equipment is less than its car- rying amount, the asset may be written down. These situations occur when the asset is impaired (discussed in Chapter 11) and in situations where the asset is being held for sale. A long-lived asset classified as held for sale should be measured at the lower of its carrying amount or fair value less costs to sell. In that case, a reasonable valuation for the asset can be obtained, based on the sales price. A long-lived asset is not depreciated if it is classified as held for sale. This is because such assets are not being used to gener- ate revenues. [1]

Cost of Land All expenditures made to acquire land and ready it for use are considered part of the land cost. Thus, when Wal-Mart Stores, Inc. or Home Depot purchases land on which to build a new store, its land costs typically include (1) the purchase price; (2) closing costs, such as title to the land, attorney’s fees, and recording fees; (3) costs incurred in getting the land in condition for its intended use, such as grading, fill- ing, draining, and clearing; (4) assumption of any liens, mortgages, or encum- brances on the property; and (5) any additional land improvements that have an indefinite life.

For example, when Home Depot purchases land for the purpose of constructing a building, it considers all costs incurred up to the excavation for the new building as land costs. Removal of old buildings—clearing, grading, and filling—is a land cost because this activity is necessary to get the land in condition for its intended purpose. Home Depot treats any proceeds from getting the land ready for its intended use, such as sal- vage receipts on the demolition of an old building or the sale of cleared timber, as reduc- tions in the cost the land.

In some cases, when Home Depot purchases land, it may assume certain obligations on the land such as back taxes or liens. In such situations, the cost of the land is the cash paid for it, plus the encumbrances. In other words, if the purchase price of the land is $50,000 cash but Home Depot assumes accrued property taxes of $5,000 and liens of $10,000, its land cost is $65,000.

Home Depot also might incur special assessments for local improvements, such as pavements, street lights, sewers, and drainage systems. It should charge these costs to the Land account because they are relatively permanent in nature. That is, after installa- tion, they are maintained by the local government. In addition, Home Depot should charge any permanent improvements it makes, such as landscaping, to the Land account. It records separately any improvements with limited lives, such as private driveways, walks, fences, and parking lots, as Land Improvements. These costs are depreciated over their estimated lives.

Generally, land is part of property, plant, and equipment. However, if the major purpose of acquiring and holding land is speculative, a company more appropriately classifies the land as an investment. If a real estate concern holds the land for resale, it should classify the land as inventory.

In cases where land is held as an investment, what accounting treatment should be given for taxes, insurance, and other direct costs incurred while holding the land? Many believe these costs should be capitalized. The reason: They are not generating revenue from the investment at this time. Companies generally use this approach except when the asset is currently producing revenue (such as rental property).

Cost of Buildings The cost of buildings should include all expenditures related directly to their acquisition or construction. These costs include (1) materials, labor, and overhead costs incurred during construction, and (2) professional fees and building permits. Generally,

See the FASB Codifi cation References (page 550).

506 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

companies contract others to construct their buildings. Companies consider all costs incurred, from excavation to completion, as part of the building costs.

But how should companies account for an old building that is on the site of a newly proposed building? Is the cost of removal of the old building a cost of the land or a cost of the new building? Recall that if a company purchases land with an old building on it, then the cost of demolition less its salvage value is a cost of getting the land ready for its intended use and relates to the land rather than to the new building. In other words, all costs of getting an asset ready for its intended use are costs of that asset.

Cost of Equipment The term “equipment” in accounting includes delivery equipment, office equipment, machinery, furniture and fixtures, furnishings, factory equipment, and similar fixed assets. The cost of such assets includes the purchase price, freight and handling charges incurred, insurance on the equipment while in transit, cost of special founda- tions if required, assembling and installation costs, and costs of conducting trial runs. Costs thus include all expenditures incurred in acquiring the equipment and prepar- ing it for use.

Self-Constructed Assets Occasionally, companies construct their own assets. Determining the cost of such machinery and other fixed assets can be a problem. Without a purchase price or contract price, the company must allocate costs and expenses to arrive at the cost of the self- constructed asset. Materials and direct labor used in construction pose no problem. A company can trace these costs directly to work and material orders related to the fixed assets constructed.

However, the assignment of indirect costs of manufacturing creates special prob- lems. These indirect costs, called overhead or burden, include power, heat, light, insur- ance, property taxes on factory buildings and equipment, factory supervisory labor, depreciation of fixed assets, and supplies.

Companies can handle indirect costs in one of two ways:

1. Assign no fi xed overhead to the cost of the constructed asset. The major argument for this treatment is that indirect overhead is generally fi xed in nature. It does not increase as a result of a company constructing its own plant or equipment. This approach assumes that the company will have the same costs regardless of whether it constructs the asset or not. Therefore, to charge a portion of the over- head costs to the equipment will normally reduce current expenses and conse- quently overstate income of the current period. However, the company would assign to the cost of the constructed asset variable overhead costs that increase as a result of the construction.

2. Assign a portion of all overhead to the construction process. This approach, called a full-costing approach, follows the belief that costs should attach to all products and assets manufactured or constructed. Under this approach, a com- pany assigns a portion of all overhead to the construction process, as it would to normal production. Advocates say that failure to allocate overhead costs understates the initial cost of the asset and results in an inaccurate future allocation.

Companies should assign to the asset a pro rata portion of the fixed overhead to determine its cost. Companies use this treatment extensively because many believe that it results in a better recognition of these costs in periods benefited.

If the allocated overhead results in recording construction costs in excess of the costs that an outside independent producer would charge, the company should record the

LEARNING OBJECTIVE 2 Describe the accounting problems associated with self-constructed assets.

Property, Plant, and Equipment 507

excess overhead as a period loss rather than capitalize it. This avoids capitalizing the asset at more than its probable fair value.2

Interest Costs During Construction The proper accounting for interest costs has been a long-standing controversy. Three approaches have been suggested to account for the interest incurred in financing the construction of property, plant, and equipment:

1. Capitalize no interest charges during construction. Under this approach, inter- est is considered a cost of fi nancing and not a cost of construction. Some contend that if a company had used stock (equity) fi nancing rather than debt, it would not incur this cost. The major argument against this approach is that the use of cash, whatever its source, has an associated implicit interest cost, which should not be ignored.

2. Charge construction with all costs of funds employed, whether identifi able or not. This method maintains that the cost of construction should include the cost of fi nancing, whether by cash, debt, or stock. Its advocates say that all costs nec- essary to get an asset ready for its intended use, including interest, are part of the asset’s cost. Interest, whether actual or imputed, is a cost, just as are labor and materials. A major criticism of this approach is that imputing the cost of equity capital (stock) is subjective and outside the framework of an historical cost system.

3. Capitalize only the actual interest costs incurred during construction. This approach agrees in part with the logic of the second approach—that interest is just as much a cost as are labor and materials. But this approach capitalizes only interest costs incurred through debt fi nancing. (That is, it does not try to determine the cost of equity fi nancing.) Under this approach, a company that uses debt fi nancing will have an asset of higher cost than a company that uses stock fi nancing. Some consider this approach unsatisfactory because they believe the cost of an asset should be the same whether it is fi nanced with cash, debt, or equity.

Illustration 10-1 shows how a company might add interest costs (if any) to the cost of the asset under the three capitalization approaches.

2A committee of the AICPA argues against allocation of overhead. Instead, it supports capitalization of only direct costs (costs directly related to the specific activities involved in the construction process). This committee was concerned that the allocation of overhead costs may lead to overly aggressive allocations and therefore misstatements of income. In addition, not reporting these costs as period costs during the construction period may affect comparisons of period costs and resulting net income from one period to the next. See Accounting Standards Executive Committee, “Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment,” Exposure Draft (New York: AICPA, June 29, 2001).

LEARNING OBJECTIVE 3 Describe the accounting problems associated with interest capitalization.

Increase to Cost of Asset

Capitalize all costs of funds

Capitalize no interest

during construction

$ 0 $ ?

Capitalize actual costs incurred

during construction

GAAP

ILLUSTRATION 10-1 Capitalization of Interest Costs

508 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

GAAP requires the third approach—capitalizing actual interest (with modifica- tion). This method follows the concept that the historical cost of acquiring an asset includes all costs (including interest) incurred to bring the asset to the condition and location necessary for its intended use. The rationale for this approach is that during construction, the asset is not generating revenues. Therefore, a company should defer (capitalize) interest costs. [2] Once construction is complete, the asset is ready for its intended use and a company can earn revenues. At this point, the company should report interest as an expense and match it to these revenues. It follows that the com- pany should expense any interest cost incurred in purchasing an asset that is ready for its intended use.

To implement this general approach, companies consider three items:

1. Qualifying assets. 2. Capitalization period. 3. Amount to capitalize.

Qualifying Assets To qualify for interest capitalization, assets must require a period of time to get them ready for their intended use. A company capitalizes interest costs starting with the first expenditure related to the asset. Capitalization continues until the company substan- tially readies the asset for its intended use.

Assets that qualify for interest cost capitalization include assets under construction for a company’s own use (including buildings, plants, and large machinery) and assets intended for sale or lease that are constructed or otherwise produced as discrete projects (e.g., ships or real estate developments).

Examples of assets that do not qualify for interest capitalization are (1) assets that are in use or ready for their intended use, and (2) assets that the company does not use in its earnings activities and that are not undergoing the activities necessary to get them ready for use. Examples of this second type include land remaining undeveloped and assets not used because of obsolescence, excess capacity, or need for repair.

Capitalization Period The capitalization period is the period of time during which a company must capitalize interest. It begins with the presence of three conditions:

1. Expenditures for the asset have been made. 2. Activities that are necessary to get the asset ready for its intended use are in

progress. 3. Interest cost is being incurred.

Interest capitalization continues as long as these three conditions are present. The capitalization period ends when the asset is substantially complete and ready for its intended use.

Amount to Capitalize The amount of interest to capitalize is limited to the lower of actual interest cost incurred during the period or avoidable interest. Avoidable interest is the amount of interest cost during the period that a company could theoretically avoid if it had not made expenditures for the asset. If the actual interest cost for the period is $90,000 and the avoidable interest is $80,000, the company capitalizes only $80,000. Or, if the actual interest cost is $80,000 and the avoidable interest is $90,000, it still

UNDERLYING CONCEPTS

The objective of capi- talizing interest is to obtain a measure of acquisition cost that refl ects a company’s total investment in the asset and to charge that cost to future periods benefi ted.

Property, Plant, and Equipment 509

capitalizes only $80,000. In no situation should interest cost include a cost of capital charge for stockholders’ equity. Furthermore, GAAP requires interest capitalization for a qualifying asset only if its effect, compared with the effect of expensing inter- est, is material. [3]

To apply the avoidable interest concept, a company determines the potential amount of interest that it may capitalize during an accounting period by multiplying the interest rate(s) by the weighted-average accumulated expenditures for qualifying assets during the period.

Weighted-Average Accumulated Expenditures. In computing the weighted-average accumulated expenditures, a company weights the construction expenditures by the amount of time (fraction of a year or accounting period) that it can incur interest cost on the expenditure.

To illustrate, assume a 17-month bridge construction project with current-year pay- ments to the contractor of $240,000 on March 1, $480,000 on July 1, and $360,000 on November 1. The company computes the weighted-average accumulated expenditures for the year ended December 31 as follows.

3The interest rate to be used may rely exclusively on an average rate of all the borrowings, if desired. For our purposes, we use the specific borrowing rate followed by the average interest rate because we believe it to be more conceptually consistent. Either method can be used; GAAP does not provide explicit guidance on this measurement. For a discussion of this issue and others related to interest capitalization, see Kathryn M. Means and Paul M. Kazenski, “SFAS 34: Recipe for Diversity,” Accounting Horizons (September 1988); and Wendy A. Duffy, “A Graphical Analysis of Interest Capitalization,” Journal of Accounting Education (Fall 1990).

ILLUSTRATION 10-2 Computation of Weighted- Average Accumulated Expenditures

Expenditures

Capitalization Weighted-Average Date Amount × Period* = Accumulated Expenditures March 1 $ 240,000 10/12 $200,000 July 1 480,000 6/12 240,000 November 1 360,000 2/12 60,000 $1,080,000 $500,000

*Months between date of expenditure and date interest capitalization stops or end of year, whichever comes first (in this case, December 31).

To compute the weighted-average accumulated expenditures, a company weights the expenditures by the amount of time that it can incur interest cost on each one. For the March 1 expenditure, the company associates 10 months’ interest cost with the expenditure. For the expenditure on July 1, it incurs only 6 months’ interest costs. For the expenditure made on November 1, the company incurs only 2 months of interest cost.

Interest Rates. Companies follow the below principles in selecting the appropriate interest rates to be applied to the weighted-average accumulated expenditures:

1. For the portion of weighted-average accumulated expenditures that is less than or equal to any amounts borrowed specifi cally to fi nance construction of the assets, use the interest rate incurred on the specifi c borrowings.

2. For the portion of weighted-average accumulated expenditures that is greater than any debt incurred specifi cally to fi nance construction of the assets, use a weighted average of interest rates incurred on all other outstanding debt during the period.3

510 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

ILLUSTRATION 10-3 Computation of Weighted- Average Interest Rate

Principal Interest

12%, 2-year note $ 600,000 $ 72,000 9%, 10-year bonds 2,000,000 180,000 7.5%, 20-year bonds 5,000,000 375,000

$7,600,000 $627,000

Weighted-average interest rate = = = 8.25%Total interest Total principal

$627,000 $7,600,000

Comprehensive Example of Interest Capitalization To illustrate the issues related to interest capitalization, assume that on November 1, 2016, Shalla Company contracted Pfeifer Construction Co. to construct a building for $1,400,000 on land costing $100,000 (purchased from the contractor and included in the first payment). Shalla made the following payments to the construction company during 2017.

January 1 March 1 May 1 December 31 Total

$210,000 $300,000 $540,000 $450,000 $1,500,000

Pfeifer Construction completed the building, ready for occupancy, on December 31, 2017. Shalla had the following debt outstanding at December 31, 2017.

Specific Construction Debt

1. 15%, 3-year note to finance purchase of land and construction of the building, dated December 31, 2016, with interest payable annually on December 31 $750,000

Other Debt

2. 10%, 5-year note payable, dated December 31, 2013, with interest payable annually on December 31 $550,000

3. 12%, 10-year bonds issued December 31, 2012, with interest payable annually on December 31 $600,000

Shalla computed the weighted-average accumulated expenditures during 2017 as shown in Illustration 10-4.

Current-Year

Expenditures Capitalization Weighted-Average

Date Amount × Period = Accumulated Expenditures January 1 $ 210,000 12/12 $210,000 March 1 300,000 10/12 250,000 May 1 540,000 8/12 360,000 December 31 450,000 0 0 $1,500,000 $820,000

ILLUSTRATION 10-4 Computation of Weighted- Average Accumulated Expenditures

Note that the expenditure made on December 31, the last day of the year, does not have any interest cost.

Shalla computes the avoidable interest as shown in Illustration 10-5.

Illustration 10-3 shows the computation of a weighted-average interest rate for debt greater than the amount incurred specifically to finance construction of the assets.

Property, Plant, and Equipment 511

The interest cost that Shalla capitalizes is the lesser of $120,228 (avoidable interest) and $239,500 (actual interest), or $120,228.

Shalla records the following journal entries during 2017:

January 1

Land 100,000

Buildings (or Construction in Process) 110,000

Cash 210,000

March 1 Buildings 300,000 Cash 300,000

May 1 Buildings 540,000 Cash 540,000

December 31 Buildings 450,000 Cash 450,000 Buildings (Capitalized Interest) 120,228 Interest Expense ($239,500 − $120,228) 119,272 Cash ($112,500 + $55,000 + $72,000) 239,500

Shalla should write off capitalized interest cost as part of depreciation over the use- ful life of the assets involved and not over the term of the debt. It should disclose the total interest cost incurred during the period, with the portion charged to expense and the portion capitalized indicated.

At December 31, 2017, Shalla discloses the amount of interest capitalized either as part of the nonoperating section of the income statement or in the notes

The company determines the actual interest cost, which represents the maximum amount of interest that it may capitalize during 2017, as shown in Illustration 10-6.

Construction note $750,000 × .15 = $112,500 5-year note 550,000 × .10 = 55,000 10-year bonds 600,000 × .12 = 72,000 Actual interest $239,500

ILLUSTRATION 10-6 Computation of Actual Interest Cost

ILLUSTRATION 10-5 Computation of Avoidable Interest

Weighted-Average Accumulated Expenditures × Interest Rate = Avoidable Interest

$750,000 .15 (construction note) $112,500 70,000a .1104 (weighted average of 7,728 $820,000 other debt)

b $120,228

aThe amount by which the weighted-average accumulated expenditures exceeds the specific construction loan. bWeighted-average interest rate computation: Principal Interest

10%, 5-year note $ 550,000 $ 55,000 12%, 10-year bonds 600,000 72,000

$1,150,000 $127,000

Weighted-average interest rate = Total interest Total principal

= $127,000 $1,150,000

= 11.04%

512 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

accompanying the financial statements. We illustrate both forms of disclosure, in Illustrations 10-7 and 10-8.4

4In subsequent years of a multi-year project, Shalla would follow the same procedures as presented for year 1. That is, interest to be capitalized each year is determined, based on weighted-average expenditures in that year multiplied by the appropriate interest rate, and then compared to actual interest. Total interest for the year is then allocated to interest expense and capitalized interest.

Income from operations XXXX Other expenses and losses: Interest expense $239,500 Less: Capitalized interest 120,228 119,272

Income before income taxes XXXX Income taxes XXX

Net income XXXX

ILLUSTRATION 10-7 Capitalized Interest Reported in the Income Statement

Note 1: Accounting Policies. Capitalized Interest. During 2017, total interest cost was $239,500, of which $120,228 was capitalized and $119,272 was charged to expense.

ILLUSTRATION 10-8 Capitalized Interest Disclosed in a Note

The requirement to capitalize interest can signifi cantly impact fi nancial statements. For example, when earnings of building manufacturer Jim Walter’s Corporation dropped from $1.51 to $1.17 per share, the company offset 11 cents per share of the decline by capitalizing the interest on coal mining projects and several plants under construction.

How do statement users determine the impact of interest capitalization on a company’s bottom line? They examine the

notes to the fi nancial statements. Companies with material interest capitalization must disclose the amounts of capitalized interest relative to total interest costs. For example, Anadarko Petroleum Corporation capitalized nearly 30 percent of its total interest costs in a recent year and provided the following footnote related to capitalized interest.

WHAT DO THE NUMBERS MEAN? WHAT’S IN YOUR INTEREST?

Financial Footnotes Total interest costs incurred during the year were $82,415,000. Of this amount, the Company capitalized $24,716,000. Capitalized interest is included as part of the cost of oil and gas properties. The capitalization rates are based on the Company’s weighted-average cost of borrowings used to fi nance the expenditures.

Special Issues Related to Interest Capitalization Two issues related to interest capitalization merit special attention:

1. Expenditures for land. 2. Interest revenue.

Expenditures for Land. When a company purchases land with the intention of develop- ing it for a particular use, interest costs associated with those expenditures qualify for interest capitalization. If it purchases land as a site for a structure (such as a plant site), interest costs capitalized during the period of construction are part of the cost of the plant, not the land. Conversely, if the company develops land for lot sales, it includes any capitalized interest cost as part of the acquisition cost of the developed land. How- ever, it should not capitalize interest costs involved in purchasing land held for specula- tion because the asset is ready for its intended use.

Interest Revenue. Companies frequently borrow money to finance construction of assets. They temporarily invest the excess borrowed funds in interest-bearing securities until they need the funds to pay for construction. During the early stages of construction, interest revenue earned may exceed the interest cost incurred on the borrowed funds.

Valuation of Property, Plant, and Equipment 513

Should companies offset interest revenue against interest cost when determin- ing the amount of interest to capitalize as part of the construction cost of assets? In general, companies should not net or offset interest revenue against interest cost. Temporary or short-term investment decisions are not related to the interest incurred as part of the acquisition cost of assets. Therefore, companies should cap- italize the interest incurred on qualifying assets whether or not they temporarily invest excess funds in short-term securities. Some criticize this approach because a company can defer the interest cost but report the interest revenue in the current period.

Observations The interest capitalization requirement is still debated. From a conceptual viewpoint, many believe that, for the reasons mentioned earlier, companies should either capitalize no interest cost or all interest costs, actual or imputed.

VALUATION OF PROPERTY, PLANT, AND EQUIPMENT Like other assets, companies should record property, plant, and equipment at the fair value of what they give up or at the fair value of the asset received, whichever is more clearly evident. However, the process of asset acquisition sometimes obscures fair value. For example, if a company buys land and buildings together for one price, how does it determine separate values for the land and buildings? We examine these types of accounting problems in the following sections.

Cash Discounts When a company purchases plant assets subject to cash discounts for prompt payment, how should it report the discount? If it takes the discount, the company should consider the discount as a reduction in the purchase price of the asset. But should the company reduce the asset cost even if it does not take the discount?

Two points of view exist on this question. One approach considers the discount— whether taken or not—as a reduction in the cost of the asset. The rationale for this approach is that the real cost of the asset is the cash or cash equivalent price of the asset. In addition, some argue that the terms of cash discounts are so attractive that failure to take them indicates management error or inefficiency.

Proponents of the other approach argue that failure to take the discount should not always be considered a loss. The terms may be unfavorable, or it might not be prudent for the company to take the discount. At present, companies use both methods though most prefer the method that considers all discounts, whether taken or not.

Deferred-Payment Contracts Companies frequently purchase plant assets on long-term credit contracts, using notes, mortgages, bonds, or equipment obligations. To properly reflect cost, companies account for assets purchased on long-term credit contracts at the present value of the consideration exchanged between the contracting parties at the date of the transaction.

For example, Greathouse Company purchases an asset today in exchange for a $10,000 zero-interest-bearing note payable four years from now. The company would not record the asset at $10,000. Instead, the present value of the $10,000 note estab- lishes the exchange price of the transaction (the purchase price of the asset). Assuming an appropriate interest rate of 9 percent at which to discount this single payment of $10,000 due four years from now, Greathouse records this asset at $7,084.30 ($10,000 ×

LEARNING OBJECTIVE 4 Understand accounting issues related to acquir- ing and valuing plant assets.

INTERNATIONAL PERSPECTIVE

IFRS requires that in- terest revenue earned on specifi c borrowings should offset interest costs capitalized. The rationale is that the in- terest revenue earned is directly related to the interest cost incurred on the specifi c borrowing.

514 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

.70843). [See Table 6-2 (page 317) for the present value of a single sum, PV = $10,000 (PVF4,9%).]

When no interest rate is stated or if the specified rate is unreasonable, the com- pany imputes an appropriate interest rate. The objective is to approximate the inter- est rate that the buyer and seller would negotiate at arm’s length in a similar bor- rowing transaction. In imputing an interest rate, companies consider such factors as the borrower’s credit rating, the amount and maturity date of the note, and prevailing interest rates. The company uses the cash exchange price of the asset acquired (if determinable) as the basis for recording the asset and measuring the interest element.

To illustrate, Sutter Company purchases a specially built robot spray painter for its production line. The company issues a $100,000, five-year, zero-interest-bearing note to Wrigley Robotics, Inc. for the new equipment. The prevailing market rate of interest for obligations of this nature is 10 percent. Sutter is to pay off the note in five $20,000 installments, made at the end of each year. Sutter cannot readily determine the fair value of this specially built robot. Therefore, Sutter approximates the robot’s value by establishing the fair value (present value) of the note. Entries for the date of purchase and dates of payments, plus computation of the present value of the note, are as follows.

Date of Purchase

Equipment 75,816* Discount on Notes Payable 24,184 Notes Payable 100,000

*Present value of note = $20,000 (PVF-OA5,10%) = $20,000 (3.79079); Table 6-4 = $75,816

End of First Year

Interest Expense 7,582 Notes Payable 20,000 Cash 20,000 Discount on Notes Payable 7,582

Interest expense in the first year under the effective-interest approach is $7,582 [($100,000 − $24,184) × 10%]. The entry at the end of the second year to record interest and principal payment is as follows.

End of Second Year

Interest Expense 6,340 Notes Payable 20,000 Cash 20,000 Discount on Notes Payable 6,340

Interest expense in the second year under the effective-interest approach is $6,340 [($100,000 − $24,184) − ($20,000 − $7,582)] × 10%.

If Sutter did not impute an interest rate for deferred-payment contracts, it would record the asset at an amount greater than its fair value and overstate depreciation expense. In addition, Sutter would understate interest expense in the income statement for all periods involved.

Lump-Sum Purchases A special problem of valuing fixed assets arises when a company purchases a group of plant assets at a single lump-sum price. When this common situation occurs, the com- pany allocates the total cost among the various assets on the basis of their relative fair values. The assumption is that costs will vary in direct proportion to fair value. This is

Valuation of Property, Plant, and Equipment 515

the same principle that companies apply to allocate a lump-sum cost among different inventory items.

To determine fair value, a company should use valuation techniques that are appro- priate in the circumstances. In some cases, a single valuation technique will be appropri- ate. In other cases, multiple valuation approaches might have to be used.5

To illustrate, Norduct Homes, Inc. decides to purchase several assets of a small heat- ing concern, Comfort Heating, for $80,000. Comfort Heating is in the process of liquida- tion. Its assets sold are as follows.

5The valuation approaches that should be used are the market, income, or cost approach, or a combination of these approaches. The market approach uses observable prices and other relevant information generated by market transactions involving comparable assets. The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present value amount (discounted). The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost). In determining the fair value, the company should assume the highest and best use of the asset. [4]

Book Value Fair Value

Inventory $30,000 $ 25,000 Land 20,000 25,000 Building 35,000 50,000

$85,000 $100,000

Norduct Homes allocates the $80,000 purchase price on the basis of the relative fair values (assuming specific identification of costs is impracticable) in the fol- lowing manner.

Issuance of Stock When companies acquire property by issuing securities, such as common stock, the par or stated value of such stock fails to properly measure the property cost. If trading of the stock is active, the market price of the stock issued is a fair indication of the cost of the property acquired. The stock is a good measure of the current cash equivalent price.

For example, Upgrade Living Co. decides to purchase some adjacent land for expan- sion of its carpeting and cabinet operation. In lieu of paying cash for the land, the com- pany issues to Deedland Company 5,000 shares of common stock (par value $10) that have a fair value of $12 per share. Upgrade Living Co. records the following entry.

Land (5,000 × $12) 60,000 Common Stock 50,000 Paid-in Capital in Excess of Par—Common Stock 10,000

If the company cannot determine the market price of the common stock exchanged, it establishes the fair value of the property. It then uses the value of the property as the basis for recording the asset and issuance of the common stock.

ILLUSTRATION 10-9 Allocation of Purchase Price—Relative Fair Value Basis

Inventory × $80,000 = $20,000

Land × $80,000 = $20,000

Building × $80,000 = $40,000

$25,000 $100,000

$50,000 $100,000

516 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

Exchanges of Nonmonetary Assets The proper accounting for exchanges of nonmonetary assets, such as property, plant, and equipment, is controversial.6 Some argue that companies should account for these types of exchanges based on the fair value of the asset given up or the fair value of the asset received, with a gain or loss recognized. Others believe that they should account for exchanges based on the recorded amount (book value) of the asset given up, with no gain or loss recognized. Still others favor an approach that recognizes losses in all cases but defers gains in special situations.

Ordinarily, companies account for the exchange of nonmonetary assets on the basis of the fair value of the asset given up or the fair value of the asset received, whichever is clearly more evident. [5] Thus, companies should recognize immediately any gains or losses on the exchange. The rationale for immediate recognition is that most transac- tions have commercial substance, and therefore gains and losses should be recognized.

Meaning of Commercial Substance As indicated above, fair value is the basis for measuring an asset acquired in a non- monetary exchange if the transaction has commercial substance. An exchange has commercial substance if the future cash flows change as a result of the transaction. That is, if the two parties’ economic positions change, the transaction has commer- cial substance.

For example, Andrew Co. exchanges some of its equipment for land held by Roddick Inc. It is likely that the timing and amount of the cash flows arising for the land will dif- fer significantly from the cash flows arising from the equipment. As a result, both Andrew Co. and Roddick Inc. are in different economic positions. Therefore, the exchange has commercial substance, and the companies recognize a gain or loss on the exchange.

What if companies exchange similar assets, such as one truck for another truck? Even in an exchange of similar assets, a change in the economic position of the com- pany can result. For example, let’s say the useful life of the truck received is signifi- cantly longer than that of the truck given up. The cash flows for the trucks can differ significantly. As a result, the transaction has commercial substance, and the company should use fair value as a basis for measuring the asset received in the exchange.

However, it is possible to exchange similar assets but not have a significant differ- ence in cash flows. That is, the company is in the same economic position as before the exchange. In that case, the company recognizes a loss but generally defers a gain.

As we will see in the following examples, use of fair value generally results in recognizing a gain or loss at the time of the exchange. Consequently, companies must determine if the transaction has commercial substance. To make this determi- nation, they must carefully evaluate the cash flow characteristics of the assets exchanged.7

Illustration 10-10 summarizes asset exchange situations and the related accounting.

6Nonmonetary assets are items whose price in terms of the monetary unit may change over time. Monetary assets—cash and short- or long-term accounts and notes receivable—are fixed in terms of units of currency by contract or otherwise. 7The determination of the commercial substance of a transaction requires significant judgment. In determin- ing whether future cash flows change, it is necessary to do one of two things. (1) Determine whether the risk, timing, and amount of cash flows arising for the asset received differ from the cash flows associated with the outbound asset. Or, (2) evaluate whether cash flows are affected with the exchange versus without the exchange. Also note that if companies cannot determine fair values of the assets exchanged, then they should use recorded book values in accounting for the exchange.

INTERNATIONAL PERSPECTIVE

The FASB changed its accounting for ex- changes to converge with IFRS. Previously, the FASB used a “simi- lar in nature” criterion for exchanged assets to determine whether gains should be recog- nized. With use of the commercial substance test, GAAP and IFRS are now very similar.

Valuation of Property, Plant, and Equipment 517

As Illustration 10-10 indicates, companies immediately recognize losses they incur on all exchanges. The accounting for gains depends on whether the exchange has com- mercial substance. If the exchange has commercial substance, the company recognizes the gain immediately. However, the profession modifies the rule for immediate recogni- tion of a gain when an exchange lacks commercial substance: If the company receives no cash in such an exchange, it defers recognition of a gain. If the company receives cash in such an exchange, it recognizes part of the gain immediately.

To illustrate the accounting for these different types of transactions, we examine various loss and gain exchange situations.

Exchanges—Loss Situation When a company exchanges nonmonetary assets and a loss results, the company recog- nizes the loss immediately. The rationale: Companies should not value assets at more than their cash equivalent price. If the loss were deferred, assets would be overstated. Therefore, companies recognize a loss immediately whether the exchange has commer- cial substance or not.

For example, Information Processing, Inc. trades its used machine for a new model at Jerrod Business Solutions Inc. The exchange has commercial substance. The used machine has a book value of $8,000 (original cost $12,000 less $4,000 accumulated depre- ciation) and a fair value of $6,000. The new model lists for $16,000. Jerrod gives Informa- tion Processing a trade-in allowance of $9,000 for the used machine. Information Proc- essing computes the cost of the new asset as follows.

Accounting Guidance

Recognize gains and losses immediately.

Defer gains; recognize losses immediately.

Recognize partial gain; recognize losses immediately.*

*If cash is 25% or more of the fair value of the exchange, recognize entire gain because earnings process is complete.

Type of Exchange

Exchange has commercial substance.

Exchange lacks commercial substance—no cash received.

Exchange lacks commercial substance—cash received.

ILLUSTRATION 10-10 Accounting for Exchanges

ILLUSTRATION 10-11 Computation of Cost of New Machine

List price of new machine $16,000 Less: Trade-in allowance for used machine 9,000

Cash payment due 7,000 Fair value of used machine 6,000

Cost of new machine $13,000

Information Processing records this transaction as follows.

Equipment 13,000 Accumulated Depreciation—Equipment 4,000 Loss on Disposal of Equipment 2,000 Equipment 12,000 Cash 7,000

We verify the loss on the disposal of the used machine as follows.

ILLUSTRATION 10-12 Computation of Loss on Disposal of Used Machine

Fair value of used machine $6,000 Less: Book value of used machine 8,000

Loss on disposal of used machine $2,000

518 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

Why did Information Processing not use the trade-in allowance or the book value of the old asset as a basis for the new equipment? The company did not use the trade-in allowance because it included a price concession (similar to a price discount). Few indi- viduals pay list price for a new car. Dealers such as Jerrod often inflate trade-in allow- ances on the used car so that actual selling prices fall below list prices. To record the car at list price would state it at an amount in excess of its cash equivalent price because of the new car’s inflated list price. Similarly, use of book value in this situation would over- state the value of the new machine by $2,000.8

Exchanges—Gain Situation Has Commercial Substance. Now let’s consider the situation in which a nonmonetary exchange has commercial substance and a gain is realized. In such a case, a company usually records the cost of a nonmonetary asset acquired in exchange for another non- monetary asset at the fair value of the asset given up and immediately recognizes a gain. The company should use the fair value of the asset received only if it is more clearly evident than the fair value of the asset given up.

To illustrate, Interstate Transportation Company exchanged a number of used trucks plus cash for a semi-truck. The used trucks have a combined book value of $42,000 (cost $64,000 less $22,000 accumulated depreciation). Interstate’s purchasing agent, experienced in the secondhand market, indicates that the used trucks have a fair value of $49,000. In addition to the trucks, Interstate must pay $11,000 cash for the semi- truck. Interstate computes the cost of the semi-truck as follows.

8Recognize that for Jerrod (the dealer), the asset given up in the exchange is considered inventory. As a result, Jerrod records a sale and related cost of goods sold. The used machine received by Jerrod is recorded at fair value.

ILLUSTRATION 10-14 Computation of Gain on Disposal of Used Trucks

Fair value of trucks exchanged $49,000 Cash paid 11,000

Cost of semi-truck $60,000

ILLUSTRATION 10-13 Computation of Semi-Truck Cost

Interstate records the exchange transaction as follows.

Trucks (semi) 60,000 Accumulated Depreciation—Trucks 22,000 Trucks (used) 64,000 Gain on Disposal of Trucks 7,000 Cash 11,000

The gain is the difference between the fair value of the used trucks and their book value. We verify the computation as follows.

Fair value of used trucks $49,000 Cost of used trucks $64,000 Less: Accumulated depreciation 22,000

Book value of used trucks (42,000)

Gain on disposal of used trucks $ 7,000

In this case, Interstate is in a different economic position, and therefore the transac- tion has commercial substance. Thus, it recognizes a gain.

Lacks Commercial Substance—No Cash Received. We now assume that the Inter- state Transportation Company exchange lacks commercial substance. That is, the

Valuation of Property, Plant, and Equipment 519

economic position of Interstate did not change significantly as a result of this exchange. In this case, Interstate defers the gain of $7,000 and reduces the basis of the semi-truck. Illustration 10-15 shows two different but acceptable computations to illustrate this reduction.

Fair value of semi-truck $60,000 Book value of used trucks $42,000 Less: Gain deferred 7,000 OR Plus: Cash paid 11,000

Basis of semi-truck $53,000 Basis of semi-truck $53,000

ILLUSTRATION 10-15 Basis of Semi-Truck—Fair Value vs. Book Value

Interstate records this transaction as follows.

Trucks (semi) 53,000 Accumulated Depreciation—Trucks 22,000 Trucks (used) 64,000 Cash 11,000

If the exchange lacks commercial substance, the company recognizes the gain (reflected in the basis of the semi-truck) through lower depreciation expense or when it later sells the semi-truck, not at the time of the exchange.

Lacks Commercial Substance—Some Cash Received. When a company receives cash (sometimes referred to as “boot”) in an exchange that lacks commercial substance, it must immediately recognize a portion of the gain.9 Illustration 10-16 shows the general formula for gain recognition when an exchange includes some cash.

9When the monetary consideration is significant, i.e., 25 percent or more of the fair value of the exchange, both parties consider the transaction a monetary exchange. Such “monetary” exchanges rely on the fair values to measure the gains or losses that are recognized in their entirety. [6]

ILLUSTRATION 10-16 Formula for Gain Recognition, Some Cash Received

Cash Received (Boot) Cash Received (Boot) + Fair Value of Other Assets Received

Recognized Gain

× Total Gain =

To illustrate, assume that Queenan Corporation traded in used machinery with a book value of $60,000 (cost $110,000 less accumulated depreciation $50,000) and a fair value of $100,000. It receives in exchange a machine with a fair value of $90,000 plus cash of $10,000. Illustration 10-17 shows calculation of the total gain on the exchange.

Generally, when a transaction lacks commercial substance, a company defers any gain. But because Queenan received $10,000 in cash, it recognizes a partial gain. The portion of the gain a company recognizes is the ratio of monetary assets (cash in this case) to the total consideration received. Queenan computes the partial gain as follows.

Fair value of machine given up $100,000 Less: Book value of machine given up 60,000

Total gain $ 40,000

ILLUSTRATION 10-17 Computation of Total Gain

ILLUSTRATION 10-18 Computation of Gain Based on Ratio of Cash Received to Total Consideration Received

$10,000 $10,000 + $90,000 × $40,000 = $4,000

520 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

Because Queenan recognizes only a gain of $4,000 on this transaction, it defers the remaining $36,000 ($40,000 − $4,000) and reduces the basis (recorded cost) of the new machine. Illustration 10-19 shows the computation of the basis.

ILLUSTRATION 10-19 Computation of Basis Fair value of new machine $90,000 Book value of old machine $60,000Less: Gain deferred 36,000 OR Less: Portion of book value presumed sold 6,000*

Basis of new machine $54,000 Basis of new machine $54,000

*$10,000 $100,000

× $60,000 = $6,000

Queenan records the transaction with the following entry.

Cash 10,000 Machinery (new) 54,000 Accumulated Depreciation—Machinery 50,000 Machinery (old) 110,000 Gain on Disposal of Machinery 4,000

The rationale for the treatment of a partial gain is as follows. Before a nonmonetary exchange that includes some cash, a company has an unrecognized gain, which is the difference between the book value and the fair value of the old asset. When the exchange occurs, a portion of the fair value is converted to a more liquid asset. The ratio of this liquid asset to the total consideration received is the portion of the total gain that the company realizes. Thus, the company recognizes and records that amount.

Illustration 10-20 presents in summary form the accounting requirements for recog- nizing gains and losses on exchanges of nonmonetary assets.10

10Adapted from an article by Robert Capettini and Thomas E. King, “Exchanges of Nonmonetary Assets: Some Changes,” The Accounting Review (January 1976).

ILLUSTRATION 10-20 Summary of Gain and Loss Recognition on Exchanges of Nonmonetary Assets

1. Compute the total gain or loss on the transaction. This amount is equal to the difference between the fair value of the asset given up and the book value of the asset given up.

2. If a loss is computed in Step 1, always recognize the entire loss. 3. If a gain is computed in Step 1, (a) and the exchange has commercial substance, recognize the entire gain. (b) and the exchange lacks commercial substance, (1) and no cash is involved, no gain is recognized. (2) and some cash is given, no gain is recognized. (3) and some cash is received, the following portion of the gain is recognized:

Cash Received (Boot) Cash Received (Boot) + Fair Value of Other Assets Received

× Total Gain*

*If the amount of cash exchanged is 25% or more, both parties recognize entire gain or loss.

Companies disclose in their financial statements nonmonetary exchanges during a period. Such disclosure indicates the nature of the transaction(s), the method of account- ing for the assets exchanged, and gains or losses recognized on the exchanges. [7]

Valuation of Property, Plant, and Equipment 521

Accounting for Contributions Companies sometimes receive or make contributions (donations or gifts). Such contri- butions, nonreciprocal transfers, transfer assets in one direction. A contribution is often some type of asset (such as cash, securities, land, buildings, or use of facilities), but it also could be the forgiveness of a debt.

When companies acquire assets as donations, a strict cost concept dictates that the valuation of the asset should be zero. However, a departure from the historical cost principle seems justified; the only costs incurred (legal fees and other relatively minor expenditures) are not a reasonable basis of accounting for the assets acquired. To record nothing is to ignore the economic realities of an increase in wealth and assets. Therefore, companies use the fair value of the asset to establish its value on the books.

What then is the proper accounting for the credit in this transaction? Some believe the credit should be made to Donated Capital (an additional paid-in capital account). This approach views the increase in assets from a donation as contributed capital, rather than as earned revenue.

Others argue that companies should report donations as revenues from contribu- tions. Their reasoning is that only the owners of a business contribute capital. At issue in this approach is whether the company should report revenue immediately or over the period that the asset is employed. For example, to attract new industry a city may offer land, but the receiving enterprise may incur additional costs in the future (e.g., transpor- tation or higher state income taxes) because the location is not the most desirable. As a consequence, some argue that the company should defer the revenue and recognize it as the costs are incurred.

The FASB’s position is that in general, companies should recognize contributions received as revenues in the period received. [8]11 Companies measure contributions at the fair value of the assets received. [9] To illustrate, Max Wayer Meat Packing, Inc. has

WHAT DO THE NUMBERS MEAN? ABOUT THOSE SWAPS

Source: Adapted from Henny Sender, “Telecoms Draw Focus for Moves in Accounting,” Wall Street Journal (March 26, 2002), p. C7.

In a press release, Roy Olofson, former vice president of fi nance for Global Crossing, accused company executives of improp- erly describing the company’s revenue to the public. He said the company had improperly recorded long-term sales imme- diately rather than over the term of the contract, had improperly booked as cash transactions swaps of capacity with other car- riers, and had fi red him when he blew the whistle.

The accounting for the swaps involves exchanges of simi- lar network capacity. Companies have said they engage in such deals because swapping is quicker and less costly than building segments of their own networks, or because such pacts provide redundancies to make their own networks more reliable. In one expert’s view, an exchange of similar network capacity is the equivalent of trading a blue truck for a red truck—it shouldn’t boost a company’s revenue.

But Global Crossing and Qwest, among others, counted as revenue the money received from the other company in the swap. (In general, in transactions involving leased capac- ity, the companies booked the revenue over the life of the contract.) Some of these companies then treated their own purchases as capital expenditures, which were not run through the income statement. Instead, the spending led to the addition of assets on the balance sheet (and an infl ated bottom line).

The SEC questioned some of these capacity exchanges, because it appeared they were a device to pad revenue. This reaction was not surprising, since revenue growth was a key factor in the valuation of companies such as Global Crossing and Qwest during the craze for tech stocks in the late 1990s and 2000.

INTERNATIONAL PERSPECTIVE

IFRS provides detailed guidance on how to account for contributions and government grants.

11Although GAAP is silent on how to account for the transfers of assets from governmental units to business enterprises, the FASB is working on a project to develop disclosure requirements about government assistance (see http://www.fasb.org—click on the Presentation and Disclosure tab under the Technical Agenda). However, we believe that these basic recognition requirements should hold also for these types of contributions. Therefore, companies should record all assets at fair value and all credits as revenue.

522 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

recently accepted a donation of land with a fair value of $150,000 from the Memphis Industrial Development Corp. In return, Max Wayer Meat Packing promises to build a packing plant in Memphis. Max Wayer’s entry is:

Land 150,000 Contribution Revenue 150,000

When a company contributes a nonmonetary asset, it should record the amount of the donation as an expense at the fair value of the donated asset. If a difference exists between the fair value of the asset and its book value, the company should recognize a gain or loss. To illustrate, Kline Industries donates land to the city of Los Angeles for a city park. The land cost $80,000 and has a fair value of $110,000. Kline Industries records this donation as follows.

Contribution Expense 110,000 Land 80,000 Gain on Disposal of Land 30,000

In some cases, companies promise to give (pledge) some type of asset in the future. Should companies record this promise immediately or when they give the assets? If the promise is unconditional (depends only on the passage of time or on demand by the recipient for performance), the company should report the contribution expense and related payable immediately. If the promise is conditional, the company recognizes expense in the period benefited by the contribution, generally when it transfers the asset.

Other Asset Valuation Methods The exception to the historical cost principle for assets acquired through donation is based on fair value. Another exception is the prudent cost concept. This concept states that if for some reason a company ignorantly paid too much for an asset originally, it is theoretically preferable to charge a loss immediately.

For example, assume that a company constructs an asset at a cost much greater than its present economic usefulness. It would be appropriate to charge these excess costs as a loss to the current period, rather than capitalize them as part of the cost of the asset. In practice, the need to use the prudent cost approach seldom develops. Companies typi- cally either use good reasoning in paying a given price or fail to recognize that they have overpaid.

What happens, on the other hand, if a company makes a bargain purchase or inter- nally constructs a piece of equipment at a cost savings? Such savings should not result in immediate recognition of a gain under any circumstances.

COSTS SUBSEQUENT TO ACQUISITION After installing plant assets and readying them for use, a company incurs additional costs that range from ordinary repairs to significant additions. The major problem is allocating these costs to the proper time periods. In general, costs incurred to achieve greater future benefits should be capitalized, whereas expenditures that simply maintain a given level of services should be expensed. In order to capitalize costs, one of three conditions must be present:

1. The useful life of the asset must be increased. 2. The quantity of units produced from the asset must be increased. 3. The quality of the units produced must be enhanced.

For example, a company like Boeing should expense expenditures that do not increase an asset’s future benefits. That is, it expenses immediately ordinary repairs that maintain the existing condition of the asset or restore it to normal operating efficiency.

LEARNING OBJECTIVE 5 Describe the accounting treatment for costs sub- sequent to acquisition.

Costs Subsequent to Acquisition 523

Companies expense most expenditures below an established arbitrary minimum amount, say, $100 or $500. Although conceptually this treatment may be incorrect, expe- diency demands it. Otherwise, companies would set up depreciation schedules for an item such as a wastepaper basket.

The distinction between a capital expenditure (asset) and a revenue expenditure (expense) is not always clear-cut. Yet, in most cases, consistent application of a capital/ expense policy is more important than attempting to provide general theoretical guide- lines for each transaction. Generally, companies incur four major types of expenditures relative to existing assets.

ADDITIONS. Increase or extension of existing assets.

IMPROVEMENTS AND REPLACEMENTS. Substitution of an improved asset for an ex- isting one.

REARRANGEMENT AND REINSTALLATION. Movement of assets from one location to another.

REPAIRS. Expenditures that maintain assets in condition for operation.

MAJOR TYPES OF EXPENDITURES

WHAT DO THE NUMBERS MEAN? DISCONNECTED

Source: Adapted from Jared Sandberg, Deborah Solomon, and Rebecca Blumenstein, “Inside WorldCom’s Unearthing of a Vast Accounting Scandal,” Wall Street Journal (June 27, 2002), p. A1.

It all started with a check of the books by an internal auditor for WorldCom Inc. The telecom giant’s newly installed chief exec- utive had asked for a fi nancial review, and the auditor was spot-checking records of capital expenditures. She found the company was using an unorthodox technique to account for one of its biggest expenses: charges paid to local telephone networks to complete long-distance calls.

Instead of recording these charges as operating expenses, WorldCom recorded a signifi cant portion as capital expendi- tures. The maneuver was worth hundreds of millions of dollars to WorldCom’s bottom line. It effectively turned a loss for all of 2001 and the fi rst quarter of 2002 into a profi t. The graph below compares WorldCom’s accounting to that under GAAP. Soon after this discovery, WorldCom fi led for bankruptcy.

WorldCom’s accounting

Generally accepted accounting principles

Accounted for $3.1 billion in “line costs,” including telecom access and transport charges, as capital expenditures.

The $3.1 billion “line-cost” expense would be booked as an operating expense.

Expense

Capital Expense

Operating Expense

Amortization Cost of Business

Higher Net Income

Lower Net Income

Planned to amortize $3.1 billion over a period of time, possibly as much as 10 years.

Reported net income of $1.38 billion for 2001.

The entire $3.1 billion would have been counted as a cost of business for that quarter.

Net income for 2001 would have been a loss, amount to be determined.

UNDERLYING CONCEPTS

Expensing long-lived wastepaper baskets is an application of the materiality concept.

524 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

Additions Additions should present no major accounting problems. By definition, companies capitalize any addition to plant assets because a new asset is created. For example, the addition of a wing to a hospital, or of an air conditioning system to an office, increases the service potential of that facility. Companies should capitalize such expenditures and match them against the revenues that will result in future periods.

One problem that arises in this area is the accounting for any changes related to the existing structure as a result of the addition. Is the cost incurred to tear down an old wall, to make room for the addition, a cost of the addition or an expense or loss of the period? The answer is that it depends on the original intent. If the company had antici- pated building an addition later, then this cost of removal is a proper cost of the addi- tion. But if the company had not anticipated this development, it should properly report the removal as a loss in the current period on the basis of inefficient planning. Normally, the company retains the carrying amount of the old wall in the accounts, although theo- retically the company should remove it.

Improvements and Replacements Companies substitute one asset for another through improvements and replacements. What is the difference between an improvement and a replacement? An improvement (betterment) is the substitution of a better asset for the one currently used (say, a con- crete floor for a wooden floor). A replacement, on the other hand, is the substitution of a similar asset (a wooden floor for a wooden floor).

Many times improvements and replacements result from a general policy to mod- ernize or rehabilitate an older building or piece of equipment. The problem is differen- tiating these types of expenditures from normal repairs. Does the expenditure increase the future service potential of the asset? Or does it merely maintain the existing level of service? Frequently, the answer is not clear-cut. Good judgment is required to cor- rectly classify these expenditures.

If the expenditure increases the future service potential of the asset, a company should capitalize it. The accounting is therefore handled in one of three ways, depend- ing on the circumstances:

1. Use the substitution approach. Conceptually, the substitution approach is correct if the carrying amount of the old asset is available. It is then a simple matter to remove the cost of the old asset and replace it with the cost of the new asset.

To illustrate, Instinct Enterprises decides to replace the pipes in its plumbing system. A plumber suggests that the company use plastic tubing in place of the cast iron pipes and copper tubing. The old pipe and tubing have a book value of $15,000 (cost of $150,000 less accumulated depreciation of $135,000), and a scrap value of $1,000. The plastic tubing costs $125,000. If Instinct pays $124,000 for the new tubing after exchanging the old tubing, it makes the following entry:

Plant Assets (plumbing system) 125,000 Accumulated Depreciation—Plant Assets 135,000 Loss on Disposal of Plant Assets 14,000 Plant Assets 150,000 Cash ($125,000 − $1,000) 124,000

The problem is determining the book value of the old asset. Generally, the com- ponents of a given asset depreciate at different rates. However, generally no sepa- rate accounting is made. For example, the tires, motor, and body of a truck depreci- ate at different rates, but most companies use one rate for the entire truck. Companies can set separate depreciation rates, but it is often impractical. If a com- pany cannot determine the carrying amount of the old asset, it adopts one of two other approaches.

Costs Subsequent to Acquisition 525

2. Capitalize the new cost. Another approach capitalizes the improvement and keeps the carrying amount of the old asset on the books. The justifi cation for this approach is that the item is suffi ciently depreciated to reduce its carrying amount almost to zero. Although this assumption may not always be true, the differ- ences are often insignifi cant. Companies usually handle improvements in this manner.

3. Charge to accumulated depreciation. In cases when a company does not improve the quantity or quality of the asset itself but instead extends its useful life, the com- pany debits the expenditure to Accumulated Depreciation rather than to an asset account. The theory behind this approach is that the replacement extends the useful life of the asset and thereby recaptures some or all of the past depreciation. The net carrying amount of the asset is the same whether debiting the asset or accumulated depreciation.

Rearrangement and Reinstallation Companies incur rearrangement and reinstallation costs to benefit future periods. An example is the rearrangement and reinstallation of machines to facilitate future production.

If a company like The Coca-Cola Company can determine or estimate the original installation cost and the accumulated depreciation to date, it handles the rearrangement and reinstallation cost as a replacement. If not, which is generally the case, Coca-Cola should capitalize the new costs (if material in amount) as an asset to be amortized over future periods expected to benefit. If these costs are immaterial, if they cannot be sepa- rated from other operating expenses, or if their future benefit is questionable, the com- pany should immediately expense them.

Repairs A company makes ordinary repairs to maintain plant assets in operating condition. It charges ordinary repairs to an expense account in the period incurred, on the basis that it is the primary period benefited. Maintenance charges that occur regularly include replacing minor parts, lubricating and adjusting equipment, repainting, and cleaning. A company treats these as ordinary operating expenses.

It is often difficult to distinguish a repair from an improvement or replacement. The major consideration is whether the expenditure benefits more than one year or one operating cycle, whichever is longer. If a major repair (such as an overhaul) occurs, several periods will benefit. A company should handle the cost as an addition, improve- ment, or replacement.12

An interesting question is whether a company can accrue planned maintenance overhaul costs before the actual costs are incurred. For example, assume that Southwest Airlines schedules major overhauls of its planes every three years. Should Southwest be permitted to accrue these costs and related liability over the three-year period? Some argue that this accrue-in-advance approach better matches expenses to revenues and reports Southwest’s obligation for these costs. However, reporting a liability is inappropriate. To whom does Southwest owe? In other words, Southwest has no obligation to an outside party until it has to pay for the overhaul costs, and therefore it has no liability. As a result, companies are not permitted to accrue in advance for planned major overhaul costs either for interim or annual periods. [10]

12A committee of the AICPA has proposed (see footnote 2) that companies expense as incurred costs involved for planned major expenditures unless they represent an additional component or the replacement of an existing component.

526 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

Summary of Costs Subsequent to Acquisition Illustration 10-21 summarizes the accounting treatment for various costs incurred sub- sequent to the acquisition of capitalized assets.

ILLUSTRATION 10-21 Summary of Costs Subsequent to Acquisition of Property, Plant, and Equipment

Type of Expenditure Normal Accounting Treatment

Additions Capitalize cost of addition to asset account. Improvements and (a) Carrying value known: Remove cost of and accumulated depreciation on

replacements old asset, recognizing any gain or loss. Capitalize cost of improvement/ replacement.

(b) Carrying value unknown: 1. If the asset’s useful life is extended, debit accumulated depreciation

for cost of improvement/replacement. 2. If the quantity or quality of the asset’s productivity is increased, capitalize

cost of improvement/replacement to asset account. Rearrangement and (a) If original installation cost is known, account for cost of rearrangement/

reinstallation reinstallation as a replacement (carrying value known). (b) If original installation cost is unknown and rearrangement/reinstallation

cost is material in amount and benefits future periods, capitalize as an asset.

(c) If original installation cost is unknown and rearrangement/reinstallation cost is not material or future benefit is questionable, expense the cost when incurred.

Repairs (a) Ordinary: Expense cost of repairs when incurred. (b) Major: As appropriate, treat as an addition, improvement, or replacement.

DISPOSITION OF PROPERTY, PLANT, AND EQUIPMENT A company, like Intel, may retire plant assets voluntarily or dispose of them by sale, exchange, involuntary conversion, or abandonment. Regardless of the type of disposal, depreciation must be taken up to the date of disposition. Then, Intel should remove all accounts related to the retired asset. Generally, the book value of the specific plant asset does not equal its disposal value. As a result, a gain or loss develops.

The reason: Depreciation is an estimate of cost allocation and not a process of valu- ation. The gain or loss is really a correction of net income for the years during which Intel used the fixed asset.

Intel should show gains or losses on the disposal of plant assets in the income state- ment along with other items from customary business activities. However, if it sold, abandoned, spun off, or otherwise disposed of the “operations of a component of a busi- ness (and considered a strategic shift),” then it should report the results separately in the discontinued operations section of the income statement (as discussed in Chapter 4). That is, Intel should report any gain or loss from disposal of a business component with the related results of discontinued operations.

Sale of Plant Assets Companies record depreciation for the period of time between the date of the last depre- ciation entry and the date of sale. To illustrate, assume that Barret Company recorded depreciation on a machine costing $18,000 for nine years at the rate of $1,200 per year. If it sells the machine in the middle of the tenth year for $7,000, Barret records depreciation to the date of sale as:

Depreciation Expense ($1,200 × 12 ) 600 Accumulated Depreciation—Machinery 600

LEARNING OBJECTIVE 6 Describe the accounting treatment for the disposal of property, plant, and equipment.

Disposition of Property, Plant, and Equipment 527

The entry for the sale of the asset then is:

Cash 7,000 Accumulated Depreciation—Machinery 11,400 [($1,200 × 9) + $600] Machinery 18,000 Gain on Disposal of Machinery 400

The book value of the machinery at the time of the sale is $6,600 ($18,000 − $11,400). Because the machinery sold for $7,000, the amount of the gain on the sale is $400.

Involuntary Conversion Sometimes an asset’s service is terminated through some type of involuntary conver- sion such as fire, flood, theft, or condemnation. Companies report the difference between the amount recovered (e.g., from a condemnation award or insurance recovery), if any, and the asset’s book value as a gain or loss. They treat these gains or losses like any other type of disposition. These gains or losses are reported as other revenues and gains or other expenses and losses in the income statement.

To illustrate, Camel Transport Corp. had to sell a plant located on company prop- erty that stood directly in the path of an interstate highway. For a number of years, the state had sought to purchase the land on which the plant stood, but the company resisted. The state ultimately exercised its right of eminent domain, which the courts upheld. In settlement, Camel received $500,000, which substantially exceeded the $200,000 book value of the plant and land (cost of $400,000 less accumulated deprecia- tion of $200,000). Camel made the following entry.

Cash 500,000 Accumulated Depreciation—Plant Assets 200,000 Plant Assets 400,000 Gain on Disposal of Plant Assets 300,000

Some object to the recognition of a gain or loss in certain involuntary conversions. For example, the federal government often condemns forests for national parks. The paper companies that owned these forests must report a gain or loss on the condem- nation. However, companies such as Georgia-Pacific contend that no gain or loss should be reported because they must replace the condemned forest land immedi- ately and so are in the same economic position as they were before. The issue is whether condemnation and subsequent purchase should be viewed as one or two transactions. GAAP requires “that a gain or loss be recognized when a nonmonetary asset is involuntarily converted to monetary assets even though an enterprise rein- vests or is obligated to reinvest the monetary assets in replacement nonmonetary assets.” [11]

Miscellaneous Problems If a company scraps or abandons an asset without any cash recovery, it recognizes a loss equal to the asset’s book value. If scrap value exists, the gain or loss that occurs is the difference between the asset’s scrap value and its book value. If an asset still can be used even though it is fully depreciated, it may be kept on the books at historical cost less depreciation.

Companies must disclose in notes to the financial statements the amount of fully depreciated assets in service. For example, Petroleum Equipment Tools Inc. in its annual report disclosed, “The amount of fully depreciated assets included in property, plant, and equipment at December 31 amounted to approximately $98,900,000.”

528 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

LEARNING OBJECTIVES REVIEW 1 Understand property, plant, and equipment and its related costs. The major characteristics of property, plant, and

equipment are as follows. (1) They are acquired for use in operations and not for resale. (2) They are long-term in nature and usually subject to depreciation. (3) They possess physical substance. The costs included in initial valuation of property, plant, and equipment are as follows.

Cost of land: Includes all expenditures made to acquire land and to ready it for use. Land costs typically include (1) the purchase price; (2) closing costs, such as title to the land, attorney’s fees, and recording fees; (3) costs incurred in getting the land in condition for its intended use, such as grading, filling, draining, and clearing; (4) assumption of any liens, mortgages, or encumbrances on the property; and (5) any additional land improvements that have an indefinite life.

Cost of buildings: Includes all expenditures related directly to their acquisition or construction. These costs include (1) materials, labor, and overhead costs incurred during construction, and (2) professional fees and building permits.

Cost of equipment: Includes the purchase price, freight and handling charges incurred, insurance on the equipment while in transit, cost of special foundations if required, assembling and installation costs, and costs of conducting trial runs.

2 Describe the accounting problems associated with self-constructed assets. Indirect costs of manufacturing cre- ate special problems because companies cannot easily trace these costs directly to work and material orders related to the constructed assets. Companies might handle these costs in one of two ways: (1) assign no fixed overhead to the cost of the constructed asset, or (2) assign a portion of all overhead to the construction process. Companies use the second method extensively.

3 Describe the accounting problems associated with interest capitalization. Only actual interest (with modifica- tions) should be capitalized. The rationale for this approach is that during construction, the asset is not generating revenue and therefore companies should defer (capitalize) interest cost. Once construction is completed, the asset is ready for its intended use and revenues can be recognized. Any interest cost incurred in purchasing an asset that is ready for its intended use should be expensed.

4 Understand accounting issues related to acquiring and valuing plant assets. The following issues relate to acquiring and valuing plant assets. (1) Cash discounts: Whether taken or not, they are generally considered a reduction in the cost of the asset; the real cost of the asset is the cash or cash equivalent price of the asset. (2) Deferred-payment contracts: Com- panies account for assets purchased on long-term credit contracts at the present value of the consideration exchanged between the contracting parties. (3) Lump-sum purchase: Allocate the total cost among the various assets on the basis of their relative fair values. (4) Issuance of stock: If the stock is actively traded, the market price of the stock issued is a fair indication of the cost of the property acquired. If the market price of the common stock exchanged is not determinable, establish the fair value of the property and use it as the basis for recording the asset and issuance of the common stock. (5) Exchanges of nonmonetary assets: The accounting for exchanges of nonmonetary assets depends on whether the exchange has commercial substance. See Illustrations 10-10 (page 517) and 10-20 (page 520) for summaries of how to account for exchanges. (6) Contributions: Record at the fair value of the asset received, and credit revenue for the same amount.

5 Describe the accounting treatment for costs subsequent to acquisition. Illustration 10-21 (page 526) summarizes how to account for costs subsequent to acquisition.

REVIEW AND PRACTICE KEY TERMS REVIEW

additions, 524 avoidable interest, 508 capital expenditure, 523 capitalization period, 508 commercial substance, 516 fixed assets, 504 historical cost, 504

improvements (betterments), 524

involuntary conversion, 527 lump-sum price, 514 major repairs, 525 nonmonetary assets, 516 nonreciprocal transfers, 521

ordinary repairs, 525 plant assets, 504 property, plant, and

equipment, 504 prudent cost, 522 rearrangement and

reinstallation costs, 525

replacements, 524 revenue expenditure, 523 self-constructed asset, 506 weighted-average

accumulated expenditures, 509

6 Describe the accounting treatment for the disposal of property, plant, and equipment. Regardless of the time of disposal, companies take depreciation up to the date of disposition and then remove all accounts related to the retired asset. Gains or losses on the retirement of plant assets are shown in the income statement along with other items that arise from customary business activities. Gains or losses on involuntary conversions are reported as other revenues and gains or other expenses and losses in the income statement.

ENHANCED REVIEW AND PRACTICE Go online for multiple-choice questions with solutions, review exercises with solutions, and a full glossary of all key terms.

Practice Problem 529

PRACTICE PROBLEM

Columbia Company, which manufactures machine tools, had the following transactions related to plant assets in 2017.

Asset A: On June 2, 2017, Columbia purchased a stamping machine at a retail price of $12,000. Columbia paid 6% sales tax on this purchase. Columbia paid a contractor $2,800 for a specially wired platform for the machine, to ensure noninterrupted power to the machine. Columbia estimates the machine will have a 4-year useful life, with a salvage value of $2,000 at the end of 4 years. The machine was put into use on July 1, 2017.

Asset B: On January 1, 2017, Columbia, Inc. signed a fi xed-price contract for construction of a warehouse facility at a cost of $1,000,000. It was estimated that the project will be completed by December 31, 2017. On March 1, 2017, to fi nance the con- struction cost, Columbia borrowed $1,000,000 payable April 1, 2018, plus interest at the rate of 10%. During 2017, Columbia made deposit and progress payments totaling $750,000 under the contract; the weighted-average amount of accumulated expenditures was $400,000 for the year. The excess-borrowed funds were invested in short-term securities, from which Columbia realized investment revenue of $13,000. The warehouse was completed on December 1, 2017, at which time Columbia made the fi nal payment to the contractor. Columbia estimates the warehouse will have a 25-year useful life, with a salvage value of $20,000.

Columbia uses straight-line depreciation and employs the “half-year” convention in accounting for partial-year depreciation. (Under this straight-line approach, a half-year of depreciation is recorded in the first and last year of the asset’s useful life.) Columbia’s fiscal year ends on December 31.

Instructions (a) At what amount should Columbia record the acquisition cost of the machine? (b) What amount of capitalized interest should Columbia include in the cost of the warehouse? (c) On July 1, 2019, Columbia decides to outsource its stamping operation to Medek, Inc. As part of this plan, Columbia

sells the machine (and the platform) to Medek, Inc. for $7,000. What is the impact of this disposal on Columbia’s 2019 income before taxes?

SOLUTION

(a) Historical cost is measured by the cash or cash equivalent price of obtaining the asset and bringing it to the location and condition for its intended use. For Columbia, this is:

Price $12,000 Tax ($12,000 × .06) 720 Platform 2,800

Total $15,520

(b) $40,000 ($400,000 × .10)—Weighted-Average Accumulated Expenditures × Interest Rate = Avoidable Interest

530 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

Exercises, Problems, Problem Solution Walkthrough Videos, and many more assessment tools and resources are available for practice in WileyPLUS.

1. What are the major characteristics of plant assets? 2. Mickelson Inc. owns land that it purchased on January 1,

2000, for $450,000. At December 31, 2017, its current value is $770,000 as determined by appraisal. At what amount should Mickelson report this asset on its Decem- ber 31, 2017, balance sheet? Explain.

3. Name the items, in addition to the amount paid to the former owner or contractor, that may properly be included as part of the acquisition cost of the following plant assets. (a) Land. (b) Machinery and equipment. (c) Buildings.

4. Indicate where the following items would be shown on a balance sheet. (a) A lien that was attached to the land when purchased. (b) Landscaping costs. (c) Attorney’s fees and recording fees related to pur-

chasing land. (d) Variable overhead related to construction of machinery. (e) A parking lot servicing employees in the building.

(f) Cost of temporary building for workers during con- struction of building.

(g) Interest expense on bonds payable incurred during construction of a building.

(h) Assessments for sidewalks that are maintained by the city.

(i) The cost of demolishing an old building that was on the land when purchased.

5. Two positions have normally been taken with respect to the recording of fixed manufacturing overhead as an element of the cost of plant assets constructed by a com- pany for its own use: (a) It should be excluded completely. (b) It should be included at the same rate as is charged

to normal operations.

What are the circumstances or rationale that support or deny the application of these methods?

6. The Buildings account of Postera Inc. includes the fol- lowing items that were used in determining the basis for depreciating the cost of a building.

QUESTIONS

Since Columbia has outstanding debt incurred specifically for the construction project, in an amount greater than the weighted-average accumulated expenditures of $400,000, the interest rate of 10% is used for capitalization purposes. Capi- talization stops upon completion of the project at December 31, 2017. Therefore, the avoidable interest is $40,000, which is less than the actual interest. The investment revenue of $13,000 is irrelevant to the question addressed in this problem because such interest earned on the unexpended portion of the loan is not to be offset against the amount eligible for capitalization.

Cost $15,520 Less: Accumulated depreciation ($1,690 + $3,380 + $1,690) 6,760* Book value of machine and platform 8,760 Less: Cash received for machine and platform 7,000

Loss before income taxes $ 1,760

*Depreciable base: $15,520 − $2,000 = $13,520. Depreciation expense: $13,520 ÷ 4 = $3,380 per year.

2017: ½ year ($3,380 × .50) $1,690 2018: full year 3,380 2019: ½ year 1,690 Total $6,760

Questions 531

(a) Organization and promotion expenses. (b) Architect’s fees. (c) Interest and taxes during construction. (d) Interest revenue on investments held to fund con-

struction of a building.

Do you agree with these charges? If not, how would you deal with each of the items above in the corporation’s books and in its annual financial statements?

7. Burke Company has purchased two tracts of land. One tract will be the site of its new manufacturing plant, while the other is being purchased with the hope that it will be sold in the next year at a profit. How should these two tracts of land be reported in the balance sheet?

8. One financial accounting issue encountered when a com- pany constructs its own plant is whether the interest cost on funds borrowed to finance construction should be capitalized and then amortized over the life of the assets constructed. What is the justification for capitalizing such interest?

9. Provide examples of assets that do not qualify for interest capitalization.

10. What interest rates should be used in determining the amount of interest to be capitalized? How should the amount of interest to be capitalized be determined?

11. How should the amount of interest capitalized be dis- closed in the notes to the financial statements? How should interest revenue from temporarily invested excess funds borrowed to finance the construction of assets be accounted for?

12. Discuss the basic accounting problem that arises in han- dling each of the following situations. (a) Assets purchased by issuance of common stock. (b) Acquisition of plant assets by gift or donation. (c) Purchase of a plant asset subject to a cash discount. (d) Assets purchased on a long-term credit basis. (e) A group of assets acquired for a lump sum. (f) An asset traded in or exchanged for another asset.

13. Magilke Industries acquired equipment this year to be used in its operations. The equipment was delivered by the suppliers, installed by Magilke, and placed into oper- ation. Some of it was purchased for cash with discounts available for prompt payment. Some of it was purchased under long-term payment plans for which the interest charges approximated prevailing rates. What costs should Magilke capitalize for the new equipment pur- chased this year? Explain.

14. Schwartzkopf Co. purchased for $2,200,000 property that included both land and a building to be used in operations. The seller’s book value was $300,000 for the land and $900,000 for the building. By appraisal, the fair value was estimated to be $500,000 for the land and $2,000,000 for the building. At what amount should Schwartzkopf report the land and the building at the end of the year?

15. Pueblo Co. acquires machinery by paying $10,000 cash and signing a $5,000, 2-year, zero-interest-bearing note

payable. The note has a present value of $4,208, and Pueblo purchased a similar machine last month for $13,500. At what cost should the new equipment be recorded?

16. Stan Ott is evaluating two recent transactions involving exchanges of equipment. In one case, the exchange has commercial substance. In the second situation, the exchange lacks commercial substance. Explain to Stan the differences in accounting for these two situations.

17. Crowe Company purchased a heavy-duty truck on July 1, 2014, for $30,000. It was estimated that it would have a useful life of 10 years and then would have a trade-in value of $6,000. The company uses the straight-line method. It was traded on August 1, 2018, for a similar truck costing $42,000; $16,000 was allowed as trade-in value (also fair value) on the old truck and $26,000 was paid in cash. A comparison of expected cash flows for the trucks indicates the exchange lacks commercial sub- stance. What is the entry to record the trade-in?

18. Once equipment has been installed and placed in opera- tion, subsequent expenditures relating to this equipment are frequently thought of as repairs or general mainte- nance and, hence, chargeable to operations in the period in which the expenditure is made. Actually, determina- tion of whether such an expenditure should be charged to operations or capitalized involves a much more care- ful analysis of the character of the expenditure. What are the factors that should be considered in making such a decision? Discuss fully.

19. What accounting treatment is normally given to the fol- lowing items in accounting for plant assets? (a) Additions. (b) Major repairs. (c) Improvements and replacements.

20. New machinery, which replaced a number of employees, was installed and put in operation in the last month of the fiscal year. The employees had been dismissed after payment of an extra month’s wages, and this amount was added to the cost of the machinery. Discuss the propriety of the charge. If it was improper, describe the proper treatment.

21. To what extent do you consider the following items to be proper costs of the fixed asset? Give reasons for your opinions. (a) Overhead of a business that builds its own equipment. (b) Cash discounts on purchases of equipment. (c) Interest paid during construction of a building. (d) Cost of a safety device installed on a machine. (e) Freight on equipment returned before installation, for

replacement by other equipment of greater capacity. (f) Cost of moving machinery to a new location. (g) Cost of plywood partitions erected as part of the re-

modeling of the office. (h) Replastering of a section of the building. (i) Cost of a new motor for one of the trucks.

532 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

BRIEF EXERCISES

BE10-1 (L01) Previn Brothers Inc. purchased land at a price of $27,000. Closing costs were $1,400. An old building was removed at a cost of $10,200. What amount should be recorded as the cost of the land?

BE10-2 (L03) Hanson Company is constructing a building. Construction began on February 1 and was completed on Decem- ber 31. Expenditures were $1,800,000 on March 1, $1,200,000 on June 1, and $3,000,000 on December 31. Compute Hanson’s weighted-average accumulated expenditures for interest capitalization purposes.

BE10-3 (L03) Hanson Company (see BE10-2) borrowed $1,000,000 on March 1 on a 5-year, 12% note to help finance construc- tion of the building. In addition, the company had outstanding all year a 10%, 5-year, $2,000,000 note payable and an 11%, 4-year, $3,500,000 note payable. Compute the weighted-average interest rate used for interest capitalization purposes.

BE10-4 (L03) Use the information for Hanson Company from BE10-2 and BE10-3. Compute avoidable interest for Hanson Company.

BE10-5 (L04) Garcia Corporation purchased a truck by issuing an $80,000, 4-year, zero-interest-bearing note to Equinox Inc. The market rate of interest for obligations of this nature is 10%. Prepare the journal entry to record the purchase of this truck.

BE10-6 (L04) Mohave Inc. purchased land, building, and equipment from Laguna Corporation for a cash payment of $315,000. The estimated fair values of the assets are land $60,000, building $220,000, and equipment $80,000. At what amounts should each of the three assets be recorded?

BE10-7 (L04) Fielder Company obtained land by issuing 2,000 shares of its $10 par value common stock. The land was recently appraised at $85,000. The common stock is actively traded at $40 per share. Prepare the journal entry to record the acquisition of the land.

BE10-8 (L04) Navajo Corporation traded a used truck (cost $20,000, accumulated depreciation $18,000) for a small computer with a fair value of $3,300. Navajo also paid $500 in the transaction. Prepare the journal entry to record the exchange. (The exchange has commercial substance.)

BE10-9 (L04) Use the information for Navajo Corporation from BE10-8. Prepare the journal entry to record the exchange, assuming the exchange lacks commercial substance.

BE10-10 (L04) Mehta Company traded a used welding machine (cost $9,000, accumulated depreciation $3,000) for office equipment with an estimated fair value of $5,000. Mehta also paid $3,000 cash in the transaction. Prepare the journal entry to record the exchange. (The exchange has commercial substance.)

BE10-11 (L04) Cheng Company traded a used truck for a new truck. The used truck cost $30,000 and has accumulated depre- ciation of $27,000. The new truck is worth $37,000. Cheng also made a cash payment of $36,000. Prepare Cheng’s entry to record the exchange. (The exchange lacks commercial substance.)

BE10-12 (L04) Slaton Corporation traded a used truck for a new truck. The used truck cost $20,000 and has accumulated depreciation of $17,000. The new truck is worth $35,000. Slaton also made a cash payment of $33,000. Prepare Slaton’s entry to record the exchange. (The exchange has commercial substance.)

BE10-13 (L05) Indicate which of the following costs should be expensed when incurred. (a) $13,000 paid to rearrange and reinstall machinery. (b) $200,000 paid for addition to building. (c) $200 paid for tune-up and oil change on delivery truck. (d) $7,000 paid to replace a wooden floor with a concrete floor. (e) $2,000 paid for a major overhaul on a truck, which extends the useful life.

BE10-14 (L06) Ottawa Corporation owns machinery that cost $20,000 when purchased on July 1, 2014. Depreciation has been recorded at a rate of $2,400 per year, resulting in a balance in accumulated depreciation of $8,400 at December 31, 2017. The machinery is sold on September 1, 2018, for $10,500. Prepare journal entries to (a) update depreciation for 2018 and (b) record the sale.

BE10-15 (L06) Use the information presented for Ottawa Corporation in BE10-14, but assume the machinery is sold for $5,200 instead of $10,500. Prepare journal entries to (a) update depreciation for 2018 and (b) record the sale.

22. Neville Enterprises has a number of fully depreciated assets that are still being used in the main operations of the business. Because the assets are fully depreciated, the president of the company decides not to show them on

the balance sheet or disclose this information in the notes. Evaluate this procedure.

23. What are the general rules for how gains or losses on retirement of plant assets should be reported in income?

EXERCISES

E10-1 (L01) (Acquisition Costs of Realty) The following expenditures and receipts are related to land, land improvements, and buildings acquired for use in a business enterprise. The receipts are enclosed in parentheses.

(a) Money borrowed to pay building contractor (signed a note) $(275,000) (b) Payment for construction from note proceeds 275,000 (c) Cost of land fill and clearing 8,000 (d) Delinquent real estate taxes on property assumed by purchaser 7,000 (e) Premium on 6-month insurance policy during construction 6,000 (f) Refund of 1-month insurance premium because construction completed early (1,000) (g) Architect’s fee on building 22,000 (h) Cost of real estate purchased as a plant site (land $200,000 and building $50,000) 250,000 (i) Commission fee paid to real estate agency 9,000 (j) Installation of fences around property 4,000 (k) Cost of razing and removing building 11,000 (l) Proceeds from salvage of demolished building (5,000) (m) Interest paid during construction on money borrowed for construction 13,000 (n) Cost of parking lots and driveways 19,000 (o) Cost of trees and shrubbery planted (permanent in nature) 14,000 (p) Excavation costs for new building 3,000

Instructions Identify each item by letter and list the items in columnar form, using the headings shown below. All receipt amounts should be reported in parentheses. For any amounts entered in the Other Accounts column, also indicate the account title.

Item Land Land Improvements Buildings Other Accounts

E10-2 (L01) EXCEL (Acquisition Costs of Realty) Martin Buber Co. purchased land as a factory site for $400,000. The proc- ess of tearing down two old buildings on the site and constructing the factory required 6 months. The company paid $42,000 to raze the old buildings and sold salvaged lumber and brick for $6,300. Legal fees of $1,850 were paid for title investigation and drawing the purchase contract. Martin Buber paid $2,200 to an engineering firm for a land survey, and $68,000 for drawing the factory plans. The land survey had to be made before definitive plans could be drawn. Title insurance on the property cost $1,500, and a liability insurance premium paid during construction was $900. The contractor’s charge for construction was $2,740,000. The company paid the contractor in two installments: $1,200,000 at the end of 3 months and $1,540,000 upon completion. Interest costs of $170,000 were incurred to finance the construction.

Instructions Determine the cost of the land and the cost of the building as they should be recorded on the books of Martin Buber Co. Assume that the land survey was for the building.

E10-3 (L01) EXCEL (Acquisition Costs of Trucks) Kelly Clarkson Corporation operates a retail computer store. To improve delivery services to customers, the company purchases four new trucks on April 1, 2017. The terms of acquisition for each truck are described below.

1. Truck #1 has a list price of $15,000 and is acquired for a cash payment of $13,900. 2. Truck #2 has a list price of $16,000 and is acquired for a down payment of $2,000 cash and a zero-interest-bearing note with

a face amount of $14,000. The note is due April 1, 2018. Clarkson would normally have to pay interest at a rate of 10% for such a borrowing, and the dealership has an incremental borrowing rate of 8%.

3. Truck #3 has a list price of $16,000. It is acquired in exchange for a computer system that Clarkson carries in inventory. The computer system cost $12,000 and is normally sold by Clarkson for $15,200. Clarkson uses a perpetual inventory system.

4. Truck #4 has a list price of $14,000. It is acquired in exchange for 1,000 shares of common stock in Clarkson Corporation. The stock has a par value per share of $10 and a market price of $13 per share.

Instructions Prepare the appropriate journal entries for the above transactions for Clarkson Corporation.

E10-4 (L01,2) (Purchase and Self-Constructed Cost of Assets) Worf Co. both purchases and constructs various equipment it uses in its operations. The following items for two different types of equipment were recorded in random order during the calendar year 2017.

Exercises 533

534 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

Purchase Cash paid for equipment, including sales tax of $5,000 $105,000 Freight and insurance cost while in transit 2,000 Cost of moving equipment into place at factory 3,100 Wage cost for technicians to test equipment 4,000 Insurance premium paid during fi rst year of operation on this equipment 1,500 Special plumbing fi xtures required for new equipment 8,000 Repair cost incurred in fi rst year of operations related to this equipment 1,300

Construction Material and purchased parts (gross cost $200,000; failed to take 2% cash discount) $200,000 Imputed interest on funds used during construction (stock fi nancing) 14,000 Labor costs 190,000 Allocated overhead costs (fi xed—$20,000; variable—$30,000) 50,000 Profi t on self-construction 30,000 Cost of installing equipment 4,400

Instructions Compute the total cost for each of these two pieces of equipment. If an item is not capitalized as a cost of the equipment, indicate how it should be reported.

E10-5 (L01,3) (Treatment of Various Costs) Ben Sisko Supply Company, a newly formed corporation, incurred the follow- ing expenditures related to Land, to Buildings, and to Machinery and Equipment.

Abstract company’s fee for title search $ 520 Architect’s fees 3,170 Cash paid for land and dilapidated building thereon 87,000 Removal of old building $20,000 Less: Salvage 5,500 14,500 Interest on short-term loans during construction 7,400 Excavation before construction for basement 19,000 Machinery purchased (subject to 2% cash discount, which was not taken) 55,000 Freight on machinery purchased 1,340 Storage charges on machinery, necessitated by noncompletion of

building when machinery was delivered 2,180 New building constructed (building construction took 6 months from

date of purchase of land and old building) 485,000 Assessment by city for drainage project 1,600 Hauling charges for delivery of machinery from storage to new building 620 Installation of machinery 2,000 Trees, shrubs, and other landscaping after completion of building

(permanent in nature) 5,400

Instructions Determine the amounts that should be debited to Land, to Buildings, and to Machinery and Equipment. Assume the benefits of capitalizing interest during construction exceed the cost of implementation. Indicate how any costs not debited to these accounts should be recorded.

E10-6 (L02,4) (Correction of Improper Cost Entries) Plant acquisitions for selected companies are as follows.

1. Belanna Industries Inc. acquired land, buildings, and equipment from a bankrupt company, Torres Co., for a lump-sum price of $700,000. At the time of purchase, Torres’s assets had the following book and appraisal values.

Book Values Appraisal Values

Land $200,000 $150,000 Buildings 250,000 350,000 Equipment 300,000 300,000

To be conservative, the company decided to take the lower of the two values for each asset acquired. The following entry was made.

Land 150,000 Buildings 250,000 Equipment 300,000 Cash 700,000

2. Harry Enterprises purchased store equipment by making a $2,000 cash down payment and signing a 1-year, $23,000, 10% note payable. The purchase was recorded as follows.

Equipment 27,300 Cash 2,000 Notes Payable 23,000 Interest Payable 2,300

3. Kim Company purchased office equipment for $20,000, terms 2/10, n/30. Because the company intended to take the dis- count, it made no entry until it paid for the acquisition. The entry was:

Equipment 20,000 Cash 19,600 Purchase Discounts 400

4. Kaisson Inc. recently received at zero cost land from the Village of Cardassia as an inducement to locate its business in the Village. The appraised value of the land is $27,000. The company made no entry to record the land because it had no cost basis.

5. Zimmerman Company built a warehouse for $600,000. It could have purchased the building for $740,000. The controller made the following entry.

Buildings 740,000 Cash 600,000 Profi t on Construction 140,000

Instructions Prepare the entry that should have been made at the date of each acquisition.

E10-7 (L03) (Capitalization of Interest) Harrisburg Furniture Company started construction of a combination office and warehouse building for its own use at an estimated cost of $5,000,000 on January 1, 2017. Harrisburg expected to complete the building by December 31, 2017. Harrisburg has the following debt obligations outstanding during the construction period.

Construction loan—12% interest, payable semiannually, issued December 31, 2016 $2,000,000

Short-term loan—10% interest, payable monthly, and principal payable at maturity on May 30, 2018 1,400,000

Long-term loan—11% interest, payable on January 1 of each year. Principal payable on January 1, 2021 1,000,000

Instructions (Carry all computations to two decimal places.)

(a) Assume that Harrisburg completed the office and warehouse building on December 31, 2017, as planned at a total cost of $5,200,000, and the weighted-average amount of accumulated expenditures was $3,600,000. Compute the avoidable interest on this project.

(b) Compute the depreciation expense for the year ended December 31, 2018. Harrisburg elected to depreciate the building on a straight-line basis and determined that the asset has a useful life of 30 years and a salvage value of $300,000.

E10-8 (L03) (Capitalization of Interest) On December 31, 2016, Main Inc. borrowed $3,000,000 at 12% payable annually to finance the construction of a new building. In 2017, the company made the following expenditures related to this building: March 1, $360,000; June 1, $600,000; July 1, $1,500,000; December 1, $1,500,000. The building was completed in February 2018. Additional information is provided as follows.

1. Other debt outstanding 10-year, 13% bond, December 31, 2010, interest payable annually $4,000,000

6-year, 10% note, dated December 31, 2014, interest payable annually $1,600,000 2. March 1, 2017, expenditure included land costs of $150,000 3. Interest revenue earned in 2017 $49,000

Instructions (a) Determine the amount of interest to be capitalized in 2017 in relation to the construction of the building. (b) Prepare the journal entry to record the capitalization of interest and the recognition of interest expense, if any, at

December 31, 2017.

E10-9 (L03) (Capitalization of Interest) On July 31, 2017, Amsterdam Company engaged Minsk Tooling Company to con- struct a special-purpose piece of factory machinery. Construction was begun immediately and was completed on November 1, 2017. To help finance construction, on July 31 Amsterdam issued a $300,000, 3-year, 12% note payable at Netherlands National Bank, on which interest is payable each July 31. $200,000 of the proceeds of the note was paid to Minsk on July 31. The remainder of the proceeds was temporarily invested in short-term marketable securities (trading securities) at 10% until November 1. On

Exercises 535

536 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

November 1, Amsterdam made a final $100,000 payment to Minsk. Other than the note to Netherlands, Amsterdam’s only out- standing liability at December 31, 2017, is a $30,000, 8%, 6-year note payable, dated January 1, 2014, on which interest is payable each December 31.

Instructions (a) Calculate the interest revenue, weighted-average accumulated expenditures, avoidable interest, and total interest cost

to be capitalized during 2017. (Round all computations to the nearest dollar.) (b) Prepare the journal entries needed on the books of Amsterdam Company at each of the following dates. (1) July 31, 2017. (2) November 1, 2017. (3) December 31, 2017.

E10-10 (L03) (Capitalization of Interest) The following three situations involve the capitalization of interest.

Situation I: On January 1, 2017, Oksana Baiul, Inc. signed a fixed-price contract to have Builder Associates construct a major plant facility at a cost of $4,000,000. It was estimated that it would take 3 years to complete the project. Also on January 1, 2017, to finance the construction cost, Oksana Baiul borrowed $4,000,000 payable in 10 annual installments of $400,000, plus interest at the rate of 10%. During 2017, Oksana Baiul made deposit and progress payments totaling $1,500,000 under the contract; the weighted- average amount of accumulated expenditures was $800,000 for the year. The excess borrowed funds were invested in short-term securities, from which Oksana Baiul realized investment income of $250,000.

Instructions What amount should Oksana Baiul report as capitalized interest at December 31, 2017?

Situation II: During 2017, Midori Ito Corporation constructed and manufactured certain assets and incurred the following inter- est costs in connection with those activities.

Interest Costs Incurred

Warehouse constructed for Ito’s own use $30,000 Special-order machine for sale to unrelated customer, produced according

to customer’s specifi cations 9,000 Inventories routinely manufactured, produced on a repetitive basis 8,000

All of these assets required an extended period of time for completion.

Instructions Assuming the effect of interest capitalization is material, what is the total amount of interest costs to be capitalized?

Situation III: Peggy Fleming, Inc. has a fiscal year ending April 30. On May 1, 2017, Peggy Fleming borrowed $10,000,000 at 11% to finance construction of its own building. Repayments of the loan are to commence the month following completion of the building. During the year ended April 30, 2018, expenditures for the partially completed structure totaled $7,000,000. These expenditures were incurred evenly throughout the year. Interest earned on the unexpended portion of the loan amounted to $650,000 for the year.

Instructions How much should be shown as capitalized interest on Peggy Fleming’s financial statements at April 30, 2018? (CPA adapted)

E10-11 (L01,4) (Entries for Equipment Acquisitions) Jane Geddes Engineering Corporation purchased conveyor equip- ment with a list price of $10,000. Presented below are three independent cases related to the equipment. (Round to the nearest dollar.)

(a) Geddes paid cash for the equipment 8 days after the purchase. The vendor’s credit terms are 2/10, n/30. Assume that equipment purchases are initially recorded gross.

(b) Geddes traded in equipment with a book value of $2,000 (initial cost $8,000), and paid $9,500 in cash one month after the purchase. The old equipment could have been sold for $400 at the date of trade. (The exchange has commercial substance.)

(c) Geddes gave the vendor a $10,800 zero-interest-bearing note for the equipment on the date of purchase. The note was due in one year and was paid on time. Assume that the effective-interest rate in the market was 9%.

Instructions Prepare the general journal entries required to record the acquisition and payment in each of the independent cases above.

E10-12 (L01,2,4) (Entries for Asset Acquisition, Including Self-Construction) Below are transactions related to Duffner Company. (a) The City of Pebble Beach gives the company 5 acres of land as a plant site. The fair value of this land is determined to

be $81,000. (b) 13,000 shares of common stock with a par value of $50 per share are issued in exchange for land and buildings. The prop-

erty has been appraised at a fair value of $810,000, of which $180,000 has been allocated to land and $630,000 to buildings. The stock of Duffner Company is not listed on any exchange, but a block of 100 shares was sold by a stockholder 12 months ago at $65 per share, and a block of 200 shares was sold by another stockholder 18 months ago at $58 per share.

(c) No entry has been made to remove from the accounts for Materials, Direct Labor, and Overhead the amounts properly chargeable to plant asset accounts for machinery constructed during the year. The following information is given rela- tive to costs of the machinery constructed.

Materials used $12,500 Factory supplies used 900 Direct labor incurred 15,000 Additional overhead (over regular) caused by construction 2,700

of machinery, excluding factory supplies used Fixed overhead rate applied to regular manufacturing operations 60% of direct labor cost Cost of similar machinery if it had been purchased from

outside suppliers 44,000

Instructions Prepare journal entries on the books of Duffner Company to record these transactions.

E10-13 (L01,4) (Entries for Acquisition of Assets) Presented below is information related to Zonker Company. 1. On July 6, Zonker Company acquired the plant assets of Doonesbury Company, which had discontinued operations. The

appraised value of the property is: Land $ 400,000 Buildings 1,200,000 Equipment 800,000

Total $2,400,000

Zonker Company gave 12,500 shares of its $100 par value common stock in exchange. The stock had a market price of $168 per share on the date of the purchase of the property.

2. Zonker Company expended the following amounts in cash between July 6 and December 15, the date when it first occu- pied the building.

Repairs to building $105,000 Construction of bases for equipment to be installed later 135,000 Driveways and parking lots 122,000 Remodeling of offi ce space in building, including new partitions and walls 161,000 Special assessment by city on land 18,000

3. On December 20, the company paid cash for equipment, $260,000, subject to a 2% cash discount, and freight on equipment of $10,500.

Instructions Prepare entries on the books of Zonker Company for these transactions.

E10-14 (L04) (Purchase of Equipment with Zero-Interest-Bearing Debt) Chippewas Inc. has decided to purchase equip- ment from Central Michigan Industries on January 2, 2017, to expand its production capacity to meet customers’ demand for its product. Chippewas issues an $800,000, 5-year, zero-interest-bearing note to Central Michigan for the new equipment when the prevailing market rate of interest for obligations of this nature is 12%. The company will pay off the note in five $160,000 install- ments due at the end of each year over the life of the note.

Instructions (Round to nearest dollar in all computations.)

(a) Prepare the journal entry(ies) at the date of purchase. (b) Prepare the journal entry(ies) at the end of the first year to record the payment and interest, assuming that the company

employs the effective-interest method. (c) Prepare the journal entry(ies) at the end of the second year to record the payment and interest. (d) Assuming that the equipment had a 10-year life and no salvage value, prepare the journal entry necessary to record

depreciation in the first year. (Straight-line depreciation is employed.)

Exercises 537

538 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

E10-15 (L04) (Purchase of Computer with Zero-Interest-Bearing Debt) Cardinals Corporation purchased a computer on December 31, 2016, for $105,000, paying $30,000 down and agreeing to pay the balance in five equal installments of $15,000 pay- able each December 31 beginning in 2017. An assumed interest rate of 10% is implicit in the purchase price.

Instructions (Round to two decimal places.)

(a) Prepare the journal entry(ies) at the date of purchase. (b) Prepare the journal entry(ies) at December 31, 2017, to record the payment and interest (effective-interest method

employed). (c) Prepare the journal entry(ies) at December 31, 2018, to record the payment and interest (effective-interest method employed).

E10-16 (L03,4) GROUPWORK (Asset Acquisition) Hayes Industries purchased the following assets and constructed a building as well. All this was done during the current year.

Assets 1 and 2: These assets were purchased as a lump sum for $100,000 cash. The following information was gathered.

Description Initial Cost on Seller’s Books

Depreciation to Date on Seller’s

Books Book Value on Seller’s Books Appraised Value

Machinery $100,000 $50,000 $50,000 $90,000 Equipment 60,000 10,000 50,000 30,000

Asset 3: This machine was acquired by making a $10,000 down payment and issuing a $30,000, 2-year, zero-interest-bearing note. The note is to be paid off in two $15,000 installments made at the end of the first and second years. It was estimated that the asset could have been purchased outright for $35,900.

Asset 4: This machinery was acquired by trading in used machinery. (The exchange lacks commercial substance.) Facts concern- ing the trade-in are as follows. Cost of machinery traded $100,000 Accumulated depreciation to date of sale 40,000 Fair value of machinery traded 80,000 Cash received 10,000 Fair value of machinery acquired 70,000

Asset 5: Equipment was acquired by issuing 100 shares of $8 par value common stock. The stock had a market price of $11 per share.

Construction of Building: A building was constructed on land purchased last year at a cost of $150,000. Construction began on February 1 and was completed on November 1. The payments to the contractor were as follows.

Date Payment

2/1 $120,000 6/1 360,000 9/1 480,000 11/1 100,000

To finance construction of the building, a $600,000, 12% construction loan was taken out on February 1. The loan was repaid on November 1. The firm had $200,000 of other outstanding debt during the year at a borrowing rate of 8%.

Instructions Record the acquisition of each of these assets.

E10-17 (L04) (Nonmonetary Exchange) Busytown Corporation, which manufactures shoes, hired a recent college graduate to work in its accounting department. On the first day of work, the accountant was assigned to total a batch of invoices with the use of an adding machine. Before long, the accountant, who had never before seen such a machine, managed to break the machine. Busytown Corporation gave the machine plus $340 to Dick Tracy Business Machine Company (dealer) in exchange for a new machine. Assume the following information about the machines.

Busytown Corp. (Old Machine)

Dick Tracy Co. (New Machine)

Machine cost $290 $270 Accumulated depreciation 140 –0– Fair value 85 425

Instructions For each company, prepare the necessary journal entry to record the exchange. (The exchange has commercial substance.)

E10-18 (L04) (Nonmonetary Exchange) Cannondale Company purchased an electric wax melter on April 30, 2017, by trad- ing in its old gas model and paying the balance in cash. The following data relate to the purchase.

List price of new melter $15,800 Cash paid 10,000 Cost of old melter (5-year life, $700 salvage value) 11,200 Accumulated depreciation—old melter (straight-line) 6,300 Secondhand fair value of old melter 5,200

Instructions Prepare the journal entry(ies) necessary to record this exchange, assuming that the exchange (a) has commercial substance, and (b) lacks commercial substance. Cannondale’s fiscal year ends on December 31, and depreciation has been recorded through December 31, 2016. E10-19 (L04) (Nonmonetary Exchange) Carlos Arruza Company exchanged equipment used in its manufacturing opera- tions plus $3,000 in cash for similar equipment used in the operations of Tony LoBianco Company. The following information pertains to the exchange.

Carlos Arruza Co. Tony LoBianco Co.

Equipment (cost) $28,000 $28,000 Accumulated depreciation 19,000 10,000 Fair value of equipment 12,500 15,500 Cash given up 3,000

Instructions (a) Prepare the journal entries to record the exchange on the books of both companies. Assume that the exchange lacks

commercial substance. (b) Prepare the journal entries to record the exchange on the books of both companies. Assume that the exchange has com-

mercial substance.

E10-20 (L04) (Nonmonetary Exchange) Dana Ashbrook Inc. has negotiated the purchase of a new piece of automatic equip- ment at a price of $8,000 plus trade-in, f.o.b. factory. Dana Ashbrook Inc. paid $8,000 cash and traded in used equipment. The used equipment had originally cost $62,000; it had a book value of $42,000 and a secondhand fair value of $47,800, as indicated by recent transactions involving similar equipment. Freight and installation charges for the new equipment required a cash pay- ment of $1,100.

Instructions (a) Prepare the general journal entry to record this transaction, assuming that the exchange has commercial substance. (b) Assuming the same facts as in (a) except that fair value information for the assets exchanged is not determinable, pre-

pare the general journal entry to record this transaction.

E10-21 (L05) GROUPWORK (Analysis of Subsequent Expenditures) King Donovan Resources Group has been in its plant facility for 15 years. Although the plant is quite functional, numerous repair costs are incurred to maintain it in sound working order. The company’s plant asset book value is currently $800,000, as indicated below.

Original cost $1,200,000 Accumulated depreciation 400,000

Book value $ 800,000

During the current year, the following expenditures were made to the plant facility.

(a) Because of increased demands for its product, the company increased its plant capacity by building a new addition at a cost of $270,000.

(b) The entire plant was repainted at a cost of $23,000. (c) The roof was an asbestos cement slate. For safety purposes, it was removed and replaced with a wood shingle roof at a

cost of $61,000. Book value of the old roof was $41,000. (d) The electrical system was completely updated at a cost of $22,000. The cost of the old electrical system was not known.

It is estimated that the useful life of the building will not change as a result of this updating. (e) A series of major repairs were made at a cost of $47,000, because parts of the wood structure were rotting. The cost of

the old wood structure was not known. These extensive repairs are estimated to increase the useful life of the building.

Instructions Indicate how each of these transactions would be recorded in the accounting records.

Exercises 539

540 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

E10-22 (L05,6) (Analysis of Subsequent Expenditures) The following transactions occurred during 2017. Assume that depreciation of 10% per year is charged on all machinery and 5% per year on buildings, on a straight-line basis, with no esti- mated salvage value. Depreciation is charged for a full year on all fixed assets acquired during the year, and no depreciation is charged on fixed assets disposed of during the year.

Jan. 30 A building that cost $132,000 in 2000 is torn down to make room for a new building. The wrecking contractor was paid $5,100 and was permitted to keep all materials salvaged.

Mar. 10 Machinery that was purchased in 2010 for $16,000 is sold for $2,900 cash, f.o.b. purchaser’s plant. Freight of $300 is paid on the sale of this machinery.

Mar. 20 A gear breaks on a machine that cost $9,000 in 2009. The gear is replaced at a cost of $2,000. The replacement does not extend the useful life of the machine but does make the machine more effi cient.

May 18 A special base installed for a machine in 2011 when the machine was purchased has to be replaced at a cost of $5,500 because of defective workmanship on the original base. The cost of the machinery was $14,200 in 2011. The cost of the base was $3,500, and this amount was charged to the Machinery account in 2011.

June 23 One of the buildings is repainted at a cost of $6,900. It had not been painted since it was constructed in 2013.

Instructions Prepare general journal entries for the transactions. (Round to the nearest dollar.)

E10-23 (L05) (Analysis of Subsequent Expenditures) Plant assets often require expenditures subsequent to acquisition. It is important that they be accounted for properly. Any errors will affect both the balance sheets and income statements for a number of years.

Instructions For each of the following items, indicate whether the expenditure should be capitalized (C) or expensed (E) in the period incurred.

(a) __________ Improvement. (b) __________ Replacement of a minor broken part on a machine. (c) __________ Expenditure that increases the useful life of an existing asset. (d) __________ Expenditure that increases the efficiency and effectiveness of a productive asset but does not increase its

salvage value. (e) __________ Expenditure that increases the efficiency and effectiveness of a productive asset and increases the asset’s

salvage value. (f) __________ Expenditure that increases the quality of the output of the productive asset. (g) __________ Improvement to a machine that increased its fair market value and its production capacity by 30% without

extending the machine’s useful life. (h) __________ Ordinary repairs.

E10-24 (L06) (Entries for Disposition of Assets) On December 31, 2017, Travis Tritt Inc. has a machine with a book value of $940,000. The original cost and related accumulated depreciation at this date are as follows.

Machine $1,300,000 Less: Accumulated depreciation 360,000

Book value $ 940,000

Depreciation is computed at $60,000 per year on a straight-line basis.

Instructions Presented below is a set of independent situations. For each independent situation, indicate the journal entry to be made to record the transaction. Make sure that depreciation entries are made to update the book value of the machine prior to its disposal.

(a) A fire completely destroys the machine on August 31, 2018. An insurance settlement of $430,000 was received for this casualty. Assume the settlement was received immediately.

(b) On April 1, 2018, Tritt sold the machine for $1,040,000 to Dwight Yoakam Company. (c) On July 31, 2018, the company donated this machine to the Mountain King City Council. The fair value of the machine

at the time of the donation was estimated to be $1,100,000.

E10-25 (L06) (Disposition of Assets) On April 1, 2017, Gloria Estefan Company received a condemnation award of $430,000 cash as compensation for the forced sale of the company’s land and building, which stood in the path of a new state highway. The land and building cost $60,000 and $280,000, respectively, when they were acquired. At April 1, 2017, the accumulated

depreciation relating to the building amounted to $160,000. On August 1, 2017, Estafan purchased a piece of replacement prop- erty for cash. The new land cost $90,000, and the new building cost $400,000.

Instructions Prepare the journal entries to record the transactions on April 1 and August 1, 2017.

PROBLEMS

P10-1 (L01) EXCEL (Classification of Acquisition and Other Asset Costs) At December 31, 2016, certain accounts included in the property, plant, and equipment section of Reagan Company’s balance sheet had the following balances.

Land $230,000 Buildings 890,000 Leasehold improvements 660,000 Equipment 875,000

During 2017, the following transactions occurred. 1. Land site number 621 was acquired for $850,000. In addition, to acquire the land Reagan paid a $51,000 commission to a

real estate agent. Costs of $35,000 were incurred to clear the land. During the course of clearing the land, timber and gravel were recovered and sold for $13,000.

2. A second tract of land (site number 622) with a building was acquired for $420,000. The closing statement indicated that the land value was $300,000 and the building value was $120,000. Shortly after acquisition, the building was demolished at a cost of $41,000. A new building was constructed for $330,000 plus the following costs.

Excavation fees $38,000 Architectural design fees 11,000 Building permit fee 2,500 Imputed interest on funds used

during construction (stock fi nancing) 8,500

The building was completed and occupied on September 30, 2017. 3. A third tract of land (site number 623) was acquired for $650,000 and was put on the market for resale. 4. During December 2017, costs of $89,000 were incurred to improve leased office space. The related lease will terminate on

December 31, 2019, and is not expected to be renewed. (Hint: Leasehold improvements should be handled in the same manner as land improvements.)

5. A group of new machines was purchased under a royalty agreement that provides for payment of royalties based on units of production for the machines. The invoice price of the machines was $87,000, freight costs were $3,300, installation costs were $2,400, and royalty payments for 2017 were $17,500.

Instructions (a) Prepare a detailed analysis of the changes in each of the following balance sheet accounts for 2017.

Land Leasehold Improvements Buildings Equipment

Disregard the related accumulated depreciation accounts. (b) List the items in the situation that were not used to determine the answer to (a) above, and indicate where, or if, these

items should be included in Reagan’s financial statements. (AICPA adapted)

P10-2 (L01,6) (Classification of Acquisition Costs) Selected accounts included in the property, plant, and equipment section of Lobo Corporation’s balance sheet at December 31, 2016, had the following balances.

Land $ 300,000 Land improvements 140,000 Buildings 1,100,000 Equipment 960,000

During 2017, the following transactions occurred.

1. A tract of land was acquired for $150,000 as a potential future building site.

Problems 541

542 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

2. A plant facility consisting of land and building was acquired from Mendota Company in exchange for 20,000 shares of Lobo’s common stock. On the acquisition date, Lobo’s stock had a closing market price of $37 per share on a national stock exchange. The plant facility was carried on Mendota’s books at $110,000 for land and $320,000 for the building at the ex- change date. Current appraised values for the land and building, respectively, are $230,000 and $690,000.

3. Items of machinery and equipment were purchased at a total cost of $400,000. Additional costs were incurred as follows.

Freight and unloading $13,000 Sales taxes 20,000 Installation 26,000

4. Expenditures totaling $95,000 were made for new parking lots, streets, and sidewalks at the corporation’s various plant locations. These expenditures had an estimated useful life of 15 years.

5. A machine costing $80,000 on January 1, 2009, was scrapped on June 30, 2017. Double-declining-balance depreciation has been recorded on the basis of a 10-year life.

6. A machine was sold for $20,000 on July 1, 2017. Original cost of the machine was $44,000 on January 1, 2014, and it was depreciated on the straight-line basis over an estimated useful life of 7 years and a salvage value of $2,000.

Instructions (Round to the nearest dollar.)

(a) Prepare a detailed analysis of the changes in each of the following balance sheet accounts for 2017.

Land Buildings Land Improvements Equipment

(Hint: Disregard the related accumulated depreciation accounts.) (b) List the items in the fact situation that were not used to determine the answer to (a), showing the pertinent amounts

and supporting computations in good form for each item. In addition, indicate where, or if, these items should be included in Lobo’s financial statements.

(AICPA adapted)

P10-3 (L01,2,4) (Classification of Land and Building Costs) Spitfire Company was incorporated on January 2, 2018, but was unable to begin manufacturing activities until July 1, 2018, because new factory facilities were not completed until that date.

The Land and Buildings account reported the following items during 2018.

January 31 Land and buildings $160,000 February 28 Cost of removal of building 9,800 May 1 Partial payment of new construction 60,000 May 1 Legal fees paid 3,770 June 1 Second payment on new construction 40,000 June 1 Insurance premium 2,280 June 1 Special tax assessment 4,000 June 30 General expenses 36,300 July 1 Final payment on new construction 30,000 December 31 Asset write-up 53,800

399,950 December 31 Depreciation—2018 at 1% (4,000)

December 31, 2018 Account balance $395,950

The following additional information is to be considered.

1. To acquire land and building, the company paid $80,000 cash and 800 shares of its 8% cumulative preferred stock, par value $100 per share. Fair value of the stock is $117 per share.

2. Cost of removal of old buildings amounted to $9,800, and the demolition company retained all materials of the building. 3. Legal fees covered the following.

Cost of organization $ 610 Examination of title covering purchase of land 1,300 Legal work in connection with construction contract 1,860 $3,770

4. Insurance premium covered the building for a 2-year term beginning May 1, 2018.

5. The special tax assessment covered street improvements that are permanent in nature. 6. General expenses covered the following for the period from January 2, 2018, to June 30, 2018.

President’s salary $32,100 Plant superintendent’s salary—supervision of new building 4,200 $36,300

7. Because of a general increase in construction costs after entering into the building contract, the board of directors increased the value of the building $53,800, believing that such an increase was justified to reflect the current market at the time the building was completed. Retained earnings was credited for this amount.

8. Estimated life of building—50 years. Depreciation for 2018—1% of asset value (1% of $400,000, or $4,000).

Instructions (a) Prepare entries to reflect correct land, buildings, and depreciation accounts at December 31, 2018. (b) Show the proper presentation of land, buildings, and depreciation on the balance sheet at December 31, 2018.

(AICPA adapted)

P10-4 (L01,4,6) GROUPWORK (Dispositions, Including Condemnation, Demolition, and Trade-In) Presented below is a schedule of property dispositions for Hollerith Co.

Schedule of Property Dispositions

Cost Accumulated Depreciation

Cash Proceeds

Fair Value

Nature of Disposition

Land $40,000 — $31,000 $31,000 Condemnation Building 15,000 — 3,600 — Demolition Warehouse 70,000 $16,000 74,000 74,000 Destruction by fi re Machine 8,000 2,800 900 7,200 Trade-in Furniture 10,000 7,850 — 3,100 Contribution Automobile 9,000 3,460 2,960 2,960 Sale

The following additional information is available.

Land: On February 15, a condemnation award was received as consideration for unimproved land held primarily as an in- vestment, and on March 31, another parcel of unimproved land to be held as an investment was purchased at a cost of $35,000.

Building: On April 2, land and building were purchased at a total cost of $75,000, of which 20% was allocated to the building on the corporate books. The real estate was acquired with the intention of demolishing the building, and this was accom- plished during the month of November. Cash proceeds received in November represent the net proceeds from demolition of the building.

Warehouse: On June 30, the warehouse was destroyed by fire. The warehouse was purchased January 2, 2014, and had de- preciated $16,000. On December 27, the insurance proceeds and other funds were used to purchase a replacement warehouse at a cost of $90,000.

Machine: On December 26, the machine was exchanged for another machine having a fair value of $6,300 and cash of $900 was received. (The exchange lacks commercial substance.)

Furniture: On August 15, furniture was contributed to a qualified charitable organization. No other contributions were made or pledged during the year.

Automobile: On November 3, the automobile was sold to Jared Winger, a stockholder.

Instructions Indicate how these items would be reported on the income statement of Hollerith Co. (AICPA adapted)

P10-5 (L01,3) EXCEL (Classification of Costs and Interest Capitalization) On January 1, 2017, Blair Corporation purchased for $500,000 a tract of land (site number 101) with a building. Blair paid a real estate broker’s commission of $36,000, legal fees of $6,000, and title guarantee insurance of $18,000. The closing statement indicated that the land value was $500,000 and the building value was $100,000. Shortly after acquisition, the building was razed at a cost of $54,000.

Problems 543

544 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

Blair entered into a $3,000,000 fixed-price contract with Slatkin Builders, Inc. on March 1, 2017, for the construction of an of- fice building on land site number 101. The building was completed and occupied on September 30, 2018. Additional construction costs were incurred as follows.

Plans, specifi cations, and blueprints $21,000 Architects’ fees for design and supervision 82,000

The building is estimated to have a 40-year life from date of completion and will be depreciated using the 150% declining- balance method.

To finance construction costs, Blair borrowed $3,000,000 on March 1, 2017. The loan is payable in 10 annual installments of $300,000 starting on March 1, 2018, plus interest at the rate of 10%. Blair’s weighted-average amounts of accumulated building construction expenditures were as follows.

For the period March 1 to December 31, 2017 $1,300,000 For the period January 1 to September 30, 2018 1,900,000

Instructions (a) Prepare a schedule that discloses the individual costs making up the balance in the land account in respect of land site

number 101 as of September 30, 2018. (b) Prepare a schedule that discloses the individual costs that should be capitalized in the office building account as of

September 30, 2018. Show supporting computations in good form. (AICPA adapted)

P10-6 (L01,3) (Interest During Construction) Grieg Landscaping began construction of a new plant on December 1, 2017. On this date, the company purchased a parcel of land for $139,000 in cash. In addition, it paid $2,000 in surveying costs and $4,000 for a title insurance policy. An old dwelling on the premises was demolished at a cost of $3,000, with $1,000 being received from the sale of materials.

Architectural plans were also formalized on December 1, 2017, when the architect was paid $30,000. The necessary building permits costing $3,000 were obtained from the city and paid for on December 1 as well. The excavation work began during the first week in December with payments made to the contractor in 2018 as follows.

Date of Payment Amount of Payment

March 1 $240,000 May 1 330,000 July 1 60,000

The building was completed on July 1, 2018. To finance construction of this plant, Grieg borrowed $600,000 from the bank on December 1, 2017. Grieg had no other bor-

rowings. The $600,000 was a 10-year loan bearing interest at 8%.

Instructions Compute the balance in each of the following accounts at December 31, 2017, and December 31, 2018. (Round amounts to the nearest dollar.)

(a) Land. (b) Buildings. (c) Interest Expense.

P10-7 (L03) GROUPWORK (Capitalization of Interest) Laserwords Inc. is a book distributor that had been operating in its original facility since 1987. The increase in certification programs and continuing education requirements in several professions has contributed to an annual growth rate of 15% for Laserwords since 2012. Laserwords’ original facility became obsolete by early 2017 because of the increased sales volume and the fact that Laserwords now carries CDs in addition to books.

On June 1, 2017, Laserwords contracted with Black Construction to have a new building constructed for $4,000,000 on land owned by Laserwords. The payments made by Laserwords to Black Construction are shown in the schedule below.

Date Amount

July 30, 2017 $ 900,000 January 30, 2018 1,500,000 May 30, 2018 1,600,000

Total payments $4,000,000

Construction was completed and the building was ready for occupancy on May 27, 2018. Laserwords had no new borrow- ings directly associated with the new building but had the following debt outstanding at May 31, 2018, the end of its fiscal year.

10%, 5-year note payable of $2,000,000, dated April 1, 2014, with interest payable annually on April 1. 12%, 10-year bond issue of $3,000,000 sold at par on June 30, 2010, with interest payable annually on June 30.

The new building qualifies for interest capitalization. The effect of capitalizing the interest on the new building, compared with the effect of expensing the interest, is material.

Instructions (a) Compute the weighted-average accumulated expenditures on Laserwords’ new building during the capitalization

period. (b) Compute the avoidable interest on Laserwords’ new building. (Round to one decimal place.) (c) Some interest cost of Laserwords Inc. is capitalized for the year ended May 31, 2018. (1) Identify the items relating to interest costs that must be disclosed in Laserwords’ financial statements. (2) Compute the amount of each of the items that must be disclosed.

(CMA adapted)

P10-8 (L04) (Nonmonetary Exchanges) Holyfield Corporation wishes to exchange a machine used in its operations. Holy- field has received the following offers from other companies in the industry.

1. Dorsett Company offered to exchange a similar machine plus $23,000. (The exchange has commercial substance for both parties.)

2. Winston Company offered to exchange a similar machine. (The exchange lacks commercial substance for both parties.) 3. Liston Company offered to exchange a similar machine, but wanted $3,000 in addition to Holyfield’s machine. (The

exchange has commercial substance for both parties.)

In addition, Holyfield contacted Greeley Corporation, a dealer in machines. To obtain a new machine, Holyfield must pay $93,000 in addition to trading in its old machine.

Holyfi eld Dorsett Winston Liston Greeley

Machine cost $160,000 $120,000 $152,000 $160,000 $130,000 Accumulated depreciation 60,000 45,000 71,000 75,000 –0– Fair value 92,000 69,000 92,000 95,000 185,000

Instructions For each of the four independent situations, prepare the journal entries to record the exchange on the books of each company.

P10-9 (L04) (Nonmonetary Exchanges) On August 1, Hyde, Inc. exchanged productive assets with Wiggins, Inc. Hyde’s asset is referred to below as “Asset A,” and Wiggins’ is referred to as “Asset B.” The following facts pertain to these assets.

Asset A Asset B

Original cost $96,000 $110,000 Accumulated depreciation (to date of exchange) 40,000 47,000 Fair value at date of exchange 60,000 75,000 Cash paid by Hyde, Inc. 15,000 Cash received by Wiggins, Inc. 15,000

Instructions (a) Assuming that the exchange of Assets A and B has commercial substance, record the exchange for both Hyde, Inc. and

Wiggins, Inc. in accordance with generally accepted accounting principles. (b) Assuming that the exchange of Assets A and B lacks commercial substance, record the exchange for both Hyde, Inc.

and Wiggins, Inc. in accordance with generally accepted accounting principles.

P10-10 (L04) (Nonmonetary Exchanges) During the current year, Marshall Construction trades an old crane that has a book value of $90,000 (original cost $140,000 less accumulated depreciation $50,000) for a new crane from Brigham Manufac- turing Co. The new crane cost Brigham $165,000 to manufacture and is classified as inventory. The following information is also available.

Problems 545

546 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

Marshall Const. Brigham Mfg. Co.

Fair value of old crane $ 82,000 Fair value of new crane $200,000 Cash paid 118,000 Cash received 118,000

Instructions (a) Assuming that this exchange is considered to have commercial substance, prepare the journal entries on the books of

(1) Marshall Construction and (2) Brigham Manufacturing. (b) Assuming that this exchange lacks commercial substance for Marshall, prepare the journal entries on the books of

Marshall Construction. (c) Assuming the same facts as those in (a), except that the fair value of the old crane is $98,000 and the cash paid is

$102,000, prepare the journal entries on the books of (1) Marshall Construction and (2) Brigham Manufacturing. (d) Assuming the same facts as those in (b), except that the fair value of the old crane is $97,000 and the cash paid $103,000,

prepare the journal entries on the books of (1) Marshall Construction and (2) Brigham Manufacturing.

P10-11 (L01,4) (Purchases by Deferred Payment, Lump-Sum, and Nonmonetary Exchanges) Klamath Company, a manufac- turer of ballet shoes, is experiencing a period of sustained growth. In an effort to expand its production capacity to meet the increased demand for its product, the company recently made several acquisitions of plant and equipment. Rob Joffrey, newly hired in the position of fixed-asset accountant, requested that Danny Nolte, Klamath’s controller, review the following transactions.

Transaction 1: On June 1, 2017, Klamath Company purchased equipment from Wyandot Corporation. Klamath issued a $28,000, 4-year, zero-interest-bearing note to Wyandot for the new equipment. Klamath will pay off the note in four equal installments due at the end of each of the next 4 years. At the date of the transaction, the prevailing market rate of interest for obligations of this nature was 10%. Freight costs of $425 and installation costs of $500 were incurred in completing this transaction. The appropriate factors for the time value of money at a 10% rate of interest are given below.

Future value of $1 for 4 periods 1.46 Future value of an ordinary annuity for 4 periods 4.64 Present value of $1 for 4 periods 0.68 Present value of an ordinary annuity for 4 periods 3.17

Transaction 2: On December 1, 2017, Klamath Company purchased several assets of Yakima Shoes Inc., a small shoe manufac- turer whose owner was retiring. The purchase amounted to $220,000 and included the assets listed below. Klamath Company engaged the services of Tennyson Appraisal Inc., an independent appraiser, to determine the fair values of the assets which are also presented below.

Yakima Book Value Fair Value

Inventory $ 60,000 $ 50,000 Land 40,000 80,000 Buildings 70,000 120,000

$170,000 $250,000

During its fiscal year ended May 31, 2018, Klamath incurred $8,000 for interest expense in connection with the financing of these assets.

Transaction 3: On March 1, 2018, Klamath Company exchanged a number of used trucks plus cash for vacant land adjacent to its plant site. (The exchange has commercial substance.) Klamath intends to use the land for a parking lot. The trucks had a combined book value of $35,000, as Klamath had recorded $20,000 of accumulated depreciation against these assets. Klamath’s purchasing agent, who has had previous dealings in the secondhand market, indicated that the trucks had a fair value of $46,000 at the time of the transaction. In addition to the trucks, Klamath Company paid $19,000 cash for the land.

Instructions (a) Plant assets such as land, buildings, and equipment receive special accounting treatment. Describe the major charac-

teristics of these assets that differentiate them from other types of assets. (b) For each of the three transactions described above, determine the value at which Klamath Company should record the

acquired assets. Support your calculations with an explanation of the underlying rationale. (c) The books of Klamath Company show the following additional transactions for the fiscal year ended May 31, 2018. (1) Acquisition of a building for speculative purposes. (2) Purchase of a 2-year insurance policy covering plant equipment. (3) Purchase of the rights for the exclusive use of a process used in the manufacture of ballet shoes.

For each of these transactions, indicate whether the asset should be classified as a plant asset. If it is a plant asset, explain why it is. If it is not a plant asset, explain why not, and identify the proper classification. (CMA adapted)

CONCEPTS FOR ANALYSIS

CA10-1 WRITING (Acquisition, Improvements, and Sale of Realty) Tonkawa Company purchased land for use as its cor- porate headquarters. A small factory that was on the land when it was purchased was torn down before construction of the office building began. Furthermore, a substantial amount of rock blasting and removal had to be done to the site before construction of the building foundation began. Because the office building was set back on the land far from the public road, Tonkawa Com- pany had the contractor construct a paved road that led from the public road to the parking lot of the office building.

Three years after the office building was occupied, Tonkawa Company added four stories to the office building. The four stories had an estimated useful life of 5 years more than the remaining estimated useful life of the original office building.

Ten years later, the land and building were sold at an amount more than their net book value, and Tonkawa Company had a new office building constructed in another state for use as its new corporate headquarters.

Instructions (a) Which of the expenditures above should be capitalized? How should each be depreciated or amortized? Discuss the

rationale for your answers. (b) How would the sale of the land and building be accounted for? Include in your answer an explanation of how to deter-

mine the net book value at the date of sale. Discuss the rationale for your answer.

CA10-2 (Accounting for Self-Constructed Assets) Troopers Medical Labs, Inc., began operations 5 years ago producing stetrics, a new type of instrument it hoped to sell to doctors, dentists, and hospitals. The demand for stetrics far exceeded initial expecta- tions, and the company was unable to produce enough stetrics to meet demand.

The company was manufacturing its product on equipment that it built at the start of its operations. To meet demand, more efficient equipment was needed. The company decided to design and build the equipment, because the equipment currently available on the market was unsuitable for producing stetrics.

In 2017, a section of the plant was devoted to development of the new equipment and a special staff was hired. Within 6 months, a machine developed at a cost of $714,000 increased production dramatically and reduced labor costs substantially. Elated by the success of the new machine, the company built three more machines of the same type at a cost of $441,000 each.

Instructions (a) In general, what costs should be capitalized for self-constructed equipment? (b) Discuss the propriety of including in the capitalized cost of self-constructed assets: (1) The increase in overhead caused by the self-construction of fixed assets. (2) A proportionate share of overhead on the same basis as that applied to goods manufactured for sale. (c) Discuss the proper accounting treatment of the $273,000 ($714,000 − $441,000) by which the cost of the first machine exceeded

the cost of the subsequent machines. This additional cost should not be considered research and development costs.

CA10-3 WRITING (Capitalization of Interest) Vania Magazine Company started construction of a warehouse building for its own use at an estimated cost of $5,000,000 on January 1, 2016, and completed the building on December 31, 2016. During the con- struction period, Vania has the following debt obligations outstanding.

Construction loan—12% interest, payable semiannually, issued December 31, 2015 $2,000,000 Short-term loan—10% interest, payable monthly, and principal payable at maturity, on May 30, 2017 1,400,000 Long-term loan—11% interest, payable on January 1 of each year; principal payable on January 1, 2019 1,000,000

Total cost amounted to $5,200,000, and the weighted average of accumulated expenditures was $3,500,000. Jane Esplanade, the president of the company, has been shown the costs associated with this construction project and capi-

talized on the balance sheet. She is bothered by the “avoidable interest” included in the cost. She argues that, first, all the interest is unavoidable—no one lends money without expecting to be compensated for it. Second, why can’t the company use all the interest on all the loans when computing this avoidable interest? Finally, why can’t her company capitalize all the annual interest that accrued over the period of construction?

Instructions (Round the weighted-average interest rate to two decimal places.)

Concepts for Analysis 547

548 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

You are the manager of accounting for the company. In a memo, explain what avoidable interest is, how you computed it (being especially careful to explain why you used the interest rates that you did), and why the company cannot capitalize all its interest for the year. Attach a schedule supporting any computations that you use.

CA10-4 WRITING (Nonmonetary Exchanges) You have two clients that are considering trading machinery with each other. Although the machines are different from each other, you believe that an assessment of expected cash flows on the exchanged assets will indicate the exchange lacks commercial substance. Your clients would prefer that the exchange be deemed to have com- mercial substance, to allow them to record gains. Here are the facts:

Client A Client B

Original cost $100,000 $150,000 Accumulated depreciation 40,000 80,000 Fair value 80,000 100,000 Cash received (paid) (20,000) 20,000

Instructions (a) Record the trade-in on Client A’s books assuming the exchange has commercial substance. (b) Record the trade-in on Client A’s books assuming the exchange lacks commercial substance. (c) Write a memo to the controller of Company A indicating and explaining the dollar impact on current and future state-

ments of treating the exchange as having, versus lacking, commercial substance. (d) Record the entry on Client B’s books assuming the exchange has commercial substance. (e) Record the entry on Client B’s books assuming the exchange lacks commercial substance. (f) Write a memo to the controller of Company B indicating and explaining the dollar impact on current and future state-

ments of treating the exchange as having, versus lacking, commercial substance.

CA10-5 (Costs of Acquisition) The invoice price of a machine is $50,000. Various other costs relating to the acquisition and installation of the machine including transportation, electrical wiring, special base, and so on amount to $7,500. The machine has an estimated life of 10 years, with no salvage value at the end of that period.

The owner of the business suggests that the incidental costs of $7,500 be charged to expense immediately for the following reasons.

1. If the machine should be sold, these costs cannot be recovered in the sales price. 2. The inclusion of the $7,500 in the machinery account on the books will not necessarily result in a closer approximation of

the market price of this asset over the years, because of the possibility of changing demand and supply levels. 3. Charging the $7,500 to expense immediately will reduce federal income taxes.

Instructions Discuss each of the points raised by the owner of the business.

(AICPA adapted)

CA10-6 ETHICS (Cost of Land vs. Building—Ethics) Tones Company purchased a warehouse in a downtown district where land values are rapidly increasing. Gerald Carter, controller, and Wilma Ankara, financial vice president, are trying to allocate the cost of the purchase between the land and the building. Noting that depreciation can be taken only on the building, Carter favors placing a very high proportion of the cost on the warehouse itself, thus reducing taxable income and income taxes. Ankara, his supervisor, argues that the allocation should recognize the increasing value of the land, regardless of the depreciation potential of the warehouse. Besides, she says, net income is negatively impacted by additional depreciation and will cause the company’s stock price to go down.

Instructions Answer the following questions.

(a) What stakeholder interests are in conflict? (b) What ethical issues does Carter face? (c) How should these costs be allocated?

USING YOUR JUDGMENT

Financial Statement Analysis Case

Johnson & Johnson Johnson & Johnson, the world’s leading and most diversified healthcare corporation, serves its customers through specialized worldwide franchises. Each of its franchises consists of a number of companies throughout the world that focus on a particular

Using Your Judgment 549

healthcare market, such as surgical sutures, consumer pharmaceuticals, or contact lenses. Information related to its property, plant, and equipment in its 2014 annual report is shown in the notes to the financial statements below.

1. Property, Plant and Equipment and Depreciation

Property, plant and equipment are stated at cost. The Company utilizes the straight-line method of depreciation over the estimated useful lives of the assets:

Building and building equipment 20–40 years Land and leasehold improvements 10–20 years Machinery and equipment 2–13 years

4. Property, Plant and Equipment

At the end of 2014 and 2013, property, plant and equipment at cost and accumulated depreciation were:

(dollars in millions) 2014 2013

Land and land improvements $ 833 $ 885 Buildings and building equipment 10,046 10,423 Machinery and equipment 22,206 22,527 Construction in progress 3,600 3,298

36,685 37,133 Less accumulated depreciation 20,559 20,423

$16,126 $16,710

The Company capitalizes interest expense as part of the cost of construction of facilities and equipment. Interest expense capitalized in 2014, 2013 and 2012 was $115 million, $105 million and $115 million, respectively. Depreciation expense, including the amortization of capitalized interest in 2014, 2013 and 2012, was $2.5 billion, $2.7 billion and $2.5 billion, respectively.

Johnson & Johnson provided the following selected information in its 2014 cash flow statement.

Johnson & Johnson 2014 Annual Report

Consolidated Financial Statements (excerpts)

Net cash fl ows from operating activities $18,471

Cash fl ows from investing activities Additions to property, plant and equipment (3,714) Proceeds from the disposal of assets 4,631

Acquisitions, net of cash acquired (2,129) Purchases of investments (34,913)

Sales of investments 24,119 Other (primarily intangibles) (299)

Net cash used by investing activities (12,305)

Cash fl ows from fi nancing activities Dividends to shareholders (7,768) Repurchase of common stock (7,124) Proceeds from short-term debt 1,863

Retirement of short-term debt (1,267) Proceeds from long-term debt 2,098 Retirement of long-term debt (1,844) Proceeds from the exercise of stock options/excess tax benefi ts 1,782

Net cash used by fi nancing activities (12,260)

Effect of exchange rate changes on cash and cash equivalents (310)

Increase in cash and cash equivalents (6,404) Cash and cash equivalents, beginning of year (Note 1) 20,927

Cash and cash equivalents, end of year (Note 1) $14,523

Supplemental cash fl ow data Cash paid during the year for: Interest $ 603 Income taxes 3,536

550 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment

Instructions (a) What was the cost of buildings and building equipment at the end of 2014? (b) Does Johnson & Johnson use a conservative or liberal method to depreciate its property, plant, and equipment? (c) What was the actual interest paid by the company in 2014? (d) What is Johnson & Johnson’s free cash flow? From the information provided, comment on Johnson & Johnson’s finan-

cial flexibility.

Accounting, Analysis, and Principles Durler Company purchased equipment on January 2, 2013, for $112,000. The equipment had an estimated useful life of 5 years with an estimated salvage value of $12,000. Durler uses straight-line depreciation on all assets. On January 2, 2017, Durler exchanged this equipment plus $12,000 in cash for newer equipment. The old equipment has a fair value of $50,000.

Accounting Prepare the journal entry to record the exchange on the books of Durler Company. Assume that the exchange has commercial substance.

Analysis How will this exchange affect comparisons of the return on asset ratio for Durler in the year of the exchange compared to prior years?

Principles How does the concept of commercial substance affect the accounting and analysis of this exchange?

BRIDGE TO THE PROFESSION

FASB Codifi cation References [1] FASB ASC 360-10-35-43. [Predecessor literature: “Accounting for the Impairment or Disposal of Long-lived Assets,”

Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001), par. 34.] [2] FASB ASC 835-20-05. [Predecessor literature: “Capitalization of Interest Cost,” Statement of Financial Accounting Standards

No. 34 (Stamford, Conn.: FASB, 1979).]

[3] FASB ASC 835-20-15-4. [Predecessor literature: “Determining Materiality for Capitalization of Interest Cost,” Statement of Financial Accounting Standards No. 42 (Stamford, Conn.: FASB, 1980), par. 10.]

[4] FASB ASC 820-10-35. [Predecessor literature: “(Predecessor literature: “Fair Value Measurement,” Statement of Financial Accounting Standards No. 157 (Norwalk, Conn.: FASB, September 2006), paras. 13–18.]

[5] FASB ASC 845-10-30. [Predecessor literature: “Accounting for Nonmonetary Transactions,” Opinions of the Accounting Prin- ciples Board No. 29 (New York: AICPA, 1973), par. 18, and “Exchanges of Nonmonetary Assets, an Amendment of APB Opinion No. 29,” Statement of Financial Accounting Standards No. 153 (Norwalk, Conn.: FASB, 2004).]

[6] FASB ASC 845-10-25-6. [Predecessor literature: “Interpretations of APB Opinion No. 29,” EITF Abstracts No. 01-02 (Norwalk, Conn.: FASB, 2002).]

[7] FASB ASC 845-10-50-1. [Predecessor literature: “Accounting for Nonmonetary Transactions,” Opinions of the Accounting Principles Board No. 29 (New York: AICPA, 1973), par. 28, and “Exchanges of Nonmonetary Assets, an Amendment of APB Opinion No. 29,” Statement of Financial Accounting Standards No. 153 (Norwalk, Conn.: FASB, 2004).]

[8] FASB ASC 958-605-25-2. [Predecessor literature: “Accounting for Contributions Received and Contributions Made,” Statement of Financial Accounting Standards No. 116 (Norwalk, Conn.: FASB, 1993).]

[9] FASB ASC 845-10-30. [Predecessor literature: “Accounting for Nonmonetary Transactions,” Opinions of the Accounting Principles Board No. 29 (New York: AICPA, 1973), par. 18, and “Exchanges of Nonmonetary Assets, an Amendment of APB Opinion No. 29,” Statement of Financial Accounting Standards No. 153 (Norwalk, Conn.: FASB, 2004).]

[10] FASB ASC 360-10-25-5. [Predecessor literature: “Accounting for Planned Major Maintenance Activities,” FASB Staff Position AUG-AIR-1 (Norwalk, Conn.: FASB, September 2006), par. 5.]

[11] FASB ASC 605-40-25-2. [Predecessor literature: “Accounting for Involuntary Conversions of Nonmonetary Assets to Monetary Assets,” FASB Interpretation No. 30 (Stamford, Conn.: FASB, 1979), summary paragraph.]

Codifi cation Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE10-1 Access the glossary (“Master Glossary”) to answer the following.

(a) What does it mean to “capitalize” an item? (b) What is the definition of a nonmonetary asset? (c) What is a nonreciprocal transfer? (d) What is the definition of “contribution”?

CE10-2 Herb Scholl, the owner of Scholl’s Company, wonders whether interest costs associated with developing land can ever be capitalized. What does the Codification say on this matter? CE10-3 What guidance does the Codification provide on the accrual of costs associated with planned major maintenance activities? CE10-4 Briefly describe how the purchases and sales of inventory with the same counterparty are similar to the accounting for other nonmonetary exchanges.

Codifi cation Research Case Your client is in the planning phase for a major plant expansion, which will involve the construction of a new warehouse. The assistant controller does not believe that interest cost can be included in the cost of the warehouse, because it is a financing expense. Others on the planning team believe that some interest cost can be included in the cost of the warehouse, but no one could identify the specific authoritative guidance for this issue. Your supervisor asks you to research this issue.

(a) Is it permissible to capitalize interest into the cost of assets? Provide authoritative support for your answer. (b) What are the objectives for capitalizing interest? (c) Discuss which assets qualify for interest capitalization. (d) Is there a limit to the amount of interest that may be capitalized in a period? (e) If interest capitalization is allowed, what disclosures are required?

Bridge to the Profession 551

ADDITIONAL PROFESSIONAL RESOURCES Go to WileyPLUS for other career-readiness resources, such as career coaching, internship opportunities, and CPAexcel prep.

HERE COME THE WRITE-OFFS The credit crisis starting in late 2008 affected many financial and nonfinancial institutions. Many of the statistics related to this crisis are sobering, as noted below.

• In October 2008, the FTSE 100 in the United Kingdom suffered its biggest one-day fall since October 1987. The index closed at its lowest level since October 2004.

• The Dow Jones Industrial Average fell below the 8,000 level for the first time since 2003.

• Germany’s benchmark DAX tumbled after the collapse of the proposed rescue plan for Hypo Real Estate.

• Tightening credit and less disposable income led to Japanese electronic groups losing value. The Nikkei fell to its lowest point since February 2004.

• The Hong Kong Hang Seng dropped in line with the rest of Asia, closing below 17,000 points for the first time in two years in October 2008 and below 11,000 by November of that year.

• Governments spent billions of dollars bailing out financial institutions.

Although a financial rebound has occurred since October 2008, it is clear that most economies of the world are now in a slower growth pattern. This slowdown raises many questions related to the proper accounting for many long- term assets, such as property, plant, and equipment; intangible assets; and many types of financial assets. One of the most difficult issues relates to the possibility of higher impairment charges related to these assets and the related disclosures that may be needed. The following is an example of an impairment charge taken by Fujitsu Limited.

Impairment Losses (in part) Due to the worsening of the global business environment, Fujitsu recognized consolidated impairment losses of 58.9 billion yen in relation to property, plant, and equipment of businesses with decreased profitability. The main losses are as follows:

(1) Property, Plant, and Equipment of LSI Business Impairment losses related to the property, plant, and equipment of the LSI business of Fujitsu Microelectronics Limited totaled 49.9 billion yen. In January, Fujitsu Microelectronics announced business reforms in response to a sharp downturn in customer demand that began last autumn.

(2) Property, Plant, and Equipment of Optical Transmission Systems and Other Businesses Consolidated impairment losses of 8.9 billion yen were recognized in relation to the property, plant, and equipment of the optical transmission systems business, the electronic components business and other businesses due to their decreased profitability.

11 Depreciation, Impairments, and Depletion 1 Understand depreciation concepts and

methods of depreciation.

2 Explain special depreciation methods and other depreciation issues.

3 Explain the accounting issues related to asset impairment.

4 Explain the accounting procedures for depletion of natural resources.

5 Explain how to report and analyze property, plant, equipment, and natural resources.

LEARNING OBJECTIVES After studying this chapter, you should be able to:

553

Impairment losses for property, plant, and equipment for many companies in the next few years will be substantial. Here are some of the questions that will need to be addressed regarding possible impairments.

1. How often should a company test for impairment?

2. What are key impairment indicators?

3. What disclosures are necessary for impairments?

4. How do companies match their cash fl ows to the asset that is potentially impaired?

Assessing whether a company has impaired assets is difficult. On the technical side, assumptions on cash flows must be reasonable, supportable, and cross-checked to ensure the final answer reconciles to external market data. And in discounting future cash flows, companies must determine the appropriate discount rate.

In addition to the technical accounting issues, the environment can change quickly. Reduced spending by consumers, lack of confidence in global economic decisions, and higher volatility in both stock and commodity markets are factors to consider. Nevertheless, for investors and creditors to have assurance that the amounts reported on the balance sheet for property, plant, and equipment are relevant and representationally faithful, appropriate impairment charges must be reported on a timely basis.

Sources: A portion of this discussion is taken from “Top 10 Tips for Impairment Testing,” PricewaterhouseCoopers (Decem- ber 2008; and “Impairment of Non-Financial Assets,” PricewaterhouseCoopers (March 2015).

(3) Property, Plant, and Equipment of HDD Business (included in business restructuring expenses) Impairment losses of 16.2 billion yen have been recognized in relation to the property, plant, and equipment of the reorganized HDD business. These losses are included in business restructuring expenses. The impairment loss includes 5.3 billion yen recognized in the third quarter for the discontinuation of the HDD head business.

DEPRECIATION, IMPAIRMENTS, AND DEPLETION

This chapter also includes numerous conceptual and international discussions that are integral to the topics presented here.

DEPRECIATION

• Factors involved • Methods of

depreciation

PRESENTATION AND ANALYSIS

• Presentation • Analysis

SPECIAL METHODS AND OTHER ISSUES

• Special depreciation methods

• Other depreciation issues

IMPAIRMENTS

• Recognizing impairments

• Measuring impairments

• Restoration of loss

• Assets to be disposed of

DEPLETION

• Establishing a base

• Write-off of resource cost

• Estimating reserves

• Liquidating dividends

• Continuing controversy

PREVIEW OF CHAPTER 11 As noted in the opening story, both U.S. and foreign companies are affected by impairment rules. These rules recognize that when economic conditions deteriorate, companies may need to write off an asset’s cost to indicate the decline in its usefulness. The purpose of this chapter is to examine the depreciation process and the methods of writing off the cost of property, plant, and equipment and natural resources. The content and organization of the chapter are as follows.

554 Chapter 11 Depreciation, Impairments, and Depletion

DEPRECIATION—A METHOD OF COST ALLOCATION Most individuals at one time or another purchase and trade in an automobile. The automobile dealer and the buyer typically discuss what the trade-in value of the old car is. Also, they may talk about what the trade-in value of the new car will be in sev- eral years. In both cases, a decline in value is considered to be an example of depreciation.

To accountants, however, depreciation is not a matter of valuation. Rather, depre- ciation is a means of cost allocation. Depreciation is the accounting process of allocat- ing the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset. For example, a company like Goodyear (one of the world’s largest tire manufacturers) does not depreciate assets on the basis of a decline in their fair value. Instead, it depreciates assets through systematic charges to expense.

This approach is employed because the value of the asset may fluctuate between the time the asset is purchased and the time it is sold or junked. Attempts to measure these interim value changes have not been well received because values are difficult to mea- sure objectively. Therefore, Goodyear charges the asset’s cost to depreciation expense over its estimated life. It makes no attempt to value the asset at fair value between acqui- sition and disposition. Companies use the cost allocation approach because it recog- nizes the expense in the periods expected to benefit from the use of the asset and because fluctuations in fair value are uncertain and difficult to measure.

When companies write off the cost of long-lived assets over a number of periods, they typically use the term depreciation. They use the term depletion to describe the reduction in the cost of natural resources (such as timber, gravel, oil, and coal) over a period of time. The expiration of intangible assets, such as patents or copyrights, is called amortization (discussed in Chapter 12).

Factors Involved in the Depreciation Process Before establishing a pattern of charges to revenue, a company must answer three basic questions:

1. What depreciable base is to be used for the asset? 2. What is the asset’s useful life? 3. What method of cost apportionment is best for this asset?

The answers to these questions involve combining several estimates into one single figure. Note the calculations assume perfect knowledge of the future, which is never attainable.

Depreciable Base for the Asset The base established for depreciation is a function of two factors: the original cost, and salvage or disposal value. We discussed historical cost in Chapter 10. Salvage value is the estimated amount that a company will receive when it sells the asset or removes it from service. It is the amount to which a company writes down or depreciates the asset during its useful life. If an asset has a cost of $10,000 and a salvage value of $1,000, its depreciation base is $9,000.

LEARNING OBJECTIVE 1 Understand depreciation concepts and methods of depreciation.

ILLUSTRATION 11-1 Computation of Depreciation Base

Original cost $10,000 Less: Salvage value 1,000

Depreciation base $ 9,000

Depreciation—A Method of Cost Allocation 555

From a practical standpoint, companies often assign a zero salvage value. Some long-lived assets, however, have substantial salvage values.

Estimation of Service Lives The service life of an asset often differs from its physical life. A piece of machinery may be physically capable of producing a given product for many years beyond its service life. But a company may not use the equipment for all that time because the cost of pro- ducing the product in later years may be too high. For example, the old Slater cotton mill in Pawtucket, Rhode Island, is preserved in remarkable physical condition as an historic landmark in U.S. industrial development, although its service life was termi- nated many years ago.1

Companies retire assets for two reasons: physical factors (such as casualty or expi- ration of physical life) and economic factors (obsolescence). Physical factors are the wear and tear, decay, and casualties that make it difficult for the asset to perform indefi- nitely. These physical factors set the outside limit for the service life of an asset.

We can classify the economic or functional factors into three categories:

1. Inadequacy results when an asset ceases to be useful to a company because the demands of the fi rm have changed. An example would be the need for a larger building to handle increased production. Although the old building may still be sound, it may have become inadequate for the company’s purpose.

2. Supersession is the replacement of one asset with another more effi cient and eco- nomical asset. Examples would be the replacement of the mainframe computer with a PC network, or the replacement of the Boeing 767 with the Boeing 787.

3. Obsolescence is the catchall for situations not involving inadequacy and supersession.

Because the distinction between these categories appears artificial, it is probably best to consider economic factors collectively instead of trying to make distinctions that are not clear-cut.

To illustrate the concepts of physical and economic factors, consider a new nuclear power plant. Which is more important in determining the useful life of a nuclear power plant—physical factors or economic factors? The limiting factors seem to be (1) ecological considerations, (2) competition from other power sources, and (3) safety concerns. Physical life does not appear to be the primary factor affecting useful life. Although the plant’s physical life may be far from over, the plant may become obsolete in 10 years.

For a house, physical factors undoubtedly are more important than the economic or functional factors relative to useful life. Whenever the physical nature of the asset pri- marily determines useful life, maintenance plays an extremely vital role. The better the maintenance, the longer the life of the asset.2

In most cases, a company estimates the useful life of an asset based on its past experience with the same or similar assets. Others use sophisticated statistical meth- ods to establish a useful life for accounting purposes. And in some cases, companies select arbitrary service lives. In a highly industrial economy such as that of the United States, where research and innovation are so prominent, technological fac- tors have as much effect, if not more, on service lives of tangible plant assets as physical factors do.

1Taken from J. D. Coughlan and W. K. Strand, Depreciation Accounting, Taxes and Business Decisions (New York: The Ronald Press, 1969), pp. 10–12. 2The airline industry also illustrates the type of problem involved in estimation. In the past, aircraft were assumed not to wear out—they just became obsolete. However, some jets have been in service as long as 20 years, and maintenance of these aircraft has become increasingly expensive. As a result, some airlines now replace aircraft not because of obsolescence but because of physical deterioration.

556 Chapter 11 Depreciation, Impairments, and Depletion

Methods of Depreciation The third factor involved in the depreciation process is the method of cost apportion- ment. The profession requires that the depreciation method employed be “systematic and rational.” Companies may use a number of depreciation methods, as follows.

1. Activity method (units of use or production). 2. Straight-line method. 3. Decreasing-charge methods (accelerated): (a) Sum-of-the-years’-digits. (b) Declining-balance method. 4. Special depreciation methods: (a) Group and composite methods. (b) Hybrid or combination methods.3

To illustrate these depreciation methods, assume that Stanley Coal Mines recently purchased an additional crane for digging purposes. Illustration 11-2 contains the perti- nent data concerning this purchase.

WHAT DO THE NUMBERS MEAN? ALPHABET DUPE

Sources: Adapted from Herb Greenberg, “Alphabet Dupe: Why EBITDA Falls Short,” Fortune (July 10, 2000), p. 240; and V. Monga, “Operating Efficiency Runs High at U.S. Firms,” Wall Street Journal (February 28, 2012), p. B7.

Some companies try to imply that depreciation is not a cost. For example, in their press releases they will often make a big- ger deal over earnings before interest, taxes, depreciation, and amortization (often referred to as EBITDA) than net income under GAAP. They like it because it “dresses up” their earnings numbers. Some on Wall Street buy this hype because they don’t like the allocations that are required to determine net income. Some banks, without batting an eyelash, even let companies base their loan covenants on EBITDA.

For example, look at Premier Parks, which operates the Six Flags chain of amusement parks. Premier touts its EBITDA performance. But that number masks a big part of how the company operates—and how it spends its money. Premier argues that analysts should ignore depreciation for big-ticket items like roller coasters because the rides have a long life. Critics, however, say that the amusement industry has to spend as much as 50 percent of its EBITDA just to keep its

rides and attractions current. Those expenses are not optional—let the rides get a little rusty, and ticket sales start to tail off. That means analysts really should view depreciation associated with the costs of maintaining the rides (or buying new ones) as an everyday expense. It also means investors in those companies should have strong stomachs.

What’s the risk of trusting a fad accounting measure? Just look at one year’s bankruptcy numbers. Of the 147 companies tracked by Moody’s that defaulted on their debt, most bor- rowed money based on EBITDA performance. The bankers in those deals probably wish they had looked at a few other fac- tors. On the other hand, nonfi nancial companies in the S&P 500 recently generated a substantial EBITDA margin of 20.9 percent. Some analysts are concerned that such a high num- ber suggests that companies are reluctant to incur costs and want to stockpile cash. The lesson? Investors will do well to avoid focus on any single accounting measure.

3Accounting Trends and Techniques recently reported that of its 500 surveyed companies, for reporting purposes, 490 used straight-line, 9 used declining-balance, 2 used sum-of-the-years’-digits, 9 used an accelerated method (not specified), 12 used units-of-production, and 17 used group/composite.

UNDERLYING CONCEPTS

Depreciation attempts to recognize the cost of an asset to the periods that benefi t from the use of that asset.

ILLUSTRATION 11-2 Data Used to Illustrate Depreciation Methods

Cost of crane $500,000 Estimated useful life 5 years Estimated salvage value $50,000 Productive life in hours 30,000 hours

Depreciation—A Method of Cost Allocation 557

Activity Method The activity method (also called the variable-charge or units-of-production approach) assumes that depreciation is a function of use or productivity, instead of the passage of time. A company considers the life of the asset in terms of either the output it pro- vides (units it produces) or an input measure such as the number of hours it works. Conceptually, the proper cost association relies on output instead of hours used, but often the output is not easily measurable. In such cases, an input measure such as machine hours is a more appropriate method of measuring the dollar amount of depre- ciation charges for a given accounting period.

The crane poses no particular depreciation problem. Stanley can measure the usage (hours) relatively easily. If Stanley uses the crane for 4,000 hours the first year, the depre- ciation charge is:

The major limitation of this method is that it is inappropriate in situations in which depreciation is a function of time instead of activity. For example, a building steadily deteriorates due to the elements (time) regardless of its use. In addition, where eco- nomic or functional factors affect an asset, independent of its use, the activity method loses much of its significance. For example, if a company is expanding rapidly, a par- ticular building may soon become obsolete for its intended purposes. In both cases, activity is irrelevant. Another problem in using an activity method is the difficulty of estimating units of output or service hours received.

In cases where loss of utility results from variation in activity or productivity, the activity method does the best to record expenses in the same period as associated reve- nues. Companies that desire low depreciation during periods of low productivity, and high depreciation during high productivity, either adopt or switch to an activity method. In this way, a plant running at 40 percent of capacity generates 60 percent lower depre- ciation charges. Inland Steel, for example, switched to units-of-production depreciation at one time and reduced its losses by $43 million, or $1.20 per share.

Straight-Line Method The straight-line method considers depreciation as a function of time rather than a function of usage. Companies widely use this method because of its simplicity. The straight-line procedure is often the most conceptually appropriate, too. When creeping obsolescence is the primary reason for a limited service life, the decline in usefulness may be constant from period to period. Stanley computes the depreciation charge for the crane as follows.

ILLUSTRATION 11-3 Depreciation Calculation, Activity Method—Crane Example

(Cost less Salvage Value) × Hours This Year Total Estimated Hours

= Depreciation Charge

($500,000 − $50,000) × 4,000 30,000

= $60,000

UNDERLYING CONCEPTS

If benefi ts fl ow on a “straight-line” basis, then justifi cation exists for recording the cost of the asset on a straight- line basis.

The major objection to the straight-line method is that it rests on two tenuous assumptions. (1) The asset’s economic usefulness is the same each year, and (2) the maintenance and repair expense is essentially the same each period.

One additional problem that occurs in using straight-line—as well as some others—is that distortions in the rate of return analysis (income/assets) develop.

Cost less Salvage Value Estimated Service Life = Depreciation Charge

$500,000 − $50,000 5

= $90,000

ILLUSTRATION 11-4 Depreciation Calculation, Straight-Line Method— Crane Example

558 Chapter 11 Depreciation, Impairments, and Depletion

Illustration 11-5 indicates how the rate of return increases, given constant revenue flows, because the asset’s book value decreases.

UNDERLYING CONCEPTS

The expense recogni- tion principle does not justify a constant charge to income. If the benefi ts from the asset decline as the asset ages, then a decreasing charge to income better captures the use of the asset.

ILLUSTRATION 11-5 Depreciation and Rate of Return Analysis—Crane Example

Undepreciated Income (after Rate of Return Depreciation Asset Balance depreciation (Income ÷ Year Expense (book value) expense) Assets)

0 $500,000 1 $90,000 410,000 $100,000 24.4% 2 90,000 320,000 100,000 31.3 3 90,000 230,000 100,000 43.5 4 90,000 140,000 100,000 71.4 5 90,000 50,000 100,000 200.0

ILLUSTRATION 11-6 Sum-of-the-Years’-Digits Depreciation Schedule— Crane Example

Remaining Book Depreciation Life in Depreciation Depreciation Value, End Year Base Years Fraction Expense of Year

1 $450,000 5 5/15 $150,000 $350,000 2 450,000 4 4/15 120,000 230,000 3 450,000 3 3/15 90,000 140,000 4 450,000 2 2/15 60,000 80,000 5 450,000 1 1/15 30,000 50,000a

15 15/15 $450,000

aSalvage value.

Decreasing-Charge Methods The decreasing-charge methods provide for a higher depreciation cost in the earlier years and lower charges in later periods. Because these methods allow for higher early- year charges than in the straight-line method, they are often called accelerated depre- ciation methods.

What is the main justification for this approach? The rationale is that companies should charge more depreciation in earlier years because the asset is most productive in its earlier years. Furthermore, the accelerated methods provide a constant cost because the depreciation charge is lower in the later periods, at the time when the repair and maintenance costs are often higher. Generally, companies use one of two decreasing- charge methods: the sum-of-the-years’-digits method or the declining-balance method.

Sum-of-the-Years’-Digits. The sum-of-the-years’-digits method results in a decreas- ing depreciation charge based on a decreasing fraction of depreciable cost (original cost less salvage value). Each fraction uses the sum of the years as a denominator (5 + 4 + 3 + 2 + 1 = 15). The numerator is the number of years of estimated life remaining as of the beginning of the year. In this method, the numerator decreases year by year, and the denominator remains constant (5/15, 4/15, 3/15, 2/15, and 1/15). At the end of the asset’s useful life, the balance remaining should equal the salvage value. Illustration 11-6 shows this method of computation.4

4What happens if the estimated service life of the asset is, let us say, 51 years? How would we calculate the sum-of-the-years’-digits? Fortunately mathematicians have developed the following formula that permits easy computation:

n(n + 1) 2 =

51(51 + 1) 2 = 1,326

Special Depreciation Methods and Other Issues 559

Declining-Balance Method. The declining-balance method utilizes a depreciation rate (expressed as a percentage) that is some multiple of the straight-line method. For exam- ple, the double-declining rate for a 10-year asset is 20 percent (double the straight-line rate, which is 1/10 or 10 percent). Companies apply the constant rate to the declining book value each year.

Unlike other methods, the declining-balance method does not deduct the salvage value in computing the depreciation base. The declining-balance rate is multiplied by the book value of the asset at the beginning of each period. Since the depreciation charge reduces the book value of the asset each period, applying the constant-declining-balance rate to a successively lower book value results in lower depreciation charges each year. This process continues until the book value of the asset equals its estimated salvage value. At that time, the company discontinues depreciation.

Companies use various multiples in practice. For example, the double-declining- balance method depreciates assets at twice (200 percent) the straight-line rate. Illustra- tion 11-7 shows Stanley’s depreciation charges if using the double-declining approach.

5A pure form of the declining-balance method (sometimes appropriately called the “fixed percentage of book value method”) has also been suggested as a possibility. This approach finds a rate that depreciates the asset exactly to salvage value at the end of its expected useful life. The formula for determination of this rate is as follows.

Depreciation rate = 1 − Salvage value

Acquisition cost n√

The life in years is n. After computing the depreciation rate, a company applies it on the declining book value of the asset from period to period, which means that depreciation expense will be successively lower. This method is not used extensively in practice due to cumbersome computations. Further, it is not permitted for tax purposes.

Companies often switch from the declining-balance method to the straight-line method near the end of the asset’s useful life to ensure that they depreciate the asset only to its salvage value.5

SPECIAL DEPRECIATION METHODS AND OTHER ISSUES

Special Depreciation Methods Sometimes companies adopt special depreciation methods. Reasons for doing so might be that a company’s assets have unique characteristics, or the nature of the industry. Two of these special methods are:

1. Group and composite methods. 2. Hybrid or combination methods.

Group and Composite Methods Companies often depreciate multiple-asset accounts using one rate. For example, AT&T might depreciate telephone poles, microwave systems, or switchboards by groups.

ILLUSTRATION 11-7 Double-Declining Depreciation Schedule— Crane Example

Book Value of Rate on Balance Book Asset, Beginning Declining Depreciation Accumulated Value, End Year of Year Balancea Expense Depreciation of Year

1 $500,000 40% $200,000 $200,000 $300,000 2 300,000 40 120,000 320,000 180,000 3 180,000 40 72,000 392,000 108,000 4 108,000 40 43,200 435,200 64,800 5 64,800 40 14,800b 450,000 50,000

aBased on twice the straight-line rate of 20% ($90,000/$450,000 = 20%; 20% × 2 = 40%). bLimited to $14,800 because book value should not be less than salvage value.

LEARNING OBJECTIVE 2 Explain special deprecia- tion methods and other depreciation issues.

560 Chapter 11 Depreciation, Impairments, and Depletion

Two methods of depreciating multiple-asset accounts exist: the group method and the composite method. The choice of method depends on the nature of the assets involved. Companies frequently use the group method when the assets are similar in nature and have approximately the same useful lives. They use the composite approach when the assets are dissimilar and have different lives. The group method more closely approximates a single-unit cost procedure because the dispersion from the average is not as great. The computation for group or composite methods is essentially the same: find an average and depreciate on that basis.

Companies determine the composite depreciation rate by dividing the depreciation per year by the total cost of the assets. To illustrate, Mooney Motors establishes the compos- ite depreciation rate for its fleet of cars, trucks, and campers as shown in Illustration 11-8.

ILLUSTRATION 11-8 Depreciation Calculation, Composite Basis

Depreciation Original Salvage Depreciation Estimated per Year Asset Cost Value Base Life (yrs.) (straight-line)

Cars $145,000 $25,000 $120,000 3 $40,000 Trucks 44,000 4,000 40,000 4 10,000 Campers 35,000 5,000 30,000 5 6,000

$224,000 $34,000 $190,000 $56,000

Composite depreciation rate = $56,000$224,000 = 25%

Composite life = 3.39 years ($190,000 ÷ $56,000)

If there are no changes in the asset account, Mooney will depreciate the group of assets to the residual or salvage value at the rate of $56,000 ($224,000 × 25%) a year. As a result, it will take Mooney 3.39 years to depreciate these assets. The length of time it takes a company to depreciate its assets on a composite basis is called the composite life.

We can highlight the differences between the group or composite method and the single-unit depreciation method by looking at asset retirements. If Mooney retires an asset before or after the average service life of the group is reached, it buries the result- ing gain or loss in the Accumulated Depreciation account. This practice is justified because Mooney will retire some assets before the average service life and others after the average life. For this reason, the debit to Accumulated Depreciation is the difference between original cost and cash received. Mooney does not record a gain or loss on disposition.

To illustrate, suppose that Mooney Motors sold one of the campers with a cost of $5,000 for $2,600 at the end of the third year. The entry is:

Accumulated Depreciation—Plant Assets 2,400 Cash 2,600 Cars, Trucks, and Campers 5,000

If Mooney purchases a new type of asset (mopeds, for example), it must compute a new depreciation rate and apply this rate in subsequent periods.

Illustration 11-9 presents a typical financial statement disclosure of the group depre- ciation method for Ampco-Pittsburgh Corporation.

The group or composite method simplifies the bookkeeping process and tends to average out errors caused by over- or underdepreciation. As a result, gains or losses on disposals of assets do not distort periodic income.

ILLUSTRATION 11-9 Disclosure of Group Depreciation Method

Ampco-Pittsburgh Corporation

Depreciation rates are based on estimated useful lives of the asset groups. Gains or losses on normal retirements or replacements of depreciable assets, subject to composite depreciation methods, are not recognized; the difference between the cost of the assets retired or replaced and the related salvage value is charged or credited to the accumulated depreciation.

On the other hand, the unit method (depreciation of single assets) has several advantages over the group or composite methods. (1) It simplifies the computation mathematically. (2) It identifies gains and losses on disposal. (3) It isolates depreciation on idle equipment. (4) It represents the best estimate of the depreciation of each asset, not the result of averaging the cost over a longer period of time. As a consequence, com- panies generally use the unit method.6 Unless stated otherwise, you should use the unit method in homework problems.

Hybrid or Combination Methods In addition to the depreciation methods already discussed, companies are free to develop their own special or tailor-made depreciation methods. GAAP requires only that the method result in the allocation of an asset’s cost over the asset’s life in a system- atic and rational manner.

For example, the steel industry widely uses a hybrid depreciation method, called the production variable method, that is a combination straight-line/activity approach. The following note from WHX Corporation’s annual report explains one variation of this method.

WHAT DO THE NUMBERS MEAN? DECELERATING DEPRECIATION Which depreciation method should management select? Many believe that the method that best matches revenues with expenses should be used. For example, if revenues generated by the asset are constant over its useful life, select straight-line depreciation. On the other hand, if revenues are higher (or lower) at the beginning of the asset’s life, then use a decreasing (or increasing) method. Thus, if a company can reliably esti- mate revenues from the asset, selecting a depreciation method that best matches costs with those revenues would seem to provide the most useful information to investors and creditors for assessing the future cash fl ows from the asset.

Managers in the real estate industry face a different chal- lenge when considering depreciation choices. Real estate

managers object to traditional depreciation methods because in their view, real estate often does not decline in value. In addi- tion, because real estate is highly debt-fi nanced, most real estate concerns report losses in earlier years of operations when the sum of depreciation and interest exceeds the reve- nue from the real estate project. As a result, real estate compa- nies, like Kimco Realty, argue for some form of increasing- charge method of depreciation (lower depreciation at the beginning and higher depreciation at the end). With such a method, companies would report higher total assets and net income in the earlier years of the project.7

6Many believe that an even better way to depreciate property, plant, and equipment is to use component depreciation. Under component depreciation, a company should depreciate over its expected useful life any part or portion of property, plant, and equipment that can be separately identified as an asset. For example, a company could separate the various components of a building (e.g., roof, heating and cooling system, elevator, leasehold improvements) and depreciate each component over its useful life. In fact, IFRS requires use of component depreciation. 7In this regard, real estate investment trusts (REITs) often report (in addition to net income) an earnings measure, funds from operations (FFO), that adjusts income for depreciation expense and other noncash expenses. This method is not GAAP. There is mixed empirical evidence about whether FFO or GAAP income is more useful to real estate investment trust investors. See, for example, Richard Gore and David Stott, “Toward a More Informative Measure of Operating Performance in the REIT Industry: Net Income vs. FFO,” Accounting Horizons (December 1998); and Linda Vincent, “The Information Content of FFO for REITs,” Journal of Accounting and Economics (January 1999).

ILLUSTRATION 11-10 Disclosure of Hybrid Depreciation Method

WHX Corporation

The Company utilizes the modified units of production method of depreciation which recognizes that the depreciation of steelmaking machinery is related to the physical wear of the equipment as well as a time factor. The modified units of production method provides for straight-line depreciation charges modified (adjusted) by the level of raw steel production. In the prior year, depreciation under the modified units of production method was $21.6 million or 40% less than straight-line depreciation, and in the current year it was $1.1 million or 2% more than straight-line depreciation.

Special Depreciation Methods and Other Issues 561

562 Chapter 11 Depreciation, Impairments, and Depletion

Other Depreciation Issues We still need to discuss several special issues related to depreciation:

1. How should companies compute depreciation for partial periods? 2. Does depreciation provide for the replacement of assets? 3. How should companies handle revisions in depreciation rates?

Depreciation and Partial Periods Companies seldom purchase plant assets on the first day of a fiscal period or dispose of them on the last day of a fiscal period. A practical question is: How much depreciation should a company charge for the partial periods involved?

In computing depreciation expense for partial periods, companies must determine the depreciation expense for the full year and then prorate this depreciation expense between the two periods involved. This process should continue throughout the useful life of the asset.

Assume, for example, that Steeltex Company purchases an automated drill machine with a five-year life for $45,000 (no salvage value) on June 10, 2016. The company’s fiscal year ends December 31. Steeltex therefore charges depreciation for only 62/3 months dur- ing that year. The total depreciation for a full year (assuming straight-line depreciation) is $9,000 ($45,000/5). The depreciation for the first, partial year is therefore:

62/3 12 × $9,000 = $5,000

The partial-period calculation is relatively simple when Steeltex uses straight-line depreciation. But how is partial-period depreciation handled when it uses an acceler- ated method such as sum-of-the-years’-digits or double-declining-balance? As an illus- tration, assume that Steeltex purchased another machine for $10,000 on July 1, 2016, with an estimated useful life of five years and no salvage value. Illustration 11-11 shows the depreciation figures for 2016, 2017, and 2018.

Sometimes a company like Steeltex modifies the process of allocating costs to a par- tial period to handle acquisitions and disposals of plant assets more simply. One varia- tion is to take no depreciation in the year of acquisition and a full year’s depreciation in

ILLUSTRATION 11-11 Calculation of Partial-Period Depreciation, Two Accelerated Methods

Sum-of-the-Years’-Digits Double-Declining-Balance

1st full year (5/15 × $10,000) = $3,333.33 (40% × $10,000) = $4,000 2nd full year (4/15 × 10,000) = 2,666.67 (40% × 6,000) = 2,400 3rd full year (3/15 × 10,000) = 2,000.00 (40% × 3,600) = 1,440

Depreciation from July 1, 2016, to December 31, 2016

6/12 × $3,333.33 = $1,666.67 6/12 × $4,000 = $2,000

Depreciation for 2017

6/12 × $3,333.33 = $1,666.67 6/12 × $4,000 = $2,000 6/12 × 2,666.67 = 1,333.33 6/12 × 2,400 = 1,200 $3,000.00 $3,200

or ($10,000 − $2,000) × 40% = $3,200

Depreciation for 2018

6/12 × $2,666.67 = $1,333.33 6/12 × $2,400 = $1,200 6/12 × 2,000.00 = 1,000.00 6/12 × 1,440 = 720 $2,333.33 $1,920

or ($10,000 − $5,200) × 40% = $1,920

Special Depreciation Methods and Other Issues 563

the year of disposal. Other variations charge one-half year’s depreciation both in the year of acquisition and in the year of disposal (referred to as the half-year convention), or charge a full year in the year of acquisition and none in the year of disposal.

In fact, Steeltex may adopt any one of these fractional-year policies in allocating cost to the first and last years of an asset’s life so long as it applies the method consistently. However, unless otherwise stipulated, companies normally compute depreciation on the basis of the nearest full month.

Illustration 11-12 shows depreciation allocated under five different fractional-year policies using the straight-line method on the $45,000 automated drill machine pur- chased by Steeltex Company on June 10, 2016, discussed earlier.

ILLUSTRATION 11-12 Fractional-Year Depreciation Policies

Machine Cost = $45,000 Depreciation Allocated per Period Over 5-Year Life* Fractional-Year Policy 2016 2017 2018 2019 2020 2021

1. Nearest fraction of a year. $5,000a $9,000 $9,000 $9,000 $9,000 $4,000b

2. Nearest full month. 5,250c 9,000 9,000 9,000 9,000 3,750d

3. Half year in period of acquisition and disposal. 4,500 9,000 9,000 9,000 9,000 4,500 4. Full year in period of acquisition, none in period of disposal. 9,000 9,000 9,000 9,000 9,000 –0– 5. None in period of acquisition,

full year in period of disposal. –0– 9,000 9,000 9,000 9,000 9,000 a6.667/12 ($9,000) b5.333/12 ($9,000) c7/12 ($9,000) d5/12 ($9,000) *Rounded to nearest dollar.

Depreciation and Replacement of Property, Plant, and Equipment A common misconception about depreciation is that it provides funds for the replace- ment of fixed assets. Depreciation is like other expenses in that it reduces net income. It differs, though, in that it does not involve a current cash outflow.

To illustrate why depreciation does not provide funds for replacement of plant assets, assume that a business starts operating with plant assets of $500,000 that have a useful life of five years. The company’s balance sheet at the beginning of the period is:

Plant assets $500,000 Stockholders’ equity $500,000

Year 1 Year 2 Year 3 Year 4 Year 5

Revenue $ –0– $ –0– $ –0– $ –0– $ –0– Depreciation (100,000) (100,000) (100,000) (100,000) (100,000)

Loss $(100,000) $(100,000) $(100,000) $(100,000) $(100,000)

Plant assets –0– Stockholders’ equity –0–

If we assume that the company earns no revenue over the five years, the income statements are:

Total depreciation of the plant assets over the five years is $500,000. The balance sheet at the end of the five years therefore is:

This extreme example illustrates that depreciation in no way provides funds for the replacement of assets. The funds for the replacement of the assets come from the rev- enues (generated through use of the asset). Without the revenues, no income material- izes and no cash inflow results.

564 Chapter 11 Depreciation, Impairments, and Depletion

Revision of Depreciation Rates When purchasing a plant asset, companies carefully determine depreciation rates based on past experience with similar assets and other pertinent information. The provisions for depreciation are only estimates, however. Companies may need to revise them dur- ing the life of the asset. Unexpected physical deterioration or unforeseen obsolescence may decrease the estimated useful life of the asset. Improved maintenance procedures, revision of operating procedures, or similar developments may prolong the life of the asset beyond the expected period.8

For example, assume that International Paper Co. purchased machinery with an original cost of $90,000. It estimates a 20-year life with no salvage value. However, dur- ing year 6, International Paper estimates that it will use the machine for an additional 25 years. Its total life, therefore, will be 30 years instead of 20. Depreciation has been recorded at the rate of 1/20 of $90,000, or $4,500 per year by the straight-line method. On the basis of a 30-year life, International Paper should have recorded depreciation as 1/30 of $90,000, or $3,000 per year. It has therefore overstated depreciation, and under- stated net income, by $1,500 for each of the past five years, or a total amount of $7,500. Illustration 11-13 shows this computation.

ILLUSTRATION 11-13 Computation of Accumulated Difference Due to Revisions

Per For 5 Year Years

Depreciation charged per books (1/20 × $90,000) $4,500 $22,500 Depreciation based on a 30-year life (1/30 × $90,000) (3,000) (15,000) Excess depreciation charged $1,500 $ 7,500

International Paper should report this change in estimate in the current and pro- spective periods (prospectively): It should not make any changes in previously reported results. And it does not adjust opening balances nor attempt to “catch up” for prior periods. The reason? Changes in estimates are a continual and inherent part of any esti- mation process. Continual restatement of prior periods would occur for revisions of estimates unless handled prospectively. Therefore, no entry is made at the time the change in estimate occurs. Charges for depreciation in subsequent periods (assuming use of the straight-line method) are determined by dividing the remaining book value less any salvage value by the remaining estimated life.

ILLUSTRATION 11-14 Computing Depreciation after Revision of Estimated Life

Machinery $90,000 Less: Accumulated depreciation 22,500

Book value of machinery at end of 5th year $67,500

Depreciation (future periods) = $67,500 book value ÷ 25 years remaining life = $2,700

The entry to record depreciation for each of the remaining 25 years is:

Depreciation Expense 2,700 Accumulated Depreciation—Machinery 2,700

8As an example of a change in operating procedures, General Motors (GM) used to write off its tools— such as dies and equipment used to manufacture car bodies—over the life of the body type. Through this procedure, it expensed tools twice as fast as Ford and three times as fast as Chrysler. However, with changes in body types, it slowed the depreciation process on these tools and lengthened the lives on its plant and equipment. These revisions reduced depreciation and amortization charges by approximately $1.23 billion, or $2.55 per share, in the year of the change. In Chapter 22, we provide a more complete discussion of changes in estimates.

Impairments 565

The amount of depreciation expense recorded depends on both the depreciation method used and estimates of service lives and salvage values of the assets. Differences in these choices and estimates can signifi cantly impact a company’s reported results and can make it diffi cult to compare the depre- ciation numbers of different companies.

An analyst determines the impact of these management choices and judgments on the amount of depreciation expense by examining the notes to fi nancial statements. For example, Willamette Industries provided the note to the right in its fi nancial statements.

As indicated, when Willamette Industries extended the estimated service lives of its machinery and equipment by fi ve years, it increased income by nearly $54 million.

WHAT DO THE NUMBERS MEAN? DEPRECIATION CHOICES

Note 4: Property, Plant, and Equipment (partial)

Range of Useful Lives

Land — Buildings 15–35 Machinery & equipment 5–25 Furniture & fi xtures 3–15

During the year, the estimated service lives for most machin- ery and equipment were extended fi ve years. The change was based upon a study performed by the company’s engineering department, comparisons to typical industry practices, and the effect of the company’s extensive capital investments which have resulted in a mix of assets with longer productive lives due to technological advances. As a result of the change, net income was increased by $54,000,000.

IMPAIRMENTS The general accounting standard of lower-of-cost-or-net realizable value (or mar- ket in some cases) for inventories does not apply to property, plant, and equip- ment. Even when property, plant, and equipment has suffered partial obsolescence, accountants have been reluctant to reduce the asset’s carrying amount. Why? Because, unlike inventories, it is difficult to arrive at a fair value for property, plant, and equipment that is not subjective and arbitrary.

For example, Falconbridge Ltd. Nickel Mines had to decide whether to write off all or a part of its property, plant, and equipment in a nickel-mining operation in the Dominican Republic. The project had been incurring losses because nickel prices were low and operating costs were high. Only if nickel prices increased by approximately 33 percent would the project be reasonably profitable. Whether a write-off was appro- priate depended on the future price of nickel. Even if the company decided to write off the asset, how much should be written off?

Recognizing Impairments As discussed in the opening story, the credit crisis starting in late 2008 affected many financial and nonfinancial institutions. As a result of the global slump, many companies are considering write-offs of some of their long-lived assets. These write-offs are referred to as impairments.

Various events and changes in circumstances might lead to an impairment. Exam- ples are:

• A significant decrease in the fair value of an asset. • A significant change in the extent or manner in which an asset is used. • A significant adverse change in legal factors or in the business climate that affects

the value of an asset. • An accumulation of costs significantly in excess of the amount originally expected

to acquire or construct an asset. • A projection or forecast that demonstrates continuing losses associated with an

asset.

LEARNING OBJECTIVE 3 Explain the accounting issues related to asset impairment.

UNDERLYING CONCEPTS

The going concern concept assumes that the company can recover the investment in its assets. Under GAAP, companies do not report the fair value of long-lived assets because a going con- cern does not plan to sell such assets. How- ever, if the assumption of being able to recover the cost of the invest- ment is not valid, then a company should report a reduction in value.

566 Chapter 11 Depreciation, Impairments, and Depletion

These events or changes in circumstances indicate that the company may not be able to recover the carrying amount of the asset. In that case, a recoverability test is used to determine whether an impairment has occurred. [1]

To apply the first step of the recoverability test, a company like UPS estimates the future net cash flows expected from the use of that asset and its eventual disposition. If the sum of the expected future net cash flows (undiscounted) is less than the carrying amount of the asset, UPS considers the asset impaired. Conversely, if the sum of the expected future net cash flows (undiscounted) is equal to or greater than the carrying amount of the asset, no impairment has occurred.

The recoverability test therefore screens for asset impairment. For example, if the expected future net cash flows from an asset are $400,000 and its carrying amount is $350,000, no impairment has occurred. However, if the expected future net cash flows are $300,000, an impairment has occurred. The rationale for the recoverability test relies on a basic presumption: A balance sheet should report long-lived assets at no more than the carrying amounts that are recoverable.

Measuring Impairments If the recoverability test indicates an impairment, UPS computes a loss. The impair- ment loss is the amount by which the carrying amount of the asset exceeds its fair value. How does UPS determine the fair value of an asset? It is measured based on the market price if an active market for the asset exists. If no active market exists, UPS uses the present value of expected future net cash flows to determine fair value.

To summarize, the process of determining an impairment loss is as follows.

1. Review events or changes in circumstances for possible impairment. 2. If the review indicates a possible impairment, apply the recoverability test. If the

sum of the expected future net cash fl ows from the long-lived asset is less than the carrying amount of the asset, an impairment has occurred.

3. Assuming an impairment, the impairment loss is the amount by which the carrying amount of the asset exceeds the fair value of the asset. The fair value is the market price of the asset or the present value of expected future net cash fl ows.

Impairment—Example 1 M. Alou Inc. has equipment that, due to changes in its use, it reviews for possible impairment. The equipment’s carrying amount is $600,000 ($800,000 cost less $200,000 accumulated depreciation). Alou determines the expected future net cash flows (undiscounted) from the use of the equipment and its eventual disposal to be $650,000.

The recoverability test indicates that the $650,000 of expected future net cash flows from the equipment’s use exceed the carrying amount of $600,000. As a result, no impairment occurred. (Recall that the undiscounted future net cash flows must be less than the carrying amount for Alou to deem an asset to be impaired and to measure the impairment loss.) Therefore, M. Alou Inc. does not recognize an impairment loss in this case.

Impairment—Example 2 Assume the same facts as in Example 1, except that the expected future net cash flows from Alou’s equipment are $580,000 (instead of $650,000). The recoverability test indicates that the expected future net cash flows of $580,000 from the use of the asset are less than its carrying amount of $600,000. Therefore, an impairment has occurred.

INTERNATIONAL PERSPECTIVE

IFRS also uses a fair value test to measure the impairment loss. However, IFRS does not use the fi rst-stage recoverability test used under GAAP—compar- ing the undiscounted cash fl ows to the carry- ing amount. As a result, the IFRS test is more strict than GAAP.

See the FASB Codifi cation References (page 600).

Impairments 567

ILLUSTRATION 11-15 Computation of Impairment Loss

Carrying amount of the equipment $600,000 Fair value of equipment (525,000)

Loss on impairment $ 75,000

The difference between the carrying amount of Alou’s asset and its fair value is the impairment loss. Assuming this asset has a fair value of $525,000, Illustration 11-15 shows the loss computation.

M. Alou Inc. records the impairment loss as follows.

Loss on Impairment 75,000 Accumulated Depreciation—Equipment 75,000

Alou reports the impairment loss as part of income from continuing operations, in the “Other expenses and losses” section. Costs associated with an impairment loss are the same costs that would flow through operations and that it would report as part of con- tinuing operations. Alou will continue to use these assets in operations. Therefore, it should not report the loss below “Income from continuing operations.”

A company that recognizes an impairment loss should disclose the asset(s) impaired, the events leading to the impairment, the amount of the loss, and how it determined fair value (disclosing the interest rate used, if appropriate).

Restoration of Impairment Loss After recording an impairment loss, the reduced carrying amount of an asset held for use becomes its new cost basis. A company does not change the new cost basis except for depreciation or amortization in future periods or for additional impairments.

To illustrate, assume that Damon Company at December 31, 2016, has equipment with a carrying amount of $500,000. Damon determines this asset is impaired and writes it down to its fair value of $400,000. At the end of 2017, Damon determines that the fair value of the asset is $480,000. The carrying amount of the equipment should not change in 2017 except for the depreciation taken in 2017. Damon may not restore an impair- ment loss for an asset held for use. The rationale for not writing the asset up in value is that the new cost basis puts the impaired asset on an equal basis with other assets that are unimpaired.

Impairment of Assets to Be Disposed Of What happens if a company intends to dispose of the impaired asset, instead of holding it for use? At one time, Kroger recorded an impairment loss of $54 million on property, plant, and equipment it no longer needed due to store closures. In this case, Kroger reports the impaired asset at the lower-of-cost-or-net realizable value (fair value less costs to sell). Because Kroger intends to dispose of the assets in a short period of time, it uses net realizable value in order to provide a better measure of the net cash flows that it will receive from these assets.

Kroger does not depreciate or amortize assets held for disposal during the period it holds them. The rationale is that depreciation is inconsistent with the notion of assets to be disposed of and with the use of the lower-of-cost-or-net realizable value. In other words, assets held for disposal are like inventory; companies should report them at the lower-of-cost-or-net realizable value.

INTERNATIONAL PERSPECTIVE

IFRS permits write-ups for subsequent recov- eries of impairment, back up to the original amount before the impairment. GAAP pro- hibits those write-ups, except for assets to be disposed of.

568 Chapter 11 Depreciation, Impairments, and Depletion

Because Kroger will recover assets held for disposal through sale rather than through operations, it continually revalues them. Each period, the assets are reported at the lower-of-cost-or-net realizable value. Thus, Kroger can write up or down an asset held for disposal in future periods, as long as the carrying value after the write-up never exceeds the carrying amount of the asset before the impairment. Companies should report losses or gains related to these impaired assets as part of income from continuing operations.

Illustration 11-16 summarizes the key concepts in accounting for impairments.

ILLUSTRATION 11-16 Graphic of Accounting for Impairments

Recoverability Test

Expected future net cash flows less than carrying amount?

No impairment

Impairment

Assets held for use

Assets held for disposal

1. Impairment loss: excess of carrying amount over fair value less cost of disposal.

2. No depreciation taken.

3. Restoration of impairment loss permitted.

1. Impairment loss: excess of carrying amount over fair value.

2. Depreciate on new cost basis.

3. Restoration of impairment loss not permitted.

Measurement of Impairment Loss

Yes

DEPLETION Natural resources, often called wasting assets, include petroleum, minerals, and tim- ber. They have two main features: (1) the complete removal (consumption) of the asset, and (2) replacement of the asset only by an act of nature. Unlike plant and equipment, natural resources are consumed physically over the period of use and do not maintain their physical characteristics. Still, the accounting problems associated with natural resources are similar to those encountered with fixed assets. The questions to be answered are:

1. How do companies establish the cost basis for write-off? 2. What pattern of allocation should companies employ?

Recall that the accounting profession uses the term depletion for the process of allocating the cost of natural resources.

LEARNING OBJECTIVE 4 Explain the accounting procedures for depletion of natural resources.

Depletion 569

Establishing a Depletion Base How do we determine the depletion base for natural resources? For example, a com- pany like ExxonMobil makes sizable expenditures to find natural resources. And for every successful discovery, there are many failures. Furthermore, the company encoun- ters long delays between the time it incurs costs and the time it obtains the benefits from the extracted resources. As a result, a company in the extractive industries, like Exxon- Mobil, frequently adopts a conservative policy in accounting for the expenditures related to finding and extracting natural resources.

Computation of the depletion base involves four factors: (1) acquisition cost of the deposit, (2) exploration costs, (3) development costs, and (4) restoration costs.

Acquisition Costs Acquisition cost is the price ExxonMobil pays to obtain the property right to search and find an undiscovered natural resource. It also can be the price paid for an already- discovered resource. A third type of acquisition cost can be lease payments for property containing a productive natural resource. Included in these acquisition costs are royalty payments to the owner of the property.

Generally, the acquisition cost of natural resources is recorded in an account titled Undeveloped Property. ExxonMobil later assigns that cost to the natural resource if exploration efforts are successful. If the efforts are unsuccessful, it writes off the acquisi- tion cost as a loss.

Exploration Costs As soon as a company has the right to use the property, it often incurs exploration costs to find the resource. When exploration costs are substantial, some companies capitalize them into the depletion base. In the oil and gas industry, where the costs of finding the resource are significant and the risks of finding the resource are very uncertain, most large companies expense these costs. Smaller oil and gas companies often capitalize these exploration costs. We examine the unique issues related to the oil and gas industry on pages 572–573 (see “Continuing Controversy”).

Development Costs Companies divide development costs into two parts: (1) tangible equipment costs and (2) intangible development costs. Tangible equipment costs include all of the transporta- tion and other heavy equipment needed to extract the resource and get it ready for market. Because companies can move the heavy equipment from one extracting site to another, companies do not normally include tangible equipment costs in the depletion base. Instead, they use separate depreciation charges to allocate the costs of such equip- ment. However, some tangible assets (e.g., a drilling rig foundation) cannot be moved. Companies depreciate these assets over their useful life or the life of the resource, which- ever is shorter.

Intangible development costs, on the other hand, are such items as drilling costs, tunnels, shafts, and wells. These costs have no tangible characteristics but are needed for the production of the natural resource. Intangible development costs are consid- ered part of the depletion base.

Restoration Costs Companies sometimes incur substantial costs to restore property to its natural state after extraction has occurred. These are restoration costs. Companies consider restora- tion costs part of the depletion base. The amount included in the depletion base is the fair value of the obligation to restore the property after extraction. A more complete discussion of the accounting for restoration costs and related liabilities (sometimes

570 Chapter 11 Depreciation, Impairments, and Depletion

referred to as asset retirement obligations) is provided in Chapter 13. Similar to other long-lived assets, companies deduct from the depletion base any salvage value to be received on the property.

Write-Off of Resource Cost Once the company establishes the depletion base, the next problem is determining how to allocate the cost of the natural resource to accounting periods.

Normally, companies compute depletion (often referred to as cost depletion) on a units-of-production method (an activity approach). Thus, depletion is a function of the number of units extracted during the period. In this approach, the total cost of the natu- ral resource less salvage value is divided by the number of units estimated to be in the resource deposit, to obtain a cost per unit of product. To compute depletion, the cost per unit is then multiplied by the number of units extracted.

For example, MaClede Co. acquired the right to use 1,000 acres of land in Alaska to mine for silver. The lease cost is $50,000, and the related exploration costs on the prop- erty are $100,000. Intangible development costs incurred in opening the mine are $850,000. Total costs related to the mine before the first ounce of silver is extracted are, therefore, $1,000,000. MaClede estimates that the mine will provide approximately 100,000 ounces of silver. Illustration 11-17 shows computation of the depletion cost per unit (depletion rate).

If MaClede extracts 25,000 ounces in the first year, then the depletion for the year is $250,000 (25,000 ounces × $10). It records the depletion as follows.

Inventory (silver) 250,000 Silver Mine 250,000

MaClede debits Inventory for the total depletion for the year and credits Silver Mine to reduce the carrying value of the natural resource. MaClede credits Inventory when it sells the inventory and debits Cost of Goods Sold. The amount not sold remains in inventory and is reported in the current assets section of the balance sheet.9

Sometimes companies use an Accumulated Depletion account. In that case, MaClede’s balance sheet would present the cost of the natural resource and the amount of accumulated depletion entered to date as follows.

ILLUSTRATION 11-17 Computation of Depletion Rate

Total Cost − Salvage Value Total Estimated Units Available

= Depletion Cost per Unit

$1,000,000

100,000 = $10 per ounce

9The tax law has long provided a deduction against revenue from oil, gas, and most minerals for the greater of cost or percentage depletion. The percentage (statutory) depletion allows some companies a write-off ranging from 5 percent to 22 percent (depending on the natural resource) of gross revenue received. As a result of this tax benefit, the amount of depletion may exceed the cost assigned to a given natural resource. An asset’s carrying amount may be zero, but the company may take a depletion deduction if it has gross revenue. The significance of the percentage depletion allowance is now greatly reduced since Congress repealed it for most oil and gas companies.

For purposes of homework, credit depletion to the asset account.

Silver mine (at cost) $1,000,000 Less: Accumulated depletion 250,000 $750,000

ILLUSTRATION 11-18 Balance Sheet Presentation of Natural Resource

Depletion 571

MaClede may also depreciate on a units-of-production basis the tangible equipment used in extracting the silver. This approach is appropriate if it can directly assign the estimated lives of the equipment to one given resource deposit. If MaClede uses the equipment on more than one job, other cost allocation methods such as straight-line or accelerated depreciation methods would be more appropriate.

Estimating Recoverable Reserves Sometimes companies need to change the estimate of recoverable reserves. They do so either because they have new information or because more sophisticated production processes are available. Natural resources such as oil and gas deposits and some rare metals have recently provided the greatest challenges. Estimates of these reserves are in large measure merely “knowledgeable guesses.”

This problem is the same as accounting for changes in estimates for the useful lives of plant and equipment. The procedure is to revise the depletion rate on a prospective basis: A company divides the remaining cost by the new estimate of the remaining recoverable reserves. This approach has much merit because the required estimates are so uncertain.

WHAT DO THE NUMBERS MEAN? RESERVE SURPRISE

Sources: S. Labaton and J. Gerth, “At Shell, New Accounting and Rosier Outlook,” New York Times (nytimes.com) (March 12, 2004); J. Ball, C. Cummins, and B. Bahree, “Big Oil Differs with SEC on Methods to Calculate the Industry’s Reserves,” Wall Street Journal (February 24, 2005), p. C1; and H. Bashir and D. Holtam, “The Impact of Plummeting Crude Oil Prices on Company Finances,” Deloitte UK (2015), http://www2.deloitte.com/uk/en/pages/ energy-and-resources/articles/crude-awakening.html#.

Cuts in the estimates of oil and natural gas reserves at Royal Dutch Shell, El Paso Corporation, and other energy compa- nies at one time highlighted the importance of reserve disclo- sures. Investors believe that these disclosures provide useful information for assessing the future cash fl ows from a compa- ny’s oil and gas reserves. For example, when Shell’s estimates turned out to be overly optimistic (to the tune of 3.9 billion bar- rels or 20 percent of reserves), Shell’s stock price fell.

The experience at Shell and other companies has led the SEC to look at how companies are estimating their “proved” reserves. Proved reserves are quantities of oil and gas that can be shown “with reasonable certainty to be recoverable in future years. . . .” The phrase “reasonable certainty” is crucial to this guidance, but differences in interpretation of what is reasonably certain can result in a wide range of estimates.

And the problem of evaluation is compounded by deter- mining the prices for crude oil. For example, the price of crude oil fell more than 50 percent from $115 per barrel in June 2014 to $50 per barrel in early January 2015. These rapidly changing oil prices can make it diffi cult to judge the present value of assets for investment decisions on capital allocation or for evaluation of impairments.

In one case, for example, ExxonMobil’s estimate was 29 percent higher than an estimate the SEC developed. Exxon- Mobil was more optimistic about the effects of new technology that enables the industry to retrieve more of the oil and gas it fi nds. Thus, to ensure the continued usefulness of reserve infor- mation disclosures, the SEC continues to work on measurement methodologies that keep up with technology changes in the oil and gas industry.

Liquidating Dividends A company often owns as its only major asset a property from which it intends to extract natural resources. If the company does not expect to purchase additional properties, it may gradually distribute to stockholders their capital investments by paying liquidat- ing dividends, which are dividends greater than the amount of accumulated net income.

The major accounting problem is to distinguish between dividends that are a return of capital and those that are not. Because the dividend is a return of the investor’s origi- nal contribution, the company issuing a liquidating dividend should debit Paid-in Capi- tal in Excess of Par for that portion related to the original investment, instead of debiting Retained Earnings.

To illustrate, at year-end, Callahan Mining had a retained earnings balance of $1,650,000, accumulated depletion on mineral properties of $2,100,000, and paid-in

572 Chapter 11 Depreciation, Impairments, and Depletion

capital in excess of par of $5,435,493. Callahan’s board declared a dividend of $3 per share on the 1,000,000 shares outstanding. It records the $3,000,000 cash dividend as follows.

Retained Earnings 1,650,000 Paid-in Capital in Excess of Par—Common Stock 1,350,000 Cash 3,000,000

Callahan must inform stockholders that the $3 dividend per share represents a $1.65 ($1,650,000 ÷ 1,000,000 shares) per share return on investment and a $1.35 ($1,350,000 ÷ 1,000,000 shares) per share liquidating dividend.

Continuing Controversy A major controversy relates to the accounting for exploration costs in the oil and gas industry. Conceptually, the question is whether unsuccessful ventures are a cost of those that are successful. Those who support the full-cost concept argue that the cost of drill- ing a dry hole is a cost needed to find the commercially profitable wells. Others believe that companies should capitalize only the costs of successful projects. This is the successful-efforts concept. Its proponents believe that the only relevant measure for a project is the cost directly related to that project, and that companies should report any remaining costs as period charges. In addition, they argue that an unsuccessful com- pany will end up capitalizing many costs that will make it, over a short period of time, show no less income than does one that is successful.10

The FASB has attempted to narrow the available alternatives, with little success. Here is a brief history of the debate.

1. 1977—The FASB required oil and gas companies to follow successful-efforts accounting. Small oil and gas producers, voicing strong opposition, lobbied exten- sively in Congress. Governmental agencies assessed the implications of this stan- dard from a public interest perspective and reacted contrary to the FASB’s position.11

2. 1978—In response to criticisms of the FASB’s actions, the SEC reexamined the issue and found both the successful-efforts and full-cost approaches inadequate. Neither method, said the SEC, refl ects the economic substance of oil and gas exploration. As a substitute, the SEC argued in favor of a yet-to-be developed method, reserve rec- ognition accounting (RRA), which it believed would provide more useful informa- tion. Under RRA, as soon as a company discovers oil, it reports the value of the oil on the balance sheet and in the income statement. Thus, RRA is a fair value approach, in contrast to full-costing and successful-efforts, which are historical cost approaches. The use of RRA would make a substantial difference in the balance sheets and income statements of oil companies. For example, Atlantic Richfi eld Co. at one time reported net producing property of $2.6 billion. Under RRA, the same proper- ties would be valued at $11.8 billion.

3. 1979–1981—As a result of the SEC’s actions, the FASB issued another standard that suspended the requirement that companies follow successful-efforts accounting.

10Large international oil companies such as ExxonMobil use the successful-efforts approach. Most of the smaller, exploration-oriented companies use the full-cost approach. The differences in net income figures under the two methods can be staggering. Analysts estimated that the difference between full-cost and successful-efforts for ChevronTexaco would be $500 million over a 10-year period (income lower under successful-efforts). 11The Department of Energy indicated that companies using the full-cost method at that time would reduce their exploration activities because of the unfavorable earnings impact associated with successful-efforts accounting. The Justice Department asked the SEC to postpone adoption of one uniform method of accounting in the oil and gas industry until the SEC could determine whether the information reported to investors would be enhanced and competition constrained by adoption of the successful-efforts method.

Presentation and Analysis 573

Therefore, full-costing was again permissible. In attempting to implement RRA, however, the SEC encountered practical problems in estimating (1) the amount of the reserves, (2) the future production costs, (3) the periods of expected disposal, (4) the discount rate, and (5) the selling price. Companies needed an estimate for each of these to arrive at an accurate valuation of existing reserves. Estimating the future selling price, appropriate discount rate, and future extraction and delivery costs of reserves that are years away from realization can be a formidable task.

4. 1981—The SEC abandoned RRA in the primary fi nancial statements of oil and gas producers. The SEC decided that RRA did not possess the required degree of reli- ability for use as a primary method of fi nancial reporting. However, it continued to stress the need for some form of fair-value-based disclosure for oil and gas reserves. As a result, the profession now requires fair value disclosures for those natural resources.

Currently, companies can use either the full-cost approach or the successful-efforts approach. It does seem ironic that Congress directed the FASB to develop one method of accounting for the oil and gas industry, and when the FASB did so, the government chose not to accept it. Subsequently, the SEC attempted to develop a new approach, failed, and then urged the FASB to develop the disclosure requirements in this area. After all these changes, the two alternatives still exist.12

The controversy in the oil and gas industry provides a number of lessons. First, it demonstrates the strong infl uence that the federal government has in fi nancial reporting matters. Second, the concern for economic consequences places pressure on the FASB to weigh the economic effects of any required stan- dard. Third, the experience with RRA highlights the problems that accompany any proposed change from an historical cost to a fair value approach. Fourth, this controversy illustrates the diffi culty of establishing standards when affected groups have differing viewpoints.

Indeed, failure to consider the economic consequences of accounting principles is a frequent criticism of the profession. However, the neutrality concept requires that the statements be free from bias. Freedom from bias requires that the state- ments refl ect economic reality, even if undesirable effects occur. Finally, the debate over oil and gas accounting reinforces the need for a conceptual framework with carefully developed guidelines for recognition, measurement, and reporting, so that interested parties can more easily resolve issues of this nature in the future.

EVOLVING ISSUE FULL-COST OR SUCCESSFUL-EFFORTS?

PRESENTATION AND ANALYSIS Presentation of Property, Plant, Equipment, and Natural Resources A company should disclose the basis of valuation—usually historical cost—for prop- erty, plant, equipment, and natural resources along with pledges, liens, and other com- mitments related to these assets. It should not offset any liability secured by property, plant, equipment, and natural resources against these assets. Instead, this obligation

12One requirement of the full-cost approach is that companies can capitalize costs only up to a ceiling, which is the present value of company reserves. Companies must expense costs above that ceiling. When the price of oil fell in the mid-1980s, so did the present value of companies’ reserves, which forced expensing of costs beyond the ceiling. Companies lobbied for leniency, but the SEC decided that the write-offs had to be taken. Mesa Limited Partnerships restated its $31 million profit to a $169 million loss, and Pacific Lighting restated its $44.5 million profit to a $70.5 million loss.

INTERNATIONAL PERSPECTIVE

IFRS also permits com- panies to use either full-cost or successful- efforts approaches.

LEARNING OBJECTIVE 5 Explain how to report and analyze property, plant, equipment, and natural resources.

574 Chapter 11 Depreciation, Impairments, and Depletion

should be reported in the liabilities section. The company should segregate property, plant, and equipment not currently employed as producing assets in the business (such as idle facilities or land held as an investment) from assets used in operations.

When depreciating assets, a company credits a valuation account such as Accumu- lated Depreciation—Equipment. Using an accumulated depreciation account permits the user of the financial statements to see the original cost of the asset and the amount of depreciation that the company charged to expense in past years.

When depleting natural resources, some companies use an accumulated depletion account. Many, however, simply credit the natural resource account directly. The ratio- nale for this approach is that the natural resources are physically consumed, making direct reduction of the cost of the natural resources appropriate.

Because of the significant impact on the financial statements of the depreciation method(s) used, companies should disclose the following.

1. Depreciation expense for the period. 2. Balances of major classes of depreciable assets, by nature and function. 3. Accumulated depreciation, either by major classes of depreciable assets or in total. 4. A general description of the method or methods used in computing depreciation with

respect to major classes of depreciable assets. [2]13

Special disclosure requirements relate to the oil and gas industry. Companies engaged in these activities must disclose the following in their financial statements: (1) the basic method of accounting for those costs incurred in oil and gas producing activities (e.g., full-cost versus successful-efforts), and (2) how the company disposes of costs related to extractive activities (e.g., expensing immediately versus deprecia- tion and depletion). [3]14

The 2014 annual report of International Paper Company in Illustration 11-19 shows a typical disclosure. It uses condensed balance sheet data supplemented with details and policies in notes to the financial statements.

13Some believe that companies should disclose the average useful life of the assets or the range of years of asset life to help users understand the age and life of property, plant, and equipment. 14Public companies, in addition to these two required disclosures, must include as supplementary informa- tion numerous schedules reporting reserve quantities; capitalized costs; acquisition, exploration, and development activities; and a standardized measure of discounted future net cash flows related to proved oil and gas reserve quantities. Given the importance of these disclosures, the SEC has issued rules for disclosures to help investors better understand the nature of oil and gas company operations. These rules provide updated guidance on (1) estimates of quantities of proved reserves, (2) estimates of future net revenues, and (3) disclosure of reserve information. See “Modernization of Oil and Gas Reporting,” SEC Financial Reporting Release No. 78 (Release No. 33-8995) (December 31, 2008).

ILLUSTRATION 11-19 Disclosures for Property, Plant, Equipment, and Natural Resources

International Paper Company

Consolidated Balance Sheet (partial)

In millions at December 31 2014 2013

Assets Total current assets $ 7,959 $ 9,025 Plants, properties and equipment, net 12,728 13,672 Forestlands 507 557 Investments 248 733 Financial assets of special purpose entities 2,145 2,127 Goodwill 3,773 3,987 Deferred charges and other assets 1,324 1,427

Total assets $28,684 $31,528

Presentation and Analysis 575

Note 1 (partial)

Plants, Properties and Equipment. Plants, properties and equipment are stated at cost, less accumu- lated depreciation. Expenditures for betterments are capitalized, whereas normal repairs and mainte- nance are expensed as incurred. The units-of-production method of depreciation is used for major pulp and paper mills, and the straight-line method is used for other plants and equipment. Annual straight-line depreciation rates are, for buildings—2.5% to 8.5%, and for machinery and equipment—5% to 33%.

Forestlands. At December 31, 2014, International Paper and its subsidiaries owned or managed ap- proximately 334,000 acres of forestlands in Brazil, and through licenses and forest management agree- ments had harvesting rights on government-owned forestlands in Russia. Costs attributable to timber are expensed as trees are cut. The rate charged is determined annually based on the relationship of incurred costs to estimated current merchantable volume.

Note 8 (partial) Plants, properties and equipment by major classification were:

In millions at December 31 2014 2013

Pulp, paper and packaging facilities $31,805 $32,268 Other plants, properties and equipment 1,263 1,478 Gross cost 33,068 33,746 Less: Accumulated depreciation 20,340 20,074

Plants, properties and equipment, net $12,728 $13,672

In millions 2014 2013 2012

Depreciation expense $1,308 $1,415 $1,390

Analysis of Property, Plant, and Equipment Analysts evaluate assets relative to activity (turnover) and profitability.

Asset Turnover How efficiently a company uses its assets to generate sales is measured by the asset turnover. This ratio divides net sales by average total assets for the period. The resulting number is the dollars of sales produced by each dollar invested in assets. To illustrate, we use the following data from the Johnson & Johnson 2014 annual report. Illustration 11-20 shows computation of the asset turnover.

The asset turnover shows that Johnson & Johnson generated sales of $0.56 per dollar of assets in the year ended December 28, 2014.

Asset turnovers vary considerably among industries. For example, a large utility like Ameren has a ratio of 0.32 times. A large grocery chain like Kroger has a ratio of 2.73 times. Thus, in comparing performance among companies based on the asset turnover ratio, you need to consider the ratio within the context of the industry in which a com- pany operates.

ILLUSTRATION 11-20 Asset Turnover Asset Turnover = Net SalesAverage Total Assets

= $74,331($131,119 + $132,683)/2

= .56

Johnson & Johnson (in millions)

Net sales $ 74,331 Total assets, 12/28/14 131,119 Total assets, 12/24/13 132,683 Net income 16,323

576 Chapter 11 Depreciation, Impairments, and Depletion

Profi t Margin on Sales Another measure for analyzing the use of property, plant, and equipment is the profit margin on sales (return on sales). Calculated as net income divided by net sales, this profitability ratio does not, by itself, answer the question of how profitably a company uses its assets. But by relating the profit margin on sales to the asset turnover during a period of time, we can ascertain how profitably the company used assets during that period of time in a measure of the return on assets. Using the Johnson & Johnson data shown on page 575, we compute the profit margin on sales and the return on assets as follows.

ILLUSTRATION 11-21 Profi t Margin on Sales Profit Margin on Sales =

Net Income Net Sales

= $16,323$74,331 = 21.96%

Return on Assets = Profit Margin on Sales × Asset Turnover = 21.96% × .5635 = 12.37%

Return on Assets = Net IncomeAverage Total Assets

= $16,323($131,119 + $132,683)/2

= 12.37%

ILLUSTRATION 11-22 Return on Assets

Return on Assets The return on assets (ROA) is computed directly by dividing net income by average total assets. Using Johnson & Johnson’s data, we compute the ratio as follows.

The 12.37 percent return on assets computed in this manner equals the 12.37 percent rate computed by multiplying the profit margin on sales by the asset turnover. The rate of return on assets measures profitability well because it combines the effects of profit margin and asset turnover.

APPENDIX 11A INCOME TAX DEPRECIATION

For the most part, a financial accounting course does not address issues related to the computation of income taxes. However, because the concepts of tax depreciation are similar to those of book depreciation and because tax depreciation methods are some- times adopted for book purposes, we present an overview of this subject.

Congress passed the Accelerated Cost Recovery System (ACRS) as part of the Eco- nomic Recovery Tax Act of 1981. The goal was to stimulate capital investment through faster write-offs and to bring more uniformity to the write-off period. For assets pur- chased in the years 1981 through 1986, companies use ACRS and its preestablished “cost recovery periods” for various classes of assets.

LEARNING OBJECTIVE *6 Describe income tax methods of depreciation.

YOU WILL WANT TO READ THE

IFRS INSIGHTS ON PAGES 601–609 For discussion of IFRS related to property, plant, and equipment.

In the Tax Reform Act of 1986 Congress enacted a Modified Accelerated Cost Recovery System, known as MACRS. It applies to depreciable assets placed in service in 1987 and later. The following discussion is based on these MACRS rules. Realize that tax depreciation rules are subject to change annually.15

MODIFIED ACCELERATED COST RECOVERY SYSTEM The computation of depreciation under MACRS differs from the computation under GAAP in three respects: (1) a mandated tax life, which is generally shorter than the economic life; (2) cost recovery on an accelerated basis; and (3) an assigned salvage value of zero.

Tax Lives (Recovery Periods) Each item of depreciable property belongs to a property class. The recovery period (depreciable tax life) of an asset depends on its property class. Illustration 11A-1 presents the MACRS property classes.

15For example, in an effort to jump-start the economy following the September 11, 2001, terrorist attacks, Congress passed the Job Creation and Worker Assistance Act of 2002 (the Act). The Act allows a 30 percent first-year bonus depreciation for assets placed into service after September 11, 2001, but before September 11, 2004. A follow-up provision enacted in 2003 extended the tax savings to assets placed in service before January 1, 2005. And in 2010, Congress extended bonus depreciation for smaller companies. These laws encourage companies to invest in fixed assets because they can front-load depreciation expense, which lowers taxable income and amount of taxes companies pay in the early years of an asset’s life. Although the Act may be a good thing for the economy, it can distort cash flow measures—making them look artificially strong when the allowances are in place but reversing once the bonus depreciation expires. See D. Zion and B. Carcache, “Bonus Depreciation Boomerang,” Credit Suisse First Boston Equity Research (February 19, 2004).

ILLUSTRATION 11A-1 MACRS Property Classes

3-year property Includes small tools, horses, and assets used in research and development activities 5-year property Includes automobiles, trucks, computers and peripheral equipment, and office

machines 7-year property Includes office furniture and fixtures, agriculture equipment, oil exploration and

development equipment, railroad track, manufacturing equipment, and any property not designated by law as being in any other class

10-year property Includes railroad tank cars, mobile homes, boilers, and certain public utility property 15-year property Includes roads, shrubbery, and certain low-income housing 20-year property Includes waste-water treatment plants and sewer systems 27.5-year property Includes residential rental property 39-year property Includes nonresidential real property

Tax Depreciation Methods Companies compute depreciation expense using the tax basis—usually the cost—of the asset. The depreciation method depends on the MACRS property class, as shown below.

ILLUSTRATION 11A-2 Depreciation Method for Various MACRS Property Classes

MACRS Property Class Depreciation Method

3-, 5-, 7-, and 10-year property Double-declining-balance 15- and 20-year property 150% declining-balance 27.5- and 39-year property Straight-line

Appendix 11A: Income Tax Depreciation 577

578 Chapter 11 Depreciation, Impairments, and Depletion

Depreciation computations for income tax purposes are based on the half-year con- vention. That is, a half year of depreciation is allowable in the year of acquisition and in the year of disposition.16 A company depreciates an asset to a zero value so that there is no salvage value at the end of its MACRS life.

Use of IRS-published tables, shown in Illustration 11A-3, simplifies application of these depreciation methods.

16The tax law requires mid-quarter and mid-month conventions for MACRS purposes in certain circumstances.

ILLUSTRATION 11A-3 IRS Table of MACRS Depreciation Rates, by Property Class

MACRS Depreciation Rates by Class of Property

Recovery 3-year 5-year 7-year 10-year 15-year 20-year Year (200% DB) (200% DB) (200% DB) (200% DB) (150% DB) (150% DB)

1 33.33 20.00 14.29 10.00 5.00 3.750 2 44.45 32.00 24.49 18.00 9.50 7.219 3 14.81* 19.20 17.49 14.40 8.55 6.677 4 7.41 11.52* 12.49 11.52 7.70 6.177 5 11.52 8.93* 9.22 6.93 5.713 6 5.76 8.92 7.37 6.23 5.285 7 8.93 6.55* 5.90* 4.888 8 4.46 6.55 5.90 4.522 9 6.56 5.91 4.462* 10 6.55 5.90 4.461 11 3.28 5.91 4.462 12 5.90 4.461 13 5.91 4.462 14 5.90 4.461 15 5.91 4.462 16 2.95 4.461 17 4.462 18 4.461 19 4.462 20 4.461 21 2.231

*Switchover to straight-line depreciation.

Example of MACRS To illustrate depreciation computations under both MACRS and GAAP straight-line accounting, assume the following facts for a computer and peripheral equipment pur- chased by Denise Rode Company on January 1, 2016.

Acquisition Date January 1, 2016

Cost $100,000 Estimated useful life 7 years Estimated salvage value $16,000 MACRS class life 5 years MACRS method 200% declining-balance GAAP method Straight-line Disposal proceeds—January 2, 2023 $11,000

Using the rates from the MACRS depreciation rate schedule for a 5-year class of prop- erty, Rode computes depreciation as follows for tax purposes.

ILLUSTRATION 11A-4 Computation of MACRS Depreciation

MACRS Depreciation

2016 $100,000 × .20 = $ 20,000 2017 $100,000 × .32 = 32,000 2018 $100,000 × .192 = 19,200 2019 $100,000 × .1152 = 11,520 2020 $100,000 × .1152 = 11,520 2021 $100,000 × .0576 = 5,760 Total depreciation $100,000

Rode computes the depreciation under GAAP straight-line method, with $16,000 of estimated salvage value and an estimated useful life of 7 years, as shown in Illustration 11A-5.

Appendix 11A: Income Tax Depreciation 579

ILLUSTRATION 11A-5 Computation of GAAP Depreciation

GAAP Depreciation

($100,000 − $16,000) ÷ 7 = $12,000 annual depreciation × 7 years 1/1/16–1/2/23 $84,000 total depreciation

The MACRS depreciation recovers the total cost of the asset on an accelerated basis. But, a taxable gain of $11,000 results from the sale of the asset at January 2, 2023. There- fore, the net effect on taxable income for the years 2016 through 2023 is $89,000 ($100,000 depreciation − $11,000 gain).

Under GAAP, the company recognizes a loss on disposal of $5,000 ($16,000 book value − $11,000 disposal proceeds). The net effect on income before income taxes for the years 2016 through 2023 is $89,000 ($84,000 depreciation + $5,000 loss), the same as the net effect of MACRS on taxable income.

Even though the net effects are equal in amount, the deferral of income tax pay- ments under MACRS from early in the life of the asset to later in the life is desirable. The different amounts of depreciation for income tax reporting and financial GAAP reporting in each year are a matter of timing and result in temporary differences, which require interperiod tax allocation. (See Chapter 19 for an extended treatment of this topic.)

OPTIONAL STRAIGHT-LINE METHOD An alternate MACRS method exists for determining depreciation deductions. Based on the straight-line method, it is referred to as the optional (elective) straight-line method. This method applies to the six classes of property described earlier. The alternate MACRS applies the straight-line method to the MACRS recovery periods. It ignores salvage value.

Under the optional straight-line method, in the first year in which the property is put in service, the company deducts half of the amount of depreciation that would be permitted for a full year (half-year convention). Use the half-year convention for homework problems.

TAX VERSUS BOOK DEPRECIATION GAAP requires that companies allocate the cost of depreciable assets to expense over the expected useful life of the asset in a systematic and rational manner. Some argue that from a cost-benefit perspective it would be better for companies to adopt the MACRS approach in order to eliminate the necessity of maintaining two different sets of records.

However, the tax laws and financial reporting have different objectives. The pur- pose of taxation is to raise revenue from constituents in an equitable manner. The pur- pose of financial reporting is to reflect the economic substance of a transaction as closely as possible and to help predict the amounts, timing, and uncertainty of future cash flows. Because these objectives differ, the adoption of one method for both tax and book purposes in all cases is not in accordance with GAAP.

580 Chapter 11 Depreciation, Impairments, and Depletion

LEARNING OBJECTIVES REVIEW 1 Understand depreciation concepts and methods of depreciation. Depreciation allocates the cost of tangible assets

to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset. Three factors involved in the depreciation process are (1) determining the depreciation base for the asset, (2) estimating service lives, and (3) selecting a method of cost apportionment (depreciation).

Methods of depreciation are as follows. (1) Activity method: Assumes that depreciation is a function of use or productivity instead of the passage of time. The life of

the asset is considered in terms of either the output it provides, or an input measure such as the number of hours it works. (2) Straight-line method: Considers depreciation a function of time instead of a function of usage. The straight-line procedure

is often the most conceptually appropriate when the decline in usefulness is constant from period to period. (3) Decreasing-charge methods: Provide for a higher depreciation cost in the earlier years and lower charges in later periods. The

main justification for this approach is that the asset is the most productive in its early years.

2 Explain special depreciation methods and other depreciation issues. Two special depreciation methods are as follows. (1) Group and composite methods: The group method is frequently used when the assets are fairly similar in nature and have approximately the same useful lives. The composite method may be used when the assets are dissimilar and have differ- ent lives. (2) Hybrid or combination methods: These methods may combine straight-line/activity approaches. Other deprecia- tion issues relate to partial period depreciation and changes in depreciation estimates.

3 Explain the accounting issues related to asset impairment. The process to determine an impairment loss is as follows. (1) Review events and changes in circumstances for possible impairment. (2) If events or changes suggest impair- ment, determine if the sum of the expected future net cash flows from the long-lived asset is less than the carrying amount of the asset. If less, measure the impairment loss. (3) The impairment loss is the amount by which the carrying amount of the asset exceeds the fair value of the asset.

After a company records an impairment loss, the reduced carrying amount of the long-lived asset is its new cost basis. Impairment losses may not be restored for assets held for use. If the company expects to dispose of the asset, it should report the impaired asset at the lower-of-cost-or-net realizable value. It is not depreciated. It can be continuously revalued, as long as the write-up is never to an amount greater than the carrying amount before impairment.

4 Explain the accounting procedures for depletion of natural resources. To account for depletion of natural resources, companies (1) establish the depletion base and (2) write off resource cost. Four factors are part of establishing the depletion base: (a) acquisition costs, (b) exploration costs, (c) development costs, and (d) restoration costs. To write off resource cost, companies normally compute depletion on the units-of-production method. Thus, depletion is a function of the number of units withdrawn during the period. To obtain a cost per unit of product, the total cost of the natural resource less sal- vage value is divided by the number of units estimated to be in the resource deposit. To compute depletion, this cost per unit is multiplied by the number of units withdrawn.

REVIEW AND PRACTICE KEY TERMS REVIEW

accelerated depreciation methods, 558

activity method, 557 amortization, 554 asset turnover, 575 composite approach, 560 composite depreciation

rate, 560 cost depletion, 570 declining-balance

method, 559

decreasing-charge methods, 558

depletion, 554, 568 depreciation, 554 depreciation base, 554 development costs, 569 double-declining-balance

method, 559 exploration costs, 569 full-cost concept, 572 group method, 560

impairment, 565 inadequacy, 555 liquidating dividends, 571 *Modified Accelerated Cost

Recovery System (MACRS), 577

natural resources, 568 obsolescence, 555 percentage depletion, 570(n) profit margin on sales, 576 recoverability test, 566

reserve recognition accounting (RRA), 572

restoration costs, 569 return on assets (ROA), 576 salvage value, 554 straight-line method, 557 successful-efforts

concept, 572 sum-of-the-years’-digits

method, 558 supersession, 555

5 Explain how to report and analyze property, plant, equipment, and natural resources. The basis of valuation for property, plant, and equipment and for natural resources should be disclosed along with pledges, liens, and other commit- ments related to these assets. Companies should not offset any liability secured by property, plant, and equipment or by natu- ral resources against these assets, but should report it in the liabilities section. When depreciating assets, credit a valuation account normally called Accumulated Depreciation. When depleting assets, use an accumulated depletion account, or credit the depletion directly to the natural resource account. Companies engaged in significant oil and gas producing activities must provide additional disclosures about these activities. Analysis may be performed to evaluate the asset turnover, profit margin on sales, and return on assets.

*6 Describe income tax methods of depreciation. Congress enacted a Modified Accelerated Cost Recovery System (MACRS) in the Tax Reform Act of 1986. It applies to depreciable assets placed in service in 1987 and later. The computation of depreciation under MACRS differs from the computation under GAAP in three respects: (1) a mandated tax life, which is generally shorter than the economic life; (2) cost recovery on an accelerated basis; and (3) an assigned salvage value of zero.

PRACTICE PROBLEM

Norwel Company manufactures miniature circuit boards used in smartphones. On June 5, 2017, Norwel purchased a circuit board stamping machine at a retail price of $24,000. Norwel paid 5% sales tax on this purchase and hired a contractor to build a specially wired platform for the machine for $1,800, to meet OSHA safety requirements. Norwel estimates the machine will have a 5-year useful life, with a salvage value of $2,000 at the end of 5 years. Norwel uses straight-line depreciation and employs the “half-year” convention in accounting for partial-year depreciation. Norwel’s fi scal year ends on December 31.

Instructions (a) At what amount should Norwel record the acquisition cost of the machine? (b) How much depreciation expense should Norwel record in 2017 and in 2018? (c) At what amount will the machine be reported in Norwel’s balance sheet at December 31, 2018? (d) During 2019, Norwel’s circuit board business is experiencing significant competition from companies with more

advanced low-heat circuit boards. As a result, at June 30, 2019, Norwel conducts an impairment evaluation of the stamping machine purchased in 2017. Norwel determines that undiscounted future cash flows for the machine are estimated to be $15,200 and the fair value of the machine, based on prices in the re-sale market, to be $13,400. Prepare the journal entry to record an impairment, if any, on the stamping machine.

Practice Problem 581

ENHANCED REVIEW AND PRACTICE Go online for multiple-choice questions with solutions, review exercises with solutions, and a full glossary of all key terms.

SOLUTION

(a) Historical cost is measured by the cash or cash equivalent price of obtaining the asset and bringing it to the location and condition for its intended use. For Norwel, this is:

Price $24,000 Tax ($24,000 × .05) 1,200 Platform 1,800

Total $27,000

582 Chapter 11 Depreciation, Impairments, and Depletion

(b) Depreciable base: $27,000 − $2,000 = $25,000

Depreciation expense: $25,000 ÷ 5 = $5,000 per year

2017: 1/2 year = $5,000 × .50 = $2,500 2018: full year = $5,000

Machinery $27,000 Less: Accumulated depreciation 7,500

Book value $19,500

(d) Norwel first conducts the recoverability test, comparing the book value of the machine to the undiscounted future cash flows. This indicates the future cash flows ($15,200) are less than the June 30, 2019, book value ($17,000*).

*Cost $27,000 Less: Accumulated depreciation ($2,500 + $5,000 + $2,500) 10,000 Book value of machine and platform $17,000

Thus, Norwel will record an impairment, based on comparison of the fair value of the machine and platform to the book value. The entry is as follows.

Loss on Impairment ($17,000 − $13,400) 3,600 Accumulated Depreciation—Machinery 3,600

1. Distinguish among depreciation, depletion, and amor- tization.

2. Identify the factors that are relevant in determining the annual depreciation charge, and explain whether these factors are determined objectively or whether they are based on judgment.

3. Some believe that accounting depreciation measures the decline in the value of fixed assets. Do you agree? Explain.

4. Explain how estimation of service lives can result in unrealistically high carrying values for fixed assets.

5. The plant manager of a manufacturing firm suggested in a conference of the company’s executives that accoun- tants should speed up depreciation on the machinery in the finishing department because improvements were

rapidly making those machines obsolete, and a depreci- ation fund big enough to cover their replacement is needed. Discuss the accounting concept of depreciation and the effect on a business concern of the depreciation recorded for plant assets, paying particular attention to the issues raised by the plant manager.

6. For what reasons are plant assets retired? Define inad- equacy, supersession, and obsolescence.

7. What basic questions must be answered before the amount of the depreciation charge can be computed?

8. Workman Company purchased a machine on January 2, 2017, for $800,000. The machine has an estimated useful life of 5 years and a salvage value of $100,000. Deprecia- tion was computed by the 150% declining-balance

Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.

QUESTIONS

Exercises, Problems, Problem Solution Walkthrough Videos, and many more assessment tools and resources are available for practice in WileyPLUS.

method. What is the amount of accumulated deprecia- tion at the end of December 31, 2018?

9. Silverman Company purchased machinery for $162,000 on January 1, 2017. It is estimated that the machinery will have a useful life of 20 years, salvage value of $15,000, production of 84,000 units, and working hours of 42,000. During 2017, the company uses the machin- ery for 14,300 hours, and the machinery produces 20,000 units. Compute depreciation under the straight-line, units-of-output, working hours, sum-of-the-years’-dig- its, and double-declining-balance methods.

10. What are the major factors considered in determining what depreciation method to use?

11. Under what conditions is it appropriate for a business to use the composite method of depreciation for its plant assets? What are the advantages and disadvan- tages of this method?

12. If Remmers, Inc. uses the composite method and its composite rate is 7.5% per year, what entry should it make when plant assets that originally cost $50,000 and have been used for 10 years are sold for $14,000?

13. A building that was purchased on December 31, 2003, for $2,500,000 was originally estimated to have a life of 50 years with no salvage value at the end of that time. Depre- ciation has been recorded through 2017. During 2018, an examination of the building by an engineering firm dis- closes that its estimated useful life is 15 years after 2017. What should be the amount of depreciation for 2018?

14. Charlie Parker, president of Spinners Company, has recently noted that depreciation increases cash pro- vided by operations and therefore depreciation is a good source of funds. Do you agree? Discuss.

15. Andrea Torbert purchased a computer for $8,000 on July 1, 2017. She intends to depreciate it over 4 years using the double-declining-balance method. Salvage value is $1,000. Compute depreciation for 2018.

16. Walkin Inc. is considering the write-down of its long- term plant because of a lack of profitability. Explain to the management of Walkin how to determine whether a write-down is permitted.

17. Last year, Wyeth Company recorded an impairment on an asset held for use. Recent appraisals indicate that the asset has increased in value. Should Wyeth record this recovery in value?

18. Toro Co. has equipment with a carrying amount of $700,000. The expected future net cash flows from the equipment are $705,000, and its fair value is $590,000. The equipment is expected to be used in operations in the future. What amount (if any) should Toro report as an impairment to its equipment?

19. Explain how gains or losses on impaired assets should be reported in income.

20. It has been suggested that plant and equipment could be replaced more quickly if depreciation rates for income tax and accounting purposes were substan- tially increased. As a result, business operations would receive the benefit of more modern and more efficient plant facilities. Discuss the merits of this proposition.

21. Neither depreciation on replacement cost nor deprecia- tion adjusted for changes in the purchasing power of the dollar has been recognized as generally accepted accounting principles for inclusion in the primary financial statements. Briefly present the accounting treatment that might be used to assist in the mainte- nance of the ability of a company to replace its produc- tive capacity.

22. List (a) the similarities and (b) the differences in the accounting treatments of depreciation and cost depletion.

23. Describe cost depletion and percentage depletion. Why is the percentage depletion method permitted?

24. In what way may the use of percentage depletion vio- late sound accounting theory?

25. In the extractive industries, businesses may pay divi- dends in excess of net income. What is the maximum permissible? How can this practice be justified?

26. The following statement appeared in a financial maga- zine: “RRA—or Rah-Rah, as it’s sometimes dubbed— has kicked up quite a storm. Oil companies, for exam- ple, are convinced that the approach is misleading. Major accounting firms agree.” What is RRA? Why might oil companies believe that this approach is mis- leading?

27. Shumway Oil uses successful-efforts accounting and also provides full-cost results as well. Under full- cost, Shumway Oil would have reported retained earnings of $42 million and net income of $4 million. Under successful-efforts, retained earnings were $29 million, and net income was $3 million. Explain the difference between full-costing and successful-efforts accounting.

28. Wal-Mart Stores, Inc. in 2014 reported net income of $16.4 billion, net sales of $482.2 billion, and average total assets of $204.2 billion. What is Wal-Mart’s asset turnover? What is Wal-Mart’s return on assets?

*29. What is a modified accelerated cost recovery system (MACRS)? Speculate as to why this system is now required for tax purposes.

Brief Exercises 583

BRIEF EXERCISES

(Unless otherwise instructed, round all answers to the nearest dollar.) BE11-1 (L01) Fernandez Corporation purchased a truck at the beginning of 2017 for $50,000. The truck is estimated to have a salvage value of $2,000 and a useful life of 160,000 miles. It was driven 23,000 miles in 2017 and 31,000 miles in 2018. Compute depreciation expense for 2017 and 2018.

584 Chapter 11 Depreciation, Impairments, and Depletion

BE11-2 (L01) Lockard Company purchased machinery on January 1, 2017, for $80,000. The machinery is estimated to have a salvage value of $8,000 after a useful life of 8 years. (a) Compute 2017 depreciation expense using the straight-line method. (b) Compute 2017 depreciation expense using the straight-line method assuming the machinery was purchased on September 1, 2017. BE11-3 (L01) Use the information for Lockard Company given in BE11-2. (a) Compute 2017 depreciation expense using the sum-of-the-years’-digits method. (b) Compute 2017 depreciation expense using the sum-of-the-years’-digits method, assuming the machinery was purchased on April 1, 2017. BE11-4 (L01) Use the information for Lockard Company given in BE11-2. (a) Compute 2017 depreciation expense using the double-declining-balance method. (b) Compute 2017 depreciation expense using the double-declining-balance method, assum- ing the machinery was purchased on October 1, 2017. BE11-5 (L01) Cominsky Company purchased a machine on July 1, 2018, for $28,000. Cominsky paid $200 in title fees and county property tax of $125 on the machine. In addition, Cominsky paid $500 shipping charges for delivery, and $475 was paid to a local contractor to build and wire a platform for the machine on the plant floor. The machine has an estimated useful life of 6 years with a salvage value of $3,000. Determine the depreciation base of Cominsky’s new machine. Cominsky uses straight- line depreciation. BE11-6 (L02) Dickinson Inc. owns the following assets.

Asset Cost Salvage Estimated Useful Life

A $70,000 $7,000 10 years B 50,000 5,000 5 years C 82,000 4,000 12 years

Compute the composite depreciation rate and the composite life of Dickinson’s assets. BE11-7 (L02) Holt Company purchased a computer for $8,000 on January 1, 2016. Straight-line depreciation is used, based on a 5-year life and a $1,000 salvage value. In 2018, the estimates are revised. Holt now feels the computer will be used until Decem- ber 31, 2019, when it can be sold for $500. Compute the 2018 depreciation. BE11-8 (L03) Jurassic Company owns equipment that cost $900,000 and has accumulated depreciation of $380,000. The expected future net cash flows from the use of the asset are expected to be $500,000. The fair value of the equipment is $400,000. Prepare the journal entry, if any, to record the impairment loss. BE11-9 (L04) Everly Corporation acquires a coal mine at a cost of $400,000. Intangible development costs total $100,000. After extraction has occurred, Everly must restore the property (estimated fair value of the obligation is $80,000), after which it can be sold for $160,000. Everly estimates that 4,000 tons of coal can be extracted. If 700 tons are extracted the first year, prepare the journal entry to record depletion. BE11-10 (L05) In its 2014 annual report, Campbell Soup Company reports beginning-of-the-year total assets of $8,113 mil- lion, end-of-the-year total assets of $8,323 million, total sales of $8,268 million, and net income of $807 million. (a) Compute Campbell’s asset turnover. (b) Compute Campbell’s profit margin on sales. (c) Compute Campbell’s return on assets using (1) asset turnover and profit margin and (2) net income. (Round to two decimal places.) *BE11-11 (L06) Francis Corporation purchased an asset at a cost of $50,000 on March 1, 2017. The asset has a useful life of 8 years and a salvage value of $4,000. For tax purposes, the MACRS class life is 5 years. Compute tax depreciation for each year 2017–2022.

EXERCISES

E11-1 (L01) EXCEL (Depreciation Computations—SL, SYD, DDB) Deluxe Ezra Company purchases equipment on Janu- ary 1, Year 1, at a cost of $469,000. The asset is expected to have a service life of 12 years and a salvage value of $40,000.

Instructions (a) Compute the amount of depreciation for each of Years 1 through 3 using the straight-line depreciation method. (b) Compute the amount of depreciation for each of Years 1 through 3 using the sum-of-the-years’-digits method. (c) Compute the amount of depreciation for each of Years 1 through 3 using the double-declining-balance method. (In

performing your calculations, round constant percentage to the nearest one-hundredth of a point and round answers to the nearest dollar.)

E11-2 (L01) (Depreciation—Conceptual Understanding) Rembrandt Company acquired a plant asset at the beginning of Year 1. The asset has an estimated service life of 5 years. An employee has prepared depreciation schedules for this asset using three different methods to compare the results of using one method with the results of using other methods. You are to assume that the following schedules have been correctly prepared for this asset using (1) the straight-line method, (2) the sum-of-the- years’-digits method, and (3) the double-declining-balance method.

Year Straight-Line Sum-of-the- Years’-Digits

Double-Declining- Balance

1 $ 9,000 $15,000 $20,000 2 9,000 12,000 12,000 3 9,000 9,000 7,200 4 9,000 6,000 4,320 5 9,000 3,000 1,480

Total $45,000 $45,000 $45,000

Instructions Answer the following questions.

(a) What is the cost of the asset being depreciated? (b) What amount, if any, was used in the depreciation calculations for the salvage value for this asset? (c) Which method will produce the highest charge to income in Year 1? (d) Which method will produce the highest charge to income in Year 4? (e) Which method will produce the highest book value for the asset at the end of Year 3? (f) If the asset is sold at the end of Year 3, which method would yield the highest gain (or lowest loss) on disposal of the asset?

E11-3 (L01,2) (Depreciation Computations—SYD, DDB—Partial Periods) Judds Company purchased a new plant asset on April 1, 2017, at a cost of $711,000. It was estimated to have a service life of 20 years and a salvage value of $60,000. Judds’ accounting period is the calendar year.

Instructions (a) Compute the depreciation for this asset for 2017 and 2018 using the sum-of-the-years’-digits method. (b) Compute the depreciation for this asset for 2017 and 2018 using the double-declining-balance method.

E11-4 (L01,2) EXCEL (Depreciation Computations—Five Methods) Jon Seceda Furnace Corp. purchased machinery for $315,000 on May 1, 2017. It is estimated that it will have a useful life of 10 years, salvage value of $15,000, production of 240,000 units, and working hours of 25,000. During 2018, Seceda Corp. uses the machinery for 2,650 hours, and the machinery produces 25,500 units.

Instructions From the information given, compute the depreciation charge for 2018 under each of the following methods. (Round to the near- est dollar.)

(a) Straight-line. (d) Sum-of-the-years’-digits. (b) Units-of-output. (e) Declining-balance (use 20% as the annual rate). (c) Working hours.

E11-5 (L01,2) (Depreciation Computations—Four Methods) Robert Parish Corporation purchased a new machine for its assembly process on August 1, 2017. The cost of this machine was $117,900. The company estimated that the machine would have a salvage value of $12,900 at the end of its service life. Its life is estimated at 5 years, and its working hours are estimated at 21,000 hours. Year-end is December 31.

Instructions Compute the depreciation expense under the following methods. Each of the following should be considered unrelated.

(a) Straight-line depreciation for 2017. (b) Activity method for 2017, assuming that machine usage was 800 hours. (c) Sum-of-the-years’-digits for 2018. (d) Double-declining-balance for 2018.

E11-6 (L01,2) (Depreciation Computations—Five Methods, Partial Periods) Muggsy Bogues Company purchased equip- ment for $212,000 on October 1, 2017. It is estimated that the equipment will have a useful life of 8 years and a salvage value of $12,000. Estimated production is 40,000 units and estimated working hours are 20,000. During 2017, Bogues uses the equipment for 525 hours and the equipment produces 1,000 units.

Instructions Compute depreciation expense under each of the following methods. Bogues is on a calendar-year basis ending December 31.

(a) Straight-line method for 2017. (b) Activity method (units of output) for 2017.

Exercises 585

586 Chapter 11 Depreciation, Impairments, and Depletion

(c) Activity method (working hours) for 2017. (d) Sum-of-the-years’-digits method for 2019. (e) Double-declining-balance method for 2018.

E11-7 (L01,2) (Different Methods of Depreciation) Jackel Industries presents you with the following information.

Description Date

Purchased Cost Salvage Value

Life in Years

Depreciation Method

Accumulated Depreciation to 12/31/18

Depreciation for 2019

Machine A 2/12/17 $142,500 $16,000 10 (a) $33,350 (b) Machine B 8/15/16 (c) 21,000 5 SL 29,000 (d) Machine C 7/21/15 75,400 23,500 8 DDB (e) (f) Machine D 10/12/(g) 219,000 69,000 5 SYD 70,000 (h)

Instructions Complete the table for the year ended December 31, 2019. The company depreciates all assets using the half-year convention.

E11-8 (L01,2) (Depreciation Computation—Replacement, Nonmonetary Exchange) George Zidek Corporation bought a machine on June 1, 2015, for $31,000, f.o.b. the place of manufacture. Freight to the point where it was set up was $200, and $500 was expended to install it. The machine’s useful life was estimated at 10 years, with a salvage value of $2,500. On June 1, 2016, an essential part of the machine is replaced, at a cost of $1,980, with one designed to reduce the cost of operating the machine. The cost of the old part and related depreciation cannot be determined with any accuracy.

On June 1, 2019, the company buys a new machine of greater capacity for $35,000, delivered, trading in the old machine which has a fair value and trade-in allowance of $20,000. To prepare the old machine for removal from the plant cost $75, and expenditures to install the new one were $1,500. It is estimated that the new machine has a useful life of 10 years, with a salvage value of $4,000 at the end of that time. (The exchange has commercial substance.)

Instructions Assuming that depreciation is to be computed on the straight-line basis, compute the annual depreciation on the new equipment that should be provided for the fiscal year beginning June 1, 2019. (Round to the nearest dollar.)

E11-9 (L02) (Composite Depreciation) Presented below is information related to LeBron James Manufacturing Corporation.

Asset Cost Estimated Salvage Estimated Life (in years)

A $40,500 $5,500 10 B 33,600 4,800 9 C 36,000 3,600 9 D 19,000 1,500 7 E 23,500 2,500 6

Instructions (a) Compute the rate of depreciation per year to be applied to the plant assets under the composite method. (b) Prepare the adjusting entry necessary at the end of the year to record depreciation for the year. (c) Prepare the entry to record the sale of asset D for cash of $4,800. It was used for 6 years, and depreciation was entered

under the composite method.

E11-10 (L01) (Depreciation Computations, SYD) Five Satins Company purchased a piece of equipment at the beginning of 2014. The equipment cost $430,000. It has an estimated service life of 8 years and an expected salvage value of $70,000. The sum- of-the-years’-digits method of depreciation is being used. Someone has already correctly prepared a depreciation schedule for this asset. This schedule shows that $60,000 will be depreciated for a particular calendar year.

Instructions Show calculations to determine for what particular year the depreciation amount for this asset will be $60,000.

E11-11 (L01,2) (Depreciation—Change in Estimate) Machinery purchased for $60,000 by Tom Brady Co. in 2013 was origi- nally estimated to have a life of 8 years with a salvage value of $4,000 at the end of that time. Depreciation has been entered for 5 years on this basis. In 2018, it is determined that the total estimated life should be 10 years with a salvage value of $4,500 at the end of that time. Assume straight-line depreciation.

Instructions (a) Prepare the entry to correct the prior years’ depreciation, if necessary. (b) Prepare the entry to record depreciation for 2018.

E11-12 (L01,2) (Depreciation Computation—Addition, Change in Estimate) In 1990, Herman Moore Company completed the construction of a building at a cost of $2,000,000 and first occupied it in January 1991. It was estimated that the building will have a useful life of 40 years and a salvage value of $60,000 at the end of that time.

Early in 2001, an addition to the building was constructed at a cost of $500,000. At that time, it was estimated that the remaining life of the building would be, as originally estimated, an additional 30 years, and that the addition would have a life of 30 years and a salvage value of $20,000.

In 2019, it is determined that the probable life of the building and addition will extend to the end of 2050, or 20 years beyond the original estimate.

Instructions (a) Using the straight-line method, compute the annual depreciation that would have been charged from 1991 through

2000. (b) Compute the annual depreciation that would have been charged from 2001 through 2018. (c) Prepare the entry, if necessary, to adjust the account balances because of the revision of the estimated life in 2019. (d) Compute the annual depreciation to be charged, beginning with 2019.

E11-13 (L01,2) (Depreciation—Replacement, Change in Estimate) Greg Maddox Company constructed a building at a cost of $2,200,000 and occupied it beginning in January 1998. It was estimated at that time that its life would be 40 years, with no salvage value.

In January 2018, a new roof was installed at a cost of $300,000, and it was estimated then that the building would have a useful life of 25 years from that date. The cost of the old roof was $160,000.

Instructions (a) What amount of depreciation should have been charged annually from the years 1998 to 2017? (Assume straight-line

depreciation.) (b) What entry should be made in 2018 to record the replacement of the roof? (c) Prepare the entry in January 2018 to record the revision in the estimated life of the building, if necessary. (d) What amount of depreciation should be charged for the year 2018?

E11-14 (L01) (Error Analysis and Depreciation, SL and SYD) Mike Devereaux Company shows the following entries in its Equipment account for 2018. All amounts are based on historical cost.

Equipment

2018 2018 Jan. 1 Balance 134,750 June 30 Cost of equipment sold Aug. 10 Purchases 32,000 (purchased prior 12 Freight on equipment to 2018) 23,000 purchased 700 25 Installation costs 2,700 Nov. 10 Repairs 500

Instructions (a) Prepare any correcting entries necessary. (b) Assuming that depreciation is to be charged for a full year on the ending balance in the asset account, compute the

proper depreciation charge for 2018 under each of the methods listed below. Assume an estimated life of 10 years, with no salvage value. The machinery included in the January 1, 2018, balance was purchased in 2016.

(1) Straight-line. (2) Sum-of-the-years’-digits.

E11-15 (L01,2) (Depreciation for Fractional Periods) On March 10, 2019, Lost World Company sells equipment that it pur- chased for $192,000 on August 20, 2012. It was originally estimated that the equipment would have a life of 12 years and a sal- vage value of $16,800 at the end of that time, and depreciation has been computed on that basis. The company uses the straight- line method of depreciation.

Instructions (a) Compute the depreciation charge on this equipment for 2012, for 2019, and the total charge for the period from 2013 to

2018, inclusive, under each of the six following assumptions with respect to partial periods. (1) Depreciation is computed for the exact period of time during which the asset is owned. (Use 365 days for base and

record depreciation through March 9, 2019.)

Exercises 587

588 Chapter 11 Depreciation, Impairments, and Depletion

(2) Depreciation is computed for the full year on the January 1 balance in the asset account. (3) Depreciation is computed for the full year on the December 31 balance in the asset account. (4) Depreciation for one-half year is charged on plant assets acquired or disposed of during the year. (5) Depreciation is computed on additions from the beginning of the month following acquisition and on disposals to

the beginning of the month following disposal. (6) Depreciation is computed for a full period on all assets in use for over one-half year, and no depreciation is charged

on assets in use for less than one-half year. (Use 365 days for base.) (b) Briefly evaluate the methods above, considering them from the point of view of basic accounting theory as well as

simplicity of application.

E11-16 (L03) (Impairment) Presented below is information related to equipment owned by Suarez Company at December 31, 2017.

Cost $9,000,000 Accumulated depreciation to date 1,000,000 Expected future net cash fl ows 7,000,000 Fair value 4,800,000

Assume that Suarez will continue to use this asset in the future. As of December 31, 2017, the equipment has a remaining useful life of 4 years.

Instructions (a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2017. (b) Prepare the journal entry to record depreciation expense for 2018. (c) The fair value of the equipment at December 31, 2018, is $5,100,000. Prepare the journal entry (if any) necessary to

record this increase in fair value.

E11-17 (L03) (Impairment) Assume the same information as E11-16, except that Suarez intends to dispose of the equipment in the coming year. It is expected that the cost of disposal will be $20,000.

Instructions (a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2017. (b) Prepare the journal entry (if any) to record depreciation expense for 2018. (c) The asset was not sold by December 31, 2018. The fair value of the equipment on that date is $5,300,000. Prepare

the journal entry (if any) necessary to record this increase in fair value. It is expected that the cost of disposal is still $20,000.

E11-18 (L03) (Impairment) The management of Petro Garcia Inc. was discussing whether certain equipment should be writ- ten off as a charge to current operations because of obsolescence. This equipment has a cost of $900,000 with depreciation to date of $400,000 as of December 31, 2017. On December 31, 2017, management projected its future net cash flows from this equipment to be $300,000 and its fair value to be $230,000. The company intends to use this equipment in the future.

Instructions (a) Prepare the journal entry (if any) to record the impairment at December 31, 2017. (b) Where should the gain or loss (if any) on the write-down be reported in the income statement? (c) At December 31, 2018, the equipment’s fair value increased to $260,000. Prepare the journal entry (if any) to record this

increase in fair value. (d) What accounting issues did management face in accounting for this impairment?

E11-19 (L04) (Depletion Computations—Timber) Stanislaw Timber Company owns 9,000 acres of timberland purchased in 2006 at a cost of $1,400 per acre. At the time of purchase, the land without the timber was valued at $400 per acre. In 2007, Stanislaw built fire lanes and roads, with a life of 30 years, at a cost of $84,000. Every year, Stanislaw sprays to prevent disease at a cost of $3,000 per year and spends $7,000 to maintain the fire lanes and roads. During 2008, Stanislaw selectively logged and sold 700,000 board feet of timber, of the estimated 3,500,000 board feet. In 2009, Stanislaw planted new seedlings to replace the trees cut at a cost of $100,000.

Instructions (a) Determine the depreciation expense and the cost of timber sold related to depletion for 2008.

(b) Stanislaw has not logged since 2008. If Stanislaw logged and sold 900,000 board feet of timber in 2019, when the timber cruise (appraiser) estimated 5,000,000 board feet, determine the cost of timber sold related to depletion for 2019.

E11-20 (L04) (Depletion Computations—Oil) Diderot Drilling Company has leased property on which oil has been discov- ered. Wells on this property produced 18,000 barrels of oil during the past year that sold at an average sales price of $55 per barrel. Total oil resources of this property are estimated to be 250,000 barrels.

The lease provided for an outright payment of $500,000 to the lessor (owner) before drilling could be commenced and an annual rental of $31,500. A premium of 5% of the sales price of every barrel of oil removed is to be paid annually to the lessor. In addition, Diderot (lessee) is to clean up all the waste and debris from drilling and to bear the costs of reconditioning the land for farming when the wells are abandoned. The estimated fair value, at the time of the lease, of this clean-up and reconditioning is $30,000.

Instructions From the provisions of the lease agreement, you are to compute the cost per barrel for the past year, exclusive of operating costs, to Diderot Drilling Company. (Round to the nearest cent.)

E11-21 (L04) (Depletion Computations—Timber) Forda Lumber Company owns a 7,000-acre tract of timber pur- chased in 2003 at a cost of $1,300 per acre. At the time of purchase, the land was estimated to have a value of $300 per acre without the timber. Forda Lumber Company has not logged this tract since it was purchased. In 2017, Forda had the timber cruised. The cruise (appraiser) estimated that each acre contained 8,000 board feet of timber. In 2017, Forda built 10 miles of roads at a cost of $7,840 per mile. After the roads were completed, Forda logged and sold 3,500 trees containing 850,000 board feet.

Instructions (a) Determine the cost of timber sold related to depletion for 2017. (b) If Forda depreciates the logging roads on the basis of timber cut, determine the depreciation expense for 2017. (c) If Forda plants five seedlings at a cost of $4 per seedling for each tree cut, how should Forda treat the reforestation?

E11-22 (L04) (Depletion Computations—Mining) Alcide Mining Company purchased land on February 1, 2017, at a cost of $1,190,000. It estimated that a total of 60,000 tons of mineral was available for mining. After it has removed all the natural resources, the company will be required to restore the property to its previous state because of strict environmental protection laws. It estimates the fair value of this restoration obligation at $90,000. It believes it will be able to sell the property afterwards for $100,000. It incurred developmental costs of $200,000 before it was able to do any mining. In 2017, resources removed totaled 30,000 tons. The company sold 22,000 tons.

Instructions Compute the following information for 2017.

(a) Per unit material cost. (b) Total material cost of December 31, 2017, inventory. (c) Total material cost in cost of goods sold at December 31, 2017.

E11-23 (L04) (Depletion Computations—Minerals) At the beginning of 2017, Aristotle Company acquired a mine for $970,000. Of this amount, $100,000 was ascribed to the land value and the remaining portion to the minerals in the mine. Surveys conducted by geologists have indicated that approximately 12,000,000 units of ore appear to be in the mine. Aristotle incurred $170,000 of development costs associated with this mine prior to any extraction of minerals. It also determined that the fair value of its obligation to prepare the land for an alternative use when all of the mineral has been removed was $40,000. During 2017, 2,500,000 units of ore were extracted and 2,100,000 of these units were sold.

Instructions Compute the following.

(a) The total amount of depletion for 2017. (b) The amount that is charged as an expense for 2017 for the cost of the minerals sold during 2017.

Exercises 589

590 Chapter 11 Depreciation, Impairments, and Depletion

E11-24 (L05) GROUPWORK (Ratio Analysis) The 2014 annual report of Tootsie Roll Industries contains the following information.

(in millions) December 31, 2014 December 31, 2013

Total assets $910.4 $888.4 Total liabilities 219.3 208.1 Net sales 539.9 539.6 Net income 63.2 60.8

Instructions Compute the following ratios for Tootsie Roll for 2014.

(a) Asset turnover. (b) Return on assets. (c) Profit margin on sales. (d) How can the asset turnover be used to compute the return on assets?

*E11-25 (L06) (Book vs. Tax (MACRS) Depreciation) Futabatei Enterprises purchased a delivery truck on January 1, 2017, at a cost of $27,000. The truck has a useful life of 7 years with an estimated salvage value of $6,000. The straight-line method is used for book purposes. For tax purposes, the truck, having an MACRS class life of 7 years, is classified as 5-year property; the optional MACRS tax rate tables are used to compute depreciation. In addition, assume that for 2017 and 2018 the company has revenues of $200,000 and operating expenses (excluding depreciation) of $130,000.

Instructions (a) Prepare income statements for 2017 and 2018. (The final amount reported on the income statement should be income

before income taxes.) (b) Compute taxable income for 2017 and 2018. (c) Determine the total depreciation to be taken over the useful life of the delivery truck for both book and tax purposes. (d) Explain why depreciation for book and tax purposes will generally be different over the useful life of a depreciable

asset.

*E11-26 (L06) (Book vs. Tax (MACRS) Depreciation) Shimei Inc. purchased computer equipment on March 1, 2017, for $31,000. The computer equipment has a useful life of 10 years and a salvage value of $1,000. For tax purposes, the MACRS class life is 5 years.

Instructions (a) Assuming that the company uses the straight-line method for book and tax purposes, what is the depreciation expense

reported in (1) the financial statements for 2017 and (2) the tax return for 2017? (b) Assuming that the company uses the double-declining-balance method for both book and tax purposes, what is the

depreciation expense reported in (1) the financial statements for 2017 and (2) the tax return for 2017? (c) Why is depreciation for tax purposes different from depreciation for book purposes even if the company uses the same

depreciation method to compute them both?

PROBLEMS

P11-1 (L02) EXCEL GROUPWORK (Depreciation for Partial Period—SL, SYD, and DDB) Alladin Company purchased Machine #201 on May 1, 2017. The following information relating to Machine #201 was gathered at the end of May.

Price $85,000 Credit terms 2/10, n/30 Freight-in $ 800 Preparation and installation costs $ 3,800 Labor costs during regular production operations $10,500

It is expected that the machine could be used for 10 years, after which the salvage value would be zero. Alladin intends to use the machine for only 8 years, however, after which it expects to be able to sell it for $1,500. The invoice for Machine #201 was paid May 5, 2017. Alladin uses the calendar year as the basis for the preparation of financial statements.

Instructions (a) Compute the depreciation expense for the years indicated using the following methods. (Round to the nearest dollar.) (1) Straight-line method for 2017. (2) Sum-of-the-years’-digits method for 2018. (3) Double-declining-balance method for 2017. (b) Suppose Kate Crow, the president of Alladin, tells you that because the company is a new organization, she expects it

will be several years before production and sales reach optimum levels. She asks you to recommend a depreciation method that will allocate less of the company’s depreciation expense to the early years and more to later years of the assets’ lives. What method would you recommend?

P11-2 (L01,2) (Depreciation for Partial Periods—SL, Act., SYD, and Declining-Balance) The cost of equipment purchased by Charleston, Inc., on June 1, 2017, is $89,000. It is estimated that the machine will have a $5,000 salvage value at the end of its service life. Its service life is estimated at 7 years, its total working hours are estimated at 42,000, and its total production is esti- mated at 525,000 units. During 2017, the machine was operated 6,000 hours and produced 55,000 units. During 2018, the machine was operated 5,500 hours and produced 48,000 units.

Instructions Compute depreciation expense on the machine for the year ending December 31, 2017, and the year ending December 31, 2018, using the following methods.

(a) Straight-line. (d) Sum-of-the-years’-digits. (b) Units-of-output. (e) Declining-balance (twice the straight-line rate). (c) Working hours.

P11-3 (L01,2) (Depreciation—SYD, Act., SL, and DDB) The following data relate to the Machinery account of Eshkol, Inc. at December 31, 2017.

Machinery

A B C D

Original cost $46,000 $51,000 $80,000 $80,000 Year purchased 2012 2013 2014 2016 Useful life 10 years 15,000 hours 15 years 10 years Salvage value $ 3,100 $ 3,000 $ 5,000 $ 5,000 Depreciation Sum-of-the- Double-declining- method years’-digits Activity Straight-line balance Accum. depr. through 2017* $31,200 $35,200 $15,000 $16,000

*In the year an asset is purchased, Eshkol, Inc. does not record any depreciation expense on the asset. In the year an asset is retired or traded in, Eshkol, Inc. takes a full year’s depreciation on the asset.

The following transactions occurred during 2018. (a) On May 5, Machine A was sold for $13,000 cash. The company’s bookkeeper recorded this retirement in the following

manner in the cash receipts journal.

Cash 13,000 Machinery (Machine A) 13,000

(b) On December 31, it was determined that Machine B had been used 2,100 hours during 2018. (c) On December 31, before computing depreciation expense on Machine C, the management of Eshkol, Inc. decided the

useful life remaining from January 1, 2018, was 10 years. (d) On December 31, it was discovered that a machine purchased in 2017 had been expensed completely in that year. This

machine cost $28,000 and has a useful life of 10 years and no salvage value. Management has decided to use the double- declining-balance method for this machine, which can be referred to as “Machine E.”

Instructions Prepare the necessary correcting entries for the year 2018. Record the appropriate depreciation expense on the above-mentioned machines. No entry is necessary for Machine D.

P11-4 (L01,2) (Depreciation and Error Analysis) A depreciation schedule for semi-trucks of Ichiro Manufacturing Com- pany was requested by your auditor soon after December 31, 2018, showing the additions, retirements, depreciation, and

Problems 591

592 Chapter 11 Depreciation, Impairments, and Depletion

other data affecting the income of the company in the 4-year period 2015 to 2018, inclusive. The following data were ascertained.

Balance of Trucks account, Jan. 1, 2015 Truck No. 1 purchased Jan. 1, 2012, cost $18,000 Truck No. 2 purchased July 1, 2012, cost 22,000 Truck No. 3 purchased Jan. 1, 2014, cost 30,000 Truck No. 4 purchased July 1, 2014, cost 24,000

Balance, Jan. 1, 2015 $94,000

The Accumulated Depreciation—Trucks account previously adjusted to January 1, 2015, and entered in the ledger, had a bal- ance on that date of $30,200 (depreciation on the four trucks from the respective dates of purchase, based on a 5-year life, no sal- vage value). No charges had been made against the account before January 1, 2015.

Transactions between January 1, 2015, and December 31, 2018, which were recorded in the ledger, are as follows.

July 1, 2015 Truck No. 3 was traded for a larger one (No. 5), the agreed purchase price of which was $40,000. Ichiro. paid the automobile dealer $22,000 cash on the transaction. The entry was a debit to Trucks and a credit to Cash, $22,000. The transaction has com- mercial substance.

Jan. 1, 2016 Truck No. 1 was sold for $3,500 cash; entry debited Cash and credited Trucks, $3,500. July 1, 2017 A new truck (No. 6) was acquired for $42,000 cash and was charged at that amount to the Trucks account. (Assume truck No. 2

was not retired.) July 1, 2017 Truck No. 4 was damaged in a wreck to such an extent that it was sold as junk for $700 cash. Ichiro received $2,500 from the

insurance company. The entry made by the bookkeeper was a debit to Cash, $3,200, and credits to Miscellaneous Income, $700, and Trucks, $2,500.

Entries for straight-line depreciation had been made at the close of each year as follows: 2015, $21,000; 2016, $22,500; 2017, $25,050; and 2018, $30,400.

Instructions (a) For each of the 4 years, compute separately the increase or decrease in net income arising from the company’s errors in

determining or entering depreciation or in recording transactions affecting trucks, ignoring income tax considerations. (b) Prepare one compound journal entry as of December 31, 2018, for adjustment of the Trucks account to reflect the correct

balances as revealed by your schedule, assuming that the books have not been closed for 2018.

P11-5 (L01,4) (Depletion and Depreciation—Mining) Khamsah Mining Company has purchased a tract of mineral land for $900,000. It is estimated that this tract will yield 120,000 tons of ore with sufficient mineral content to make mining and processing profitable. It is further estimated that 6,000 tons of ore will be mined the first and last year and 12,000 tons every year in between. (Assume 11 years of mining operations.) The land will have a salvage value of $30,000.

The company builds necessary structures and sheds on the site at a cost of $36,000. It is estimated that these structures can serve 15 years but, because they must be dismantled if they are to be moved, they have no salvage value. The company does not intend to use the buildings elsewhere. Mining machinery installed at the mine was purchased secondhand at a cost of $60,000. This machinery cost the former owner $150,000 and was 50% depreciated when purchased. Khamsah Mining estimates that about half of this machinery will still be useful when the present mineral resources have been exhausted, but that dismantling and re- moval costs will just about offset its value at that time. The company does not intend to use the machinery elsewhere. The remain- ing machinery will last until about one-half the present estimated mineral ore has been removed and will then be worthless. Cost is to be allocated equally between these two classes of machinery.

Instructions (a) As chief accountant for the company, you are to prepare a schedule showing estimated depletion and depreciation costs

for each year of the expected life of the mine. (b) Also compute the depreciation and depletion for the first year assuming actual production of 5,000 tons. Nothing

occurred during the year to cause the company engineers to change their estimates of either the mineral resources or the life of the structures and equipment.

P11-6 (L04) (Depletion, Timber, and Unusual Loss) Conan O’Brien Logging and Lumber Company owns 3,000 acres of tim- berland on the north side of Mount Leno, which was purchased in 2005 at a cost of $550 per acre. In 2017, O’Brien began selec- tively logging this timber tract. In May 2017, Mount Leno erupted, burying the timberland of O’Brien under a foot of ash. All of the timber on the O’Brien tract was downed. In addition, the logging roads, built at a cost of $150,000, were destroyed, as well as the logging equipment, with a net book value of $300,000.

At the time of the eruption, O’Brien had logged 20% of the estimated 500,000 board feet of timber. Prior to the eruption, O’Brien estimated the land to have a value of $200 per acre after the timber was harvested. O’Brien includes the logging roads in the depletion base.

O’Brien estimates it will take 3 years to salvage the downed timber at a cost of $700,000. The timber can be sold for pulp wood at an estimated price of $3 per board foot. The value of the land is unknown, but must be considered nominal due to future uncertainties.

Instructions (a) Determine the depletion cost per board foot for the timber harvested prior to the eruption of Mount Leno. (b) Prepare the journal entry to record the depletion prior to the eruption. (c) If this tract represents approximately half of the timber holdings of O’Brien, determine the amount of the unusual loss

due to the eruption of Mount Leno for the year ended December 31, 2017.

P11-7 (L01,4) (Natural Resources—Timber) Bronson Paper Products purchased 10,000 acres of forested timberland in March 2017. The company paid $1,700 per acre for this land, which was above the $800 per acre most farmers were paying for cleared land. During April, May, June, and July 2017, Bronson cut enough timber to build roads using moveable equipment purchased on April 1, 2017. The cost of the roads was $250,000, and the cost of the equipment was $225,000; this equipment was expected to have a $9,000 salvage value and would be used for the next 15 years. Bronson selected the straight-line method of depreciation for the moveable equipment. Bronson began actively harvesting timber in August and by December had harvested and sold 540,000 board feet of timber of the estimated 6,750,000 board feet available for cutting.

In March 2018, Bronson planted new seedlings in the area harvested during the winter. Cost of planting these seedlings was $120,000. In addition, Bronson spent $8,000 in road maintenance and $6,000 for pest spraying during calendar-year 2018. The road maintenance and spraying are annual costs. During 2018, Bronson harvested and sold 774,000 board feet of timber of the esti- mated 6,450,000 board feet available for cutting.

In March 2019, Bronson again planted new seedlings at a cost of $150,000, and also spent $15,000 on road maintenance and pest spraying. During 2019, the company harvested and sold 650,000 board feet of timber of the estimated 6,500,000 board feet available for cutting.

Instructions Compute the amount of depreciation and depletion expense for each of the 3 years (2017, 2018, and 2019). Assume that the roads are usable only for logging and therefore are included in the depletion base.

P11-8 (L01) GROUPWORK (Comprehensive Fixed-Asset Problem) Darby Sporting Goods Inc. has been experiencing growth in the demand for its products over the last several years. The last two Olympic Games greatly increased the popularity of basketball around the world. As a result, a European sports retailing consortium entered into an agreement with Darby’s Roundball Division to purchase basketballs and other accessories on an increasing basis over the next 5 years.

To be able to meet the quantity commitments of this agreement, Darby had to obtain additional manufacturing capacity. A real estate firm located an available factory in close proximity to Darby’s Roundball manufacturing facility, and Darby agreed to purchase the factory and used machinery from Encino Athletic Equipment Company on October 1, 2016. Renovations were neces- sary to convert the factory for Darby’s manufacturing use.

The terms of the agreement required Darby to pay Encino $50,000 when renovations started on January 1, 2017, with the bal- ance to be paid as renovations were completed. The overall purchase price for the factory and machinery was $400,000. The build- ing renovations were contracted to Malone Construction at $100,000. The payments made, as renovations progressed during 2017, are shown below. The factory was placed in service on January 1, 2018.

1/1 4/1 10/1 12/31

Encino $50,000 $90,000 $110,000 $150,000 Malone 30,000 30,000 40,000

On January 1, 2017, Darby secured a $500,000 line-of-credit with a 12% interest rate to finance the purchase cost of the factory and machinery, and the renovation costs. Darby drew down on the line-of-credit to meet the payment schedule shown above; this was Darby’s only outstanding loan during 2017.

Bob Sprague, Darby’s controller, will capitalize the maximum allowable interest costs for this project. Darby’s policy regard- ing purchases of this nature is to use the appraisal value of the land for book purposes and prorate the balance of the purchase price over the remaining items. The building had originally cost Encino $300,000 and had a net book value of $50,000, while the machinery originally cost $125,000 and had a net book value of $40,000 on the date of sale. The land was recorded on Encino’s books at $40,000. An appraisal, conducted by independent appraisers at the time of acquisition, valued the land at $290,000, the building at $105,000, and the machinery at $45,000.

Problems 593

594 Chapter 11 Depreciation, Impairments, and Depletion

Angie Justice, chief engineer, estimated that the renovated plant would be used for 15 years, with an estimated salvage value of $30,000. Justice estimated that the productive machinery would have a remaining useful life of 5 years and a salvage value of $3,000. Darby’s depreciation policy specifies the 200% declining-balance method for machinery and the 150% declining- balance method for the plant. One-half year’s depreciation is taken in the year the plant is placed in service, and one-half year is allowed when the property is disposed of or retired. Darby uses a 360-day year for calculating interest costs.

Instructions (a) Determine the amounts to be recorded on the books of Darby Sporting Goods Inc. as of December 31, 2017, for each of

the following properties acquired from Encino Athletic Equipment Company. (1) Land. (2) Buildings. (3) Machinery. (b) Calculate Darby Sporting Goods Inc.’s 2018 depreciation expense, for book purposes, for each of the properties acquired

from Encino Athletic Equipment Company. (c) Discuss the arguments for and against the capitalization of interest costs. (CMA adapted)

P11-9 (L03) (Impairment) Roland Company uses special strapping equipment in its packaging business. The equipment was purchased in January 2016 for $10,000,000 and had an estimated useful life of 8 years with no salvage value. At December 31, 2017, new technology was introduced that would accelerate the obsolescence of Roland’s equipment. Roland’s controller estimates that expected future net cash flows on the equipment will be $6,300,000 and that the fair value of the equipment is $5,600,000. Roland intends to continue using the equipment, but it is estimated that the remaining useful life is 4 years. Roland uses straight-line depreciation.

Instructions (a) Prepare the journal entry (if any) to record the impairment at December 31, 2017. (b) Prepare any journal entries for the equipment at December 31, 2018. The fair value of the equipment at December 31,

2018, is estimated to be $5,900,000. (c) Repeat the requirements for (a) and (b), assuming that Roland intends to dispose of the equipment and that it has not

been disposed of as of December 31, 2018.

P11-10 (L01) GROUPWORK (Comprehensive Depreciation Computations) Kohlbeck Corporation, a manufacturer of steel products, began operations on October 1, 2016. The accounting department of Kohlbeck has started the fixed-asset and depreciation schedule presented on page 595. You have been asked to assist in completing this schedule. In addition to ascer- taining that the data already on the schedule are correct, you have obtained the following information from the company’s records and personnel. 1. Depreciation is computed from the first of the month of acquisition to the first of the month of disposition.

2. Land A and Building A were acquired from a predecessor corporation. Kohlbeck paid $800,000 for the land and building together. At the time of acquisition, the land had an appraised value of $90,000, and the building had an appraised value of $810,000.

3. Land B was acquired on October 2, 2016, in exchange for 2,500 newly issued shares of Kohlbeck’s common stock. At the date of acquisition, the stock had a par value of $5 per share and a fair value of $30 per share. During October 2016, Kohl- beck paid $16,000 to demolish an existing building on this land so it could construct a new building.

4. Construction of Building B on the newly acquired land began on October 1, 2017. By September 30, 2018, Kohlbeck had paid $320,000 of the estimated total construction costs of $450,000. It is estimated that the building will be completed and occupied by July 2019.

5. Certain equipment was donated to the corporation by a local university. An independent appraisal of the equipment when donated placed the fair value at $40,000 and the salvage value at $3,000.

6. Machinery A’s total cost of $182,900 includes installation expense of $600 and normal repairs and maintenance of $14,900. Salvage value is estimated at $6,000. Machinery A was sold on February 1, 2018.

7. On October 1, 2017, Machinery B was acquired with a down payment of $5,740 and the remaining payments to be made in 11 annual installments of $6,000 each beginning October 1, 2017. The prevailing interest rate was 8%. The following data were abstracted from present value tables (rounded).

Present Value of $1.00 at 8% Present Value of an Ordinary Annuity of $1.00 at 8%

10 years .463 10 years 6.710 11 years .429 11 years 7.139 15 years .315 15 years 8.559

KOHLBECK CORPORATION Fixed-Asset and Depreciation Schedule

For Fiscal Years Ended September 30, 2017, and September 30, 2018

Depreciation Expense Year Ended

Estimated September 30 Acquisition Depreciation Life in

Assets Date Cost Salvage Method Years 2017 2018

Land A October 1, 2016 $ (1) N/A* N/A N/A N/A N/A Building A October 1, 2016 (2) $40,000 Straight-line (3) $13,600 (4) Land B October 2, 2016 (5) N/A N/A N/A N/A N/A Building B Under $320,000 — Straight-line 30 — (6) Construction to date Donated Equipment October 2, 2016 (7) 3,000 150% declining- 10 (8) (9) balance Machinery A October 2, 2016 (10) 6,000 Sum-of-the- 8 (11) (12) years’-digits Machinery B October 1, 2017 (13) — Straight-line 20 — (14)

*N/A—Not applicable

Instructions For each numbered item on the schedule above, supply the correct amount. (Round each answer to the nearest dollar.)

P11-11 (L01,2) (Depreciation for Partial Periods—SL, Act., SYD, and DDB) On January 1, 2015, a machine was purchased for $90,000. The machine has an estimated salvage value of $6,000 and an estimated useful life of 5 years. The machine can operate for 100,000 hours before it needs to be replaced. The company closed its books on December 31 and operates the machine as fol- lows: 2015, 20,000 hours; 2016, 25,000 hours; 2017, 15,000 hours; 2018, 30,000 hours; and 2019, 10,000 hours.

Instructions (a) Compute the annual depreciation charges over the machine’s life assuming a December 31 year-end for each of the fol-

lowing depreciation methods. (1) Straight-line method. (3) Sum-of-the-years’-digits method. (2) Activity method. (4) Double-declining-balance method. (b) Assume a fiscal year-end of September 30. Compute the annual depreciation charges over the asset’s life applying each

of the following methods. (1) Straight-line method. (3) Double-declining-balance method. (2) Sum-of-the-years’-digits method.

*P11-12 (L01,6) EXCEL (Depreciation—SL, DDB, SYD, Act., and MACRS) On January 1, 2016, Locke Company, a small machine-tool manufacturer, acquired for $1,260,000 a piece of new industrial equipment. The new equipment had a useful life of 5 years, and the salvage value was estimated to be $60,000. Locke estimates that the new equipment can produce 12,000 machine tools in its first year. It estimates that production will decline by 1,000 units per year over the remaining useful life of the equipment.

The following depreciation methods may be used: (1) straight-line, (2) double-declining-balance, (3) sum-of-the-years’-digits, and (4) units-of-output. For tax purposes, the class life is 7 years. Use the MACRS tables for computing depreciation.

Instructions (a) Which depreciation method would maximize net income for financial statement reporting for the 3-year period ending

December 31, 2018? Prepare a schedule showing the amount of accumulated depreciation at December 31, 2018, under the method selected. Ignore present value, income tax, and deferred income tax considerations.

(b) Which depreciation method (MACRS or optional straight-line) would minimize net income for income tax reporting for the 3-year period ending December 31, 2018? Determine the amount of accumulated depreciation at December 31, 2018. Ignore present value considerations.

(AICPA adapted)

Problems 595

596 Chapter 11 Depreciation, Impairments, and Depletion

CONCEPTS FOR ANALYSIS

CA11-1 (Depreciation Basic Concepts) Burnitz Manufacturing Company was organized on January 1, 2017. During 2017, it has used in its reports to management the straight-line method of depreciating its plant assets.

On November 8, you are having a conference with Burnitz’s officers to discuss the depreciation method to be used for income tax and stockholder reporting. James Bryant, president of Burnitz, has suggested the use of a new method, which he feels is more suitable than the straight-line method for the needs of the company during the period of rapid expansion of production and capacity that he foresees. Following is an example in which the proposed method is applied to a fixed asset with an original cost of $248,000, an estimated useful life of 5 years, and a salvage value of approximately $8,000.

Accumulated Years of Depreciation Book Value Life Fraction Depreciation at End at End Year Used Rate Expense of Year of Year

1 1 1/15 $16,000 $ 16,000 $232,000 2 2 2/15 32,000 48,000 200,000 3 3 3/15 48,000 96,000 152,000 4 4 4/15 64,000 160,000 88,000 5 5 5/15 80,000 240,000 8,000

The president favors the new method because he has heard that:

1. It will increase the funds recovered during the years near the end of the assets’ useful lives when maintenance and replace- ment disbursements are high.

2. It will result in increased write-offs in later years and thereby will reduce taxes.

Instructions (a) What is the purpose of accounting for depreciation? (b) Is the president’s proposal within the scope of generally accepted accounting principles? In making your decision,

discuss the circumstances, if any, under which use of the method would be reasonable and those, if any, under which it would not be reasonable.

(c) The president wants your advice on the following issues. (1) Do depreciation charges recover or create funds? Explain. (2) Assume that the Internal Revenue Service accepts the proposed depreciation method in this case. If the proposed

method were used for stockholder and tax reporting purposes, how would it affect the availability of cash flows generated by operations?

CA11-2 WRITING (Unit, Group, and Composite Depreciation) The certified public accountant is frequently called upon by management for advice regarding methods of computing depreciation. Of comparable importance, although it arises less fre- quently, is the question of whether the depreciation method should be based on consideration of the assets as units, as a group, or as having a composite life.

Instructions (a) Briefly describe the depreciation methods based on treating assets as (1) units and (2) a group or as having a composite

life. (b) Present the arguments for and against the use of each of the two methods. (c) Describe how retirements are recorded under each of the two methods.

(AICPA adapted)

CA11-3 (Depreciation—Strike, Units-of-Production, Obsolescence) The following are three different and unrelated situa- tions involving depreciation accounting. Answer the question(s) at the end of each situation.

Situation I: Recently, Broderick Company experienced a strike that affected a number of its operating plants. The controller of this company indicated that it was not appropriate to report depreciation expense during this period because the equipment did not depreciate and an improper matching of costs and revenues would result. She based her position on the following points.

1. It is inappropriate to charge the period with costs for which there are no related revenues arising from production. 2. The basic factor of depreciation in this instance is wear and tear. Because equipment was idle, no wear and tear

occurred.

Instructions Comment on the appropriateness of the controller’s comments.

Situation II: Etheridge Company manufactures electrical appliances, most of which are used in homes. Company engineers have designed a new type of blender which, through the use of a few attachments, will perform more functions than any blender cur- rently on the market. Demand for the new blender can be projected with reasonable probability. In order to make the blenders, Etheridge needs a specialized machine that is not available from outside sources. It has been decided to make such a machine in Etheridge’s own plant.

Instructions (a) Discuss the effect of projected demand in units for the new blenders (which may be steady, decreasing, or increasing)

on the determination of a depreciation method for the machine. (b) What other matters should be considered in determining the depreciation method? (Ignore income tax consider-

ations.)

Situation III: Haley Paper Company operates a 300-ton-per-day kraft pulp mill and four sawmills in Wisconsin. The company is in the process of expanding its pulp mill facilities to a capacity of 1,000 tons per day and plans to replace three of its older, less efficient sawmills with an expanded facility. One of the mills to be replaced did not operate for most of 2017 (current year), and there are no plans to reopen it before the new sawmill facility becomes operational.

In reviewing the depreciation rates and in discussing the salvage values of the sawmills that were to be replaced, it was noted that if present depreciation rates were not adjusted, substantial amounts of plant costs on these three mills would not be depreciated by the time the new mill came on stream.

Instructions What is the proper accounting for the four sawmills at the end of 2017?

CA11-4 WRITING (Depreciation Concepts) As a cost accountant for San Francisco Cannery, you have been approached by Phil Perriman, canning room supervisor, about the 2017 costs charged to his department. In particular, he is concerned about the line item “depreciation.” Perriman is very proud of the excellent condition of his canning room equipment. He has always been vigilant about keeping all equipment serviced and well oiled. He is sure that the huge charge to depreciation is a mistake; it does not at all reflect the cost of minimal wear and tear that the machines have experienced over the last year. He believes that the charge should be considerably lower.

The machines being depreciated are six automatic canning machines. All were put into use on January 1, 2017. Each cost $625,000, having a salvage value of $55,000 and a useful life of 12 years. San Francisco depreciates this and similar assets using double-declining-balance depreciation. Perriman has also pointed out that if you used straight-line depreciation, the charge to his department would not be so great.

Instructions Write a memo dated January 22, 2017, to Phil Perriman to clear up his misunderstanding of the term “depreciation.” Also, calcu- late year-1 depreciation on all machines using both methods. Explain the theoretical justification for double-declining-balance and why, in the long run, the aggregate charge to depreciation will be the same under both methods.

CA11-5 ETHICS (Depreciation Choice—Ethics) Jerry Prior, Beeler Corporation’s controller, is concerned that net income may be lower this year. He is afraid upper-level management might recommend cost reductions by laying off accounting staff, including him.

Prior knows that depreciation is a major expense for Beeler. The company currently uses the double-declining-balance method for both financial reporting and tax purposes, and he’s thinking of selling equipment that, given its age, is primarily used when there are periodic spikes in demand. The equipment has a carrying value of $2,000,000 and a fair value of $2,180,000. The gain on the sale would be reported in the income statement. He doesn’t want to highlight this method of increasing in- come. He thinks, “Why don’t I increase the estimated useful lives and the salvage values? That will decrease depreciation

Concepts for Analysis 597

598 Chapter 11 Depreciation, Impairments, and Depletion

expense and require less extensive disclosure, since the changes are accounted for prospectively. I may be able to save my job and those of my staff.”

Instructions Answer the following questions.

(a) Who are the stakeholders in this situation? (b) What are the ethical issues involved? (c) What should Prior do?

USING YOUR JUDGMENT

Instructions Refer to P&G’s financial statements and the accompanying notes to answer the following questions.

(a) What descriptions are used by P&G in its balance sheet to classify its property, plant, and equipment? (b) What method or methods of depreciation does P&G use to depreciate its property, plant, and equipment? (c) Over what estimated useful lives does P&G depreciate its property, plant, and equipment? (d) What amounts for depreciation and amortization expense did P&G charge to its income statement in 2014, 2013,

and 2012? (e) What were the capital expenditures for property, plant, and equipment made by P&G in 2014, 2013, and 2012?

Comparative Analysis Case The Coca-Cola Company and PepsiCo., Inc. The financial statements of Coca-Cola and PepsiCo are presented in Appendices C and D, respectively. The companies’ com- plete annual reports, including the notes to the financial statements, are available online.

Instructions Use the companies’ financial information to answer the following questions.

(a) What amount is reported in the balance sheets as property, plant, and equipment (net) of Coca-Cola at December 31, 2014, and of PepsiCo at December 31, 2014? What percentage of total assets is invested in property, plant, and equip- ment by each company?

(b) What depreciation methods are used by Coca-Cola and PepsiCo for property, plant, and equipment? How much depreciation and amortization was reported by Coca-Cola and PepsiCo in 2014? In 2013? (Use cash flow statement amounts.)

(c) Compute and compare the following ratios for Coca-Cola and PepsiCo for 2014. (1) Asset turnover. (2) Profit margin on sales. (3) Return on assets. (d) What amount was spent in 2014 for capital expenditures by Coca-Cola and PepsiCo?

Financial Statement Analysis Case McDonald’s Corporation McDonald’s is the largest and best-known global food-service retailer, with more than 32,000 restaurants in 118 countries. On any day, McDonald’s serves approximately 1 percent of the world’s population. The following is information related to McDonald’s property and equipment.

McDonald’s Corporation Summary of Significant Accounting Policies Section

Property and Equipment. Property and equipment are stated at cost, with depreciation and amortization provided using the straight-line method over the following estimated useful lives: buildings—up to 40 years; leasehold improvements—the lesser of useful lives of assets or lease terms, which generally include option periods; and equipment—three to 12 years.

[In the notes to the financial statements:]

Property and Equipment Net property and equipment consisted of:

December 31 (In millions) 2014 2013

Land $ 5,788.4 $ 5,849.3 Buildings and improvements on owned land 14,322.4 14,715.6 Buildings and improvements on leased land 13,284.0 13,825.2 Equipment, signs and seating 5,113.8 5,376.8 Other 617.5 588.7

39,126.1 40,355.6 Accumulated depreciation and amortization (14,568.6) (14,608.3) Net property and equipment $24,557.5 $25,747.3

Depreciation and amortization expense for property and equipment was (in millions): 2014—$1,539.3; 2013—$1,498.8; 2012—$1,402.2.

[In its 6-year summary, McDonald’s provides the following information.]

(in millions) 2014 2013 2012

Cash provided by operations $6,370 $7,121 $6,966 Capital expenditures 2,583 2,825 3,049

Instructions (a) What method of depreciation does McDonald’s use? (b) Does depreciation and amortization expense cause cash flow from operations to increase? Explain. (c) What does the schedule of cash flow measures indicate?

Accounting, Analysis, and Principles Electroboy Enterprises, Inc. operates several stores throughout the western United States. As part of an operational and financial re- porting review in a response to a downturn in its markets, the company’s management has decided to perform an impairment test on five stores (combined). The five stores’ sales have declined due to aging facilities and competition from a rival that opened new stores in the same markets. Management has developed the following information concerning the five stores as of the end of fiscal 2016.

Original cost $36 million Accumulated depreciation $10 million Estimated remaining useful life 4 years Estimated expected future annual cash fl ows (not discounted) $4.0 million per year Appropriate discount rate 5 percent

Accounting (a) Determine the amount of impairment loss, if any, that Electroboy should report for fiscal 2016 and the book value at

which Electroboy should report the five stores on its fiscal year-end 2016 balance sheet. Assume that the cash flows occur at the end of each year.

(b) Repeat part (a), but instead assume that (1) the estimated remaining useful life is 10 years, (2) the estimated annual cash flows are $2,720,000 per year, and (3) the appropriate discount rate is 6 percent.

Analysis Assume that you are a financial analyst and you participate in a conference call with Electroboy management in early 2017 (be- fore Electroboy closes the books on fiscal 2016). During the conference call, you learn that management is considering selling the five stores, but the sale won’t likely be completed until the second quarter of fiscal 2017. Briefly discuss what implications this would have for Electroboy’s 2016 financial statements. Assume the same facts as in part (b) above.

Using Your Judgment 599

600 Chapter 11 Depreciation, Impairments, and Depletion

Principles Electroboy management would like to know the accounting for the impaired asset in periods subsequent to the impairment. Can the assets be written back up? Briefly discuss the conceptual arguments for this accounting.

BRIDGE TO THE PROFESSION

FASB Codifi cation References [1] FASB ASC 360-10-05. [Predecessor literature: “Accounting for the Impairment or Disposal of Long-lived Assets,” Statement

of Financial Accounting Standards No. 144 (Norwalk, Conn.: 2001).] [2] FASB ASC 360-10-50-1. [Predecessor literature: “Omnibus Opinion—1967,” Opinions of the Accounting Principles Board No.

12 (New York: AICPA, 1967), par. 5.] [3] FASB ASC 932-235-50-1. [Predecessor literature: “Disclosures about Oil and Gas Producing Activities,” Statement of Finan-

cial Accounting Standards Board No. 69 (Stamford, Conn.: FASB, 1982).]

Codifi cation Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE11-1 Access the glossary (“Master Glossary”) to answer the following.

(a) What is the definition of amortization? (b) What is the definition of impairment? (c) What is the definition of recoverable amount? (d) What are activities, as they relate to the construction of an asset?

CE11-2 Your client, Barriques Inc., is contemplating a restructuring of its operations, including the possibility of spinning off some of its assets to the original owners. However, management is unsure of the accounting for any impairment on the assets. What does the authoritative literature say about these types of impairments? CE11-3 Your great-uncle, who is a CPA, is impressed that you are majoring in accounting. But, he believes that depreciation is something that companies do based on past practice, not on the basis of any authoritative guidance. Provide the authoritative literature to support the practice of fixed-asset depreciation. CE11-4 What is the nature of SEC guidance concerning property, plant, and equipment disclosures?

Codifi cation Research Case Matt Holmes recently joined Klax Company as a staff accountant in the controller’s office. Klax Company provides warehousing services for companies in several midwestern cities.

The location in Dubuque, Iowa, has not been performing well due to increased competition and the loss of several custom- ers that have recently gone out of business. Matt’s department manager suspects that the plant and equipment may be impaired and wonders whether those assets should be written down. Given the company’s prior success, this issue has never arisen in the past, and Matt has been asked to conduct some research on this issue.

(a) What is the authoritative guidance for asset impairments? Briefly discuss the scope of the standard (i.e., explain the types of transactions to which the standard applies).

(b) Give several examples of events that would cause an asset to be tested for impairment. Does it appear that Klax should perform an impairment test? Explain.

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IFRS Insights 601

Components Component Amount Component Useful Life

Airframe $60,000,000 20 years Engine components 32,000,000 8 years Other components 8,000,000 5 years

ILLUSTRATION IFRS11-1 Airplane Components

LEARNING OBJECTIVE 7 Compare the accounting for property, plant, and equipment under GAAP and IFRS.

IFRS Insights GAAP adheres to many of the same principles of IFRS in the accounting for property, plant, and equip- ment. Major differences relate to use of component depreciation, impairments, and revaluations.

RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to property, plant, and equipment.

Similarities • The defi nition of property, plant, and equipment is essentially the same under GAAP and IFRS. • Under both GAAP and IFRS, changes in depreciation method and changes in useful life are

treated in the current and future periods. Prior periods are not affected. • The accounting for plant asset disposals is the same under GAAP and IFRS. • The accounting for the initial costs to acquire natural resources is similar under GAAP

and IFRS. • Under both GAAP and IFRS, interest costs incurred during construction must be capitalized.

Recently, IFRS converged to GAAP. • The accounting for exchanges of non-monetary assets is essentially the same between IFRS and

GAAP. GAAP requires that gains on exchanges of non-monetary assets be recognized if the exchange has commercial substance. This is the same framework used in IFRS.

• GAAP and IFRS both view depreciation as allocation of cost over an asset’s life. GAAP permits the same depreciation methods (straight-line, diminishing-balance, units-of-production) as IFRS.

Differences • IFRS requires component depreciation. Under GAAP, component depreciation is permitted but

is rarely used. • Under IFRS, companies can use either the historical cost model or the revaluation model.

GAAP does not permit revaluations of property, plant, and equipment or mineral resources. • In testing for impairments of long-lived assets, GAAP uses a different model than IFRS to test

for impairments (details of the IFRS impairment test is presented in the About the Numbers dis- cussion). As long as future undiscounted cash fl ows exceed the carrying amount of the asset, no impairment is recorded. The IFRS impairment test is stricter. However, unlike GAAP, rever- sals of impairment losses are permitted.

ABOUT THE NUMBERS

Component Depreciation Under IFRS, companies are required to use component depreciation. IFRS requires that each part of an item of property, plant, and equipment that is significant to the total cost of the asset must be depreciated separately. Companies therefore have to exercise judgment to determine the proper allocations to the components. As an example, when a company like Nokia purchases a building, it must determine how the various building components (e.g., the foundation, structure, roof, heating and cooling system, and elevators) should be segregated and depreciated.

To illustrate the accounting for component depreciation, assume that EuroAsia Airlines pur- chases an airplane for $100,000,000 on January 1, 2017. The airplane has a useful life of 20 years and a residual value of $0. EuroAsia uses the straight-line method of depreciation for all its air- planes. EuroAsia identifies the following components, amounts, and useful lives, as shown in Illustration IFRS11-1.

ILLUSTRATION IFRS11-3 Presentation of Carrying Amount of Airplane

Non-current assets Airplane $100,000,000 Less: Accumulated depreciation—airplane 8,600,000

$ 91,400,000

Illustration IFRS11-2 shows the computation of depreciation expense for EuroAsia for 2017.

Components Component Amount ÷ Useful Life = Component Depreciation Airframe $ 60,000,000 20 $3,000,000 Engine components 32,000,000 8 4,000,000 Other components 8,000,000 5 1,600,000

Total $100,000,000 $8,600,000

ILLUSTRATION IFRS11-2 Computation of Component Depreciation

As indicated, EuroAsia records depreciation expense of $8,600,000 in 2017 as follows.

Depreciation Expense 8,600,000 Accumulated Depreciation—Airplane 8,600,000

On the statement of financial position at the end of 2017, EuroAsia reports the airplane as a single amount. The presentation is shown in Illustration IFRS11-3.

In many situations, a company may not have a good understanding of the cost of the indi- vidual components purchased. In that case, the cost of individual components should be esti- mated based on reference to current market prices (if available), discussion with experts in valuation, or use of other reasonable approaches.

Recognizing Impairments As discussed in the textbook, the credit crisis starting in late 2008 has affected many financial and non-financial institutions. As a result of this global slump, many companies are considering write- offs of some of their long-lived assets. These write-offs are referred to as impairments. The accounting for impairments is different under GAAP and IFRS.

A long-lived tangible asset is impaired when a company is not able to recover the asset’s car- rying amount either through using it or by selling it. To determine whether an asset is impaired, on an annual basis, companies review the asset for indicators of impairments—that is, a decline in the asset’s cash-generating ability through use or sale. This review should consider internal sources (e.g., adverse changes in performance) and external sources (e.g., adverse changes in the business or regulatory environment) of information. If impairment indicators are present, then an impairment test must be conducted. This test compares the asset’s recoverable amount with its carrying amount. If the carrying amount is higher than the recoverable amount, the difference is an impairment loss. If the recoverable amount is greater than the carrying amount, no impair- ment is recorded.

Recoverable amount is defined as the higher of fair value less costs to sell or value-in-use. Fair value less costs to sell means what the asset could be sold for after deducting costs of dis- posal. Value-in-use is the present value of cash flows expected from the future use and eventual sale of the asset at the end of its useful life. Illustration IFRS11-4 highlights the nature of the impairment test.

602 Chapter 11 Depreciation, Impairments, and Depletion

IFRS Insights 603

If either the fair value less costs to sell or value-in-use is higher than the carrying amount, there is no impairment. If both the fair value less costs to sell and value-in-use are lower than the carrying amount, a loss on impairment occurs.

Example: No Impairment Assume that Cruz Company performs an impairment test for its equipment. The carrying amount of Cruz’s equipment is $200,000, its fair value less costs to sell is $180,000, and its value-in-use is $205,000. In this case, the value-in-use of Cruz’s equipment is higher than its carrying amount of $200,000. As a result, there is no impairment. (If a company can more readily determine value-in- use (or fair value less costs to sell) and it determines that no impairment is needed, it is not required to compute the other measure.)

Example: Impairment Assume the same information for Cruz Company above except that the value-in-use of Cruz’s equipment is $175,000 rather than $205,000. Cruz measures the impairment loss as the difference between the carrying amount of $200,000 and the higher of fair value less costs to sell ($180,000) or value-in-use ($175,000). Cruz therefore uses the fair value less cost of disposal to record an impairment loss of $20,000 ($200,000 − $180,000). Cruz makes the following entry to record the impairment loss.

Loss on Impairment 20,000 Accumulated Depreciation—Equipment 20,000

Loss on Impairment is reported in the income statement in the “Other income and expense” sec- tion. The company then either credits Equipment or Accumulated Depreciation—Equipment to reduce the carrying amount of the equipment for the impairment. For purposes of homework, credit accumulated depreciation when recording an impairment for a depreciable asset.

Reversal of Impairment Loss After recording the impairment loss, the recoverable amount becomes the basis of the impaired asset. What happens if a review in a future year indicates that the asset is no longer impaired because the recoverable amount of the asset is higher than the carrying amount? In that case, the impairment loss may be reversed.

To illustrate, assume that Tan Company purchases equipment on January 1, 2017, for $300,000, with a useful life of three years, and no residual value. Its depreciation and related carrying amount over the three years is as follows.

ILLUSTRATION IFRS11-4 Impairment Test

Recoverable Amount

Fair Value Less Costs to Sell Value-in-Use

Carrying Amount Compared to

Higher of

Year Depreciation Expense Carrying Amount

2017 $100,000 ($300,000/3) $200,000 2018 $100,000 ($300,000/3) $100,000 2019 $100,000 ($300,000/3) –0–

604 Chapter 11 Depreciation, Impairments, and Depletion

At the end of 2018, Tan determines that the recoverable amount of the equipment is $96,000, which is greater than its carrying amount of $90,000. In this case, Tan reverses the previously rec- ognized impairment loss with the following entry.

Accumulated Depreciation—Equipment 6,000 Recovery of Loss from Impairment 6,000

The recovery of the impairment loss is reported in the “Other income and expense” section of the income statement. The carrying amount of Tan’s equipment is now $96,000 ($90,000 + $6,000) at December 31, 2018. The general rule related to reversals of impairments is as follows. The amount of the recovery of the loss is limited to the carrying amount that would result if the impairment had not occurred. For example, the carrying amount of Tan’s equipment at the end of 2018 would be $100,000, assuming no impairment. The $6,000 recovery is therefore permitted because Tan’s carrying amount on the equipment is now only $96,000.

However, any recovery above $10,000 is not permitted. The reason is that any recovery above $10,000 results in Tan carrying the asset at a value above its historical cost.

Revaluations Up to this point, we have assumed that companies use the historical cost principle to value long- lived tangible assets after acquisition. However, under IFRS companies have a choice. They may value these assets at cost or at fair value.

Recognizing Revaluations Network Rail (a company in Great Britain) is an example of a company that elected to use fair values to account for its railroad network. Its use of fair value led to an increase of £4,289 million to its long-lived tangible assets. When companies choose to fair value their long-lived tangible assets subsequent to acquisition, they account for the change in the fair value by adjusting the appropriate asset account and establishing an unrealized gain on the revalued long-lived tangible asset. This unrealized gain is often referred to as revaluation surplus.

Revaluation—Land. To illustrate revaluation of land, assume that Siemens Group purchased land for $1,000,000 on January 5, 2017. The company elects to use revaluation accounting for the land in subsequent periods. At December 31, 2017, the land’s fair value is $1,200,000. The entry to record the land at fair value is as follows.

Land 200,000 Unrealized Gain on Revaluation (land) 200,000

The land is reported on the statement of financial position at $1,200,000, and Unrealized Gain on Revaluation (land) increases other comprehensive income in the statement of comprehensive

At December 31, 2017, Tan determines it has an impairment loss of $20,000 and therefore makes the following entry.

Loss on Impairment 20,000 Accumulated Depreciation—Equipment 20,000

Tan’s depreciation expense and related carrying amount after the impairment is as indicated in Illustration IFRS11-5.

ILLUSTRATION IFRS11-5 Carrying Value of Impaired Asset

Year Depreciation Expense Carrying Amount

2018 $90,000 ($180,000/2) $90,000 2019 $90,000 ($180,000/2) -0-

IFRS Insights 605

income. In addition, if this is the only revaluation adjustment to date, the statement of financial position reports accumulated other comprehensive income of $200,000.

Revaluation—Depreciable Assets. To illustrate the accounting for revaluations of depreciable assets, assume that Lenovo Group purchases equipment for $500,000 on January 2, 2017. The equipment has a useful life of five years, is depreciated using the straight-line method of deprecia- tion, and its residual value is zero. Lenovo chooses to revalue its equipment to fair value over the life of the equipment. Lenovo records depreciation expense of $100,000 ($500,000 ÷ 5) at Decem- ber 31, 2017, as follows.

December 31, 2017 Depreciation Expense 100,000 Accumulated Depreciation—Equipment 100,000 (To record depreciation expense in 2017)

After this entry, Lenovo’s equipment has a carrying amount of $400,000 ($500,000 − $100,000). Lenovo receives an independent appraisal for the fair value of equipment at December 31, 2017, which is $460,000. To report the equipment at fair value, Lenovo does the following.

1. Reduces the Accumulated Depreciation—Equipment account to zero. 2. Reduces the Equipment account by $40,000—it then is reported at its fair value of $460,000. 3. Records Unrealized Gain on Revaluation (equipment) for the difference between the fair

value and carrying amount of the equipment, or $60,000 ($460,000 − $400,000).

The entry to record this revaluation at December 31, 2017, is as follows.

December 31, 2017

Accumulated Depreciation—Equipment 100,000 Equipment 40,000 Unrealized Gain on Revaluation (equipment) 60,000 (To adjust the equipment to fair value and

record revaluation increase)

The equipment is now reported at its fair value of $460,000 ($500,000 − $40,000). As an alternative to the entry shown here, companies restate on a proportionate basis the cost and accumulated depreciation of the asset, such that the carrying amount of the asset after revaluation equals its revalued amount.

The increase in the fair value of $60,000 is reported on the statement of comprehensive income as other comprehensive income. In addition, the ending balance is reported in accumulated other comprehensive income on the statement of financial position in the equity section. Illustration IFRS11-6 shows the presentation of revaluation elements.

ILLUSTRATION IFRS11-6 Financial Statement Presentation—Revaluations

On the statement of comprehensive income: Depreciation expense $100,000 Other comprehensive income Unrealized gain on revaluation (equipment) $ 60,000

On the statement of financial position:

Non-current assets Equipment ($500,000 − $40,000) $460,000 Accumulated depreciation—equipment ($100,000 − $100,000) –0– Carrying amount $460,000 Equity

Accumulated other comprehensive income $ 60,000

606 Chapter 11 Depreciation, Impairments, and Depletion

As indicated, at December 31, 2017, the carrying amount of the equipment is now $460,000. Lenovo reports depreciation expense of $100,000 in the income statement and Unrealized Gain on Revaluation (equipment) of $60,000 in “Other comprehensive income.” Assuming no change in the useful life of the equipment, depreciation in 2018 is $115,000 ($460,000 ÷ 4).

In summary, a revaluation increase generally goes to equity. A revaluation decrease is reported as an expense (as an impairment loss), unless it offsets previously recorded revaluation increases. If the revaluation increase offsets a revaluation decrease that went to expense, then the increase is reported in income. Under no circumstances can the Accumulated Other Compre- hensive Income account related to revaluations have a negative balance.

ON THE HORIZON With respect to revaluations, as part of the conceptual framework project, the Boards will examine the measurement bases used in accounting. It is too early to say whether a converged conceptual framework will recommend fair value measurement (and revaluation accounting) for property, plant, and equipment. However, this is likely to be one of the more contentious issues, given the long-standing use of historical cost as a measurement basis in GAAP.

1. Mandall Company constructed a warehouse for $280,000 on January 2, 2017. Mandall estimates that the warehouse has a useful life of 20 years and no residual value. Construction records indicate that $40,000 of the cost of the warehouse relates to its heating, ventilation, and air conditioning (HVAC) system, which has an estimated useful life of only 10 years. What is the first year of depreciation expense using straight- line component depreciation under IFRS?

(a) $28,000. (c) $16,000. (b) $14,000. (d) $4,000.

2. Francisco Corporation is constructing a new building at a total initial cost of $10,000,000. The building is expected to have a useful life of 50 years with no residual value. The building’s finished surfaces (e.g., roof cover and floor cover) are 5% of this cost and have a useful life of 20 years. Building services systems (e.g., electric, heating, and plumbing) are 20% of the cost and have a useful life of 25 years. The depreciation in the first year using component depreciation, assuming straight-line depreciation with no residual value, is:

(a) $200,000. (c) $255,000. (b) $215,000. (d) None of the above.

3. Which of the following statements is correct? (a) Both IFRS and GAAP permit revaluation of prop-

erty, plant, and equipment.

(b) IFRS permits revaluation of property, plant, and equipment but not GAAP.

(d) GAAP permits revaluation of property, plant, and equipment but not IFRS.

4. Hilo Company has land that cost $350,000 but now has a fair value of $500,000. Hilo Company decides to use the reval- uation method specified in IFRS to account for the land. Which of the following statements is correct?

(a) Hilo Company must continue to report the land at $350,000.

(b) Hilo Company would report a net income increase of $150,000 due to an increase in the value of the land.

(d) Hilo Company would credit Revaluation Surplus by $150,000.

5. Under IFRS, value-in-use is defined as: (a) net realizable value. (b) fair value. (c) future cash fl ows discounted to present value. (d) total future undiscounted cash fl ows.

IFRS SELF-TEST QUESTIONS

IFRS CONCEPTS AND APPLICATION IFRS11-1 Walkin Inc. is considering the write-down of its long-term plant because of a lack of profitability. Explain to the management of Walkin how to determine whether a write-down is permitted.

IFRS11-2 Last year, Wyeth Company recorded an impairment on an asset held for use. Recent appraisals indicate that the asset has increased in value. Should Wyeth record this recovery in value?

IFRS11-3 Toro Co. has equipment with a carrying amount of $700,000. The value-in-use of the equipment is $705,000, and its fair value less costs of disposal is $590,000. The equipment is expected to be used in operations in the future. What amount (if any) should Toro report as an impairment to its equipment?

IFRS Insights 607

IFRS11-4 Explain how gains or losses on impaired assets should be reported in income.

IFRS11-5 Tanaka Company has land that cost $15,000,000. Its fair value on December 31, 2017, is $20,000,000. Tanaka chooses the revaluation model to report its land. Explain how the land and its related valuation should be reported.

IFRS11-6 Why might a company choose not to use revaluation accounting?

IFRS11-7 Ortiz purchased a piece of equipment that cost $202,000 on January 1, 2017. The equipment has the following com- ponents.

Component Cost Residual Value Estimated Useful Life

A $70,000 $7,000 10 years B 50,000 5,000 5 years C 82,000 4,000 12 years

Compute the depreciation expense for this equipment at December 31, 2017.

IFRS11-8 Tan Chin Company purchases a building for $11,300,000 on January 2, 2017. An engineer’s report shows that of the total purchase price, $11,000,000 should be allocated to the building (with a 40-year life), $150,000 to 15-year property, and $150,000 to 5-year property. No residual (salvage) value should be considered. Compute depreciation expense for 2017 using component depreciation.

IFRS11-9 Brazil Group purchases a vehicle at a cost of $50,000 on January 2, 2017. Individual components of the vehicle and useful lives are as follows.

Cost Useful Lives

Tires $ 6,000 2 years Transmission 10,000 5 years Trucks 34,000 10 years

Instructions (Assume no residual (salvage) value.)

(a) Compute depreciation expense for 2017, assuming Brazil depreciates the vehicle as a single unit. (b) Compute depreciation expense for 2017, assuming Brazil uses component depreciation. (c) Why might a company want to use component depreciation to depreciate its assets?

IFRS11-10 Jurassic Company owns machinery that cost $900,000 and has accumulated depreciation of $380,000. The present value of expected future net cash flows from the use of the asset are expected to be $500,000. The fair value less cost of disposal of the equipment is $400,000. Prepare the journal entry, if any, to record the impairment loss.

IFRS11-11 Presented below is information related to equipment owned by Pujols Company at December 31, 2017.

Cost (residual value $0) $9,000,000 Accumulated depreciation to date 1,000,000 Value-in-use 5,500,000 Fair value less cost of disposal 4,400,000

Assume that Pujols will continue to use this asset in the future. As of December 31, 2017, the equipment has a remaining useful life of 8 years. Pujols uses straight-line depreciation.

Instructions (a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2017. (b) Prepare the journal entry to record depreciation expense for 2018. (c) The recoverable amount of the equipment at December 31, 2018, is $6,050,000. Prepare the journal entry (if any) neces-

sary to record this increase.

IFRS11-12 Assume the same information as in IFRS11-11, except that Pujols intends to dispose of the equipment in the coming year.

journal entry (if any) necessary to record this increase. It is expected that the cost of disposal is $20,000.

608 Chapter 11 Depreciation, Impairments, and Depletion

Liberty reported the following additional data. Amounts for Kimco Realty (which follows GAAP) in the same year are provided for comparison.

Liberty Kimco (pounds sterling, in thousands) (dollars, in millions)

Total revenues £ 741 $ 517 Average total assets 5,577 4,696 Net income 125 297

Instructions (a) Compute the following ratios for Liberty and Kimco. (1) Return on assets. (2) Profit margin on sales. (3) Asset turnover.

How do these companies compare on these performance measures? (b) Liberty reports a revaluation surplus of £1,952. Assume that £1,550 of this amount arose from an increase in the net

replacement value of investment properties during the year. Prepare the journal entry to record this increase. (c) Under U.K. (and IASB) standards, are Liberty’s assets and equity overstated? If so, why? When comparing Liberty to

U.S. companies, like Kimco, what adjustments would you need to make in order to have valid comparisons of ratios such as those computed in (a) above?

Professional Research IFRS11-15 Matt Holmes recently joined Klax Company as a staff accountant in the controller’s office. Klax Company pro- vides warehousing services for companies in several European cities. The location in Koblenz, Germany, has not been perform- ing well due to increased competition and the loss of several customers that have recently gone out of business. Matt’s depart- ment manager suspects that the plant and equipment may be impaired and wonders whether those assets should be written down. Given the company’s prior success, this issue has never arisen in the past, and Matt has been asked to conduct some research on this issue.

IFRS11-13 Falcetto Company acquired equipment on January 1, 2016, for $12,000. Falcetto elects to value this class of equip- ment using revaluation accounting. This equipment is being depreciated on a straight-line basis over its 6-year useful life. There is no residual value at the end of the 6-year period. The appraised value of the equipment approximates the carrying amount at December 31, 2016 and 2018. On December 31, 2017, the fair value of the equipment is determined to be $7,000.

Instructions (a) Prepare the journal entries for 2016 related to the equipment. (b) Prepare the journal entries for 2017 related to the equipment. (c) Determine the amount of depreciation expense that Falcetto will record on the equipment in 2018.

International Reporting Case

IFRS11-14 Companies following international accounting standards are permitted to revalue fixed assets above the assets’ historical costs. Such revaluations are allowed under various countries’ standards and the standards issued by the IASB. Liberty International, a real estate company headquartered in the United Kingdom (U.K.), follows U.K. standards. In a recent year, Liberty disclosed the following information on revaluations of its tangible fixed assets. The revaluation reserve measures the amount by which tangible fixed assets are recorded above historical cost and is reported in Liberty’s stock- holders’ equity.

Liberty International Completed Investment Properties

Completed investment properties are professionally valued on a market value basis by external valuers at the balance sheet date. Surpluses and deficits arising during the year are reflected in the revalution reserve.

IFRS Insights 609

International Financial Reporting Problem Marks and Spencer plc (M&S)

IFRS11-16 The financial statements of M&S are presented in Appendix E. The company’s complete annual report, including the notes to the financial statements, is available online.

Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions.

(a) What descriptions are used by M&S in its statement of fi nancial position to classify its property, plant, and equipment?

(b) What method or methods of depreciation does M&S use to depreciate its property, plant, and equipment? (c) Over what estimated useful lives does M&S depreciate its property, plant, and equipment? (d) What amounts for depreciation expense did M&S charge to its income statement in 2015 and 2014? (e) What were the capital expenditures for property, plant, and equipment made by M&S in 2015 and 2014?

ANSWERS TO IFRS SELF-TEST QUESTIONS

1. c 2. c 3. b 4. d 5. c

(a) What is the authoritative guidance for asset impairments? Briefl y discuss the scope of the standard (i.e., explain the types of transactions to which the standard applies).

(b) Give several examples of events that would cause an asset to be tested for impairment. Does it appear that Klax should perform an impairment test? Explain.

IS THIS SUSTAINABLE? Companies are increasing their focus on sustainability issues. Companies like Southwest Airlines, Clorox, and Northrop Grumman are executing strategic initiatives including fuel-spill control, use of recycled materi- als, and water conservation. Why the growing importance of responsible management of resource use? One reason is that market participants are now more interested in investing in companies that are pursuing sustain- ability strategies.

For example, as indicated in the following graph, sustainable investing by professional portfolio managers in the United States has increased from below $500 billion in the mid-1990s to nearly $5 trillion (or 30.2% of the total under management) in 2014.

Intangible Assets12 1 Describe the characteristics, valuation,

and amortization of intangible assets.

2 Describe the accounting for various types of intangible assets.

3 Explain the accounting issues for recording goodwill.

4 Explain impairment procedures and presentation requirements for intangible assets.

5 Describe accounting and presentation for research and development and similar costs.

LEARNING OBJECTIVES After studying this chapter, you should be able to:

Sustainability Investing in the United States (1995–2014)

Years

1,000

1995 1997 1999 2001 2003 2005 2007 2010 2012 2014

2,000

3,000

4,000

$5,000

(in b

ill io

ns )

Source: Social Investment Forum.

In light of investor focus on sustainability, it is not surprising that companies are increasing the amount of information reported to the market about their sustainability efforts. However, rather than adding a line item in the income statement or balance sheet, companies instead provide more useful information about the future cash flow consequences of sustainability strategies, which are intangible and usually “nonfinancial” in nature.

Consider, for example, the disclosure of information about greenhouse gases. The Securities and Exchange Commission has identified the circumstances in which public companies should disclose information related to

611

climate change, as well as the impact on financial performance of their efforts to manage the consequences of greenhouse gas emis- sions. So here’s the paradox: If nonfinancial data, such as greenhouse gas emissions per dollar of revenue, is included in a financial report for investors, how can it still be called nonfinancial?

As with the reporting of research and development expenditures and other intangible assets—many of which do not show up on a balance sheet or income statement—companies are now exploring ways to combine the nonfinancial information with man- dated disclosures in what is called an integrated report. In such a report, a company might disclose data on any of dozens of metrics beyond conventional accounting measures, whether they are “integrated” or released separately. Practitioners collectively refer sustainability reporting as ESG for the three major categories of data—environmental, social, and corporate governance.

While 266 U.S. companies issued a sustainability report in 2013, there was significant variation in the content and format. Only a handful, like those prepared by Clorox, Northrop Grumman, SAS, Genentech, and Polymer Group Inc., integrated a sustainability report with the financial statements. And with the emergence of sustainability and integrated reporting standards, companies are voluntarily seeking assurance that their sustainability reports are meeting these standards. For example, over half of the world’s largest companies recently reporting on sustainability also invested in external assurance for their reports. With standards and assurance, it is hoped that sustainability reports will gain the same credibility as the GAAP-based financial statements.

Sources: S. Lopresti and P. Lilak, “Do Investors Care About Sustainability?” PwC (March 2012); E. Rostin, “ Non-Financial Data Are Material: The Sus- tainability Paradox,” www.bloombergnews.com (April 13, 2012); and Trends in External Assurance of Sustainability Reports: Update on the U.S. Global Reporting Initiative (July 2014).

INTANGIBLE ASSETS

INTANGIBLE ASSET ISSUES

• Characteristics • Valuation • Amortization

TYPES OF INTANGIBLES

• Marketing-related • Customer-related • Artistic-related • Contract-related • Technology-related • Goodwill

IMPAIRMENT AND PRESENTATION OF INTANGIBLES

• Limited-life intangibles • Indefinite-life intangibles

other than goodwill • Goodwill • Presentation

RESEARCH AND DEVELOPMENT COSTS

• Identifying R&D • Accounting for R&D • Similar costs • Presentation

This chapter also includes numerous conceptual and international discussions that are integral to the topics presented here.

612 Chapter 12 Intangible Assets

INTANGIBLE ASSET ISSUES

Characteristics Gap Inc.’s most important asset is its brand image, not its store fixtures. The Coca-Cola Company’s success comes from its secret formula for making Coca-Cola, not its plant facilities. America Online’s subscriber base, not its Internet connection equipment, pro- vides its most important asset. The U.S. economy is dominated by information and ser- vice providers. For these companies, their major assets are often intangible in nature.

What exactly are intangible assets? Intangible assets have two main characteristics. [1]

1. They lack physical existence. Tangible assets such as property, plant, and equip- ment have physical form. Intangible assets, in contrast, derive their value from the rights and privileges granted to the company using them.

2. They are not fi nancial instruments. Assets such as bank deposits, accounts receivable, and long-term investments in bonds and stocks also lack physical substance. How- ever, fi nancial instruments derive their value from the right (claim) to receive cash or cash equivalents in the future. Financial instruments are not classifi ed as intangibles.

In most cases, intangible assets provide benefits over a period of years. Therefore, companies normally classify them as long-term assets.

Following a discussion of the general valuation and accounting provisions for intangible assets, we present a more extensive discussion of the types of intangible assets and their accounting.

Valuation Purchased Intangibles Companies record at cost intangibles purchased from another party. Cost includes all acquisition costs plus expenditures to make the intangible asset ready for its intended use. Typical costs include purchase price, legal fees, and other incidental expenses.

Sometimes companies acquire intangibles in exchange for stock or other assets. In such cases, the cost of the intangible is the fair value of the consideration given or the fair value of the intangible received, whichever is more clearly evident. What if a company buys several intangibles, or a combination of intangibles and tangibles? In such a “basket purchase,” the company should allocate the cost on the basis of fair val- ues. Essentially, the accounting treatment for purchased intangibles closely parallels that for purchased tangible assets.1

Internally Created Intangibles Sometimes a company may incur substantial research and development (R&D) costs to create an intangible. For example, Google expensed the R&D costs incurred to develop its valuable search engine. Costs incurred internally to create intangibles are generally expensed.

How do companies justify this approach? Some argue that the costs incurred inter- nally to create intangibles bear no relationship to their real value. Therefore, they rea- son, expensing these costs is appropriate. Others note that it is difficult to associate internal costs with a specific intangible. Still others contend that due to the underlying subjectivity related to intangibles, companies should follow a conservative approach— that is, expense as incurred. As a result, companies capitalize only direct costs incurred in developing the intangible, such as legal costs, and expense the rest.

LEARNING OBJECTIVE 1 Describe the characteris- tics, valuation, and amorti- zation of intangible assets.

See the FASB Codifi cation References (page 650).

1The accounting in this section relates to the acquisition of a single asset or group of assets. The accounting for intangible assets acquired in a business combination (transaction in which the purchaser obtains control of one or more businesses) is discussed later in this chapter.

UNDERLYING CONCEPTS

Intangible Asset Issues 613

Amortization of Intangibles The allocation of the cost of intangible assets in a systematic way is called amortization. Intangibles have either a limited (finite) useful life or an indefinite useful life. For example, a company like Walt Disney Company has both types of intangibles. Disney amortizes its limited-life intangible assets (e.g., copyrights on its movies and licenses related to its branded products). It does not amortize indefinite-life intangible assets (e.g., the Disney trade name or its Internet domain name).

Limited-Life Intangibles Companies amortize their limited-life intangibles by systematic charges to expense over their useful life. The useful life should reflect the periods over which these assets will con- tribute to cash flows. Disney, for example, considers these factors in determining useful life:

1. The expected use of the asset by the company. 2. The expected useful life of another asset or a group of assets to which the useful life

of the intangible asset may relate (such as lease rights to a studio lot). 3. Any legal, regulatory, or contractual provisions that may limit the useful life. 4. Any provisions (legal, regulatory, or contractual) that enable renewal or extension

of the asset’s legal or contractual life without substantial cost. This factor assumes that there is evidence to support renewal or extension. Disney also must be able to accomplish renewal or extension without material modifi cations of the existing terms and conditions.

5. The effects of obsolescence, demand, competition, and other economic factors. Examples include the stability of the industry, known technological advances, legis- lative action that results in an uncertain or changing regulatory environment, and expected changes in distribution channels.

6. The level of maintenance expenditure required to obtain the expected future cash fl ows from the asset. For example, a material level of required maintenance in rela- tion to the carrying amount of the asset may suggest a very limited useful life. [2]

The amount of amortization expense for a limited-life intangible asset should reflect the pattern in which the company consumes or uses up the asset, if the company can reli- ably determine that pattern. For example, assume that Second Wave, Inc. purchases a license to provide a specified quantity of a gene product called Mega. Second Wave should amortize the cost of the license following the pattern of use of Mega. If Second Wave’s license calls for it to provide 30 percent of the total the first year, 20 percent the second year, and 10 percent per year until the license expires, it would amortize the license cost using that pattern. If it cannot determine the pattern of production or consumption, Sec- ond Wave should use the straight-line method of amortization. (For homework problems, assume the use of the straight-line method unless stated otherwise.) When Second Wave amor- tizes these licenses, it should show the charges as expenses. It should credit either the appropriate asset accounts or separate accumulated amortization accounts.

The amount of an intangible asset to be amortized should be its cost less residual value. The residual value is assumed to be zero unless at the end of its useful life the intangible asset has value to another company. For example, if Hardy Co. commits to purchasing an intangible asset from U2D Co. at the end of the asset’s useful life, U2D Co. should reduce the cost of its intangible asset by the residual value. Similarly, U2D Co. should consider fair values, if reliably determined, for residual values.

What happens if the life of a limited-life intangible asset changes? In that case, the remaining carrying amount should be amortized over the revised remaining useful life. Companies should, on a regular basis, evaluate the limited-life intangibles for impair- ment. Similar to the accounting for property, plant, and equipment, an impairment loss should be recognized if the carrying amount of the intangible is not recoverable and its carrying amount exceeds its fair value. (We will cover impairment of intangibles in more detail later in the chapter.)

614 Chapter 12 Intangible Assets

Indefi nite-Life Intangibles If no factors (legal, regulatory, contractual, competitive, or other) limit the useful life of an intangible asset, a company considers its useful life indefinite. An indefinite life means that there is no foreseeable limit on the period of time over which the intangible asset is expected to provide cash flows. A company does not amortize an intangible asset with an indefinite life. To illustrate, assume that Double Clik Inc. acquired a trade- mark that it uses to distinguish a leading consumer product. It renews the trademark every 10 years. All evidence indicates that this trademarked product will generate cash flows for an indefinite period of time. In this case, the trademark has an indefinite life; Double Clik does not record any amortization.

Companies should test indefinite-life intangibles for impairment at least annually. As we will discuss in more detail later in the chapter, the impairment test for indefinite- life intangibles differs from the one for limited-life intangibles. Only the fair value test is performed for indefinite-life intangibles; there is no recoverability test for these intangi- bles. The reason? Indefinite-life intangible assets might never fail the undiscounted cash flows recoverability test because cash flows could extend indefinitely into the future.

Illustration 12-1 summarizes the accounting treatment for intangible assets.

INTERNATIONAL PERSPECTIVE

IFRS requires capitaliza- tion of some develop- ment costs.

LEARNING OBJECTIVE 2 Describe the accounting for various types of intan- gible assets.

TYPES OF INTANGIBLE ASSETS As indicated, the accounting for intangible assets depends on whether the intangible has a limited or an indefinite life. There are many different types of intangibles, often classified into the following six major categories. [3]

1. Marketing-related intangible assets. 2. Customer-related intangible assets.

ILLUSTRATION 12-1 Accounting Treatment for Intangibles

Manner Acquired

Type of Intangible Purchased Internally Created Amortization Impairment Test

Limited-life intangibles

Capitalize Expense* Over useful life Recoverability test and then fair value test

Indefinite-life intangibles

Capitalize Expense* Do not amortize

Fair value test only

*Except for direct costs, such as legal costs.

WHAT DO THE NUMBERS MEAN? ARE ALL BRANDS THE SAME?

Source: “Untouchable Intangibles: Sometimes You See Brands on the Balance Sheet, Sometimes You Don’t,” The Economist (August 30, 2014).

Does it matter how a company builds brand value? In a word, yes. If the brand is internally developed, its value does not appear in the fi nancial statements. This is the case for The Coca-Cola Company, whose brand value is estimated to be roughly worth $81.6 billion but its balance sheet values its “trademarks with indefi nite-lives” (i.e., brands) at just $6.7 billion. As you are learning in this chapter, this reporting results because the accounting rules prohibit companies from recognizing brands and many other “intangible” assets if they created them internally. In contrast, when Procter & Gamble (P&G) acquired Gillette in 2005, it real- ized an additional $24 billion in intangible assets on its balance

sheet. That is, P&G paid $57 billion for Gillette and estimated the Gillette brand value to be worth $24 billion of the total paid.

Some have criticized this inconsistency in accounting, noting that information about the value of a brand is important to investors in consumer-product companies. Those sup- porting the difference in accounting cite the diffi culty in arriv- ing at reliable estimates of internally generated intangible assets. This latter argument seems to be carrying the day in support of the current accounting, under which only pur- chased intangibles, including brands, are recognized in accounting reports.

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3. Artistic-related intangible assets. 4. Contract-related intangible assets. 5. Technology-related intangible assets. 6. Goodwill.

Marketing-Related Intangible Assets Companies primarily use marketing-related intangible assets in the marketing or pro- motion of products or services. Examples are trademarks or trade names, newspaper mastheads, Internet domain names, and noncompetition agreements.

A trademark or trade name is a word, phrase, or symbol that distinguishes or iden- tifies a particular company or product. Trade names like Kleenex, Pepsi-Cola, Buick, Excedrin, Wheaties, and Sunkist create immediate product identification in our minds, thereby enhancing marketability. Under common law, the right to use a trademark or trade name, whether registered or not, rests exclusively with the original user as long as the original user continues to use it. Registration with the U.S. Patent and Trademark Office provides legal protection for an indefinite number of renewals for periods of 10 years each. Therefore, a company that uses an established trademark or trade name may properly consider it to have an indefinite life and does not amortize its cost.

If a company buys a trademark or trade name, it capitalizes the purchase price as the cost of the asset. If a company develops a trademark or trade name, it capitalizes costs related to securing it, such as attorney fees, registration fees, design costs, consult- ing fees, and successful legal defense costs. However, it excludes research and develop- ment costs. When the total cost of a trademark or trade name is insignificant, a company simply expenses it.

The value of a marketing-related intangible can be substantial. Consider Internet domain names. The name Drugs.com at one time sold for $800,000. The bidding for the name Loans.com approached $500,000. An expansion of domain names will allow indus- tries to use terms like .cars or even Internet slang like lol. This expansion has led to a new wave of domain name activity. For a fee of $185,000, companies can register their own domain names. Applications received include company names (such as Microsoft, which would have the name .microsoft) and for city-based domains (such as .nyc and .berlin).

Company names also identify qualities and characteristics that companies work hard and spend much to develop. In a recent year, an estimated 1,230 companies took on new names in an attempt to forge new identities and paid over $250 million to corporate-identity consultants. Among these were